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Tobin's q, agency conflicts, and differential wealth effects of international joint ventures
Global Finance Journal 12 (2001) 267 – 283
Tobin’s q, agency conflicts, and differential wealth effects of international joint ventures Jae Hoon Mina, Larry J. Pratherb,* a
Department of Finance and Insurance, Seowon University, 231 Mochung-dong, Hungdok-ku, Chungju, Chungbuk 361-762, South Korea b Department of Economics, Finance, and Urban Studies, East Tennessee State University, Box 70686, Johnson City, TN 37614, USA Received 13 November 1998; received in revised form 19 March 1999; accepted 19 February 2001
Abstract This article examines announcement effects of 240 international joint ventures (IJVs) undertaken by US firms to ascertain their impact on shareholders’ wealth. The objective is to ascertain whether the mixed results of announcement effects reported in the literature can be explained. Theory suggests that IJVs would result in differential stock price reactions due to firm-specific characteristics. Therefore, it is hypothesized that IJVs would elicit a positive stock price reaction, on average. Also, it is hypothesized that this reaction should be greater for high Tobin’s q firms and for low free cash flow firms. Empirical analysis reveals that firm-specific characteristics do influence announcement effects and suggests that these factors may explain the mixed announcement effects documented in the literature. D 2001 Elsevier Science Inc. All rights reserved. Keywords: International joint ventures; Tobin’s q; Free cash flow
1. Introduction International alliances have grown at a torrid pace in recent years and these alliances are becoming more important strategically (e.g., Geringer & Hebe`rt, 1989; Serapio & Cascio,
* Corresponding author. Tel.: +1-423-439-5668. E-mail addresses: [email protected] (J.H. Min), [email protected] (L.J. Prather). 1044-0283/01/$ – see front matter D 2001 Elsevier Science Inc. All rights reserved. PII: S 1 0 4 4 - 0 2 8 3 ( 0 1 ) 0 0 0 3 2 - 1
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1996). Therefore, it is important to ascertain whether international joint ventures (IJVs) are in the best interest of the firm’s shareholders. However, extant literature on the wealth effects of IJVs is sparse and the results are mixed (e.g., Chen, Hu, & Shieh, 1991; Chung, Koford, & Lee, 1993; Crutchley, Guo, & Hansen, 1991; Finnerty, Owers, & Rogers, 1986; Lee & Wyatt, 1990; Lummer & McConnell, 1990). Therefore, it is important to investigate, and attempt to explain, the previous results. One explanation for differential findings in IJV studies is that the Tobin’s q differs among the previous samples. Tobin’s q is frequently regarded as the growth opportunities of the firm under current management. Previous studies find differential announcement effects for well-managed (high q) and poorly managed (low q) bidders in tender offers (e.g., Lang, Stultz, & Walkling, 1989, 1991). This evidence is plausible since it is reasonable to believe that, on average, good managers make better decisions than poor managers. Therefore, differential stock price reaction to announcements should exist between well-managed and poorly managed firms. However, Tobin’s q is not strictly confined to be a measure of management quality. Tobin’s q can also be a proxy for growth opportunities. However, since Tobin’s q is important in determining the reaction to announcements of acquisitions, it may also be a determinant of the reaction to IJV announcements. Another factor worthy of consideration is that differences may exist in the free cash flow of sample firms. Several influential studies raise the potential for agency problems between managers and shareholders due to free cash flow and insist that managers might pursue personal goals rather than maximizing shareholders’ wealth (e.g., Jensen, 1986, 1988; Jensen & Meckling, 1976). The authors of previous IJV studies believe that the negative reaction they find may be related to free cash flow, but neither provides an empirical examination (e.g., Chung et al., 1993; Lee & Wyatt, 1990). Studies of foreign acquisitions (e.g., Doukas, 1995) also report a negative relation between free cash flow and announcement-day bidder returns, supporting the free cash flow/overinvestment hypothesis in Jensen and Meckling (1976). Since theory suggests that free cash flow may be an important determinant in the acceptance of a project, and empirical evidence on acquisitions supports this theory, it is appropriate to determine whether this effect can help explain the differential announcement effects for IJVs reported in the literature. The goal of this study is to attempt to explain the differential announcement effects reported in other IJV studies. It is hypothesized that these differential responses can be explained by firm-specific characteristics related to sample composition. Therefore, previous work is extended to examine the effect of Tobin’s q and free cash flow on the announcement effect of IJVs. This study contributes to the literature by showing that Tobin’s q has an important impact on the announcement effect of IJVs. Further, an interesting relationship between Tobin’s q and free cash flow on the announcement effect is documented. Section 2 reviews relevant literature and develops the hypotheses and Section 3 presents details on the data and methodology employed. Empirical results and conclusions are presented in Sections 4 and 5, respectively.
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2. Background and hypotheses Finance theory posits that in fulfilling their responsibility to maximize shareholder wealth, managers should undertake only positive net present value (NPV) projects. Since the value of the firm is the sum of the NPVs of the projects it has undertaken, positive NPV projects increase the value of the firm. Thus, announcements of these projects should elicit a positive stock price reaction. Therefore, under the assumption that managers attempt to maximize shareholders’ wealth, the first hypothesis is: Hypothesis 1: The announcement of an IJV should elicit a positive stock price reaction for the US announcing firm. However, extant evidence on wealth effects of IJVs is mixed. One study examines international and domestic JVs to determine their wealth effects (e.g., Finnerty, Owers, & Rogers, 1986). This study finds an insignificant market reaction and the authors conclude that, on average, these are zero NPV projects since they do not affect shareholders’ wealth. Other studies report more troubling results, negative announcement effects (Chung et al., 1993; Lee & Wyatt, 1990). This is clearly inconsistent with expected results given the managerial charge to increase shareholders’ wealth (or firm value). However, studies of China–US IJVs (e.g., Chen et al., 1991) and Japanese–US JVs (e.g., Crutchley et al., 1991) report positive announcement effects for the US firm. These results are consistent with the findings for increases in capital expenditures (e.g., McConnell & Muscarella, 1985) and for domestic joint ventures (McConnell & Nantell, 1985). This is also consistent with managers fulfilling their fiduciary responsibility by undertaking positive NPV projects. 2.1. Tobin’s q and agency problems One explanation for the mixed empirical results is that some firms have better growth opportunities under current management than others. Several merger and acquisition studies use Tobin’s q as a proxy for managerial performance (e.g., Lang et al., 1989, 1991). These studies find that the gains from tender offers are maximized when high q (well-managed) bidders are combined with low q (poorly managed) targets. Similarly, studies that examine international acquisitions of US firms find that managerial performance, as represented by Tobin’s q, determines investors’ perceptions about the investment decision (e.g., Doukas, 1995). However, an alternate explanation for Tobin’s q is related to the growth opportunities in the industry. Since the quality of management may result in differential wealth effects for well-managed and poorly managed firms, it is important to test whether management quality is an important determinant of market reaction. While management quality cannot be precisely determined, one commonly used proxy is Tobin’s q. Tobin’s q is a measure of the book-to-market value of the firm. Under the value additivity principal, the market value of the firm is the NPV of all current projects under current management plus the NPV of all expected growth opportunities. If management only accepts positive NPV projects, the market value of the firm will increase by the sum of the realized NPVs. This indicates that value has been created by
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management through the judicious selection of projects. Thus, positive NPV projects will increase the value of the firm and Tobin’s q. That is because positive NPV projects will cause the market value of the firm to exceed the book value of the firm so q will be greater than one. If management is not value-maximizing, the negative NPV projects that it accepts would cause the value of the firm, and Tobin’s q, to decrease. Therefore, the second hypothesis is: Hypothesis 2: The market response to IJV announcements will be directly related to Tobin’s q. While any expansion should only be undertaken if it adds value to the firm, studies suggest that agency problems between managers and shareholders may cause managers to pursue personal goals rather than maximizing shareholders’ wealth (e.g., Jensen, 1986, 1988; Jensen & Meckling, 1976). Specifically, those studies suggest a potential overinvestment problem in firms with excessive cash flow. This can arise if the expansion is an attempt to add prestige to the manager. Therefore, managers in such firms may expand their firm size beyond the optimal level through investing in value-decreasing projects. One argument is that incumbent managers may be tempted to increase their firm size and waste excess cash on negative NPV projects because their compensation depends upon the size of the assets under their discretion (e.g., Jensen, 1986). Therefore, the free cash flow variable acts as a proxy for agency costs since it may measure a firm’s vulnerability to wasting shareholders’ wealth. The free cash flow/overinvestment theory suggests that differential announcement effects should result for firms with high free cash flow (HFCF) and low free cash flow (LFCF). Managers of firms with HFCF may overinvest since they have excess cash at their disposal. Managers of LFCF firms, on the other hand, are disciplined by the market since they must finance their investments externally. These funds would be unavailable, or prohibitively expensive, if the market did not believe that the project was worthwhile. Two studies offer the free cash flow hypothesis as one possible explanation for the negative announcement-day returns to IJVs but do not empirically test this explanation (e.g., Chung et al., 1993; Lee & Wyatt, 1990). The free cash flow problem is potentially more severe in IJV expansions since eventual failure of IJVs may be more easily attributed to factors beyond the initiating managers’ control. Two examples of these factors are victimization and management conflicts (e.g., Chung et al., 1993). Victimization arises from one partner taking advantage of the alliance to the other’s detriment. This violates the trust necessary for sustained cooperation (Madhok, 1995). These types of conflicts potentially mitigate being disciplined for undertaking a venture that turns out poorly. Therefore, the third hypothesis is: Hypothesis 3: Market response to IJV announcements will be inversely related to the amount of free cash flow. It is reasonable that the effect of free cash flow is related to Tobin’s q if Tobin’s q is a valid proxy for management quality. This arises because well-managed firms might not exhibit the same reaction to excess cash as poorly managed firms. If management is value-maximizing, it
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may resist squandering cash through overinvesting. Therefore, well-managed (high Tobin’s q) firms may not require the discipline of the market to prevent overinvestment. Alternatively, poor management may be more prone to overinvesting. This provides the impetus to control for the interaction of Tobin’s q and cash flow. Formally, the fourth hypothesis is: Hypothesis 4: Shareholders of high Tobin’s q firms with LFCF benefit most from IJV announcements, and shareholders of low Tobin’s q firms with HFCF benefit least.
