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Journal of Corporate Finance 14 (2008) 118 – 132

www.elsevier.com/locate/jcorpfin

Ownership structure, cash flow, and capital investment:

Evidence from East Asian economies before the financial crisis ☆
K.C. John Wei a,⁎, Yi Zhang b
a
Department of Finance, Hong Kong University of Science and Technology, Clearwater Bay, Kowloon, Hong Kong
b
Department of Finance, Guanghua School of Management, Peking University, Beijing 100871, China
Received 21 August 2007; received in revised form 31 January 2008; accepted 14 February 2008
Available online 26 February 2008

Abstract

Using financial and ownership data from eight East Asian emerging markets before the Asian financial crisis, we document that
while the sensitivity of a firm's capital investment to its cash flow decreases as the cash-flow rights of its largest shareholders
increase, this sensitivity increases as the degree of the divergence between the control rights and cash-flow rights of the firm's
largest shareholders increases. We interpret the results to be consistent with the free cash-flow hypothesis, which postulates that too
much free cash flow in the hands of entrenched managers is likely to lead to overinvestment. This is particularly true for firms with
the greatest divergence between the largest shareholders' control rights and their cash-flow rights and for firms with lower
profitability.
© 2008 Elsevier B.V. All rights reserved.

JEL classification: G32; G34

Keywords: Investment-cash flow sensitivity; Capital investment; Pyramids; Voting rights; Cash-flow rights; East Asia

1. Introduction

The effect of cash flow on capital investment has been extensively studied with the role that financing constraints
play receiving the most attention. In a perfect market without asymmetric information or financial constraints, a firm's
cash flow should not affect its capital investments. Instead, capital investments should be solely determined by the

☆
The previous versions of the paper were titled “Ownership structure, cash flow, and corporate investment: evidence from East Asian emerging
markets” and “Corporate governance, overinvestment and the Asian financial crisis”. The authors appreciate helpful comments and suggestions from
Dolly King, Yrjo Koskinen, and seminar participants at Hong Kong University of Science and Technology, Peking University, the 2005 Chinese
Finance Annual Meetings, where it was awarded the third prize for best papers, the 4th NTU International Conference on Economics, Finance and
Accounting in Taipei, the 2006 JBF Conference in Beijing, the 2006 China International Conference in Finance, where it was named the winner of the
best paper award, and the 2006 European Finance Association meetings in Zurich. The authors also wish to thank Jeffry M. Netter (the editor) and an
anonymous referee for insightful comments and suggestions and Dr. Virginia Unkefer for editorial assistance. John Wei acknowledges financial
support from an RGC Competitive Earmarked Research Grant of the Hong Kong Special Administration Region, China (HKUST6014/01H) and Yi
Zhang acknowledges financial support from the National Science Foundation of China (70603001).
⁎ Corresponding author. Tel.: +852 2358 7676; fax: +852 2358 1749.
E-mail addresses: johnwei@ust.hk (K.C.J. Wei), zhangyi@gsm.pku.edu.cn, zhangyi.05@hotmail.com (Y. Zhang).

0929-1199/$ - see front matter © 2008 Elsevier B.V. All rights reserved.
doi:10.1016/j.jcorpfin.2008.02.002
 K.C.J. Wei, Y. Zhang / Journal of Corporate Finance 14 (2008) 118–132 119

firm's investment opportunities. However, in the real market, although firms tend to invest more following increases in
their stock prices, cash flow is a better predictor than stock prices of a firm's capital investments.1
There are two competing explanations for the positive relation between cash flow and corporate investments. The
first explanation is based on the agency costs of free cash flow as suggested by Jensen (1986). Jensen shows that
managers have a tendency to overspend their free cash flow on unprofitable projects for their own private benefits. This
free cash-flow hypothesis suggests that the positive relation between cash flow and investment is basically a symptom
of overinvestment. Firms tend to overinvest, not because external capital is too expensive, but because internal capital
is too inexpensive. The alternative explanation is based on asymmetric information. For example, Myers and Majluf
(1984) show that the cost of external funds is more expensive than is the cost of internal funds due to asymmetric
information problems. This asymmetric information hypothesis argues that the positive relation between cash flow and
investment is typically a symptom of underinvestment. Firms tend to pass up some positive net present value projects
because the cost of external capital is too high compared with the cost of internal capital.
The empirical results from Fazzari et al. (1988), Hoshi et al. (1991), and other follow-up studies seem to support the
asymmetric information hypothesis. These studies show that financially constrained firms tend to have higher
investment-cash flow sensitivities. Further, Lamont (1997) and Shin and Stulz (1998) document that capital invest-
ments by segments of a diversified firm depend on the cash flow from other segments. These results suggest that
because the cost of external capital is significantly more expensive than the cost of internal capital, financial constraints
are an important factor when a firm makes its investment decisions. However, Kaplan and Zingales (1997) provide both
theoretical arguments and empirical evidence that investment-cash flow sensitivities are not good indicators of
financial constraints. Whether or not investment-cash flow sensitivities are valid measures of financial constraints is
still the subject of debate.2
The existing studies on investment-cash flow sensitivities seldom consider the overinvestment argument caused by the
agency problem, which creates conflicts between managers and shareholders (Jensen and Meckling, 1976).3 Recent
studies suggest that since large shareholders have strong incentives to maximize the value of the stocks they own, large
shareholders can help to overcome this agency problem.4 However, large shareholders are also associated with negative
entrenchment effects.5 The empirical results from Morck et al. (1988) and McConnell and Servaes (1990) appear to
substantiate both the enhancement and entrenchment effects of large shareholders. They find an inverse U-shaped relation
between managerial equity ownership and firm valuation. That is, firm valuation initially increases as managerial
ownership increases. However, after a certain point, firm value starts to decrease as managerial ownership increases,
because managers become entrenched and start to pursue their private benefits at the expense of outside investors.6
Hadlock (1998) argues that if the positive investment-cash flow relation is caused by a managerial preference to
overinvest internal funds, then the positive investment-cash flow sensitivity should decrease as the alignment of interests
between managers and shareholders increases. On the other hand, if the positive investment-cash flow relation is caused by
a managerial preference for underinvestment, the positive investment-cash flow sensitivity should increase as the
alignment of interests between managers and shareholders increases. Using managers' ownership data from 1975 as his
measure of the alignment of interests between managers and shareholders along with financial data from 1973–1976,
Hadlock (1998) finds an inverse U-shaped relation between managerial ownership and investment-cash flow sensitivities
for the U.S. firms in his sample. He interprets the results to be consistent with the underinvestment hypothesis caused by
asymmetric information.
In this paper, we extend Hadlock's (1998) work to use the information on both large shareholders' cash-flow rights
and the divergence between large shareholders' control rights and their cash-flow rights to disentangle the positive

