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Accounting and the

Investment Opportunity Set


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Accounting and the
Investment Opportunity Set

Ahmed Riahi-Belkaoui

QUORUM BOOKS
Westport, Connecticut London
Library of Congress Cataloging-in-Publication Data

Riahi-Belkaoui, Ahmed, 1943-


Accounting and the investment opportunity set / Ahmed Riahi-Belkaoui.
p. cm.
Includes bibliographical references and index.
ISBN 1-56720-367-1 (alk. paper)
1. InvestmentsMathematical models. 2. CorporationsAccounting. I. Title.
HG4515.2.R53 2000
658.15dc21 99-056362
British Library Cataloguing in Publication Data is available.
Copyright 2000 by Ahmed Riahi-Belkaoui
All rights reserved. No portion of this book may be
reproduced, by any process or technique, without the
express written consent of the publisher.
Library of Congress Catalog Card Number: 99-056362
ISBN: 1-56720-367-1
First published in 2000
Quorum Books, 88 Post Road West, Westport, CT 06881
An imprint of Greenwood Publishing Group, Inc.
www.quorumbooks.com
Printed in the United States of America

The paper used in this book complies with the


Permanent Paper Standard issued by the National
Information Standards Organization (Z39.48-1984).
10 9 8 7 6 5 4 3 2 1
Copyright Acknowledgments
The author and publisher gratefully acknowledge permission for use of the following material:
Kallapur, Sanjay and M. A. Trombley, "The Association between Investment Opportunity Set
Proxies and Realized Growth," Journal of Business Finance and Accounting (April/May
1999), pp. 505-519.
Miles, James A., "Growth Options and the Real Determinants of Systematic Risk," Journal
of Business and Finance Accounting (Spring 1986), pp. 95-105.
To Dimitra
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Contents

Exhibits ix
Preface xiii
1 Nature and Measurement of the Investment Opportunity Set 1
Appendix 1.1: "The Association between Investment
Opportunity Set Proxies and Realized Growth" 11
Appendix 1.2: "Growth Options and the Real Determinants of
Systematic Risk" 26
2 Empirical Validation of a General Model of Growth
Opportunities 37
3 Investment Opportunity Set Dependence of Dividend Yield
and Price Earnings Ratio 59
4 The Role of Multinationality and Profitability in the
Determination of the Investment Opportunity Set 69
5 The Role of the Investment Opportunity Set in Corporate
Financing 83
6 The Role of the Investment Opportunity Set in a Model of
International Production 101
7 Growth Opportunities and Disclosure Adequacy 119
Vlll Contents

8 The Role of Growth Opportunities in Determining


Systematic Risk 131
9 Growth Opportunities and Reputation Building 149
10 Growth Opportunities and Earnings Management 161
11 Growth Opportunities, Internalization, and Market
Valuation of Multinational Firms 173
12 Contextual Accrual and Cash Flow-Based Valuation Models:
Impact of Multinationality and Growth Opportunities 183
Index 193
Exhibits

2. 1 A General Model of Growth Opportunities 38


2. 2 Descriptive Statistics and Correlation of Three Measures
of Multinationality for Forbes' The Most International
100 U.S. Firms 43
2. 3 Selected Statistics Related to a Common Factor Analysis
of Three Measures of Multinationality for Forbes' The
Most International 100 U.S. Firms 44
2. 4 Selected Statistics Related to a Common Factor Analysis
of Measures of Reputation 46
2. 5 Descriptive Statistics and Correlation of Three Measures
of the Investment Opportunity Set for Forbes' The Most
International 100 U.S. Firms 47
2. 6 Selected Statistics Related to a Common Factor Analysis
of Three Measures of the Investment Opportunity Set for
Forbes' The Most International 100 U.S. Firms 49
27 Descriptive Statistics and Correlations 51
28 Regression Results 52
3. 1 Descriptive Statistics for the Basic Model 62
3. 2 Correlation between Explanatory Variables 63
3. 3 Basic Valuation Model Results 64
<: Exhibits

4.1 Descriptive Statistics and Correlation of Three Measures


of Multinationality for Forbes' The Most International
100 U.S. Firms for the 1987-1992 Period 73
4.2 Selected Statistics Related to a Common Factor Analysis
of Three Measures of Multinationality for Forbes' The
Most International 100 U.S. Firms for the 1987-1992
Period 74
4.3 Descriptive Statistics and Correlation of Three Measures
of the Investment Opportunity Set for Forbes' The Most
International 100 U.S. Firms for the 1987-1992 Period 76
4.4 Selected Statistics Related to a Common Factor Analysis
of Three Measures of the Investment Opportunity Set for
Forbes' The Most International 100 U.S. Firms for the
1987-1992 Period 77
4.5 Regression Results for Rate of Return on Assets 78
5.1 Descriptive Statistics and Correlation of Three Measures
of Multinationality for Forbes' The Most International
100 U.S. Firms for the 1987-1992 Period 87
5.2 Selected Statistics Related to a Common Factor Analysis
of Three Measures of Multinationality for Forbes' The
Most International 100 U.S. Firms for the 1987-1992
Period 88
5.3 Descriptive Statistics and Correlation of Three Measures
of the Investment Opportunity Set for Forbes' The Most
International 100 U.S. Firms for the 1987-1992 Period 89
5.4 Selected Statistics Related to a Common Factor Analysis
of Three Measures of the Investment Opportunity Set for
Forbes' The Most International 100 U.S. Firms for the
1987-1992 Period 90
5.5 Results of Overall Analysis of Covariance for Market
Debt-to-Equity Ratio 91
5.6 Comparisons of the Debt-to-Equity Ratio by
Multinationality and Growth 92
5.7 Mean Comparisons of Market Debt-to-Equity Means by
Multinationality and by Investment Opportunity Sets and
^-Probabilities 94
6.1 General Model of International Production 102
6.2 Descriptive Statistics and Correlation of Three Measures
of Multinationality for Forbes' The Most International
100 U.S. Firms 107
Exhibits xi

6.3 Selected Statistics Related to a Common Factor Analysis


of Three Measures of Multinationality for Forbes' The
Most International 100 U.S. Firms 108
6.4 Descriptive Statistics and Correlation of Three Measures
of the Investment Opportunity Set for Forbes' The Most
International 100 U.S. Firms 110
6.5 Selected Statistics Related to a Common Factor Analysis
of Three Measures of the Investment Opportunity Set for
Forbes' The Most International 100 U.S. Firms 111
6.6 Descriptive Statistics and Correlations 112
6.7 Regression Results of Linear Models 113
7.1 Selected Statistics Related to a Common Factor Analysis
of Three Measures of the Investment Opportunity Set for
Forbes' The Most International 100 U.S. Firms 124
7.2 Summary Statistics 125
7.3 Correlations among Selected Variables 125
7.4 Explaining Corporate Disclosure Quality 126
8.1 Selected Statistics Related to a Common Factor Analysis
of Three Measures of Multinationality for Forbes' The
Most International 100 U.S. Firms for the 1987-1990
Period 135
8.2 Selected Statistics Related to a Common Factor Analysis
of Measures of Reputation 137
8.3 Selected Statistics Related to a Common Factor Analysis
of Three Measures of the Investment Opportunity Set for
Forbes' The Most International 100 U.S. Firms 139
8.4 Summary Statistics for Empirical Variables 141
8.5 Results of Pooled Time-Series Cross-Sectional Association
Regression of Systematic Risk and Multinationality and
Selected Variables 142
8.6 Relation between Systematic Risk and Multinationality
and Selected Variables for High and Low Investment
Opportunity Set 143
9.1 Descriptive Statistics 154
9.2 Correlations 155
9.3 Explaining Corporate Reputation 156
10.1 Selected Statistics Related to a Common Factor Analysis
of Three Measures of the Investment Opportunity Set for
Forbes' The Most International 100 U.S. Firms 165
xii Exhibits

10.2 Results of Regression EstimationModel (1) 166


10. 3 Descriptive Statistics 167
10. 4 Results of Regression EstimationModel (2) 168
11. 1 Sample Statistics 177
11. 2 OLS Regression of g-Value on the Degree of
Multinationality as Measured by Foreign Sales/Total Sales 178
11. 3 OLS Regression of g-Value on the Degree of
Multinationality as Measured by Foreign Sales/Total Sales
and Its Interactions with Investment Opportunity 179
12. 1 Selected Statistics Related to a Common Factor Analysis
of Three Measures of Multinationality for Forbes' The
Most International 100 U.S. Firms for the 1987-1990
Period 187
12. 2 Descriptive Statistics and Correlations 188
12. 3 Regression Results of Linear Models 190
Preface

A firm's value is composed of assets in place that are visible and unob-
servable growth opportunities. These growth opportunities constitute the
investment opportunity set of the firm. It is this investment opportunity set
that is the major determinant on one hand of corporate strategy and ac-
counting strategy, and on the other hand of the market's response to the
firm. The importance of the concept is beginning to be acknowledged in
the empirical accounting, finance, and management literature where the
investment opportunity set variable is introduced as either an explanatory
or moderating variable of the relationship between accounting and/or eco-
nomic phenomena and various predictor variables. The objective of this
book is to explicate the concept of growth opportunities or investment
opportunity set (Chapter 1), to provide a general model for its measurement
(Chapter 2), to show its role in a general valuation model based on divi-
dend yield and price earnings ratio (Chapter 3), in the relationship between
profitability and multinationality (Chapter 4), in the determination of cap-
ital structure (Chapter 5), in a general model of corporate disclosure (Chap-
ter 7), in the relationship between systematic risk and multinationality
(Chapter 8), in a model of reputation building (Chapter 9), and in earnings
management (Chapter 10), to explain the relative market value compared
to the accounting value of a multinational firm (Chapter 11), and to dif-
ferentiate between the usefulness of accrual and cash flow based valuation
models (Chapter 12).
Chapter 1 examines the nature and measurement of growth opportunities
or investment opportunity set as they have been treated in the accounting
XIV Preface

and finance literature. The concept of growth opportunities is shown to be


defined in the various contexts of corporate borrowing, capacity choice,
market valuation, systematic risk and capital budgeting. In all these con-
texts, it is generally viewed as call options whose value depends on the
discretionary future investments by the firm. In terms of measurement,
proxies were used and can be classified into three types: price-based prox-
ies, investment-based proxies, and variance measures.
Chapter 2 states a general model of growth opportunities combining the
advantages of corporate reputation, multinationality, size, and profitability,
and the limitation of leverage and systematic risk. Using a sample of U.S.
multinational firms, the evidence validates this statement by showing
growth opportunities, as measured by the investment opportunity set, to
be positively related to corporate reputation, multinational size, and prof-
itability, and negatively related to leverage and systematic risk.
Chapter 3 develops and tests a market valuation model whose main pre-
diction is that equity value depends on the relative level of the investment
opportunity set. The study shows that firms in a high investment oppor-
tunity set group are "price-earnings valued" and that firms in a low in-
vestment opportunity set are "dividend-yield valued."
Chapter 4 examines the role of multinationality and profitability as de-
terminants of the investment opportunity set. The study shows a significant
relationship between investment opportunity set on one hand and profita-
bility and multinationality on the other hand, conditioned by inflation and
growth rate, size of the firm, and index of business formation.
Chapter 5 examines whether the investment opportunity set is associated
with corporate financing, and whether such association varies over firms
with different levels of multinationality. The findings support the multi-
nationality contingency view of the relationship between the investment
opportunity set and corporate financing.
Chapter 6 restates a general model of international production combin-
ing the three features of the eclectic paradigm with behavioral and financing
considerations. The evidence validates the restatement and possible exten-
sions of the eclectic paradigm of international production by showing that
multinationality is positively related to the investment opportunity set, the
level of foreign assets, the difference between the rates of return in foreign
assets and total assets, corporate reputation, and leverage.
Chapter 7 investigates the determinants of voluntary disclosure choice.
The results show the disclosure scores to increase in firm size, in growth
opportunities, and in multinationality.
Chapter 8 analyzes the association between multinationality and system-
atic risk as measured by the market model beta. Unlike previous studies
the result of this study is positively related to the level of multinationality
after controlling for growth opportunities and other factors known to be
associated with systematic risk. The difference with the previous studies is
Preface xv

due to a consideration of growth opportunities as measured by the


investment opportunity set. While systematic risk is negatively related to
multinationality for high investment opportunity set firms, it is positively
related to multinationality for low investment opportunity firms.
Chapter 9 examines the role of growth opportunities in reputation build-
ing. Corporate audiences construct the reputation of a firm by interpreting
informational signals about the firm from various monitors. The results of
an empirical study of large U.S. firms supported the general hypothesis that
corporate audiences construct reputations on the basis of information
about a firm's asset management performance, specifically using market
and accounting signals indicating the size of the firm, the level of the in-
vestment opportunity set, and the level of multinationality.
Chapter 10 examines the relationship between the level of the investment
opportunity set and managers' accounting choices in multinational firms.
It is argued that the level of the investment opportunity set, a measure of
growth opportunities, affects net income and net wealth and thereby po-
litical costs and political risk. The relationship provides management an
incentive to reduce political costs and political risk by using income de-
crease accruals. The results of this study indicate that the managers of firms
with a high level of the investment opportunity set make accounting choice
to reduce reported earnings.
Chapter 11 examines the role of growth opportunities to explain the
relative market value compared to the accounting value for a multinational
firm. The results are consistent with internalization theory in that greater
multinationality corresponds to a high valuation if growth opportunities
are high. However, greater multinationality alone does not correlate posi-
tively to a significantly greater value, which differs from the tenets of im-
perfect capital markets but correlates negatively to a significantly greater
value, which confirms the views of the management objectives theory.
Chapter 12 examines the impact of contextual factors of multinationality
and growth opportunities in accrual and cash flow based valuation models.
The results of a price level regression confirmed that the market value of
equity is higher the larger the cash flows and the smaller the accruals under
conditions of high multinationality and greater opportunities.
The book should be of interest to CEOs and other executives as well as
to undergraduates and should be useful in graduate courses covering the
potential links between the level of the investment opportunity set on one
hand and corporate or accounting strategies on the other hand.
Many people helped in the development of his book. I received consid-
erable assistance from the University of Illinois at Chicago research as-
sistants, especially Yukie Miura and Rebecca Mach. I also thank Eric
Valentine, Nicole Cournoyer, and the entire production team at Quorum
Books for their continuous and intelligent support.
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1

Nature and Measurement of the


Investment Opportunity Set

INTRODUCTION
Firms may be viewed as a bundle of human and physical assets to be chan-
neled toward goals such as maximizing shareholders' return. This view of
firms focuses on their observable features and ignores potential contribu-
tions to the return of the firm that are unobservable. One important con-
tribution is generally expressed as growth opportunities or investment
opportunity set. They refer to contributions and options that can be exer-
cised by firms to generate future profits. Their definition and measurement
in the literature are still at an early stage. The contribution of this chapter
is to examine the nature and measurement of these growth opportunities
or investment opportunity set as they have been treated in the accounting
and finance literature.

CONTRIBUTIONS TO THE NATURE OF THE


INVESTMENT OPPORTUNITY SET

Contributions in the Context of Corporate Borrowing


Myers' contribution to the concept of investment opportunity set and
growth options was made in the context of a search for the determinants
of corporate borrowing. 1 The basic thesis of the paper is that the issuance
of risky debt reduces the present market value of a firm holding real option
by inducing a suboptimal strategy or by forcing the firm and its creditors
2 Accounting and the Investment Opportunity Set

to bear the costs of avoiding the suboptimal strategy. Central to this thesis
is the notion of corporate assets and growth opportunities as call options
whose value depends on the discretionary future investment by the firm.
Basically the current equilibrium value of a firm, V, is assumed to be broken
down into the present value of assets already in the place VA and the present
value of future growth opportunities VG,

Basically VG is the present value of the firm's options to make future


investments while VA reflects the assets whose value does not depend on
such investments. As stated by Myers:

Thus the most fundamental distinction is not between "growth opportunities" and
"assets in place," but between (1) assets that can be regarded as call options, in the
sense that their ultimate value depends, at least, on future discretionary investments
by the firm, and (2) assets whose ultimate value does not depend on further dis-
cretionary "investment."2

The firm needs then to make these discretionary investments as the value
of the firm is not limited to the values of its specific assets but to its value
as a going concern. What is needed to maintain the value of the going
concern is to keep up its investment. As stated by Myers:

This is not simply a matter of maintaining plant and eq'uipment. There is a continual
effort devoted to advertising, sales, improving efficiency, incorporating new tech-
nology, and recruiting and training employees. All these activities require discre-
tionary outlays.3

Note that the real options making the investment opportunity set may
be either (a) firm-specific, having no value to any other firm, or (b) not
firm-specific, able to be traded in their own and imperfect secondary mar-
kets. Examples of real options that are separable, objectively identifiable,
relatively long-lived, and for which reasonable secondary markets exist in-
clude patents, certain trade markets, and franchise and operating licenses.4

Contributions in the Context of Capacity Choice


Pindyck's contribution to the concept of investment opportunity set in-
fluence on growth options is made in the context of determining a capacity
choice and firm value given the inevitability of most major investment ex-
penditures.
This inevitability refers to the fact that following a firm's decision to
invest, the expenditures become sunk costs. In addition, the inevitability
Nature and Measurement 3

results in the "killing" of an optionthe option to productively invest any


time in the future. The major consequence is the need to change the net
present value rules. As stated by Pindyck:

As a result, the Net Present Value (NPV) rule "Invest when the value of a unit of
capital is at least as large as the purchase and installation cost of the unit" is not
valid. Instead the value of a unit must exceed the purchase and installation cost by
an amount equal to the value of keeping the firm's option to invest these resources
elsewhere alivean opportunity cost of investing.5

This reasoning implies that the market value of a firm is equal to (a) the
value of installed capacity and (b) the value of the firm's operations to add
more capacity later.6 It is these "operating options" on growth opportunity
units that largely determine firm value in the presence of irreversibility and
demand uncertainty. Therefore, these options to productively invest are
crucial assets, which firms hold even if they are price-taker in products and
input markets. As stated by Pindyck,

In some cases, it is the result of a patent on a production technology, or ownership


of land or natural resources. More generally, a firm's managerial resources, repu-
tation, market position, and possible scale, all of which may have been built up
over time, enable it to productively undertake investments that individuals or other
firms cannot undertake.7

The investment decision implied by the irreversibility condition and the


growth opportunities perspective is to invest only if the benefits exceed
costs by a certain positive amount. This rule is shared by authors of other
research papers. 8-10

Contributions in the Context of Market Valuation and


Systematic Risk
Myers viewed the value of growth opportunities as the present value of
the firm's options to make future investments.11 This is viewed favorably
by the market as empirical evidence suggesting that a material portion of
the market value of equity is accounted for by growth opportunities. For
example, in the studies by Kester, which compare the capitalized value of
the firm's current earnings stream and the market value of equity, the value
of growth opportunities is half or more of the market value of equity of
many firms. He also finds that the proportion is about 70 to 80% in in-
dustries with high demand volatility. 12 ' 13 Similarly, Pindyck agrees that the
fraction of market value determined by the value of capital in place should
be only one-half or less for firms with reasonable demand volatility.14 He
4 Accounting and the Investment Opportunity Set

specifically argues that if demand volatility is 0.2 or more, more than half
of the firm's value is accounted for by its growth opportunities. 15
Growth opportunities were also associated with systematic risk. Chung
and Charoenuong used contingent claim analysis to divide the firm's sys-
tematic risk into the risk associated with assets in place and the risk arising
from future growth opportunities. 16 They justify the contingent claims anal-
ysis as follows:

Contingent claims analysis is well-suited to such decomposition, since a growth


opportunity can be regarded as a call option on a real asset where the option's
exercise price is the future investment needed to acquire the asset. Whether the
option has any value at expiration depends on the asset's future value.17

Basically, they predicted that the greater the portion of a stock's market
value accounted for by the firm's growth opportunities, the higher the stock
price. The following equation is used to measure the market beta of the
firm's equity (BM):

where BFA is the beta of equity associated with assets in place, PVIGO is
the present value of investments in growth opportunities, and VE is the
current equilibrium market value of the firm's equity.
The equation indicates that the market beta is made of the risk of equity
associated with assets already in place and the uncertainty associated with
growth opportunities. The rationale for the positive relation between the
market beta and growth opportunities is made as follows:

Economic intuition underlying this result is simple: since the risk of the call option
(i.e., the growth opportunity) is greater than that of the underlying asset, and since
the market beta is the weighted average of the beta of equity associated with assets
in place and the beta of growth opportunities, it follows that the market beta will
be larger than the beta of equity associated with assets in place.18

The prediction of this study is in contradiction with other studies that view
growth opportunities as the existence of positive economic results arising
from a firm's monopoly power in factor and/or output markets and that
show that the larger the market power, the lower the systematic risk. 19-21
The prediction of Chung and Charaenwong 22 was, however, verified by
Miles, 23 who found that beta depends on the profitability of future invest-
ment, the quantity of future investments and the firm's own instantaneous
return variance.
Nature and Measurement 5

Contributions in the Context of Capital Budgeting

Kester's contribution to the concept of growth opportunities on invest-


ment opportunity set was made in the context of capital budgeting. 2 4 H e
suggested that managers think of investment opportunities as options on
the company's future growth. Similarly, to call options on securities, these
growth options can be viewed as real value to a firm that possesses them
and capital budgetary decisions can be analyzed in those terms, as stated
by Kester:

Securities options give the owners the right (as distinct from an obligation) to buy
a security at a fixed, predetermined price (called the exercise price) on or before
some fixed date (the maturity date). By way of analogy, a discretionary opportunity
to invest capital in productive assets, like plant, equipment, and brand names at
some future point in time is like a call option in real assets, or a "growth option."
The cost of the investment represents the option's exercise price. The value of the
option (its underlying "security") is the present value of expected cash flows plus
the value of any new growth opportunities expected through ownership and em-
ployment of the assets. The time to maturity is the amount of time available before
the opportunity disappears. 25

These growth options can be detected by the observed differences be-


tween the market value of a company's equity and the capitalized value of
its current earnings systems. In a conventional capital budgeting, the op-
portunity to undertake a project is worth at least the present value of the
project's cash inflow less the present value of its outflow. However, the
opportunity to invest can be worth much more than the project's net pres-
ent value. Therefore, projects that create new growth options in risky en-
vironments deserve a higher recognition and primary in the capital
budgeting process. The process should consider classifying projects more
accurately according to their growth options characteristics before making
a final choice. A major advantage of this new perspective is stated as fol-
lows:

By thinking of discretionary investment opportunities as options on real assets,


executives will address other relevant questions that have received little attention
so far. How, for example, are growth options created, and which will be most
valuable? How permanent and how liquid are growth options as components of
company value? Does it matter whether a company owns a growth option exclu-
sively as a collective option of the industry? What influence do industry structure
and competitive interaction have on growth option value? What auxiliary financial
decisions are required to permit the future conversion of growth options to real
assets?26
6 Accounting and the Investment Opportunity Set

MEASUREMENT OF THE INVESTMENT OPPORTUNITY


SET
The investment opportunity set represents the growth prospects or
growth opportunities of the firm. It depends on firm-specific factors such
as physical and human capital in place, as well as on industry-specific and
macroeconomic factors.27 While the assets-in-price are visible, the growth
opportunities are not. The investment opportunity set is not observable and
can only be approximated by proxy variables. The proxy variables used in
the accounting and finance literature to capture the idea of the investment
opportunity set can be generally classified into three types: price-based
proxies, investment-based proxies, and variance measures.28
The price-based proxies are based on the idea that the growth oppor-
tunities are already impounded in stock prices leading to a high market
value relative to assets in place. Some of the price-based proxies include
the following:

a. Market value of equity plus book value of debt.


b. Market-to-book value of equity.29-31
c. Book-to-market value of assets.32
d. Tobin's Q, the ratio of replacement value of assets to market value.33
e. Earnings to price ratios.34,35
f. Ratio of property, plant, and equipment to firm value.36
g. Ratio of depreciation to firm value.37

The investment-based proxies are based on the idea that higher level of in-
vestment activity is positively related to the investment opportunity set of the
firm. The higher level of investment can be approximated by the level of re-
search and development activity. Some of the investment-based proxies are:

a. The ratio of research and development to assets.38


b. The ratio of research and development to sales.39
c. The ratio of research and development to firm value.40
d. The ratio of capital expenditures to firm value.41
e. The ratio of capital expenditures to asset book value.42

The variance measures are based on the idea that they are more valuable
as the variability of returns on the underlying asset increases. Some of the
variance measures used are:

a. The variance of total return.43


b. The market value beta.44
Nature and Measurement 7

While most studies in accounting and finance relied on use of the above
measures of the investment opportunity set, Gaver and Gaver 4 5 combined
some measures into a composite measure using factor analysis. M o r e
specifically, the factor analyzed mix measures of the investment oppor-
tunity set: market-to-book assets (MKTBKASS), market-to-book equity
(MKTBKEQ), the earnings/price ratio (EP), the research and development-
to-assets ratio ( R & D ) , the variance of the return on the firm (VAR), and
the consumers' choice of growth-oriented mutual funds (FUNDS). These
variables are defined as follows:

FUNDS = Number of growth-oriented mutual funds holding firm's


shares at the end of 1985 46

With the proliferation of proxies for the measurement of the investment


opportunity set, a research question is to determine which one is most likely
to be associated with realized growth. Kallapur and Trombley conducted
such an analysis with the assumption that investment opportunities, on
average, lead to actual investment and therefore affect realized growth
within a three-to-five-year period examined. 4 7 Their findings are as follows:

The results in this paper show that variables which incorporate book and market
measures (book-to-market value of assets and equity, Tobin's Q - 1 and ratios of
fixed assets and depreciation expense to market value) are consistently negatively
correlated with realized growth, which can be viewed as a benchmark proxy for
8 Accounting and the Investment Opportunity Set

the IOS. Capital investment activity as measured by the ratio of capital expenditures
to assets is positively correlated with realized growth. However, we find that ratios
of R&D to sales, assets, or market value do not exhibit a consistent or strong
association with realized book value growth. It appears that R&D intensity, as
measured by these variables, [does] not proxy for growth as well as the book-to-
market variables we examine. Also, we find that the E/P ratio, often cited as a
measure of growth expectations, exhibits not consistent association with realized
growth. Multivariate analysis suggests that dividend policy may reveal some incre-
mental information about the firm's growth prospects relative to book-to-market
measures alone, but that the other variables examined seem to show little promise
for constructing a multivariate growth proxy. 48

CONCLUSIONS

This chapter examined the nature and measurement of the investment


opportunity set or growth opportunities as they have been treated in the
accounting and finance literature. The concept of growth opportunities has
been defined in the various contexts of corporate borrowings, capacity
choice, market valuation, systematic risk and capital budgeting. In all these
contexts it is generally viewed as call options whose value depends on the
discretionary future investments by the firm. In terms of measurement,
proxies were used and can be classified into three types: price-based prox-
ies, investment-based proxies, and variance measures. M o r e work needs to
be done to refine both the definition and measurement of growth oppor-
tunities or investment opportunity set.

NOTES
1. Myers, Stewart C , "Determinants of Corporate Borrowing," Journal of Fi-
nancial Economics 5 (1977): pp. 147-175.
2. Ibid., p. 155.
3. Ibid., p. 156.
4. Ibid., p. 164.
5. Pindyck, Robert S., "Irreversible Investment, Capacity Choice, and the Value
of the Firm," American Economic Review (December 1988): pp. 969-985.
6. Ibid., p. 569.
7. Ibid., p. 970.
8. McDonald, Robert and Daniel Siegel, "The Value of Waiting to Invest,"
Quarterly Journal of Economics (November 1966): pp. 707-727.
9. Brennan, Michael J. and Eduardo Schwartz, "Evaluating Natural Resource
Involvements," Journal of Business 58 (1985): pp. 135-157.
10. Majd, Saman and Robert S. Pindyck, "Time to Build, Portion Value, and
Investment Decisions," Journal of Financial Economics (March 1987): pp. 7-27.
11. Myers, "Determinants of Corporate Borrowing."
12. Kester, C , "An Options Approach to Corporate Finance," in Handbook of
Corporate Finance, 2d ed. E. Altman (Ed.), Wiley, New York, 1986.
Nature and Measurement 9

13. Kester, C , "Today's Options for Tomorrow's Growth," Harvard Business


Review (March-April 1984): pp. 153-160.
14. Pindyck, "Irreversible Investment, Capacity Choice, and the Value of the
Firm."
15. Ibid., p. 979.
16. Chung, Kee H. and Charlie Charoenuong, "Investment Options, Assets in
Place, and the Risk of Stocks," Financial Management (Autumn 1991): pp. 21-33.
17. Ibid., p. 22.
18. Ibid., p. 24.
19. Thomadakis, S., "A Model of Market Power, Valuation and the Firm's Re-
turns," Bell Journal of Economics and Management Science (Spring 1976):
pp. 150-162.
20. Subrahmassyan, M. and S. Thomadakis, "Systematic Risk and the Theory
of the Firm," Quarterly Journal of Economics (May 1980): pp. 437-451.
21. Chan, K., D. Chang, and G. Hite, "Systematic Risk and Market Power: An
Application of Tobin's q" Quarterly Review of Economics and Statistics (Autumn
1986): pp. 58-72.
22. Chung and Charaenwong, "Investment Options, Assets in Place, and the
Risk of Stocks."
23. Miles, James A., "Growth Options and the Real Determinants of Systematic
Risk," Journal of Business Finance and Accounting (Spring 1986): pp. 95-109.
24. Kester, "Today's Options for Tomorrow's Growth."
25. Ibid., p. 154.
26. Ibid., p. 159.
27. Kallapur, S. and M. A. Trombley, "The Association between Investment Op-
portunity Set Proxies and Realized Growth, "Journal of Business, Finance, and Ac-
counting (April/May 1999): pp. 505-519.
28. Ibid.
29. Collins, D. W. and S. P. Kothari, "An Analysis of Inter-temporal and Cross-
Sectional Determinants of Earnings Response Coefficients," Journal of Accounting
and Economics (July 1993): pp. 143-181.
30. Chung and Charaenwong, "Investment Options, Assets in Place, and the
Risk of Stocks."
31. Lowellen, William, Claudis Loderer, and Kenneth Martin, "Executive Com-
pensation and Executive Incentive Problems: An Empirical Analysis," Journal of
Accounting and Economics (December 1987): pp. 287-310.
32. Smith, C. W. and R. L. Watts, "The Investment Opportunity Set and Cor-
porate Financing, Dividend and Compensation Policies," Journal of Financial Eco-
nomics (December 1992): pp. 263-292.
33. Skinner, D. J., "The Investment Opportunity Set and Accounting Procedure
Choice: Preliminary Evidence," Journal of Accounting and Economics (October
1993): pp. 407-447.
34. Kester, W. C , "Today's Options for Tomorrow's Growth."
35. Chung and Charaenwong, "Investment Options, Assets in Place and the Risk
of Stocks."
36. Skinner, "The Investment Opportunity Set and Accounting Procedure
Choice."
10 Accounting and the Investment Opportunity Set

37. Smith and Watts, "The Investment Opportunity Set and Corporate Financ-
ing."
38. Gaver, J. J. and K. M. Gaver, "Additional Evidence on the Association be-
tween the Investment Opportunity Set and Corporate Financing, Dividend and
Compensation Policies," Journal of Accounting and Economics 16 (1993): pp. 125-
160.
39. Skinner, "The Investment Opportunity Set and Accounting Procedure
Choice."
40. Smith and Watts, "The Investment Opportunity Set and Corporate Financ-
ing."
41. Ibid.
42. Kallapur and Trombley, "The Association between Investment Opportunity
Set Proxies and Realized Growth."
43. Gaver and Gaver, "Additional Evidence on the Association between the In-
vestment Opportunity Set and Corporate Financing."
44. Skinner, "The Investment Opportunity Set and Accounting Procedure
Choice."
45. Gaver and Gaver, "Additional Evidence on the Association between the In-
vestment Opportunity Set and Corporate Financing."
46. Ibid., pp. 133-134.
47. Kallapur and Trombley, "The Association between Investment Opportunity
Set Proxies and Realized Growth."
48. Ibid., pp. 517-518.

REFERENCES
Chung, K. and C. Charoenwong. "Investment Options, Assets in Place, and the
Risk of Stocks." Financial Management 20 (1991): 21-33.
Kallapur, S. and M. A. Trombley. "The Association between Investment Oppor-
tunity Set Proxies and Realized Growth." Journal of Business Finance and
Accounting (April/May 1999): 505-519.
Kester, W. C. "Today's Options for Tomorrow's Growth." Harvard Business Re-
view (March-April 1984): 153-160.
Miles, James A. "Growth Options and the Real Determinants of Systematic Risk."
Journal of Business Finance and Accounting (Spring 1986): 95-109.
Myers, S. "Determinants of Corporate Borrrowing." Journal of Financial Econom-
ics 5 (1977): 147-175.
Pindyck, R. S. "Irreversible Investment, Capacity Choice, and the Value of the
Firm." American Economic Review (December 1988): 969-985.
Nature and Measurement 11

Appendix 1.1: Sanjay Kallapur and Mark A.


Trombley, "The Association between
Investment Opportunity Set Proxies and
Realized Growth," Journal of Business Finance
and Accounting (April/May 1999),
pp.505-519.

1. INTRODUCTION
A number of recent studies in accounting and finance, including
Smith and Watts (1992), Gaver and Gaver (1993), and Skinner
(1993) examine the association between proxies for the
investment opportunity set (IOS), and financing, dividend,
compensation, and accounting policies. Relying mainly on
intuitive arguments these studies use different proxies for the
unobservable IOS. Future growth is an implication of IOS, and
we evaluate various proxies for IOS on the basis of their
association with realized growth. In conducting our analysis, we
assume that investment opportunities, on average, lead to actual
investment and therefore affect realized growth within the three-
to five-year period we examine.
We use the ex-post growth in book values during the three
years subsequent to a base year as our growth measure. However,
we evaluate the sensitivity of our findings using alternative growth
measures such as asset and sales growth, calculated over three-
*The authors are respectively, Assistant Professor at Purdue Uninversicy and Associate
Professor at the University of Arizona. They acknowledge Rashad Abdel-Khalik, Anwer
Ahmed. Bipin Ajinkya. Mary Barth. Dan Dhaiiwal, John Elliott, Ken Gaver, Kermit
Rohrbach. Terry Sheviin, Carolyn Takeda, Michael Weisbach, and participants in
accounting research forums at the University of Arizona, the University of Florida, the
Hong Kong University of Science and Technology, and the London Business School for
numerous heipful comments and suggestions on a previous version of this paper. (Paper
received January 1998, revised and accepted July 1998)
Address for correspondence: Mark A. Trombley, University of Arizona, 301 McCIelland
Hall. Tucson. AZ 85721, USA.
e-mail: trombley(otu.arizona.edu

S Blackweii Publishers Ltd. 1999. 108 Cowlev Road. Oxford OX4 1JF, UK
and 350 Main Street, Maiden. MA 02148. USA.
12 Accounting and the Investment Opportunity Set

and five-year periods. We perform the analysis using annual


samples consisting of all Compustat firms with available data
centered on 1978 througn 1991 as base years. This allows us to
evaluate the consistency of results across the periods and thus
reduce the possibility of incorrect inference due to temporal
sampling variation.
Using association with realized growth as the benchmark, we
find that the book-to-market ratio is a valid growth proxy.
Consistent with the results of Smith and Watts (1992), we find
that among the commonly used proxies, the book-to-market ratio
is the one most highly correlated with future growth. This result
holds for all the book-to-market measures, namely book to
market value of assets and equity, Tobin's Q and also the ratio of
book value of property, plant and equipment to market value of
assets. This finding is important because it suggests that simpler
proxies are as effective as the more difficult-to-calculate Tobin's
Q. However, we fail to document a consistent relation between
realized growth and the earnings-price ratio, another commonly
used measure of expected growth. Capital expenditures (deflated
by book value of assets, but not by market value of assets) are
associated with growth, but we fail to find a consistently positive
association between R&D intensity and growth. Therefore R&D
intensity may not be as good a growth proxy as is the book-to-
market ratio. As for the policy variables, dividend payout and
dividend yield are lower for high-growth firms, as expected.
However, realized book value growth and leverage measures are
significantly positively associated, contrary to expectations.
Our results should help researchers in constructing
appropriate growth proxies. They also help to interpret the
findings in previous studies that are not robust to the choice of
the growth proxy. For example, Smith and Watts (1992) find that
several of their regression coefficients become insignificant when
they use the earnings to price ratio instead of the ratio of book to
market value of assets as the growth proxy. Our results suggest
that the lack of significance of those coefficients could be
attributable to the fact that earnings to price ratio is not a good
growth proxy.
The remainder of the paper is organized as follows. The
investment opponunity set and its proxies are described in
Section 2, followed by a section documenting sample selection

Blackwcll Publishers Ltd 1999


Nature and Measurement 13

and variable definitions. In subsequent sections, the association


between investment opportunity set proxy variables and policy
variables and realized growth are explored using univariate
approach and multivariate approaches, and a final section
discusses conclusions and implications.

2. THE INVESTMENT OPPORTUNITY SET AND ITS PROXIES

Myers (1977) introduced the term investment opportunity set*


(IOS) to refer to the extent to which firm value depends on
future discretionary expenditures by the firm. Thus IOS refers
not only to traditional investment opportunities such as the right
to explore for minerals, but also to other discretionary
expenditures such as the extent of brand advertising required
in future to ensure the success of the firm. In general, the firm's
investment opponunity set will depend on firm-specific factors
such as physical and human capital in place, as well as on
industry-specific and macro-economic factors. Because the firm's
investment opportunity set consists of projects which allow the
firm to grow, the investment opportunity set can be thought of as
the growth prospects of the firm.
Several proxies have been used in the accounting and finance
literature to capture Myers' .idea of the IOS. They can be
classified into three types: price-based proxies, investment-based
proxies, and variance measures. The price-based proxies are:
market to book value of equity, MVE/BVE (Collins and Kothari,
1989: Lewellen, Loderer and Martin, 1987; and Chung and
Charoenwong, 1991); book to market value of assets, A/V (Smith
and Watts, 1992); Tobin's Q (Skinner, 1993); earnings to price
ratios, E/P (Kester, 1984; Chung and Charoenwong, 1991; and
Smith and Watts, 1992); ratio of property, plant, and equipment
to firm value, PPE/V (Skinner, 1993); and ratio of depreciation
to firm value, DEP/V (Smith and Watts, 1992). The price-based
proxies rely on the idea that if growth prospects of the firm are at
least partially impounded in stock prices, then growth firms will
have higher market values relative to assets in place. The
investment-based proxies are: the ratio of R&D to assets, R&D/
A (Gaver and Gaver, 1993); sales, R&D/S (Skinner, 1993); and
firm values, R&D/V (Smith and Watts, 1992); and ratio of capital

Blackwell Publishers Ltd 1999


14 Accounting and the Investment Opportunity Set

expenditures to value, CAPX/V (Smith and W?tts, 1992). These


proxies rely on the idea that a high level of investment actrity is
p sitively related to the investment opportunity set of the firm.
R&D is itself an investment, and is also is expected to create
further investment opportunities for firms. Variance measures
include the variance of returns (Gaver and Gaver, 1993; and
Smith and Watts, 1992), and asset betas (Skinner, 1993). These
measures rely on the idea that options become more valuable as
the variability of returns on the underlying asset increases. While
most of the above-mentioned studies use the measures' singly,
Gaver and Gaver combine their measures into a composite
measure using factor analysis.
Findings in previous studies have not been entirely robust to
the choice of the proxy. For example, Smith and Watts find that
several of their regression coefficients become insignificant when
the earnings to price ratio is used as an IOS proxy instead of A/V.
When they use R&D/V, many regression coefficients similarly
become insignificant, and one (coefficient of IOS proxy in a
regression with the existence of a bonus plan as the dependent
variable) changes in sign. Gaver and Gaver's reported
correlations among their IOS proxies are generally of the
expected sign, but several of them are insignificant (e.g., between
MVE/BVE and R&D/A or variance of returns). Similarly, in
Skinner's logit regression of goodwill method" choice on IOS
proxies, the coefficients on R&D/S and Tobin's Qare of opposite
signs. Thus an evaluation of the association between IOS proxies
and realized growth can help researchers interpret findings of
studies invoking the IOS construct.
We use the percentage change in book value measured over a
three-year period as our growth measure. This measure is
consistent with the Ohlson model that has recently received
attention in accounting (Bernard, 1993; and Ohlson, 1995), in
which firm value arises from the firm's ability to earn above
normal returns on book value. We note that this measure may be
affected by merger and acquisition activities. The impact of
merger activity depends on the accounting method used for the
transaction; if pooling is used, book value is retroactively restated
to reflect the transaction and therefore growth measures reflect
the actual book value growth of the combined firm. If purchase
accounting is used, book value growth (as well as other growth

Blackwell Publishers Ltd 1999


Nature and Measurement 15

measures) are potentially overstated depending on the type of


consideration given in the transaction - the greatest over-
statement occurs for purchase-type transactions in which
common stock constitutes all or a large part of the consideration.
This type of transaction is relatively uncommon, since most
purchase transactions involve cash rather than stock, and most
transactions involving stock tend to be accounted for as poolings-
of-interests. The net effect is that although book value growth
may be contaminated by merger and acquisition activity, we
believe the noise from this source is not likely to result in a
substantial loss of power in our tests.
The three-year period for our tests is used because preliminary
analysis yielded similar but slightly weaker results using growth
measured over five years. However, as a check of robustness of
our findings we repeated our analysis of the associations between
financial statement variables and growth using alternative growth
measures calculated over three- and five-year periods. Our results
were generally similar for sales, asset, and book value growth.
However, the associations were much weaker for earnings
growth. It would seem that the articulation of earnings and
book value should lead to similar results for these two growth
measures. However, earnings growth and book value growth are
not monotonic, since it is possible to have positive book value
growth even when there is negative earnings growth, as long as
earnings remain positive and exceed the firm's dividend
payments. We believe that the weak associations between IOS
measures and earnings growth could be attributable to
measurement problems such as the greater variability of earnings
and the relatively high frequency of negative reported earnings.

3. SAMPLE SELECTION AND VARIABLES

(i) Sample Selection


The data used in this studv consists of 14 annual samples from
1978 to 1991. Each sample consists of all firms for which market
value and financial statement information are available on the
Standard and Poor's Compustat Primary-Supplementary-Tertiary,
Full Coverage, or Research files." Regulated utilities (SIC codes

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16 Accounting and the Investment Opportunity Set

49XX) and financial institutions (SIC codes 6XXX) are excluded


from the samples. The resulting annual samples include a
minimum of 2,945 firms (1978) and a maximum of 4,039 firms
(1987).