3. Data and methodology The sample consists of 240 IJVs undertaken from 1988 through 1992. The Wall Street Journal Index is used to identify the IJVannouncement and the announcement date. The sample covers only completed IJVs by firms listed on the NYSE or AMEX whose stock market data are available in CRSP and Standard & Poors COMPUSTAT tapes. IJVs in the banking industry (two-digit SIC codes 60–67) are excluded from the sample, as are announcements for firms if other firm-specific events (e.g., capital expenditures, or earnings, or dividend announcements) occur during the announcement period (10 days before or after the joint venture announcement). More than half of the sample (56%) is in the chemical, equipment, or electronics industry. By company, the most active firms in the sample are AT&T and GM (11 cases each), GE (10 cases), and finally Coca-Cola and Alcoa (6 cases each). Further details concerning the composition of the data set, such as the breakdown by SIC code, geographic area, year, degree of host country development, and type of ownership, are presented in Table 1. To test the hypotheses, the full sample is stratified in several ways. First, the Tobin’s q ratio is used as a proxy for growth opportunities under current management and the market’s evaluation of the firm. The method reported in Chung and Pruitt (1994) is used to calculate Tobin’s q and classify a firm as high q if the Tobin’s q ratio is greater than unity. Otherwise, it is classified as low q. The median q of the sample is 0.85. Second, free cash flow is used as a proxy for agency costs. The cash flow measure is the ratio of the firm’s operating income before depreciation minus interest, taxes, and dividends on common and preferred stocks to the firm’s total book asset value. This is similar to the approach in Lang et al. (1991). Assignment of observations to the HFCF group is made if the cash flow ratio of the firm is greater than the median cash flow ratio of the entire sample. Otherwise, the observation is classified as LFCF. Among the 240 IJVs, 73 are classified as well-managed firms and 167 as poorly managed firms. One hundred eighteen firms are classified as HFCF and 122 as LFCF. To measure the announcement effects of IJVs on the returns to the US firm’s shareholders, the event-study methodology in Brown and Warner (1985) is employed. The abnormal return is computed as Eq. (1): ARit ¼ Rit ðai þ bi Rmt Þ
ð1Þ
where Rit is the realized return on stock i on day t, Rmt is the CRSP equally weighted market return on day t, and ai and bi are the market model parameter estimates for stock i during the
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Table 1 Joint venture sample characteristics Two-digit SIC
Industry
10 13
Mining Oil and gas
15 – 16
Construction
20 21 26 27 28 29 30 32 33 34 35 36 37 38 40 45 48 49 51 53 57 58
Number of sample
Year
Number of sample
Geographic area
Number of sample
3 6
1988 1989
28 30
66 30
4
1990
56
Food and beverage Cigarettes Paper
15 1 4
1991 1992
49 77
Printing and publishing Chemicals Petroleum refining Rubber and plastics Glass Iron and steel Metal fabrication Machinery Electronics Transportation equipment Measurement instrument Railroads Air transport Communications Services Wholesale Merchandise stores Electronic stores Eating places Total
1
Japan Former Sovieta Eastern Europeb China Germany South Americac France
32 17 3 1 16 9 16 28 42
16 11 11 11 8
South Korea UK Italy India Mexico Turkey Others
7 6 6 6 5 3 54
Total
240
9 3 1 17 4 1 2 2 3 240
Total
240
Degree of development in host countriesd
Number of sample
Type of ownership of foreign partners
Number of sample
Industrialized Developing Total
126 114 240
Private Government Total
161 79 240
a b c d
Includes Russia, Ukraine, Belarus, Kazakhstan, and Uzbekistan. Includes Hungary, Czechoslovakia, Poland, and Romania. Includes Argentina, Brazil, Chile, Colombia, and Venezuela. Classified by IMF.
control period (event day 150 through 11). The coefficients estimated are used to compute the abnormal daily returns for the announcement period (event days 10 to + 10)
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where event day + t( t) represents the tth trading day after (before) the announcement date (t = 0). ARit is the abnormal return on stock i on day t, and is measured as the difference between the observed daily return and the expected daily return (as measured by the OLS market model). The average abnormal return (AARt) across takeovers on day t is then measured by Eq. (2): N 1X AARt ¼ ARit N i¼1
ð2Þ
where N is the number of joint venture announcements. The cumulative abnormal return (CAR) between event days T1 and T2 is calculated as Eq. (3): CART 1;T2 ¼
T2 X
AARt
ð3Þ
T1
where T1 is the beginning day of the interval in the event period and T2 is the ending day of the interval in the event period. The estimated values of AARs and CARs are tested for a statistically significant difference from zero using the standardized t test in Brown and Warner (1985). Additionally, the nonparametric binomial sign test is used to test whether the number positive event day returns are greater than expected. Finally, cross-sectional regression analysis is used to more closely examine the effects of factors that are theoretically important. Both announcement-day AARs and 2-day CARs are the dependent variables. The two explanatory variables used are Tobin’s q and the cash flow measure.
4. Empirical results Table 2 displays the average announcement effect for the full sample of 240 IJVs on common stock returns. The announcement-day AARs are a positive 0.397% and are significant at the .01 level. Further, 59% of the AARs are positive on the announcement day, which is statistically significant. AARs for the 5-day period before or after the announcement day are not statistically different from zero except for day t + 2, which is marginally significant (.10 level). Two-day CARs are a positive 0.380% on the announcement day. These results support the view that managers are acting in the best interest of shareholders and attempting to discover profitable opportunities. The results are consistent with the findings in Chen et al. (1991), Crutchley et al. (1991), and Lummer and McConnell (1990). However, the results are contrary to the finding of no significant reaction in Finnerty, Owers and Rogers (1986) and to the negative significant reaction reported in Chung et al. (1993) and Lee and Wyatt (1990). One explanation for differential announcement effects is that differences in sample composition exist in terms of Tobin’s q or agency problems.
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Table 2 Announcement effects for US firms Event day
AARs
t statistics ( P value)
CARs
Percent positivea
5 4 3 2 1 0 +1 +2 +3 +4 +5
0.0004488 0.0005491 0.0008562 0.0004815 0.0001716 0.0039719 0.0012974 0.0017593 0.0008220 0.0006880 0.0009967
0.549 0.016 0.446 1.068 0.516 2.692 1.058 1.329 0.562 0.301 0.356
0.0004488 0.0009979 0.0003071 0.0003747 0.0003099 0.0038003 0.0026745 0.0004619 0.0025813 0.0015100 0.0003087
52 52 48 53 50 59 44 51 48 51 48
(.291) (.493) (.328) (.143) (.303) (.004)*** (.145) (.093)* (.287) (.381) (.361)
The sample consists of 240 IJV announcements. a The percentage of joint ventures with positive abnormal returns. * Denotes statistical significance at 10% level. *** Denotes statistical significance at 1% level.
Therefore, it is important to test the other hypotheses to discover the influence of other theoretically important factors. Table 3 presents the announcement effects of IJVs on stock returns after dividing the sample into high and low Tobin’s q firms (panels A and B, respectively). As hypothesized, a differential market response between the groups is observed. Panel A shows that the 73 IJVs of firms in the high Tobin’s q group display a positive announcement-day AAR of 0.697% that is significant at the .01 level. Further, 65% of those AARs is positive. However, AARs on day + 1 are negative and significant at the .05 level and the AARs on day + 2 are positive and significant at the .10 level. Other event days exhibit insignificant reaction. This inconsistent reaction is puzzling, but is consistent with a situation where the market first reacts positively to good news, then questions whether the news was as good as originally anticipated. It appears that it takes several days for the market to arrive at a consensus and provides further impetus to conduct further testing since it suggests that some other factor besides Tobin’s q may be important to market participants. Two-day CARs for the high q group are 0.845% on the announcement day. Combined, these findings are consistent with the premise that high q firms elicit positive market reaction to the announcement of IJVs. One interpretation of this result is that managers of high q firms are acting in the best interest of shareholders and engaging only in projects that increase the value of the firm and thus shareholders’ wealth. Panel B shows that the 167 IJVs of firms in the low Tobin’s q group display a positive but insignificant announcement-day AAR of 0.266% despite 56% of the AARs being positive. AARs for the 5 days on either side of the announcement day are also insignificant with the exception of days 2 and + 3. Both are significant at the .10 level, but it is impossible to ascertain the reason for the marginal significance. Additionally, the 2-day CARs for the low q group are 0.177% on the announcement day. This combined evidence suggests that the market is indifferent to the announcement of IJVs by low q firms.
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Table 3 The influence of Tobin’s q on announcement returns CARs
Percent positivea
Panel A: AARs and CARs to US firms with high Tobin’s q ratio (q > 1) 5 0.0016672 0.978 (.165) 4 0.0025762 0.713 (.239) 3 0.0013539 0.632 (.264) 2 0.0030068 0.333 (.370) 1 0.0014723 0.467 (.321) 0 0.0069730 3.111 (.001)*** +1 0.0051271 2.352 (.011)** +2 0.0031123 1.572 (.060)* +3 0.0017913 1.045 (.149) +4 0.0004327 0.306 (.380) +5 0.0003090 0.267 (.395)
(n = 73) 0.0016672 0.0042434 0.0012223 0.0043607 0.0015345 0.0084453 0.0018459 0.0020148 0.0013210 0.0013586 0.0007417
53 55 48 42 53 65 34 58 47 57 44
Panel B: AARs and CARs to US firms with low Tobin’s q ratio (q < 1) 5 0.0000839 0.011 (.495) 4 0.0003370 0.451 (.326) 3 0.0006365 0.116 (.453) 2 0.0020064 1.500 (.067)* 1 0.0008901 0.928 (.177) 0 0.0026600 1.169 (.121) +1 0.0003766 0.286 (.387) +2 0.0011678 0.554 (.290) +3 0.0019643 1.365 (.086)* +4 0.0007996 0.158 (.437) +5 0.0015675 0.604 (.273)
(n = 167) 0.0000839 0.0004209 0.0009735 0.0013699 0.0011163 0.0017699 0.0030366 0.0015444 0.0031321 0.0027639 0.0007679
51 51 48 56 49 56 49 49 49 49 49
Event day
AARs
t statistics ( P value)
The high q sample consists of 73 IJV announcements with Tobin’s q ratios exceeding unity, whereas the low q sample consists of 167 IJV announcements with Tobin’s q ratios less than unity. a The percentage of joint ventures with positive abnormal returns. * Denotes statistical significance at 10% level. ** Denotes statistical significance at 5% level. *** Denotes statistical significance at 1% level.