1
See, for example, Fazzari et al. (1988) and Morck et al. (1990). Also see Hubbard (1998) for an excellent review of this literature.
2
See, for example, Cleary (1999), Fazzari et al. (2000) and Kaplan and Zingales (2000).
3
There are studies that empirically test agency problems and the overinvestment hypothesis from different angles. For example, Harvey et al.
(2004) find that debt mitigates agency problems associated with overinvestment. Dittmar et al. (2003), Pinkowitz et al. (2006), and Kalcheva and
Lins (in press) find evidence of overinvestment by entrenched managers related to cash holdings.
4
For example, Shleifer and Vishny (1997, p. 754) point out, “Large shareholders thus address the agency problem in that they have both a general
interest in profit maximization, and enough control over the assets of the firm to have their interest respected”.
5
Again, Shleifer and Vishny (1997, p. 758) argue, “The large shareholders represent their own interests, which need not coincide with the
interests of other investors in the firm, or with the interests of employees and managers”.
6
Stulz (1988) has formally modeled this negative effect of large shareholders on firm value, which predicts an inverse U-shaped relation between
managerial ownership and firm value.
120 K.C.J. Wei, Y. Zhang / Journal of Corporate Finance 14 (2008) 118–132

enhancement effect from the negative entrenchment effect of large shareholders. Using the information on both control
rights and cash-flow rights more effectively distinguishes between the two competing explanations for why cash flow
affects capital investment than does using the information on managerial cash-flow rights alone. Further, the existing
literature suggests that while the positive enhancement effect is related to the cash-flow rights of large shareholders, the
negative entrenchment effect is more associated with the control rights of large shareholders. However, as pointed out
by Claessens et al. (2002), it is difficult to separate the incentive effect from the entrenchment effect of large
shareholders using U.S. firms, since stocks in U.S. firms are widely held and there is little divergence between control
rights and cash-flow rights. In contrast, in East Asian emerging economies, many firms are owned and controlled by
single large shareholders via pyramid ownership structures. Many of the firms in these pyramid structures exhibit high
ownership concentration and high levels of divergence between the control rights and cash-flow rights of large
shareholders.7 Thus, East Asian corporations provide an excellent sample with which to study the effect of the
separation between the cash-flow rights and control rights of large shareholders on corporate investment.
The implication of Hadlock's (1998) results suggests that, if firms typically overinvest their internal capital, the
investment-cash flow sensitivity should decrease as the cash-flow rights of the large shareholders increase and this
sensitivity should increase as the divergence between the control rights and cash-flow rights of the large shareholders
increases. On the other hand, if asymmetric information typically raises the cost of external funds, we expect to observe
the opposite results. If the capital market is perfect and the availability of internal funds does not affect investment
choices, then managerial ownership structures should not have any effect on the relation between cash flow and
corporate investment.
Using financial and ownership data from eight East Asian emerging markets during 1993–1996, our empirical
results support the overinvestment hypothesis caused by the agency costs of free cash flow. More specifically, the
investment-cash flow sensitivity is negatively related to the cash-flow rights of the largest shareholders, while this
sensitivity is positively associated with the divergence between the control rights and cash-flow rights of the largest
shareholders, especially among firms with lower returns on assets (ROA). Our results not only support the
overinvestment hypothesis, but also provide evidence for the positive enhancement effect related to the cash-flow
rights and the negative entrenchment effect associated with the control rights of the largest shareholders on corporate
investment. Our results complement those of Claessens et al. (2002), Lins (2003), and Joh (2003). These studies show
that firm valuation is negatively associated with the separation of cash-flow ownership from control.
Moreover, our evidence of overinvestment by East Asian corporations immediately before the Asian financial crisis
may contribute to our understanding of this devastating financial crisis that began with the devaluation of the Thai baht
on July 2, 1997. Weak corporate governance, especially the divergence between the control rights and cash-flow rights
of large shareholders, has been cited as one of the causes of the crisis. Several studies have examined the impact of
corporate governance on firm performance during the East Asian financial crisis of 1997–1998. Johnson et al. (2000)
find that measures of corporate governance, particularly the effectiveness of protections for minority shareholders,
explain the extent of the exchange rate depreciation and the stock market decline during the crisis better than do
standard macroeconomic measures. Mitton (2002) finds that corporate governance and disclosure are positively related
to firm performance during the time of the crisis (1997–1998). Lemmon and Lins (2003) also offer similar results.
The rest of this paper is organized as follows. Section 2 discusses our hypothesis development. Section 3 describes
our data and empirical specifications. Section 4 reports our baseline results, while Section 5 presents the robustness
checks. Section 6 concludes the paper.

2. Hypothesis development

2.1. The overinvestment hypothesis resulting from the agency costs of free cash flow

The overinvestment hypothesis proposed by Jensen (1986) argues that managers have a tendency to overinvest
internally generated funds. Hadlock (1998) further argues that if the positive investment-cash flow relation is caused by a

7
See La Porta et al. (1999) and Claessens et al. (2000) for detailed discussions of ownership structures around the world and Asian firms,
respectively. Also see Claessens et al. (2002) for evidence on the incentive and entrenchment effects of the largest shareholders on firm value in East
Asian corporations.
 K.C.J. Wei, Y. Zhang / Journal of Corporate Finance 14 (2008) 118–132 121

managerial preference to overinvest internal funds, there should be a negative relation between the investment-cash flow
sensitivity and the alignment of interests between managers and shareholders. In East Asia, ownership is concentrated as
opposed to being diffused as in the U.S. In addition, in East Asian economies, many firms are owned and controlled by
single large shareholders via pyramid ownership structures. In these economies, the nature of agency problems shifts
away from the conflicts of interest between managers and shareholders to the conflicts of interest between controlling
owners or large shareholders (who happen to be managers in most cases) and minority shareholders.
In this case, there are two effects on the overinvestment problem: the enhancement effect related to cash-flow rights
and the entrenchment effect associated with the control rights of large shareholders (Claessens et al., 2002). The
overinvestment problem is alleviated when large shareholders have a high level of cash-flow rights, since their interests
are more aligned with those of minority shareholders. Conversely, the overinvestment problem is aggravated when there
is a high level of divergence between the control rights and cash-flow rights of large shareholders, since their interests are
less aligned with those of minority shareholders. The above discussion leads to the following testable hypothesis:
Hypothesis 1. If large shareholders have a preference for overinvestment resulting from the agency costs of free cash
flow, the investment-cash flow sensitivity decreases as the level of large shareholders' cash-flow rights increases, while
this sensitivity increases as the degree of divergence between large shareholders' control rights and their cash-flow
rights increases.

2.2. The underinvestment hypothesis resulting from asymmetric information problems in the capital markets

There is an alternative view based on asymmetric information problems. Myers and Majluf (1984) show how a firm
may underinvest in the presence of asymmetric information problems in the capital markets. Hadlock (1998) further
suggests that if the positive investment-cash flow sensitivity is caused by a managerial preference for underinvestment,
there should be a positive relation between the investment-cash flow sensitivity and the alignment of interests between
managers and shareholders.8 We can extend Hadlock's argument to infer that the underinvestment problem is aggravated
when large shareholders have a high level of cash-flow rights or when there is little divergence between the control rights
and cash-flow rights of large shareholders. The above discussion leads to the following testable hypothesis.
Hypothesis 2. If large shareholders have a preference for underinvestment resulting from asymmetric information
problems in the capital markets, the investment-cash flow sensitivity increases as large shareholders' cash-flow rights
increase and decreases as the divergence between large shareholders' control rights and cash-flow rights increases.