(ii) Variable Definitions


We generally follow previous studies in measuring the IOS
proxies and financing, dividend, and compensation variables.
The variables are defined in Table 1. For consistency we define all
book-to-market measures with market values in the denominator
- they are all thus expected to be negatively correlated with
realized growth. For completeness we include ratios of capital
expenditures to both market and book values of assets, although
Smith and Watts use only the market value deflator. The variance
of total returns is calculated for each firm using annual data over
the entire 1978 to 1994 period, following the approach in Gaver
and Gaver (1993).3
The financing policy variable is leverage, and dividend policy is
measured by yield and payout. According to Myers* and Jensen's
(1986) arguments, high growth firms should have lower debt.
High growth firms are also expected to have lower dividend
payout and yield and more stock-based compensation (Smith and
Watts, 1992; and Gaver and Gaver, 1993). Our compensation
policy variable differs from those of Gaver and Gaver - we use a
dummy variable available in Compustat indicating whether the
company has any employee stock option plans, while Gaver and
Gaver use the level of compensation for the five highest paid
officers, along with dummy variables for bonus plans and
performance plans, all obtained from proxy statements. We
choose not to include these additional compensation variables in
our analysis because the effon involved in collecting the data
would have required substantial reduction of the sample size. In
addition, the strongest results in previous studies are for option
plans.

(Hi) Descriptive Statistics


Descriptive statistics for our samples are presented in Table 2 on
a pooled basis. The variables with earnings in the denominator

Blackwell Publishers Ltd 1999


Nature and Measurement 17

Table 1
Variable Definitions

Variable Description Compustat Data Items


Name

Panel A: Investment Opportunity Set Proxy Variables


Price-based proxies
V Market value of equity plus book (25x199)4-6-60
value of debt
AA r Ratio of book-to-market value of 6+V
assets
BVE/MVE Ratio of book-to-market value of 60 + (25x199)
equity
PPE/V Ratio of book value of PPE to firm 8 T V
value
TOBIN-Q Tobins-^, the ratio of replacement ((8xD) + ( 6 - 8 ) ) * V ,
value of assets to market value where D is the increase
in the nonresidential
GNP deflator over the
mean age of PPE,
calculated as
((7 - 8) -4-103)
DEP/V Ratio of depreciation expense to 103 + V
value
E/P Earnings-price ratio 58 +199

Investment-based proxies
R&D/V Ratio of R&D expense to firm value 46 + V
R&D/A Ratio of R&D expense to total assets 46 -r6
R&D/S Rauo of R&D expense tosaies 46-5-12
CAPX/V Rauo of capital additions to firm 128 + V .
value
CAPX/A Rauo of capital addidons to asset 128-r6
book value
Variance measures
VARRET Variance of total return Var((24x25)(24x25)_l
+(26x25) + 19 + 15|
+{6_ l 60- l +(24x25).!]
BETA Market model beta Based on 36 monthly
observations obtained
from Center for
Research in Security
Prices data.

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18 Accounting and the Investment Opportunity Set

Table 1 (Continued)

Variable Description Compustat Data Items


' 'a me

Panel B: Financing, Dividend and Compensation Policy Variables


D/E Book debt to equity ratio (6 - 60 - 130)
-K60+130)
D/A Book debt to asset ratio ( 6 - 6 0 - 130) r 6
D/MVE Market debt to equity ratio (6-60-130)
+((25x199) + 130))
DPAY Dividend pavout ratio 26 + 58
DYLD Dividend vield 26 + 199
OPT Duinmv variable equal to one if firm 215f
has shares reserved for option plans.
zero otherwise
Sow.
t Item 215 includes options issued but not yet exercised plus options reserved for future
issuance. .As a result, a nonzero value for OPT indicates that the company has an approved
option plan, but not necessarily that options have been issued pursuant to the plan.
Untorrunatelv, this variable was recendy added to Compustat databases so it is available
oniv tor years after 1984.

(e.g., DPAY) all have large numbers of missing observations due


to the incidence of negative earnings figures; firm-year
observations with negative earnings were coded as missing for
these variables. In order to reduce the effect of oudiers on
results, variables were coded as missing if they were more than
five standard deviations away from the annual sample means; this
procedure affected less than one percent of the observations for
any variable in any year, but results in different numbers of
available observations among the variables.

4. UNIVARIATE ANALYSIS

(i) IOS Proxies


Table 3 presents the annual rank correlations between variables
of interest and realized book value growth for 20 portfolios of
firms formed by ranking on realized book value growth each year.
That is, within each year, firms were ranked based on realized
book value growth over the three succeeding years (BGRO+3);
the 5% of firms with the highest book value growth in the three

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Nature and Measurement 19

Table 2
Descriptive Statistics

.V Mean Std. Dev. Median 25 75


Percentile Percentile

Realized Growth:
AGRO.j 51249 0.085 0.232 0.068 -0.028 0.177
SGRO.3 50312 0.096 0.297 0.073 -0.021 0.178
IGRO.-, 28582 0.140 0.422 0.097 -0.082 0.276
BGRO.3 46441 0.088 0.265 0.071 -0.031 0.179

[OS Proxy Variables:


A/V 51128 0.788 0.347 0.801 0.538 1.022
BVE/MVE 49409 0.841 0.727 0.649 0.363 1.086
PPE, V 51201 0.271 0.225 0.213 0.099 0.382
TOBINS-Q-1 50202 0.919 0.466 0.890 0.585 1.189
DEP/V 50947 0.036 0.031 0.029 0.015 0.047
E/P 36434 0.094 0.076 0.077 0.048 0.119
RD.-V 51068 0.015 0.028 0.000 0.000 0.019
RD/S 50700 0.134 1.926 0.000 0.000 0.026
RD.'A 51245 0.028 0.059 0.000 0.000 0.030
CAPX,V 50149 0.057 0.057 0.043 0.020 0.079
CAPX/A 50155 0.081 0.077 0.059 0.030 0.106
VARRET 48363 0.345 0.862 0.093 0.038 0.255
BETA 36867 1.183 0.571 1.162 0.827 1.520

Policy Variables:
D/E 49472 1.705 3.234 1.004 0.509 1.784
D/A 51454 0.527 0.395 0.512 6.344 0.659
D/MVE 51330 1.403 2.594 0.668 0.252 1.511
DPAY 36421 0.269 0.759 0.104 0.000 0.331
DYLD 51381 0.015 0.027 0.000 0.000 0.024
OPT 31284 0.494 0.500 0.000 0.000 1.000

years following year / were placed in portfolio 1 for year /, the next
highest 5% in portfolio 2, and so on. The means of book value growth
and of the variables of interest were calculated for each portfolio for
that year, and the Spearman rank correlation between the portfolio
means of book value growth and the variables of interest were then
calculated and included in the table. This procedure was repeated
for each year from 1978 to 1991. Significance for the mean correlation
over the entire sample period is assessed using ^-statistics calculated
after applying the Newey-West (1987) correction for serial
correlation, a necessary correction since the correlations are
calculated over three-year overlapping periods.

C Blackwell Publishers Lid 1999


Table 3
Rank Correlation of Realized Book Value Growth with IOS Proxy Variables and Policy Variables

Predicted
Sign 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 Mean itstatiitic /-

IOS Proxy Variables:


A/V - -093 -092 -0.76 -0.58 -0.76 -0.69 -0.80 -0.84 -0.78 -0.75 -0.87 -0.91 -0.97 -0.83 -0.815 -23.92 0/14
BVE/MVE - -098 -0.96 -0.90 -0.74 -0.84 -0.71 -0.92 -0.96 -0.90 -0.84 -0.90 -097 -0.98 -0.88 -0.893 -34.63 0/14
PPE/V - -085 -0.80 -0.62 -0.46 -0.90 -0.82 -0.89 -0.80 -0.50 -0.53 -0.65 -0.78 -0.89 -0.73 -0.729 -17.61 0/14
TOB1NS-Q - -0.94 -0.87 -0.75 -0.57 -0.70. -0.63 -0.72 -0.83 -0.75 -075 -0.82 -0.88 -0.95 -0.86 -0.788 -20.56 0/14
DEP/V - -0.93 -0.87 -0.72 -0.56 -0.95 -0.90 -0.96 -0.94 -0.78 -0.70 -0.83 -0.87 -0.97 -0.82 -0.843 -27.66 0/14
E/P - -0.50 -0.46 -0.19 -0.17 -0.51 0.28 0.14 0.30 0.13 -0.02 0.12 -0.47 -0.59 -0.51 -0.174 -V53 5/9
RD/V + 0.49 0.25 0.02 0.26 0.17 - 0 . 5 2 -0.56 -0.65 -0.74 -0.75 -0.46 -0.39 -0.33 -0.64 -0.275 -1.71 5/9
RD/A + 0.62 0.79 0.50 0.56 0.43 0.15 -0.04 -0.03 -0.23 -0.13 0.05 0.37 0.27 0.02 0.238 1.97 10/4
RD/S + 041 0.59 026 003 0.23 -0.21 -0.40 -0.25 -0.15 -0.33 -0.23 0.13 0.31 0.16 0.040 0.36 8/6
CAPX/V + Oil -0.33 -0.47 -0.79 -0.75 -0.59 -0.80 -0.62 -0.33 -0.41 -0.35 -0.55 -069 -0.55 -0.509 -6.71 1/13
CAPX/A + 093 0.91 0.64 0.26 0.04 0 3 3 0.43 0.73 0.54 0.59 0.70 0.68 0.52 0.61 0.564 6.85 14/0
VARRET + 0.36 0.37 0.44 0.23 0.17 0.09 0.09 0.07 0.04 0.05 0.12 0.21 0.26 0.20 0.190 1.61 14/0
BETA + 0.40 0.39 0.49 032 0.12 -0.22 -0.26 0.12 0.32 -0.07 0.30 0.46 0.46 0.31 0.224 1.62 .1/3

/>o/ify Variables:
D/E - 0.21 0.20 0.29 0.37 0.53 0.51 0.55 0.54 0.34 0.21 0.38 0.36 0.36 0.47 0.381 8.94 14/0
D/A _ 0.27 0.24 0.32 0.52 0.70 0.69 0.66 0.72 0.80 0.76 0.66 0.49 0.42 0.78 0.575 8.33 14/0
D/MVE _ - 0 . 7 4 - 0 . 8 2 -0.87 - 0 . 7 3 -0.44 0.26 -0.48 - 0 . 4 3 0.00 - 0 . 6 6 - 0 . 7 9 -0.51 - 0 . 5 9 - 0 . 6 8 - 0 . 5 3 5 -6.01 2/12
DPAY _ - 0 . 7 2 - 0 . 9 3 - 0 . 7 8 - 0 . 8 0 -0.62 -0.68 -0.78 -0.71 - 0 . 5 3 - 0 . 6 5 - 0 . 8 3 - 0 . 7 7 -0.91 - 0 . 7 2 - 0 . 7 4 6 --25.24 0/14
DYLD _ -0.64 - 0 . 6 0 - 0 . 5 2 -0.35 -0.46 -0.24 -0.25 - 0 . 3 5 - 0 . 2 2 -0.21 -0.25 - 0 . 5 8 -0.81 - 0 . 6 3 - 0 . 4 3 7 - 6 . 3 2 0/14
OPT + - - - - - - 0.12 - 0 . 2 2 0.13 0.29 0.17 0.48 0.53 0.59 0.262 1.17 7/1
Nature and Measurement 21

Univariate results for the investment opportunity set proxy


variables, presented in Table 3, show that all of the price-based
investment c >portunity set proxies (A/V, BVE/MVE, PPE/V and
Tobin's QT ) are significandy negatively correlated with
subsequent book value growth, as expected. Surprisingly, the
earnings to price ratio (calculated only for firms with positive
earnings) does not exhibit significant correlation with
subsequent realized growth, contrary to expectations that this
measure should be lower for high-growth firms. Additional
analysis (not reported in the table) indicates that growth firms
have higher returns on assets in the previous years. Thus a
possible explanation for the lack of association between E/P
ratios and growth is that although growth firms have fewer assets-
in-place relative to firm value, those assets-in-place produce a
higher income stream than those of non-growth firms; these two
offsetting effects equalize the mean E/P ratios for growth firms
and non-growth firms.
R&D spending appears to be only weakly and inconsistently
correlated with realized growth. This result is surprising in view of
the strong intuitive grounds for expecting a positive association
between R&D intensity and growth. This result was identical for
other growth measures as well - assets, sales, and earnings - with
inconsistent and generally weak correlations across the annual
samples. Similarly, a subset of the samples was adjusted for
median industry levels of the R&D ratios, and the result of no
apparent relation between R&D intensity and realized growth was
unaffected.
Several explanations are possible for the lack of relationship
between R&D spending and realized growth. If firms with high
R&D intensity continue to increase R&D expenditures over the
three-year measurement horizon, growth of income and book
value may be understated because of rules requiring expensing of
R&D. However, this problem does not influence sales growth, for
which similar results were obtained. Alternatively, R&D may
result in cost savings rather than new products in some
industries, or it may take longer than three to five years for
R&D to translate into new product sales and growth. We did find
R&D/A and R&D/S to be correlated with discretionary
expenditures (defined as the sum of capital expenditures,
advertising, and R&D) over the subsequent three years, deflated

Blackwell Publishers Ltd 1999


22 Accounting and the Investment Opportunity Set

by assets in the base year. This evidence is consistent with a


relation between R&D and Myers' definition of growth as the
extent to which firm value depends on future discretionary
expenditure by the firm. However, the evidence is also consi cent
with mere serial correlation in R&D expenditures, rather than a
causal relation between current R&D and future discretionary
expenditures-no consistent relation is found when R&D is
excluded from discretionary expenditures. Overall, we conclude
that R&D intensity does not proxy for growth as well as the book-
to-market IOS proxies do.
Correlations for the two capital expenditure measures are
statistically different from zero, but in opposite directions. While
CAPX/A is positively correlated with growth, as expected, CAPX/
V appears to be negatively correlated with growth. This negative
correlation could be attributable to the use of a market value
measure in the denominator of GAPX/V, causing the ratio to
behave more as a book-to-market measure than as a measure of
investment activity. This may also account for the negative (but
insignificant) correlation between R&D/V and growth. The
volatility measures beta and the variance of total returns are
not significandy associated with realized growth.

(ii) Financing, Dividend, and Compensation Policy Variables


Univariate results for the variables which measure the financing,
dividend and compensation policies of the firm presented in
Table 3 show, contrary to expectations, that the debt-to-equity
ratio (D/E) and debt-to-assets ratio (D/A) are significantly
positively correlated with realized book value growth. However,
both D/E and D/A are strongly negatively correlated with sales
and asset growth, as expected (not reported in the table).
The market-valuerbased measure of leverage (D/MVE) is
negatively correlated with subsequent growth. As discussed
earlier in connection with the capital expenditure variables, the
variables with market value in the denominator and book value
measures in the numerator, as with D/MVE, may be highly
correlated with the book-to-market measures and may not be
useful measures of non-book-to-market constructs.
Both of the dividend measures, the payout ratio (DPAY) and
the market-value-based measure, yield (DYLD), are negatively

O BUckwell Publishers Ltd 1999


Nature and Measurement 23

correlated with realized growth, as expected. This is a stronger


result than in Gaver and Gaver (1993), who find a difference in
dividend yield, but not payout. As discussed above, the results for
ratio .ariables with market value denominators (e.g., dividend
yield) should be viewed with suspicion because they may behave
like book-to-market measures; in this case the confirmatory
result for DPAY provides credibility for the observed negative
correlation.
The use of option plans is positively correlated with realized
growth, although the association is not statistically significant.
The positive correlation is slightly stronger (average coefficient
significant at the 5% level) when sales or assets are used to
measure growth.
In addition to the univariate tests reported in Table 3, we also
considered the relative explanatory power of the variables using
partial correlations with growth after controlling for book-to
market. Although many of the variables exhibit partial
correlations which are consistent in sign over the sample period,
the potential explanatory power of most of the variables
incremental to the explanatory power of BVE/MVE (the book-
to-market measure used as the partial variable) seems to be quite
low. For example, the capital expenditure variables seem to be
essentially uncorrelated with growth after controlling for the
book-to-market measure. Of the other variables, dividend yield
(DYLD) has the largest average partial correlation with growth
after controlling for book-to-market. This implies that a
classification model which includes both book-to-market and
dividend yield may provide a better growth proxy than market-to-
book alone.

5. CONCLUSION

The results in this paper show that variables which incorporate


book and market measures (book-to-market value of assets and
equity, Tobin's-(7~l, and ratios of fixed assets and depreciation
expense to market value) are consistently negatively correlated
with realized growth, which can be viewed as a benchmark proxy
for the IOS. Capital investment activity as measured by the ratio
of capital expenditures to assets is positively correlated with

C Blackwell Publishers Ltd 1999


24 Accounting and the Investment Opportunity Set

realized growth. However, we find that ratios of R8cD to sales,


assets, or market value do not exhibit a consistent or strong
association with realized book value growth. It appears that R&D
intensity, as measured b; these variable*, do not proxy for growth
as well as the book-to-market variables we examine. Also, we find
that the E/P ratio, Oiten cited as a measure of growth
expectations, exhibits no consistent association with realized
growth. Multivariate analysis suggests that dividend policy may
reveal some incremental information about the firm's growth
prospects relative to book-to-market measures alone, but tjiat the
other variables examined seem to show little promise for
constructing a multivariate growth proxy.

NOTES
1 Results using these growth measures can be obtained upon request from
the authors.
2 The Primary-Supplementary-Tertiary files include the largest US firms, as
well as large non-US firms with shares represented by American Depository
Receipts; most of these firms are listed on the New York or American Stock
Exchanges. The Full Coverage file includes mosdy smaller firms which trade
on the NASDAQ system. The Research file consists of firms removed from
the other files for any reason.
3 In addition to the total return variable used by Gaver and Gaver, we also ran
tests using the variance of common stock returns using daily and monthly
observations, with similar results.

REFERENCES
Bernard. V. (1993), 'Accounting Based Valuation, Determinants of Market-To-
Book Ratios, and Implications for Financial Statement Analysis', Working
Paper (University of Michigan).
Chung, K. and C. Charoenwong (1991), 'Investment Options, Assets-In-Place,
and the Risk of Stocks', Financial Management, Vol. 20, No. 3, pp. 21-33.
Collins, D.W. and S.P. Kothari (1989), 'An Analysis of Inter-Temporal and
Cross-Sectional Determinants of Earnings Response Coefficients', Journal of
Accounting and Economics, Vol. 11, No. 2/3 (July), pp. 143-81.
Gaver, J.J. and K. M. Gaver (1993), 'Additional Evidence on the Association
Between the Investment Opportunity Set and Corporate Financing,
Dividend and Compensation Policies', Journal of Accounting and Economics,
Vol. 16, No. 1/2/3 (January/April/July), pp. 125-40.
Jensen. M. (1986), 'Agency Costs and Free Cash Flow, Corporate Finance, and
Takeovers', American Economic Review, Vol. 76, No. 2 (May), pp. 323-29.
Kester, W.C. (1984), 'Today's Options for Tomorrow's Growth', Harvard

Blackwell Publishers Ltd 1999


Nature and Measurement 25

Business Review, Vol. 62, No. 2 (March-April), pp. 153-60.


Lewellen, \ . . . C Loderer and K. Martin (1987), 'Executive Compensation
Contracts and Executive Incentive Problems: An Empirical Analysis*,
Journal of Accounting and Economics* Vol. 9, No. 3 (July), pp. 287-310.
Myers, S.C. (1977), 'Detem inants of Corporate Borrowing', Journal of Financial
Economics, Vol. 5, No. 2 (June), pp. 147-75.
Newey, W. and K. West (1987), 4A Simple, Positive Semi-Definite,
Heteroskedasticity and Autocorrelation Consistent Covariance Matrix',
Econometrica, Vol. 55, No. 3 (May), pp. 703-08.
Ohlson, J. A. (1995), 'Earnings, Book Values and Dividends in Security
Valuation', Contemporary Accounting Research, Vol. 12, No. 2 (Spring),
661-68.
Skinner, D. J. (1993), 'The Investment Opportunity Set and Accounting
Procedure Choice: Preliminary Evidence', Journal of Accounting and
Economics, Vol. 16. No. 4 (October), pp. 407-46.
Smith. C. W. and R. L. Watts (1992), 'The Investment Opportunity Set and
Corporate Financing, Dividend and Compensation Policies', Journal of
Financial Economics, Vol. 32, No. 3 (December), pp. 263-92.
26 Accounting and the Investment Opportunity Set

Appendix 1.2: James A. Miles, "Growth


Options and the Real Determinants of
Systematic Risk," Journal of Business Finance
and Accounting (Spring 1986), pp. 95-106.

This paper is concerned with the real determinants of the systematicriskor beta
of a firm. Real determinants are properties of the future cash flows provided by
real assets already owned by the firm and by options for future purchase of real
assets. Beta is linked to the path which the market value of the firm is expected
to trace over time so that the real determinants of beta and the real deter-
minants of market value are essentially the same for the individual firm. The
market value of a firm is the sum of the values of the assets already in place and
of the future investment opportunities of the firm.1 In this paper, the
multiperiod capital asset pricing model (CAPM) is used to value the cash flows
generated by assets in place and the options pricing model (OPM) is used to
value growth opportunities. The beta of a firm is a weighted average of the beta
for assets in place and the beta of the growth options where the weights are the
respective market values of these two components. This paper is based primarily
on work by Broyles and Cooper (1981), although Myers (1977), and Myers
and Turnbull (1977), have applied the multiperiod CAPM to the problem of
specifying the real determinants of beta for assets in place. Myers and Turnbull
conclude that beta is a function of the covariance between cash flow and the
return on the market portfolio, the time pattern of the cash flows, and the
expectations revision process.2
In this paper, the real determinants for the beta of growth options are itemized
and their impact upon the beta of the firm is specified. Growth options are in-
tangible assets. To value them requires assumptions as to how future invest-
ment opportunities are made available to the firm. Since the objective here is to
examine the effect of growth options on beta, the assumptions about the nature
of the growth options are kept as general as possible. It is found that beta
depends on the profitability of future investment, the quantity of future in-
vestments, and the firm's own instantaneous return variance. The particular
influence which each of these variables has upon systematic risk depends upon
investors' expectations revision processes for cash flows.

The author is Associate Professor of Finance, at the College of Business Administration,


Pennsylvania State University. (Paper received January 1985)
Nature and Measurement 27

THE ASSUMPTIONS

Using the following assumptions, bo. i the capital asset pricing model and the
option pricing model can be derived.

(a) All individuals have a strictly concave utility function.

(b) For any future point in time, investors have homogeneous beliefs about
the density function of asset values.

(c) Capital markets are perfect and there are no taxes.

(d) There is a known instantaneously riskless interest rate which is constant


over time.

(e) The distribution of firm asset value at the end of any finite time interval
is log normal. If the asset is a cash flow to be received at a future date,
this asumption implies the cash flow is lognormal.

(f) The variance of the rate of return on any asset is constant.

VALUATION OF A FIRM HAVING NO GROWTH OPPORTUNITIES

Since neither taxes nor other imperfections affecting the relevance of capital
structure are assumed, the following valuation analysis applies both to the equity
of an unlevered firm and to the total value of debt and equity for a levered firm.
The firm owns a sequence of cash flows X\, X\, . . . XT. Letting V\ represent the
market value of A"i at time /, the previous assumptions imply

where (A' j 0O) is the expected value operator given the information set at
time 0, V\1 is the market value at time 1 of the aggregate value of all risky firms,
R< is the discrete time riskless rate of interest, and A - [E{RM) - R/]/G(RKI).
By defining R4 as the value satisfying

a risk-adjusted discount rate can be derived from the capital asset pricing
model. Let V\ represent the time 1 value of Af2. Assume that cov(Af Fff) and
G{ V*1) are constant for all i and that A is constant over time. Then the value of
Xi at time 1 is
28 Accounting and the Investment Opportunity Set

The value of X2 at time 0 equals the value of V\ at time 0. Since RA is constant


over time, V\ is random given the information at time 0 only if E{X\ \ 0i) is
uncertain at time 0 If between time 0 and time 1, expectations are not revised
with respect to X2,T\ en

Firm value (assuming no new investment opportunities) when expectations for


a particular cash flow are only revised during the period preceding that cash
flow is

Suppose that E(Xi | 0 0 is revised continuously over the interval / - 0 to / - 1.


Specifically, assume E(X2 \ <px) and V) are perfectly correlated random
variables over the interval t 0 to / 1. This assumption implies that any revi-
sion of expectations for Xx also pertains to X2\ the elasticity of expectations
equals one. Since E(X2 | 0O) and V] are perfectly correlated, the same risk-
adjusted discount rate applies to both and

Generalizing to the case of 7* cash flows yields

In the following analysis, it is assumed that the assets already in place generate
a level perpetuity. Let rj be the elasticity of expectations so that here, either
r\ = 0 or r\ 1. By defining Rn - Rf + rj(RA - /?/), equations (2) and (3) can both
be expressed as

or, assuming a level perpetuity,

GROWTH OPTIONS
The previous analysis is valid only for firms with no growth opportunities. In
this section it is assumed that for any time i>Q, the firm has the option of in-
Nature and Measurement 29

vesting C, to purchase an expected level perpetuity o((lE(Xi*. i | (pi) per period.


Here, X*i is the unc tain cash flow at time i+ 1 generated by the assets
already in place at time 0. The firm at time 0 owns an expected level perpetuity
generated by assets in place. At the end of each future period, the r rm has le
option of purchasing 100a, percent of that original perpetuity. Suppose the cur-
rent capital budget calls for an a % increase in the replacement value of plant
and equipment. This Should' increase the expected future cash stream about
a %. The definition of growth options here implies that each new investment
increases the existing cash stream by the factor (1 + a), in traditional cost of
capital analysis, it is assumed that all new projects produce incremental cash
flows with the same risk characteristics as the existing cash flows of the firm.
This definition of growth options is the natural extension of this 4 single risk-
class firm' concept to deal with future investment opportunities.
Define VA(i,t) as follows:

VA(i,t) is the value at time t of 100a, percent of the cash stream generated by
assets in place at time 0 but where the first cash flow included in VA(i,t) is at
time z+ 1. At time z>0, if VA(i,i)>C the firm can increase shareholder
wealth by spending C, to purchase something worth VA(it i). At time 0, the firm
owns the option to purchase VA{iti) at time i at a cost (exercise price) of C.3
This real option has many of the characteristics of a financial call option. The
value of a growth option, given our assumptions, can be specified as

where .V( ) is the standardized normal cumulative probability density func-


tion, a1 is the instantaneous variance of percentage returns on VA(i,t), r/is the
instantaneous risk-free rate of return,

and

The total value of the firm at time 0 can be written as

where the summation term equals PVGOo, the present value of the firm's
growth options at time 0. Equation (8) shows that VTo is a portfolio consisting
of assets already in place plus a collection of growth options. The systematic
30 Accounting and the Investment Opportunity Set

risk observed on VTo is a value-weighted average of the betas on the com-


ponents of the portfolio. T h e observed average return on VTQ is frequently used
as an estimate of the cost of capital and employed in capital budgeting deci-
sions. However, when net present value i.- measured, the incremental wish
flows are valued not as options but as assets already in place. The correct way to
measure the required rate of return (or beta) for capital budgeting purposes is
to estimate the expected return on VAQ.

OBSERVED BETAS AND GROWTH OPTIONS

Conceptual Framework

Let rA represent the return for the firm's assets already in place; TA is the instan-
taneous return (for / 0 ) on J ^ ( 0 , 0 ) . Let r& represent the return on the ith
growth option at / 0. Since any option can be represented as a levered position
in the underlying security, the ith growth option is equivalent to a levered posi-
tion in VA(i,o). Letting rA represent the return on VA(l,0)t

T h e expression N(d\)VA(i,Q)/VG(i,Q) is always greater than or equal to one


implying thac the underlying asset return is magnified to produce the option
return r<;,.* Combining the definition of beta with the previous equation yields

or

where /?< is the beta for the :th growth option and /k, is the beta of the under-
lying security. Since N{d\)VA(i,Q)/VG(ifi)^ 1, one knows that/fa^/Zii; the
systematic risk of the ith growth option is greater than or equal to the systematic
risk of VA(i,Q). T h e relationship between the systematic risk .of the growth
options and the systematic risk of assets already in place cannot be specified
unless rjy the elasticity of expectations is specified.
T h e comparative static results for call options can be applied to show that 5

The value of the ith growth option is a decreasing function of the required in-
Nature and Measurement 31

vestment outlay and is an increasing function of the value of assets already in


place and of the risk-free rate, x, and a1. One can see here that own variance
has a positive impact upon the value of the firm.6 The comparative static results
for the beta of a call option can be employed to show that'

Two results here are of special interest. The beta of the ith growth option is a
decreasing function of the firm's own variance. Also, under certain conditions
shown beiow, the systematic risk of the ith growth option is a decreasing func-
tion of the firm's ratio of market value to replacement cost. To see this, note
that the ith growth option can (conceptually) be subdivided into G call options
each with an exercise price of one dollar and an underlying security value of
K4(t,0)/G. From the definitions of VA0 and K4(i,0),

If we let R Vo represent the replacement value of the firm and assume that C, -
aRVo, then

The right hand side of this equation contains the ratio VAJRVo which is the
ratio of market value for assets already in place to replacement value. This ratio
will be abbreviated as MVRVR. The value of the ith growth option is an in-
creasing function of this ratio while the beta of that growth option is a decreas-
ing function of the ratio. By assuming G - CLRV0, it is implied that each period
the firm has the option to invest an additional 100a percent of the current
replacement value.
The total value of the firm, VTo, is the sum of VA0 (the value of the cash flows
generated by assets in place) plus PVGOo, the present value of all growth
options. Note that

The firm's systematic risk, /?r, is a weighted average of PA, the systematic risk
for cash flows generated by assets already in place, and PQ, the systematic risk of
the growth options. Specifically,
32 Accounting and the Investment Opportunity Set

as Po is simply a weighted average (by market values) of the individual pa. The
weights are based upon percentage of PVGOo attributed to each growth option.
.Also,

where

meaning that WA is the fraction of total firm value attributable to assets already
in place. We now want to specify the determinants of PT, the observable
systematic risk. It is convenient to delineate two cases, 77 = 0 and 77 = l. 8 If
77 0, expectations are never revised so that for any 1 >t>0, VA(i,t) is known
for certain. Consequently, every growth option is a risk-free asset implying
Pa - 0 for all i and, therefore, Pa 0. For rj 0, the presence of growth options
lowers Pr below pA. If 77 = 1, then #<, PA and since the systematic risk of an
option generally exceeds the systematic risk of the underlying security, we have
PG>PA and the presence of growth options tends to elevate pr above PA. The
impact of or, MVRVR, and own-variance (<Jl 2) upon the firm's systematic risk
is studied below for the two special cases f] = 1 and rj =* 0.

Case 1: (rj = 1)
Beginning with a, the percentage of the existing cash flow which can be pur-
chased each period, it should be clear that if G - (XRV0, then increasing a in-
creases the value of each growth option but leaves each Pa unchanged. Hence,
Pi, remains constant but 1 - WA, the weight assigned to Pc in equation 14, is
larger so that

and

Therefore, an increase in a1 generally will lower Pc but raise (1 - WA) and the
overall effect upon /?/ could be positive, negative, or zero.
It was shown previously that the value of the ith growth option was an in-
creasing function of M V R V R . It was also shown that each Pa is a decreasing
function of that ratio. The overall impact of the market value to replacement
value ratio upon Pr could be either positive, negative, or zero as increasing the
ratio reduces Pc and increases (1 - WA). In summary, if 77- 1, SP^da > 0
while SPr/Sa2 and 8Prld{MVRVR) ceuld be either positive, negative, or zero
depending upon the particular firm.
Nature and Measurement 33

Case 2: (rj - 0)
If the elasticity of expectations is zero, then the market value of the cash flow
stream derived from assets already in place is known for certain for each futur *
point in time. For the ith period, the value of the cash flow stream attributable
to assets already in place at time zero equals aVA(0,0) since investor expecta-
tions will not be revised. For the zth period, either a^i4(0,0) > G and the in-
vestment is made or or ^4 (0,0) < G and no investment is undertaken. The
important point is that the decision to invest at time : or not to invest at time i
can be made at time 0; the net present value of any future investment proposal
is known for certain at time 0.
Assume that C, - a(R VQ). Then the net present value of the investment pro-
posal at time i can be written as

Either VAo > RVQ and future investments are made or the firm will make no
further investment. The value of the ith growth option is simply

if VAo > RVQ and zero otherwise. Clearly, each VG(i90) is an increasing func-
tion of MVRVR if MVRVR > 1. If MVRVR is greater than 1, each VG^Q) is
also an increasing function of a, the fraction of the existing cash flow stream
which can be purchased in each succeeding period. Since all future market
values are certain at time zero when 77 = 0, each growth option is a risk-free
asset and Pa 0 for i > 0. Unlike the case of 77 = 1, if 77 - 0 the existence of
growth options always causes pr to be less than PA. Since increasing either a or
the market value to replacement value ratio increases PVGOo.

and

provided the market value to replacement value ratio (MVR VR) is greater than
1. If MVRVR ^ l,SPr/Sa - 0 and SPr/SMVRVR) - 0.

An Example
Tables 1 and 2 provide examples of the impact which growth options can have
upon systematic risk. Table 1 assumes 77 - 1 while 77 = 0 in Table 2. The
assumptions specified in Table 1 are such that the firm's beta at time 0 in the
absence of growth options would be 1.42. When 77 1, the presence of growth
34 Accounting and the Investment Opportunity Set

Table 1 (77= 1.0)


PT as a Function of Instantaneous Return Variance, the Ratio for Market
Value of Assets Already in Place to Replacement Value, and a

Assumptions: r\ = 1.0, R = 0.05, 4Cov (I /?*. r ) - 0.025


E[Rv\ - 0.12, ah 0.02, Vf 0 for i >
100
G - aRVo.

MVRVR/a' 0.05 0.15 0.25 0.45 0.65


a - 0.00 1.42 1.42 1.42 1.42 1.42
0.8 1.46 1.50 1.50 1.49 1.47
1.0 1.50 1.52 1.51 1.49 1.47
a - 0.05 1.2 1.55 1.54 1.52 1.49 1.47
1.6 1.59 1.55 1.52 1.49 1.47
2.0 1.59 1.55 1.52 1.48 1.47
0.8 1.54 1.65 1.63 1.58 1.54
1.0 1.67 1.70 1.66 1.59 1.54
a = 0.15 1.2 1.78 1.73 1.67 1.59 1.54
1.6 1.87 1.75 1.67 1.58 1.53
2.0 1.86 1.73 1.65 1.57 1.52
0.8 1.61 1.77 1.73 1.65 1.58
1.0 1.82 1.84 1.76 1.65 1.58
or - 0.25 1.2 1.99 1.88 1.77 1.65 1.58
1.6 2.10 1.88 1.76 1.63 1.57
2.0 2.06 1.85 1.73 1.61 1.55

Table 2 (77 = 0)
Pr as a Function of Alpha and MVRVR

Assumptions: rj 0, R - 0.05, bCov(I R,T) - 0.025


E[Rx,] 0.12, a\t - 0.02, Hfv - 0 for i > 100
C - aRVo.
Note: PA 0.0676

Alpha/ MVRVR 1.0 1.2 1.6 2.0


0.05 0.0676 0.0579 0.0491 0.0450
0.15 0.0676 0.0450 0.0318 0.0270
0.25 0.0676 0.0369* 0.0235 0.0193
Nature and Measurement 35

options raises the firm's systematic risk. Clearly, all three variables (alpha,
MVR VR, and own-variance) have a strong impact upon the observable beta. In
Table 2, 77 = 0 and all other assumptions are the same as in Table 1. The asset
beta in Table 2, pA% is 0.0676. Since when 77 - 0, all growth options are riskless,
the observed beta shown in Table 2 is a lecreasing function of both alpha and
MVRVR. IfMVRVR ^ 1, then the net present value of any future investment
is either zero or negative so that MVRVR ^ 1 implies the absence of growth
options and PA Pr.
Is the observed rate of return on total firm value a reasonable proxy for the
hurdle rate used in net present value computations? Tables 1 and 2 show/hat
the answer depends upon a number of variables. For firms that expect a Mow*
level of future investment activity, a 'low' return on future investment, and a
high own-variance of return, the observed beta is fairly close to the beta needed
to compute the required rate of return on investment. O n the other hand,
higher levels of these same variables lead to substantial differences between the
observed beta and the beta required for capital budgeting purposes. T h e tables
are not complete but intended only as a first pass approximation of'real world'
values.

CONCLUDING REMARKS

In this paper, the capital asset pricing model was used to value assets in place
and an option pricing model was used to value growth options. T h e beta of the
firm is a weighted average of the asset beta and the beta of the growth options.
For capital budgeting, the asset beta should be used and not the firm beta. The
analysis presented here shows that the difference between the asset beta and the
firm beta for the single-risk-class firm is a function of the quantity of future in-
vestment opportunities, the ratio of'market value to replacement cost, and the
return variance on assets already in place.

NOTES

1 The notion that assets can be firmly and irrevocable 'in place' is employed here only as an ap-
proximation. Financial managers can elect to exercise the firm's abandonment option. See
Robichek and Van Home (1967).
2 The authors conclude that beta is a decreasing function of the firm's growth rate. When growth
is attained through the exercising of growth options (as is the case in this paper), beta can be an
increasing function of growth.
3 Here, it is assumed that the growth options resemble European call options in that they can
only be exercised at a precise point in time. Optimal timing of new investments is an unresolv-
ed issue.
4 Equation (9) is derived for the general case of a financial call option in Copeland and Weston
(1979) pages 409-410 and also bv Galai and Masulis(1976) based upon the work of Black and
Scholes(1973).
5 For a proof, see Galai and Masulis (1976).
36 Accounting and the Investment Opportunity Set

6 Note here that the firm's own-variance is a value-enhancing factor. It has been shown
elsewhere (Calais -Masulis. 1976) that own-variance affects the allocation of value between
debt and equity. Here, we note that total f.~m value is an increasing function of own-variance.
7 See Galai - Masulis (1976).
8 The two extreme cases of n 0 and n - I have been delineated here to simplify the exposition.
Clearly, there is a r\ between 0 and 1 which leaves the firm's asset beta unaffected.
9 This is true only if MVBVR > 1.

REFERENCES
Bhattacharya, S. (1978), "Project Valuation With Mean-Reverting Cash Flow Stream,"Journal
of Finance, 23. (December 1978), pp. 1317-31.
Black. F. and M. Scholes (1973), "The Pricingof Options and Corporate Liabilities, "Journal of
Political Economy. (May-June) 1973), pp. 637-54.
Bogue. M. and R. Roll (1974), "Capital Budgeting for P.isky Projects with Imperfect' Markets
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Publishing Company, 1979.
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Turnbull. S.M. (.1977), "Market Value and Systematic Risk," Journal of Finance 32 (September
1977), pp. 1125-42.
2

Empirical Validation of a General


Model of Growth Opportunities

INTRODUCTION
The firm is comprised of values assets-in-place and future investment op-
tions or growth opportunities. The lower the proportion of firm value rep-
resented by assets-in-place, the higher the growth opportunities. Myers
describes these potential investment opportunities as call options whose
values depend on the likelihood that management will exercise them. 1 Like
call options, these growth opportunities represent real value of the firm.2
Growth options include such discretionary expenditures as capacity expan-
sion projects, new product introductions, acquisition of other firms, in-
vestments in brand name through advertising, and even maintenance and
replacement of existing assets.3 A significant portion of the market value
of equity is accounted for by growth opportunities. 4-6 In addition, empirical
results suggest that growth opportunities influence various corporate policy
decisions. 7-12 In light of the importance of growth opportunities, this study
states, first, a general model of growth opportunities that can be used to
estimate growth opportunities. Second, empirical evidence is provided to
validate this statement.

A GENERAL MODEL OF GROWTH OPPORTUNITIES


A general and operationally testable model of growth opportunities rests
on combining the firm advantages and limitations. As shown in Exhibit
2.1, the model argues that growth opportunities, as measured by the in-
38 Accounting and the Investment Opportunity Set

Exhibit 2.1
A General Model of Growth Opportunities

Firm Advantages

1 Corporate Reputation

2 Multinationality

3 Size

Growth Opportunities

4 Profitability

Firm Limitations

1 Leverage

2, Systematic Risk

vestment opportunity set, are positively related to the firm's advantages of


corporate reputation, multinationality, size, and profitability, and nega-
tively related to leverage and systematic risk.
The rationale for the model follows.

Reputation Advantages
The reputation of a firm is crucial for various decisions ranging from
resource allocation and career decisions to product choices, to name only
a few.13 It is an important signal of the firms' organizational effectiveness.14
To create the right impression or reputation, firms signal their key char-
acteristics to constituents to maximize their social status. 15 In fact, cor-
porate audiences were found to construct reputations on the basis of
accounting and market information or signals regarding firm perfor-
mance. 16 ' 17 These reputations have become established and constitute sig-
General Model of Growth Opportunities 39

nals that may affect the actions of firms' stakeholders. Specifically, a good
reputation can be construed as a competitive advantage within an indus-
try. 18 Favorable reputations can create favorable situations for firms that
include: (1) the generation of excess returns by inhibiting the mobility of
rivals in an industry; 19 (2) the capability of charging premium prices to
consumers; 20 and (3) the creation of a better image in the capital markets
and to investors.21 Those situations create growth opportunities for the
firm. Accordingly the following hypothesis applies:

Hypothesis 1: Growth opportunities, as measured by the investment


opportunity set, vary directly with the level of reputa-
tion.

Multinationality Advantages
The multinational firm is a collection of valuable options and generates
profits that enhance its value.22 The arbitrage benefits result from (a) the
exploitation of various institutional imperfections; (b) timing options; (c)
technology options; and (d) staging options. 23 ' 24 Better financing bargains 25
as well as capital availability26 are also possible through internationaliza-
tion. In addition, multinational firms can achieve arbitrage benefits in fi-
nancing cash flows by (a) exploiting financial bargains; (b) reducing taxes
on financial flows; and (c) mitigating risks or shifting them to agents with
a comparative advantage in bearing them. 27 The definition of multination-
ality as a collection of options and arbitrage benefits suggests a positive
relation with growth options as defined by the investment opportunity set.
More growth options are more likely to result from increased internation-
alization. Accordingly the following hypothesis applies:

Hypothesis 2: Growth opportunities, as measured by the investment


opportunity set, vary directly with the level of multi-
nationality.

Size Advantages
Large and more established firms often have advantages over their
smaller peers in their ability to exploit emerging opportunities. 28 There is
evidence that persistently profitable firms are those that hold the dominant
market position in their industry.29 In addition, large firms are more apt to
increase the value of investment options by making differential investments
in the creation of barriers to entry that halt or delay the competitive factors
that drive returns on investment projects toward the firm's opportunity
cost. The generation of economics of scale, product differentiation, brand
40 Accounting and the Investment Opportunity Set

loyalty, and patents are some examples of these activities.30 Accordingly


the following hypothesis applies:

Hypothesis 3: Growth opportunities, as measured by the investment


opportunity set, vary directly with the size of the firm.

Profitability Advantages
Two seminal papers from financial economics combine to provide a the-
oretical framework for describing the investment opportunity set. Myers 31
depicts firm value as a combination of income generating assets-in-place
(Va) and growth opportunities (Vg).