Although both groups show positive market reaction, only high q firms exhibit statistically significant reaction. These results are broadly consistent with the results reported in Doukas (1995) and Lang et al. (1991) for acquisitions and suggest that high q firms receive more favorable response when they announce new investment decisions. This lends support to Hypothesis 2. As previously discussed, another potential explanation for the negative market reaction reported in Chung et al. (1993) and Lee and Wyatt (1990) is the agency problem created by free cash flow. Table 4 presents the results of the announcement effects of IJVs for HFCF and LFCF firms. Panel B shows that the 122 IJVs by LFCF firms exhibit a positive announcement-day AAR of 0.460% that is statistically significant at the .05 level. Further, 62% of the announcement-day AARs are positive, which is also significant. Additionally, the 3-day period on either side of the announcement day exhibits insignificant reaction. This would
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Table 4 Effects of free cash flow on announcement returns CARs
Percent positivea
Panel A: AARs and CARs to US firms with HFCF ratios (n = 118) 5 0.0018515 0.587 (.279) 4 0.0042364 2.268 (.012)** 3 0.0018035 0.981 (.164) 2 0.0014761 1.171 (.122) 1 0.0013508 0.897 (.185) 0 0.0033203 1.477 (.071)* +1 0.0029177 1.691 (.046)** +2 0.0027885 1.559 (.061)* +3 0.0000878 0.171 (.432) +4 0.0021734 1.478 (.071)* +5 0.0003739 0.378 (.353)
0.0018515 0.0023849 0.0024329 0.0003274 0.0001253 0.0019695 0.0004026 0.0001292 0.0028763 0.0020856 0.0059124
50 56 49 53 45 56 39 56 48 43 51
Panel B: AARs and CARs To US firms with LFCF ratios (n = 122) 5 0.0026736 1.347 (.090)* 4 0.0030173 2.207 (.014)** 3 0.0000601 0.339 (.367) 2 0.0004804 0.346 (.364) 1 0.0009255 0.157 (.437) 0 0.0046021 2.323 (.011)** +1 0.0002697 0.178 (.429) +2 0.0007638 0.330 (.371) +3 0.0015322 0.620 (.268) +4 0.0034555 1.876 (.031)** +5 0.0015991 0.872 (.192)
0.0026736 0.0003437 0.0029572 0.0004203 0.0004451 0.0055276 0.0048718 0.0010335 0.0022960 0.0049877 0.0018564
53 48 47 52 55 62 49 47 48 59 44
Event day
AARs
t statistics ( P value)
a
The percentage of joint ventures with positive abnormal returns. * Denotes statistical significance at 10% level. ** Denotes statistical significance at 5% level.
support the view that the market has little reservation about the positive news conveyed by these announcements. Two-day CARs are also positive (0.553%). The 118 IJVs by HFCF firms, in panel A, appear to be more difficult for the market to interpret since significant reactions occur over 3 days and the reaction oscillates between positive and negative. The announcement-day AARs are 0.332% and marginally significant (.10 level). Additionally, 56% of the announcement-day AARs are positive. However, day t + 1 AARs are 0.291% and significant at the .05 level, with only 39% being positive (61% negative). Day t + 2 AARs turn positive (0.278%) and are marginally significant (.10 level). Also, 56% of the day t + 2 AARs are positive. It is not possible to explain this oscillation; however, this behavior is consistent with a situation where a high level of market uncertainty exists and market participants take several days to come to a consensus about the true value of the undertaking. Two-day CARs are 0.197% on the announcement day. Combined, these results lend support to the hypothesis that free cash flow is an important factor to the market.
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Since it is hypothesized that the effect of free cash flow may be related to the Tobin’s q (if q is a valid proxy for the quality of management), it is important to control for the interaction of Tobin’s q and cash flow. Table 5 reports the announcement effect results after controlling for both Tobin’s q and free cash flow. Four sample groups are examined to ascertain differential market response (high Tobin’s q firms with HFCF, high Tobin’s q firms with LFCF, low Tobin’s q firms with HFCF, and low Tobin’s q firms with LFCF).
Table 5 Announcement returns by Tobin’s q and free cash flow High q and high cash flow (n = 47) Event day AARs Panel 5 4 3 2 1 0 +1 +2 +3 +4 +5
t statistics
High q and low cash flow (n = 26) CARs
t statistics
CARs
Percent positivea
A: Comparisons of US firms’ AARs and CARs surrounding announcement dates of joint ventures 0.000030 0.112 0.000030 49 0.004736 1.488* 0.004736 62 0.002350 0.914 0.002320 55 0.002985 0.035 0.007721 54 0.004582 1.645* 0.002232 43 0.004467 1.152 0.007452 58 0.000048 0.181 0.004534 47 0.008528 0.802 0.004061 35 0.001738 0.675 0.001690 47 0.007275 1.690** 0.001253 65 0.006740 2.506*** 0.005002 66 0.007393 1.844** 0.014668 65 0.007309 2.907*** 0.000569 23 0.001183 0.031 0.006218 54 0.004459 1.803** 0.000285 60 0.000677 0.209 0.000506 54 0.001978 0.861 0.000481 40 0.001455 0.594 0.000778 58 0.001347 0.588 0.003325 49 0.003649 1.304* 0.002194 73 0.000823 0.645 0.000524 51 0.000621 0.419 0.003028 31
Low q and high cash flow (n = 71) Event day AARs Panel 5 4 3 2 1 0 +1 +2 +3 +4 +5
Percent positivea AARs
t statistics
Low q and low cash flow (n = 96) CARs
Percent positivea AARs
t statistics
CARs
Percent positivea
B: Comparisons of US firms’ AARs and CARs surrounding announcement dates of joint ventures 0.003057 0.849 0.003057 51 0.002115 0.745 0.002115 51 0.005485 2.180** 0.002428 57 0.004643 2.470*** 0.002528 46 0.000036 0.073 0.005521 54 0.001133 0.217 0.005776 44 0.002422 1.362* 0.002458 58 0.001699 0.808 0.000566 56 0.001020 0.608 0.001402 44 0.000794 0.701 0.000905 52 0.001056 0.134 0.000036 50 0.003846 1.658** 0.003052 61 0.000011 0.185 0.001045 49 0.000663 0.217 0.004509 48 0.001682 0.543 0.001671 54 0.000787 0.263 0.001450 45 0.001455 0.922 0.003137 54 0.002341 1.008 0.003128 45 0.002721 1.427* 0.001266 39 0.003403 1.437* 0.005744 55 0.001167 0.036 0.003888 51 0.001864 0.764 0.001539 48
The sample consists of 240 IJV announcements. a The percentage of joint ventures with positive abnormal returns. * Denotes statistical significance at 10% level. ** Denotes statistical significance at 5% level. *** Denotes statistical significance at 1% level.
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The top-right quadrant presents the results for the 26 IJVs of high Tobin’s q firms with LFCF. The announcement-day AARs are 0.739% and statistically significant at the .01 level. Day t 1 also exhibits positive and significant AARs, which could be attributed to leakage of information. On both days, 65% of the AARs are positive. Further, no significant reaction is observed on other event days surrounding the announcement, but some noise in the data is present on event days t 5 and t + 4. The 2-day CARs are 1.467%. As hypothesized, the high q firms with LFCF elicit the most positive reaction of the four groups, and the reaction is confined to days t 1 and t = 0. This is consistent with the market being confident that these firms are making wise decisions about undertaking the IJV. The top-left quadrant presents the results for the 47 IJVs of high Tobin’s q firms with HFCF. Sixty-six percent of the AARs on t = 0 are positive and the average AAR is 0.674% and statistically significant. Curiously, the day t + 1 AAR is 0.730%, day t + 2 is 0.445%, and both are statistically significant. Only 23% of the AARs is positive (67% negative) on Day t + 1, whereas 60% of the AARs are positive on day t + 2. The market reaction is not confined to a single day and some ambiguity appears to exist concerning the benefit of the IJV. While this result cannot be explained with certainty, it is interesting that the reaction becomes more ambiguous with higher free cash flow. This supports the contention that free cash flow has some impact on the formation of expectations by market participants. The 2-day CARs are 0.500%. The bottom-right quadrant presents the results of 96 IJVs of the low Tobin’s q and LFCF sample. Announcement-day AARs are a positive 0.384% and statistically significant. Further, 61% of the AARs are positive. However, the magnitude and percentage of the AARs that are positive are much smaller than for either of the high Tobin’s q samples. Additionally, this sample suggests that the market response is unambiguous since the AARs for other event days are insignificant except for noise at days t 4 and t + 4. The 2-day CARs are 0.305% on the announcement day. This can be interpreted as the LFCF acting to bond management so that only good projects are undertaken. Noticeably, only the 71 IJVs of the low Tobin’s q HFCF sample in the bottom-left quadrant show insignificant market reaction at announcement date. It appears that the market is unimpressed by IJVs of low q HFCF firms. These results are generally consistent with Jensen’s free cash flow/overinvestment hypothesis and the acquisition studies in Doukas (1995) and Lang et al. (1991). The above results lend support to the contention that high Tobin’s q firms and firms with LFCF elicit a stronger reaction than their counterparts (ceteris paribus). However, they fail to test directly whether differences between the groups are statistically significant. Previous discussions of the event study results concentrate on the market reaction for a given group such as HFCF. While helpful in determining whether these factors may explain conflicting previous results, it falls short of testing whether significant differences exist between the sample pairs. Table 6 provides this information by summarizing the results of univariate t test statistics on the mean differences in the announcement-day AARs and 2-day CARs between various sample pairs. Sample pair (1) indicates that Tobin’s q is an important factor. The mean difference in announcement effect between the high q and low q groups is significant at the 6% level for
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Table 6 Univariate test of mean difference in AARs and 2-day CARs Sample pairs
Mean (AARs)
Standard deviation
t value on difference
(1) High q group Low q group (2) High cash group Low cash group (3) High q/high cash High q/low cash (4) High q/high cash Low q/high cash (5) High q/high cash Low q/low cash (6) High q/low cash Low q/high cash (7) High q/low cash Low q/low cash (8) Low q/high cash Low q/low cash
0.006973 0.002660 0.003320 0.004602 0.006740 0.007393 0.006740 0.001056 0.006740 0.003846 0.007393 0.001056 0.007393 0.003846 0.001056 0.003846
0.016540 0.016493 0.015904 0.017293 0.015199 0.019040 0.015199 0.016134 0.015199 0.016796 0.019040 0.016134 0.019040 0.016796 0.016134 0.016796
1.86* 0.29 0.16 1.92* 1.12 1.64* 1.08 0.71
Mean (CARs)
Standard deviation
t value on difference
0.008445 0.001770 0.001970 0.005528 0.005002 0.014668 0.005002 0.000036 0.005002 0.003052 0.014668 0.000036 0.014668 0.003052 0.000036 0.003052
0.025760 0.024912 0.026148 0.024407 0.027798 0.021644 0.027798 0.024799 0.027798 0.025061 0.021644 0.024799 0.021644 0.025061 0.024799 0.025061
1.89* 1.08 1.53 1.01 0.42 2.66*** 2.15** 0.77
* Denotes statistical significance at 10% level. ** Denotes statistical significance at 5% level. *** Denotes statistical significance at 1% level.
