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This paper examines the relationship between CEO’s tenure and their firm’s investment efficiency. Over-investment is greater in the early years than in the later years of CEO’s service. Consistent with prior literature, the results also suggest over-investment increases with firm’s internally-generated cash flow.

This paper examines firm investment decisions during CEO’s tenure. In theory, managers should invest projects with positive NPV to maximize the value of shareholders. However, prior research has found that managers don’t always pick value maximizing projects. Richardson takes a sample of 1496 firms for the period of 1997- 2002 and finds that over-investment is concentrated in firms with the highest level of free cash flow [

Prior research mostly implicitly indicates that managers are homogenous, which is inconsistent with reality. According to upper echelons theory, a firm’s behavior can be affected by management’s background characteristics, including gender, age, education, tenure and so on. Investment decision is among many important decisions managers must make, and can also be affected by managers’ characteristics. Pan et al. take the sample of 5420 CEOs that take office between 1980 and 2009, and find the asset growth tends to be 3.2 percentage points lower in the later years of a CEO’s tenure than in his first three years in office [

One of the key questions is how to measure a firm’s over-investment. This paper uses the model of Richardson to measure over-investment. Richardson’s model is widely used in investment efficiency literature in China (e.g. Zhang [

The contribution of this paper is to examine manager’s investment decisions during the tenure. Prior studies on investment efficiency mainly focus on over-investment under implicit hypothesis that managers are homogeneous. In this paper, I introduce managers’ tenure into over-investment analysis and provide direct evidence on the relation between over-investment and tenure.

The rest of the paper is organized as follows. Section 2 reviews the related literature and presents the hypotheses. Section 3 is the methodology used in this paper. Section 4 describes the sample selection process. Section 5 discusses empirical results, and Section 6 is the conclusions and implications.

Prior research has confirmed that over-investment exists in firms. Harford uses a sample of 487 takeover bids, and finds that firms with large amount of cash are more likely to make acquisitions which subsequently experience abnormal declines in operating performance [

Over-investment may become severe in the presence of rich internally generated cash flow. In perfect capital markets, a firm’s investment activities would not be influenced by internally generated cash flow. If a firm needed additional cash to finance an investment activity it would simply raise that cash from external capital markets. If the firm had excess cash beyond that needed to fund available positive NPV projects (including options on future investment), it would distribute free cash flow to external markets. However, firms don’t operate in such a perfect world. Capital market frictions may impede management’s ability to raise cash flow from external capital markets. Firms with more volatile cash flows will want to retain cash for the periods when cash flow is low, and firms who find it more difficult to raise external capital will desire larger cash holdings (e.g., Opler et al. [

H1: Firms with rich free cash flow over-invest.

Prior studies mostly base their conclusions on the implicit hypothesis that managers have the same characteristics, which is inconsistent with the reality. According to upper echelons theory, which is proposed by Hambrick and Mason, management’s background characteristics, including tenure, can influence their perceptibility, value and behavior, which will in turn influence the firms’ decisions [

As CEOs’ tenure extends, CEOs can accumulate work experience, gain specific knowledge, and get profound understanding about many complex scenarios faced by the company, thus easily avoiding personal preference and making smart investment decisions. Main proposed that CEO should be offered longer contractual term than other employees, because longer term can help CEO invest in human capital and reduce the probability of inefficient investment decision because of lacking experience [

H2: The over-investment of free cash flow is greater in the early years of CEOs’ service than in the later years of CEOs’ service.

I use a cross-section model proposed by Richardson to estimate expected investment. He combines prior literature in economics and finance examining firm level investment decisions and suggests the following model to estimate expected investment.

The proxy for I_{MAINTENANCE} is amortization and depreciation. Amortization and depreciation is an estimate of the portion of total investment expenditure that is necessary to maintain plants, equipment and other operating assets.

Expected investment is an increasing function of growth opportunity. I use the past two years’ average sales growth as proxy of growth opportunity, instead of measures involving market price like book-to-market of equity (BM) and earnings-price ratios (EP). China’s stock market is far from efficient, and the stock price is severely affected by investors’ behavior and macroeconomic policies. The sales growth measure is widely used by Chinese researchers (e.g. Shen et al. [

The additional control variables that have been shown in prior research to be determinants of investment decisions are included in the model, such as leverage, firm size, firm age, the level of cash, stock returns and prior firm level investment. Indicator variables for industry membership and temporal effects to capture additional variation in investment expenditure that are not explained by measures of growth opportunities and financing constraints are also included. The detailed definitions of these variables are in

I firstly estimate the above equation using all observations for which required data are available on CSMAR database. The residuals of the regression are used as measures of inefficient investment. This paper focuses on over-investment, so I will choose positive residuals for further research. Then I use the following model to test hypothesis H1 and hypothesis H2.

The dependent variable in this model is measures of over-investment. FCF is a firm’s free cash flow. According to Richardson’s definition, free cash flow is cash flow beyond what is necessary to maintain assets in place (including servicing existing debt) and to finance expected new investments. Free cash flow is calculated using the following two equations:

is a measure of cash flow generated from assets in place.

Tenure is an indicator variable that equals zero for firm-years that correspond to the first three years of CEOs’ service, and is one otherwise. I consider the CEO change year and the two following years as early years. I predict a negative coefficient on Tenure, consistent with hypothesis H2 that over-investment is larger in the early years of CEO’s service in the later years.