Firms with more assets-in-place have less of their value determined by


growth opportunities and vice versa.
Myers' concept of firm value is consistent with that of Miller and Modi-
gliana (MM), 32 who modeled the value of firm based upon (1) the market
rate of return, (2) the earnings power of assets-in-place, and (3) the oppor-
tunities for making additional investments in real assets that will yield more
than the normal rate of return (i.e., growth opportunities). MM's Equation
(12) (using their notation) shows the value of the firm (V) at time 0:

where X(0) are earnings from assets-in-place, n is the cost of capital, n* is


some internal rate of return that exceeds , and I is investment made at
time t. The second right-hand-section term encompasses Myers' growth
term (Vg) and is what is commonly called the investment opportunity set
(IOS). Holding firm value constant, the two right-hand-section terms are
inversely related. This is the "normal" view of growth firms, forgoing earn-
ings from assets-in-place [X (0)] in the first term by plowing them back
into investment (I) in the second term. A recent example is the wireless
communication industry in the 1980s, showing consistently depressed earn-
ings (and losses) due to significant investments, which combined to result
in rapidly increasing firm value. 33 Since both the first and second right-
hand-section terms should be correlated with firm value, they are correlated
with each other. Accordingly the following hypothesis applies:

Hypothesis 4: Growth opportunities, as measured by the investment


opportunity set, vary directly with the level of profita-
bility.
General Model of Growth Opportunities 41

Leverage Limitations
Myers 34 argued that for firms with growth opportunities, the existence
of risky debt, maturing after the investment option, causes the firm to forgo
profitable investment resulting in an underinvestment scenario. Growth
firms tend to issue less debt than firms without growth opportunities be-
cause equity financing controls the potential underinvestment problem as-
sociated with risky debt. 35 Prior empirical research in financial economics
examining the cross-sectional differences in major corporate policy de-
cisions relied on contracting cost explanations and presented empirical
evidence regarding the relationship between growth opportunities and lev-
erage.36' 37 Accordingly the following hypothesis applies:

Hypothesis 5: Growth opportunities, as measured by the investment


opportunity set, are negatively related to the level of
leverage.

Systematic Risk Limitations


The effect of the firm's growth opportunities on systematic risk depends
on the definition of growth. The definition of growth as expansion yielded
a negative relationship between growth and systematic risk.38"43 The defi-
nition of growth as monopoly power in factor and/or output market re-
sulting in larger economic rents also yielded a negative relationship between
growth and systematic risk. Finally, the definition of growth as real options
yielded a positive relationship between growth and systematic risk. 44,45 On
the other hand, Booth46 and Conine 47 argued that the relationship between
growth and beta could be either positive or negative, depending on relative
values of other parameters in the model. Accordingly the following hy-
pothesis applies:

Hypothesis 6: Growth opportunities, as measured by the investment


opportunity set, are negatively related to the level of
systematic risk.

RESEARCH MODEL

Model
In this study, a regression of the investment opportunity set level of U.S.
MNEs against variables of reputation, multinationality, size, profitability,
leverage, and systematic risk is presented as evidence of the validity of a
statement of growth opportunities as follows:
42 Accounting and the Investment Opportunity Set

where:

IOS ; , = Investment opportunity set for firm / in year t.


REPjt = Corporate reputation for firm / in year t.
MULTYjt = Level of multinationality for firm / in year t.
LEVjt = Leverage ratio equal to long-term debt/total assets for firm / in year t.
BETAjt = Systematic risk for firm / in year t.
LSIZEjt = Logarithm of total assets for firm / in year t.
ROAjt = Profitability measured as rate of return on assets of firm / in year t.

Data and Sample Selection

The population consists of firms included in Forbes' M o s t International


100 American Manufacturing and Service Firms and Fortune's surveys of
corporate reputation from 1 9 8 7 to 1 9 9 3 . The security data are collected
from the CRSP return files. The accounting variables are collected from
C O M P U S T A T . The derivations of multinationality, corporate reputation,
systematic risk, and investment opportunity set variables are explained
later. The final sample includes 323 firm-year observations that have all
the variables over the period of analysis.

Measuring Multinationality
Previous research has attempted to measure these attributes of multina-
tionality:

1. Performancein terms of what goes on overseas.48


2. Structurein terms of resources used overseas.49
3. Attitude or Conductin terms of what is top management's orientation. 50 Sul-
livan51 developed nine measures of which five were shown to have a high reli-
ability in the construction of a homogeneous measure of nationality: (1) foreign
sales as a percentage of total sales (FSTS), (2) foreign assets over total assets
(FATA), (3) overseas subsidiaries as a percentage of total subsidiaries (OSTS),
(4) top management's international experience (TMIE), and (5) psychic disper-
sion of international operations (PDIO).

In this study we follow a similar approach by measuring multinationality


through three measures: (1) foreign sales/total sales (FSTS), (2) foreign prof-
its/total profits (FPTP), and (3) foreign assets/total assets (FATA).
Descriptive statistics and correlations among the three multinationality
General M o d e l of G r o w t h Opportunities 43

Exhibit 2.2
Descriptive Statistics and Correlation of Three Measures of Multinationality for
Forbes9 The Most International 100 U.S. Firms

Panel A: Descriptive Statistics

FP/TP' FS/TSb FA/TAC


Maximum 914.3 93 91
Third Quartile 61.9 47.4 41.4
Median 41.3 36.7 30.5
First Quartile 25 25.7 22.6
Minimum 0.2 6.6 2.7
Mean 52.81 37.45 39.92

Panel B: Correlations

FP/TP FS/TS FA/TA


FP/TP 1.000
FSTTS 0.280 1.000
FAfTA 0.034 0.193* 1.000

* Denotes p-value < 0.05.


a
FP/TP = Foreign profits/total profits.
ll
FS/TS = Foreign sales/total sales.
C
FA/TA = Foreign assets/total assets.

measures are shown in Exhibit 2.2. Correlations among the variables are
positive, and with one exception, all significant. The nonsignificant corre-
lation is between FPTP and FATA. The low correlations between FPTP,
FSTS, and FATA indicate that each variable can make a unique contribu-
tion as a multinationality measure. Thus, a factor analysis of all observa-
tions is used to isolate the factor common to the three measures. Exhibit
2.3 reports the results. One common factor appears in the intercorrelations
among the three variables, as the first eigenvalue value alone exceeds the
sum of the commonalities. The common factor is significantly positively
Exhibit 2.3
Selected Statistics Related to a Common Factor Analysis of Three Measures of
Multinationality for Forbes' The Most International 100 U.S. Firms

1. Eigenvalues of the Correlation Matrix:

Eigenvalues 1 2 3
1.3615 0.9680 0.6705

2. Factor Pattern

FACTOR1

FS^S FP/TP FA/TA


0.80529 0.50172 0.67918
FA/TA

3. Final Communality Estimates: Total = 1.361489

FS/TS FP/TP FA/TA


0.648491 0.251718 0.461280

4. Standardized Scoring Coefficients

FACTOR2
FS/TS FP/TP FATA
0.59148 0.36850 0.49885

5. Descriptive Statistics of the Common Factor Extracted from the Three Measures of

Multinationality

Maximum 2039.24

Third Quartile 74.70

Median 57.03

First Quartile 40.76

Minimum 5.17

Mean 64.35
General Model of Growth Opportunities 45

correlated with the three measures. These factor scores were used to mea-
sure the degree of multinationality of firms in the sample.

Measuring Corporate Reputation


The Fortune survey covers every industry group comprising four or more
companies. The industry groups are based on categories established by the
U.S. Office of Management and Budget (OMB). The survey asked execu-
tives, directors, and analysts in particular to rate a company on the follow-
ing eight key attributes of reputation:

1. Quality of management
2. Quality of products/service offered
3. Innovativeness
4. Value as long-term investment
5. Soundness of financial position
6. Ability to attract/develop/keep talented people
7. Responsibility to the community/environment
8. Wise use of corporate assets

Ratings were on a scale of 0 (poor) to 10 (excellent). The score met the


multiple-consistency ecological model view of organizational effectiveness.
For purposes of our study, the 1987 to 1993 Fortune magazine surveys
were used. To obtain a unique configuration, a factor analysis is used to
isolate the factor common to the eight measures of reputation. All the ob-
servations were subjected to factor analysis and one common factor was
found to explain the intercorrelations among the eight individual mea-
sures.52 Exhibit 2.4 reports the results of the common factor analysis. One
common factor appears to explain the intercorrelations among the eight
variables, as the first eigenvalue alone exceeds the sum of the commonali-
ties. The common factor is significantly and positively correlated with the
eight measures. The factor scores are used to measure the corporate repu-
tation of firms.

Measuring the Investment Opportunity Set


Because the investment opportunity set is not observable there has not
been a consensus on an appropriate proxy variable. Similar to Smith and
Watts 53 and Gaver and Gaver54 we use an ensemble of variables to measure
the investment opportunity set. The three measures of the investment op-
portunity set used are market-to-book assets (MASS), market-to-book en-
Exhibit 2.4
Selected Statistics Related to a Common Factor Analysis of Measures of
Reputation

1. Eigenvalues of the Correlation Matrix:

Eigenvalues

1 2 3 4 5 6 7 8
1.7776 1.4596 0.3841 0.1347 0.1120 0.0549 0.0482 0.0339

2. Factor Pattern

FACTOR1

R{ 0.9530 *4 0.9645 R7 0.8072

R2 0.9180 *5 0.8982 Rs 0.9479

R2 0.8789 *6 0.9805

3. Final Communality Estimates: Total = 1.389626

R, R, Rj R4 RS R6 R7 RS
0.9083 0.8428 0.7726 0.9304 0.8069 0.9614 0.6515 0.8986

4. Standardized Scoring Coefficients

FACTOR1

R{ 0.1407 R< 0.1424 R7 0.1191

R2 0.1355 Rs 0.1325 R8 0.1399

Rj 0.1297 R6 0.1447

5. Descriptive Statistics of the Common Factor Extracted from the Three Measures of

Multinationality

Third Quartile 7.288

Median 6.614

First Quartile 6.105

Minimum 3.235

Mean 6.622

Variable definitions:
R^ = Quality of management.
R2 = Quality of products/services.
R3 = Innovativeness.
R4 = Value as long-term investment.
Rs = Soundness of financial position.
R6 = Ability to attract, develop, and keep talented people.
R7 = Responsibility to the community and environment.
Rs = Wise use of corporate assets.
General Model of Growth Opportunities 47

Exhibit 2.5
Descriptive Statistics and Correlation of Three Measures of the Investment
Opportunity Set for Forbes' The Most International 100 U.S. Firms

Panel A: Descriptive Statistics

MASS" MQVb EP
Maximum 6.4943 60 0.5175
Third Quartile 1.8556 3.1851 0.1081
Median 1.2905 1.9090 0.0713
First Quartile 1.0618 1.2666 0.0482
Minimum 0.8745 4.3333 2.1536
| Mean 0.3081 2.7020 0.0638 1

Panel B: Correlation

1 MASS MQV EP
\MASS 1.000
MQV 0.0399* 1.000
| EP 0.0158* 0.0230* 1.000

* Denotes p-value < 0.05.


'MASS = Market-to-book assets.
b
MQV Market-to-book equity.
C
EP = Earnings/price ratio.

tity ( M Q V ) , and the earnings/price ratio (EP). These variables are defined
as follows:

MASS = (Assets - Total Common Equity + Shares Outstanding* Share Closing


Price )/Assets
MQV - (Shares Outstanding* Share Closing Price)/Total Common Equity
EP = (Primary EPS before Extraordinary Items)/Share Closing Price

Descriptive statistics and correlations among the three measures of the in-
vestment opportunity set are shown in Exhibit 2.5. Correlations a m o n g the
48 Accounting and the Investment Opportunity Set

three variables are significant. The low correlations indicate that each var-
iable makes a unique contribution as a measure of the investment oppor-
tunity set. The results of the factor analysis are shown in Exhibit 2.6. One
common factor appears to explain the intercorrelations among the three
individual measures. It is used here as a measure of the investment oppor-
tunity set.

Measuring the Systematic Risk


The capital asset pricing model asserts that in equilibrium, and under
certain conditions, the risk premium for an individual security, E (R,) -
E (RF) is related to the risk premium of the market, E (R7) E (RF) by
the expression:

where:

E (RF) = risk-free rate


E (Rm) = expected return on a market factor
at = cov (RfR-J/var(R-J

ai is a measure of the systematic or nondiversifiable risk. Its estimation is


operationally possible using the one-factor market model, which asserts a
linear relationship between the rate of return on security I, Rin and the
market rate of return, Rrn for a period t. It is expressed in this study as
follows:

where:

rit = continuously compounded rate of return of security /' at period t

Rit noncompounded single-period return of security i in period t


r, = market factor in period t log.
Exhibit 2.6
Selected Statistics Related to a Common Factor Analysis of Three Measures of
the Investment Opportunity Set for Forbes9 The Most International 100
U.S. Firms

1. Eigenvalues of the Correlation Matrix: Total = 3 Average = 1

Eigenvalues 1 2 3
1.0540 0.9868 0.9592

2. Factor Pattern

FACTOR!
MASS MQV EP
0.62821 0.66411 0.46722

3. Final Communality Estimates: Total = 1.053994

MASS MQV EP
0.394651 0.441045 0.218299

4. Standardized Scoring Coefficients

FACTOR1
MASS MQV EP
0.59603 0.441045 0.44329

5. Descriptive Statistics of the Common Factor Extracted from the Three Measures of the
Investment

Oprx>rtunity

Maximum 9.3595

Third Quartile 3.2200

Median 2.0450

First Quartile 1.5085

Minimum 2.5209

Means 1.9812
50 Accounting and the Investment Opportunity Set

elt logarithm of the residual term


Dlt = cash dividend per share
<* at = parameters of the least squares regression

rit is used instead of Rit because it is admitted that, first, rit has fewer outliers
in its relative frequency distribution and therefore will yield more efficient
risk statistics than Rit and, second, rit is distributed more symmetrically than
the positively skewed Rit variable. Besides, the results of the model are not
changed by restating them in terms of rit instead of Rit.

RESULTS
Panel A of Exhibit 2.7 reports descriptive statistics used in our tests and
Panel B shows correlations among the variables. The correlations reported
in Panel B of Exhibit 2.7 show that some correlations are significant at the
0.01 level. The significant associations among some of the variables indicate
some degree of collinearity among the independent variables in the regres-
sion analysis. However, the maximum condition index in all regression is
only 4.43. As suggested by Belsley et al., 55 mild collinearity is diagnosed
for maximum-condition indices between 5 and 10 and severe collinearity
over 30. Thus, collinearity does not seem to influence our results.
For the multivariate regression to be reported, we performed additional
specification tests, including checks for normality and consideration of a
scatter plot. A null hypothesis of normality could not be rejected at the
0.01 level in all cases, and the plots revealed some heteroscedasticity but
no obvious problems. Therefore, we calculated the ^-statistics after cor-
recting for heteroscedasticity in the manner described by White. 56
Exhibit 2.8 presents the results of the regression of the determinants of
the investment opportunity set. The regression was significant with an F-
value of 23.798. The independent variables were explained by 30.28% of
the variance in the dependent variable of the investment opportunity set.
As expected all the independent variables were significant with the correct
sign. Growth opportunities, as measured by the investment opportunity set,
are positively related to the level of corporate reputation, multinationality,
size, and profitability, and negatively related to leverage and systematic
risk. The results verified the statement of a general model of growth op-
portunities.

CONCLUSIONS
A general model of growth opportunities combining the advantages of
corporate reputation, multinationality, size, and profitability and the limi-
tations of leverage and systematic risk is tested using a sample of U.S.
Exhibit 2.7
Descriptive Statistics and Correlations
Panel A: Descriptive Statistics

Variable Mean Standard Maximum Median Minimum


Deviation

IOS 18.552 15.073 117.006 1.930 0.695

MULTY 54.324 28.357 325.478 51.274 6.210


LEV 0.354 0.187 1.44 0.374 0.257

BETA 0.009 0.013 1.104 0.004 0.021

LSIZE 9.325 1.106 12.353 9.073 7.617

ROA 0.057 0.056 0.221 0.057 0.021

REP 6.622 0.968 9.022 6.614 3.235

Panel B: Correlations

| Variables(1) IOS REP MULTY LEV BETA LSIZE ROA

/OS 1.000

\REP 0.1804 1.000

MULTY 0.0834 -0.0504 1.000

LEV -0.4205* 0.3054* 0.0850 b 1.000

BETA -0.0695 0.4574* 0.0634 0.1781* 1.000

LSIZE 0.3719 0.0150 -0.0554 -0.3972* 0.4557* 1.000


ROA -0.2546" 0.5352* -0.1123* 0.4597' 0.2230* -0.2996*

n)
Variable definitions:
IOS: Investment opportunity set.
REP: Reputation score.
MULTY: Multinationality score.
LEV: Leverage ratio.
LSIZE: Logarithm of total assets.
BETA: Systematic risk.
ROA: Rate of return on assets.
(2)
Significant at a 0.01 level.
Significant at a 0.05 level.
52 Accounting and the Investment O p p o r t u n i t y Set

Exhibit 2.8
Regression Results

Variables Coefficient^
Intercept -.387.533
(-5.604)'
REP 17.200
(3.215)*
MULTY 0.682
(3.619)*
LEV -137.029
(-4.552)'
BETA -2098.43
(-5.214)*
LSIZE 33.564
(5.453)'
ROA 185.340
(3.451)'
F 23.798'
2
Adjusted R 30.28%

(1 ]
Variable definitions:
REP: Reputation score.
MULTY: Multinationality score.
LEV: Leverage ratio.
BETA: Systematic risk.
LSIZE: Logarithm of total assets.
ROA: Rate of return on assets.
(2)i1
Significant at a 0.01 level.

MNE's. The evidence validates this statement of growth opportunities by


showing that growth opportunities, as measured by the investment oppor-
tunity set, are positively related to corporate reputation, multinationality,
size, and profitability, and negatively related to leverage and systematic
risk. The results are dependent on the choice of surrogate measures for
both dependent and independent variables. Future research needs to ex-
amine the sensitivity of the results to other potential surrogate measures.
General Model of Growth Opportunities 53

NOTES
1. Myers, S., "Determinants of Corporate Borrowing,"Journal of Financial
Economics 5 (1977): pp. 147-175.
2. Kester, W. C , "Today's Options for Tomorrow's Growth," Harvard Busi-
ness Review (March-April 1984): pp. 153-160.
3. Mason, S. P. and R. C. Merton. "The Role of Contingent Claims Analysis
in Corporate Finance," in E. I. Altman, ed., Recent Advances in Corporate Finance,
Irwin, Homewood, IL, 1985: pp. 7-54.
4. Kester, "Today's Options for Tomorrow's Growth."
5. Kester, W. C , "An Option Approach to Corporate Finance," ch. 5. in E. I.
Altman, ed., Handbook of Corporate Finance, Wiley, New York, 1986: pp. 3-35.
6. Pindyck, R., "Irreversible Investment, Capacity Choice, and the Value of the
Firm," American Economic Review (December 1988): pp. 969-985.
7. Smith, C. and R. Watts, "The Investment Opportunity Set and Corporate
Financing, Dividend, and Compensation Policies," Journal of Financial Economics
32 (1992): pp. 263-292.
8. Baber, W. R., S. N. Janakiraman, and Kang Sok-Hyon, "Investment Oppor-
tunities and the Structure of Executive Compensation," Journal of Accounting and
Economics 21 (1996): pp. 297-318.
9. Skinner, D. J., "The Investment Opportunity Set and Accounting Procedure
Choice," Journal of Accounting and Economics 16 (1993): pp. 403-445.
10. Miles, J. A., "Growth Options and the Real Determinants of Systematic
Risk," Journal of Business Finance and Accounting 13 (1986): pp. 95-105.
11. Gaver, J. J. and K. M. Gaver, "Additional Evidence on the Association be-
tween the Investment Opportunity Set and Corporate Financing, Dividend and
Compensation Policies," Journal of Accounting and Economics 16 (1993): pp. 125-
160.
12. Riahi-Belkaoui, A. and R. D. Picur, "Multinationality and Profitability: The
Contingency of the Investment Opportunity Set," Managerial Finance 24(5) (1998):
3-14.
13. Dowling, G. R. "Managing Your Corporate Images," Industrial Marketing
Management 15 (1986): pp. 109-115.
14. Riahi-Belkaoui, A. and E. Pavlik., Accounting for Corporate Reputation,
Greenwood Publishing, Westport, CT, 1992.
15. Spencer, A. M., Market Signaling: Information Transfer in Hiring and Re-
lated Screening Process, Harvard University Press, Cambridge, MA, 1974.
16. Fombrum, C. and M. Shanely, "What's in a Name? Reputational Building
and Corporate Strategy," Academy of Management Journal 33 (1990): pp. 2 3 3 -
258.
17. Belkaoui, A., "Organizational Effectiveness, Social Performance and Eco-
nomic Performance," Research in Corporate Social Performance and Policy 12
(1992): pp. 143-155.
18. Riahi-Belkaoui and Pavlik, Accounting for Corporate Reputation.
19. Fombrum and Shanley, "What's in a Name?"
20. Caves, R. E. and M. E. Porter, "From Entry Barrier to Mobility Barriers,"
Quarterly Journal of Economics 91 (1977): pp. 421-434.
54 Accounting and the Investment Opportunity Set

21. Klein, B. and K. Leffler, "The Role of Market Forces in Assuring Contractual
Performance," Journal of Political Economy 85 (1981): pp. 615-641.
22. Beatty, R. P. and J. R. Ritter, "Investment Banking, Reputation, and Under-
pricing of Initial Public Offerings," Journal of Financial Economics 15 (1986):
pp. 213-232.
23. Tsetsekos, G. P., "Multinationality and Common Stock Offering," Journal
of International Business Studies 25 (1991): pp. 325-342.
24. Dunning, J. H. (1995), "Reappraising the Eclectic Paradigm in an Age of
Alliance Capitalism," Journal of International Business Studies (1986): pp. 4 6 1 -
492.
25. Kogut, B., "Foreign Direct Investment as a Sequential Process," in C. Kin-
delberger and D. Andretsh, eds., The Multinational Corporation in the 1980's. MIT
Press, Cambridge, MA, 1983: pp. 38-56.
26. Giavazzi, F. and A. Giovannini, Limiting Exchange Rate Flexibility: The
European Monetary System, MIT Press, Cambridge, MA, 1989.
27. Tsetsekos, "Multinationality and Common Stock Offering."
28. Gaver and Gaver, Additional Evidence on the Association between the In-
vestment Opportunity Set and Corporate Financing.
29. Mueller, D., "Persistent Performance among Large Corporations," in L. G.
Thomas III, ed., The Economics of Strategic Planning: Essays in Honor of Joel
Dean, D. C. Heath, Lexington, MA, 1986: pp. 31-61.
30. Chung, K. H. and C. Charroenwong, "Investment Options, Assets in Place,
and the Risk of Stocks," Financing Management (Autumn 1991): pp. 21-33.
31. Myers, "Determinants of Corporate Borrowing."
32. Miller, M. H. and F. Modigliani, "Dividend Policy, Growth, and the Valu-
ation of Shares," Journal of Business 4 (1961): pp. 411-433.
33. Amir, Eli and B. Lev, "Value-Relevance of Nonfinancial Information: The
Wireless Communications Industry," Journal of Accounting and Economics 22
(1996): pp. 3-30.
34. Myers, "Determinants of Corporate Borrowing."
35. Ibid.
36. Gaver and Gaver, Additional Evidence on the Association between the In-
vestment Opportunity Set and Corporate Financing.
37. Smith and Watts, "The Investment Opportunity Set and Corporate Financ-
ing."
38. Beaver, W., P. Kettler, and M. Scholes, "The Association between Market-
Determined and Accounting-Determined Risk Measures," The Accounting Review
(October 1970): pp. 654-682.
39. Pettit, R. and R. Westerfield, "A Model of Capital Asset Risk," Journal of
Financial and Quantitative Analysis (March 1972): pp. 1649-1688.
40. Breen, W. and E. Lerner, "Corporate Financial Strategies and Market Mea-
sures of Risk and Return," Journal of Finance (May 1973): pp. 339-352.
41. Rosenberg, B. and W. McKibben, "The Prediction of Systematic and Specific
Risk in Common Stock," Journal of Financial and Quantitative Analysis (March
1973): pp. 317-334.
42. Thompson, D., "Sources of Systematic Risk to Common Stocks," Journal of
Business (April 1976): pp. 173-188.
General Model of Growth Opportunities 55

43. Eskew, R., "The Forecasting Ability of Accounting Risk Measures: Some
Additional Evidence," The Accounting Review (January 1979): pp. 107-118.
44. Christie, A., "Equity Risk, the Opportunity Set, Production Costs and Debt,"
Working paper, University of Rochester, Rochester, NY, 1989.
45. Chung, K. H. and C. Charroenwong, "Investment Options, Assets in Place,
and the Risk of Stocks,"Financial Management (Autumn 1991): pp. 21-33.
46. Booth, L., "Market Structure Uncertainty and the Cost of Equity Capital,"
Journal of Banking and Finance 3 (1981): pp. 467-482.
47. Conine, J., "On the Theoretical Relationship between Business Risk and
Price Elasticity of Demand," Journal of Business Finance and Accounting 3 (1983):
pp. 173-182.
48. Dunning, J. H., "Reappraising the Eclectic Paradigm in an Age of Alliance
Capitalism," Journal of International Business Studies 26 (1986): pp. 461-492.
49. Stopford, J. M. and L. T. Wells, Managing the Multinational Enterprise, Ba-
sic Books, New York, 1972.
50. Perlmutter, H. V., "The Tortuous Evaluation of the Multinational Corpo-
ration," Columbia Journal of World Business 4 (1969): pp. 9-18.
51. Sullivan, D., "Measuring the Degree of Internationalization of a Firm," Jour-
nal of International Business Studies 25 (1994): pp. 325-342.
52. Hartman, H. H., Modern Factor Analysis, 3d ed., University of Chicago
Press, Chicago, 1976.
53. Smith and Watts, "The Investment Opportunity Set and Corporate Financ-
ing."
54. Gaver and Gaver, Additional Evidence on the Association between the In-
vestment Opportunity Set and Corporate Financing.
55. Belsley, D., E. Kuh, and R. Welsch, Regression Diagnostics: Identifying In-
fluential Data and Sources of Collinearity, New York, Wiley, 1980.
56. White, H. A., "Heteroskedasticity-Consistent Covariance Matrix Estimator
and a Direct Test for Heteroskedasticity," Econometrica 10 (1980): pp. 817-838.

REFERENCES
Amir, Eli and B. Lev. "Value-Relevance of Nonfinancial Information: The Wireless
Communications Industry." Journal of Accounting and Economics 22
(1996): 3-30.
Baber, W. R., S. N. Janakiraman, and Kang Sok-Hyon. "Investment Opportunities
and the Structure of Executive Compensation." Journal of Accounting and
Economics 21 (1996): 297-318.
Beatty, R. P. and J. R. Ritter. "Investment Banking, Reputation, and Underpricing
of Initial Public Offerings." Journal of Financial Economics 15 (1986): 2 1 3 -
232.
Beaver, W., P. Kettler, and M. Scholes. "The Association between Market-
Determined and Accounting-Determined Risk Measures." The Accounting
Review (October 1970): 654-682.
Belkaoui, A. "Organizational Effectiveness, Social Performance and Economic Per-
formance." Research in Corporate Social Performance and Policy 12 (1992):
143-155.
56 Accounting and the Investment Opportunity Set

Belsley, D., E. Kuh, and R. Welsch. Regression Diagnostics: Identifying Influential


Data and Sources of Collinearity. New York: Wiley, 1980.
Booth, L. "Market Structure Uncertainty and the Cost of Equity Capital." Journal
of Banking and Finance 3 (1981): 467-482.
Breen, W. and E. Lerner. "Corporate Financial Strategies and Market Measures of
Risk and Return." Journal of Finance (May 1973): 339-352.
Caves, R. E. and M. E. Porter. "From Entry Barrier to Mobility Barriers." Quar-
terly Journal of Economics 91 (1977): 421-434.
Christie, A. "Equity Risk, the Opportunity Set, Production Costs and Debt." Work-
ing paper. University of Rochester, Rochester, NY, 1989.
Chung, K. H. and C. Charroenwong. "Investment Options, Assets in Place, and the
Risk of Stocks." Financial Management (Autumn 1991): 21-33.
Conine, J. "On the Theoretical Relationship between Business Risk and Price Elas-
ticity of Demand." Journal of Business Finance and Accounting 3 (1983):
173-182.
Dowling, G. R. "Managing Your Corporate Images." Industrial Marketing Man-
agement 15 (1986): 109-115.
Dunning, J. H. "Reappraising the Eclectic Paradigm in an Age of Alliance Capital-
ism." Journal of International Business Studies 26 (1986): 461-492.
Eiteman, D. and A. Stonehill. Multinational Business Finance. Boston: Addison-
Wesley, 1986.
Eskew, R. "The Forecasting Ability of Accounting Risk Measures: Some Additional
Evidence." The Accounting Review (January 1979): 107-118.
Fombrum, C. and M. Shanely. "What's in a Name? Reputational Building and
Corporate Strategy." Academy of Management Journal 33 (1990)i 233-258.
Gaver, J. J. and K. M. Gaver. "Additional Evidence on the Association between the
Investment Opportunity Set and Corporate Financing, Dividend and Com-
pensation Policies." Journal of Accounting and Economics 16 (1993): 125-
160.
Giavazzi, F. and A. Giovannini. Limiting Exchange Rate Flexibility: The European
Monetary System. Cambridge, MA: MIT Press, 1989.
Hartman, H. H. Modern Factor Analysis, 3d ed. University of Chicago Press: Chi-
cago, 1976.
Kester, W. C. "Today's Options for Tomorrow's Growth." Harvard Business Re-
view (March-April 1984): 153-160.
, "An Option Approach to Corporate Finance," ch. 5. in E. I. Altman, ed.,
Handbook of Corporate Finance. New York: Wiley, 1986: 3-35.
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and D. Andretsh, eds. The Multinational Corporation in the 1980's. Cam-
bridge, MA: MIT Press, 1983: 38-56.
Mason, S. P. and R. C. Merton. "The Role of Contingent Claims Analysis in Cor-
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Miles, J. A. "Growth Options and the Real Determinants of Systematic Risk." Jour-
nal of Business Finance and Accounting 13 (1986): 95-105.
General Model of Growth Opportunities 57

Miller, M. H. and F. Modigliani. "Dividend Policy, Growth, and the Valuation of


Shares." Journal of Business 4 (1961): 411-433.
Mueller, D. "Persistent Performance among Large Corporations." In L. G. Thomas
III, ed. The Economics of Strategic Planning: Essays in Honor of Joel Dean.
Lexington, MA: D. C. Heath, 1986: 31-61.
Myers, S. "Determinants of Corporate Borrowing." Journal of Financial Economics
5 (1977): 147-175.
Perlmutter, H. V. "The Tortuous Evaluation of the Multinational Corporation."
Columbia Journal of World Business 4 (1969): 9-18.
Pettit, R. and R. Westerfield. "A Model of Capital Asset Risk." Journal of Financial
and Quantitative Analysis (March 1972): 1649-1688.
Pindyck, R. "Irreversible Investment, Capacity Choice, and the Value of the Firm."
American Economic Review (December 1988): 969-985.
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. Accounting for Corporate Reputation. Westport, CT: Greenwood Publish-
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tingency of the Investment Opportunity Set." Managerial Finance 24 (5)
(1998): 3-14.
Rosenberg, B. and W. McKibben. "The Prediction of Systematic and Specific Risk
in Common Stock." Journal of Financial and Quantitative Analysis (March
1973): 317-334.
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Choice." Journal of Accounting and Economics 16 (1993): 403-445.
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Stopford, J. M. and L. T. Wells. Managing the Multinational Enterprise. New York:
Basic Books, 1972.
Sullivan, D. "Measuring the Degree of Internationalization of a Firm." Journal of
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ness (April 1976): 173-188.
Tsetsekos, G. P. "Multinationality and Common Stock Offering." Journal of In-
ternational Business Studies 25 (1991): 325-342.
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Direct Test for Heteroskedasticity." Econometrica 10 (1980): 817-838.
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3

Investment Opportunity Set


Dependence of Dividend Yield and
Price Earnings Ratio

INTRODUCTION
Valuation models based on accounting information show equity to be re-
lated to accounting earnings, 1-3 to balance sheet measures of assets and
liabilities,4 or to both book value and earnings. The last model is based on
the notion that in more realistic settings with market imperfections, ac-
counting systems can provide information about book value and earnings
as complementary, rather than redundant, components of equity value.5
For example, Ohlson expresses price as a linear function of book value and
abnormal earnings. 6,7 A linear form where equity value is an additive func-
tion of earnings and book value is typically assumed in most empirical
specifications derived from the model. 8,9 Such a model can be refined fur-
ther by decomposing the earnings component into dividends and retained
earnings. 10 What results is a valuation model that relates equity to divi-
dends, retained earnings, and book value. The presence of dividends and
retained earnings in the model is compatible with survey and empirical
evidence that suggests that the dominant valuation model used by analysts
is the price-earnings (PE) ratio, but that other approaches such as the div-
idend yield are also important. In fact, there is evidence of industry
dependence in analysts' preferences, between the dividend yield and price-
earnings ratio valuation models.11 These results raise the question of the
nature and importance of the roles of dividend and earnings in a valuation
model. This chapter argues that the function depends on the relative level
of the investment opportunity set. Firms in a high investment oppor-
60 Accounting and the Investment Opportunity Set

tunity set group are shown to be PE-valued while firms in a low investment
opportunity set are shown to be "yield valued."

HYPOTHESES
The first objective of the study is to extend the basic valuation model to
include both dividends and retained earnings as a result of the analysts' use
of both price-earnings (PE) ratio and dividend yield in determining and
evaluating share price. The following null hypotheses are expected to be
rejected:

Hypothesis 1: There is no correlation between dividends and share


prices.
Hypothesis 2: There is no correlation between earnings and share
prices.

The second objective is to test the investment opportunity set dependence


of dividend yield and PE ratio. The presence of a high investment oppor-
tunity set implies profitability and growth opportunities that can translate
into even higher profitability.
On the basis of the evidence or the merits of higher investment oppor-
tunity set, dividends are expected to be of greater valuation relevance for
firms with low investment opportunity set level. One may also argue that
firms in a low investment opportunity set group are valued on the basis of
dividends alone, such that retained earnings are not value-relevant. This
implies the rejection of the following null Hypotheses 3 and 5 and accep-
tance of Hypothesis 4:

Hypothesis 3: For firms with a low investment opportunity set level,


there is no difference in the value relevance of dividends
and retained earnings.
Hypothesis 4: For firms with a low investment opportunity set level,
retained earnings are not value-relevant.
Hypothesis 5: There is no difference in the value relevance of dividends
between firms with a high investment opportunity set
level and firms with a low investment opportunity set
level.

Similarly, for firms with a high investment opportunity set level, earnings
are expected to be value-relevant. Therefore, both earnings and dividends
will be value-relevant for these firms. This implies acceptance of the fol-
lowing Hypothesis 6 and rejection of Hypothesis 7:
Dividend Yield and Price Earnings Ratio 61

Hypothesis 6: For firms with a high investment opportunity set level,


there is no difference in the value relevance of dividends
and retained earnings.
Hypothesis 7: There is no difference in the value relevance of retained
earnings between firms with a high investment oppor-
tunity set level and firms with a low investment set op-
portunity set level.

MARKET-BASED MODEL
The study sets a valuation model rather than an event study. The de-
pendant variable is price rather than returns, and the independent variables
are levels rather than expected differences. All the tests are derived from
an empirical version expressing the market price (?) as a function of book
value per share (BV) and earnings per share ():

To examine dividend relevance, earnings per share (E) is decomposed


into dividend per share (DV) and retained earnings per share (RE). An
argument for dividends as a sign of value has been made in both survey
and empirical research. 12,13 Therefore:

To examine investment opportunity set relevance to the role of dividends


and retained earnings the following model is proposed.

where IOS = dummy variable that takes the value of 1 for high investment
opportunity set and the value of 0 for low investment opportunity set.
Equation (3) will be used to test each of the null hypotheses.

METHODS

Sample
The population consists of all the firms in Forbes' Most International
Firms from 1992 to 1998. The firms included in the study were classified
with either a high investment opportunity set group or a low investment
opportunity set group. Based on a factor score of investment opportunity
set, high investment opportunity set firms were chosen from the top 2 5 %
62 Accounting and the Investment Opportunity Set

Exhibit 3.1
Descriptive Statistics for the Basic Model
Variables Mean Standard Skewness Kurtosis Minimum Maximum
Deviation
Pu 47.288 23.777 1.093 2.226 2 170

BVic 25.109 16.249 1.319 2.726 -3 113

REie 3.495 4.638 0.883 23.113 -26.252 52.279

DVie 0.066 0.113 0.553 5.012 0.000 1.788

Note: P is the price per share for firm at the end of financial year t, BV is the book value of
equity per share, RE is the retained earnings per share, and DV is the dividend per share.
The full sample of 356 firm-years consists of all the firms in Forbes' 100 Most Multi-
national Firms with data available for all the variables in the basic model. Outliers were
defined as the top and bottom of 0.5% of cases for each of the basic model variables
(BV, RE, DV). The sample is drawn from the years 1992-1998.

of the distribution scores while low investment opportunity set firms were
chosen from the bottom 2 5 % of the distribution factor scores. The final
sample included 256 firm-year observations. The derivation of the invest-
ment opportunity set share is explained as follows.

Measuring the Investment Opportunity Set


Three measures of the investment opportunity set, namely market-to-
book assets, market-to-book equity and earnings/price ratio were factor
analyzed. One common factor appeared to explain the intercorrela-
tions among these three individual measures. Based on the factor shares,
high growth firms were chosen from the top 2 5 % of the distribution shares
while low growth firms were chosen from the bottom 2 5 % of the distri-
bution factor scores. The two groups were used for testing the hypotheses.

RESULTS
Descriptive statistics concerning the variables used in the model are
shown in Exhibit 3.1. The data exhibit a moderate amount of skewness
and kurtosis. The matrix for the correlations between all the variables used
Dividend Yield and Price Earnings Ratio 63

Exhibit 3.2
Correlation between Explanatory Variables

P BV RE DV

p 1.000(0.0) 0.3899 (0.0001) 0.3563 (0.0001) 0.4272 (0.0001)

BV 1.000(0.0) 1.1766(0.0001) 0.3276 (0.0001)

RE 1.000(0.0) 0.6995 (0.0001)

DV 1.000(0.0)

Note: Variables are defined in Exhibit 3.1.

in the analysis is presented in Exhibit 3.2. The low intercorrelations among


the prediction variables used in the model indicate no reason to suspect
multicollinearity, and various diagnostic tests run on the derived regression
models confirmed it was not a problem. Exhibit 3.3 presents the results of
the regression coefficients for all the independent variables using the pooled
sample and the results for individual years. The Breusch and Pagan (1979)
test for heteroscedasticity yielded a x1 with a minimum of 137.65 and a
maximum of 183.62 for all the regressions, indicating that heteroscedastic-
ity would be a problem in these regressions. Accordingly, the reported t-
statistics were based on White's heteroscedasticity corrected covariance
matrix. 14
The results of all the regressions show a high JR2 (a minimum of 0.75 in
1997 and a maximum of 0.35 in 1993), together with significant coeffi-
cients on BV, IOSRE, DV, and IOSDV. As expected the results confirm a
strong cross-sectional relationship between price on one hand and book
value, retained earnings, and dividends on the other hand. Both Hypotheses
1 and 2 are therefore rejected consistent with the use of RE and DV in the
valuation model.
Hypothesis 3 is firmly rejected. In all the regression results, the coefficient
in RE is much smaller than the coefficient on DV. A stronger test of the
relaionship is provided by Hypothesis 4, which stipulates that dividends
are not relevant. Hypothesis 4 is supported as the coefficient of RE is sig-
64 Accounting and the Investment Opportunity Set

Exhibit 3.3
Basic Valuation Model Results
a b c d e F g F Adjusted
R2

Probed - 23.322 0.586 0.657 0.352 10.562 62.523 -4.701 35.728 0.28
Sample (17.325)* (8.625)' (0.304) (0.258) (3.265)' (5.263)' (-1.937)"

1992 25.262 0.325 2.608 1.256 11.552 23.182 -7.582 18.232' 0.31
(7.702)* (5.625)* (0.520) (0.028) (2.932)' (1.878)" (-2.856)'

1993 17.325 0256 5.624 1.862 9.189 48.023 -41.703 18.150' 0.35
(8.725)* (3.252)* (1.068) (0.528) (3.812)' (3.568)' (-2.386)'

1994 29.368 0.095 1.625 1.321 12.054 68.325 -31.526 18.425' 0.36
(9.274)* (4.262)' (0.321) (0.625) (2.979)' (4.685)* (-3.705)'

1995 32.628 0.325 0.385 0.529 9.862 53.262 -2.392 12.062' 0.26
(8.678)* (3.023)* (0.062) (0.302) (2.816)' (2.812)' (-2.479)*

1996 30.262 0.632 0.285 0.632 10.232 51.321 -30.625 13.256' 0.23
(11.324)* (6.325)* (0.023) (0.502) (2.916)' (2.812)' (-3.859)'

1997 34.256 0.526 0.386 0.635 11.231 48.325 -29.682 11.282' 0.25
(11.234)* (8.324)* (0.321) (0.208) (2.854)' (2.979)' (-3.256)'

1998 32.342 0.542 0.292 0.636 12.325 43.525 -28.523 15.623' 0.28
(10.862)' (7.283)' (0.295) (0.218) (2.625)' (3.682)' (-4.262)'

n
The estimated equation is:

h
The variables are defined in Exhibit 3.1.
c
* Significant at 0.01.
** Significant at 0.05.
^-statistics are in parentheses.

nificant in all cases. In addition, when a restriction that the coefficient of


RE is equal to zero is imposed in the model Wald statistic of 6.32 allows
a rejection of the null hypothesis that the coefficient in RE is equal to zero.
Hypothesis 5 is also rejected. IOSDV is negative and significant in all
cases indicating that there is a difference between firms in both groups,
with the rate at which dividends are capitalized being lower for the high
investment opportunity set group. Hypothesis 7 is also rejected as the co-
efficient on IOSRE is large, positive, and significant in all cases, establishing
Dividend Yield and Price Earnings Ratio 65

a relationship between price and retained earnings for firms in a high in-
vestment opportunity set group.
Finally, Hypothesis 6 is rejected in favor of retained earnings being more
important for firms in a high investment opportunity set group. Further
testing of Hypothesis 6 by imposing a restriction on the model that the
sum of the coefficients on RE (i.e., d and e) is equal to the sum of those
on DV (i.e., f and g) results in a significant Wald statistic of 8.42, and a
rejection of Hypothesis 6.

CONCLUSIONS
This chapter developed and tested a market valuation model whose
main prediction is that equity value is a function of earnings, dividends,
and book value, where the function depends on the relative level of the in-
vestment opportunity set. Using a sample of U.S. multinational companies,
the study shows that firms in a high investment opportunity set group are
"PE valued" and that firms in a low investment opportunity set group are
"dividend yield valued." For firms in a low investment opportunity set
group, dividends are of greater relevance than earnings, while for firms in
a high investment opportunity set group both retained earnings and divi-
dends are relevant even though retained earnings are more relevant than
dividends.