both AARs on the announcement-date and 2-day CARs. Although both groups show a positive market reaction, the results suggest that high q firms receive a more favorable response from investors when they announce new investment decisions. Based on these results, the conclusion is that shareholders of high q firms benefit more from IJV announcements than shareholders of low q firms. This result is consistent with the acquisition results in Doukas (1995) and Lang et al. (1989, 1991). Sample pair (2) compares the sample mean differences in announcement-day AARs and 2-day CARs for HFCF and LFCF firms. The differences in AARs and CARs between the two groups are not statistically significant at conventional levels. This suggests that the sample split by the free cash flow measure alone does not explain differential market reactions to investment decisions. Sample pairs (3) through (8) examine various combinations of Tobin’s q and free cash flow to detect important differential market reaction. This allows closer examination of the effects of free cash flow after controlling for Tobin’s q. This is important in determining whether excess free cash flow creates more concern for low q firms than high q firms. This line of inquiry is important if Tobin’s q is viewed as a proxy for management quality. The only sample pairs that show significant differences are (4), (6), and (7). Comparing the mean difference in AARs at the announcement date for sample pairs (4) and (6) (the high Tobin’s q subgroups with the low Tobin’s q HFCF group) yields significance at the 10% level. As expected, both high Tobin’s q subgroups elicit more positive and statistically significant returns. This suggests that the quality of management is important but free cash flow alone
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may not be vitally important. Tobin’s q loses significance in sample pair (5) and the high q HFCF group fails to significantly outperform the low q LFCF group. This could indicate that free cash flow may have some influence, but the influence is too weak to provide us with conclusive results. Again, these results are broadly consistent with the results in Doukas (1995) and Lang et al. (1991). Similarly, the 2-day CARs for sample pair (7) are statistically significant. The high q LFCF group significantly outperforms the low q LFCF group at the 5% level. Again, these results are consistent with the results in Doukas (1995) and Lang et al. (1991). Another approach to examine the effect of joint venture characteristic variables on the announcement-day AARs or 2-day CARs is by regressing the abnormal returns on the characteristic variables. This allows determination of the average change in abnormal returns for changes in potentially important characteristic variables. Table 7 provides the results of cross-sectional regression analysis between joint venture characteristic variables and AARs on the announcement date. Regression (1) examines the impact of Tobin’s q and free cash flow. Since it is hypothesized that a higher Tobin’s q will result in higher abnormal returns and that HFCF will result in less positive returns, the coefficient for Tobin’s q is expected to be positive and significant and the coefficient for free cash flow is expected to be negative and significant. As expected, the coefficient for Tobin’s q is positive and statistically significant at the .01 level, further supporting the results in Doukas (1995) and Lang et al. (1991) and the results reported in Tables 3 and 6. The conclusion is that Tobin’s q is an important factor in determining the market’s reaction to IJV announcements. Since it is hypothesized that free cash flow is an important factor, its coefficient is expected to be negative and significant. While the coefficient is negative, it is not statistically significant at conventional levels. However, this result is consistent with the results in Table 6. Free cash Table 7 Announcement returns on joint venture characteristic variables Joint venture characteristic variables (t values in parenthesis) Regression
a
TQa
Cashb
(1)
0.001 (0.45) 0.002 (0.82)
0.003 (2.63)***
0.011 ( 0.52)
(6) a
HQ/HCc
HQ/LCd
LQ/LCe
N 240
0.005 (1.65)*
0.006 (1.52)
0.002 (0.71)
240
Tobin’s q (TQ) is calculated by dividing the total market value of the firm by its replacement value. The cash flow variable (Cash) is the ratio of a firm’s operating income before depreciation net of interest, taxes, and dividends to its total book asset value. c HQ/HC is a dummy variable that takes on a value of 1 if a firm has a high Tobin’s q and high cash flow; otherwise, it is 0. d LQ/HC is a dummy variable that takes on a value of 1 if a firm has a low Tobin’s q and high cash flow; otherwise, it is 0. e LQ/LC is a dummy variable that takes on a value of 1 if a firm has a low Tobin’s q and high cash flow; otherwise, it is 0. * Denotes statistical significance at 10%. *** Denotes statistical significance at 1%. b
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flow alone is not an important factor. In regression (2), the possible interaction between Tobin’s q and free cash flow is examined. The approach is to run a regression with three dummy variables representing the high q–high cash flow group (HQ/HC), high q–low cash flow group (HQ/LC), and the low q–low cash flow group (LQ/LC). The constant term represents the low q– high cash flow group. The results are generally consistent with expectations. The most positive reaction, as expected, is for firms with high Tobin’s q and LFCF. However, the reaction falls short of statistical significance at conventional levels (11%). Also, as expected, the high Tobin’s q HFCF dummy variable is positive and significant, indicating that the market responds favorably to the announcement of IJVs by these firms. Finally, as expected, the low Tobin’s q groups variables have the smallest magnitude and neither comes close to being statistically significant. These results are broadly consistent with those reported in Doukas (1995) and Lang et al. (1991).
5. Conclusion The announcement effects of US firms’ IJVs are examined to ascertain whether IJVs elicit a response similar to that of other important firm announcements. It is hypothesized that differential wealth effects for individual firms would be driven by Tobin’s q and the level of potential agency costs between management and shareholders arising from free cash flow. The primary objective was to explain differences in previously reported IJV announcementday abnormal returns reported in the literature. The findings suggest that, on average, shareholders experience small but significantly positive returns on the joint venture announcement date. This result is consistent with the positive reaction reported in other IJV studies (e.g., Chen et al., 1991; Crutchley et al., 1991; Lummer & McConnell, 1990). As hypothesized, the most positive stock price reaction occurs when firms with high Tobin’s q and LFCFs announce IJVs. Conversely, there was insignificant market reaction to joint venture announcements of low q firms with HFCF. These results are consistent with the findings in Doukas (1995) and Lang et al. (1991) for acquisitions. The conclusion is that mixed results reported in past IJV research may be due to sample biases arising from firm-specific characteristics. Also, Tobin’s q offers important insights that may help explain market reaction. The implication of this study is that Tobin’s q is an important factor in explaining market response, but free cash flow is not. While explanation of free cash flow’s insignificance is beyond the scope of this manuscript, one explanation is that advances in corporate governance have mitigated the imperfect contracting problem by increasing goal congruence between managers and shareholders. Another possibility is that other factors are also important and interact in such a way that free cash flow alone is insignificant. As in all studies, several limitations exist. Arguably, the most important weakness is the interpretation of Tobin’s q. One approach is to view Tobin’s q as a proxy for the quality of management, but that interpretation is imprecise (see Lang et al., 1989 for a thorough review of this issue). However, Tobin’s q has been used in many previous studies and has
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been shown to exhibit significant explanatory power in predicting market response to other announcements. This study’s contribution to the literature is that sample characteristics may well explain extant mixed results of IJV announcement effects on stock returns. However, it fell short of the goal of explaining negative announcement period returns in Chung et al. (1993) and Lee and Wyatt (1990). Therefore, more work remains to be done. Several areas remain interesting avenues for further investigation. One possibility is that the differential reaction may be due to whether the partner is a public or government-owned firm. Theoretically, it is difficult to ascertain the type of impact, but there are obvious advantages and potential disadvantages in partnering with a government firm. Another possibility is to consider the industry informationprocessing load since Madhavan and Prescott (1995) suggest that it is important in determining market reaction. Third, further work could consider the degree of foreign partner managerial involvement, track records of partners, and local partner managerial responsibility since it is found to be important in other studies (e.g., Inkpen & Beamish, 1997). Fourth, the amount of experience with wholly owned international subsidiaries, cultural distance between the countries involved in the IJV, and domestic joint venture experience may be important since these factors are theoretically important to IJV stability and longevity (e.g., Barkema, Shenkar, Vermeulen, & Bell, 1997). Finally, the relationship between the firms before the joint venture may be important since joint ventures are more likely to dissolve when the partners are competitors or when their product markets overlap (e.g., Park & Ungson, 1997). Thus, those factors may offer some additional explanation of the market response to IJV announcements. Acknowledgments We wish to thank participants at the 1998 annual meetings of the Southwestern Finance Association, Eastern Finance Association, European Financial Management Association, and the faculty at the University of Oklahoma for comments on an earlier version of this manuscript. We also thank the editor (Manuchehr Shahrokhi) and an anonymous referee for beneficial suggestions that strengthened the manuscript.
References Barkema, H. G., Shenkar, O., Vermeulen, F., & Bell, J. H. J. (1997). Working abroad, working with others: how firms learn to operate international joint ventures. Academy of Management Journal, 40, 426 – 442. Brown, S. J., & Warner, J. B. (1985). Using daily stock returns: the case of event studies. Journal of Financial Economics, 14, 3 – 31. Chen, H., Hu, M. Y., & Shieh, J. C. P. (1991, Winter). The wealth effect of international joint ventures: the case of US involvement in China. Financial Management, 20, 31 – 41. Chung, I. Y., Koford, K. J., & Lee, I. (1993). Stock market views of corporate multinationalism: some evidence from announcements of international joint ventures. Quarterly Review of Economics and Finance, 33, 275 – 293. Chung, K. H., & Pruitt, S. W. (1994, Autumn). A simple approximation of Tobin’s q. Financial Management, 23, 70 – 74.
