The Influence of Overvalued Equity on Overinvestment and its Relation to Financial Reporting Quality’s Effect
Asian Tax Journal Vol. 22 No. 2 (2021), pp. 91-132
Abstract
The prior literature provides a direct test of one implication of overvaluation hypothesis (Jensen 2005). This is, in Jensen’s (2005) agency theory of overvalued equity when a firm’s stock becomes overvalued, this induces managers to intervene in unprofitable investments to pursue empire building or to maximize private gains, and take an excessive approach to capital, which can lead to overinvestment for firms’ investing decisions. Thus, we empirically examine whether the overvalued equity is positively related to overinvestment in Korea’s settings. Meanwhile, Biddle et al. (2009) suggested that firms with lower financial reporting quality measured by the accruals quality are more likely to overinvestment. Therefore, in this paper, we extend prior research and empirically explore whether the positive association between overvalued equity and overinvestment becomes strengthened for firms with lower financial reporting quality (i.e., accruals quality). For analysis, we use three proxies for overvalued equity (i.e., PER, PBR, PFCFR), following Park and Kim (2019). We also identify overvalued equity (hereafter OVE) is an indicator variable equal to 1 if the firm has been in the top quintile of PER, PBR, and PFCFR in year t, and 0 otherwise, respectively. Following Francis et al. (2005), we use accruals quality (AQ) as a proxy for financial reporting quality (i.e., Biddle et al. 2009). Following Park and Kim (2018), we also calculate the three investment measures (i.e., the level of total investment, abnormal investment, and overinvestment). Our sample covers KOSPI and KOSDAQ listed firms with available data in non－financial industries with fiscal year－end in December from 2004 to 2018 based on the dependent variable, thus our final sample 17, 356 firm－year observations. The empirical results are as follows. First, we find that the coefficients on OVE are all positive and statistically significant, indicating that overvalued firms engage in more invest or abnormal investment, and overinvestment than firms that were deemed to not be overvalued, consistent with Jensen’s (2005) conjecture for agency problem of overvalued equity. Therefore, this findings suggest that firm with overvalued equity leads managers over－invest in investing decision because the market over－values them. In addition, when we divided in both capital investments and R&D investments, we also find that these results mainly driven by R&D investments. Second, we do not find evidence that, on average, the positive relation between overvalued equity and overinvestment is more pronounced for firms with lower financial reporting quality (i.e., accruals quality). However, when we partition the sample into KOSPI and KOSDAQ, consistent with as our expected, more interesting is that the positive and significantly relation between overvalued equity and overinvestment would be stronger when firms with lower financial reporting quality in mainly KOSPI samples. In sum, our study contributes to the literature on overvaluation, financial reporting quality, and investment in several important ways. First, we extended and empirically test Jensen’s (2005) agency theory of overvalued equity in Korea’s settings. Specifically, our research is the first to show that interaction with overvalued equity and financial reporting quality, which are a contributing factor to firm’s investment decisions. Thus, we argue that the findings of this study represent an important complement to the prior literature on overvaluation, accounting quality, and firms’ investment policy. In addition, our research helps investors, regulators, and policymakers understand managers’ decision processes with regard to overinvestment.
Keywords
- Overvalued equity
- Investment
- Abnormal investment
- Overinvestment
- Financial reporting quality
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