NOTES
1. Ball, R. and P. Brown, "An Empirical Evaluation of Accounting Income
Numbers," Journal of Accounting Research (Autumn 1968): pp. 159-178.
2. Barth, M., "Relative Measurement Errors among Alternative Pension Asset
and Liability Measures," The Accounting Review (July 1991): pp. 433-463.
3. Collins, D. and S. P. Kohari, "An Analysis of Intertemporal and Cross-
Sectional Determinants of ERCs," Journal of Accounting and Economics (March
1992): pp. 143-183.
4. Landsman, W., "An Empirical Investigation of Pension Fund Property
Rights," The Accounting Review (October 1986): pp. 44-64.
5. Burgstahler, D. C. and I. D. Dichev, "Earnings, Adaptation and Equity
Value," The Accounting Review (April 1997): pp. 187-216.
6. Ohlson, J. A., "Earnings, Book Values and Dividends in Security Valuation,"
Contemporary Accounting Research (Spring 1995): pp. 661-687.
7. Ohlson, J. A., "A Synthesis of Security Valuation Theory and the Role of
Dividends, Cash Flows and Earnings," Contemporary Accounting Research (Spring
1990): pp. 648-647.
8. Easton, P. and T. Harris, "Earnings as an Explanatory Variable for Re-
turns," Journal of Accounting Research (Spring 1991): pp. 19-36.
66 Accounting and the Investment Opportunity Set

9. Sougiannis, T., "The Accounting Based Valuation of Corporate RLD," The


Accounting Review (January 1994): pp. 44-68.
10. Rees, William P., "The Impact of Dividends, Debt and Investment on Val-
uation Models," Journal of Business Finance and Accounting 24 (1997): pp. 1111
1140.
11. Barker, R. C , "Survey and Market-Based Evidence of Industry-Dependence
in Analysts' Preference between the Dividend Yield and Price-Earnings Ratio
Valuation Models," Journal of Business Finance and Accounting 96 (1999):
393-418.
12. Battacharya, O. "Imperfect Information, Dividend Policy and the Bird in the
Hand Fallacy,"Bell Journal of Economics 10 (1979): pp. 259-270.
13. Miller, M. and K. Rock, "Dividend Policy under Asymmetric Information,"
Journal of Finance 94 (1985): 1039-1051.
14. White, H., "A Heteroskedasticity-Consistent Covariance Matrix Estimator
and a Direct Test of Heteroskedasticity," Econometrika 48 (1990): pp. 17-38.

REFERENCES
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Journal of Accounting Research (Autumn 1968): 159-178.
Barker, R. G. "Survey and Market-Based Evidence of Industry-Dependence in An-
alysts' Preference between the Dividend Yield and Price-Earnings Ratio Val-
uation Models." Journal of Business Finance and Accounting 96 (1999):
393-418.
Barth, M. "Relative Measurement Errors among Alternative Pension Asset and Li-
ability Measures." The Accounting Review (July 1991): 433-463.
Battacharya, O. "Imperfect Information, Dividend Policy and the Bird in the Hand
Fallacy." Bell Journal of Economics 10 (1979): 259-270.
Burgstahler, D. C. and I. D. Dichev. "Earnings, Adaptation and Equity Value." The
Accounting Review (April 1997): 187-216.
Collins, D. and S. P. Kohari. "An Analysis of Intertemporal and Cross-Sectional
Determinants of ERCs." Journal of Accounting and Economics (March
1992): 143-183.
Easton, P. and T. Harris. "Earnings as an Explanatory Variable for Returns." Jour-
nal of Accounting Research (Spring 1991): 19-36.
Landsman, W. "An Empirical Investigation of Pension Fund Property Rights." The
Accounting Review (October 1986): 44-64.
Miller, M. and K. Rock. "Dividend Policy under Asymmetric Information." Journal
of Finance 94 (1985): 1039-1051.
Ohlson, J. A. "Earnings, Book Values and Dividends in Security Valuation." Con-
temporary Accounting Research (Spring 1995): 661-687.
. "A Synthesis of Security Valuation Theory and the Role of Dividends, Cash
Flows and Earnings." Contemporary Accounting Research (Spring 1990):
648-647.
Rees, William P. "The Impact of Dividends, Debt and Investment on Valuation
Models." Journal of Business Finance and Accounting 24 (1997): 1111
1140.
Dividend Yield and Price Earnings Ratio 67

Sougiannis, T. "The Accounting Based Valuation of Corporate RLD." The Ac-


counting Review (January 1994): 44-68.
White, H. "A Heteroskedasticity-Consistent Covariance Matrix Estimator and a
Direct Test of Heteroskedasticity." Econometrika 48 (1990): 17-38.
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4

The Role of Multinationality and


Profitability in the Determination of
the Investment Opportunity Set

INTRODUCTION
The firm may be viewed as a combination of assets-in-place and future
investment options. The lower the proportion of firm value represented by
assets-in-place, the higher the growth opportunities. Myers1 describes these
potential investment opportunities as call options whose values depend on
the likelihood that management will exercise them. Like call options, the
growth options represent real value to the firm.2 These growth options are
intangible assets that represent the investment opportunity set of a firm.
Given that the market value of a firm is comprised of the value of assets-
in-place and the present value of these growth opportunities, the difference
in market values of firms implies a difference in the investment opportunity
set. Firm-specific and economic-based variables are potential determinants
of the cross-sectional differences in the investment opportunity set. This
study considers the two firm variables of multinationality and profitability
as determinants of the investment opportunity set. Accordingly, it examines
the impact of multinationality and profitability on the investment oppor-
tunity set, conditioned by size and macroeconomic variables. The results,
based on a sample of 600 firm-year observations from Forbes3 Most Inter-
national 100 American Manufacturing and Service Firms from the 1987-
1992 period, indicate a significant positive relation with multinationality
and profitability, inflation, and GNP growth rate, and a negative relation
with size and the index of business formation.
70 Accounting and the Investment Opportunity Set

BACKGROUND AND HYPOTHESES

Profitability and the Investment Opportunity Set


Cross-sectional differences in the investment opportunity set lead to dif-
ferences in the optimality of alternative financing, dividend, and compen-
sation policies. 3,4 This is a verification of Myers' 5 prediction that the larger
the proportion of firm value represented by growth options (i.e., the lower
the assets-in-place), the lower the firm's leverage, and the higher its equity-
to-value ratio. Like call options on securities, the investment opportunity
set (or growth options) represents real value and profit potential to the
firms that possess it.6 Its value, estimated by a comparison of the capitalized
value of the firm's current earnings stream and the market value of the
firm's equity, is half or more of the market value of equity of many firms,
and about 70 to 80% in industries with high demand volatility.7 More
recently, Pindyck8 showed that the fraction of market value attributable to
the value of capital in place should be only one-half or less for firms with
reasonable demand volatility. He specifically argued that if the demand
volatility is 0.2 or more, more than half of the firm's value is accounted
for by its growth opportunities. Similarly, Miles9 found that the beta of
these growth options depends on the profitability of future investment, the
quantity of future investments, and the firm's own instantaneous return
variance. In addition, two seminal papers from financial economics com-
bine to provide a theoretical framework for describing the investment
opportunity set. Myers 10 depicts firm value as a combination of income-
generating assets-in-place (Va) and growth opportunities (Vg).

Firms with more assets-in-place have less of their value determined by


growth opportunities and vice versa.
Myers' concept of firm value is consistent with that of Miller and Mo-
digliani11 (MM), who modeled the value of firm based upon (1) the market
rate of return, (2) the earning power of assets-in-place, and (3) the oppor-
tunities for making additional investments in real assets that will yield more
than the normal rate of return (i.e., growth opportunities). MM's Equation
(12) (using their notation) shows the value of the firm (V) at time 0:

where X(0) are earnings from assets-in-place, n is the cost of capital, n* is


some internal rate of return that exceeds w, and I is investment made at
time t. The second right-hand-section term encompasses Myers' growth
Multinationality and Profitability 71

term (Vg) and is what is commonly called the investment opportunity set
(IOS). Holding firm value constant, the two right-hand-section terms are
inversely related. This is the "normal" view of growth firms, forgoing earn-
ings from assets-in-place [X(0)] in the first term, by plowing them back into
investment (I) in the second term. A recent example is the wireless com-
munications industry during the 1980s, showing consistently depressed
earnings (and losses) due to significant investments, which combined to
result in rapidly increasing firm value. Since both the first and second right-
hand-section terms should be correlated with firm value, they are correlated
with each other. Accordingly:

Hypothesis 1: There is a positive relationship between the investment


opportunity set and profitability.

Multinationality and the Investment Opportunity Set


The multinational firm is a collection of valuable options and generates
profits that enhance its value. The arbitrage benefits result from (a) the
exploitation of various institutional imperfections; (b) timing options; (c)
technology options; and (d) staging options. 12,13 Better financing bargains 14
as well as capital availability15 are also possible through internationaliza-
tion. In addition, multinational firms can achieve arbitrage benefits in fi-
nancing cash flows by (a) exploiting financial bargains; (b) reducing taxes
on financial flows; and (c) mitigating risks or shifting them to agents with
a comparative advantage in bearing them.16 This definition of multination-
ality as a collection of options and arbitrage benefits suggests a positive
relation with growth options as defined by the investment opportunity set.
More growth options are more likely to result from increased internation-
alization. Accordingly:

Hypothesis 2: There is a positive relation between the investment op-


portunity set and multinationality.

METHODS

Data Analysis and Sample


A multiple regression was used to test the relationship between the in-
vestment opportunity set on one hand and profitability and multination-
ality on the other hand. The model's control variables are size, annual
percentage changes in gross national product (GNP), annual inflation rate,
and the index of business formation.
The sample consisted of all the firms included in Forbes3 Most Inter-
72 Accounting and the Investment Opportunity Set

national 100 American Manufacturing and Service Firms for the 1987-
1992 period.

Measuring Multinationality
Previous research has attempted to measure three attributes of the degree
of multinationality:

1. Performance in terms of what goes on overseas.17


2. Structure in terms of how resources are used overseas.18
3. Attitude or conduct in terms of what is top management orientation.19

Nine measures were identified to include: (1) foreign sales as a percentage


of total sales (FSTS), (2) research and development intensity (RDI), (3)
advertising intensity (AI), (4) export sales as a percentage of total sales
(ESTS), (5) foreign profits as a percentage of total profits (FPTP), (6) foreign
assets over total assets (FATA), (7) overseas subsidiaries as a percentage of
total subsidiaries (OSTS), (8) top management's international experience
(TMIE), and (9) psychic dispersion of international operations (PDIO).20
Of these nine measures, an item-total analysis showed the five variables of
FSTS, FATA, OSTS, PDIO, and TMIE to have a high reliability in the
construction of a homogeneous measure of multinationality. 21 We follow
a similar approach in this study, using an ensemble of variables to measure
multinationality. Three measures of multinationality generally available are
used in this study: foreign sales/total sales (FSTS), foreign profits/total prof-
its (FPTP), and foreign assets/total assets (FATA). Descriptive statistics and
correlations among the three measures of multinationality are shown in
Exhibit 4.1. Correlations among the variables are positive, and with one
exception, all are significant. The nonsignificant correlation is between
FPTP and FATA. The low correlations between FPTP, FSTS, and FATA
indicate that each variable can make a unique contribution as a measure
of multinationality. To obtain a unique contribution, a factor analysis is
used to isolate the factor common to the three measures of multinationality.
All the observations were subjected to factor analysis and one common
factor was found to explain the intercorrelations among the three individ-
ual measures. 22 Exhibit 4.2 reports the results of the common factor anal-
ysis. One common factor appears to explain the intercorrelations among
the three variables, as the first eigenvalue alone exceeds the sum of the
commonalities. The common factor is significantly and positively correlated
with the three measures. 23 As pointed out earlier, based on these factor
scores, high multinationality firms were chosen from the top 2 5 % of the
Multinationality and Profitability 73

Exhibit 4.1
Descriptive Statistics and Correlation of Three Measures of Multinationality for
Forbes' The Most International 100 U.S. Firms for the 1987-1992 Period
Panel A: Descriptive Statistics

pp/Xpa FS/TSb FA/TAC


Maximum 914.3 93 91
Third Quartile 61.9 47.4 41.4
Median 41.3 36.7 30.5
First Quartile 25 25.7 22.6
Minimum 0.2 6.6 2.7
Mean 52.81 37.45 39.92

Panel B: Correlations

1 FP/TP
FP/TP
1.000
FS/TS FA/TA

FS/TS 0.280 1.000


FA/TA 0.034 0.193* 1.000

* Denotes p-value < 0.05.


a
FP/TP = Foreign profits/total profits.
b
FS/TS = Foreign sales/total sales.
C
FA/TA = Foreign assets/total assets.

distribution factor scores while low multinationality firms were chosen


from the bottom 2 5 % of the distribution factor scores.

Measuring the Investment Opportunity Set


Because the investment opportunity set is not observable there has not
been a consensus on an appropriate proxy variable. Similar to Smith and
Watts 24 and Gaver and Gaver,25 we use an ensemble of variables to measure
the investment opportunity set. The three measures of the investment op-
Exhibit 4.2
Selected Statistics Related to a Common Factor Analysis of Three Measures of
Multinationality for Forbes' The Most International 100 U.S. Firms for the
1987-1992 Period

1. Eigenvalues of the Correlation Matrix:

Eigenvalues 1 23

1.3615 0.9680 0.6705

2. Factor Pattern

FACTOR1

FS/TS 0.80529

FP/TP 0.50172

FA/TA 0.67918

3. Final Communality Estimates: Total = 1.361489

FS/TS FP/TP FA/TA

0.648491 0.251718 0.461280

4. Standardized Scoring Coefficients

FACTOR1

FS/TS 0.59148

FP/TP 0.36850

FA/TA 0.49885

5. Descriptive Statistics of the Common Factor Extracted from the Three Measures of

Multinationality

Maximum 2039.24

Third Quartile 74.70

Median 57.03

First Quartile 4 0.76

Minimum 5.17

Mean 64.35
Multinationality and Profitability 75

portunity set used are: market-to-book assets (MASS), market-to-book en-


tity (MQV), and the earnings/price ratio (EP). These variables are defined
as follows:

MASS = (Assets Total Common Equity + Shares Outstanding*Share Closing


Price )/Assets
MQV = (Shares Outstanding*Share Closing Price)/Total Common Equity
EP = (Primary EPS before Extraordinary Items)/Share Closing Price

Descriptive statistics and correlations among the three measures of the


investment opportunity set are shown in Exhibit 4.3. Correlations among
the three variables are significant. The low correlations indicate that each
variable makes a unique contribution as a measure of the investment op-
portunity set. The results of the factor analysis are shown in Exhibit 4.4.
One common factor appears to explain the intercorrelations among the
three individual measures. As pointed out earlier, based on these factor
scores, high growth firms were chosen from the top 2 5 % of the distribution
scores while low growth firms were chosen from the bottom 2 5 % of the
distribution factor scores.

Profitability
The central profitability measure used in this study is a time series of the
rate of return on assets over the 1987-1992 period. It is computed as fol-
lows:

Rate of Return on Assets (ROA) = Net Profit/Total Assets

Conditioning Firm and Economy Variables


In the logarithm of total assets, annual percentage change in gross na-
tional product and inflation rate, and an index of net business formation
were used as conditioning variables. The logarithm of total assets was used
to control for size. The annual percentage change in gross national product
and in inflation rate as well as the index of business formation controlled
for changes in growth opportunities related to major external shifts in ag-
gregate demand and provided an analysis conditioned by macroeconomic
variables. The macroeconomic variables were obtained from the Economic
Report of the President.26
76 Accounting and the Investment Opportunity Set

Exhibit 4.3
Descriptive Statistics and Correlation of Three Measures of the Investment
Opportunity Set for Forbes9 The Most International 100 U.S. Firms for the
1987-1992 Period
Panel A: Descriptive Statistics

MASS MQV EP
Maximum 6.4943 60 0.5175
1 Third Quartile 1.8556 3.1851 0.1081
I Median 1.2905 1.9090 0.0713
I First Quartile 1.0618 1.2666 0.0482
1 Minimum 0.8745 4.3333 2.1536
[ Mean 0.3081 2.7020 0.0638

Panel B: Correlation

MASS MQV EP
Mass 1.000
MQV 0.0399** 1.000
i EP 0.0158** 0.0230** 1.000

'Denotes /?-value < 0.01.


** Denotes p-value < 0.05.
a
MASS = Market-to-book assets.
b
MQV = Market-to-book equity.
C
EP = Earnings/price ratio.

RESULTS AND DISCUSSION


Exhibit 4.5 presents the results of the regression between the investment
opportunity set index on one hand and the index of multinationality and
rate of return on assets on the other hand. Size, annual percentage changes
in GNP and inflation, and the index of business formation are used as
Exhibit 4.4
Selected Statistics Related to a Common Factor Analysis of Three Measures of
the Investment Opportunity Set for Forbes' The Most International 100 U.S.
Firms for the 1987-1992 Period

1. Eigenvalues of the Correlation Matrix: Total = 3 Average = 1

Eigenvalue 1 2 3

1.0540 0.9868 0.9592

2. Factor Pattern

FACTOR1

MASS 0.62821

MQV 0.66411

EP 0.46722

3. Final Communality Estimates: Total = 1.053994

MASS MQV EP

0.394651 0.441045 0.218299

4. Standardized Scoring Coefficients

FACTOR1

MASS 0.59603

MQV 0.63009

EP 0.44329

5. Descriptive Statistics of the Common Factor Extractedfromthe Three Measures of the

Investment Opportunity

Maximum 9.3595

Third Quartile 3.2200

Median 2.0450

First Quartile 1.5085

Minimum 2.5209

Mean 1.9812
78 Accounting and the Investment Opportunity Set

Exhibit 4.5
Regression Results for Rate of Return on Assets

Sources Coefficient P
Intercept 74.458 2.780*

Index of Multinationality 0.8942 2.358*


Rate of Return on Assets 19.273 5.085*
Conditioning Variables
Size (Log of Assets) -0.421 -2.462*
I Annual Percentage Changes 1.2052 2.133**

I in GNP
Annual Percentage Changes 3.1233 2.589*

in Inflation
Index of Business -0.6917 -2.576*

Formation

F 13.607*

! R2 0.2418

* Significant at a 0.01 level.


**Significant at a 0.05 level.

conditioning variables. The overall model is significant (F = 13.607, p


0.001) and explains 24.18% of the variations in the investment opportunity
set index. As hypothesized, both the index of multinationality and the rate
of return on assets are significantly and positively related to the index rep-
resenting the investment opportunity set. In addition, all the conditioning
variables are significantly related to the investment opportunity set.
The results point to the salient role of multinationality and profitability
in creating growth opportunities to the firm. Basically, the higher the mul-
tinationality and the profitability the higher the growth opportunities to
the firm as defined by the investment opportunity set. Multinationality pres-
ents the ideal context for the creation of valuable options and benefits that
Multinationality and Profitability 79

define the growth opportunities of the investment opportunity set. Simi-


larly, profitability defines the quality and quantity of future investments
that also define the growth opportunities of the investment opportunity set.
Future research needs to correct for some of the limitations of this study.
First, the sample may not be limited to Forbes' Most International Firms.
Second, other proxy variables for multinationality and the investment op-
portunity set may be used. Finally, other explanatory variables besides mul-
tinationality and profitability should be included as potential determinants
of the investment opportunity set.

NOTES
1. Myers, S., "Determinants of Corporate Borrowing," Journal of Financial
Economics (1977): pp. 147-175.
2. Kester, W. C , "Today's Options for Tomorrow's Growth," Harvard Busi-
ness Review (March-April 1984): 153-160.
3. Gaver, J.J. and K. M. Gaver, "Additional Evidence on the Association be-
tween the Investment Opportunity Set and Corporate Financing, Dividend, and
Compensation Policies," Journal of Accounting and Economics (1993): pp. 125-
160.
4. Smith, C. W. and R. L. Watts, "The Investment Opportunity Set and Cor-
porate Financing, Dividend and Compensation Policies," Journal of Financial Eco-
nomics (1992): pp. 263-292.
5. Myers, "Determinants of Corporate Borrowing"; Kester, "Today's Options
for Tomorrow's Growth."
6. Kester, "Today's Options for Tomorrow's Growth."
7. Kester, W. C , "An Options Approach to Corporate Finance," in Handbook
of Corporate Finance, 2d ed., E. Altman (ed.), Wiley, New York, 1986.
8. Pindyck, R., "Irreversible Investment, Capacity Choice, and the Value of the
Firm," American Economic Review (1988): pp. 969-985.
9. Miles, J. A., "Growth Options and the Real Determinants of Systematic
Risk," Journal of Business Finance and Accounting 13 (1986): pp. 411-433.
10. Myers, "Determinants of Corporate Borrowing."
11. Miller, Merton H. and Franco Modigliani, "Dividend Policy, Growth, and
the Valuation of Shares," Journal of Business (1961): pp. 411-433.
12. Baldwin, C , "The Capital Factor: Competition for Capital in Global Envi-
ronment," (1986) in Dunning, John H. "Reappraising the Eclectic Paradigm in an
Age of Alliance Capitalism," Journal of International Business Studies (1995):
pp. 461-492.
13. Kogut, Bruce, "Foreign Direct Investment as a Sequential Process," in C.
Kindelberger and D. Andretsh (eds.), The Multinational Corporation in the 1980's,
MIT Press, Cambridge, MA, (1983): pp. 38-56.
14. Giavazzi and Giovannini, Limiting Exchange Rate Flexibility: The European
Monetary System, Cambridge, MA: MIT Press, 1989.
15. Eiteman, D. and A. Stonehill, Multinational Business Finance, Addison-
Wesley, Boston, 1986.
80 Accounting and the Investment Opportunity Set

16. Ibid.
17. Tsetsekos, George P., "Multinationality and Common Stock Offering," Jour-
nal of International Financial Management and Accounting 3 (1991): 1-16.
18. Dunning, John, "Reappraising the Eclectic Paradigm in an Age of Alliance
Capitalism," Journal of International Business Studies 26 (1995): pp. 461-492.
19. Stopford, John M. and Louis T. Wells, Managing the Multinational Enter-
prise, Basic Books, New York, 1972.
20. Perlmutter, H. V., "The Tortuous Evaluation of the Multinational Corpo-
ration," Columbia Journal of World Business 4 (1969): pp. 9-18.
21. Sullivan, Daniel, "Measuring the Degree of Internationalization of a Firm,"
Journal of International Business Studies (1994): pp. 325-334.
22. Ibid.
23. Hartman, H. H., Modern Factor Analysis, 3d ed., University of Chicago
Press, Chicago, 1976.
24. Smith and Watts, "The Investment Opportunity Set and Corporate Financ-
ing."
25. Gaver and Gaver, "Additional Evidence on the Association between the In-
vestment Opportunity Set and Corporate Financing."
26. Economic Report of the President, United States Government Printing Office,
Washington, DC, 1995.

REFERENCES
Dunning, John. "Reappraising the Eclectic Paradigm in an Age of Alliance Capi-
talism." Journal of International Business Studies 26 (1995): 461-492.
Economic Report of the President. Washington, DC: United States Government
Printing Office, 1995.
Eiteman, D. and A. Stonehill. Multinational Business Finance. Boston: Addison-
Wesley, 1986.
Gaver, J. J. and K. M. Gaver. "Additional Evidence on the Association between the
Investment Opportunity Set and Corporate Financing, Dividend, and Com-
pensation Policies." Journal of Accounting and Economics (1993): 125-160.
Giavazzi, F. and A. Giovannini. Limiting Exchange Rate Flexibility: The European
Monetary System. Cambridge, MA: MIT Press, 1989.
Hartman, H. H. Modern Factor Analysis, 3d ed. Chicago: University of Chicago
Press, 1976.
Kester, W. C. "Today's Options for Tomorrow's Growth." Harvard Business Re-
view (March-April 1984): 153-160.
. "An Options Approach to Corporate Finance," in Handbook of Corporate
Finance, 2d ed. E. Altman (ed.)., New York: Wiley, 1986.
Kogut, Bruce. "Foreign Direct Investment as a Sequential Process," in The Multi-
national Corporation in the 1980's. C. Kindelberger and D. Andretsh (eds.).
Cambridge, MA: MIT Press, 1983: 38-56.
. "Designing Global Strategies: Profiting from Operational Flexibility." Sloan
Management Review (1985): 27-38.
Miles, J. A. "Growth Options and the Real Determinants of Systematic Risk." Jour-
nal of Business Finance and Accounting 13 (1986): 95-106.
Multinationality and Profitability 81

Miller, Merton H. and Franco Modigliani. "Dividend Policy, Growth, and the Val-
uation of Shares." Journal of Business (1961): 441-433.
Myers, S. "Determinants of Corporate Borrowing." Journal of Financial Economics
(1977): 147-175.
Perlmutter, H. V. "The Tortuous Evaluation of the Multinational Corporation."
Columbia Journal of World Business 4 (1969): 9-18.
Pindyck, R. "Uncertainty and Exhaustible Resource Market." Journal of Political
Economy (1980): 1203-1225.
. "Irreversible Investment, Capacity Choice, and the Value of the Firm."
American Economic Review (1988): 969-985.
Smith, C. W. and R. L. Watts. "The Investment Opportunity Set and Corporate
Financing, Dividend and Compensation Policies." Journal of Financial Eco-
nomics (1992): 263-292.
Stopford, John M. and Louis T. Wells. Managing the Multinational Enterprise.
New York: Basic Books, 1972.
Sullivan, Daniel. "Measuring the Degree of Internationalization of a Firm." Journal
of International Business Studies (1994): 325-334.
Tsetsekos, George P. "Multinationality and Common Stock Offering." Journal of
International Financial Management and Accounting 3 (1991): 1-16.
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5

The Role of the Investment


Opportunity Set in Corporate
Financing

INTRODUCTION
This chapter examines the association between the investment opportunity
set and corporate financing given different levels of multinationality. The-
ories of corporate financing often have emphasized the various roles of
debt, including the tax advantage of debt, the choice of debt level to signal
firm quality, 1,2 the use of debt as an antitakeover device,3 the agency costs
of debt,4-5 and the usefulness of debt for restricting a managerial discretion.6
There is, however, no consensus about which determinants have an impact
on the capital-structure decision, or how they affect performance.7 These
theories suggest that the firm's choice of capital structure is a function of
attributes that determine the various costs and benefits associated with debt
and equity financing.8 These attributes include the collateral value of as-
sets,9' 10 nondebt tax shields,11 growth, 12-14 uniqueness,15 firm size, 16 ' 17 in-
dustry classification,18'19 volatility,20 and profitability.21' 22 We agree that
Barton and Gordon's 23 suggestion to employ a managerial perspective will
add to the understanding of the capital-structure decision. A similar per-
spective has been implied by several financial theorists who are (1) frus-
trated by the lack of understanding of the issue,24 or by the "absurd" results
that some theories may imply,25 and (2) interested in the exploration of
behavior beyond what is allowed by mathematical modeling,26 interested
in the role of top management in the capital structure decision,27-30 or
concerned that multiple objectives and contextual factors that are not fi-
nancial in nature may be important to the problem. 31 ' 32
84 Accounting and the Investment Opportunity Set

Specifically, we test whether the investment opportunity set is associated


with corporate financing, and whether such association varies over firms
with different levels of multinationality. The analysis is conducted at the
firm level to allow for more powerful tests than at the industry level. In
addition, composite measures of multinationality and the investment op-
portunity set are used to reduce classification errors in both variables.
Specifically, a common factor analysis is used to create an index of multi-
nationality (IOM) and an index of investment opportunity set (IOS). A
covariance analysis of the market debt/equity of our sample firms suggests
that the investment opportunity set creates different corporate financing in
firms that vary in terms of multinationality after controlling for size,
changes in GNP, inflation rate, and the index of business formation. In
general the findings support a contingency view of the association between
the investment opportunity set and corporate financing.

BACKGROUND AND HYPOTHESES

Corporate Financing and the Investment Opportunity Set


The firms may be viewed as a combination of assets in place and future
investment options. The lower the proportion of firm value represented by
assets-in-place, the higher the proportion of firm value represented by
growth opportunities. Myers 33 argued that for firms with growth oppor-
tunities in their investment opportunity sets, the existence of risky debt,
maturing after the investment option, causes the firm to forgo profitable
investment, resulting in an underinvestment scenario. Growth firms tend to
issue less debt than firms without growth opportunities. As a result, em-
pirical research in finance and accounting examining the cross-sectional
differences in major corporate policy decisions relies on contracting-cost
explanations and presents empirical evidence regarding the relation be-
tween the investment opportunity set and financing policies. 34,35 More ev-
idence is provided in this chapter.

Hypothesis 1: Growth firms have lower debt/equity than nongrowth


firms.

Corporate Financing and Multinationality


Firms make investment in physical and human capital internationally,
thus determining level of multinationality. Myers' theory can be expanded
to explain how international conditions can lead a multinational corpora-
tion to either accelerate the shift from one financing method to the next or
rearrange the pecking order.36 A situation characterized by lower country
risk, higher interest rates, expected strength of host country currency,
Corporate Financing 85

blocked funds, and lower withholding and corporate taxes calls for a higher
amount of external debt financing by the parent and a lower amount by
the subsidiary, and vice versa. Where internal funding is not available to
the parent, the same conditions that encourage use of debt financing by the
subsidiary will result in a more debt-intensive capital structure for the mul-
tinational firm.37 An alternative explanation for the higher debt of multi-
national firms is that multinational firms, having diversified cash flows, may
be able to support more debt. Accordingly:

Hypothesis 2: High multinationality firms have higher debt/equity ra-


tios than low multinationality firms.

METHOD

Data Analysis
Covariance analysis was used to test the overall relation between: (1)
corporate financing and the investment opportunity set, (2) corporate fi-
nancing and multinationality, and (3) the interaction of corporate financ-
ing, multinationality, and the investment opportunity set. The control
variables are size, annual percentage changes in gross national product
(GNP) as well as inflation rate, and the index of business formation.

Selection of Firms
The population consists of firms included in Forbes'' Most International
100 American Manufacturing and Service Firms for the 1987-1992 period.
The sample consists of firms that are either high on multinationality and
investment opportunity set or low on both variables. Common factor anal-
yses were used to create an index of multinationality (IOM) and an in-
dex of investment opportunity set (IOS). Firm-year observations in the
top quartiles of both indices were partioned in a high-growth, high-
multinationality subsample and firm-year observations in the bottom quar-
tile of both indices were classified in a low-growth, low-multinationality
subsample. The first subsample of high growth, high multinationality in-
cluded 80 firm-year observations while the second sample of low growth,
low multinationality included 121 firm-year observations.

Measuring Multinationality
Previous research has attempted to measure the following attributes of
multinationality:
86 Accounting and the Investment Opportunity Set

1. Performancein terms of what goes on overseas.38


2. Structurein terms of resources used overseas.39
3. Attitude or Conductin terms of what is top management's orientation.40 Sul-
livan41 developed nine measures of which five were shown to have a high reli-
ability in the construction of a homogeneous measure of nationality: (1) foreign
sales as a percentage of total sales (FSTS), (2) foreign assets over total assets
(FATA), (3) overseas subsidiaries as a percentage of total subsidiaries (OSTS),
(4) top management's international experience (TMIE), and (5) psychic disper-
sion of international operations (PDIO).

In this study we measure multinationality through three measures: (1)


foreign sales/total sales (FSTS), (2) foreign profits/total profits (FPTP), and
(3) foreign assets/total assets (FATA).42
Descriptive statistics and correlations among the three multinationality
measures are shown in Exhibit 5.1. Correlations among the variables are
positive, and with one exception, all significant. The nonsignificant corre-
lation is between FPTP and FATA. The low correlations between FPTP,
FSTS, and FATA indicate that each variable can make a unique contribu-
tion as a multinationality measure. Thus, a factor analysis of all observa-
tions is used to isolate the factor common to the three measures. Exhibit
5.2 reports the results. One common factor appears in the intercorrelations
among the three variables, as the first eigenvalue value alone exceeds the
sum of the commonalities. The common factor is significantly positively
correlated with the three measures. As pointed out earlier, based on these
factor scores, high multinationality firms were chosen from the top 2 5 %
of the distribution factor scores while low multinationality firms were cho-
sen from the bottom 2 5 % of the distribution factor scores.

Measuring the Investment Opportunity Set


Because the investment opportunity set is not observable, there has not
been a consensus in an appropriate proxy variable. Similar to Smith and
Watts 43 and Gaver and Gaver,44 we use a set of three variables to measure
the investment opportunity set: market-to-book assets (MASS), market-to-
book equity (MQV), and the earnings/price ratio (EP). These variables are
defined as follows:

MASS = (Assets - Total Common Equity + Shares Outstanding X Share Closing


Price)/Assets
MQV = (Shares Outstanding X Share Closing Price)/Total Common Equity
EP = (Primary EPS before Extraordinary Items)/Share Closing Price.
Corporate Financing 87

Exhibit 5.1
Descriptive Statistics and Correlation of Three Measures of Multinationality for
Forbes' The Most International 100 U.S. Firms for the 1987-1992 Period

Panel A: Descriptive Statistics

FP/TP* FS/TSb FA/TAC


| Maximum 914.3 93 91
| Third Quantile 61.9 47.4 41.4
| Median 41.3 36.7 30.5
First Quantile 25 25.7 22.6
| Minimum 0.2 6.6 2.7
|| Mean 52.81 37.45 39.92

Panel B: Correlations

FP/TP FS/TS FATA


FP/TP 1.000
FS/TS 0.280 1.000
FA/TA 0.034 0.193* 1.000

* Denotes p-value < 0.05.


a
FP/TP = Foreign profits/total profits.
h
FS/TS = Foreign sales/total sales.
C
FA/TA = Foreign assets/total assets.

Descriptive statistics and correlation among the three measures of the


investment opportunity set are shown in Exhibit 5.3. Correlations a m o n g
the three variables are significant. The low correlations indicate that each
variable makes a unique contribution as a measure of the investment op-
portunity set. The results of the factor analysis are shown in Exhibit 5.4.
O n e c o m m o n factor appears to explain the interrelations a m o n g the three
individual measures. Based on these factor scores, high growth firms were
chosen from the top 2 5 % of the distribution factor scores while low growth
firms were chosen from the bottom 2 5 % of the distribution factor scores.
88 Accounting and the Investment Opportunity Set

Exhibit 5.2
Selected Statistics Related to a Common Factor Analysis of Three Measures of
Multinationality for Forbes' The Most International 100 U.S. Firms for the
1987-1992 Period

1. Eigenvalues of the Correlation Matrix:

Eigenvalues 1 2 3

1.3615 0.9680 0.6705

2. Factor Pattern

FACTOR1 FS/TS FP/TP FA/TA

0.80529 0.50172 0.67918

3. Final Communality Estimates: Total1=1.361489


= 1.361489

FS/TS FP/TP FA/TA

0.648491 0.251718 0.461280

4. Standardized Scoring Coefficients

FACTOR1 FS/TS FP/TP FA/TA

0.59148 0.36850 0.49885

5. Descriptive Statistics of the Common Factor Extracted from the Three Measures of

Multinationality:

Maximum 2039.24 Third Quartile 74.70

Median 57.03 First Quartile 40.76

Minimum 5.17 Mean 64.35

C o r p o r a t e Financing

The central corporate financing measure used in this study was a time
series of the ratio of market debt to equity over the 1 9 8 7 - 1 9 9 2 period,
computed as follows:

Market Debt/Equity = Total Liabilities/(Shares Outstanding X Share


Closing Price)
Exhibit 5.3
Descriptive Statistics and Correlation of Three Measures of the Investment
Opportunity Set for Forbes' The Most International 100 U.S. Firms for the
1987-1992 Period

Panel A: Descriptive Statistics

MASS MQV EP
Maximum 6.4943 60 0.5175
Third Quartile 1.8556 3.1851 0.1081
Median 1.2905 1.9090 0.0713
First Quartile 1.0618 1.2666 0.0482
Minimum 0.8745 0.3333 0.1536
Mean 0.3081 2.7020 0.0638

Panel B: Correlations

MASS MQV EP
Mass 1.000
MQV 0.0399** 1.000
EP 0.0158** 0.0230** 1.000

**Denotes p-value < 0.05.


a
MASS = Market-to-Book Assets.
b
MQV = Market-to-Book Equity.
C
EP = Earnings/Price Ratio.
Exhibit 5.4
Selected Statistics Related to a Common Factor Analysis of Three Measures of
the Investment Opportunity Set for Forbes' The Most International 100 U.S.
Firms for the 1987-1992 Period
1. Eigenvalues of the Correlation Matrix

Eigenvalue 1 2 3

1.0540 0.9868 0.9592

2. Factor Pattern

FACTOR1

MASS MQV EP

0.62821 0.66411 0.46722

3. Final Communality Estimates: Total = 1.053994

MASS MQV EP

0.394651 0.441045 0.218299

4. Standardized Scoring Coefficients

FACTOR1

MASS MQV EP

0.59603 0.63009 0.44329

5. Descriptive Statistics of the Common Factor Extractedfromthe Three Measures of the

Investment Oprx>rtiinity

Maximum 9.3595

Third Quartile 3.2200

Median 2.0450

First Quartile 1.5085

Minimum 2.5209

Means 1.9812
Corporate Financing 91

Exhibit 5.5
Results of Overall Analysis of Covariance for Market Debt-to-Equity Ratio

Sources F P
Multinationality 13.62 0.0003

Investment Opportunity Set 88.06 0.0001


Interaction 10.34 0.0025
Covariates
| Size (Log of Assets) 69.21 0.0001
Annual Percentage Changes 0.08 0.7715

in GNP
Annual Percentage Changes 2.95 0.0875

in Inflation
Index of Business 0.23 0.6337

Formation

Covariates
Covariates included: the logarithm of total assets, annual percentage
changes in gross national product and in inflation rate, and an index of net
business formation. The logarithm of total assets was used to control for
size. The other three covariates controlled for changes in corporate financ-
ing related to major shifts in aggregate demand. They also resulted in an
analysis conditioned by macroeconomic variables. The macroeconomic var-
iables were obtained from the Economic Report of the President.45

RESULTS
The effects on corporate financing of multinationality, the investment
opportunity set, and their interaction are first examined by an F-test of the
difference between variances after controlling for the covariates.
Exhibit 5.5 presents the results of the covariance analysis for market
debt/equity. The overall analysis of covariance is statistically significant (F
(7,200) = 4.30, p = 0.0002, and R2 = 0.13). A further nondirectional F-
92 Accounting and the Investment Opportunity Set

Exhibit 5.6
Comparisons of the Debt-to-Equity Ratio by Multinationality and Growth
Panel A:

By Multinationality

Treatment Mean Standard t-Probability


Deviation

1. High 11.6732 1.1741 0.0003

Multinationality

2. Low 5.9107 1.0340

Multinationality

Panel B:
By Growth

Treatment Mean Standard Deviation t-Probability

1. High 6.3886 1.3492 0.0164

Growth

2. Low 11.2153 1.1889

Growth

test for differences in variance indicates that: (1) multinationality leads to


a different capital structure, and (2) the investment opportunity set of the
sample firms is associated with cross-sectional differences in capital struc-
ture. A third interesting result is the significant interaction effect, which
implies the investment opportunity set has a different impact depending on
the multinationality level. The significance level of the covariates indicates
that only size and the annual percentage changes in inflation are important
controls.
Exhibit 5.6 presents the results of the mean comparisons of the debt-to-
equity ratio by growth type and multinationality type. Hypothesis 1 states
Corporate Financing 93

that growth firms have a lower debt-to-equity ratio than nongrowth firms.
This is supported by the results in Exhibit 5.6, which show a significant
difference between the debt/equity of high growth firms (6.3686) and the
debt/equity of low growth firms (11.215). H2 states that high multination-
ality firms have a higher debt to equity ratio than low multinationality
firms. This is also supported by the results in Exhibit 5.6 which show a
significant difference between the high multinationality firms (11.6732) and
the low multinationality firms (5.9107).
Exhibit 5.7 presents the interaction effects of means and graphically il-
lustrates that significant difference between the debt-to-equity ratio of high
growth firms and low growth firms (as stated in Hypothesis 1) holds under
both high multinationality and low multinationality conditions, but at an
increased level for high multinationality (as hypothesized in Hypothesis 2).