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Crutchley, C. E., Guo, E., & Hansen, R. S. (1991, Winter). Stockholder benefits from Japanese – US joint ventures. Financial Management, 20, 22 – 30. Doukas, J. (1995). Overinvestment, Tobin’s q and gains from foreign acquisitions. Journal of Banking and Finance, 19, 1285 – 1303. Finnerty, J. E., Owers, J. E., & Rogers, R. C. (1986). The valuation impact of joint ventures. Management International Review, 26, 14 – 25. Geringer, J. M., & Hebe`rt, L. (1989). Measuring performance of international joint ventures. Journal of International Business Studies, 22, 249 – 264. Inkpen, A. C., & Beamish, P. W. (1997). Knowledge, bargaining power, and the instability of international joint ventures. Academy of Management Review, 22, 177 – 202. Jensen, M. C. (1986). Agency costs of free cash flow, corporate finance, and takeovers. American Economics Review Proceedings, 76, 323 – 329. Jensen, M. C. (1988, Winter). Takeovers: their causes and consequences. Journal of Economic Perspectives, 2, 21 – 48. Jensen, M. C., & Meckling, W. H. (1976). Theory of the firm: managerial behavior, agency costs and ownership structure. Journal of Economics, 3, 305 – 360. Lang, L. H. P., Stultz, R. M., & Walkling, R. A. (1989). Tobin’s q and the gains from successful tender offers. Journal of Financial Economics, 24, 137 – 154. Lang, L. H. P., Stultz, R. M., & Walkling, R. A. (1991). A test of the free cash flow hypothesis: the case of bidder returns. Journal of Financial Economics, 29, 315 – 335. Lee, I., & Wyatt, S. B. (1990, November). The effect of international joint ventures on shareholders wealth. Financial Review, 25, 641 – 649. Lummer, S. L., & McConnell, J. J. (1990). Stock valuation effects of international joint ventures. Pacific-Basin Capital Markets Research, 531 – 546. Madhavan, R., & Prescott, J. E. (1995). Market value impact of joint ventures: the effect of industry informationprocessing load. Academy of Management Journal, 38, 900 – 915. Madhok, A. (1995). Revisiting multinational firms’ tolerance for joint ventures: a trust based approach. Journal of International Business Studies, 26, 117 – 137. McConnell, J., & Muscarella, C. J. (1985). Corporate expenditure decisions and the market value of the firm. Journal of Financial Economics, 14, 399 – 422. McConnell, J. J., & Nantell, T. J. (1985, June). Corporate combinations and common stock returns: the case of joint ventures. Journal of Finance, 40, 519 – 536. Park, S. H., & Ungson, G. R. (1997). The effect of national culture, organizational complementarity, and economic motivation on joint venture dissolution. Academy of Management Journal, 40, 279 – 307. Serapio, M. G. Jr., & Cascio, W. F. (1996). End-games in international alliances. Academy of Management Executive, 10, 62 – 73.
Tobin’s q, agency conflicts, and differential wealth effects of international joint ventures Jae Hoon Mina, Larry J. Pratherb,* a
Department of Finance and Insurance, Seowon University, 231 Mochung-dong, Hungdok-ku, Chungju, Chungbuk 361-762, South Korea b Department of Economics, Finance, and Urban Studies, East Tennessee State University, Box 70686, Johnson City, TN 37614, USA Received 13 November 1998; received in revised form 19 March 1999; accepted 19 February 2001
Abstract This article examines announcement effects of 240 international joint ventures (IJVs) undertaken by US firms to ascertain their impact on shareholders’ wealth. The objective is to ascertain whether the mixed results of announcement effects reported in the literature can be explained. Theory suggests that IJVs would result in differential stock price reactions due to firm-specific characteristics. Therefore, it is hypothesized that IJVs would elicit a positive stock price reaction, on average. Also, it is hypothesized that this reaction should be greater for high Tobin’s q firms and for low free cash flow firms. Empirical analysis reveals that firm-specific characteristics do influence announcement effects and suggests that these factors may explain the mixed announcement effects documented in the literature. D 2001 Elsevier Science Inc. All rights reserved. Keywords: International joint ventures; Tobin’s q; Free cash flow
1. Introduction International alliances have grown at a torrid pace in recent years and these alliances are becoming more important strategically (e.g., Geringer & Hebe`rt, 1989; Serapio & Cascio,
* Corresponding author. Tel.: +1-423-439-5668. E-mail addresses: [email protected] (J.H. Min), [email protected] (L.J. Prather). 1044-0283/01/$ – see front matter D 2001 Elsevier Science Inc. All rights reserved. PII: S 1 0 4 4 - 0 2 8 3 ( 0 1 ) 0 0 0 3 2 - 1
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1996). Therefore, it is important to ascertain whether international joint ventures (IJVs) are in the best interest of the firm’s shareholders. However, extant literature on the wealth effects of IJVs is sparse and the results are mixed (e.g., Chen, Hu, & Shieh, 1991; Chung, Koford, & Lee, 1993; Crutchley, Guo, & Hansen, 1991; Finnerty, Owers, & Rogers, 1986; Lee & Wyatt, 1990; Lummer & McConnell, 1990). Therefore, it is important to investigate, and attempt to explain, the previous results. One explanation for differential findings in IJV studies is that the Tobin’s q differs among the previous samples. Tobin’s q is frequently regarded as the growth opportunities of the firm under current management. Previous studies find differential announcement effects for well-managed (high q) and poorly managed (low q) bidders in tender offers (e.g., Lang, Stultz, & Walkling, 1989, 1991). This evidence is plausible since it is reasonable to believe that, on average, good managers make better decisions than poor managers. Therefore, differential stock price reaction to announcements should exist between well-managed and poorly managed firms. However, Tobin’s q is not strictly confined to be a measure of management quality. Tobin’s q can also be a proxy for growth opportunities. However, since Tobin’s q is important in determining the reaction to announcements of acquisitions, it may also be a determinant of the reaction to IJV announcements. Another factor worthy of consideration is that differences may exist in the free cash flow of sample firms. Several influential studies raise the potential for agency problems between managers and shareholders due to free cash flow and insist that managers might pursue personal goals rather than maximizing shareholders’ wealth (e.g., Jensen, 1986, 1988; Jensen & Meckling, 1976). The authors of previous IJV studies believe that the negative reaction they find may be related to free cash flow, but neither provides an empirical examination (e.g., Chung et al., 1993; Lee & Wyatt, 1990). Studies of foreign acquisitions (e.g., Doukas, 1995) also report a negative relation between free cash flow and announcement-day bidder returns, supporting the free cash flow/overinvestment hypothesis in Jensen and Meckling (1976). Since theory suggests that free cash flow may be an important determinant in the acceptance of a project, and empirical evidence on acquisitions supports this theory, it is appropriate to determine whether this effect can help explain the differential announcement effects for IJVs reported in the literature. The goal of this study is to attempt to explain the differential announcement effects reported in other IJV studies. It is hypothesized that these differential responses can be explained by firm-specific characteristics related to sample composition. Therefore, previous work is extended to examine the effect of Tobin’s q and free cash flow on the announcement effect of IJVs. This study contributes to the literature by showing that Tobin’s q has an important impact on the announcement effect of IJVs. Further, an interesting relationship between Tobin’s q and free cash flow on the announcement effect is documented. Section 2 reviews relevant literature and develops the hypotheses and Section 3 presents details on the data and methodology employed. Empirical results and conclusions are presented in Sections 4 and 5, respectively.
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2. Background and hypotheses Finance theory posits that in fulfilling their responsibility to maximize shareholder wealth, managers should undertake only positive net present value (NPV) projects. Since the value of the firm is the sum of the NPVs of the projects it has undertaken, positive NPV projects increase the value of the firm. Thus, announcements of these projects should elicit a positive stock price reaction. Therefore, under the assumption that managers attempt to maximize shareholders’ wealth, the first hypothesis is: Hypothesis 1: The announcement of an IJV should elicit a positive stock price reaction for the US announcing firm. However, extant evidence on wealth effects of IJVs is mixed. One study examines international and domestic JVs to determine their wealth effects (e.g., Finnerty, Owers, & Rogers, 1986). This study finds an insignificant market reaction and the authors conclude that, on average, these are zero NPV projects since they do not affect shareholders’ wealth. Other studies report more troubling results, negative announcement effects (Chung et al., 1993; Lee & Wyatt, 1990). This is clearly inconsistent with expected results given the managerial charge to increase shareholders’ wealth (or firm value). However, studies of China–US IJVs (e.g., Chen et al., 1991) and Japanese–US JVs (e.g., Crutchley et al., 1991) report positive announcement effects for the US firm. These results are consistent with the findings for increases in capital expenditures (e.g., McConnell & Muscarella, 1985) and for domestic joint ventures (McConnell & Nantell, 1985). This is also consistent with managers fulfilling their fiduciary responsibility by undertaking positive NPV projects. 2.1. Tobin’s q and agency problems One explanation for the mixed empirical results is that some firms have better growth opportunities under current management than others. Several merger and acquisition studies use Tobin’s q as a proxy for managerial performance (e.g., Lang et al., 1989, 1991). These studies find that the gains from tender offers are maximized when high q (well-managed) bidders are combined with low q (poorly managed) targets. Similarly, studies that examine international acquisitions of US firms find that managerial performance, as represented by Tobin’s q, determines investors’ perceptions about the investment decision (e.g., Doukas, 1995). However, an alternate explanation for Tobin’s q is related to the growth opportunities in the industry. Since the quality of management may result in differential wealth effects for well-managed and poorly managed firms, it is important to test whether management quality is an important determinant of market reaction. While management quality cannot be precisely determined, one commonly used proxy is Tobin’s q. Tobin’s q is a measure of the book-to-market value of the firm. Under the value additivity principal, the market value of the firm is the NPV of all current projects under current management plus the NPV of all expected growth opportunities. If management only accepts positive NPV projects, the market value of the firm will increase by the sum of the realized NPVs. This indicates that value has been created by
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management through the judicious selection of projects. Thus, positive NPV projects will increase the value of the firm and Tobin’s q. That is because positive NPV projects will cause the market value of the firm to exceed the book value of the firm so q will be greater than one. If management is not value-maximizing, the negative NPV projects that it accepts would cause the value of the firm, and Tobin’s q, to decrease. Therefore, the second hypothesis is: Hypothesis 2: The market response to IJV announcements will be directly related to Tobin’s q. While any expansion should only be undertaken if it adds value to the firm, studies suggest that agency problems between managers and shareholders may cause managers to pursue personal goals rather than maximizing shareholders’ wealth (e.g., Jensen, 1986, 1988; Jensen & Meckling, 1976). Specifically, those studies suggest a potential overinvestment problem in firms with excessive cash flow. This can arise if the expansion is an attempt to add prestige to the manager. Therefore, managers in such firms may expand their firm size beyond the optimal level through investing in value-decreasing projects. One argument is that incumbent managers may be tempted to increase their firm size and waste excess cash on negative NPV projects because their compensation depends upon the size of the assets under their discretion (e.g., Jensen, 1986). Therefore, the free cash flow variable acts as a proxy for agency costs since it may measure a firm’s vulnerability to wasting shareholders’ wealth. The free cash flow/overinvestment theory suggests that differential announcement effects should result for firms with high free cash flow (HFCF) and low free cash flow (LFCF). Managers of firms with HFCF may overinvest since they have excess cash at their disposal. Managers of LFCF firms, on the other hand, are disciplined by the market since they must finance their investments externally. These funds would be unavailable, or prohibitively expensive, if the market did not believe that the project was worthwhile. Two studies offer the free cash flow hypothesis as one possible explanation for the negative announcement-day returns to IJVs but do not empirically test this explanation (e.g., Chung et al., 1993; Lee & Wyatt, 1990). The free cash flow problem is potentially more severe in IJV expansions since eventual failure of IJVs may be more easily attributed to factors beyond the initiating managers’ control. Two examples of these factors are victimization and management conflicts (e.g., Chung et al., 1993). Victimization arises from one partner taking advantage of the alliance to the other’s detriment. This violates the trust necessary for sustained cooperation (Madhok, 1995). These types of conflicts potentially mitigate being disciplined for undertaking a venture that turns out poorly. Therefore, the third hypothesis is: Hypothesis 3: Market response to IJV announcements will be inversely related to the amount of free cash flow. It is reasonable that the effect of free cash flow is related to Tobin’s q if Tobin’s q is a valid proxy for management quality. This arises because well-managed firms might not exhibit the same reaction to excess cash as poorly managed firms. If management is value-maximizing, it
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may resist squandering cash through overinvesting. Therefore, well-managed (high Tobin’s q) firms may not require the discipline of the market to prevent overinvestment. Alternatively, poor management may be more prone to overinvesting. This provides the impetus to control for the interaction of Tobin’s q and cash flow. Formally, the fourth hypothesis is: Hypothesis 4: Shareholders of high Tobin’s q firms with LFCF benefit most from IJV announcements, and shareholders of low Tobin’s q firms with HFCF benefit least.