3. Data description and empirical specification

3.1. Sample selection

We start with all firms in East Asia from 1991–1996 that appeared on the Worldscope tape. Regarding ownership
data, we focus on ultimate ownership. We use ownership data assembled by Claessens et al. (2000).9 Claessens et al.
(2000) collected 1996 data on the ownership of corporations in Hong Kong, Indonesia, Japan, Korea, Malaysia, the
Philippines, Singapore, Taiwan, and Thailand. Their main source was Worldscope, supplemented by other sources that
describe ownership structures. From a complete sample of 5284 publicly listed corporations in the nine East Asian
countries, ownership data were collected for 2980 firms. The procedure of identifying ultimate owners is similar to the
one used by La Porta et al. (1999). An ultimate owner is defined as the shareholder who has the determining voting rights
of the company and is not controlled by anybody else. If a company does not have an ultimate owner, it is classified as
widely held. To economize on the data collection task, the ultimate owners' voting right level is set at 50% and not traced
any further once the level exceeds 50%. Although a firm can have more than one ultimate owner, we focus on the largest
ultimate owner. As our definition of ownership relies on both cash-flow rights and voting control rights, the cash-flow

8
Dybvig and Zender (1991) show that the underinvestment problem is alleviated when large shareholders have few cash-flow rights.
9
The dataset is also used by Claessens et al. (2002) and Fan and Wong (2002). We thank Joseph Fan and Larry Lang for their generousness in
providing us with their ownership data.
122 K.C.J. Wei, Y. Zhang / Journal of Corporate Finance 14 (2008) 118–132

rights that support the control by ultimate owners are further identified. Firm-specific information on pyramid ownership
structures and crossholdings is used to draw the distinction between cash-flow rights and control rights.
In our analysis, we use a subset of these firms. First, we exclude from the sample all Japanese firms. Most Japanese
firms have dispersed ownership structures, and ownership and management are separated far more often in Japan than
in other East Asian economies. The most important shareholders in most Japanese firms are widely held financial
institutions, again unlike in many other economies in the region. These financial institutions and their affiliated firms
often work together to influence the governance of their corporations. Thus, including Japan in our sample would be
less useful for disentangling the incentive and entrenchment effects of concentrated ownership and control. Second, we
follow the literature to exclude firms that operate in financial industries (SIC 6000–6999) and regulated utilities (SIC
4900–4999), since their investment behavior should be different from the investment behaviors of other industries. We
then merge the ownership data with the Worldscope financial data.
We use the Worldscope database instead of the PACAP database, because PACAP does not provide firms' capital
expenditures. Though capital expenditures could be inferred from other accounting data, different accounting standards
in each country would lead to incomparable measures of capital expenditures. There are many firms with missing
capital expenditures in the Worldscope database. We dropped these firm-years from our sample. We also dropped firm-
years with missing values on variables such as assets, lagged assets, lagged Tobin's Q, and lagged sales. The merger of
the 1996 ownership data with the 1993–1996 financial data requires us to assume that the ownership and control
structures of the firms did not change substantially during that period. This is a reasonable assumption, since the
economic and political conditions were relatively stable during our sample period. These sample selection criteria
result in a final sample of 2555 firm-years from 994 corporations in eight East Asian economies over the period of
1993–1996.10 To include as many observations as possible, we use unbalanced panel data in our analyses, although we
also analyze a smaller balanced panel dataset in the robustness checks. Broken down by economies, the sample covers
458 firm-years for 193 firms from Hong Kong, 288 firm-years for 101 firms from Indonesia, 477 firm-years for 202
firms from Korea, 390 firm-years for 127 firms from Malaysia, 133 firm-years for 60 firms from the Philippines, 397
firm-years for 143 firms from Singapore, 194 firm-years for 91 firms from Taiwan, and 218 firm-years for 77 firms
from Thailand.

3.2. Summary statistics of ownership structures

Panel A of Table 1 documents the largest shareholders' control rights, cash-flow rights, and the difference between
control rights and cash-flow rights in eight East Asian economies. The definition of cash-flow rights and control rights
follows Claessens et al. (2000) and Claessens et al. (2002). The mean of the largest shareholders' control rights is
29.31% and the median is 28.00%. The mean of the largest shareholders' cash-flow rights is 24.44% and the median is
24.00%. The mean of the difference between control rights and cash-flow rights is 4.88%. This is not a large difference
because over half the firms in the sample do not exhibit a separation between control rights and cash-flow rights. A
quarter of the firms have a difference between control rights and cash-flow rights that is larger than 9%. The maximum
of the difference between control rights and cash-flow rights is 38%. This shows that the difference between control
rights and cash-flow rights of the largest shareholders is very significant in over a quarter of East Asian corporations.

3.3. Summary statistics of firm characteristics

Panel B of Table 1 presents summary statistics of firm characteristics for the entire sample and for sub-samples
based on the largest shareholders' cash-flow rights quartiles. We note that investment, cash flow, and asset size vary
significantly across quartiles based on the largest shareholders' cash-flow rights. However, interpreting the variations
in the summary statistics on the reported variables across cash-flow quartiles as evidence for or against the presence of
underinvestment or overinvestment may be problematic or premature. We do not make any inferences directly based on
these summary statistics.

10
The two extreme percentiles of firm-year observations of cash flow/assets, investment/assets, and lagged sales/assets are eliminated from the
sample. Our results remain unchanged without this elimination procedure.
 K.C.J. Wei, Y. Zhang / Journal of Corporate Finance 14 (2008) 118–132 123

Table 1
Summary statistics
Panel A: control rights and cash-flow rights of the largest ultimate owners
# of firms Mean SE Minimum 1st quartile Median 3rd quartile Maximum
Control rights (%)
974 29.31 12.33 0.00 22.00 28.00 36.00 63.00

Cash-flow rights (%)

974 24.44 12.40 0.00 15.00 24.00 32.00 59.00

The difference between control rights and cash-flow rights (%)