DISCUSSION
Our central proposition is that the investment opportunity set is associ-
ated with different capital structures in firms that have different levels of
multinationality. The results support this contingency view of the relation
between the investment opportunity set and corporate financing.
Hypothesis 1 was confirmed: growth firms have lower debt-to-equity ra-
tios than nongrowth firms. Consistent with Smith and Watts 46 and Gaver
and Gaver,47 these results suggest that contracting-cost explanations for
corporate financing imply these decisions depend on the firm's investment
opportunity set. Variation in the investment opportunity set leads to dif-
ferences in the optimality of corporate financing with growth firms pur-
suing a lower debt-to-equity ratio than nongrowth firms.
Hypothesis 2 was confirmed; high multinationality firms have higher
debt/equity than low multinationality firms. Multinational conditions call
for a more debt-intensive capital structure.
The results also show a link between capital structure, the investment
opportunity set, and multinationality. At different multinationality levels,
different investment opportunity sets influence capital structure strategies.
These results complement and add to the strategic-growth paradigm. 48
Based on a firm's heterogeneous capabilities and resources, the strategic-
group paradigm enables researchers and practioners to consolidate indus-
trial firms into sets of similar competitors, the so-called strategic groups.
While a more comprehensive review of the literature is provided by McGee
and Thomas, 49 Thomas and Venkatraman, 50 and Barney and Hoskisson, 51
the results of this study indicate that the strategic linkages between multi-
nationality and the investment opportunity set need to be taken into ac-
count in the formation of strategic groups. Better strategic groups could be
identified by a simultaneous consideration of multinationality and the in-
vestment opportunity set.
94 Accounting and the Investment Opportunity Set

Exhibit 5.7
Mean Comparisons of Market Debt-to-Equity Means by Multinationality and by
Investment Opportunity Sets and ^-Probabilities
Panel A: Means

I Treatments High Multinationality Low Multinationality


| 1. High Investment 7.9052 4.8320

| Opportunity Set
1 2. Low Investment 15.4411 6.9895

I Opportunity Set

Panel B: t-Probability of Mean Comparisons

1 Treatments l.Low 2. Low 3. High 4. High


Multinationality/ Multinationality/ Multinationality/ Multinationality/
Low Investment High Investment Low Investment High Investment
Opportunity Set Opportunity Set Opportunity Set Opportunity Set

1 1. Low
1 Multinationality/
Low Investment
Opportunity Set
2. Low 0.0520
Multinationality/
High Investment
Opportunity Set
3. High 0.0001 0.0002
Multinationality/
Low Investment
Opportunity Set

4. High 0.0884 0.0870 0.0073


Multinationality/
High Investment
Opportunity Set

Additional research is needed to verify the results of this study and test
questions that it raises. Replication needs to consider using different data
and different measures of multinationality and investment opportunity set,
as well as using a control group of essentially domestic firms. Until further
research is completed, the results of the leverage differences must be inter-
preted with caution.
Corporate Financing 95

NOTES
1. Modigliani, F. and M. H. Miller, "Corporate Income Taxes and the Cost of
Capital: A Correction," American Economic Review 3 (1963): pp. 433-443.
2. Ross, S. A., "The Determination of Financial Structure: The Incentive-
Signaling Approach," Bell Journal of Economics 8 (1977): pp. 23-40.
3. Leland, H. and D. Pyle, "Informational Asymmetries, Financial Structure,
and Financial Intermediation," Journal of Finance 32 (1977): pp. 371-387.
4. Harris, M. and A. Raviv, "Corporate Control Contests and Capital Struc-
ture," Journal of Financial Economics 20 (1988): pp. 55-86.
5. Jensen, M. C. and W. H., Meckling, "Theory of the Firm: Managerial Be-
havior Agency Costs and Ownership Structure," Journal of Financial Economics 3
(1976): pp. 305-360.
6. Myers, S. C , "Determinants of Corporate Borrowing," Journal of Financial
Economics 5 (1977): pp. 147-176.
7. Jensen, M. C , "Agency Costs of Free Cash Flow, Corporate Finance, and
Takeovers," American Economic Review 76 (1986): pp. 323-329.
8. Titman, S. and R. Wessels, "The Determinants of Capital Structure Choice,"
Journal of Finance 43 (1988): pp. 1-19.
9. Scott, J., "Bankruptcy, Secured Debt, and Optimal Capital Structure," Jour-
nal of Finance 32 (1977): pp. 1-19.
10. Myers, S. C. and N. Majluf, "Corporate Financing and Investment Decisions
when Firms Have Information Investors Do Not Have," Journal of Financial Eco-
nomics 13 (1984): pp. 187-221.
11. DeAngelo, H. and R. Masulis, "Optimal Capital Structure under Corporate
and Personal Taxation," Journal of Financial Economics 8 (1980): pp. 3-27.
12. Jensen, M. C. and W. H. Meckling, "Theory of the Firm: Managerial Be-
havior Agency Costs and Ownership Structure," Journal of Financial Economics 3
(1976): pp. 305-360.
13. Warner, J., "Bankruptcy Costs: Some Evidence," Journal of Finance 32
(1977): pp. 337-347.
14. Green, R., "Investment Incentives, Debt, and Warrants," Journal of Finan-
cial Economics 12 (1984): pp. 115-135.
15. Titman, S. and R. Wessels, "The Determinants of Capital Structure Choice,"
Journal of Finance 43 (1988): pp. 1-19.
16. Warner, "Bankruptcy Costs."
17. Ang, J., J. Chua, and J. McConnell, "The Administrative Costs of Corporate
Bankruptcy: A Note," Journal of Finance 37 (1982): pp. 219-226.
18. Belkaoui, A., "A Canadian Survey of Financial Structure," Financial Man-
agement 4 (1975): pp. 74-79.
19. Titman, S. and R. Wessels, "The Determinants of Capital Structure Choice,"
Journal of Finance 43 (1988): pp. 1-19.
20. Ibid.
21. Donaldson, G., Corporate Debt Capacity: A Study of Corporate Debt Policy
and the Determinants of Corporate Debt Capacity, Harvard University Graduate
School of Business, Division of Research, Boston, 1961.
22. Brealy, R. and S. Myers, Principles of Corporate Finance, McGraw-Hill,
New York, 1984.
96 Accounting and the Investment Opportunity Set

23. Barton, S. L. and P. J. Gordon, "Corporate Strategy: Useful Perspective for


the Study of Capital Structure?" Academy of Management Review 12 (1987):
pp. 67-75.
24. Meyers, S. C , "Capital Structure Puzzle," Journal of Finance 39 (1984):
pp. 575-591.
25. Ross., S. A., "The Determination of Financial Structure: The Incentive-
Signaling Approach,"'Bell Journal of Economics 8 (1977): pp. 23-40.
26. Hempel, G. H., "Teaching and Research in Finance: Perceptions, Conflicts,
and the Future," Financial Management 12 (1983): pp. 5-10.
27. Donaldson, Corporate Debt Capacity, p. 87.
28. Carleton, W. T., "An Agenda for More Effective Research in Corporate Fi-
nance," Financial Management 4 (1978): p. 79.
29. Walker, E. W. and J. W. Petty, "Financial Differences between Large and
Small Firms," Financial Management 4 (1978): pp. 61-68.
30. Andrews, K. R., The Concept of Corporate Strategy, Irwin, Homewood, IL,
1980.
31. Findlay, M. C. and G. A. Whitmore, "Beyond Shareholder Wealth Maxi-
mation,"Financial Management 4 (1974): pp. 25-35.
32. Carleton, W. T. and L. H. Silberman, "Joint Determination of Rate of Re-
turn and Capital Structure: An Economic Analysis," Journal of Finance 32 (1977):
pp. 811-821.
33. Myers, S. C , "The Capital Structure Puzzle," Journal of Finance 39 (1984):
pp. 575-591.
34. Myers, "Determinants of Corporate Borrowing."
35. Gaver, J. J. and K. M. Gaver, "Additional Evidence on the Association be-
tween the Investment Opportunity Set and Corporate Financing, Dividend, and
Compensation Policies,"Journal of Accounting and Economics 16 (1993): pp. 125-
160.
36. Smith, C. W. and R. L. Watts, "The Investment Opportunity Set and Cor-
porate Financing, Dividend and Compensation Policies,"Journal of Financial Eco-
nomics 32 (1992): pp. 263-292.
37. Madura, Jeff, International Financial Management, West Publishing Com-
pany, St. Paul, MN, 1995.
38. Ibid.
39. Dunning, John H., "Reappraising the Eclectic Paradigm in an Age of Alliance
Capitalism," Journal of International Business Studies, 26 (1995): pp. 461-492.
40. Stopford, John M. and Louis T. Wells, Managing the Multinational Enter-
prise, Basic Books, New York, 1972.
41. Sullivan, D., "Measuring the Degree of Internationalization of a Firm," Jour-
nal of International Business Studies 25 (1994): pp. 325-342.
42. Perlmutter, Howard V., "The Tortuous Evaluation of the Multinational Cor-
poration," Columbia Journal of World Business 4 (January-February 1969): pp. 9 -
18.
43. Smith and Watts, "The Investment Opportunity Set and Corporate Financ-
ing."
44. Gaver and Gaver, "Additional Evidence on the Association between the In-
vestment Opportunity Set and Corporate Financing."
45. Economic Report of the President. United States Government Printing Office,
Washington, DC, 1995.
Corporate Financing 97

46. Smith and Watts, "The Investment Opportunity Set and Corporate Financ-
ing."
47. Gaver and Gaver, "Additional Evidence on the Association between the In-
vestment Opportunity Set and Corporate Financing."
48. Ibid.
49. McGee, J. and H. Thomas, "Strategic Groups: Theory, Research and Tax-
onomy," Strategic Management Journal 7 (1986): pp. 141-160.
50. Thomas, H. and N. Venkatraman, "Research on Strategic Groups: Progress
and Prognosis," Journal of Management Studies 25 (1988): pp. 537-555.
51. Barney, J. B. and R. E. Hoskisson, "Untested Assertions in Strategic Group
Research," Managerial and Decision Economics 11 (1990): pp. 187-198.

REFERENCES
Andrews, K. R. The Concept of Corporate Strategy. Homewood, IL: Irwin, 1980.
Ang, J., J. Chua, and J. McConnell. "The Administrative Costs of Corporate Bank-
ruptcy: A Note." Journal of Finance 37 (1982): 219-226.
Barney, J. B. and R. E. Hoskisson. "Untested Assertions in Strategic Group Re-
search." Managerial and Decision Economics 11 (1990): 187-198.
Barton, S. L. and P. J. Gordon. "Corporate Strategy: Useful Perspective for the
Study of Capital Structure?" Academy of Management Review 12 (1987):
67-75.
Belkaoui, A. "A Canadian Survey of Financial Structure." Financial Management
4 (1975): 74-79.
Brealy, R. and S. Myers. Principles of Corporate Finance. New York: McGraw-
Hill, 1984.
Carleton, W. T. "An Agenda for More Effective Research in Corporate Finance."
Financial Management 4 (1978): 79.
Carleton, W. T. and I. H. Silberman. "Joint Determination of Rate of Return and
Capital Structure: An Economic Analysis." Journal of Finance 32 (1977):
811-821.
DeAngelo, H. and R. Masulis. "Optimal Capital Structure under Corporate and
Personal Taxation." Journal of Financial Economics 8 (1980): 3-27.
Donaldson, G. Corporate Debt Capacity: A Study of Corporate Debt Policy and
the Determinants of Corporate Debt Capacity. Boston: Harvard University
Graduate School of Business, Division of Research, 1961.
Dunning, John H. "Reappraising the Eclectic Paradigm in an Age of Alliance Cap-
italism." Journal of International Business Studies 26 (1995): 461-492.
Economic Report of the President. Washington, DC: United States Government
Printing Office, 1995.
Findlay, M. C. and G. A. Whitmore. "Beyond Shareholder Wealth Maximation."
Financial Management 4 (1974): 25-35.
Gaver. J. J. and K. M. Gaver. "Additional Evidence on the Association between the
Investment Opportunity Set and Corporate Financing, Dividend, and Com-
pensation Policies." Journal of Accounting and Economics 16 (1993): 125-
160.
Green, R. "Investment Incentives, Debt, and Warrants." Journal of Financial Eco-
nomics 12 (1984): 115-135.
98 Accounting and the Investment Opportunity Set

Harris, M. and A. Raviv. "Corporate Control Contests and Capital Structure."


Journal of Financial Economics 20 (1988): 55-86.
Hempel, G. H. "Teaching and Research in Finance: Perceptions, Conflicts, and the
Future." Financial Management 12 (1983): 5-10.
Jensen, M. C. "Agency Costs of Free Cash Flow, Corporate Finance, and Take-
overs." American Economic Review 76 (1986): 323-329.
Jensen, M. C. and W. H. Meckling. "Theory of the Firm: Managerial Behavior
Agency Costs and Ownership Structure." Journal of Financial Economics 3
(1976): 305-360.
Leland, H. and D. Pyle. "Informational Asymmetries, Financial Structure, and Fi-
nancial Intermediation." Journal of Finance 32 (1977): 371-387.
Madura, Jeff. International Financial Management. St. Paul, MN: West Publishing
Company, 1995.
McGee, J. and H. Thomas. "Strategic Groups: Theory, Research and Taxonomy."
Strategic Management Journal 7 (1986): 141-160.
Modigliani, F. and M. H. Miller. "Corporate Income Taxes and the Cost of Cap-
ital: A Correction." American Economic Review 3 (1963): 433-443.
Montgomery, C. A. and H. Singh. "Diversification Strategy and Systematic Risk."
Strategic Management Journal 5 (1984): 181-191.
Myers, S. C. "Determinants of Corporate Borrowing." Journal of Financial Eco-
nomics 5 (1977): 147-176.
. "The Capital Structure Puzzle." Journal of Finance 39 (1984): 575-591.
Myers, S. C. and N. Majluf. "Corporate Financing and Investment Decisions when
Firms Have Information Investors Do Not Have." Journal of Financial Eco-
nomics 13 (1984): 187-221.
Perlmutter, Howard V. "The Tortuous Evaluation of the Multinational Corpora-
tion." Columbia Journal of World Business 4 (January-February 1969): 9-
18.
Porter, M. Competitive Advantage: Creating and Sustaining Superior Performance.
New York: Free Press, 1985.
Ross, S. A. "The Determination of Financial Structure: The Incentive-Signaling Ap-
proach." Bell Journal of Economics 8 (1977): 23-40.
Scott, J. "Bankruptcy, Secured Debt, and Optimal Capital Structure." Journal of
Finance 32 (1977): 1-19.
Smith, C. W. and R. L. Watts. "The Investment Opportunity Set and Corporate
Financing, Dividend and Compensation Policies." Journal of Financial Eco-
nomics 32 (1992): 263-292.
Stopford, John M. and Louis T. Wells. Managing the Multinational Enterprise.
New York: Basic Books, 1972.
Sullivan, D. "Measuring the Degree of Internationalization of a Firm." Journal of
International Business Studies 25 (1994): 325-342.
Thomas, H. and N. Venkatraman. "Research on Strategic Groups: Progress and
Prognosis." Journal of Management Studies 25 (1988): 537-555.
Titman, S. "The Effect of Capital Structure on a Firm's Liquidation Decision."
Journal of Financial Economics 13 (1984): 137-151.
Titman, S. and R. Wessels. "The Determinants of Capital Structure Choice." Jour-
nal of Finance 43 (1988): 1-19.
Corporate Financing 99

Walker, E. W. and J. W. Petty. "Financial Differences between Large and Small


Firms." Financial Management 4 (1978): 61-68.
Warner, J. "Bankruptcy Costs: Some Evidence." Journal of Finance 32 (1977): 3 3 7 -
347.
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6

The Role of the Investment


Opportunity Set in a Model of
International Production

INTRODUCTION
The eclectic paradigm of international production by MNEs (multinational
enterprises) argues that the initial act of foreign production by enterprises
and the growth of such production depend crucially upon the configuration
of three elements: firm-specific (or ownership-specific) advantages, country-
specific (or locational) advantages, and internalization advantages. 1-3
While, as argued by Dunning, 4 it remains a robust general framework for
explaining and analyzing not only the economic rationale of economic pro-
duction but many organizational and impact issues in relation to MNE
activity, it also can accommodate extensions to allow for firm-specific be-
havioral differences and financing differences.5 This chapter restates such a
general model of international production combining the three features of
the eclectic paradigm with the behavioral and financing differences in an
operationally testable manner. Second, empirical evidence is provided to
validate this restatement and possible extensions of the eclectic paradigm
of international production.

A GENERAL MODEL OF INTERNATIONAL PRODUCTION


The general and operationally testable paradigm of international pro-
duction rests on a combination of the three tenets of the eclectic paradigm
and behavioral and financing considerations. As shown in Exhibit 6.1, the
model argues that the growth of international production as measured by
the level of multinationality is a function of:
102 Accounting and the Investment Opportunity Set

Exhibit 6.1
General Model of International Production

Ownership Investment Opportunity

Advantages Set (IOS)

Locational Level of Foreign

Advantages Assets (LFA)

Multinationality

(MULTY)

Internalization Difference Between Rate

Advantages of Return on Foreign

Assets and Rate of Return

on Total Assets (RR)

Behavioral Corporate Reputation/

Consideration Measure of Size (CRS)

Financing Leverage Ratio

Considerations (LEV)

a. The ownership advantages as measured by the investment opportunity set of the


MNEs
b. The locational advantages as measured by the level of the MNEs' foreign assets
c. The internalization advantages as measured by the difference between the rate
of return in foreign assets and the total rate of return of the MNEs
d. The behavioral considerations as measured by an index of corporate reputation
deflated by a measure of size
e. The financing considerations as measured by a leverage ratio

The rationale for the model and the choice of measures follows.
Model of International Production 103

Ownership Advantages
The eclectic paradigm of international production specifies ownership
advantages as one of the three determinants of the extent, form, and pattern
of international production. They include both proprietary know-how
(unique assets) and transactional advantages that outweigh the costs of
servicing an unfamiliar or distant environment. Basically, the firm has
unique ownership advantages that its competitors do not have. These
unique ownership advantages are the future investment options of the firm.
The firm may be viewed as a combination of assets-in-place and future
investment options. The lower the proportion of firm value represented by
assets-in-place, the higher the growth opportunities. Myers6 describes these
potential investment opportunities as call options whose values depend on
the likelihood that management will exercise them. Like call options, the
growth options represent real value to the firm.7 These growth options are
intangible assets or ownership advantages that represent the investment
opportunity set.
The multinational firm is a collection of valuable options and generates
profits that enhance its value.8 The arbitrage benefits result from (a) the
exploitation of various institutional imperfections; (b) timing options; (c)
technology options; and (d) staging options. 9,10 Better financing bargains 11
as well as capital availability12 are also possible through internationaliza-
tion. In addition, multinational firms can achieve arbitrage benefits in fi-
nancing cash flows by (a) exploiting financial bargains; (b) reducing taxes
on financial flows; and (c) mitigating risks or shifting them to agents with
a comparative advantage in bearing them. 13 This definition of multination-
ality as a collection of options and arbitrage benefits suggests a positive
relation with growth options as defined by the investment opportunity set.
Following the first tenet of the eclectic paradigm, the level of multination-
ality will be a function of the level of investment opportunity set.

Locational Advantages
The eclectic paradigm of international production specifies locational ad-
vantages as the second determinant of the extent, form, and pattern of
international production. Basically, the benefits of MNEs are associated
with locating certain activities in particular countries. When it is in the best
interest of the MNEs to locate their activities in other than the home coun-
try, the MNEs use their locational advantages to respond to a kind of
spatial market failure, basically "internalizing exogenous spatial imperfec-
tions." 14 The size of the investment, located in particular countries, indi-
cates the extent and the saliency of the locational advantages. Following
the second tenet of the eclectic paradigm, the level of multinationality of
an MNE will be a function of the level of foreign assets as a surrogate
measure of locational advantages.
104 Accounting and the Investment Opportunity Set

Internalization Advantages
The internationalization advantages are the third level of the eclectic par-
adigm of international production. They refer to the relative benefits as-
sociated with serving foreign markets. With internalization advantages
present, it is to the benefit of the MNE to transfer its ownership advantages
abroad rather than sell them. The perceived great costs of transactional
failure lead the MNE to transfer its advantages across national borders
rather than by contractual agreements with foreign firms. As argued by
Rugman, 15 the MNE has in a sense "internalized" the market for its use.
The MNE will proceed with the internalization if the rate of return on
foreign assets is superior or equal to the rate of return on total assets.
Following the third tenet of the eclectic paradigm, the level of multination-
ality of an MNE will be a function of the difference between the rate of
return on foreign assets and the rate of return on total assets.

Firm-Specific Behavioral Differences


One extension of the eclectic paradigm of international production is the
consideration of firm-specific behavioral differences.16 Basically, MNEs
adopt specific strategies to define their international posture. While these
strategies may not be known to the general public, they are reflected in the
reputation of the firm.
The reputation of a firm is important for various decisions ranging from
resource allocation and career decisions to product choices, to name only a
few.17 It is an important signal of the firm's organizational effectiveness. Fa-
vorable reputations can create favorable situations for firms that include: (1)
the generation of excess returns by inhibiting the mobility of rivals in an in-
dustry 18 ; (2) the capability of charging premium prices to consumers 19 , and
(3) the creation of a better image in the capital markets and to investors.20 To
create the right impression or reputation, firms signal their key characteris-
tics to constituents to maximize their social status. 21 In fact, corporate audi-
ences were found to construct reputations on the basis of accounting and
market information or signals regarding firm performance. 22-24 These repu-
tations have become established and constitute signals that may affect the
actions of firms' stakeholders, including their shareholders. Specifically, a
good reputation can be construed as a competitive advantage within an
industry. 25 This implies that investors incorporate reputation in determining
firm value. Firms with good reputation are more prone to engaging in in-
ternational production. Therefore, the level of multinationality will be a
function of the firm's reputation.

Financing Advantages
Another extension of the eclectic paradigm of international production
is the consideration of firm-financing differences.26 It arises from Aliber's 27
Model of International Production 105

dissatisfaction with the eclectic paradigm, and his focus on financing as a


determinant of multinationality. The MNE uses different currencies to ac-
quire foreign assets, taking advantage of structural or transactional imper-
fections in international capital and foreign exchange markets. It is the
ability to finance investments in different currencies that characterizes the
uniqueness of the MNE. This ability to finance part of its production in its
home currency and other parts in other currencies depends on the ability
of the firm to raise capital, i.e., on its leverage. Therefore, the level of
multinationality will depend on the financial leverage of the MNE.

RESEARCH MODEL
In this study, a regression of the level of multinationality of U.S. MNEs
against the variables of investment opportunity set, foreign assets, leverage,
differences in ratios of return on foreign assets and total assets, and cor-
porate reputation is presented as evidence of the validity of a restatement
and possible extensions of the eclectic paradigm of international produc-
tion. The model is expressed as follows:

where:

MULTYjt = Level of multinationality for firm / in year t.


IOSit Investment opportunity set for firm / in year t.
LFA/t = Logarithm of foreign assets for firm / in year t.
RRjt = Difference between the rate of return in foreign assets and the total rate of
return for firm / in year t.
CRSjt = Corporate reputation deflated by a measure of size for firm / in year t.
Measures of firm size to be used include (a) total assets, (b) total revenues, (c) total
cash flow, and (d) number of employees.
LEVjt = Leverage ratio equal to buy learn debt/total assets for firm / in year t.

Data and Sample Selection


The population consists of firms included in Forbes' Most International
100 American Manufacturing and Service Firms and Fortune's surveys of
corporate reputation from 1987 to 1993. The security data are collected
from the CRSP return files. The accounting variables are collected from
COMPUSTAT. The derivations of multinationality, corporate reputation,
and investment opportunity set variables are explained later. The final sam-
ple includes 323 firm-year observations that have all the variables over the
period of analysis.
106 Accounting and the Investment Opportunity Set

Measuring Multinationality
Previous research has attempted to measure the following attributes of
multinationality:

1. Performancein terms of what goes on overseas.28


2. Structurein terms of resources used overseas.29
3. Attitude or Conductin terms of what is top management's orientation.30

Sullivan31 developed nine measures of which five were shown to have a


high reliability in the construction of a homogeneous measure of nation-
ality: (1) foreign sales as a percentage of total sales (FSTS), (2) foreign assets
over total assets (FATA), (3) overseas subsidiaries as a percentage of total
subsidiaries (OSTS), (4) top management's international experience (TMIE)
and (5) psychic dispersion of international operations (PDIO).
In this study we follow a similar approach by measuring multinationality
through three measures: (1) foreign sales/total sales (FSTS), (2) foreign prof-
its/total profits (FPTP), and (3) foreign assets/total assets (FATA).
Descriptive statistics and correlations among the three multinationality
measures are shown in Exhibit 6.2. Correlations among the variables are
positive, and with one exception, all significant. The nonsignificant corre-
lation is between FPTP and FATA. The low correlations between FPTP,
FSTS, and FATA indicate that each variable can make a unique contribu-
tion as a multinationality measure. Thus, a factor analysis of all observa-
tions is used to isolate the factor common to the three measures. Exhibit
6.3 reports the results. One common factor appears in the intercorrelations
among the three variables, as the first eigenvalue alone exceeds the sum of
the commonalities. The common factor is significantly positively correlated
with the three measures. These factor scores were used to measure the
degree of multinationality of firms in the sample.

Measuring Corporate Reputation


The independent variable of reputation is the combined score obtained
from an annual Fortune magazine survey. The Fortune survey covers every
industry group comprising four or more companies. The industry groups
are based on categories established by the U.S. Office of Management and
Budget (OMB). The survey asked executives, directors, and analysts in par-
ticular to rate a company on the following eight key attributes of reputa-
tion:

1. Quality of management
2. Quality of products/service offered
Model of International Production 107

Exhibit 6.2
Descriptive Statistics and Correlation of Three Measures of Multinationality for
Forbes' The Most International 100 U.S. Firms

Panel A: Descriptive Statistics

FP/TP1 FS/TSb FA/TAC


Maximum 914.3 93 91
Third Quartile 61.9 47.4 41.4
Median 41.3 36.7 30.5
First Quartile 25 25.7 22.6
Minimum 0.2 6.6 2.7
Mean 52.81 37.45 39.92

Panel B: Correlations

FT/TP FS/TS FA/TA


FP/TP 1.000
FS/TS 0.280 1.000
FA/TA 0.034 0.193* 1.000

'Denotes p-value < 0.05.


a
FP/TP = Foreign profits/total profits.
b
FS/TS = Foreign sales/total sales.
C
FA/TA = Foreign assets/total assets.

3. Innovativeness
4. Value as long-term investment
5. Soundness of financial position
6. Ability to attract/develop/keep talented people
7. Responsibility to the community/environment
8. Wise use of corporate asset

Ratings were on a scale of 0 (poor) to 10 (excellent). The score met the


multiple-consistency ecological model view of organization effectiveness.
For the purpose of our study, the 1987 to 1993 Fortune magazine surveys
were used. The use of the overall score rather than factor analysis of the
Exhibit 6.3
Selected Statistics Related to a Common Factor Analysis of Three Measures of
Multinationality for Forbes' The Most International 100 U.S. Firms

1. Eigenvalues of the Correlation Matrix:

Eigenvalues t 2 3

1.3615 0.9680 0.6705

2. Factor Pattern

FACTOR 1

FS/TS FP/TP FA/TA

0.80529 0.50172 0.67918

3. Final Communality Estimates: Total = 1.361489

FS/TS FP/TP FA/TA

0.648491 0.251718 0.461280

4. Standardized Scoring Coefficients

FACTOR 2

FS/TS FP/TP FA/TA .

0.59148 0.36850 0.49885

5. Descriptive Statistics of the Common Factor Extracted from the Three Measures of

Multinationality

Maximum 2039.24

Third Quartile 74.70

Median 57.03

First Quartile 40.76

Minimum 5.17

Mean 64.35
Model of International Production 109

eight scores is based on the fact that: (a) it is the overall score that is
published in Fortune magazine rather than the eight scores on the attribute,
and (b) it is then the overall score that is perceived by the readers as well
as the respondents of the survey as the reputation index. From previous
experience, the respondents know that the means of their scores on the
eight attributes will be published as the overall score of reputation. From
the purpose of this study, the overall score of reputation is deflated by a
measure size.

Measuring the Investment Opportunity Set


Because the investment opportunity set is not observable there has not
been a consensus on an appropriate proxy variable. Similar to Smith and
Watts 32 and Gaver and Gaver33 we use an ensemble of variables to measure
the investment opportunity set. The three measures of the investment op-
portunity set used: are market-to-book assets (MASS), market-to-book en-
tity (MQV), and the earnings/price ratio (EP). These variables are defined
as follows:

MASS = (Assets - Total Common Equity + Shares Outstanding* Share Closing


Price )/Assets
MQV = (Shares Outstanding* Share Closing Price)/Total Common Equity
EP = (Primary EPS before Extraordinary Items)/Share Closing Price

Descriptive statistics and correlations among the three measures of the in-
vestment opportunity set are shown in Exhibit 6.4. Correlations among the
three variables are significant. The low correlations indicate that each var-
iable makes a unique contribution as measure of the investment opportu-
nity set. The results of the factor analysis are shown in Exhibit 6.5. One
common factor appears to explain the intercorrelations among the three
individual measures. It is used here as a measure of the investment oppor-
tunity set.

RESULTS
Panel A of Exhibit 6.6. reports descriptive statistics used in our tests and
Panel B shows correlations among the variables. The correlations reported
in Panel B of Exhibit 6.6 show that all the correlations between MULTY
and the other variables in the study are significant at the 0.01 level. The
significant associations among some of the variables indicate some degree
of collinearity among the independent variables in the regression analysis.
110 Accounting and the Investment Opportunity Set

Exhibit 6.4
Descriptive Statistics and Correlation of Three Measures of the Investment
Opportunity Set for Forbes' The Most International 100 U.S. Firms

Panel A: Descriptive Statistics

MASS' MQVb EP0


1 Maximum 6.4943 60 0.5175
| Third Quartile 1.8556 3.1851 0.1081
1 Median 1.2905 1.9090 0.0713
| First Quartile 1.0618 1.2666 0.0482
| Minimum 0.8745 4.3333 2.1536
I Mean 0.3081 2.7020 0.0638

Panel B: Correlation

1 MASS MQV EP
|MASS 1.000
|MQV 0.0399* 1.000
[EP 0.0158* 0.0230* 1.000

"Denotes p-value < 0.05.


a
MASS = Market-to-book assets.
b
MQV = Market-to-book equity.
C
EP = Earnings/price ratio.

However, the maximum condition index in all regression is only 4.43. As


suggested by Belsley et al., 34 mild collinearity is diagnosed for maximum
condition indices between 5 and 10 and severe collinearity over 30. Thus,
collinearity does not seem to influence our results.
For each of the multivariate regression to be reported, we performed
additional specification tests, including checks for normality and consid-
eration of various scatter plots. A null hypothesis of normality could not
be rejected at the 0.01 level in all cases, and the plots revealed some het-
Exhibit 6.5
Selected Statistics Related to a Common Factor Analysis of Three Measures of
the Investment Opportunity Set for Forbes' The Most International 100
U.S. Firms

1. Eigenvalues of the Correlation Matrix: Total = 3 Average = 1

Eigenvalue 1 2 3

1.0540 0.9868 0.9592

2. Factor Pattern

FACTOR1

MASS MQV EP

0.62821 0.66411 0.46722

3. Final Communality Estimates: Total = 1.053994

MASS MQV EP

0.394651 0.441045 0.218299

4. Standardized Scoring Coefficients

FArTOR 1

MASS MQV EP

0.59603 0.63009 0.44329

5. Descriptive Statistics of the Common Factor Extractedfromthe Three Measures of the

Investment Opportunity

Maximun 9.3595

Third Quartile 3.2200

Median 2.0450

First Quartile 1.5085

Minimum 2.5209

Mean 1.9812
112 Accounting and the Investment Opportunity Set

Exhibit 6.6
Descriptive Statistics and Correlations

Panel A: Descriptive Statistics*

Standard
Variables Mean Deviation Minimum 25% Median Maximum
MULTY 54.723 33.132 6.2109 37.3224 51.1514 418.685
IOS 52305 120138 16.5372 5289.2 13614 1048948
LFA 12.655 1.0913 10.7142 11.869 12.4091 16.1078
RR 0.0062 0.1887 -3.6832 -0.0087 0.0069 0.2894

CRS 0.0008 0.00066 0.00002 0.00022 0.00070 0.00287


|LEV 1.109 5.7555 0.3588 0.0275 0.0655 57.8261

Panel B: Correlations b

MULTY IOS LFA RR CRS LEV

MULTY

IOS 0.2363*

LFA 0.1407* 0.4417*


RR -0.3558* 0.1082* 0.0478

CRS 0.1106* -0.3058* -0.7677* -0.3437

LEV 0.0996* -0.0701 -0.0068 0.00152 0.0844

a
Total observations: 323 firm-year observations.
ll
Person correlations are below the diagonal.

eroskedasticity but no other obvious problems. Therefore, we calculated


the ^-statistics after correcting for heteroskedasticity in the manner de-
scribed by White. 35
Exhibit 6.1 presents the results of four regressions that differ in the way
corporate reputation was deflated. Size is measured by total assets in Model
1, cash flow in Model 2, net profit in Model 3, and rank of employees in
Model 4. In all four cases multinationality was found to be positively re-
lated to the investment opportunity set, logarithm of foreign assets, the
difference between the rates of return on foreign assets and total assets,
corporate reputation, and leverage. R2 was the greatest (56.76%) when cor-
Model of International Production 113

Exhibit 6.7
Regression Results of Linear Models

Model 1 ( 2 ) Model 2 Model 3 Model 4


(1)
Intercept -203.732 -31.566 -41.102 -74.297
(-12.688)* (-2.476)* (-3.298)* (-5.482)*

IOS 0.000014 0.000032 0.000029 0.000034


(2.248)* (3.829)* (3.659)* (4.297)*

LFA 17.882 5.653 6.449 8.5599


(15.284)* (5.752)* (6.676)* (8.446)*
RR 176.953 167.977 161.859 165.100
(9.961) (7.532)* (7.495)* (7.891)*

CRS 27936 5804.73 421.601 1600.68


(15.027)* (5.168)* (7.084)* (8.583)*

LEV 0.3113 0.7989 0.8798 0.6384


(2.693)* (2.672)* (3.054)* (2.268)*

Adjusted R2 0.5676 0.3179 0.3614 0.3997

^Variable Definitions'.
IOS = Investment opportunity set
LFA = Logarithm of foreign assets
RR = Difference between the rates of return in foreign/assets and total assets
CRS = Corporate reputation deflated by size
LEV = Leverage ratio
{2)
Model Differences: The numbers differ in the measure of size used to deflate corporate
reputation. Size is measured by total assets in Model 1, cash flow in Model 2, profit in
Model 3, and number of employees in Model 4.

porate reputation was deflected by total assets. The results verified the re-
statement and possible extensions of the eclectic paradigm of international
productions.

CONCLUSIONS
A general model of international production that combines the three ten-
ets of the eclectic paradigm and behavioral and financing considerations is
tested using a sample of U.S. MNEs. The evidence validates this restatement
and possible extensions of the eclectic paradigm of international production
by showing that multinationality is positively related to the investment op-
114 Accounting and the Investment Opportunity Set

portunity set, the level of foreign assets, the difference between the rates of
return on foreign and total assets, the corporate reputation deflated by size,
and leverage. The results are dependent on the choice of surrogate measures
used for the measurement of ownership advantages, locational advantages,
internalization advantages, and behavioral and financing considerations.
Future research needs to examine the sensitivity of the results to other po-
tential surrogate measures.

NOTES
1. Dunning, John H., Explaining International Production, Unwin Hyman,
London, 1998.
2. Dunning, John H., "The Eclectic Paradigm of International Production: A
Restatement and Some Possible Extensions," Journal of International Business
Studies 19(1) (1988): pp. 1-32.
3. Rugman, Alan M. and Alain Verbeke, "A Note on the Transnational Solu-
tion and the Transaction Cost," Journal of International Business Studies 23(4)
(1992): pp. 761-771.
4. Dunning, Explaining International Production.
5. Dunning, "The Eclectic Paradigm of International Production."
6. Myers, S., "Determinants of Corporate Borrowing," Journal of Financial
Economics (1977): pp. 147-175.
7. Kester, W. C , "Today's Options for Tomorrow's Growth," Harvard Busi-
ness Review (March-April 1984): pp. 153-160.
8. Tsetsekos, George P., "Multinationality and Common Stock Offering," Jour-
nal of International Financial Management and Accounting (1991): pp. 1-16.
9. Baldwin, C , "The Capital Factor: Competition for Capital in Global Envi-
ronment," in Dunning, John H., 1995, "Reappraising the Eclectic Paradigm in an
Age of Alliance Capitalism," Journal of International Business Studies (1986):
pp. 461-492.
10. Kogut, Bruce, "Foreign Direct Investment as a Sequential Process," in C.
Kindelberger and D. Andretsh (eds.), The Multinational Corporation in the 1980's,
MIT Press, Cambridge, MA, 1983: pp. 38-56.
11. Giavazzi, F. and A. Giovannini, Limiting Exchange Rate Flexibility: The
European Monetary System, MIT Press, Cambridge, MA, 1989.
12. Eiteman, D. and A. Stonehill, Multinational Business Finance, Addison-
Wesley, Boston, 1986.
13. Tsetsekos, "Multinationality and Common Stock Offering."
14. Rugman, Inside the Multinationals.
15. Ibid.
16. Dunning, "The Eclectic Paradigm of International Production."
17. Dowling, G. R., "Managing Your Corporate Images," Industrial Marketing
Management 15 (1986): pp. 109-115.
18. Caves, R. E. and M. E. Porter, "From Entry Barrier to Nobility Barriers,"
Quarterly Journal of Economics 91 (1977): pp. 421-434.
19. Klein, B. and K. Leffler, "The Role of Market Forces in Assuring Contractual
Performance," Journal of Political Economy 85 (1981): pp. 615-641.
Model of International Production 115

20. Beatty, R. P. and J. R. Ritter, "Investment Banking, Reputation, and Under-


pricing of Initial Public Offerings," Journal of Financial Economics 15 (1986):
pp. 213-232.
21. Spence, A. M., Market Signaling: Information Transfer in Hiring and Re-
lated Screening Process, Harvard University Press, Cambridge, MA, 1974.
22. Fombrum, C. and M. Shanley, "What's in a Name? Reputational Building
and Corporate Strategy," Academy of Management Journal 33 (1990): pp. 2 3 3 -
258.
23. Belkaoui, Ahmed, "Organizational Effectiveness, Social Performance and
Economic Performance," Research in Corporate Social Performance and Policy 12
(1992): pp. 143-155.
24. Riahi-Belkaoui, Ahmed and E. Pavlik, "Asset Management Performance and
Reputation Building for Large U.S. Firms," British Journal of Management 2
(1991): pp. 231-238.
25. Fombrum and Shanley, "What's in a Name?"
26. Dunning, Explaining International Production.
27. Aliber, R., "Money, Multinationals and Sovereigns," in C. P. Kindelberger
and D. B. Andretsh (eds.), The Multinational Corporation in the 1980s, MIT Press,
Cambridge, MA, 1983.
28. Dunning, John H., "Reappraising the Eclectic Paradigm in an Age of Alliance
Capitalism," Journal of International Business Studies 26 (1995): pp. 461-492.
29. Stopford, John M. and Louis T. Wells, Managing the Multinational Enter-
prise, Basic Books, New York, 1972.
30. Perlmutter, Howard V., "The Tortuous Evaluation of the Multinational Cor-
poration," Columbia Journal of World Business 4 (January-February 1969): pp. 9 -
18.
31. Sullivan, D., "Measuring the Degree of Internationalization of a Firm," Jour-
nal of International Business Studies 25 (1994): pp. 325-342.
32. Smith, C. W. and R. L. Watts, "The Investment Opportunity Set and Cor-
porate Financing, Dividend and Compensation Policies," Journal of Financial Eco-
nomics (1992): pp. 263-292.
33. Gaver, J.J. and K. M. Gaver, "Additional Evidence on the Association be-
tween the Investment Opportunity Set and Corporate Financing, Dividend, and
Compensation Policies," Journal of Accounting and Economics (1993): pp. 125-
160.
34. Belsley, D., E. Kuh, and R. Welsch, Regression Diagnostics: Identifying In-
fluential Data and Source of Collinearity, Wiley, New York, 1980.
35. White, H. A., "Heteroskedasticity-Consistent Covariance Matrix Estimator
and a Direct Test for Heteroskedasticity," Econometrika 10 (1980): pp. 817-838.

REFERENCES
Aliber, R. "Money, Multinationals and Sovereigns." In C. P. Kindelberger and
D. B. Andretsh, The Multinational Corporation in the 1980s. Cambridge:
MIT Press, 1983.
Beatty, R. P. and J. R. Ritter. "Investment Banking, Reputation, and Underpricing
of Initial Public Offerings." Journal of Financial Economics 15 (1986): 2 1 3 -
232.
116 Accounting and the Investment Opportunity Set

Belkaoui, Ahmed. "Organizational Effectiveness, Social Performance and Economic


Performance." Research in Corporate Social Performance and Policy 12
(1992): 143-155.
Belsley, D., E. Kuh, and R. Welsch. Regression Diagnostics: Identifying Influential
Data and Source of Collinearity. New York: Wiley, 1980.
Caves, R. E. and M. E. Porter. "From Entry Barrier to Nobility Barriers." Quarterly
Journal of Economics 91 (1977): 421-434.
Dowling, G. R. "Managing Your Corporate Images." Industrial Marketing Man-
agement 15 (1986): 109-115.
Dunning, John H. "The Eclectic Paradigm of International Production: A Restate-
ment and Some Possible Extensions." Journal of International Business Stud-
ies 19(1) (1988a): 1-32.
. Explaining International Production. London: Unwin Hyman, 1998b.
. "Reappraising the Eclectic Paradigm in an Age of Alliance Capitalism."
Journal of International Business Studies 26 (1995): 461-492.
Eiteman, D. and A. Stonehill. Multinational Business Finance. Boston: Addison-
Wesley, 1986.
Fombrum, C. and M. Shanley. "What's in a Name? Reputational Building and
Corporate Strategy." Academy of Management Journal 33 (1990): 233-258.
Gaver, J. J. and K. M. Gaver. "Additional Evidence on the Association between the
Investment Opportunity Set and Corporate Financing, Dividend, and Com-
pensation Policies." Journal of Accounting and Economics (1993): 125-160.
Giavazzi, F. and A. Giovannini. Limiting Exchange Rate Flexibility: The European
Monetary System. Cambridge, MA: MIT Press, 1989.
Hartman, H. H. Modern Factor Analysis, 3d ed. Chicago: University of Chicago
Press, 1976.
Kester, W. C. "Today's Options for Tomorrow's Growth." Harvard Business Re-
view (March-April 1984): 153-160.
Klein, B. and K. Leffler. "The Role of Market Forces in Assuring Contractual Per-
formance." Journal of Political Economy 85 (1981): 615-641.
Kogut, Bruce. "Foreign Direct Investment as a Sequential Process." In C. Kindel-
berger and D. Andretsh (eds.). The Multinational Corporation in the 1980's.
Cambridge, MA: MIT Press: 1983: 38-56.
Myers, S. "Determinants of Corporate Borrowing." Journal of Financial Economics
(1977): 147-175.
Perlmutter, Howard V. "The Tortuous Evaluation of the Multinational Corpora-
tion." Columbia Journal of World Business 4 (January-February 1969): 9-
18.
Riahi-Belkaoui, Ahmed and E. Pavlik. "Asset Management Performance and Rep-
utation Building for Large U.S. Firms." British Journal of Management 2
(1991): 231-238.
Rugman, A. M. Inside the Multinationals: The Economics of International Markets.
New York: Columbia University Press, 1981.
Rugman, Alan M. and Alain Verbeke. "A Note on the Transnational Solution and
the Transaction Cost." Journal of International Business Studies 23(4)
(1992): 761-771.
Model of International Production 117

Smith, C. W. and R. L. Watts. "The Investment Opportunity Set and Corporate


Financing, Dividend and Compensation Policies." Journal of Financial Eco-
nomics (1992): 263-292.
Spence, A. M. Market Signaling: Information Transfer in Hiring and Related
Screening Process. Cambridge, MA: Harvard University Press, 1974.
Stopford, John M. and Louis T. Wells. Managing the Multinational Enterprise.
New York: Basic Books, 1972.
Sullivan, D. "Measuring the Degree of Internationalization of a Firm." Journal of
International Business Studies 25 (1994): 325-342.
Tsetsekos, George P. "Multinationality and Common Stock Offering." Journal of
International Financial Management and Accounting (1991): 1-16.
White, H. A. "Heteroskedasticity-Consistent Covariance Matrix Estimator and a
Direct Test for Heteroskedasticity." Econometrica 10 (1980): 817-838.
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7

Growth Opportunities and


Disclosure Adequacy

INTRODUCTION
This chapter examines the cross-sectional variation in analysts' published
evaluations of firm's disclosure practices and provides evidence the analysts'
ratings are increasing in firm size, growth opportunities as measured by the
investment opportunity set, and the degree of multinationality.
The extent to which mandatory disclosure requirements are exceeded
differs from firm to firm, with a great latitude existing for both voluntary
and discretionary disclosures. The primary users of this information are the
analysts. In fact, analyst ratings of these varied corporate disclosures are
included in the Report of the Financial Analysts Federation Corporate In-
formation Committee (FAF Reports), providing an overall measure of the
firm's effectiveness in communicating with investors. The main objective of
this study is to explain these analysts' ratings of firm disclosure, with the
assumption that the analyst ratings measure disclosure informativeness.
Theoretical research on motivations for disclosure is used to link the ana-
lysts' ratings to firm characteristics. The study builds on previous research
on cross-sectional determinants of analysts' ratings of corporate disclosure
to add as potential determinants the variables of size, growth opportunities,
and multinationality. 1

LITERATURE AND MOTIVATION


As in Lang and Lundholm, 2 the empirical analysis is based on a survey
of the theoretical and empirical literatures rather than relying on any par-
120 Accounting and the Investment Opportunity Set

ticular model. Three potential explanatory variables are considered and


grouped into three categoriesperformance variables (growth opportuni-
ties), structural variable (firm size), and multinationality variable (the level
of multinationality or foreign involvement).