3. Data and methodology The sample consists of 240 IJVs undertaken from 1988 through 1992. The Wall Street Journal Index is used to identify the IJVannouncement and the announcement date. The sample covers only completed IJVs by firms listed on the NYSE or AMEX whose stock market data are available in CRSP and Standard & Poors COMPUSTAT tapes. IJVs in the banking industry (two-digit SIC codes 60–67) are excluded from the sample, as are announcements for firms if other firm-specific events (e.g., capital expenditures, or earnings, or dividend announcements) occur during the announcement period (10 days before or after the joint venture announcement). More than half of the sample (56%) is in the chemical, equipment, or electronics industry. By company, the most active firms in the sample are AT&T and GM (11 cases each), GE (10 cases), and finally Coca-Cola and Alcoa (6 cases each). Further details concerning the composition of the data set, such as the breakdown by SIC code, geographic area, year, degree of host country development, and type of ownership, are presented in Table 1. To test the hypotheses, the full sample is stratified in several ways. First, the Tobin’s q ratio is used as a proxy for growth opportunities under current management and the market’s evaluation of the firm. The method reported in Chung and Pruitt (1994) is used to calculate Tobin’s q and classify a firm as high q if the Tobin’s q ratio is greater than unity. Otherwise, it is classified as low q. The median q of the sample is 0.85. Second, free cash flow is used as a proxy for agency costs. The cash flow measure is the ratio of the firm’s operating income before depreciation minus interest, taxes, and dividends on common and preferred stocks to the firm’s total book asset value. This is similar to the approach in Lang et al. (1991). Assignment of observations to the HFCF group is made if the cash flow ratio of the firm is greater than the median cash flow ratio of the entire sample. Otherwise, the observation is classified as LFCF. Among the 240 IJVs, 73 are classified as well-managed firms and 167 as poorly managed firms. One hundred eighteen firms are classified as HFCF and 122 as LFCF. To measure the announcement effects of IJVs on the returns to the US firm’s shareholders, the event-study methodology in Brown and Warner (1985) is employed. The abnormal return is computed as Eq. (1): ARit ¼ Rit ðai þ bi Rmt Þ
ð1Þ
where Rit is the realized return on stock i on day t, Rmt is the CRSP equally weighted market return on day t, and ai and bi are the market model parameter estimates for stock i during the
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Table 1 Joint venture sample characteristics Two-digit SIC
Industry
10 13
Mining Oil and gas
15 – 16
Construction
20 21 26 27 28 29 30 32 33 34 35 36 37 38 40 45 48 49 51 53 57 58
Number of sample
Year
Number of sample
Geographic area
Number of sample
3 6
1988 1989
28 30
66 30
4
1990
56
Food and beverage Cigarettes Paper
15 1 4
1991 1992
49 77
Printing and publishing Chemicals Petroleum refining Rubber and plastics Glass Iron and steel Metal fabrication Machinery Electronics Transportation equipment Measurement instrument Railroads Air transport Communications Services Wholesale Merchandise stores Electronic stores Eating places Total
1
Japan Former Sovieta Eastern Europeb China Germany South Americac France
32 17 3 1 16 9 16 28 42
16 11 11 11 8
South Korea UK Italy India Mexico Turkey Others
7 6 6 6 5 3 54
Total
240
9 3 1 17 4 1 2 2 3 240
Total
240
Degree of development in host countriesd
Number of sample
Type of ownership of foreign partners
Number of sample
Industrialized Developing Total
126 114 240
Private Government Total
161 79 240
a b c d
Includes Russia, Ukraine, Belarus, Kazakhstan, and Uzbekistan. Includes Hungary, Czechoslovakia, Poland, and Romania. Includes Argentina, Brazil, Chile, Colombia, and Venezuela. Classified by IMF.
control period (event day 150 through 11). The coefficients estimated are used to compute the abnormal daily returns for the announcement period (event days 10 to + 10)
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where event day + t( t) represents the tth trading day after (before) the announcement date (t = 0). ARit is the abnormal return on stock i on day t, and is measured as the difference between the observed daily return and the expected daily return (as measured by the OLS market model). The average abnormal return (AARt) across takeovers on day t is then measured by Eq. (2): N 1X AARt ¼ ARit N i¼1
ð2Þ
where N is the number of joint venture announcements. The cumulative abnormal return (CAR) between event days T1 and T2 is calculated as Eq. (3): CART 1;T2 ¼
T2 X
AARt
ð3Þ
T1
where T1 is the beginning day of the interval in the event period and T2 is the ending day of the interval in the event period. The estimated values of AARs and CARs are tested for a statistically significant difference from zero using the standardized t test in Brown and Warner (1985). Additionally, the nonparametric binomial sign test is used to test whether the number positive event day returns are greater than expected. Finally, cross-sectional regression analysis is used to more closely examine the effects of factors that are theoretically important. Both announcement-day AARs and 2-day CARs are the dependent variables. The two explanatory variables used are Tobin’s q and the cash flow measure.
4. Empirical results Table 2 displays the average announcement effect for the full sample of 240 IJVs on common stock returns. The announcement-day AARs are a positive 0.397% and are significant at the .01 level. Further, 59% of the AARs are positive on the announcement day, which is statistically significant. AARs for the 5-day period before or after the announcement day are not statistically different from zero except for day t + 2, which is marginally significant (.10 level). Two-day CARs are a positive 0.380% on the announcement day. These results support the view that managers are acting in the best interest of shareholders and attempting to discover profitable opportunities. The results are consistent with the findings in Chen et al. (1991), Crutchley et al. (1991), and Lummer and McConnell (1990). However, the results are contrary to the finding of no significant reaction in Finnerty, Owers and Rogers (1986) and to the negative significant reaction reported in Chung et al. (1993) and Lee and Wyatt (1990). One explanation for differential announcement effects is that differences in sample composition exist in terms of Tobin’s q or agency problems.
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Table 2 Announcement effects for US firms Event day
AARs
t statistics ( P value)
CARs
Percent positivea
5 4 3 2 1 0 +1 +2 +3 +4 +5
0.0004488 0.0005491 0.0008562 0.0004815 0.0001716 0.0039719 0.0012974 0.0017593 0.0008220 0.0006880 0.0009967
0.549 0.016 0.446 1.068 0.516 2.692 1.058 1.329 0.562 0.301 0.356
0.0004488 0.0009979 0.0003071 0.0003747 0.0003099 0.0038003 0.0026745 0.0004619 0.0025813 0.0015100 0.0003087
52 52 48 53 50 59 44 51 48 51 48
(.291) (.493) (.328) (.143) (.303) (.004)*** (.145) (.093)* (.287) (.381) (.361)
The sample consists of 240 IJV announcements. a The percentage of joint ventures with positive abnormal returns. * Denotes statistical significance at 10% level. *** Denotes statistical significance at 1% level.
Therefore, it is important to test the other hypotheses to discover the influence of other theoretically important factors. Table 3 presents the announcement effects of IJVs on stock returns after dividing the sample into high and low Tobin’s q firms (panels A and B, respectively). As hypothesized, a differential market response between the groups is observed. Panel A shows that the 73 IJVs of firms in the high Tobin’s q group display a positive announcement-day AAR of 0.697% that is significant at the .01 level. Further, 65% of those AARs is positive. However, AARs on day + 1 are negative and significant at the .05 level and the AARs on day + 2 are positive and significant at the .10 level. Other event days exhibit insignificant reaction. This inconsistent reaction is puzzling, but is consistent with a situation where the market first reacts positively to good news, then questions whether the news was as good as originally anticipated. It appears that it takes several days for the market to arrive at a consensus and provides further impetus to conduct further testing since it suggests that some other factor besides Tobin’s q may be important to market participants. Two-day CARs for the high q group are 0.845% on the announcement day. Combined, these findings are consistent with the premise that high q firms elicit positive market reaction to the announcement of IJVs. One interpretation of this result is that managers of high q firms are acting in the best interest of shareholders and engaging only in projects that increase the value of the firm and thus shareholders’ wealth. Panel B shows that the 167 IJVs of firms in the low Tobin’s q group display a positive but insignificant announcement-day AAR of 0.266% despite 56% of the AARs being positive. AARs for the 5 days on either side of the announcement day are also insignificant with the exception of days 2 and + 3. Both are significant at the .10 level, but it is impossible to ascertain the reason for the marginal significance. Additionally, the 2-day CARs for the low q group are 0.177% on the announcement day. This combined evidence suggests that the market is indifferent to the announcement of IJVs by low q firms.
