Capital Investment and Earnings: International Evidence

20 Pages Posted: 8 Oct 2009

See all articles by A. Can Inci

A. Can Inci

Bryant University

Bong‐Soo Lee

Florida State University

Jungwon Shu

University of Seoul

Abstract

We examine the nature of the dynamic linkage (causality) between earnings and capital investment using firm-level data from around the world to see whether the legal environment, including corporate governance and monitoring mechanisms, and financial development are important in the profitability of capital investment.

Using firms in 40 countries over the period 1988–2004, we find that the causality from earnings to capital investment is positive and strong in almost all countries, irrespective of the type of legal system and the degree of financial development. However, the causality from capital investment to earnings is generally negative for firms in civil law and financially undeveloped countries, while the causality is generally positive in common law and financially developed countries. Therefore, our international cross-country study enables us to find that the legal system and financial development are factors in the determination of the profitability of capital investment.

Our findings imply that internal financing is a significant constraint for capital investment, which provides support for the pecking order theory even for financially developed markets and for the free cash flow theory. Common law and financially developed countries tend to provide better shareholder protection with more efficient corporate governance and better investment decisions.

To encourage managers to make capital investments in value-increasing projects, it is important to further improve a legal environment that includes corporate governance, monitoring, and incentive mechanisms. Financial development that includes effective financial regulatory agencies should be sought.

Suggested Citation

Inci, Ahmet Can and Lee, Bong Soo and Shu, Jungwon, Capital Investment and Earnings: International Evidence. Corporate Governance: An International Review, Vol. 17, Issue 5, pp. 526-545, September 2009, Available at SSRN: https://ssrn.com/abstract=1484111 or http://dx.doi.org/10.1111/j.1467-8683.2009.00749.x

Ahmet Can Inci (Contact Author)

Bryant University ( email )

1150 Douglas Pike
Smithfield, RI 02917
United States

Bong Soo Lee

Florida State University ( email )

Tallahasse, FL 32306
United States

Jungwon Shu

University of Seoul

Seoul
Korea, Republic of (South Korea)

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