974 4.88 7.61 0.00 0.00 0.00 9.00 38.00

Panel B: summary statistics of relevant variables

Variable All firms Quartile 1 Quartile 2 Quartile 3 Quartile 4
Investment/Assets (%) 6.52 6.63⁎⁎ 7.11⁎⁎ 5.45⁎⁎ 7.14⁎⁎
Tobin's Q 1.30 1.22 1.31 1.32 1.37⁎⁎
Cash flow/Assets (%) 8.04 6.26⁎⁎ 8.05 8.28⁎⁎ 9.74⁎⁎
Sales/Assets (%) 67.10 67.60 70.30⁎⁎ 59.50⁎⁎ 68.90
Market cap (in million $) 201.20 243.50 222.53 198.50⁎⁎ 137.80⁎⁎
Total assets (in million $) 284.10 449.00⁎⁎ 298.60⁎⁎ 249.90⁎⁎ 185.80⁎⁎
Debt ratio (%) 28.10 31.70⁎⁎ 27.20 25.60 27.60⁎⁎
ROA (%) 5.48 4.95⁎⁎ 5.70 5.20⁎⁎ 6.51⁎⁎
Current ratio ($) 1.33 1.31 1.34 1.34 1.33
Number of observations 2555 643 621 699 592
Panel A of this table reports ownership structures (in percent) of the largest ultimate owners in East Asian firms. To be included in the sample, a firm
must have at least one year of capital expenditures and other financial data in the Worldscope database between 1993 and 1996 and have lagged
financial data as well. The ultimate ownership data is obtained from Claessens et al. (2000). Cash-flow rights and control rights are based on common
stock ownership. There are a total of 974 firms for the 1996 in the sample. Panel B reports summary statistics of relevant variables. All reported
figures are the medians and are calculated over the complete set of firm-years from 1993 to 1996. “Investment/Assets” is capital expenditures over
assets. “Tobin's Q” is the market value of equity plus assets minus the book value of equity over assets. “Cash flow/Assets” is operating cash flow
over assets. “Sales/Assets” is sales over assets in the previous year. “Market cap” is the market value of equity. “Total assets” is the total assets of the
firm. “Debt ratio” is total debt over asset. ROA is operating income over assets. Current ratio is current assets over current liabilities. Firms with the
cash-flow rights of the largest ultimate owners at or below the 25th percentile is classified as Quartile 1 firms, above the 25th percentile and below the
50th percentile as Quartile 2 firms, at or above the 50th percentile and at or below 75th percentile as Quartile 3 firms, and above the 75th percentile as
Quartile 4 firms. ⁎ and ⁎⁎ denote the median difference of the corresponding variable between the current ownership quartile and the next larger
ownership quartile at the 10% and 5% significant levels, respectively, using a Wilcoxon Rank-Sum test. In the Quartile 4 column, this denotes the test
of the difference between Quartile 4 and Quartile 1.

3.4. Empirical specification

To investigate the role of ownership structures on investment-cash flow sensitivities, we use the same basic
approach as Fazzari et al. (1988) and others. These authors regress investment on Tobin's Q, cash flow, and other
control variables. They interpret differences in the investment-cash flow relationship between different groups of firms
as evidence of financial constraints. Hadlock (1998) interacts cash flow with managerial cash-flow rights to examine
the managerial enhancement effect on investment. To examine the managerial entrenchment effect on investment, we
interact cash flow with “the difference between the largest shareholders' control rights and their cash-flow rights”
(denoted as “Divergence” or “Control minus ownership”). Based on the discussion above, we use the following
regression model to perform our tests:

Iit CFit CFit CFit

¼ b0 þ b1 Qi;t
1 þ b2 þ b3  Cashrighti;t
1 þ b4  Divergencei;t
1 þ BYit þ eit ; ð1Þ
Ai;t
1 Ai;t
1 Ai;t
1 Ai;t
1

where I is investment, A is assets, Q is a measure of Tobin's Q, CF is cash flow, Cashright is the largest shareholder's
cash-flow rights, Divergence is the largest shareholder's control rights minus his/her cash-flow rights, and Y is a set of
124 K.C.J. Wei, Y. Zhang / Journal of Corporate Finance 14 (2008) 118–132

Table 2
Investment regression results from sub-samples grouped by the level of cash-flow rights and by the level of separation between cash-flow rights and
control rights
Cash-flow N Tobin's Q Cash flow/assets Adjusted
rights R2
Coefficient (SE) [t-stat] Coefficient (SE) [t-stat]
Panel A: portfolios sorted by the largest shareholders' cash-flow rights
Quartile 1 643 − 0.0065 (0.0045) – 0.408 (0.064) – 0.035
Quartile 2 621 0.0049 (0.0045) [1.96] 0.326 (0.037) [1.11] 0.145
Quartile 3 699 − 0.0053 (0.0040) [0.21] 0.272 (0.048) [1.70] 0.052
Quartile 4 592 0.0011 (0.0048) [1.21] 0.370 (0.063) [0.43] 0.053

Panel B: portfolios sorted by the largest shareholders' “control minus ownership”

=0 1559 0.0053 (0.0042) – 0.247 (0.032) – 0.078
N0 996 0.0116 (0.0082) [0.73] 0.516 (0.064) [3.92] 0.053
This table reports the regression results of capital investment/assets on Tobin's Q, cash flow/assets, sales/assets, and time fixed effects. The regression
coefficients on sales/assets and the year dummies are not reported. In panel A, all firms identified in 1995 are sorted into quartiles based on the largest
shareholders' cash-flow rights. Firms with the cash-flow rights of the largest ultimate owners at or below the 25th percentile are classified as Quartile
1 firms, above the 25th percentile and below the 50th percentile as Quartile 2 firms, at or above the 50th percentile and at or below 75th percentile as
Quartile 3 firms, and above the 75th percentile as Quartile 4 firms. In panel B, all firms are separately sorted into two groups based on the difference
between the largest shareholders' control rights and cash-flow rights as “control minus ownership”. A firm is designated as in the “control minus
ownership = 0” group if its “control minus cash-flow rights” is zero. A firm is designated as in the “control minus ownership N 0” group if its “control
minus cash-flow rights” is greater than zero. The regressions are performed separately for each group of firms using the 1993–1996 panel data. Year
and four-digit code industry dummy variables are included in all regressions. Panel A reports the result based on “cash-flow rights” sorting, while
panel B based on “control minus ownership” sorting. “SE” is standard error. t-statistics (“t-stat”) in panel A test the hypothesis of no difference
between the coefficients in each quartile and in Quartile 1. t-statistics in panel B test the hypothesis of no difference between the coefficients in the
“control minus ownership = 0” group and in the “control minus ownership N 0” group.

control variables.11 If firms face asymmetric information problems (i.e., the underinvestment hypothesis), we expect β3
to be positive and, if the entrenchment effect is important, we expect β4 to be negative. If firms face agency problems
from free cash flow (i.e., the overinvestment hypothesis), we expect β3 to be negative and, if the entrenchment effect is
important, we expect β4 to be positive. If the capital market is perfect and there is no agency problem, we expect both
β3 and β4 to be zero.

