Investment–cash flow sensitivity and investor protection

Journal of Business, Finance and Accounting, forthcoming, doi

Research

Corporate Governance

Corporate Finance

We examine the role of country-level legal investor protection (i.e., shareholder and creditor protection) on firm investment–cash flow sensitivity

Published

August 16, 2022

Abstract:

We examine the role of country-level legal investor protection (i.e., shareholder and creditor protection) on firm investment–cash flow sensitivity. Using underexplored research data on investor protection across 21 countries and working with a conservative empirical design, we extend prior literature on the relation between investor protection and investment–cash flow sensitivity and provide new evidence on how these country-level attributes interact to explain a firm’s investment–cash flow sensitivity. We find that either the strong legal protection of minority shareholders or the strong legal protection of creditors reduces the sensitivity of investment to internal cash flow. However, in countries with strong levels of both minority shareholder and creditor protection, investment–cash flow sensitivity increases. Our results remain robust after controlling for several alternative explanations. The results support the argument that overregulation arises when policymakers increase investor protection at levels that lead firms to avoid external sources of finance, hampering firm investment. Our findings suggest that countries face a regulatory trade-off such that increasing investor protection (either shareholder or creditors protection) enhances financial markets efficiency, but excessive regulation can indeed lead to financial markets inefficiencies.

Co-authored with Luiz Ricardo Kabbach de Castro, Eduardo Schiehll and Paulo Terra.