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Table 3 The influence of Tobin’s q on announcement returns CARs
Percent positivea
Panel A: AARs and CARs to US firms with high Tobin’s q ratio (q > 1) 5 0.0016672 0.978 (.165) 4 0.0025762 0.713 (.239) 3 0.0013539 0.632 (.264) 2 0.0030068 0.333 (.370) 1 0.0014723 0.467 (.321) 0 0.0069730 3.111 (.001)*** +1 0.0051271 2.352 (.011)** +2 0.0031123 1.572 (.060)* +3 0.0017913 1.045 (.149) +4 0.0004327 0.306 (.380) +5 0.0003090 0.267 (.395)
(n = 73) 0.0016672 0.0042434 0.0012223 0.0043607 0.0015345 0.0084453 0.0018459 0.0020148 0.0013210 0.0013586 0.0007417
53 55 48 42 53 65 34 58 47 57 44
Panel B: AARs and CARs to US firms with low Tobin’s q ratio (q < 1) 5 0.0000839 0.011 (.495) 4 0.0003370 0.451 (.326) 3 0.0006365 0.116 (.453) 2 0.0020064 1.500 (.067)* 1 0.0008901 0.928 (.177) 0 0.0026600 1.169 (.121) +1 0.0003766 0.286 (.387) +2 0.0011678 0.554 (.290) +3 0.0019643 1.365 (.086)* +4 0.0007996 0.158 (.437) +5 0.0015675 0.604 (.273)
(n = 167) 0.0000839 0.0004209 0.0009735 0.0013699 0.0011163 0.0017699 0.0030366 0.0015444 0.0031321 0.0027639 0.0007679
51 51 48 56 49 56 49 49 49 49 49
Event day
AARs
t statistics ( P value)
The high q sample consists of 73 IJV announcements with Tobin’s q ratios exceeding unity, whereas the low q sample consists of 167 IJV announcements with Tobin’s q ratios less than unity. a The percentage of joint ventures with positive abnormal returns. * Denotes statistical significance at 10% level. ** Denotes statistical significance at 5% level. *** Denotes statistical significance at 1% level.
Although both groups show positive market reaction, only high q firms exhibit statistically significant reaction. These results are broadly consistent with the results reported in Doukas (1995) and Lang et al. (1991) for acquisitions and suggest that high q firms receive more favorable response when they announce new investment decisions. This lends support to Hypothesis 2. As previously discussed, another potential explanation for the negative market reaction reported in Chung et al. (1993) and Lee and Wyatt (1990) is the agency problem created by free cash flow. Table 4 presents the results of the announcement effects of IJVs for HFCF and LFCF firms. Panel B shows that the 122 IJVs by LFCF firms exhibit a positive announcement-day AAR of 0.460% that is statistically significant at the .05 level. Further, 62% of the announcement-day AARs are positive, which is also significant. Additionally, the 3-day period on either side of the announcement day exhibits insignificant reaction. This would
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Table 4 Effects of free cash flow on announcement returns CARs
Percent positivea
Panel A: AARs and CARs to US firms with HFCF ratios (n = 118) 5 0.0018515 0.587 (.279) 4 0.0042364 2.268 (.012)** 3 0.0018035 0.981 (.164) 2 0.0014761 1.171 (.122) 1 0.0013508 0.897 (.185) 0 0.0033203 1.477 (.071)* +1 0.0029177 1.691 (.046)** +2 0.0027885 1.559 (.061)* +3 0.0000878 0.171 (.432) +4 0.0021734 1.478 (.071)* +5 0.0003739 0.378 (.353)
0.0018515 0.0023849 0.0024329 0.0003274 0.0001253 0.0019695 0.0004026 0.0001292 0.0028763 0.0020856 0.0059124
50 56 49 53 45 56 39 56 48 43 51
Panel B: AARs and CARs To US firms with LFCF ratios (n = 122) 5 0.0026736 1.347 (.090)* 4 0.0030173 2.207 (.014)** 3 0.0000601 0.339 (.367) 2 0.0004804 0.346 (.364) 1 0.0009255 0.157 (.437) 0 0.0046021 2.323 (.011)** +1 0.0002697 0.178 (.429) +2 0.0007638 0.330 (.371) +3 0.0015322 0.620 (.268) +4 0.0034555 1.876 (.031)** +5 0.0015991 0.872 (.192)
0.0026736 0.0003437 0.0029572 0.0004203 0.0004451 0.0055276 0.0048718 0.0010335 0.0022960 0.0049877 0.0018564
53 48 47 52 55 62 49 47 48 59 44
Event day
AARs
t statistics ( P value)
a
The percentage of joint ventures with positive abnormal returns. * Denotes statistical significance at 10% level. ** Denotes statistical significance at 5% level.
support the view that the market has little reservation about the positive news conveyed by these announcements. Two-day CARs are also positive (0.553%). The 118 IJVs by HFCF firms, in panel A, appear to be more difficult for the market to interpret since significant reactions occur over 3 days and the reaction oscillates between positive and negative. The announcement-day AARs are 0.332% and marginally significant (.10 level). Additionally, 56% of the announcement-day AARs are positive. However, day t + 1 AARs are 0.291% and significant at the .05 level, with only 39% being positive (61% negative). Day t + 2 AARs turn positive (0.278%) and are marginally significant (.10 level). Also, 56% of the day t + 2 AARs are positive. It is not possible to explain this oscillation; however, this behavior is consistent with a situation where a high level of market uncertainty exists and market participants take several days to come to a consensus about the true value of the undertaking. Two-day CARs are 0.197% on the announcement day. Combined, these results lend support to the hypothesis that free cash flow is an important factor to the market.
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Since it is hypothesized that the effect of free cash flow may be related to the Tobin’s q (if q is a valid proxy for the quality of management), it is important to control for the interaction of Tobin’s q and cash flow. Table 5 reports the announcement effect results after controlling for both Tobin’s q and free cash flow. Four sample groups are examined to ascertain differential market response (high Tobin’s q firms with HFCF, high Tobin’s q firms with LFCF, low Tobin’s q firms with HFCF, and low Tobin’s q firms with LFCF).
Table 5 Announcement returns by Tobin’s q and free cash flow High q and high cash flow (n = 47) Event day AARs Panel 5 4 3 2 1 0 +1 +2 +3 +4 +5
t statistics
High q and low cash flow (n = 26) CARs
t statistics
CARs
Percent positivea
A: Comparisons of US firms’ AARs and CARs surrounding announcement dates of joint ventures 0.000030 0.112 0.000030 49 0.004736 1.488* 0.004736 62 0.002350 0.914 0.002320 55 0.002985 0.035 0.007721 54 0.004582 1.645* 0.002232 43 0.004467 1.152 0.007452 58 0.000048 0.181 0.004534 47 0.008528 0.802 0.004061 35 0.001738 0.675 0.001690 47 0.007275 1.690** 0.001253 65 0.006740 2.506*** 0.005002 66 0.007393 1.844** 0.014668 65 0.007309 2.907*** 0.000569 23 0.001183 0.031 0.006218 54 0.004459 1.803** 0.000285 60 0.000677 0.209 0.000506 54 0.001978 0.861 0.000481 40 0.001455 0.594 0.000778 58 0.001347 0.588 0.003325 49 0.003649 1.304* 0.002194 73 0.000823 0.645 0.000524 51 0.000621 0.419 0.003028 31
Low q and high cash flow (n = 71) Event day AARs Panel 5 4 3 2 1 0 +1 +2 +3 +4 +5
Percent positivea AARs
t statistics
Low q and low cash flow (n = 96) CARs
Percent positivea AARs
t statistics
CARs
Percent positivea
B: Comparisons of US firms’ AARs and CARs surrounding announcement dates of joint ventures 0.003057 0.849 0.003057 51 0.002115 0.745 0.002115 51 0.005485 2.180** 0.002428 57 0.004643 2.470*** 0.002528 46 0.000036 0.073 0.005521 54 0.001133 0.217 0.005776 44 0.002422 1.362* 0.002458 58 0.001699 0.808 0.000566 56 0.001020 0.608 0.001402 44 0.000794 0.701 0.000905 52 0.001056 0.134 0.000036 50 0.003846 1.658** 0.003052 61 0.000011 0.185 0.001045 49 0.000663 0.217 0.004509 48 0.001682 0.543 0.001671 54 0.000787 0.263 0.001450 45 0.001455 0.922 0.003137 54 0.002341 1.008 0.003128 45 0.002721 1.427* 0.001266 39 0.003403 1.437* 0.005744 55 0.001167 0.036 0.003888 51 0.001864 0.764 0.001539 48
The sample consists of 240 IJV announcements. a The percentage of joint ventures with positive abnormal returns. * Denotes statistical significance at 10% level. ** Denotes statistical significance at 5% level. *** Denotes statistical significance at 1% level.
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The top-right quadrant presents the results for the 26 IJVs of high Tobin’s q firms with LFCF. The announcement-day AARs are 0.739% and statistically significant at the .01 level. Day t 1 also exhibits positive and significant AARs, which could be attributed to leakage of information. On both days, 65% of the AARs are positive. Further, no significant reaction is observed on other event days surrounding the announcement, but some noise in the data is present on event days t 5 and t + 4. The 2-day CARs are 1.467%. As hypothesized, the high q firms with LFCF elicit the most positive reaction of the four groups, and the reaction is confined to days t 1 and t = 0. This is consistent with the market being confident that these firms are making wise decisions about undertaking the IJV. The top-left quadrant presents the results for the 47 IJVs of high Tobin’s q firms with HFCF. Sixty-six percent of the AARs on t = 0 are positive and the average AAR is 0.674% and statistically significant. Curiously, the day t + 1 AAR is 0.730%, day t + 2 is 0.445%, and both are statistically significant. Only 23% of the AARs is positive (67% negative) on Day t + 1, whereas 60% of the AARs are positive on day t + 2. The market reaction is not confined to a single day and some ambiguity appears to exist concerning the benefit of the IJV. While this result cannot be explained with certainty, it is interesting that the reaction becomes more ambiguous with higher free cash flow. This supports the contention that free cash flow has some impact on the formation of expectations by market participants. The 2-day CARs are 0.500%. The bottom-right quadrant presents the results of 96 IJVs of the low Tobin’s q and LFCF sample. Announcement-day AARs are a positive 0.384% and statistically significant. Further, 61% of the AARs are positive. However, the magnitude and percentage of the AARs that are positive are much smaller than for either of the high Tobin’s q samples. Additionally, this sample suggests that the market response is unambiguous since the AARs for other event days are insignificant except for noise at days t 4 and t + 4. The 2-day CARs are 0.305% on the announcement day. This can be interpreted as the LFCF acting to bond management so that only good projects are undertaken. Noticeably, only the 71 IJVs of the low Tobin’s q HFCF sample in the bottom-left quadrant show insignificant market reaction at announcement date. It appears that the market is unimpressed by IJVs of low q HFCF firms. These results are generally consistent with Jensen’s free cash flow/overinvestment hypothesis and the acquisition studies in Doukas (1995) and Lang et al. (1991). The above results lend support to the contention that high Tobin’s q firms and firms with LFCF elicit a stronger reaction than their counterparts (ceteris paribus). However, they fail to test directly whether differences between the groups are statistically significant. Previous discussions of the event study results concentrate on the market reaction for a given group such as HFCF. While helpful in determining whether these factors may explain conflicting previous results, it falls short of testing whether significant differences exist between the sample pairs. Table 6 provides this information by summarizing the results of univariate t test statistics on the mean differences in the announcement-day AARs and 2-day CARs between various sample pairs. Sample pair (1) indicates that Tobin’s q is an important factor. The mean difference in announcement effect between the high q and low q groups is significant at the 6% level for
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Table 6 Univariate test of mean difference in AARs and 2-day CARs Sample pairs
Mean (AARs)
Standard deviation
t value on difference
(1) High q group Low q group (2) High cash group Low cash group (3) High q/high cash High q/low cash (4) High q/high cash Low q/high cash (5) High q/high cash Low q/low cash (6) High q/low cash Low q/high cash (7) High q/low cash Low q/low cash (8) Low q/high cash Low q/low cash
0.006973 0.002660 0.003320 0.004602 0.006740 0.007393 0.006740 0.001056 0.006740 0.003846 0.007393 0.001056 0.007393 0.003846 0.001056 0.003846
0.016540 0.016493 0.015904 0.017293 0.015199 0.019040 0.015199 0.016134 0.015199 0.016796 0.019040 0.016134 0.019040 0.016796 0.016134 0.016796
1.86* 0.29 0.16 1.92* 1.12 1.64* 1.08 0.71
Mean (CARs)
Standard deviation
t value on difference
0.008445 0.001770 0.001970 0.005528 0.005002 0.014668 0.005002 0.000036 0.005002 0.003052 0.014668 0.000036 0.014668 0.003052 0.000036 0.003052
0.025760 0.024912 0.026148 0.024407 0.027798 0.021644 0.027798 0.024799 0.027798 0.025061 0.021644 0.024799 0.021644 0.025061 0.024799 0.025061
1.89* 1.08 1.53 1.01 0.42 2.66*** 2.15** 0.77
* Denotes statistical significance at 10% level. ** Denotes statistical significance at 5% level. *** Denotes statistical significance at 1% level.