Disclosure and Growth Opportunities


The firm may be viewed as a combination of assets-in-place and future
investment options. The lower the proportion of firm value represented by
assets-in-place, the higher the growth opportunities. Myers describes these
potential investment opportunities as call options whose values depend on
the likelihood that management will exercise them. 3 Like call options, the
growth options represent value to the firm.4 These growth options are in-
tangible assets or ownership advantages that represent the investment op-
portunity set (IOS). The higher these growth options, the more likely there
will be a good firm performance. In fact, theoretical models developed by
Bushman and Indjejikian5 and Kim and Smith6 suggest that as a firm's IOS
increases, stock price becomes relatively more informative about firm per-
formance. One implication is that firms that have experienced an expansion
in investment opportunities will increase their disclosures to match their
market performance. In addition, the expansion of new investment oppor-
tunities or product markets may adversely impact accounting earnings in
the short term. 7 The development of investment opportunities requires im-
mediate outlays of capital while the payoffs may not be immediately re-
flected in accounting earnings. This is generally consistent with Yermack,8
who finds evidence of an unexpectedly negative relationship between a
firm's market-to-book ratios (a known IOS proxy) and the granting of
stock options. The implication is that firms experiencing an expansion in
investment opportunities with no present payoffs should increase their dis-
closures to counteract any adverse effect to the accounting earnings in the
short run. This is generally consistent with Skinner,9 who finds evidence
suggesting that the IOS affects the "accepted set" of accounting procedures.
Taken as a whole, the results from both theoretical and empirical re-
search suggest disclosure could be increasing in firm performance as mea-
sured by the investment opportunities set.

Disclosure and Firm Size


There are a number of reasons why we might expect a positive associ-
ation between disclosure and firm size. One main reason is provided by
agency theory. The proportion of outside capital tends to be higher for
larger firms.10 Similarly, agency costs increase with the amount of outside
capital. 11 Accordingly, the potential benefits from shareholder-debtholder-
Disclosure Adequacy 121

manager contractingincluding the extent of financial disclosurewould


also increase with firm size.12
Other reasons include (a) the disclosure cost hypothesis, whereby the
costs are decreasing in firm size leading to more affordable disclosure,13 (b)
the transactions cost hypothesis, whereby the incentives for private infor-
mation acquisitions are greater for large firms resulting in disclosure in-
creasing with firm size,14 and (c) the legal cost hypothesis, whereby dollar
values of damages in securities litigations are a function of firm size leading
to higher disclosure with larger size.15

Disclosure and Multinationality


There are basically two main reasons why we might expect a positive
association between disclosure and multinationality.
The first reason is provided by the capital-need hypothesis whereby much
of the impetus for voluntary disclosure by multinational firms surrounds
the need to raise capital at the lowest possible cost. 16,17 The pressure for
information associated with global competition for capital manifests itself
in the supplemental voluntary disclosures that multinational firms have
been found to make. 18,19
The second reason is provided by the multiple-listing hypothesis.20 Mul-
tinational firms are generally listed in more than one stock exchange. The
firms with multiple listings are more likely to have a greater number of
shareholders thereby making monitoring costs more significant. One way
of reducing shareholders' monitoring costs and of alleviating the moral
hazard problem is through disclosure in corporate annual reports.

METHOD

Model
This chapter examines the cross-sectional variations in analysts' pub-
lished evaluation of firms' disclosure practices and hypothesizes that the
analysts' ratings are increasing in the degree of multinationality, the level
of growth opportunities as measured by the investment opportunity set,
and size. The model to be tested is as follows:

where:

DISClt = Average of total FAF disclosure score over the year t, t 1, and t - 2.
MULTYit = Degree of multinationality of firm / in year t as measured by foreign
profit/total profit.
122 Accounting and the Investment Opportunity Set

IOSlt = Investment opportunity set of firm i in year t.


LRlt = Logarithm of total revenues at the end of year t.

The model was run for the 1986-1990 period and for each individual
year in that period.

Sample
To ensure the greatest sample of firms for which data would be available
for all variables, the initial sample chosen was for all firms included in
Forbes' 1986 to 1990 survey of the largest U.S. multinationals and in the
annual volumes of the Report of the Financial Analysts Federation Cor-
porate Information Committee.11 A sample of 313 observations was ob-
tained. The disclosure scores for each firm were averaged over three
consecutive years (year t, t - 1, t - 2) to obtain the disclosure metric
(DISC) capturing a firm's current and past disclosure performance. Multi-
nationality was measured by foreign profit/total profit. Size was measured
by the logarithm of the total revenues at the end of the year. Both the
measurement of corporate disclosure (DISC) and investment opportunity
set (IOS) are explained in the next two sections.

The Disclosure Quality Measure (DISC)


To measure disclosure, this study uses data from the annual volumes of
the Report of the Financial Analysts Federation Corporate Information
Committee.11 It is generally considered as a comprehensive measure of the
informativeness of a firm's disclosure policy.23"27 The data measure the
firm's effectiveness in communicating with investors and the extent to
which the firm provides information so that investors have the information
necessary to make informed judgment across all types of disclosures. The
disclosures provided through annual reports, quarterly reports, proxy state-
ments, published information in the form of press releases and fact books,
and direct disclosures to and communication with analysts are used for the
evaluation of the firm's disclosure practices. In the FAF report, analysts
evaluate the complete range of a firm's disclosures, summarizing their eval-
uations by score (out of 100 possible points) on the firm's total disclosure
efforts and separate scores for the different disclosure categories. Although
these scores are based on analysts' perceptions of corporate disclosure prac-
tices, any potential biases or errors are minimized by a procedure that (a)
requires the reporting of average scores (across industry analysts), and (b)
rests on the use of detailed guidelines and a comprehensive checklist of
criteria that allows a standardization of the rating process both within and
across industries.
Disclosure Adequacy 123

Because corporate audiences may be expected to consider both past and


present disclosures in their reputation assessments, the disclosure metric,
DISC, to be used in this study is the average of the total disclosure score
of a firm over three consecutive years (years t, t 1, t 2).

Measuring the Investment Opportunity Set


There has not been a consensus on an appropriate proxy variable for the
investment opportunity set. Similar to Smith and Watts 28 and Gaver and
Gaver,29 we use an ensemble of variables to measure the investment op-
portunity set. The three measures of the investment opportunity set used
are: market-to-book assets (MASS), market-to-book equity (MQV), and the
earnings/price ratio (EP). These variables are defined as follows:

MASS = (Assets - Total Common Equity + Shares Outstanding * Share Closing


Price )/Assets
MQV = (Shares Outstanding * Share Closing Price/Total Common Equity)
EP = (Primary EPS before Extraordinary Items)/Share Closing Price

The results of a factor analysis of the three measures of the investment


opportunity set are shown in Exhibit 7.1. One common factor appears
to explain the intercorrelations among the three individual measures. The
factor score for each firm is used as the measure of the investment oppor-
tunity set.

RESULTS

Descriptive Statistics and Correlation Analysis


Exhibit 7.2 presents the descriptive statistics for all the variables used in
the study. The median disclosure score is 56.31. A wide dispersion is pres-
ent with a minimum of 47.31, a maximum of 76.73, and a standard de-
viation of 6.895. The median of the revenues of 15,012 (in millions)
indicates a sample of large U.S. firms, with a wide variation as indicated
by the minimum and maximum values. The investment opportunity set
varies from a minimum of 0.187 to a maximum of 7.383. Finally the mul-
tinationality variable, as measured by foreign profits/total profits varies
widely from a minimum of 0.1 to a maximum of 87.5.
Exhibit 7.3 presents the rank-order correlations for the variables used in
this study. The low intercorrelations among the predictor variables used in
the model indicate no reason to suspect multicollinearity, and various di-
agnostic tests run on the derived regression models confirmed that it was
not a problem.
124 Accounting and the Investment Opportunity Set

Exhibit 7.1
Selected Statistics Related to a Common Factor Analysis of Three Measures of
the Investment Opportunity Set for Forbes' The Most International
100 U.S. Firms
1. Eigenvalues of the Correlation Matrix

Eigenvalue 1 2 3

1.0540 0.9868 0.9592

2. Factor Pattern

Factor MASS MQV EP


0.62821 0.66411 0.46722

3. Final Communality Estimates: Total = 1.053994

MASS MQV EP
0.394651 0.441045 0.218299
4. Standardized Scoring Coefficients

Factor MASS MQV EP


0.59603 0.63009 0.44329
5. Descriptive Statistics of the Common Factor Extracted from the Three
Measures of the Investment Opportunity

Maximum Third Median First Minimum Mean


Quartile Quartile
9.3595 3.2200 2.0450 1.5085 2.5209 1.9812

Regression Analysis
To examine the incremental explanatory power of the variables ex-
pressed in Equation (1), multiple regressions were estimated. Exhibit 7.4
presents the results of the regression coefficients for all the independent
variables, using measures of corporate disclosure as dependent variables.
The Breusch and Pagan30 test for heteroskedasticity yielded a x 2 with a
minimum of 133.82 and a maximum of 162.32 for all the regressions,
indicating that heteroskedasticity could be a problem in these regres-
sions. Accordingly, the reported ^-statistics are based on White's 31
heteroskedasticity-corrected covariance matrix. The results, in all cases,
Disclosure Adequacy 125

Exhibit 7.2
Summary Statistics

Variables Number of Mean Standard Median Minimum Maximum


Observatio Deviation
ns
MULTY 313 48.375 58.131 38 0.1 87.5
DISC 313 57.868 6.895 56.312 47.315 76.730
IOS 313 0.561 0.821 0.511 0.187 7.383
R 313 15,012.65 18,953.44 8331 2318 126,932

Variable definitions:
MULTY: Multinationality measured as foreign profits/total profits.
DISC: FAF disclosure scale.
IOS: Investment opportunity set score.
R: Total revenues.

Exhibit 7.3
Correlations among Selected Variables*

DISC MELTY IOS R

DISC 1.000 0.019 0.1799 0.674


(0.00) (0.698) (0.0009) (0.0001)

MULTY 1.000 -0.1657 0.0319


(0.00) (0.0032) (0.5195)

IOS 1.000 0.0181


(0.00) (0.3385)

R 1.000
(0.00)

*/?-Values for two-tailed tests are provided in parentheses. Variables are defined in footnote
of Exhibit 7.2.
126 Accounting and the Investment Opportunity Set

Exhibit 7.4
Explaining Corporate Disclosure Quality

Independent Intercept MULTY IOS LR F Adjusted


/ Dependent R2
Variables
DISC -7.474 0.010 1.026 7.228 240.24* 75.31
(1986- (-3.496)* (2.348)* (4.058)* (26.203)*
1990)
DISC 1986 -9.952 0.011 1.026 7.228 240.24* 70.66
(-3.920) (2.457) (4.058) (26.203)*

DISC 1987 -10.112 0.011 1.049 7.242 228.47* 69.60


(-3.878)* (2.510)* (4.147)* (25.591)*

DISC 1988 -10.761 0.011 0.998 7.319 241.99* 70.81


(-4.187)* (2.515)* (3.935)* (96.149)*

DISC 1989 -11.275 0.011 1.007 7.373 253.33* 71.75


(-4.463)* (2.659* (94.002)* (26.925*

DISC 1990 -10.684 0.011 1.021 7.307 245.83* 71.21


(-4.211)* (2.593)* (4.048)* (26.536)*

Variables are defined in footnote of Exhibit 7.2.


* Absolute value of ^-statistics is in parentheses, significant at a = 0.01.

corroborate the significance of size, multinationality, and investment op-


portunity set as determinants of voluntary disclosure choice measured by
the disclosure scores prepared by the Financial Analysts Federation.

CONCLUSION
This chapter investigated the determinants of voluntary disclosure choice,
as measured by disclosure scores prepared by the Financial Analysts Fed-
eration. The empirical results are consistent with existing theories and the-
ses on voluntary disclosure choice.
First, the result that the disclosure scores increase in firm size, as mea-
sured by the logarithm of revenues, is consistent with agency theory con-
Disclosure Adequacy 127

siderations, the disclosure cost hypothesis, the transaction costs hypothesis,


and the legal cost hypothesis.
Second, the result that disclosure scores increase in growth opportunities,
as measured by the investment opportunity set, is consistent with the role
of the expansion of growth opportunities in leading firms to be more in-
formative.
Finally, the result that disclosure scores increase in multinationality, as
measured by foreign profits/total profits, is consistent with the capital-need
hypothesis and the multiple-listing hypothesis.

NOTES
1. Lang, M. and R. Lundholm, "Cross-Sectional Determinants of Analysts Rat-
ings of Corporate Disclosures," Journal of Accounting Research 31 (Autumn 1993):
pp. 246-271.
2. Ibid.
3. Myers, S., "Determinants of Corporate Borrowing," Journal of Financial
Economics (1977): pp. 147-175.
4. Kester, W. C , "Today's Options for Tomorrow's Growth," Harvard Busi-
ness Review (March-April 1984): pp. 153-160.
5. Bushman, R. and R. Indjejikian, "Accounting Income, Stock Price, and
Managerial Compensation," Journal of Accounting and Economics 16 (1993):
pp. 3-24.
6. Kim, O. and Y. Smith, "Incentive Efficiency of Compensation Based on Ac-
counting and Market Performance," Journal of Accounting and Economics 16
(1993): pp. 25-53.
7. Abbott, Lawrence J., Executive Compensation Subsequent to a Split in IOS,
University of Memphis, 1999.
8. Yermack, D., "Do Corporations Award CEO Stock Options Effectively?"
Journal of Financial Economics 39 (1995): pp. 237-269.
9. Skinner, D. J., "The Investment Opportunity Set and Accounting Procedure
Choice: Preliminary Evidence," Journal of Accounting and Economics 160 (1993):
pp. 407-446.
10. Leftwich, R., R. Watts, and J. Zimmerman, "Voluntary Corporate Disclo-
sure: The Case of Interim Reporting," Journal of Accounting Research, Supplement
(1981): pp. 50-77.
11. Jensen, H. and W. Meckling, "Theory of the Firm: Managerial Behavior,
Agency Costs and Ownership Structure," Journal of Financial Economics (October
1976): pp. 305-360.
12. Chow, Chee W. and Adrian Wang-Borem, "Voluntary Financial Disclosure
by Mexican Corporations," The Accounting Review (July 1987): pp. 533-541.
13. Lang and Lundholm, "Cross-Sectional Determinants of Analysts Ratings."
14. King, R., G. Pownall, and G. Waymire, "Expectations Adjustments in
Timely Management Forecasts: Review, Synthesis, and Suggestions for Further Re-
search," Journal of Accounting Literature 9 (1990): pp. 113-144.
15. Skinner, Why Firms Voluntarily Disclose Bad News.
128 Accounting and the Investment Opportunity Set

16. Choi, F. D. S., "Financial Disclosure and Entry to the European Capital
Market," Journal of Accounting Research (Autumn 1973): pp. 159-175.
17. Spero, L. L. "The Extent and Cases of Voluntary Disclosure of Financial
Information in Three European Capital Markets: An Exploratory Study," unpub-
lished doctoral dissertation, Harvard University, 1979.
18. Meek, Gary M., Clare B. Roberts, and Sidney J. Gray, "Facts Influencing
Voluntary Annual Report Disclosures by U.S., U.K. and Continental European
Multinational Corporations," Journal of International Business Studies 96(3)
(1987): pp. 555-572.
19. Meek, Gary M. and Sidney J. Gray, "Globalization of Stock Markets and
Foreign Listing Requirements: Voluntary Disclosures of Continental European
Companies Listed on the London Stock Exchange," Journal of International Busi-
ness Studies 20(2) (1980): pp. 315-338.
20. Cooke, Terry E., "Voluntary Corporate Disclosure by Swedish Companies,"
Journal of International Financial Management and Accounting (Summer, 1989):
pp. 171-195.
21. Financial Analysts Federation (FAF), Report of the Financial Analysts Fed-
eration Corporate Information Committee, FAF, New York, 1986-1990.
22. Ibid.
23. Lang and Lundholm, "Cross-Sectional Determinants of Analysts Ratings."
24. Farragher, E., R. Kleiman and M. Baza, "Do Investors Relations Make a
Difference?" Quarterly Review of Economics and Finance 34 (Winter 1994):
pp. 403-412.
25. Welker, M., "Disclosure Policy, Information Asymmetry and Liquidity in
Equity Markets," Contemporary Accounting Research 11 (Spring 1995): pp. 801
827.
26. Sengupta, Partha, "Corporate Disclosure Quality and the Cost of Debt," The
Accounting Review 4 (October 1998): pp. 459-474.
27. Botosan, C , "Disclosure Level of the Cost of Equity Capital," The Account-
ing Review 72 (July 1997): pp. 323-349.
28. Smith, C. W. and R. L. Watts, "The Investment Opportunity Set and Cor-
porate Financing, Dividend and Compensation Policies," Journal of Financial Eco-
nomics 5 (1992): pp. 263-292.
29. Gaver, J. J. and K. M. Gaver, "Additional Evidence on the Association be-
tween the Independent Opportunity Set and Corporate Financing, Dividend and
Compensation Policies," Journal of Accounting and Economics 6 (1993): pp. 125-
160.
30. Breusch, T. and A Pagan, "A Simple Test for the Heteroskedasticity and
Random Coefficient Variation," Econometrica 47 (1979): pp. 1287-1294.
31. White, H., "A Heteroskedasticity-Consistent Covariance Matrix Estimator
and a Direct Test for Heteroskedasticity," Econometrica 48 (1980): pp. 817-838.

REFERENCES
Abbott, Lawrence J. Executive Compensation Subsequent to a Split in IOS. Uni-
versity of Memphis, 1999.
Botosan, C. "Disclosure Level of the Cost of Equity Capital." The Accounting
Review 72 (July 1997): 323-349.
Disclosure Adequacy 129

Breusch, T. and A Pagan. "A Simple Test for the Heteroskedasticity and Random
Coefficient Variation." Econometrica 47 (1979): 1287-1294.
Bushman, R. and R. Indjejikian. "Accounting Income, Stock Price, and Managerial
Compensation." Journal of Accounting and Economics 16 (1993): 3-24.
Choi, F. D. S. "Financial Disclosure and Entry to the European Capital Market."
Journal of Accounting Research (Autumn 1973): 159-175.
Chow, Chee W. and Adrian Wang-Borem. "Voluntary Financial Disclosure by
Mexican Corporations." The Accounting Review (July 1987): 533-541.
Cooke, Terry E. "Voluntary Corporate Disclosure by Swedish Companies." Journal
of International Financial Management and Accounting (Summer 1989):
171-195.
Farragher, E., R. Kleiman, and M. Baza. "Do Investors Relations Make a Differ-
ence?" Quarterly Review of Economics and Finance 34 (Winter 1994): 4 0 3 -
412.
Financial Analysts Federation (FAF). Report of the Financial Analysts Federation
Corporate Information Committee. New York: FAF, 1986-1990.
Gaver, J. J. and K. M. Gaver. "Additional Evidence on the Association between the
Independent Opportunity Set and Corporate Financing, Dividend and Com-
pensation Policies." Journal of Accounting and Economics 6 (1993): 125-
160.
Jensen, H. and W. Meckling. "Theory of the Firm: Managerial Behavior, Agency
Costs and Ownership Structure." Journal of Financial Economics (October
1976): 305-360.
Kester, W. C. "Today's Options for Tomorrow's Growth." Harvard Business Re-
view (March-April 1984): 153-160.
Kim, O. and Y. Smith. "Incentive Efficiency of Compensation Based on Accounting
and Market Performance." Journal of Accounting and Economics 16 (1993):
25-53.
King, R., G. Pownall, and G. Waymire. "Expectations Adjustments in Timely Man-
agement Forecasts: Review, Synthesis, and Suggestions for Further Re-
search." Journal of Accounting Literature 9 (1990): 113-144.
Lang, M. and R. Lundholm. "Cross-Sectional Determinants of Analysts Ratings of
Corporate Disclosures." Journal of Accounting Research 31 (Autumn 1993):
246-271.
. "Corporate Disclosure Policy and Analyst Behavior." The Accounting Re-
view 71 (October 1996): 467-492.
Leftwich, R., R. Watts, and J. Zimmerman. "Voluntary Corporate Disclosure: The
Case of Interim Reporting." Journal of Accounting Research Supplement
(1981): 50-77.
Meek, Gary M. and Sidney J. Gray. "Globalization of Stock Markets and Foreign
Listing Requirements: Voluntary Disclosures of Continental European Com-
panies Listed on the London Stock Exchange." Journal of International Busi-
ness Studies 20(2) (1980): 315-338.
Meek, Gary M., Clare B. Roberts, and Sidney J. Gray. "Factors Influencing Vol-
untary Annual Report Disclosures by U.S., U.K. and Continental European
Multinational Corporations." Journal of International Business Studies 96
(3) (1987): 555-572.
130 Accounting and the Investment Opportunity Set

Myers, S. "Determinants of Corporate Borrowing." Journal of Financial Economics


(1977): 147-175.
Sengupta, Partha. "Corporate Disclosure Quality and the Cost of Debt." The Ac-
counting Review 4 (October 1998): 459-474.
Skinner, D. J. Why Firms Voluntarily Disclose Bad News. Working paper, Univer-
sity of Michigan, 1992.
. "The Investment Opportunity Set and Accounting Procedure Choice: Pre-
liminary Evidence." Journal of Accounting and Economics 160 (1993): 4 0 7 -
446.
Smith, C. W. and R. L. Watts. "The Investment Opportunity Set and Corporate
Financing, Dividend and Compensation Policies." Journal of Financial Eco-
nomics 5 (1992): 263-292.
Spero, L. L. "The Extent and Cases of Voluntary Disclosure of Financial Infor-
mation in Three European Capital Markets: An Exploratory Study." Un-
published doctoral dissertation, Harvard University, 1979.
Welker, M. "Disclosure Policy, Information Asymmetry and Liquidity in Equity
Markets." Contemporary Accounting Research 11 (Spring 1995): 801-827.
White, H. "A Heteroskedasticity-Consistent Covariance Matrix Estimator and a
Direct Test for Heteroskedasticity." Econometrica 48 (1980): 817-838.
Yermack, D. "Do Corporations Award CEO Stock Options Effectively?" Journal
of Financial Economics 39 (1995): 237-269.
8

The Role of Growth Opportunities


in Determining Systematic Risk

INTRODUCTION
Multinationality of a firm is the degree of its international diversification
and involvement. The question is whether a firm can truly reduce its sys-
tematic risk (measured by the market model beta) by increasing its multi-
nationality. Various studies have examined the issue of the nature of the
association between the level of multinationality and systematic risk. The
overwhelming evidence is of a negative relationship between systematic risk
and multinationality. 1-5 With one exception (Goldberg and Heflin) these
studies did not control for accounting variables found to be able to explain
and forecast market risk. 6-9 In addition, all these studies failed to investigate
the impact of growth opportunities, as measured by the investment oppor-
tunity set, on the relationships between systematic risk and multinational-
ity. This study corrects for both limitations by (1) investigating the
association between multinationality and systematic risk after controlling
for corporate reputation and other factors known to be associated with
systematic risk and (2) evaluating the impact of the investment opportunity
set on the association. Briefly, the results of this study suggest that (1)
systematic risk is positively related to multinationality even after controlling
for corporate reputation and other known factors, and (2) the relation is,
however, negative for high investment opportunity set firms and positive
only for low investment opportunity set firms.
The second section of this chapter discusses the hypothesis development.
132 Accounting and the Investment Opportunity Set

The next section discusses the methods and measures. Results are then pre-
sented. The final section presents a conclusion.

HYPOTHESIS DEVELOPMENT
The benefits of multinationality are essentially in terms of higher returns.
However, the multinational stock prices are also affected by foreign and
local factors. Therefore, multinationality is most likely to have an effect on
the betas of multinational firms. The risk characteristics of the multina-
tional firm most likely reflect the overall firm's characteristics as well as the
foreign environment. Our main hypothesis is of a positive association be-
tween the systematic risk of a multinational firm and its level of multina-
tionality. However, as stated earlier, there is a lot of evidence of a negative
relationship between systematic risk and multinationality. This evidence is
due to the failure to account for the role of growth opportunities in the
relationship between multinationality and systematic risk. The eclectic par-
adigm of international production specifies ownership advantages as one
of the three determinants of the extent, form, and pattern of international
production. 10,11 These ownership advantages include both proprietary
know-how (unique assets) and transactional advantages that outweigh the
costs of servicing an unfamiliar or distant environment. Basically, the mul-
tinational firm possesses unique ownership advantages that its competitors
do not possess. These unique ownership advantages are the future invest-
ment options of the firm or growth opportunities. The firm may be viewed
as a combination of assets-in-place and future investment options. The
lower the proportion of firm value represented by assets-in-place, the higher
the growth opportunities. Myers 12 describes these potential investment op-
portunities as call options whose values depend on the likelihood that man-
agement will exercise them. Like call options, the growth options represent
value to the firm.13 These growth options are intangible assets or ownership
advantages that represent the investment opportunity set. The higher these
growth options the more beneficial is multinationality. In other words, in
terms of our research question, the higher the growth options the more
likely the association between multinationality and systematic risk will be
negative. Our second hypothesis is of a negative association between the
systematic risk and multinationality of a firm with high growth options.

METHODS

Sample
The population consists of firms included in both Forbes* Most Inter-
national 100 American Manufacturing and Service Firms and Fortune's
surveys of corporate reputation from 1987 to 1990. The security data are
Systematic Risk 133

selected from the CRSP Return files. The accounting variables are collected
from both C O M P U S T A T and Forbes' articles. The corporate reputation
measures are collected from Fortune's surveys. The derivation of the mul-
tinationality and reputation measures indices are explained later. The final
sample included 322 firm-year observations.

Control Variable Selection

Various studies attempted to explain and forecast market risk using ac-
counting variables. 1 4 - 1 8 Three variables consistently identified as related to
systematic risk are leverage (positive relationship), size (negative relation-
ship), and earnings variability (positive relationship). Accordingly, these
three variables are used in this study as control variables. In addition to
these three variables, this study uses corporate reputation as another con-
trol variable. T o create the right impression or reputation, firms signal their
key characteristics to constituents to maximize their social status. 1 9 Basi-
cally, corporate audiences were found to construct reputations on the basis
of accounting and market information or signals regarding firm perfor-
mance. 2 0 - 2 2 Their reputations have become established and constitute sig-
nals that may affect the actions of firms' stakeholders, including their
shareholders.

Method of Analyzing the Effect of Multinationality on


Systematic Risk

T o analyze the effect of multinationality on systematic risk, we estimate


the following regression:

where:

BETAlt = Systematic risk of firm / for period t.


MULTYlt = Multinationality score of firm / for period t.
REPlt = Reputation score of firm / for period t.
VROAlt = Variance of return in assets of firm / for period t where the variance is
computed over the eight quarters beginning with the first quarter of the year of
observation.
LEV(t = Leverage of firm / for period t, computed as the ratio of equity to total
assets.
SIZElt = Size measured as logarithm of total assets of firm / for period t.
134 Accounting and the Investment Opportunity Set

The related research, discussed above, suggests that * 2 , <*3, * 4 , oc55 > 0. In
the context of Equation (1) the first hypothesis is H a : ^ 1 < 0. Our second
hypothesis is H a : o^ < 0 for high growth firms.
All the analyses are conducted on observations that are pooled cross-
sectionally over time.

MEASURES

Measuring Multinationality
Previous research has attempted to measure three attributes of multina-
tionality:

1. Performancein terms of what goes on overseas.23


2. Structurein terms of resources used overseas.24
3. Attitude or Conductin terms of what is top management's orientation.25

Sullivan26 developed nine measures of which five were shown to have a


high reliability in the construction of a homogeneous measure of nation-
ality: (1) foreign sales as a percentage of total sales (FSTS), (2) foreign assets
over total assets (FATA), (3) overseas subsidiaries as a percentage of total
subsidiaries (OSTS), (4) top management's international experience
(TMIE), and (5) psychic dispersion of international operations (PDIO).
In this study we follow a similar approach by measuring multinationality
through three measures: (1) foreign sales/total sales (FSTS), (2) foreign prof-
its/total profits (FPTP), and (3) foreign assets/total assets (FATA). A factor
analysis of all observations is used to isolate the factor common to the
three measures. Exhibit 8.1 reports the results. One common factor appears
in the intercorrelations among the three variables, as the first eigenvalue
alone exceeds the sum of the commonalities. The common factor is posi-
tively correlated with the three measures. The factor scores are used to
measure the degree of multinationality of firms in the sample.

Measuring Corporate Reputation


The Fortune survey covers every industry group comprising four or more
companies. The industry groups are based on categories established by the
U.S. Office of Management and Budget (OMB). The survey asked execu-
tives, directors, and analysts in particular to rate a company on the follow-
ing eight key attributes of reputation:

1. Quality of management
2. Quality of products/services offered
Exhibit 8.1
Selected Statistics Related to a Common Factor Analysis of Three Measures of
Multinationality for Forbes' The Most International 100 U.S. Firms for the
1987-1990 Period

1. Eigenvalues of the Correlation Matrix:

Eigenvalues 1 2 3

1.8963 0.9169 0.1868

2. Factor Pattern

FACTOR1

FS/TS 0.93853

FP/TP 0.40913

FA/TA 0.92089

3. Final Communality Estimates: Total = 1.389626

FS/TS FP/TP FA/TA

0.8808 0.16738 0.84804

4. Standardized Scoring Coefficients

FACTOR1

FS/TS 0.49494

FP/TP 0.21575

FA/TA 0.48563

5. Descriptive Statistics of the Common Factor Extracted from the Three

Measures of Multinationality
Maximum 201.059

Third Quartile 52.231

Median 41.50

First Quartile 30.648

Minimum 5.198

Mean 43.062

Variable definitions:
FS/TS: Foreign sales/total sales
FP/TP: Foreign profits/total profits
FA/TA: Foreign assets/total assets
136 Accounting and the Investment Opportunity Set

3. Innovativeness
4. Value as long-term investment
5. Soundness of financial position
6. Ability to attract/develop/keep talented people
7. Responsibility to the community/environment
8. Wise use of corporate assets

Ratings were as a scale of 0 (poor) to 10 (excellent). The score met the


multiple-constituency ecological model view of organizational effectiveness.
For purposes of this study, the 1987 to 1990 Fortune magazine surveys
were used. To obtain a unique configuration, a factor analysis is used to
isolate the factor common to the eight measures of reputation. All the ob-
servations were subjected to factor analysis and one common factor was
found to explain the intercorrelations among the eight individual measures.
Exhibit 8.2 reports the results of the common factor analysis. One common
factor appears to explain the intercorrelations among the eight variables,
as the first eigenvalue alone exceeds the sum of the commonalities. The
common factor is significantly and positively correlated with the eight
measures. The factor scores are used to measure the corporate reputation
of firms.

Measuring Systematic Risk


The capital asset pricing model asserts that in equilibrium, and under
certain conditions, the risk premium for an individual security, E (R,) E
(RF), is related to the risk premium of the market, E (Rm) E (RF), by the
expression:

where:

E (RF) = risk-free rate


E (Rm) = expected return on a market factor
ai = cov (R RJ/var(Rm)

ai is a measure of the systematic or nondiversifiable risk. Its estimation is


operationally possible using the one-factor market model, which asserts a
linear relationship between the rate of return on security /, RfY5 and the
market rate of return, R,n for a period t. It is expressed in this study as
follows:
Exhibit 8.2
Selected Statistics Related to a Common Factor Analysis of Measures of
Reputation

1. Eigenvalues of the Correlation Matrix:

Eigenvalues

1 2 3 4 5 6 7 8
6.7776 0.4596 0.3841 0.1347 0.1120 0.0549 0.0482 0.0331

2. Factor Pattern

FACTOR1

*x 0.9530 *4 0.9645 Ri 0.8072

*2 0.9180 *S 0.8982 R* 0.9479

*3 0.8789 R* 0.9805

3. Final Communality Estimates: Total = 1.389626

R\ Rz R3 R$ Rs ^6 RJ R%

0.9093 0.8438 0.7726 0.9304 0.8069 0.9614 0.6516 0.8986

4. Standardized Scoring Coefficients

FACTOR1

R, 0.1407 RA 0.1424 R7 0.1191

R2 0.1355 Rs 0.1326 Rs 0.1399

R3 0.1297 R6 0.1447

5. Descriptive Statistics of the Common Factor Extracted from the Eight Measures of

Reputation

Third Quartile 7.288

Median 6.618

First Quartile 6.105

Minimum 3.235

Mean 6.622

Variable definitions:
R t = Quality of management.
JR 2 Quality of products/services.
R 3 = Innovativeness.
R4 = Value as long-term investment.
Rs = Soundness of financial position.
R6 = Ability to attract, develop, and keep talented people.
R7 = Responsibility to the community and environment.
Rs = Wise use of corporate assets.
138 Accounting and the Investment Opportunity Set

where:

rit continuously compounded rate of return of security / at period t


= log.(/ + R)
= \oge[(P, + D,)/P,.,]
Rit = noncompounded single-period return of security i in period t
rm = market factor in period t log,,
eit = logarithm of the residual term
Dit = cash dividend per share
<*,-, at parameters of the least squares regression

rit is used instead of Rit because it is admitted that, first, rit has fewer outliers
in its relative frequency distribution and therefore will yield more efficient
risk statistics than Rit and, second, rit is distributed more symmetrically than
the positively skewed Rit variable. Besides, the results of the model are not
changed by restating them in terms of rit instead of Rit.

Measuring the Investment Opportunity Set


Because the investment opportunity set is not observable there has not
been a consensus on an appropriate proxy variable. Similar to Smith and
W a t t s 2 7 and Gaver and Gaver, 2 8 we use an ensemble of variables to measure
the investment opportunity set. The three measures of the investment op-
portunity set used are: market-to-book assets (MASS), market-to-book en-
tity ( M Q V ) , and the earnings/price ratio (EP). These variables are defined
as follows:

MASS = (Assets - Total Common Equity + Shares Outstanding*Share Closing


Price)/Assets
MV = (Shares Outstanding*Share Closing Price)/Total Common Equity
EP = (Primary EPS before Extraordinary Items)/Share Closing Price

The results of a factor analysis of the three measures of the investment


opportunity set are shown in Exhibit 8.3. One common factor appears to
Exhibit 8.3
Selected Statistics Related to a Common Factor Analysis of Three Measures of
the Investment Opportunity Set for Forbes' The Most International 100
U.S. Firms

1. Eigenvalues of the Correlation Matrix: Total = 3 Avenue = 1

Eigenvalue 1 2 3

1.0540 0.9868 0.9592

2. Factor Pattern

FACTOR1

MASS 0.62821

MQV 0.66411

EP 0.46722

3. Final Co mmunality Estimates: Total = 1.053994

MASS MQV EP

0.394651 0.441045 0.218299

4. Standardized Scoring Coefficients

FACTOR1

MASS 0.59603

MQV 0.63009

EP 0.44329

5. Descriptive Statistics of the Common Factor Extracted from the Three Measures of

the Investment Opportunity

Maximum 9.3595

Third Quartile 3.2200

Median 2.0450

First Quartile 1.5085

Minimum 2.5209

Mean 1.9812
140 Accounting and the Investment Opportunity Set

explain the intercorrelations among the three individual measures. Based


on their factor scores, high growth firms are chosen from the top 2 5 % of
the distribution scores while low growth firms are chosen from the bottom
2 5 % of the distribution factor scores. The two groups are used for testing
the second hypothesis.

RESULTS

The Association of Multinationality with Systematic Risk


Exhibit 8.4 contains the descriptive statistics for the total sample for all
the variables as well as the Pearson correlation coefficients among the re-
gression variables. Exhibit 8.5 presents the estimated coefficients and t-
statistics from the estimation of Equation (1). As shown in Exhibit 8.4 the
null hypothesis is rejected for ^x. Consistent with expectation, the multi-
nationality score is significant and positive. All the control variables (REP,
VROA, LEV, and SIZE) are significant and positive. The estimate of 1
indicates that an increase of, say, 10% in the multinationality score is as-
sociated with a 0.00001 increase in BETA. The results show that the sys-
tematic risk of U.S. multinational firms is positively related to the level of
multinationality after controlling for corporate reputation and other factors
known to be associated with systematic risk.

Growth Opportunities Effect


Previous research has shown multinationality to be instead negatively
related to systematic risk.29 The difference in the results is attributed to a
failure in considering the difference in the growth opportunities of firms in
the sample, as measured by the investment opportunity set. Exhibit 8.5
shows the estimated coefficients and ^-statistics from the estimation of
Equation (1) for both a high investment opportunity set subsample and a
low investment opportunity set subsample.
As shown in Exhibit 8.6, the coefficient in the multinationality score is
significant and negative for the high investment opportunity set subsample
and significant and positive for the low investment subsample. All the con-
trol variables are, as expected, significant and positive for both groups of
firms. The results indicate that increases in multinationality are associated
with an increase in systematic risk for low investment opportunity set firms
and a decrease in systematic risk for high investment opportunities set. It
is the presence of strong growth opportunities that leads to a negative as-
sociation between systematic risk and multinationality.
Exhibit 8.4
Summary Statistics for Empirical Variables

Panel A: Distributional Characteristics

Variables Mean Median Range


\BETA 1.009 1.004 0.106
MULTY 54.32 51.27 319.2
LEV 0.354 0.374 1.704

SIZE 16438 6175 136404


VROA 1.116 0.120 8.13
REP 6.622 6.614 5.78

Panel B: Pearson Correlation Among Regression Variables

BETA MULTY LEV SIZ VROA REP


BETA 1.000
MULTY 0.123 1.000
a
LEV 0.492 0.089b 1.000
b
SIZE -0.158 -0.084 -0.447* 1.000
a
VROA 0.279 0.026 0.268* -0.201* 1.000
a
REP 0.650* -0.050 0.305 -0.078 0.0564 1.000

1. Variable definitions:
BETA: Systematic Risk
MULTY: Index of Multinationality
LEV: Leverage Ratio
VROA: Variance of Return in Assets
SIZE: Size
REP: Index of Reputation
2. "Significant at the 0.01 level.
Significant at the 0.05 level.
Exhibit 8.5
Results of Pooled Time-Series Cross-Sectional Association Regression of
Systematic Risk and Multinationality and Selected Variables

Coefficients

INTERCEPT -0.1182<2)

(-18.477)

MULTY" 0.0001

(6.769)"

\REP 0.003

(5.189)"

VROA 0.0008

(5.305)"

LEV 0.0275

-- (7.265)"

SIZE 0.009

(16.422)"

ADJUSTED R2 57.07%

n = 322

1. Variable definitions:
MULTY: Index of multinationality
REP: Index of reputation
VROA: Variance of return in assets
LEV: Leverage ratio
SIZE: Firm size computed as log of total assets.
2. The regression is OLS. ^-statistics are shown in parentheses based upon the White (1980)
corrected standard errors.
3. Superscript a represents statistical significance at the 1% level for the one-tailed test.
Systematic Risk 143

Exhibit 8.6
Relation between Systematic Risk and Multinationality and Selected Variables for
High and Low Investment Opportunity Set

High Investment Low Investment


Opportunity Set Opportunity Set
INTERCEPT -0.058 -0.082
(-5.183)" (-12.549)"
\ MULTY -0.000017 0.0001
(-5.380)" (4.744)"
\REP 0.0046 0.001
(3.424)" (4.540)"
VROA 0.0003 0.0003
(8.650)" (3.070)"
\LEV 0.022 0.013"
(3.482)" (3.552)"
ISIZE 0.003 0.007
(2.730)" (13.895)"
\ ADJUSTED R2 49.29% 72.74%
n= 89 89

"Significant at the 0.01 level.

CONCLUSIONS AND IMPLICATIONS


This chapter examines the association between the level of multination-
ality of U.S. multinationality firms and systematic risk as measured by the
market model beta. Unlike previous studies, the results of this study show
that systematic risk is positively related to the level of multinationality.
However, a consideration of the growth opportunities of firms, as measured
by the investment opportunity set, shows that the relation is negative for
high investment opportunity set firms and positive for low investment op-
portunity set firms. The increase in systematic risk, following an increase
in multinationality, is the result of lack of growth opportunities. It is when
multinationality is associated with high growth opportunities that system-
atic risk is negatively related to international diversification.
144 Accounting and the Investment Opportunity Set

NOTES
1. Goldberg, S. R. and F. L. Heflin, "The Association between the Level of
International Diversification and Risk," Journal of International Financial Man-
agement and Accounting 6 (1995): pp. 1-25.
2. Hughes, J. S., D. E. Logue, and R. J. Sweeney, "Corporate International Di-
versification and Market Assigned Measures of Risk and Diversification," Journal
of Financial and Quantitative Analysis 10 (November 1975): pp. 627-637.
3. Agmon, T. and D. R. Lessard, "Investor Recognition of Corporate Interna-
tional Diversification," Journal of Finance 32 (September): pp. 1049-1055.
4. Madura, J. and L. C. Rose, "Impact of International Sales Degree and Di-
versity on Corporate Risk," International Trade Journal (Spring 1989): pp. 2 6 1 -
276.
5. Rugman, A. R., "Foreign Operations and the Stalreity of U.S. Corporate
Earnings: Risk Reduction by International Diversification," Journal of Finance
(March 1977): pp. 233-234.
6. Belkaoui, A., "Accounting Determinants of Systematic Risk in Canadian
Common Stocks: A Multivariate Approach," Accounting and Business Research 33
(Winter 1978): pp. 3-10.
7. Bowman, R. G., "The Theoretical Relationship between Systematic Risk and
Financial (Accounting) Variables "Journal of Finance 34 (June 1979): pp. 617-630.
8. Hill, N. C. and B. K. Stone, "Accounting Betas, Systematic Operating Risk,
and Financial Leverage: A Risk-Composition Approach to the Determinants of Sys-
tematic Risk," Journal of Financial and Quantitative Analysis 15 (September 1980):
pp. 595-637.
9. Beaver, W., P. Kettler, and M. Scholes, "The Association between Market
Determined and Accounting Determined Risk Measures," The Accounting Review
45 (October 1970): pp. 654-682.
10. Dunning, John H., Explaining International Production, Urwin Hyman,
London, 1988.
11. Dunning, John H., "The Eclectic Paradigm of International Production: Four
Restatements and Some Possible Extensions," Journal of International Business
Studies 19(1) (1988): pp. 1-32.
12. Myers, S., "Determinants of Corporate Borrowing," Journal of Financial
Economics (1977): pp. 147-175.
13. Kester, W. C , "Today's Options for Tomorrow's Growth,"Harvard Busi-
ness Review (March-April 1984): pp. 153-160.
14. Belkaoui, "Accounting Determinants of Systematic Risk."
15. Bowman, "The Theoretical Relationship between Systematic Risk and Fi-
nancial Variables."
16. Hill and Stone, "Accounting Betas."
17. Beaver, et al., "The Association between Market Determined and Accounting
Determined Risk Measures."
18. Goldberg and Heflin, "The Association between the Level of International
Diversification and Risk."
19. Spence, A. M., Market Signaling: Information Transfer in Hiring and Re-
lated Screening Process, Harvard University Press, Cambridge, MA, 1974.
Systematic Risk 145

20. Forbrum, C. and M. Shanley, "What's in a Name? Reputational Building


and Corporate Strategy,"Academy of Management Journal 33 (1990): pp. 2 3 3 -
258.
21. Belkaoui, Ahmed, "Organizational Effectiveness, Social Performance and
Economic Performance," Research in Corporate Social Performance and Policy 12
(1992): pp. 143-155.
22. Riahi-Belkaoui, Ahmed and E. Pavlik, "Asset Management Performance and
Reputation Building for Large U.S. Firms," British Journal of Management 2
(1991): pp. 231-238.
23. Dunning, John H., "Reappraising the Eclectic Paradigm in an Age of Alliance
Capitalism," Journal of International Business Studies 26 (1995): pp. 461-492.
24. Stopford, John M. and Louis T. Wells, Managing the Multinational Enter-
prise, Basic Books, New York, 1972.
25. Perlmutter, Howard V., "The Tortuous Evaluation of the Multinational Cor-
poration," Columbia Journal of World Business 4 (January-February 1969): pp. 9 -
18.
26. Sullivan, D., "Measuring the Degree of Internationalization of a Firm," Jour-
nal of International Business Studies 25 (1994): pp. 325-342.
27. Smith, C. W. and R. L. Watts, "The Investment Opportunity Set and Cor-
porate Financing, Dividend and Compensation Policies," Journal of Financial Eco-
nomics 2 (1992): pp. 263-292.
28. Gaver, J. J. and K. M. Gaver, "Additional Evidence on the Association be-
tween the Investment Opportunity Set and Corporate Financing, Dividend, and
Compensation Policies," Journal of Accounting and Economics 3 (1993): pp. 125-
160.
29. Goldberg and Heflin, "The Association between the Level of International
Diversification and Risk."