4. Regression results

4.1. Regression results based on portfolios sorted by the largest shareholders' ownership

We begin with simple tests of Hypotheses 1 and 2 based on portfolio analysis. To conduct the tests, we first assign all
firms in our sample to quartiles according to the largest shareholders' cash-flow rights (Cashright). We also separately
assign all sample firms to two groups according to their “Control minus ownership” (Divergence) values. Firms with
Divergence values equal to zero are assigned to the “Control minus ownership = 0” group and those with Divergence
values greater than zero are assigned to the “Control minus ownership N 0” group. We then estimate the following
simple investment equation separately for each group:
Iit CFit
¼ b0 þ b1 Qi;t
1 þ b2 þ BYit þ eit : ð2Þ
Ai;t
1 Ai;t
1

The results from the 1993–1996 panel data are reported in Table 2. Panel A reports the results based on sorting of the
largest shareholders' cash-flow rights. Under this sorting, capital investment is sensitive to cash flow in all quartiles. In
addition, there is an association between cash-flow rights and investment-cash flow sensitivities. The estimated
coefficient on cash flow falls from 0.408 in Quartile 1 to 0.326 in Quartile 2, and further down to 0.272 in Quartile 3.
Thus, firms in which the largest shareholders have extensive cash-flow rights have smaller investment-cash flow

11
Baker et al. (2003) and Shin and Stulz (1998) also use assets in the denominator in their studies.
 K.C.J. Wei, Y. Zhang / Journal of Corporate Finance 14 (2008) 118–132 125

sensitivities than do firms in which the largest shareholders have limited cash-flow rights. A formal test shows that the
difference in the estimated coefficient on cash flow is statistically significant between Quartile 1 and Quartile 3 at the
10% level with a t-statistic of 1.70. The results imply that the overinvestment problem is alleviated in firms in which the
largest shareholders have extensive cash-flow rights, which is consistent with the overinvestment hypothesis suggested
by the agency problems of free cash flow. However, the estimated coefficient on cash flow in Quartile 4 increases to
0.370 from 0.272 in Quartile 3. This may suggest that the entrenchment effect appears to become more significant as
the largest shareholders' control rights increase along with their cash-flow rights. However, we need to examine the
cash-flow rights and control rights simultaneously to disentangle the two effects.
In summary, the results in panel A of Table 2 show that there is a U-shaped relationship between investment-cash
flow sensitivities and the cash-flow rights of the largest shareholders, which is opposite to the finding by Hadlock
(1998) in U.S. firms. This perhaps suggests that the overinvestment hypothesis is more appropriate in describing
investment activities in East Asian countries than the underinvestment hypothesis is.
Panel B of Table 2 reports the results based on the “control minus ownership” sorting. The results indicate that there
is indeed a strong relationship between “Control minus ownership” and the effect of cash flow on investment. The
estimated coefficient on cash flow increases from 0.247 in the “Control minus ownership = 0” group to 0.516 in the
“Control minus ownership N 0” group. Thus, firms that have a separation between the largest shareholders' control
rights and their cash-flow rights have more than double the sensitivity of investment to cash flow than do firms that
have no such separation. A formal test shows that the difference in the estimated coefficients on cash flow is
statistically significant between the two groups at the 1% level with a t-statistic of 3.92. These results imply that the
overinvestment problem is aggravated in firms with a separation between the largest shareholders' control rights and
their ownership, which is also consistent with the overinvestment hypothesis.

4.2. Baseline regression results

The results from the portfolio analyses in the last sub-section support the overinvestment hypothesis. In this section,
we use the entire sample for a formal test of our hypotheses. Since the ownership data are collected from 1996, we use
the 1993–1996 panel data. The regression results from Eq. (1) are reported in Table 3. Model 1 of Table 3 reports the
estimates from a standard investment-cash flow regression. The estimated coefficient on lagged sales/assets is positive

Table 3
Regression of investment on Tobin's Q, cash flow, and the largest shareholders' ownership structures
Independent variable Model 1 Model 2 Model 3 Model 4
Intercept 0.066⁎⁎ 0.069⁎⁎ 0.065⁎⁎ 0.067⁎⁎
(7.39) (7.63) (8.11) (7.43)
Sales 0.015 0.016 0.017 0.017
(0.32) (0.36) (0.37) (0.38)
Tobin's Q 0.007⁎ 0.007⁎ 0.006⁎ 0.007⁎
(1.89) (1.92) (1.67) (1.72)
Cash flow 0.316⁎⁎ 0.540⁎ 0.426⁎⁎ 0.426⁎⁎
(10.57) (5.73) (4.05) (4.05)
Cash flow × Cash-flow rights − 0.955⁎⁎ − 0.633
(− 2.50) (− 1.57)
Cash flow × (Control minus ownership) 1.340⁎⁎ 1.097⁎⁎
(3.07) (2.37)
Country and industry dummies Yes Yes Yes Yes
Adjusted R2 0.071 0.064 0.064 0.061
Number of observations 2555 2555 2555 2555
This table reports fixed-effect regression results of capital investment on Tobin's Q, cash flow, interactions of cash flow with the largest shareholders'
cash-flow rights and with the difference between the largest shareholders' control rights and cash-flow rights (denoted as “control minus ownership”),
controls, the country dummies, and the four-digit industry code dummies in 1993–1996. “Investment” is defined as capital expenditures over assets.
“Sales” is the total sales over assets in the previous year. “Tobin's Q” is defined as the market value of equity plus assets minus the book value of
equity over assets. “Cash flow” is operating cash flow over assets. “Cash-flow right” is the largest shareholders' cash-flow rights. “Control minus
ownership” is the difference between the largest shareholders' control rights and cash-flow rights. Firm fixed effects and year dummy variables are
included in all regressions. t-statistics are in parentheses. ⁎ and ⁎⁎ denote significance at the 10% and 5% levels, respectively.
126 K.C.J. Wei, Y. Zhang / Journal of Corporate Finance 14 (2008) 118–132

but insignificant. Both coefficients on lagged Tobin's Q and on cash flow have the expected positive signs and are
significant, which is also consistent with previous studies that use U.S. data (e.g., Fazzari et al., 1988).
Model 2 includes a term that interacts cash flow with the largest shareholders' cash-flow rights (Cash flow × Cash-
flow rights). The coefficient of interest in this case is the coefficient on the interaction term (β3 in Eq. (1)). The
estimated coefficient on Cash flow × Cash-flow rights is − 0.955, which is negative and significant at the 5% level with
a t-statistic of − 2.50. This result shows that the sensitivity of investment to cash flow falls rapidly as the largest
shareholders' cash-flow rights increase. This result strongly supports the overinvestment hypothesis that is heightened
by the largest shareholders' enhancement effect on investment.
Model 3 includes a term that interacts cash flow with “Control minus ownership” (Cash flow × (Control minus
ownership)). The coefficient of interest in this case is the coefficient on the interaction term (β4 in Eq. (1)). The coefficient
on Cash flow × (Control minus ownership) is 1.34, which is positive and significant at the 1% level with a t-statistic of
3.07. This implies that the sensitivity of investment to cash flow increases rapidly as the degree of separation between the
largest shareholders' ownership and their control rights increases. This result is also consistent with the overinvestment
hypothesis that is heightened by the largest shareholders' entrenchment effect on investment.
Model 4 reports results from our full model by interacting cash flow with both cash-flow rights and “Control minus
ownership”. We use this specification as our baseline specification for any comparisons below. The coefficients of
interest in this case are the coefficients on the interaction terms (β3 and β4 in Eq. (1)). The coefficient on Cash
flow × Cash-flow rights is − 0.633, which is negative and close to significant at the 10% level. The coefficient on Cash
flow × (Control minus ownership) is 1.097, which is positive and significant at the 5% level with a t-statistic of 2.37.
The results demonstrate that the sensitivity of investment to cash flow simultaneously decreases as the largest
shareholders' cash-flow rights increase and it increases as the degree of separation between the largest shareholders'
ownership and their control rights increases. The results are consistent with the overinvestment hypothesis, which is
heightened by the largest shareholders' enhancement and entrenchment effects on investment. This suggests that using
East Asian firms allows us to detect both the enhancement and entrenchment effects of the largest shareholders on
investment. These effects are difficult to identify in typical U.S. firms.
Overall, the results in Table 3 support the overinvestment hypothesis caused by the agency costs of free cash flow using
our East Asian sample. They do not support the underinvestment hypothesis caused by asymmetric information problems
as documented by Hadlock (1998) on a U.S. sample. Our results and approach offer a much clearer picture of the impact of
ownership structures on the investment-cash flow sensitivity than previous studies have been able to show. In particular,
we disentangle the enhancement effect from the entrenchment effect on investment. When large shareholders care more
about shareholder value, the agency costs of free cash flow are less severe and the overinvestment problem also becomes
less severe. On the other hand, when the degree of separation between ownership and control rights is great, the
overinvestment problem is aggravated.