The empirical tests employ financial statement data and management characteristics data of A-share companies in CSMAR, covering the period of 2008-2014. I exclude financial institutions from my analysis because the demarcation between operating, investing, and financing activities is ambiguous for these firms. Besides, I exclude ST (Specially Treated) firms from my sample because financial data of these firms is abnormal. I also require that each industry-year group has at least ten observations. In the empirical analysis that follows I scale all financial variables by average total assets. The sample is also truncated at 1% to minimize the influence of outliers, and finally includes 6141 firm-year observations.

Variables | Definition |
---|---|

I_{NEW} | New Investment |

Growth | Growth rate of sales, proxy for investment opportunity |

Cash | Balance of cash and short term investments deflated by total assets measured at the start of the year |

Age | The log of the number of years the firm has been established |

Size | The log of total assets measured at the start of the year |

Stock Returns | The stock returns for the year prior to the investment year. It is measured as the change in market value of the firm over that prior year |

Year Indicators | A vector of indicator variables to capture annual fixed effects |

Industry Indicators | A vector of indicator variable to capture industry fixed effects. |

An estimate of over-investment | |

FCF | Free cash flow, cash flow beyond that necessary to maintain assets in place |

Tenure | CEO’s tenure, indicator variables, 1 indicates CEO’s tenure is more than 3 years, 0 less than 3 years |

The empirical tests can be divided into two stages. Firstly, I use Richardson’s model to measure over-invest- ment. Over-investment is defined as investment expenditure beyond that required to maintain assets in place and to finance expected new investments in positive NPV projects (Richardson [

The determinants of expected investment include growth opportunities, leverage, firm age, firm size, cash balance, industry fixed effects and annual fixed effects.

The fitted value of the model above is a firm’s expected investment given certain investment opportunities, leverage and cash. The residual is an estimate of inefficient investment. The positive residual represents over- investment, and the negative residual under-investment. This paper focuses on over-investment, so I choose observations with positive residuals for further research.

Variables | Predicted Signs | Coefficients (t value) |
---|---|---|

Intercept | −0.075 | |

(−3.64)^{***} | ||

Cash | + | 0.047 |

(4.89)^{***} | ||

Size | + | 0.007 |

(9.16)^{***} | ||

Growth | + | 0.011 |

(1.70)^{*} | ||

Leverage | − | −0.019 |

(−3.42)^{***} | ||

+ | 0.339 | |

(27.16)^{***} | ||

Age | − | −0.014 |

(−4.77)^{***} | ||

StockReturns | + | 0.002 |

−0.86 | ||

YearIndicator | Yes | |

IndustryIndicator | Yes | |

Adjusted R2 | 0.205 |

The second stage of empirical analysis is to research the relationship between over-investment and free cash flow and tenure. I regress over-investment on free cash flow and tenure, and the results are in

The results above provide robust evidence for my hypotheses. In consistent with prior literature, I find a positive relation between cash flow and over-investment using Chinese A-share listed firms. Besides, I find CEO’s tenure has explanatory power to over-investment even after controlling the effect of cash flow on over-invest- ment. The result suggests that managers in early years of service tend to invest more inefficiently.

This paper, based on agency theory and upper echelons theory, examines the over-investment behavior during

Variables | Mean | Std Dev | Q1 | Median | Q3 |
---|---|---|---|---|---|

0.066 | 0.069 | 0.019 | 0.041 | 0.093 | |

FCF | 0.059 | 0.077 | 0.017 | 0.064 | 0.097 |

Tenure | 2.73 | 2.83 | 0 | 2 | 5 |

Variables | Model | ||
---|---|---|---|

Ⅰ | Ⅱ | Ⅲ | |

Intercept | 0.059 | 0.074 | 0.058 |

(30.14)^{***} | (31.23)^{***} | (19.19)^{***} | |

FCF | 0.129 | 0.0252 | |

(6.39)^{***} | (7.98)^{***} | ||

Tenure | −0.013 | −0.00058 | |

(−4.21)^{***} | (−0.15) | ||

FCF*Tenure | −0.207 | ||

(−5.09)^{***} | |||

Adjusted R^{2} | 0.0198 | 0.0085 | 0.0401 |

CEOs’ tenure. I predict that there is a positive relationship between over-investment and free cash flow, and the over-investment of free cash flow is severer in the early years of CEO’s service than the later years. For the sample period 2008-2014, the empirical results show that, as expected, firms with rich free cash flow tend to over-invest, and the over-investment of free cash flow is larger in the early years than in the later years of CEOs’ service.

The results not only help understand a firm’s investment behavior, but also provide helpful guidelines to human resources management practices. This paper presents evidence that CEOs’ tenure can influence a firm’s investment efficiency. The over-investment of free cash flow is less in the later years of CEOs’ service than in the early years of CEOs’ service. As CEOs’ tenure extends, they gain profound understanding of the business and thus can better evaluate a new investment project. From the perspective of investment efficiency, longer term CEO tends to make better investment decisions.

Xia Jiang, (2016) Over-Investment of Free Cash Flow during CEO’s Tenure. Technology and Investment,07,51-58. doi: 10.4236/ti.2016.73007