REFERENCES
Agmon, T. and D. R. Lessard. "Investor Recognition of Corporate International
Diversification." Journal of Finance 32 (September 1977): 1049-1055.
Beatty, R. P. and J. R. Ritter. "Investment Banking, Reputation, and Underpricing
of Initial Public Offerings." Journal of Financial Economics 15 (1986): 2 1 3 -
232.
Beaver, W., P. Kettler, and M. Scholes. "The Association between Market Deter-
mined and Accounting Determined Risk Measures." The Accounting Review
45 (October 1970): 654-682.
Belkaoui, A. "Accounting Determinants of Systematic Risk in Canadian Common
Stocks: A Multivariate Approach." Accounting and Business Research 33
(Winter 1978): 3-10.
. "Organizational Effectiveness, Social Performance and Economic Perfor-
mance." Research in Corporate Social Performance and Policy 12 (1992):
143-155.
Belsley, D., E. Kuh, and R. Welsch. Regression Diagnostics: Identifying Influential
Data and Sources of Collinearity. New York: Wiley, 1980.
Bernard, V. "Cross-Sectional Dependence and Problems in Inference in Market-
146 Accounting and the Investment Opportunity Set

Based Accounting Research." Journal of Accounting Research (Spring 1987):


1-48.
Bowman, R. G. "The Theoretical Relationship between Systematic Risk and Finan-
cial (Accounting) Variables." Journal of Finance 34 (June 1979): 617-630.
Dunning, John H. Explaining International Production. London: Urwin Hyman,
1988a.
. "The Electic Paradigm of International Production: Four Restatements and
Some Possible Extensions." Journal of International Business Studies 19(1)
(1988b): 1-32.
. "Reappraising the Eclectic Paradigm in an Age of Alliance Capitalism."
Journal of International Business Studies 26 (1995): 461-492.
Eiteman, D. and A. Stonehill. Multinational Business Finance. Boston: Addison-
Wesley, 1986.
Forbrum, C. and M. Shanley. "What's in a Name? Reputational Building and Cor-
porate Strategy." Academy of Management Journal 33 (1990): 233-258.
Gaver, J. J. and K. M. Gaver. "Additional Evidence on the Association between the
Investment Opportunity Set and Corporate Financing, Dividend, and Com-
pensation Policies." Journal of Accounting and Economics 3 (1993): 125-
160.
Goldberg, S. R. and F. L. Heflin. "The Association between the Level of Interna-
tional Diversification and Risk." Journal of International Financial Manage-
ment and Accounting 6 (1995): 1-25.
Hill, N. C. and B. K. Stone. "Accounting Betas, Systematic Operating Risk, and
Financial Leverage: A Risk-Composition Approach to the Determinants of
Systematic Risk." Journal of Financial and Quantitative Analysis 15 (Sep-
tember 1980): 595-637.
Hughes, J. S., D. E. Logue, and R. J. Sweeney. "Corporate International Diversifi-
cation and Market Assigned Measures of Risk and Diversification." Journal
of Financial and Quantitative Analysis 10 (November 1975): 627-637.
Kester, W. C. "Today's Options for Tomorrow's Growth." Harvard Business Re-
view (March-April 1984): 153-160.
Kogut, Bruce. "Foreign Direct Investment as a Sequential Process." In C. Kindel-
berger and D. Andretsch (eds.). The Multinational Corporation in the
1980's. Cambridge, MA: MIT Press, 1988: 38-56.
Madura, J. and L. C. Rose. "Impact of International Sales Degree and Diversity on
Corporate Risk." International Trade Journal 2 (Spring 1989): 261-276.
Myers, S. "Determinants of Corporate Borrowing. "Journal of Financial Economics
2 (1977): 147-175.
Perlmutter, Howard V. "The Tortuous Evaluation of the Multinational Corpora-
tion." Columbia Journal of World Business 4 (January-February 1969): 9-
18.
Riahi-Belkaoui, Ahmed and E. Pavlik. "Asset Management Performance and Rep-
utation Building for Large U.S. Firms." British Journal of Management 2
(1991): 231-238.
Rugman, A. R. "Foreign Operations and the Stability of U.S. Corporate Earnings:
Risk Reduction by International Diversification." Journal of Finance 3
(March 1977): 233-234.
Systematic Risk 147

Smith, C. W. and R. L. Watts. "The Investment Opportunity Set and Corporate


Financing, Dividend and Compensation Policies." Journal of Financial Eco-
nomics 2 (1992): 263-292.
Spence, A. M. Market Signaling: Information Transfer in Hiring and Related
Screening Process. Cambridge, MA: Harvard University Press, 1974.
Stopford, John M. and Louis T. Wells. Managing the Multinational Enterprise.
New York: Basic Books, 1972.
Sullivan, D. "Measuring the Degree of Internationalization of a Firm." Journal of
International Business Studies 25 (1994): 325-342.
White, H. A. "Heteroskedasticity-Consistent Covariance Matrix Estimator and a
Direct Test for Heteroskedasticity." Econometrica 10 (1980): 817-838.
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9

Growth Opportunities and


Reputation Building

INTRODUCTION
The reputation of a firm is important for various decisions ranging from
resource allocation and career decisions to product choices, to name only
a few. 1,2 It is an important signal of the firm's organizational effectiveness.
Favorable reputations can create favorable situations for firms that in-
clude: (1) the generation of excess returns by inhibiting the mobility of ri-
vals in an industry;3' 4 (2) the capability of charging premium prices to
consumers; 5 - 6 and (3) the creation of a better image in the capital markets
and investors.7-8
With few exceptions, most previous empirical studies have examined the
relationship of earnings performance and social performance.9, 10 Three
studies, however, investigated the relationship between reputation and var-
ious economic and noneconomic criteria that may be used by corporate
audiences to construct reputations.
Although the signals used in these three studies show attendance by cor-
porate audiences to different information cues, this chapter proposes that
of most importance to these parties are signals about asset management
performance. Therefore, this study proposes specific hypotheses relating as-
sessments of reputation to various information signals about a firm's asset
management performance, specifically using signals that indicate size of the
firm, the level of the firm's investment opportunity set, and multination-
ality.
150 Accounting and the Investment Opportunity Set

RELATED RESEARCH
Three studies have investigated the determinants of reputation building.
Based on the thesis that an organization's social performance is an indis-
tinguishable component of its effectiveness, Belkaoui11 and Belkaoui and
Pavlik12 expanded the definition of social performance to include organi-
zational effectiveness, and investigated the relationship between organiza-
tional effectiveness and economic performance. Following the ecological
model, organizational effectiveness by constructs' reputational ranking of
firms was used. 13 ' 14 The reputational rankings were found to be positively
related to profitability, size, and price/earnings ratio, and negatively related
to systematic risk. Using a similar approach, Fombrun and Shanley15 found
the same reputational rankings, for a different period and a different sam-
ple, to be related to the firm's risk-return profiles, resource allocations,
social responsiveness, institutional ownership, media exposure, and cor-
porate diversification. These are all signals about a firm's projects and gen-
erate reputations.
Riahi-Belkaoui and Pavlik16 presented empirical evidence that supported
the general hypotheses that corporate audiences construct reputations on
the basis of information about a firms' asset management performance,
specifically using market and accounting symbols indicating the size of the
assets, market assessment of the value of the assets in place, and turnover
and profit margin.
Finally, Riahi-Belkaoui17 hypothesized that corporate audiences will con-
struct reputation rankings on the basis of the extent of earnings manage-
ment. The results of the empirical study of the 100 most international U.S.
firms supported the hypothesis that corporate audiences construct reputa-
tions on the basis of information about a firm's extent of earnings man-
agement by assigning higher reputation for firms with a higher cash flow
from operations and lower reputations for firms with higher total accruals.

REPUTATION BUILDING

Objective Function and Stewardship


This chapter hypothesizes that corporate audiences attend to different
features of firms' asset management performance in constructing reputa-
tional rankings. The focus on asset management performance rather than
other attributes of firm performance results from specific expectations of
corporate audiences about the objectives of management and the nature of
asset stewardship.
Organizations are social units deliberately constructed and reconstructed
to seek specific goals.18 J. D. Thompson 19 differentiated between goals held
Reputation Building 151

for an organization and goals of an organization. The former goals are


held by outside members of the organization who have a given interest in
the activities of the firm, while the latter are the goals held by persons and/
or managers who are part of the "dominant coalition" in terms of holding
enough control to commit the organization to a given direction. The same
distinction is made by Perrow20 as official goals versus operative goals. The
main difference between the goals arises when the official goals held by
corporate audiences conform to a managerial-welfare-maximization
model. 21 The shareholder-wealth-maximization model holds that the op-
erative goals are to maximize the wealth of stockholders. The firm accepts
all projects yielding more than the cost of capital and therefore is only
interested in an efficient use of the assets of the firm. The management-
welfare-maximization model holds that managers run firms for their own
benefit.22 It follows that corporate audiences committed to a shareholder-
wealth-maximization view of operative goals will construct reputations on
the basis of information about a firm's asset management performance.
The stewardship concept is basically a feature of the principal-agent re-
lationship, whereby the agent is assumed to safeguard the resources of the
principal. The stewardship concept has evolved over time. Birnberg23 dis-
tinguished four periods: (1) the pure custodial period; (2) the traditional
custodial period; (3) the asset utilization period; and (4) the open-ended
period. The first two periods refer to the need for the agent to return the
resources intact to the principal by performing minimal tasks to fulfill the
custodial function. The third period refers to the need for the agent to
provide initiative and insight in using the assets to conform to agreed-upon
plans. Finally, the open-ended period differs from the asset utilization pe-
riod by providing more flexibility in the use of assets and enabling the agent
to chart the course of asset utilization. The third and fourth periods are
more reflective of the contemporary conception of stewardship. It follows
that corporate audiences holding these views of stewardship will construct
reputations on the basis of information about firms' asset management per-
formance.

Interpreting Ambiguous Signals about Asset Management


Based on the shareholder-wealth-maximization model for operative goals
of firms, and the asset-utilization and open-ended use of assets for views
of stewardship, corporate audiences are assumed to construct reputations
on the basis of informational signals about firms' asset management per-
formance. Asset management performance is perceived to be a combination
of firm size, level of the investment opportunity set, and level of multina-
tionality.
152 Accounting and the Investment Opportunity Set

Size
Large firms are more politically sensitive than small firms.24 If their prof-
its are also large, they fear government actions. 25,26 The amount and qual-
ity of information of large firms will be larger in response to the increased
scrutiny. 27-29 As a result, it may be safe to assume that corporate audiences
will appreciate better the information quality of large firms and assign them
a better reputation. The following hypothesis will be tested:

Hypothesis 1: The larger the firm, the better its reputation.

Level of the Investment Opportunity Set


The level of the investment opportunity set is a measure of the growth
opportunities or the firm's future investment opportunities. It can be per-
ceived as a measure of future and present managerial performance. As a
measure of future and present managerial performance, the level of the
investment opportunity set can also be interpreted as a signal of asset man-
agement performance. The following hypothesis will be tested:

Hypothesis 2: The greater the level of the investment opportunity set


of a firm, the better its reputation.

Level of Multinationality
A firm's efficient use of its assets is best reflected in the degree to which
it takes advantage of both local and foreign opportunities. The foreign
opportunities can be expressed by the level of multinationality. Given the
profit-related results of multinationality, the level of multinationality can
be perceived as a good signal of asset management performance. The fol-
lowing hypothesis will be tested:

Hypothesis 3: The greater a firm's level of multinationality, the better


its reputation.

THE MODEL
The three hypotheses may be expressed by the following model:

where:

REPU = Overall score of reputation


REP2t = Score on quality of management
Reputation Building 153

REP3t = Score on quality of products/services offered


REP4t = Score on innovativeness
REPSt = Score of value as a long-term investment
REP6t = Score on soundness of financial position
REP7t = Score on ability to attract/develop/keep talented people
REPSt = Score on responsibility to the community/environment
REP9t = Score on use of corporate assets
SIZE = Firm size
IOS = Investment opportunity set level
MULTY = Multinationality level

The model was run for the period 1 9 8 6 - 1 9 9 0 .

THE DATA

Dependent Variable

The main dependent variable of reputation is the combined score ob-


tained in an annual Fortune magazine survey. The Fortune survey covers
every industry group comprising four or more companies. The industry
groups are based on categories established by the U.S. Office of Manage-
ment and Budget (OMB). The survey asked executives, directors, and an-
alysts in particular industries to rate a company on the following eight key
attributes of reputation:

1. Quality of management
2. Quality of products/services offered
3. Innovativeness
4. Value as a long-term investment
5. Soundness of financial position
6. Ability to attract/develop/keep talented people
7. Responsibility to the community/environment
8. Wise use of corporate assets.

Ratings were on a scale of 0 (poor) to 10 (excellent). The score met the


multiple-consisting ecological view of organization effectiveness. For the
purpose of this study, the 1 9 8 6 - 1 9 9 0 Fortune magazine surveys were used.
The use of the overall score is based on the facts that: (a) it is the overall
score that is published in Fortune magazine rather than the eight scores on
the attributes, and (b) it is then the overall score that is perceived by the
readers as well as the reputation index. From previous experience, the re-
154 Accounting and the Investment Opportunity Set

Exhibit 9.1
Descriptive Statistics

Variables Mean Standard Minimum Maximum


Variables

MULTY 35.073 14.962 6.600 76.100

IOS 0.5611 0.824 -8.787 7.383

SIZE 15,013 18,953 9,318 126,932

* Variable definitions:
MULTI = Multinationality measured as foreign revenues/total revenues
IOS = Level of investment opportunity set
SIZE = Total revenues

spondents know that the means of their scores on the eight attributes will
be published as the overall score of reputation.
Besides the overall score, the eight individual scores on the eight key
attributes of reputation were also used as dependent variables to evaluate
their differential relations with asset management performance.

Independent Variables
The independent variables include firm size, level of the investment op-
portunity set, and level of multinationality.

Sample
To ensure the greatest sample of firms for which data would be available
for all variables, the initial sample chosen was all the firms included in
Fortune's 1986-1990 studies of corporate reputation and Forbes' list of the
100 most international U.S. firms for the same period.
Exhibit 9.1 presents the basic descriptive statistics for all the variables in
the model. Exhibit 9.2 presents the intercorrelations among the variables.
The low intercorrelations among the predictor variables used in the model
Reputation Building 155

Exhibit 9.2
Correlations

Variables MULTY IOS SIZE

MULTY 1.000 0.0404 -0.0167


(0.000) (0.4571) (0.7243)

IOS 1.000 0.0181


(0.000) (0.7385)

SIZE 1.000
(0.0001)

gave no reason to suspect multicoUinearity, and various diagnostic tests run


on derived regression models confirmed that it was not a problem.

RESULTS
Exhibit 9.3 presents the results of the regression coefficients for all the
independent variables, using all the measures of reputation as dependent
variables for the 1986-1990 period.
Hypothesis 1 predicts that the firm size, as measured by the logarithm
of total revenues, will positively affect reputation. With no exception, the
results corroborate the hypothesis that corporate audiences tend to assign
higher (better) reputations to firms with higher size as measured by the
logarithm of total revenues.
Hypothesis 2 predicts that the level of the investment opportunity set, as
a measure of the firm's future investment opportunities, will positively af-
fect reputation. With no exceptions, the results for the 1986-1990 period
corroborate the hypothesis that corporate audiences tend to assign higher
reputations to firms with a higher level of investment opportunity set.
Hypothesis 3 predicts that the level of multinationality significantly in-
fluences reputational judgments. With no exceptions, the results for the
periods examined indicate that corporate audiences tend to assign higher
reputations to firms with a higher level of multinationality.
In short, the overall reputation of firms, as well as the eight component
scores of reputation, are positively related to the firm's size, level of in-
vestment opportunity set, and multinationality. An interesting result is pro-
vided by the results on reputation as measured by soundness of financial
Exhibit 9.3
Explaining Corporate Reputation

1 Independent Intercept SIZE IOS MULTY T1 F


Variables/
Dependent
Variables
Overall 5.079 0.115 0.1340 0.0132 0.062 6.375"
Corporate (7.616)' (1.734)- (1.715)- (3.450)'
i Reputation

Quality of 5.486 0.0931 0.1543 0.0100 0.034 3.407'


Management (7.081)' (1.788)*" (1.679)- (2^26)'

Quality of 6.4614 0.0158 0.0991 0.0156 0.078 8.187'


Products/ (10.645)' (1.825)"* (1.689)- (4.437)*
Services
Offered
Innovative- 5.901 0.0010 0.1310 0.0099 0.034 3.399
ness (8.455)' (1.782)** (1.683) (2.438)'

Value as a 4.256 0.1821 0.1499 0.0134 0.097 10.354"


Long-Tenn (5.602)' (2.370)' (1.663) (3.047)*
Investment

Soundness of 2.838 0.3526 0.1775 0.0184 0.097 10.354'


Financial (3.227)' (3.964)* (1.702) (3.599)'
Position

Ability to 4.2646 0.1744 0.1355 0.0156 0.077 8.065"


Attract/ (6.095)* (2.464)' (1.634) (3.847)'
Develop/
Keep
Talented
People
Responsibility 5.1881 0.0882 0.0987 0.0128 0.068 7.000'
to (9.252)' (1.756)- (1.884) (3.884)'
Community/
Environment

Wise Use of 5.7553 0.0191 ' 0.1264 0.0100 0.030 3.053'


Resources (7.890)' (1.759)- (1.864)- (2.357)'

Absolute value of tstatistics in parentheses.


* Significant at 0.01.
* * Significant at 0.05.
*** Significant at 0.001.
Reputation Building 157

position. It offers the highest R2. As expected, the results on reputation as


measured by soundness of financial position is related to our three depen-
dent variables.

DISCUSSION AND CONCLUSIONS


Both the shareholder-wealth-maximization model and the open-ended
stewardship concept maintain that corporate audiences are very much con-
cerned about managers' use of the assets of the firm. This chapter has
hypothesized that, consequently, corporate audiences will construct repu-
tational rankings on the basis of the asset management performance. More
specifically, the results of an empirical study of large U.S. firms supported
the general hypothesis that corporate audiences construct reputations on
the basis of information about a firm's asset management performance,
specifically using market and accounting signals, indicating the size of the
firm, the level of the investment opportunity set, and the level of multina-
tionality. Given the potential that reputation rankings may crystallize the
statuses of firms within an industrial social system, firms, through a thor-
ough understanding of the informational medium from which corporate
audiences construct reputations, signal these audiences about their asset
management performance through both accounting and market signals. An
interesting signal identified in this study is the unobservable level of the
investment opportunity set. In other words, corporate audiences construct
reputations on the basis of their perceptions of the level of growth oppor-
tunities to be experienced by the firms being evaluated.

NOTES
1. Dowling, G. R., "Managing Your Corporate Images,"Industrial Market
Management 15 (1986): pp. 109-115.
2. Riahi-Belkaoui, Ahmed and Ellen Pavlik, Accounting for Corporate Repu-
tation, Greenwood Publishing, Westport, CT, 1992.
3. Caves, R. E. and M. E. Porter, "From Entry Barriers to Mobility Barri-
ers," Quarterly Journal of Economics 91 1977: 421-434.
4. Wilson, R., "Reputation in Games and Markets," in Roth, A. E. (Ed.) Game-
Theoretical Models of Bargaining, Cambridge University Press, New York, 1985:
pp. 65-84.
5. Beatty, R. P. and J. R. Ritter, "Investment Banking, Reputation, and Under-
pricing of Initial Public Offerings," Journal of Financial Economics 15 (1986):
pp. 213-232.
6. Milgrom, P. and J. Roberts, "Relying on the Information of Interested Par-
ties," Rand Journal of Economics 17 (1986): pp. 18-32.
7. Klein, B. and K. Leffler, "The Role of Market Forces in Assuring Contractual
Performance," Journal of Political Economy 89 (1981): pp. 615-641.
158 Accounting and the Investment Opportunity Set

8. Milgrom, P. and J. Roberts, "Price and Advertising Signals of Product Qual-


ity," Journal of Political Economy 94 (1986): pp. 796-821.
9. Karpik, P. G. and A. Belkaoui, "Determinants of the Corporate Decisions to
Disclose Social Information,"Accounting, Auditing and Accountability Journal 2
(1989): pp. 36-51.
10. Ullman, A. A., "Data in Search of a Theory: A Critical Examination of the
Relationship among Social Performance, Social Disclosure and Economic Perfor-
mance of US Firms," Academy of Management Review 10 (1985): pp. 540-552.
11. Belkaoui, A., "Organizational Effectiveness, Social Performance and Eco-
nomic Performance,"Research in Corporate Social Performance and Policy 12
(1991): pp. 143-153.
12. Belkaoui, A. and E. Pavlik, Accounting for Corporate Reputations, Quorum
Books, Westport, CT, 1992.
13. Connolly, T., E. Conlon, and S. J. Deutsh, "Organizational Effectiveness:
A Multi-Constituency Approach,"Academy of Management Review 5 (1980):
pp. 211-217.
14. Scott, W. R., Organizations: Rational, Natural Operational Systems,
Prentice-Hall, Englewood Cliffs, NJ, 1981.
15. Fombrun, C. J. and M. Shanley, "What's in a Name? Reputation Building
and Corporate Strategy," Academy of Management Journal 33 (1990): 233-258.
16. Riahi-Belkaoui, Ahmed and Ellen Pavlik, "Asset Management Performance
and Reputation Building for Large US Firms," British Journal of Management 2
(1991): pp. 231-238.
17. Riahi-Belkaoui, Ahmed, "Earnings Management and Reputation Building
for Large US Firms," Accounting and Business Review (2) 1999: pp. 159-170.
18. Etzioni, A., Modern Organization, Prentice-Hall, Englewood Cliffs, 1964.
19. Thompson, J. D., Organizations in Action, McGraw-Hill, New York, 1976.
20. Perrow, C , "The Analysis of Goals in Complex Organizations,""American
Sociological Review 6 (1961): pp. 854-866.
21. Belkaoui, A., Conceptual Foundations of Management Accounting, Addison-
Wesley, Reading, MA, 1980.
22. Branch, B., "Corporate Objectives and Market Performance," Financial
Management (Summer 1973): pp. 24-29.
23. Birnberg, J. C , "The Role of Accounting in Financial Disclosure," Account-
ing, Organizations and Society (June 1980): pp. 71-80.
24. Watts, R. L. and J. L. Zimmerman, Positive Accounting Theory, Prentice-
Hall, Englewood Cliffs, NJ, 1986.
25. Alchian, A. A. and R. Kessel, "Competition, Monopoly and the Pursuit of
Money," in H. G. Lewis (Ed.), Aspects of Labor Economics, Princeton University
Press, Princeton, 1962: pp. 157-175.
26. Jensen, N. C. and W. H. Meckling, "Can the Corporation Survive?" Finan-
cial Analysts Journal (January-February 1978): pp. 31-37.
27. Arbel, A. and P. Sltreber, "The Neglected and Small Firm Effects," Journal
of Financial Economics (July 1984): pp. 283-294.
28. Barry, C. B. and S. J. Brown, "Differential Information and the Small Firm
Effect," Journal of Financial Economics (July 1984): pp. 283-294.
29. Freeman, R. N., "The Association between Accounting Earnings and Secu-
Reputation Building 159

rity Returns for Large and Small Firms," Journal of Accounting and Economics
(July 1987): pp. 195-228.

REFERENCES
Alchian, A. A. and R. Kessel. "Competition, Monopoly and the Pursuit of Money."
In H. G. Lewis (Ed.). Aspects of Labor Economics. Princeton: Princeton Uni-
versity Press, 1962: 157-175.
Arbel, A. and P. Sltreber. "The Neglected and Small Firm Effects." Journal of Fi-
nancial Economics (July 1984): 283-294.
Barry, C. B. and S. J. Brown. "Differential Information and the Small Firm Effect."
Journal of Financial Economics (July 1984): 283-294.
Beatty, R. P. and J. R. Ritter. "Investment Banking, Reputation, and Underpricing
of Initial Public Offerings." Journal of Financial Economics 15 (1986): 2 1 3 -
232.
Belkaoui, A. Conceptual Foundations of Management Accounting. Reading, MA:
Addison-Wesley, 1980.
. "Organizational Effectiveness, Social Performance and Economic Perfor-
mance." Research in Corporate Social Performance and Policy 12 (1991):
143-153.
Belkaoui, A. and E. Pavlik. Accounting for Corporate Reputations. Westport, CT:
Quorum Books, 1992.
Birnberg, J. C. "The Role of Accounting in Financial Disclosure." Accounting, Or-
ganizations and Society (June 1980): 71-80.
Branch, B. "Corporate Objectives and Market Performance." Financial Manage-
ment (Summer 1973): 24-29.
Caves, R. E. and M. E. Porter. "From Entry Barriers to Mobility Barriers." Quar-
terly Journal of Economics 91 (1977): 421-434.
Connolly, T., E. Conlon, and S. J. Deutsh. "Organizational Effectiveness: A Multi-
Constituency Approach." Academy of Management Review 5 (1980): 2 1 1 -
217.
Dowling, G. R. "Managing Your Corporate Images." Industrial Market Manage-
ment 15 (1986): 109-115.
Etzioni, A. Modern Organization. Englewood Cliffs, NJ: Prentice-Hall, 1964.
Fombrun, C. J. and M. Shanley. "What's in a Name? Reputation Building and
Corporate Strategy." Academy of Management Journal 33 (1990): 233-258.
Freeman, R. N. "The Association between Accounting Earnings and Security Re-
turns for Large and Small Firms." Journal of Accounting and Economics
(July 1987): 195-228.
Jensen, N. C. and W. H. Meckling. "Can the Corporation Survive?" Financial An-
alysts Journal (January-February 1978): 31-37.
Karpik, P. G. and A. Belkaoui. "Determinants of the Corporate Decisions to Dis-
close Social Information." Accounting, Auditing and Accountability Journal
2 (1989): 36-51.
Klein, B. and K. Leffler. "The Role of Market Forces in Assuring Contractual Per-
formance." Journal of Political Economy 89 (1981): 615-641.
Milgrom, P. and J. Roberts. "Price and Advertising Signals of Product Quality."
Journal of Political Economy 94 (1986a): 796-821.
160 Accounting and the Investment Opportunity Set

. "Relying on the Information of Interested Parties." Rand Journal of Eco-


nomics 17 (1986b): 18-32.
Perrow, C. "The Analysis of Goals in Complex Organizations." American Socio-
logical Review 6 (1961): 854-866.
Riahi-Belkaoui, Ahmed. "Earnings Management and Reputation Building for Large
US Firms." Accounting and Business Review 6(2) 1999: 159-170.
Riahi-Belkaoui, Ahmed and Ellen Pavlik. "Asset Management Performance and
Reputation Building for Large US Firms." British Journal of Management 2
(1991): 231-238.
. Accounting for Corporate Reputation. Westport, CT: Greenwood Publish-
ing, 1992.
Scott, W. R. Organizations: Rational, Natural Operational Systems. Englewood
Cliffs, NJ: Prentice-Hall, 1981.
Thompson, J. D. Organizations in Action. New York: McGraw-Hill, 1967.
Ullman, A. A. "Data in Search of a Theory: A Critical Examination of the Rela-
tionship among Social Performance, Social Disclosure and Economic Per-
formance of US Firms." Academy of Management Review 10 (1985): 540-
552.
Watts, R. L. and J. L. Zimmerman. Positive Accounting Theory. Englewood Cliffs,
NJ: Prentice-Hall, 1986.
Wilson, R. "Reputation in Games and Markets." In Roth, A. E. (Ed.). Game-
Theoretical Models of Bargaining. New York: Cambridge University Press,
1985: 65-84.
10

Growth Opportunities and Earnings


Management

INTRODUCTION
This chapter develops and tests the hypothesis that managers of multina-
tional firms with a high level of the investment opportunity set make ac-
counting choices to reduce reported earnings compared to managers of
multinational firms with a low level of the investment opportunity set. Un-
like other studies we assume that earnings management is a present and
continuous phenomenon rather than a behavior conditioned by an eventual
crisis. While all firms are potentially resorting to earnings management, the
level of growth opportunity, as measured by the level of the investment
opportunity set, is assumed to affect the nature of earnings management
with high growth opportunities firms potentially resorting to income-
reducing accruals. We argue that high level of investment opportunity set
causes higher actual and/or future profitability and higher reported ac-
counting numbers. A result of the actual and/or potential higher reported
accounting numbers is the possible perception of the accounting rates of
return as "excessive" and indicative of monopolistic power on the part of
the firm, thereby increasing both the political costs and the political risk.
In such a case, managers' reporting of lower earnings may be expected to
reduce both political costs and political risk.
Accrual analysis, similar to that of Jones, 1 is performed on a sample of
high and low growth opportunities multinational U.S. firms to determine
the extent of earnings management. Our findings indicate that managers of
high growth opportunity multinational firms facing potentially high polit-
162 Accounting and the Investment Opportunity Set

ical costs and political risk report income-decreasing accruals compared to


low growth opportunities firms.

GROWTH OPPORTUNITIES AND EARNINGS


MANAGEMENT
The firm is comprised of the value of assets-in-place and future invest-
ment options or growth opportunities. The lower the proportion of firm
value represented by assets-in-place, the higher the growth opportunities.
These potential investment opportunities are described by Myers 2 as call
options whose values depend on the likelihood that management will ex-
ercise them. Like call options, these growth opportunities represent real
value to the firm.3 Growth options include such discretionary expenditures
as capacity expansion prospects, new product innovations, acquisitions of
other firms, investment in brand name through advertising, and even main-
tenance and replacement of existing assets. A significant portion of the
market value of equity is accounted for by growth opportunities. 4 These
benefits of growth opportunities are expected to result in higher profita-
bility and realized growth 5 and higher political risk.6 Both increased prof-
itability and political risk are expected to induce managers to resort to
income-reducing accruals.
First, the increase in profitability of multinational firms with a high level
of growth opportunities increases both their political risibility and political
costs. The political cost hypothesis predicts that managers confronted with
the possibility of politically imposed wealth transfer will resort to earnings
management to reduce the likelihood and size of this transfer.7 These mul-
tinational firms with high growth opportunities, like high income firms,
which are particularly vulnerable to wealth-extorting political transfers in
the form of legislation and/or regulation, will have an incentive to resort
to accruals to reduce their reported income numbers compared to low
growth opportunity and low income number firms.
Second, political risk is a phenomenon that characterizes an unfriendly
climate to multinational firms with visible profitability and high growth
opportunities. 8 It refers to the potential economic losses arising as a result
of governmental measures or special situations that may limit or prohibit
the operational and profitable activities of a multinational firm. One way
to limit the potential emergence of political risk is to reduce the reported
earnings number. Earnings management in high growth opportunities mul-
tinational firms may be a way to reduce the factors mitigating the emer-
gence of political risk.
This study hypothesizes that high growth opportunities multinational
firms make accounting choices to reduce income and net worth compared
to low growth opportunity multinational firms.
Earnings Management 163

RESEARCH DESIGN
The objective of the study is to examine the potential relationship be-
tween growth opportunities and the total accruals of firms as those accruals
reflect accounting choices made by management. The technique used by
Jones 9 and Cahan 10 for the estimation of non-discretionary accruals is
adopted in this study. It estimates non-discretionary accruals by regressing
total accruals on the change in sales (a proxy for level of activity) and on
the fixed asset balance. The approach leads to an estimate of discretionary
accruals that is less biased and less noisy than earlier models11 as well as
eliminates the assumption that accruals remain stationary over time. The
basic model is as follows:

where

A = total accruals in year /total assets,,,


CHSALES,, = change in sales from year t\ to year t, (Sales Revenues,, - Sales
Revenue,, _j)/Total Assets,,, and
FIXASSETS,, = fixed assets at the end of year t, (Fixed Assets,/Total Assets,,).

In the estimation process, model (1) is expanded to include an indicator


variable to measure the discretionary accruals of high growth firms. The
expansion includes also total assets as a measure of size and dummy var-
iables for each of the years of analysis.
The effect of multinationality is tested by estimating Model (2).

where TA is total assets and YR is a dummy variable for a year of analysis.


The expected sign of the coefficient for CHSALES is positive. It is ex-
pected to be negative for all the other explanatory variables. The coefficient
of IOS will be negative if managers lower accruals for high growth firms.
As in Hall and Stammerjohan,12 a two-step generalized least square error
components model is used in this study, as it is more efficient than the
within-group estimator, fixed effects covariance model used by Cahan. 13
164 Accounting and the Investment Opportunity Set

DATA

Sample and Method


The sample consisted of all the firms included in Forbes' "most inter-
national" 100 American manufacturing and services firms in the 1987 and
1990 period. Financial data were collected from both the Forbes' articles
and COMPUSTAT. Total accruals are calculated for each firm as follows:14

Where

DEP = depreciation expense and the depletion charge for firm / in year t,
AR = accounts receivable balance for firm /, at the end of year t,
INV = inventory balance for firm i at the end of year t,
AP = accounts payable for firm /', at the end of year t,
TP = taxes payable balance for firm /', at the end of year t,
DT = deferred tax expense for firm / at the end of year t, and
TA = total asset balance for firm /, at the end of year t.

The data are pooled over time and across firms, resulting in a sample of
339 firm-years. To test the effect of the investment opportunity set on dis-
cretionary accruals, a dichotomous indicator variable, IOS, is added to
model (1). IOS takes on the value of one for the group firms classified as
high growth opportunity firms and zero for firms classified as low growth
opportunity firms. Model (1) is also expanded to include YR; dummy-
coded variable as I for year t (t = 1987-1990), and TAit for the total assets
of the firm. The YR variables measure the time effect for each of the four
years. The TA variable is added as a result of the size hypothesis whereby
large firms are expected to make income decreasing choices relative to small
firms.15 The effect of size is important given the evidence presented later
about the significant difference in size between the high growth and the
low growth firms.

Measuring the Investment Opportunity Set


Because the investment opportunity set is not observable, there has been
a consensus on an appropriate proxy variable.16 Similar to Smith and
Watts 17 and Gaver and Gaver,18 we use an ensemble of variables to measure
the investment opportunity set. The three measures of the investment op-
portunity set used are: market-to-book assets (MASS), market-to-book eq-
Earnings Management 165

Exhibit 10.1
Selected Statistics Related to a Common Factor Analysis of Three Measures of
the Investment Opportunity Set for Forbes9 The Most International 100
U.S. Firms

1. Eigenvalues of the Correlation Matrix: Total = 3, Average = 1

Eigenvalue 1 2 3
1.0540 0.9868 0.9592

2. Factor Pattern

FACTOR 1 MASS MQV EP


0.62821 0.66411 0.46722

3. Final Communality Estimates: Total = 1.053994

MASS MQV EP
0.394651 0.441045 0.218299

4. Standardized Scoring Coefficients

FACTOR 1 MASS MQV EP


0.59603 0.63009 0.43329

5. Descriptive Statistics of the Common Factor Extracted from the Three Measures
of the Investment Opportunity

Maximum Third Median First Minimum Mean


Quartile Quartile
9.3593 3.2200 2.0450 1.5085 2.5209 1.9812

uity (MV), and the earnings/price ratio (EP). These variables are defined as
follows:

MASS = [Assets Total Common Equity + Shares Outstanding*Share Closing


Price]/Assets
MV = [Shares Outstanding*Share Closing Price/Total Common Equity]
EP = [Primary EPS before Extraordinary Items]/Share Closing Price.

The results of a factor analysis of these measures of the investment oppor-


tunity set are shown in Exhibit 1 0 . 1 . One common factor appears to ex-
Exhibit 10.2
Results of Regression EstimationModel (1)

Interdependent Expected Coefficient t-value One-tailed


Variables Sign Probability

Intercept -0.0326 7.538 0.0001


CHSALES + 0.0180 4.059 0.0001
FDCASSETS - -0.1532 -7.885 0.0001
n= 339
R2 0.1723 F Statistics Probability
Adjusted R2 0,1673 30.818 0.0001

Variable definitions:

where:
DEP, = Depreciation expense and the depletion charge for firm i in year t
AR, = Accounts receivable balance for firm / at the end of year t
INV, Inventory balance for firm / at the end of year t
AP, = Accounts payable for firm /' at the end of year t
TP, = Taxes payable balance for firm i at the end of year t
DT, = Deferred tax expense for firm /' at the end of year t
TA, = Total asset balance for firm / at the end of year t
CHSALES, = (Net sales, - net sales,, J / T A ,
FIXASSETS, = Fixed assets,/TA,
Earnings Management 167

Exhibit 10.3
Descriptive Statistics
A. High Growth Sample

Variables Mean Standard Maximum Median Minimum


Deviation
Total 3624.6 28012.2 138954 246842 7682
Revenue
(thousands)
Total Assets 54186.5 50397.7 261860 35475 8462
(thousands)
Net Profit 1812 1320.65 8132 1608 0.4587

B. Low Growth Sample

Variables Mean Standard Maximum Median Minimum


Deviation

Total 6556.19 3696.6 18805 5835 2816


Revenues
(thousands)
Total Assets 9559.85 16833.05 128260 5556 2864
(thousands)
Net Profit 384.85 368.27 1925.35 382.3 -618.2

plain the intercorrelations among the three individual measures. Based on


these factor scores, high growth firms are chosen from the top 2 5 % of the
distribution scores while low growth firms are chosen from the bottom
2 5 % of the distribution factor scores.

TESTS AND RESULTS


The results for the error-components estimation of Model (1) are re-
ported in Exhibit 10.2. As expected, both CHSALES and FIXASSETS are
statistically significant. Descriptive statistics are presented in Exhibit 10.3.
The overall model is also significant with an F value of 32.618 and an
adjusted R2 of 15%. It appears that a significant portion of the variation
in accruals of multinational firms can be explained by changes in sales and
the fixed asset balance.
168 Accounting and the Investment Opportunity Set

Exhibit 10.4
Results of Regression EstimationModel (2)

Interdependent Expected Coefficient t-value One-tailed


Variables Sign Probability

Intercept -0.0158 -2.876 0.0156


CHSALES + 0.0028 4.256 0.0001
FIXASSETS + -0.1818 -6.538 0.0002
IOS + 0.0081 -2.656 0.0116
TA - -0.0000007 -2.588 0.0112
YRi -0.0031 -4.868 0.0001
YR2 -0.0018 -4.062 0.0001
YR3 -0.00132 -4.850 0.0001
R2 0.3612 F Statistics Probability
Adjusted R2 0.3322 4.856 0.0001
n 166

Variable definitions'.
TA = Total assets
TR = Year
IOS = 1 if growth opportunities are high; 0 if growth opportunities are low

The error-components regression results for Model (2) are reported in


Exhibit 10.4. The results support the view that the variation in accruals
can be explained by the change in sales, the fixed asset balance and time-
dependent effects. In addition, the variable of interest, IOS, is significant at
the 0.01 level, with a one-tailed test, and its sign is negative. Because high
growth was coded as 1, the positive sign of IOS indicates that discretionary
accruals of high growth firms were higher than low growth firms which
supports the political cost and political risk hypothesis.

SUMMARY AND CONCLUSIONS


This study examines, on a longitudinal basis, whether managers of mul-
tinational firms respond to the political costs associated with high level of
growth opportunities by adjusting their discretionary accruals. The discre-
tionary accruals for the 100 largest U.S. multinationals were examined over
the 1987-1990 period by using the residuals of a fixed effects covariance
model that regressed total accruals on the change in sales, the fixed assets
Earnings Management 169

balance, and a d u m m y variable for each of the year of study. The hypoth-
esis is tested using a tested design with a d u m m y variable, coded 1 for high
growth, included in the accrual model. This growth variable was significant
and negatively signed which indicates that the discretionary accruals were
lower for high growth firms. The results support the political cost and
political risk hypothesis associated with multinationality and are consistent
with the view that managers adjust earnings in response to a high level of
growth.
The results, however, are limited because the sample includes only the
largest U.S. multinationals. This limitation suggests one area for future re-
search. The longitudinal approach could be extended to explore response
to a wider range of growth.

NOTES
1. Jones, J., "Earnings Management during Import Relief Investigations," Jour-
nal of Accounting Research 29 (Autumn 1991): pp. 193-228.
2. Myers, S. C , "Determinants of Corporate Borrowing," Journal of Financial
Economics 5(2) (1977): pp. 147-175.
3. Kester, W. C , "Today's Options for Tomorrow's Growth," Harvard Busi-
ness Review 62(2) (1984): pp. 153-160.
4. Pindyck, Robert S., "Irreversible Investment, Capacity Choice and the Value
of the Firm," American Economic Review 78(5) (Dec 1998): 969-985.
5. Kallapur, Sanjay and Mark A. Trombley, "The Association between Invest-
ment Opportunity Set and Realized Growth," Journal of Business Finance and
Accounting 96(3) (1999): pp. 505-519.
6. Monti-Belkaoui, J. and A. Riahi-Belkaoui, The Nature, Estimation, and
Management of Political Risk, Greenwood Publishing, Westport, CT, 1999.
7. Watts, R. L. and J. L. Zimmerman, "Towards a Positive Theory of Deter-
mination of Accounting Standards," The Accounting Review 53 (January 1978):
pp. 112-134.
8. Monti-Belkaoui and Riahi-Belkaoui, The Nature, Estimation, and Manage-
ment of Political Risk.
9. Jones, "Earnings Management."
10. Cahan, S., "The Effect of Antitrust Investigations on Discretionary Accruals:
A Refined Test of the Political-Cost Hypothesis," The Accounting Review 67 (Jan-
uary 1992): pp. 77-95.
11. For example, Healy, S. C , "Political Scrutiny and Earnings Management in
the Oil Refining Industry," Journal of Accounting and Public Policy 12 (Winter
1993): pp. 325-351.
12. Hall, S. C. and W. W. Stammerjohan, "Damage Awards and Earnings Man-
agement in the Oil Industry," The Accounting Review 1 (January 1997): pp. 4 7 -
65.
13. Cahan, "The Effect of Antitrust Investigations."
170 Accounting and the Investment Opportunity Set

14. Healy, "The Effect of Bonus Schemes on Accounting Decisions," Journal of


Accounting Research 7 (1985): pp. 85-107.
15. Christie, A. A., "Aggression of Test Statistics: An Evaluation of the Evidence
on Contracting and Size Hypotheses," Journal of Accounting and Economics 12
(January 1990): pp. 15-36.
16. Kallapur and Trombley, "The Association between Investment Opportunity
Set and Realized Growth."
17. Smith, C. W. and R. L. Watts, "The Investment Opportunity Set and Cor-
porate Financing, Dividend, and Compensation Policies," Journal of Financial Eco-
nomics 32(3) (1992): pp. 263-292.
18. Gaver, J.J. and K. M. Gaver, "Additional Evidence in the Association be-
tween the Investment Opportunity Set and Corporate Financing, Dividend, and
Compensation Policies," Journal of Accounting and Economics 16(1/2/3) (1993):
pp. 125-140.