5. Robustness checks and additional tests

5.1. Alternative requirements for panel data

To work with a large sample, we use an unbalanced panel dataset in the above analyses. More specifically, we
include all firms in the sample that have at least one firm-year in the span of 1993–1996, provided that all the data
required for analysis are available. This sampling procedure might bias our results. In this section, we examine whether
our results are robust to the requirement of specific numbers of firm-years for a firm to be included in the sample.
First, we exclude firms with only one firm-year observation in 1993–1996. Column 1 of Table 4 reports the
estimated coefficients based on this reduced sample of 2292 firm-years. The results remain almost unchanged. We then
further exclude firms with only one or two firm-year observations. Column 2 of Table 4 reports estimated coefficients
based on this further reduced sample of 1786 firm-years. The results change slightly. The coefficient on Cash
flow × Cash-flow rights becomes significant at the 10% level and the significance of the coefficient on Cash
flow × (Control minus ownership) reduces to the 10% level. Finally, we include only firms with all four firm-year
observations. Column 3 of Table 4 reports the estimated coefficients based on this balanced panel data sample of only
1408 firm-years. The coefficients on all variables do change, but the signs on all variables remain the same. The
coefficient on Cash flow × Cash-flow rights improves to become significant at the 5% level. In sum, our results remain
virtually unchanged or are even stronger when we impose more stringent restrictions on firm-year observations.
 K.C.J. Wei, Y. Zhang / Journal of Corporate Finance 14 (2008) 118–132 127

Table 4
Regression of investment on Tobin's Q, cash flow, and the largest shareholders' ownership structures: alternative sample size
Independent variable At least 2 firm-years At least 3 firm-years 4 firm-years only
(Column 1) (Column 2) (Column 3)
Intercept 0.065⁎⁎ 0.064⁎⁎ 0.060⁎⁎
(7.33) (6.76) (5.70)
Sales 0.002 − 0.000 − 0.001
(0.38) (− 0.02) (− 0.26)
Tobin's Q 0.007⁎ 0.008⁎ 0.011⁎⁎
(1.72) (1.84) (2.23)
Cash flow 0.426⁎⁎ 0.473⁎⁎ 0.576⁎⁎
(4.05) (3.99) (4.14)
Cash flow × Cash-flow rights − 0.633 − 0.864⁎ − 1.29⁎⁎
(− 1.57) (− 1.87) (− 2.37)
Cash flow × (Control minus ownership) 1.097⁎⁎ 1.170⁎⁎ 1.240⁎⁎
(2.37) (2.33) (2.18)
Country and industry dummies Yes Yes Yes
Adjusted R2 0.061 0.059 0.056
Number of observations 2292 1786 1408
This table reports fixed-effect regression results of capital investment on Tobin's Q, cash flow, interactions of cash flow with cash-flow rights and
with “control minus ownership” controls, the country dummies, and the four-digit industry code dummies for the 1993–1996 panel data.
“Investment” is defined as capital expenditures over assets. “Sales” is the total sales over assets in the previous year. “Tobin's Q” is defined as the
market value of equity plus assets minus the book value of equity over assets. “Cash flow” is operating cash flow over assets. “Cash-flow right” is the
largest shareholders' cash-flow rights. “Control minus ownership” is the difference between the largest shareholders' control rights and cash-flow
rights. Column 1 reports the unbalanced panel data regression results when the sample includes 731 firms for a total of 2292 firm-years with each firm
having at least two firm-years. Column 2 reports the unbalanced panel data regression results when the sample includes 478 firms for a total of 1786
firm-years with each firm having at least three firm-years. Column 3 reports the balanced panel data regression results with 352 firms for a total of
1408 firm-years with each firm having all four firm-years. Firm fixed effects and year dummy variables are included in all regressions. t-statistics are
in parentheses. ⁎ and ⁎⁎ denote significance at the 10% and 5% levels, respectively.

Since the East Asian financial crisis took place in mid 1997, the year 1996, which is just prior to the crisis, may be
different from other years, and thus may influence our results. To test this possibility, we run the baseline regression
with the panel data from 1992–1995. The results (unreported) are similar to those on data from 1993–1996. Though
not reported, we also run a country-by-country analysis. The results are consistent with the whole sample analysis in
general (with correct signs for a majority of countries), but are weaker due to fewer observations.

5.2. Robustness checks: different sets of control variables

Our results in Table 3 may be sensitive to the exclusion or inclusion of certain control variables. In this section, we
report robustness checks to validate our results. First, sales are highly correlated with Tobin's Q, which may explain
why the coefficient on Tobin's Q is not large in Model 1 of Table 3. Model 1 of Table 5 reports the estimated
coefficients excluding sales from our baseline result reported in Model 4 of Table 3. After excluding sales, the
coefficient on Tobin's Q is positive and significant, but it does not change much. The other coefficients also do not
change much. Our results continue to support the overinvestment hypothesis caused by the agency costs of free cash
flow when excluding sales from the regression. We also replace sales/assets with sales growth in the regression. The
result (unreported) is essentially the same.
Second, it is possible that the investment-Tobin's Q relationship is not monotonic. Models 2 and 3 in Table 5 report
the results with the squared term of Tobin's Q included. Model 2 excludes sales, while Model 3 includes sales. The
results from both Models 2 and 3 indicate that the inclusion of the squared Tobin's Q does not change the coefficient on
Cash flow × Cash-flow rights or the coefficient on Cash flow × (Control minus ownership) too much except that the
former becomes significant at the 10% level, compared with our baseline result in Model 4 of Table 3.
Third, a potential explanation for our results in Table 3 is that the largest shareholders' ownership may be a proxy for
omitted variables that affect the investment-cash flow sensitivity. It is possible that the results reflect a negative
correlation between firm size and the largest shareholders' ownership. To control for this possibility, we include a term
128 K.C.J. Wei, Y. Zhang / Journal of Corporate Finance 14 (2008) 118–132

