How does asymmetric information relate to investment efficiency? Evidence from analysts' earnings forecasts and daily stock trading

Abstract

Xie, L. (2013). How does asymmetric information relate to investment efficiency? Evidence from analysts' earnings forecasts and daily stock trading (Master's thesis, Lingnan University, Hong Kong). Retrieved from http://dx.doi.org/10.14793/fin_etd.6 Terms of UseThe copyright of this thesis is owned by its author. Any reproduction, adaptation, distribution or dissemination of this thesis without express authorization is strictly prohibited.All rights reserved. The adverse selection and agency cost theories suggest that the informational transparency of a firm can help to reduce over-or under-investment. This thesis examines how information asymmetry influences firm-level investment efficiency for companies listed in the U.S. market from 1993 to 2009. Information asymmetry is measured by the dispersion and error of the earnings forecasts made by financial analysts. I investigate how information asymmetry affects firms' proneness to overor under-invest and the firms' deviations from the investment levels predicted by investment opportunities. To be consistent with the prior literature, I also use the volatility of daily stock returns and yearly high-low price spreads derived from daily stock trading as alternative proxies of information asymmetry. The results show that lower information asymmetry is associated with more efficient investment. Specifically, a good information environment reduces capital investment for firms that are more prone to over-invest and increases capital investment for those that are more prone to under-invest. In addition, lower information asymmetry is also negatively associated with firm investment when the firm is over-investing and is positively associated with firm investment when the firm is under-investing The results are robust across different regression methodologies and to different estimates of the variables. My findings are consistent with the agency theories of adverse selection and principal-agent conflict. DECLARATIONI declare that this is an original work based primarily on my own research, and I warrant that all citations of previous research, published or unpublished, have been duly acknowledged.

Cost of Capital and Investment Efficiency: A Critical Review of Empirical Literature

“…It predicts an inverse relationship between COE and IE based on an argument that where a firm lacks financial slack (that is, sufficient internal fund, marketable securities or an ability to sell risk-free debt), it could rationally prefer to forego profitable investments rather than issuing shares at a price less than their actual market value in order to finance its proposed investments. This view has been supported by scholars such as Xie (2013) who confirmed that higher COE resulting from IA would result in either underinvestment or higher dependence on internally generated funds. Consistent with this proposition, Adelegan and Ariyo (2008), Rahman et al (2013) and Rymar (2016) also extensively explained that the exorbitant COE (i.e.…”

“…internal cash flow) or pass up profitable investment projects thereby underinvesting. Xie (2013) further explained that where the capital market is imperfect with high level of asymmetric information, both shareholders and debt holders react in the same way by rationally raising the respective finance costs. Thus, the only resort is the internal cash flow, and since internal and external finance cease to be a perfect substitute in the presence of IA, a firm might end up underinvesting even if it relies heavily on internally generated funds.…”

“…Issue-Invest-Decision Theory premised that increase in COC could force a corporate firm to underinvest (that is, forgo profitable investments). Consistent with this premise, Xie (2013), Rahman et al (2013) Firth et al (2016, and Rymar (2016) argued that higher cost of equity (COE) emanating from higher information asymmetry could give rise to underinvestment problem or higher reliance on internal fund that is not sufficient for corporate investment projects. Moreover, on COC and Overinvestment, researchers like Jingeng (2002) are of the view that overinvestment problem is the result of a decrease or fall in COC.…”