REFERENCES

Cahan, S. "The Effect of Antitrust Investigations on Discretionary Accruals: A Re-


fined Test of the Political-Cost Hypothesis." The Accounting Review 67
(January 1992): 77-95.
Christie, A. A. "Aggression of Test Statistics: An Evaluation of the Evidence on
Contracting and Size Hypotheses." Journal of Accounting and Economics
12 (January 1990): 15-36.
Gaver, J. J. and K. M. Gaver. "Additional Evidence in the Association between the
Investment Opportunity Set and Corporate Financing, Dividend, and Com-
pensation Policies." Journal of Accounting and Economics 16 (1/2/3) (1993):
125-140.
Hall, S. C. and W. W. Stammer johan. "Damage Awards and Earnings Management
in the Oil Industry." The Accounting Review 1 (January 1997): 47-65.
Healy, S. C. "Political Scrutiny and Earnings Management in the Oil Refining In-
dustry." Journal of Accounting and Public Policy 12 (Winter 1993): 3 2 5 -
351.
Jones, J. "Earnings Management during Import Relief Investigations." Journal of
Accounting Research 29 (Autumn 1991): 193-228.
Kallapur, Sanjay and Mark A. Trombley. "The Association between Investment
Opportunity Set and Realized Growth." Journal of Business, Financial, and
Accounting 96(3) (1999): 505-519.
Kester, W. C. "Today's Options for Tomorrow's Growth." Harvard Business Re-
view 62(2) (1984): 153-160.
Monti-Belkaoui, J. and Riahi-Belkaoui, A. The Nature, Estimation, and Manage-
ment of Political Risk. Westport, CT: Greenwood Publishing, 1999.
Myers, S. C. "Determinants of Corporate Borrowing." Journal of Financial Eco-
nomics 5(2) (1977): 147-175.
Pindyck, Robert S. "Irreversible Investment, Capacity Choice and the Value of the
Firm." American Economic Review 78(5) (Dec 1988): 969-985.
Smith, C. W. and R. L. Watts. "The Investment Opportunity Set and Corporate
Earnings Management 171

Financing, Dividend, and Compensation Policies." Journal of Financial Eco-


nomics 32(3) (1992): 263-292.
Watts, R. L. and J. L. Zimmerman. "Towards a Positive Theory of Determination
of Accounting Standards." The Accounting Review 53 (January 1978): 112-
134.
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11

Growth Opportunities,
Internalization, and
Market Valuation of
Multinational Firms

INTRODUCTION
With the increased level of business activities conducted by multinational
firms, the international business literature raises the empirical question of
whether multinationality does in fact add to share value. 1 ' 2 Three theories
are commonly used to link multinationality to investment value, namely:
(a) the internalization theory, (b) the imperfect capital markets theory, and
(c) the managerial objectives theory.
The internalization theory maintains that foreign direct investment will
cause the increase of the market value of the firm relative to its accounting
value only if the firm can internalize markets for certain of its intangibles.
Examples of these firm-specific intangible assets include production skills,
managerial skills, patents, market abilities, and consumer goodwill. These
information-based proprietary intangible assets cannot be copied or ex-
changed at arm's length, but can only be transferred to subsidiaries, thereby
internalizing the markets for such assets. As a result, the market value of
a multinational firm, possessing these intangibles and engaging in foreign
direct investment, will be directly proportional to the firm's degree of mul-
tinationality.
The imperfect capital markets theory suggests that investors, constrained
by institutional constraints on international capital flows and the infor-
mation asymmetries that exist in global capital markets, invest in multi-
national firms to gain from the international diversification opportunities
provided by these multinational firms. This direct valuation of multina-
tional firms by investors as a means of diversifying their portfolios inter-
174 Accounting and the Investment Opportunity Set

nationally is assumed to enhance the share price of multinational firms,


independently of the information-based, proprietary intangible assets pos-
sessed by these firms.
The managerial objectives theory rests on the assumption of the differ-
ences of motives between management and shareholders. The complexity
of the multinational firm and the resulting difficulty for shareholders to
monitor management's decisions allow management to act in their own
self-interest. Management may favor international diversification because
it reduces firm-specific risk. The situation may reduce the market value of
multinational firms.3
This chapter addresses the issues by extending internalization theory to
include the role of growth opportunities on the market value of multina-
tionals relative to the accounting value, or "g-value." It tests the impli-
cations of internalization, imperfect capital markets, and managerial
objectives theories, considering the effects of growth opportunities, to ex-
plain the g-value of a multinational firm.
The results of the study support the implications of internalization theory,
and corroborate the results of Morck and Yeung, 4,5 and Mishra and Go-
belli.6 A higher level of growth opportunities leads to a higher firm g-value as
firms increase their multinationality. Conversely, while the results do not
support the imperfect capital market theory that shareholders value multi-
nationals as a means of diversifying their portfolios, they support the mana-
gerial objectives theory that the divergence of interest between management
and shareholders reduces the firm g-value with greater multinationality.

RELATED RESEARCH
As reported earlier, various empirical studies examined the implication
of either internalization, imperfect capital markets, or managerial objective
theories. Of interest to this study are two studies that examined simulta-
neously the implication of each of these theories and relied on firm-level
data. The first study, by Morck and Yeung,7 showed that the positive im-
pact of research and development and advertising spending on a firm's
Tobin's q is enhanced by multinationality, but multinationality itself has
no significant impact. Their results support the internalization theory in
that intangible assets are necessary to justify the direct foreign investment
and do not support the imperfect capital market theory in that investors
value multinational firms as a means of diversifying their portfolios inter-
nationally. The second study, by Mishra and Gobelli,8 examines the same
issues as those of Morck and Yeung9 and adds a managerial incentives
alignment variable. The results of Mishra and Gobelli are also consistent
with internalization theory in that greater multinationality corresponds to
a higher valuation of the firm if technology investment is high, and the
impact is even greater if managerial incentives alignment is high as well.
Multinational Firms 175

The results do not also support the imperfect capital markets theory. The
intangible assets examined in both studies include research and develop-
ment, and advertising spending in the case of Morck and Yeung10 and
research and development spending and managerial incentives alignment in
the case of Mishra and Gobelli.11 While these variables may act as proxies
for intangible assets whose value might be enhanced by multinational ex-
pansion, a more "encompassing" intangible that needs to be tested is the
construct of growth opportunities.

HYPOTHESES AND METHODOLOGY

Hypotheses
The first hypothesis addresses the relationship between the g-value of the
multinational firm and the level of multinationality as follows:

Hypothesis 1: The g-value of the multinational firm will be higher with


a higher level of multinationality.

The market value relative to the accounting value, denoted "g-value," is


computed as the ratio of the market value of the firm to the book value of
its assets. The market value of the firm is the sum of the market value of
its outstanding common shares plus the book values of preferred stock and
debt (both current and long-term).
The second hypothesis addresses the role of growth opportunities to ex-
plain the g-value of a multinational firm. The growth opportunities of a
firm are for various decisions ranging from resource allocation and career
decisions to product choices, to name a few. The concept is an important
signal of the firm's organizational effectiveness. Growth opportunities can
create favorable situations for a firm that include: (1) the generation of
excess returns by inhibiting the mobility of rivals in an industry; (2) the
capability of charging premium prices to consumers; and (3) the creation
of a better image in the capital markets and to investors. These growth
opportunities have become established and constitute signals that may af-
fect the activities of firms' stakeholders including their shareholders. Good
growth opportunities can be constructed as a competitive advantage within
an industry. Specifically, the investment opportunity set of a firm encom-
passes the firm-specific intangible assets that can only be transferred to
subsidiaries, local or foreign, thereby internalizing the markets for such
assets. Accordingly, the following hypothesis is proposed:

Hypothesis 2: The higher the growth opportunities, the greater the


impact of multinationality on the g-value of the multi-
national firm.
176 Accounting and the Investment Opportunity Set

Method
To test the international investment hypothesis, the following regression
model, adopted from both Morck and Yeung12 and Mishra and Gobelli,13
shows the independent variables expected to have an effect on the g-value.

The variable MNC is the degree of multinationality. It is measured by


foreign sales as a percentage of total sales. The growth opportunities con-
cept is measured by the level of the investment opportunity set, IOS. To
control for possible scale effects, a size variable measured by the logarithm
of sales is included. Similarly, to control for changes in the firm's capital
structure, a leverage variable, measured by higher debt over total assets, is
also included in Equation (1). A two-digit SIC dummy variable (industry)
is used to control for growth effects and general industry effects.
Given the assumption that the value enhancement due to multinationality
(bx) is a function of corporate reputation, Equation (2) is introduced:

The public good property of corporate reputation is assumed to make it


more valuable as the firm increases its foreign direct investment. As a result,
the internalization theory predicts that ax should be positive while a0 should
be zero. The imperfect capital markets theory, as well as theories based on
taxes or input costs, predicts that a0 should be positive while ax should be
zero. Finally, the managerial objectives theory predicts that a0 should be
negative while ax should be zero.
Substituting Equation (2) into (1) yields a new and more complete re-
gression equation that includes cross-products of the level of multination-
ality with corporate reputation:

Sample
The population consists of firms included in Forbes' Most International
100 American Manufacturing and Services Firms from 1986 to 1990. The
security data are collected from CRS Return files. The accounting variables
are collected from COMPUSTAT. The derivation of the sample includes
362 firm-year observation that have all the accounting and nonaccounting
variables over the period of analysis.
Multinational Firms

Exhibit 11.1
Sample Statistics

Variables Mean Std. Error Minimum Median Maximum

QV 0.897 0.792 0.014 0.665 5


LEV 0.645 0.187 0.120 0.625 1.25

SIZE 9.203 0.827 7.748 9.037 11.751

FS/TS 0.349 0.149 0.066 0.334 0.761

Note: QV is the q-Value computed as the ratio of the value of the firm to the book value of
total assets. LEV is the leverage computed as long-term debt over total assets. SIZE is
measured by the logarithm of total sales.

Measuring Growth Opportunity


Most studies have used proxies for the measurement of the investment
opportunity set. This study relies on a factor analysis of three measures of
the investment opportunity set, namely, market-to-book assets, market-to-
book equity, and earnings/price ratio. One common factor appeared to
explain the intercorrelations among the three individual measures. The fac-
tor scores were used as measures of the level of the investment opportunity
set of the firms in the sample.

ANALYSIS AND RESULTS


Exhibit 11.1 reports the descriptive statistics for the sample of multi-
national firms. Exhibit 11.2 reports the ordinary least square (OLS) re-
gression results for Equation (1), using three different measures of
multinationality: (a) foreign sales/total sales, (b) a dummy variable set to
1 if foreign sales/total sales > 0.30, and (c) a dummy variable set to 1 if
foreign sales/total sales > 0.50. The control variables include the invest-
ment opportunity set level, size, and leverage. The results show that for
each measure of the degree of multinationality, the g-value is positively
and significantly related to the degree of multinationality as advocated by
the international investment hypothesis (Hypothesis 1). In addition, all
the control variables are significant indicating: (a) a growth opportunity
effect in the sense that the higher the investment opportunity set score,
the higher the g-value of the firm, (b) a size effect in the sense that the
178 Accounting and the Investment Opportunity Set

Exhibit 11.2
OLS Regression of g-Value on the Degree of Multinationality as Measured by
Foreign Sales/Total Sales

Variables used to Measure the Degree of Multinationality

Independent Foreign Sales / Dummy set to 1 if Dummy set to 1 if


Variables Total Sales FS / TS > 0.30 FS/TS>0.50

Intercept 2.612(5.835)* 2.167(5.259) 2.385 (5.257) |

Degree of 0.4221 0.1325 0.1600


Multinationality (2.345)* (1.865)** (1.821)**

Investment 0.3606(10.548)* 0.3883 (10.347)* 0.3856(10.340)*


Opportunity Set

Size -0.2885 (-7.824)* -0.2754 (-7.837)* -0.3068 (-8.162)*

Leverage -1.236 (-8.565)* -1.852 (-8.926)* -1.685 (-8.530)*


2
Adjusted R 0.51 0.48 0.47

'Significant at 5% level.
'''Significant at 10% level.
Note: White's f-statistics are in parentheses. Variables defined as in Exhibit 11.1.

larger the firm size, the lower the g-value of the firm, and (c) a leverage
effect in the sense that the larger the debt constraints, the lower the q-
value.
Exhibit 11.3 reports the OLS regression results for Equation (3) using
again the three different measures of the degree of multinationality. In all
cases, the investment opportunity score has both significant independent
(main) and interaction (with the MNC variable) effects as predicted in
Equation (3). It supports the basic tenet of internalization theory as ex-
amined in this studythat increased multinationality leads to a higher firm
g-value, only in the presence of higher growth opportunities.
Multinationality appears to have a significant negative value without the
firm-specific intangible of growth opportunities. The results do not support
the imperfect capital markets theory but support the managerial objectives
theory, in the sense that the potential divergence of interest between man-
agement and shareholders leads to a lower firm g-value with greater mul-
tinationality.
Multinational Firms 179

Exhibit 11.3
OLS Regression of q-Value on the Degree of Multinationality as Measured by
Foreign Sales/Total Sales and Its Interactions with Investment Opportunity

Variables Used to Measure the Degree of Multinationality

Independent Foreign Sales / Dummy set to 1 if Dummy set 1 if


Variables Total Sales FS /TS > 0.30 FS/TS>0.50

Intercept 4.6058 (6.324)* 3.897 (6.725)* 2.850(2.761)*

Degree of -5.8725 -1.890 -0.2370


Multinationality (-3.873)* (-3.283)* (3.815)

Investment 0.0360 (3.526)* 0.1856(3.523)* 0.3876 (9.368)*


Opportunity Set

Multinationality 0.9157 0.3075 0.0528


* Reputation (4.189) (4.338)* (3.895)*

Size -0.3236 (-8.682) -0.3054(-8.277)* -0.3010 (-8.120)

Leverage -1.6488 (-8.236)* -1.8356 (-8.234)* -1.8770 (-8.725)*

Adjusted R.2 0.53 0.53 0.50

* Significant at 5% level.
Note: White's ^-statistics are in parentheses. Variables defined as in Exhibit 11.1.

CONCLUSION
Previous empirical research by Morck and Yeung14 and Mishra and Go-
belli15 found evidence to support the internalization theory that there is a
positive relationship between the market value of the firm and its multi-
nationality, and that the relationship is explained by firm-specific intangi-
bles. The intangible assets examined in these studies included research and
development and advertising spending and managerial incentives align-
ment. In addition, their evidence supported the tenets of imperfect capital
markets theory in that greater multinationality alone does not correlate
positively to a significant greater market valuation.
This study examines the role of growth opportunities as a more "encom-
passing" intangible to explain the relative market value compared to the
accounting value for a multinational firm. The results of this study are also
consistent with internalization theory in that greater multinationality cor-
180 Accounting and the Investment Opportunity Set

responds to a higher valuation of the firm if corporate reputation is high,


and the tenets of imperfect capital markets theory in that greater multi-
nationality alone does not correlate positively to a significantly greater mar-
ket value. However, this study supports the hypothesis that greater
multinationality alone correlates negatively to a significantly greater market,
value, which confirms the views of the managerial objectives theory. It
implies that while investors and the market value highly the internalization
of the markets for corporate reputation, they are less enthusiastic about
the divergence of interests with management on the merits of international
diversification.

NOTES
1. Morck, R. and B. Yeung, "Why Investors Value Multinationality," Journal
of Business 64 (1991): pp. 165-187.
2. Mishra, Chandra S. and David H. Gobelli, "Managerial Incentives, Inter-
nalization and Market Valuation of Multinational Firm," Journal of International
Business Studies 29(3) (1988): pp. 583-598.
3. Morck and Yeung, "Why Investors Value Multinationality."
4. Ibid.
5. Ibid.
6. Mishra and Gobelli, "Managerial Incentives."
7. Morck and Yeung, "Why Investors Value Multinationality."
8. Mishra and Gobelli, "Managerial Incentives."
9. Morck and Yeung, "Why Investors Value Multinationality."
10. Ibid.
11. Mishra and Gobelli, "Managerial Incentives."
12. Morck and Yeung, "Why Investors Value Multinationality."
13. Mishra and Gobelli, "Managerial Incentives."
14. Morck and Yeung, "Why Investors Value Multinationality."
15. Mishra and Gobelli, "Managerial Incentives."

REFERENCES
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Agmon, T. and D. Lessard. "Investor Recognition of Corporate International Di-
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Beatty, R. P. and J. R. Ritter. "Investment Banking, Reputation, and Underpricing
of Initial Public Offerings." Journal of Financial Economics 15 (1986): 2 1 3 -
232.
Belkaoui, Ahmed. "Organizational Effectiveness, Social Performance and Economic
Performance." Research in Corporate Social Performance and Policy 12
(1992): 143-155.
Brewer, H. L. "Investor Benefits from Corporate International Diversification."
Journal of Financial and Quantitative Analysis 16 (1981): 113-126.
Multinational Firms 181

Buckley, Peter. "The Limits of Explanation: Testing the Internalization Theory of


the Multinational Enterprise." Journal of International Business Studies
19(2) (1988): 1-16.
Buckley, Peter and M. Casson. The Future of Multinational Enterprises. London:
Macmillan, 1976.
Casson, M. The Firm and the Market. London: Basil Blackwell, 1987.
Caves, R. E. "Causes of Direct Investment: Foreign Firms' Shares in Canadian and
United Kingdom Manufacturing Industries." Review of Economics and Sta-
tistics 56 (1974): 273-293.
Caves, R. E. and M. E. Porter. "From Entry Barrier to Nobility Barriers." Quarterly
Journal of Economics 91 (1997): 4 2 1 ^ 3 4 .
Coase, R. H. "The Nature of the Firm." Economica 4 (1937): 386-405.
Doukas, J. and N. G. Travlos. "The Effect of Corporate Multinationalism on Share-
holders' Wealth: Evidence from International Acquisitions." Journal of Fi-
nance A3 (1988): 1161-1175.
Dunning, J. H. "Toward an Eclectic Theory of International Production: Some Em-
pirical Tests." Journal of International Business Studies 11 (1980): 9-31.
. "The Eclectic Paradigm of International Production: A Restatement and
Some Possible Extensions." Journal of International Business 19 (1988): 1-
31.
Dowling, G. R. "Managing Your Corporate Image." International Marketing Man-
agement 15 (1986): 109-115.
Errunza, V. R., and L. W. Senbet. "The Effects of International Operations on the
Market Values of the Firm: Theory and Evidence." Journal of Finance 36
(1981): 401-417.
Fatemi, A. M. "Shareholders Benefits from Corporate International Diversifica-
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Forbrum, C. and M. Shanley. "What's in a Name? Reputational Building and Cor-
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Kim, W. S. and E. O. Lyn. "Excess Market Value, the Multinational Corporation,
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Mishra, Chandra S. and David H. Gobelli. "Managerial Incentives, Internalization
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12

Contextual Accrual and Cash


Flow-Based Valuation Models:
Impact of Multinationality and
Growth Opportunities

INTRODUCTION
This chapter investigates the impact of the contextual factors of multina-
tionality and growth opportunities on accrual and cash flow-based valua-
tion. The nature and amount of information in cash flows and accruals
were first examined by Wilson1 using stock behavior around the release of
annual reports. He concluded that the market reacts more favorably the
larger (smaller) are the cash flows (current accruals). Bernard and Sober2
were, however, unable to confirm Wilson's results over a longer period,
and according to the state of the.economy. This chapter extends the works
of Wilson and Bernard and Sober in two ways. The first is to assess the
generality and robustness of Wilson's results by using a total market value-
based valuation model rather than an excess-return-based model. The re-
sults confirm Wilson's results. The second is to examine two contextual
models of the implications of cash and accruals. We argue that the pref-
erence of cash flows over accruals will arise under conditions of high mul-
tinationality and high growth opportunities. Support for the hypotheses
was found. In sum, we are able to identify the economic logic underlying
how the market assimilates information about cash and accruals under the
specific contextual environments of multinationality and growth opportu-
nities.
184 Accounting and the Investment Opportunity Set

MARKET VALUATION MODELS

A Simplified Model
A simplified model relates market value of equity at the end of a period
to the corresponding accruals and cash flows as follows:

where:

MVlt = Market value of equity of firm / at the end of year t


Ait = Total accruals of firm i at the end of year t
CFlt = Cash flows of firm i at the end of year t

All variables are deflated by the total assets at the end of year t.

Impact of Multinationality
Investors recognize the enhancement of firm value through internation-
alization. The evidence shows that investors recognize multinationality
given that multinational firms show lower systematic risk and unsystematic
risk compared to securities of purely domestic firms.3-5 T o test the incre-
mental association between market value of equity and multinationality,
after controlling for accruals and cash flows, Model (1) is adjusted as fol-
lows:

where:

MULTYlt = Level of multinationality of firm / at the end of year t

Impact of Growth Opportunities


To create the right future, firms develop growth opportunities. Corporate
audiences are more likely to value these growth opportunities more than
the assets-in-place. These growth opportunities have become established
and constitute signals that may affect actions of firms' stakeholders, in-
cluding their shareholders. Specifically, a good growth potential is con-
strued as a competitive advantage within an industry. This implies that
investors incorporate the growth opportunities in determining firm value.
To test for incremental association between the market value equity and
Contextual Accrual and Cash Flow-Based Valuation 185

growth opportunities after controlling for accruals, cash flows, and multi-
nationality, Model (2) is adjusted as follows:

where:

/OS,, = Investment opportunity set for firm / at the end of year t

RESEARCH METHOD
In this study, incremental associations between market value and cash
flow from operations, multinationality, and growth opportunities, after
controlling for accruals, are presented as evidence of the relevance of the
contextual environment of cash flow-based valuation models. To describe
and assess the significance of these relationships, we use three linear re-
gression approaches [Models (1) to (3)] that relate market value of equity
to the accounting and nonaccounting variables mentioned earlier.

Data and Sample Selection


The population consists of firms included in both Forbes' Most Inter-
national 100 American Manufacturing and Service Firms and Fortune's
surveys of corporate reputation from 1987 to 1990. The security data are
collected from the CSRP return files. The accounting variables are collected
from COMPUSTAT. Cash flows from operations are reported under SFAS
no. 95 (COMPUSTAT item 308). The derivation of the total accruals, mul-
tinationality, and growth opportunities variables is explained later. The
final sample included 360 firm-year observations that have all the account-
ing and nonaccounting variables.

Measuring Total Accruals


Total accruals are calculated for each firm as follows:6

where:

DEPtt = Depreciation expense and the depletion charge for firm / in year t
ARit = Accounts receivable balance for firm i at the end of year t
INVtt = Inventory balance for firm / at the end of year t
APlt = Accounts payable for firm / at the end of year t
186 Accounting and the Investment Opportunity Set

TPlt Taxes payable balance for firm /' at the end of year t
DTtt = Deferred tax expense for firm / in year t
TAit = Total asset balance for firm / at the end of year t

Measuring Multinationality
Previous research has attempted to measure these attributes of multina-
tionality:

1. Performancein terms what goes on overseas.7


2. Structurein terms of how resources are used overseas.8
3. Attitude or Conductin terms of what is top management orientation.9

Sullivan10 developed nine measures of which five were shown to have a


high reliability in the construction of a homogeneous measure of nation-
ality: (1) foreign sales as a percentage of total sales (FSTS), (2) foreign assets
over total assets (FATA), (3) overseas subsidiaries as a percentage of total
subsidiaries (OSTS), (4) top management's international experience
(TMIE), and (5) psychic dispersion of international operations (PDIO).
In this study we follow a similar approach by measuring multinationality
through three measures: (1) foreign sales/total sales (FSTS), (2) foreign
profit/total profits (FPTP), and (3) foreign assets/total assets (FATA). As
shown in Exhibit 12.1, one common factor appears in intercorrelations
among the three variables, as the first eigenvalue alone exceeds the sum of
commonalities. The common factor is significantly and positively correlated
with the three measures. As pointed out earlier, these factor scores were
used to measure the degree of multinationality of firms in the sample.

Measuring Growth Opportunities


Growth opportunities were measured using the same methodology as is
in Chapters 10 and 11.

RESULTS
Panel A of Exhibit 12.2 reports descriptive statistics for the variables used
in our tests and Panel B shows correlation among variables.
The correlations reported in Panel B of Exhibit 12.2 show that all cor-
relations between MVin Ain CFin and MULTYit are significant at the 0.01
level. The significant associations among other variables indicate some de-
gree of collinearity among the independent variables in the regression anal-
yses. However, the maximum conditions index in all subsequent regressions
with earnings and both cash flow variables is only 4.45. As suggested by
Exhibit 12.1
Selected Statistics Related to a Common Factor Analysis of Three Measures of
Multinationality for Forbes9 The Most International 100 U.S. Firms for the
1987-1990 Period

1. Eigenvalues of the Correlation Matrix:

Eigenvalues 1 2 3
1.8963 0.9169 0.1868

2. Factor Pattern

FACTOR 1 FS/TS FP/TP FA/TA


0.93853 0.40913 0.92089

3. Final Communality Estimates: Total = 1.389626

FS/TS .FP/TP FA/TA

0.8808 0.16738 0.84804

4. Standardized Scoring Coefficients

FACTOR1 FS/TS FP/TP FA/TA


FS/TS 0.49494 0.21575 0.48563

5. Descriptive Statistics of the Common Factor Extracted from the Three Measures of
Multinationality

Maximum Third Quartile Median First Quartile Minimum Mean

201.059 23.231 41.50 30.648 5.198 43.062

Variable definitions:
FS/TS: Foreign sales/Total sales.
FP/TP: Foreign profits/Total profits.
FA/TA: Foreign assets/Total assets.
Exhibit 12.2
Descriptive Statistics and Correlations
Panel A: Descriptive Statistics

Variables Mean Standard Minimum 25% Median 75% Maximum


Deviation
MVit 0.894 0.791 0.018 0.381 0.665 1.132 5
A
< 0.047 0.024 0.010 0.031 0.047 0.062 0.175
CF{ 0.104 0.062 0.052 0.065 0.112 0.143 0.254
MULTYit 43.062 19.682 5.198 30.648 41.503 52.231 201.059
9.001 |

Panel B: Correlations

MVU A, CF, MULTYu


MVit 1.000
\At 0.061* 1.000
\CFi 0.717* 0.454* 1.000
MULTYu 0.096* 0.023 -0.012 1.000
\ REPu

Variable definitions:
MVit = Market value of equity for firm i in period t
Ait = Total accruals for firm / in period t
CFlt = Cash flows from operations for firm * in period t
MULTYit = Index of multinationality for firm / in period t
Contextual Accrual and Cash Flow-Based Valuation 189

Belsey et al., 11 mild collinearity is diagnosed for maximum condition indices


between 5 and 10 and severe collinearity for an index over 30. Thus, col-
linearity does not seem to influence results.
For each of the multivariate regressions to be reported, we perform ad-
ditional specification tests, including checks for normality and considera-
tion of various scatter plots. A null hypothesis of normality could not be
rejected at the 0.01 level in all cases, and the plots revealed some hetero-
skedasticity but no other obvious problems. Therefore, we calculated the
^-statistics after correcting for heteroskedasticity in the manner described
by White. 12
Exhibit 12.3 presents the regression result for Models (1) to (3). Model
(1) relates the total market value deflated by total assets to the accruals
and cash flows from operations, also deflated by total assets. As shown in
Exhibit 12.3, the coefficient for total accruals is significantly negative while
the coefficient for cash flows is significantly positive. As expected, the total
market value is negatively related to the total accruals and positively related
to cash flows. As in Wilson,13 these results show that the market reacts
favorably the larger (smaller) are the cash flows (current accruals). At the
same time, the results show that accruals and cash flows from operations
each provide incremental value relevance beyond one another in explaining
market value.
Model (2) relates the total market value to multinationality in addition
to accruals and cash flows from operations. As shown in Exhibit 12.3, the
coefficient of multinationality is significantly positive at the 0.01 level. In
addition, R2 increased from 62.96% in Model (1) to 73.28% in Model (2).
The evidence suggests that multinationality provides incremental value rel-
evance beyond accruals and cash flows in explaining market value.
Model (3) relates the market value to the accounting variables of accruals
and cash flows and the nonaccounting variables of multinationality and
growth opportunities. As shown in Exhibit 12.3, the coefficient for growth
opportunities is significantly positive at the 0.01 level. This evidence sug-
gests that the investment opportunity set provides incremental value rele-
vance beyond accruals, cash flows, and multinationality in explaining
market value.

SUMMARY AND CONCLUSIONS


This chapter examined the generality and robustness of an accrual and
cash flow-based model that includes the contextual factors of multination-
ality and growth opportunities. The evidence confirms previous results pre-
sented by Wilson 14 using total market value as a dependent variable and a
price level rather than a return/changes regression. Basically the market
value is larger, the larger (smaller) the cash flows (current accruals). In
addition, the preference of cash flows over accruals arises under conditions
190 Accounting and the Investment Opportunity Set

Exhibit 12.3
Regression Results of Linear Models

Model 1 Model 2 Model 3

Intercept 0.17035 -0.1082 -0.6231


(2.737)* (-1.36) (-2.754)*
Au -11.2791 -16.7071 -16.395
(-9.521)* (-14.621)* (-12.302)*

CFU 11.8366 14.6982 13.347


(24.703)* (30.106)' (22.372)*

MULTY,, 0.0043 0.0059


(3.3347)* (3.382)

IOSu 0.0982
(2.671)*

Adjusted!? 0.6296 0.7328 0.7693

n 360

Model (1): MV, = aQ + aXlAit + a2iCFit + eit


Model (2): MV = a0 + aXlA,t + a2lCFit + a3lMULTYlt + e)t
Model (3): MVlt = a0 + altAit + a2lCFit + a3iMULTYit + fl4//05 + e
MV = Market value of equity of firm i at the end of year t
A = Total accruals of firm / at the end of year t
GF,, = Cash flows of firm / at the end of year t
MULTY,t = Level of multinationality of firm / at the end of year t
IOSit = Investment opportunity set for firm / at the end of year t
''Significant at 0.01 level.

of high multinationality and high growth opportunities. The results verify


the economic logic underlying how the market assimilates information
about cash and accruals under the specific contexts of multinationality and
growth opportunities. First, a price level regression seems to provide a bet-
ter specification of this economic logic. Second, contextual factors play a
fundamental role in the same economic logic. Future research needs to
examine the role of other contextual factors in the determination of the
relationship between the market value and accruals and cash flows.
Contextual Accrual and Cash Flow-Based Valuation 191

NOTES
1. Wilson, P., "The Relative Information Content of Accruals and Cash Flows:
Combined Evidence at the Earnings Announcement and Annual Report Release
Date," Journal of Accounting Research (September 1987): pp. 165-200.
2. Bernard, V. and T. Sober, "The Nature and Amount of Information in Cash
Flows and Accruals," The Accounting Review (October 1989): pp. 624-652.
3. Agmon, T. and D. Lessard, "Investor Recognition of Corporate International
Diversification," Journal of Finance (1977): pp. 1049-1055.
4. Errunza, V. and L. Senbert, "The Effects of International Corporate Diver-
sification, Market Valuation and Size Adjusted Evidence," Journal of Finance 11
(1981): pp. 717-743.
5. Yang, H., J. Wansley, and W. Lane, "Stock Market Recognition of Multi-
nationality of a Firm and International Events,"Journal of Business, Finance, and
Accounting 12 (1985): pp. 263-274.
6. Healy, P. M., "The Effect of Bonus Schemes on Accounting Decisions," Jour-
nal of Accounting and Economics 7 (1985): pp. 85-107.
7. Dunning, John H., "Reappraising the Eclectic Paradigm in an Age of Alliance
Capitalism," Journal of International Business Studies 26 (1995): pp. 461-492.
8. Stopford, John M. and Louis T. Wells, Managing the Multinational Enter-
prise, Basic Books, New York, 1972.
9. Perlmutter, H. V., "The Tortuous Evaluation of the Multinational Corpo-
ration," Columbia Journal of World Business 7 (1969): pp. 9-18.
10. Sullivan, Daniel, "Measuring the Degree of Internationalization of a Firm,"
Journal of International Business Studies (1994): pp. 325-342.
11. Belsley, D., E. Kuh, and R. Welsch, Regression Diagnostics: Identifying In-
fluential Data and Sources of Collinearity, Wiley, New York, 1980.
12. White, H., "A Heteroskedasticity-Consistent Covariance Matrix Estimator
and a Direct Test for Heteroskedasticity," Econometrica 48 (1980): pp. 857-838.
13. Wilson, "The Relative Information Content of Accruals and Cash Flows."
14. Ibid.

REFERENCES
Agmon, T. and D. Lessard. "Investor Recognition of Corporate International Di-
versification." Journal of Finance 15 (1977): 1049-1055.
Belsley, D., E. Kuh, and R. Welsch. Regression Diagnostics: Identifying Influential
Data and Sources of Colliearity. New York: Wiley, 1980.
Bernard, V. and T. Sober. "The Nature and Amount of Information in Cash Flows
and Accruals." The Accounting Review (October 1989): 624-652.
Dunning, John H. "Reappraising the Eclectic Paradigm in an Age of Alliance Cap-
italism." Journal of International Business Studies 26 (1995): 461-492.
Errunza, V. and L. Senbert. "The Effects of International Corporate Diversification,
Market Valuation and Size Adjusted Evidence." Journal of Finance 11
(1981): 717-743.
192 Accounting and the Investment Opportunity Set

Fombrum, C. and M. Shanley. "What's in a Name? Reputational Building and


Corporate Strategy." Academy of Management Journal 33 (1990): 233-258.
Healy, P. M. "The Effect of Bonus Schemes on Accounting Decisions." Journal of
Accounting and Economics 7 (1985): 85-107.
Perlmutter, H. V. "The Tortuous Evaluation of the Multinational Corporation."
Columbia Journal of World Business 7 (1969): 9-18.
Stopford, John M. and Louis T. Wells. Managing the Multinational Enterprise,
New York: Basic Books, 1972.
Sullivan, Daniel. "Measuring the Degree of Internationalization of a Firm." Journal
of International Business Studies (1994): 325-342.
White, H. "A Heteroskedasticity-Consistent Covariance Matrix Estimator and a
Direct Test for Heteroskedasticity." Econometrica 48 (1980): 857-838.
Wilson, P. "The Relative Information Content of Accruals and Cash Flows: Com-
bined Evidence at the Earnings Announcement and Annual Report Release
Date." Journal of Accounting Research (September 1987): 165-200.
Yang, H., J. Wansley, and W. Lane. "Stock Market Recognition of Multinationality
of a Firm and International Events." Journal of Business, Finance, and Ac-
counting 12 (1985): 263-274.
Index

Accrual analysis, and earnings manage- tunity set, 84; measure, 88; theory,
ment, 161, 163 role of debt in, 83
Agency theory, 120-121 Corporate reputation: growth opportu-
Asset management performance, and nities and, 39; in international pro-
corporate reputation, 150-152 duction model, 104; measurement,
45; signals of firm performance in,
Call options, growth opportunities as, 38-39; systematic risk and, 133
2,37 Corporate reputation building, 149-
Capacity choice, 2-3 157; asset management performance
Capital budgeting, 5 signals in, 149, 151-152; corporate
Capital-structure decision, 83. See also audiences' expectations in, 150-151;
Corporate financing firm size and, 152, 155-157; invest-
Cash flow-based valuation models, ment opportunity set level and, 152,
185-191 155-157; multinationality level and,
Contingent claims analysis, and sys- 152, 155-157; official goals versus
tematic risk, 4 operative goals in, 151; research,
Corporate borrowing, determinants of, 150; stewardship concept and, 151
1-2
Corporate financing: contracting-cost Debt/equity ratios, and corporate finan-
explanations for, 84, 93; and growth cing, 84-85, 92-93
versus nongrowth firms' debt/equity Demand volatility, and market valua-
ratios, 84, 92-93; and high versus tion, 3-4
low multinationality firms' debt/ Disclosure: capital-need hypothesis
equity ratios, 84-85, 92-93; impor- and, 121; disclosure cost hypothesis
tance of, 149; and investment oppor- and, 121; empirical analysis of, 1 2 1 -
194 Index

127; firm size associated with, 120- Growth opportunities: corporate repu-
121, 126-127; motivations, 119-121; tation and, 38-39; earnings manage-
multinationality associated with, ment and, 161-169; firm size and,
121, 127; multiple listing hypothesis 39-40; general model of, 37-53;
and, 121 importance of, 37; internalization
Disclosure quality measure (DISC), theory and, 175-180; leverage and,
122-123 41; multinationality and, 39; politi-
Discretionary accruals: estimation of, cal cost hypothesis and, 162, 168-
163; investment opportunity set and, 169; positively related to market
164; political cost/political risk hypo- beta, 4; profitability level and, 40;
thesis and, 168-169 systematic risk and, 4, 4 1 , 140
Discretionary investments, 2, 37 Growth versus nongrowth firms, cor-
Dividend yield, investment opportunity porate financing of, 84, 92-93
set dependence of, 60-65
High growth firms, discretionary ac-
Earnings management: level of growth cruals of, 163, 164, 168-169
opportunities and, 161-169; politi-
cal costs/risk and, 162, 168; as pres- Imperfect capital markets theory, 173-
ent and continuous, 161; and 175, 176, 179
reduction of reported earnings num- Index of business formation, 75-78
ber, 162 Inflation rate, investment opportunity
Earnings variability, and systematic set determination and, 75-78
risk, 133 Internalization theory, 104, 173; ex-
Earnings/price ratio, 7, 8, 45-48 tended to include growth opportun-
Equity value, book value and earnings ties, 175-180
in, 59 International production: arbitrage
benefits, 103, 112; corporate reputa-
Financing advantages of multinational- tion and, 104, 113; differences in
ity, 104-105 ratios of return on foreign assets and
Firm size: and growth opportunities, total assets in, 104, 113; eclectic
39-40; in investment opportunity set paradigm, 101-105; financial lever-
determination, 75-78; as signal of age in, 104, 113; foreign assets and
asset management, 152; and system- locational advantages in, 103, 112;
atic risk, 133 rationale and measures, 105; re-
Firm-specific behavioral differences, in search model, 105-114; surrogate
determination of firm value, 104 measures in, 114
Forbes' Most International 100 Ameri- Investment opportunity set: concepts, 1-
can Management and Service Firms, 5; increase in, and increased disclo-
42, 6 1 , 69, 85, 105, 176, 185 sures, 120; index, 85; theory, 40
Foreign assets, in international produc- Investment opportunity set determina-
tion model, 103 tion model: control variables in, 7 1 ;
Fortune magazine survey of corporate multinationality in, 71, 72-73; profit-
reputation, 42, 45, 105, 134, 136, ability in, 70-71, 75; regression re-
153, 185 sults and future implications, 76-79
Investment opportunity set level: divi-
GNP growth rate, in investment oppor- dends/retained earnings' value rele-
tunity set determination, 75-78 vance in, 60-65; and
Index 195

multinationality level, 103; as signal 91-93; and debt/equity ratios, 8 4 -


of asset management, 152; and sys- 85, 92-93; in determination of in-
tematic risk, 131, 140, 143-144 vestment opportunity set, 71-79;
Investment opportunity set measure- and disclosure, 121, 127; index, 85;
ment: factor analyzed composite linked to share value, 173-180; loca-
measure, 7; investment-based prox- tional, internalization, and owner-
ies, 6; market-to-book assets/equity ship advantages of, 101, 103-104;
in, 7-8, 45-48; multivariate growth measures, 42-45, 72-73; systematic
proxy, 8; price-based proxies, 6; real- risk associated with, 131, 132, 140,
ized growth and earnings/price ratio 143-144. See also International pro-
in, 7-8, 47-48; variance measures, 6 duction
Multinationality level: and corporate
Leverage: and growth opportunities, reputation, 104, 152, 155-157; and
41; and systematic risk, 133 debt/equity ratios, 84-85; and invest-
Locational advantages of multination- ment opportunity set level, 103; and
als, 104 g-value, role of growth opportunities
in, 173-180; as signal of asset man-
Managerial objectives theory, 174- agement, 152; and total assets rate
175, 176, 180 of return, 104
Managerial-welfare-maximization
model, 151 Net present value rules, 3
Market valuation: book value and
earnings in, 59; cash flows and ac-
Organizational goals, official versus
cruals in, 185-191; corporate reputa-
operative, 151
tion in, 176; demand volatility and,
Ownership advantages of multination-
70; growth opportunities and level
als, 103
of profitability in, 40; hypotheses
and methodology of expanded
Political risk: and earnings manage-
model, 175-177; in imperfect capital
markets theory, 173-175, 176, 179; ment, 162, 169; and political cost
investment opportunity set and, 3-4, hypothesis, 162, 168-169
40; issuance of risky debt and, 1-2; Price-based proxies, 6
in managerial objectives theory, 174- Price-earnings ratio, investment oppor-
175, 176, 180; multinationality tunity set dependence of, 60-65
linked to share value in, 173-180; Profitability: in determination of in-
role of growth values relative to q- vestment opportunity set, 70-79;
value in, 175; simplified model, 184- and growth opportunities, 40; meas-
185; and systematic risk, 3-4; total ures, 75
market value-based model, 183, 189;
value-relevance of dividend yield and Realized growth, as proxy measure of
price-earnings ratio in, 60-65 investment opportunity set, 7-8
Market-to-book assets (MASS), 45-48 Report of the Financial Analysts Federa-
Market-to-book equity (MQV), 45-48 tion Corporate Information Commit-
Market-to-book ratios, and granting of tee (FAF Reports), 119, 121, 122
stock options, 120
Multinationality: arbitrage benefits of, Shareholder-wealth-maximization
39; and corporate financing, 84-85, model, 151, 157
196 Index

Size. See Firm size impact of growth opportunities on,


Stewardship concept, 151, 157 131-144; leverage and, 133; measure-
Stock options, and market-to-book ment, 48-50
ratios, 120
Strategic groups, 93 Total assets rate of return, 104
Systematic risk: contingent claims analy- Transactions cost hypothesis, 121
sis and, 4; corporate reputation and,
133; and growth opportunities, 4, U.S. Office of Management and Budget
41, 140; and high versus low invest- (OMB), 153
ment opportunity, 131, 140, 1 4 3 -
144; and level of multinationality, Variance measures, 6
About the Author

AHMED RIAHI-BELKAOUI is CBA Distinguished Professor of Account-


ing in the College of Business Administration, University of Illinois at Chi-
cago. Author of more than 45 Quorum books, published or forthcoming,
and coauthor of several more, he is also a prolific writer of articles for
major scholarly and professional journals, and has served on numerous
editorial boards that oversee them.