Table 5
Regression of investment on Tobin's Q, cash flow, and the largest shareholders' ownership structures: robustness checks
Independent variable Model 1 Model 2 Model 3 Model 4 Model 5
Intercept 0.068⁎⁎ 0.063⁎⁎ 0.062⁎⁎ 0.068⁎⁎ 0.058⁎⁎
(8.18) (7.52) (6.86) (7.47) (5.28)
Sales 0.002 0.017 0.002
(0.35) (0.38) (0.34)
Tobin's Q 0.007⁎ 0.008⁎⁎ 0.008⁎⁎ 0.012⁎ 0.012⁎⁎
(1.74) (2.07) (2.06) (1.72) (2.32)
Tobin's Q squared 0.0012⁎⁎ 0.0012⁎⁎
(2.36) (2.63)
Cash flow 0.427⁎⁎ 0.422⁎⁎ 0.422⁎⁎ 0.444⁎⁎ 0.506⁎⁎
(4.06) (4.02) (4.02) (4.13) (4.42)
Cash flow × Cash-flow rights − 0.632 −0.700⁎ − 0.701⁎ − 0.677⁎ −0.678⁎
(− 1.56) (−1.73) (− 1.73) (− 1.66) (−1.66)
Cash flow × (Control minus ownership) 1.095⁎⁎ 1.160⁎⁎ 1.164⁎⁎ 1.078⁎⁎ 1.040⁎⁎
(2.37) (2.51) (2.54) (2.32) (2.24)
Cash flow × Ln(Size) − 0.036 −0.042
(− 0.84) (−0.99)
Cash flow × Tobin's Q −0.024
(−1.56)
Year and industry dummies Yes Yes Yes Yes Yes
Adjusted R2 0.062 0.053 0.052 0.056 0.055
Number of observations 2555 2555 2555 2555 2555
This table reports robustness checks for the fixed-effect regressions of investment on Tobin's Q, cash flow, interactions of cash flow with cash-flow
rights and with “control minus ownership”, controls, the country dummies, and the four-digit industry code dummies for the 1993–1996 panel data.
The regression also includes the four-digit industry dummies. “Investment” is defined as capital expenditures over assets. “Sales” is the total sales
over assets in the previous year. “Tobin's Q” is defined as the market value of equity plus assets minus the book value of equity over assets. “Cash
flow” is operating cash flow over assets. “Cash-flow right” is the largest shareholders' cash-flow rights. “Control minus ownership” is the difference
between the largest shareholders' control rights and cash-flow rights. “Ln(Size)” is the natural logarithm of assets. t-statistics are in parentheses. Firm
fixed effects and year dummy variables are included in all regressions. ⁎ and ⁎⁎ denote significance at the 10% and 5% levels, respectively.

interacting cash flow with the logarithm of the firm's book value of assets (Cash flow × Ln(Size)). The result is given in
Model 4 of Table 5. The coefficient on Cash flow × Cash-flow rights changes very little from − 0.633 to − 0.677, but it
becomes significant at the 10% level. The coefficient on Cash flow × (Control minus ownership) changes from 1.097 to
1.078 and is still highly significant. The coefficient on Cash flow × Ln(Size) is negative but insignificant.
In addition, it is possible that our results reflect a positive correlation between a firm's growth potential and the
largest shareholder's ownership. To control for this possibility, we include a term interacting cash flow with the firm's
Tobin's Q (Cash flow × Tobin's Q) in addition to the term interacting cash flow with firm size (Cash flow × Ln(Size)).
In Model 5, the coefficient on Cash flow × Tobin's Q is negative but it is insignificant. The coefficients on Cash
flow × Cash-flow rights and Cash flow × (Control minus ownership) change very little, compared with the results from
Model 4. The results from both Models 4 and 5 indicate that our conclusion about the overinvestment hypothesis
caused by the agency costs of free cash flow is robust to the inclusion of cash flow interacted with firm size and with
Tobin's Q.
In sum, the results in Table 5 indicate that our overinvestment conclusion is robust to a number of alternative
specifications with different sets of control variables that may affect our results. That is, our results supporting the
overinvestment hypothesis caused by the agency costs of free cash flow, which are heightened with the enhancement
and entrenchment effects of the largest shareholders' ownership structures, are very robust to various empirical
specifications.

5.3. Comparison of overinvestment problems between low ROA and high ROA groups

The overinvestment problem should be a more important issue in firms with a lower return on investment than in
firms with a higher return on investment. To test this hypothesis, we classify all firms into two groups. The low ROA
 K.C.J. Wei, Y. Zhang / Journal of Corporate Finance 14 (2008) 118–132 129

Table 6
Regression of investment on Tobin's Q, cash flow, and the largest shareholders' ownership structures: low ROA group versus high ROA group
Independent variable Low ROA group High ROA group
(Column 1) (Column 2)
Intercept 0.066⁎⁎ 0.042⁎⁎
(4.07) (2.11)
Sales 0.001 0.018
(0.16) (1.03)
Tobin's Q 0.013 0.009
(1.52) (1.26)
Cash flow 0.646⁎⁎ 0.589⁎⁎
(2.67) (3.14)
Cash flow × Cash-flow rights − 1.190⁎ − 0.822
(− 1.73) (− 1.43)
Cash flow × (Control minus ownership) 1.910⁎⁎ 0.239
(2.44) (0.35)
Cash flow × Ln(Size) − 0.023 − 0.024
(− 1.64) (− 0.56)
Cash flow × Tobin's Q − 0.035 − 0.015
(− 0.52) (− 0.86)
Country and industry dummies Yes Yes
Adjusted R2 0.058 0.048
Number of observations 1155 1400
This table reports fixed-effect regression results of capital investment on Tobin's Q, cash flow, interactions of cash flow with cash-flow rights and
with “control minus ownership”, controls, the country dummies, and the four-digit industry code dummies for the two groups classified based on
returns on assets (ROA). The 1993–1996 panel data is used. “Investment” is defined as capital expenditures over assets. “Sales” is the total sales over
assets in the previous year. “Tobin's Q” is defined as the market value of equity plus assets minus the book value of equity over assets. “Cash flow” is
operating cash flow over assets. “Cash-flow right” is the largest shareholders' cash-flow rights. “Control minus ownership” is the difference between
the largest shareholders' control rights and cash-flow rights. Column 1 reports the regression results for the low ROA firms with an average four-year
ROA of less than 0.05. The low ROA group includes 456 firms for a total of 1155 firm-years. Column 2 reports the regression results for the high
ROA firms with a four-year average ROA of greater than or equal to 0.05. The high ROA group includes 538 firms for a total of 1400 firm-years. Firm
fixed effects and year dummy variables are included in all regressions. t-statistics are in parentheses. ⁎ and ⁎⁎ denote significance at the 10% and 5%
levels, respectively.