both AARs on the announcement-date and 2-day CARs. Although both groups show a positive market reaction, the results suggest that high q firms receive a more favorable response from investors when they announce new investment decisions. Based on these results, the conclusion is that shareholders of high q firms benefit more from IJV announcements than shareholders of low q firms. This result is consistent with the acquisition results in Doukas (1995) and Lang et al. (1989, 1991). Sample pair (2) compares the sample mean differences in announcement-day AARs and 2-day CARs for HFCF and LFCF firms. The differences in AARs and CARs between the two groups are not statistically significant at conventional levels. This suggests that the sample split by the free cash flow measure alone does not explain differential market reactions to investment decisions. Sample pairs (3) through (8) examine various combinations of Tobin’s q and free cash flow to detect important differential market reaction. This allows closer examination of the effects of free cash flow after controlling for Tobin’s q. This is important in determining whether excess free cash flow creates more concern for low q firms than high q firms. This line of inquiry is important if Tobin’s q is viewed as a proxy for management quality. The only sample pairs that show significant differences are (4), (6), and (7). Comparing the mean difference in AARs at the announcement date for sample pairs (4) and (6) (the high Tobin’s q subgroups with the low Tobin’s q HFCF group) yields significance at the 10% level. As expected, both high Tobin’s q subgroups elicit more positive and statistically significant returns. This suggests that the quality of management is important but free cash flow alone
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may not be vitally important. Tobin’s q loses significance in sample pair (5) and the high q HFCF group fails to significantly outperform the low q LFCF group. This could indicate that free cash flow may have some influence, but the influence is too weak to provide us with conclusive results. Again, these results are broadly consistent with the results in Doukas (1995) and Lang et al. (1991). Similarly, the 2-day CARs for sample pair (7) are statistically significant. The high q LFCF group significantly outperforms the low q LFCF group at the 5% level. Again, these results are consistent with the results in Doukas (1995) and Lang et al. (1991). Another approach to examine the effect of joint venture characteristic variables on the announcement-day AARs or 2-day CARs is by regressing the abnormal returns on the characteristic variables. This allows determination of the average change in abnormal returns for changes in potentially important characteristic variables. Table 7 provides the results of cross-sectional regression analysis between joint venture characteristic variables and AARs on the announcement date. Regression (1) examines the impact of Tobin’s q and free cash flow. Since it is hypothesized that a higher Tobin’s q will result in higher abnormal returns and that HFCF will result in less positive returns, the coefficient for Tobin’s q is expected to be positive and significant and the coefficient for free cash flow is expected to be negative and significant. As expected, the coefficient for Tobin’s q is positive and statistically significant at the .01 level, further supporting the results in Doukas (1995) and Lang et al. (1991) and the results reported in Tables 3 and 6. The conclusion is that Tobin’s q is an important factor in determining the market’s reaction to IJV announcements. Since it is hypothesized that free cash flow is an important factor, its coefficient is expected to be negative and significant. While the coefficient is negative, it is not statistically significant at conventional levels. However, this result is consistent with the results in Table 6. Free cash Table 7 Announcement returns on joint venture characteristic variables Joint venture characteristic variables (t values in parenthesis) Regression
a
TQa
Cashb
(1)
0.001 (0.45) 0.002 (0.82)
0.003 (2.63)***
0.011 ( 0.52)
(6) a
HQ/HCc
HQ/LCd
LQ/LCe
N 240
0.005 (1.65)*
0.006 (1.52)
0.002 (0.71)
240
Tobin’s q (TQ) is calculated by dividing the total market value of the firm by its replacement value. The cash flow variable (Cash) is the ratio of a firm’s operating income before depreciation net of interest, taxes, and dividends to its total book asset value. c HQ/HC is a dummy variable that takes on a value of 1 if a firm has a high Tobin’s q and high cash flow; otherwise, it is 0. d LQ/HC is a dummy variable that takes on a value of 1 if a firm has a low Tobin’s q and high cash flow; otherwise, it is 0. e LQ/LC is a dummy variable that takes on a value of 1 if a firm has a low Tobin’s q and high cash flow; otherwise, it is 0. * Denotes statistical significance at 10%. *** Denotes statistical significance at 1%. b
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flow alone is not an important factor. In regression (2), the possible interaction between Tobin’s q and free cash flow is examined. The approach is to run a regression with three dummy variables representing the high q–high cash flow group (HQ/HC), high q–low cash flow group (HQ/LC), and the low q–low cash flow group (LQ/LC). The constant term represents the low q– high cash flow group. The results are generally consistent with expectations. The most positive reaction, as expected, is for firms with high Tobin’s q and LFCF. However, the reaction falls short of statistical significance at conventional levels (11%). Also, as expected, the high Tobin’s q HFCF dummy variable is positive and significant, indicating that the market responds favorably to the announcement of IJVs by these firms. Finally, as expected, the low Tobin’s q groups variables have the smallest magnitude and neither comes close to being statistically significant. These results are broadly consistent with those reported in Doukas (1995) and Lang et al. (1991).
5. Conclusion The announcement effects of US firms’ IJVs are examined to ascertain whether IJVs elicit a response similar to that of other important firm announcements. It is hypothesized that differential wealth effects for individual firms would be driven by Tobin’s q and the level of potential agency costs between management and shareholders arising from free cash flow. The primary objective was to explain differences in previously reported IJV announcementday abnormal returns reported in the literature. The findings suggest that, on average, shareholders experience small but significantly positive returns on the joint venture announcement date. This result is consistent with the positive reaction reported in other IJV studies (e.g., Chen et al., 1991; Crutchley et al., 1991; Lummer & McConnell, 1990). As hypothesized, the most positive stock price reaction occurs when firms with high Tobin’s q and LFCFs announce IJVs. Conversely, there was insignificant market reaction to joint venture announcements of low q firms with HFCF. These results are consistent with the findings in Doukas (1995) and Lang et al. (1991) for acquisitions. The conclusion is that mixed results reported in past IJV research may be due to sample biases arising from firm-specific characteristics. Also, Tobin’s q offers important insights that may help explain market reaction. The implication of this study is that Tobin’s q is an important factor in explaining market response, but free cash flow is not. While explanation of free cash flow’s insignificance is beyond the scope of this manuscript, one explanation is that advances in corporate governance have mitigated the imperfect contracting problem by increasing goal congruence between managers and shareholders. Another possibility is that other factors are also important and interact in such a way that free cash flow alone is insignificant. As in all studies, several limitations exist. Arguably, the most important weakness is the interpretation of Tobin’s q. One approach is to view Tobin’s q as a proxy for the quality of management, but that interpretation is imprecise (see Lang et al., 1989 for a thorough review of this issue). However, Tobin’s q has been used in many previous studies and has
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been shown to exhibit significant explanatory power in predicting market response to other announcements. This study’s contribution to the literature is that sample characteristics may well explain extant mixed results of IJV announcement effects on stock returns. However, it fell short of the goal of explaining negative announcement period returns in Chung et al. (1993) and Lee and Wyatt (1990). Therefore, more work remains to be done. Several areas remain interesting avenues for further investigation. One possibility is that the differential reaction may be due to whether the partner is a public or government-owned firm. Theoretically, it is difficult to ascertain the type of impact, but there are obvious advantages and potential disadvantages in partnering with a government firm. Another possibility is to consider the industry informationprocessing load since Madhavan and Prescott (1995) suggest that it is important in determining market reaction. Third, further work could consider the degree of foreign partner managerial involvement, track records of partners, and local partner managerial responsibility since it is found to be important in other studies (e.g., Inkpen & Beamish, 1997). Fourth, the amount of experience with wholly owned international subsidiaries, cultural distance between the countries involved in the IJV, and domestic joint venture experience may be important since these factors are theoretically important to IJV stability and longevity (e.g., Barkema, Shenkar, Vermeulen, & Bell, 1997). Finally, the relationship between the firms before the joint venture may be important since joint ventures are more likely to dissolve when the partners are competitors or when their product markets overlap (e.g., Park & Ungson, 1997). Thus, those factors may offer some additional explanation of the market response to IJV announcements. Acknowledgments We wish to thank participants at the 1998 annual meetings of the Southwestern Finance Association, Eastern Finance Association, European Financial Management Association, and the faculty at the University of Oklahoma for comments on an earlier version of this manuscript. We also thank the editor (Manuchehr Shahrokhi) and an anonymous referee for beneficial suggestions that strengthened the manuscript.
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