group contains firms with a four-year (1993–1996) average ROA of less than 0.05, while the high ROA group contains
firms with a four-year average ROA of greater than or equal to 0.05.12 The results are reported in Table 6. For the low
ROA group, the coefficient on Cash flow × Cash-flow rights is negative and significant at the 10% level. The
coefficient on Cash flow × (Control minus ownership) is positive and significant at the 5% level with a t-statistic of
2.44. The results demonstrate that in firms with a low ROA, the sensitivity of investment to cash flow simultaneously
decreases with the largest shareholders' cash-flow rights and increases with the degree of separation between the largest
shareholders' ownership and their control rights. The results are consistent with the overinvestment hypothesis. In the
high ROA group, the coefficient on Cash flow × Cash-flow rights is negative but not significant. The coefficient on
Cash flow × (Control minus ownership) is positive but not significant. This suggests that the overinvestment problem
caused by the agency costs of free cash flow is more severe in firms with lower returns on investments.13

12
We also use different ROA cut-off points to classify firms into low and high ROA groups. The results are essentially similar to those reported in
Table 6.
13
Previous research has documented that large shareholders in general and the separation of ownership and control rights in particular are usually
associated with family ownership. It is possible that investment behavior is different between large shareholders in a family and large shareholders
not in families. To test this hypothesis, we divide the sample into two groups: firms with family owners as the largest shareholder (about 70% of our
sample) and firms with non-family owners (including the state, or widely held corporations and financial institutions) as the largest shareholders.
The unreported results suggest that overinvestment caused by the agency costs of free cash flow is more severe in firms with family owners than in
firms with non-family owners as the largest shareholders.
130 K.C.J. Wei, Y. Zhang / Journal of Corporate Finance 14 (2008) 118–132

5.4. Discussion of endogeneity issues

The empirical tests conducted above implicitly assume that the levels of the largest shareholders' ownership and
control rights are exogenously set. An issue that might arise is the possibility of a reverse causality in terms of the
impact of the divergence between ownership and control rights on the investment-cash flow sensitivity. Suppose that
the largest shareholder faces an asymmetric information problem. He/she might then decrease his/her cash-flow rights,
but increase the level of the divergence between his/her control rights and cash-flow rights.
On the contrary, suppose that the largest shareholder faces the free cash-flow problem. He/she might then increase
his/her cash-flow rights, but decrease the level of the divergence between his/her control rights and cash-flow rights.
We could then find that as the level of cash-flow rights becomes larger and/or the divergence becomes smaller, the
investment-cash flow sensitivity decreases. Hence, this result would not tell us much about the possible entrenchment
effect of the separation between ownership and control. However, it seems unlikely that firms can change their cash-
flow rights and control rights quickly and frequently in light of temporary free cash flow or asymmetric information
problems. In fact, La Porta et al. (1999) report that the ownership structures of the top 20 to 30 East Asian firms are
relatively stable over time. As a result, the endogeneity issue would not be important in this case.

6. Conclusions

The high degree of separation between control rights and cash-flow rights in East Asian corporations provides an
excellent sample with which to study investment-cash flow sensitivities in differentiating the agency costs of free cash
flow from asymmetric information problems in capital markets. This separation may be impossible to detect in U.S.
corporations. We find that the investment-cash flow sensitivity decreases with increases in the cash-flow rights of the
largest shareholders but it increases with the degree of divergence between the control rights and cash-flow rights of the
largest shareholders. All these results are consistent with the overinvestment hypothesis caused by the agency costs of
free cash flow, but are inconsistent with the underinvestment hypothesis caused by asymmetric information problems.
Furthermore, our results also demonstrate the enhancement and entrenchment effects of the largest shareholders'
ownership and control on corporate investment.
Our study contributes to the debate on whether the positive association between cash flow and investment is due to
the largest shareholders' preferences to overinvest or to underinvest. The previous literature does not provide a good
instrument to differentiate between these two explanations. We believe that using the largest shareholders' cash-flow
rights and their control rights provides a better instrument in distinguishing between these two explanations than does
using managerial cash-flow rights alone. The reason is simple. While it is not clear how we can separate the
entrenchment effect from the enhancement effect based on the largest shareholders' cash-flow rights alone, the degree
of divergence between the largest shareholders' control rights and their cash-flow rights in East Asian corporations
does provide an excellent measure of the largest shareholders' entrenchment.
Our results are different from those reported by Hadlock (1998). Firms in both the U.S. and East Asia exhibit
strongly positive investment-cash flow sensitivities. However, our findings reveal that the reasons for the positive
investment-cash flow sensitivities are different. While Hadlock's data support the underinvestment hypothesis caused
by asymmetric information problems in U.S. corporations, we document evidence that is consistent with the
overinvestment hypothesis caused by the agency costs of free cash flow in East Asian corporations. The difference
between our results and Hadlock's may be the result of differences in institutional factors. It is well known that the U.S.
economy is characterized by dispersed ownership structures, effective capital market governance, and stronger
protections of shareholders. In contrast, the East Asian economies are distinguished by family firms, state-owned firms,
pyramid and concentrated ownership structures, weak capital market governance, and expropriation of minority
shareholders by dominant shareholders. These more fundamental factors may contribute to the differences in the
agency problems that firms in the two groups of economies face. Previous literature, for example, La Porta et al. (1999)
and Claessens et al. (2002), points out that East Asia and other countries outside the U.S. or the U.K. have different
agency problems. In fact, the agency problem in the U.S. centers on the conflicts of interest between managers and
shareholders, while the agency problem in East Asia is defined by conflicts of interest between large shareholders and
minority shareholders. We provide further evidence to support their arguments that the level of divergence between the
control rights and cash-flow rights of the largest shareholders does have an entrenchment effect on corporate
overinvestment.
 K.C.J. Wei, Y. Zhang / Journal of Corporate Finance 14 (2008) 118–132 131

Since the Asian financial crisis, people have often argued that one of the major reasons for the crisis was
overinvestment by Asian corporations due to too much cheap capital flowing into the region before the crisis. They
have further argued that the overinvestment problem was caused by poor corporate governance mechanisms in these
countries, especially in regard to the significant divergence between the control rights and cash-flow rights of the
largest shareholders (see, for example, Stiglitz (1998), Greenspan (1999), Rajan and Zingales (1998), and Yellen
(1998)). However, up to today, no direct empirical evidence has been offered to support these arguments. Our paper
provides evidence that these conjectures are correct. More specifically, we find that firms in East Asian emerging
economies showed the symptom of overinvestment before the Asian financial crisis (i.e., during our sample period
from 1993–1996). This is particularly true for firms with the greatest divergence between the largest shareholders'
control rights and their cash-flow rights and for firms with lower ROA.
Since the Asian financial crisis, the quality of corporate governance mechanisms in the East Asian region has been
substantially improved via government regulations, such as the requirement that independent directors serve on
company boards, and the scrutiny of shareholder rights activists. However, the problems of concentrated ownership
structures and the divergence between the largest shareholders' control rights and their cash-flow rights have not been
resolved. Whether or not the improvement in the quality of corporate governance mechanisms alone has changed the
investment behaviors of East Asian corporations is left for future research.

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