Journal of Asia Business Studies

Impact of investment efficiency on cost of equity: evidence from China

Muhammad Ansar Majeed, Xianzhi Zhang, Muhammad Umar,
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JABS-09-2015-0163
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 Impact of investment efficiency on cost of
equity: evidence from China
Muhammad Ansar Majeed, Xianzhi Zhang and Muhammad Umar
Muhammad Ansar
Majeed is based at the
International Business
School, Zhejiang
Gongshang University,
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Hangzhou, China.
Xianzhi Zhang is based
at the School of
Accounting, Dongbei
University of Finance and
Economics, Dalian,
China. Muhammad Umar
is based at AIR
University, Islamabad,
Pakistan.
Received 11 September 2015
Revised 5 February 2016
25 April 2016
29 May 2016
Accepted 4 June 2016
PAGE 44 JOURNAL OF ASIA BUSINESS STUDIES
Abstract
Purpose – The purpose of this study is to investigate the effect of investment efficiency on cost of equity
capital.
Design/methodology/approach – Prior research indicated that any governance mechanism which
reduces the agency conflict reduces the cost of equity capital. This study provides empirical evidence
that investment efficiency represents such governance mechanism which reduces agency conflict and
hence cost of equity. The authors use price earning growth ratio (Easton, 2004) and Ohlson and
Juettner-Nauroth (2005) model for the measurement of cost of equity while investment efficiency
measure of Biddle et al. (2009) have been employed to examine the association. We also use Chen et
al. (2013) measure of investment efficiency for robustness.
Findings – The results show that investment efficiency is negatively associated with cost of equity. It
was also found that there is a strong relationship of investment efficiency with cost of equity for
non-state-owned enterprises (NSOEs), while no significant relationship is found for state-owned
enterprises. Furthermore, overinvestment is significantly associated with cost of equity capital.
However, no significant relationship was found between underinvestment and cost of equity.
Originality/value – The results provide empirical support to the argument that investment efficiency acts
as a mechanism which represents lower agency conflict. Moreover, the findings provide evidence that
government act as “deep pocket” while NSOEs are punished by investors for inefficient resource allocation.
This study also proposes that there is a positive relationship between overinvestment and cost of equity.
Keywords Overinvestment, Underinvestment, Cost of equity, Investment efficiency
Paper type Research paper
1. Introduction
Separation of ownership from management results in agency risk which arises due to the moral
hazards and adverse selection (Jensen and Meckling, 1976). Firms employ various
governance mechanisms to protect the shareholders from the opportunistic behavior of the
managers and in certain cases majority shareholders. There is abundant prior literature which
suggests that any governance mechanism that reduces the agency risk and informational risk
can reduce the cost of equity (CoE) capital and vice versa (Huang et al., 2009; Chen et al.,
2009, 2011). Hence, the CoE may be reduced in the presence of higher quality governance
mechanisms as such mechanisms reduce the opportunistic behavior of the management.
Lambert et al. (2007) suggested another approach which may reduce the cost of capital.
According to them, accounting information disclosure quality affects the cost of capital through
two different channels. First, quality of disclosure reduces information asymmetry between
management and outside investors. Second, disclosure quality influences the real managerial
decisions (like production and investment) as well which in turn have an effect on future cash
flows and, hence, ultimately affect the cost of capital.
Preceding literature (Biddle et al., 2009; Chen et al., 2011; Cheng et al., 2013; Cutillas
Gomariz and Sánchez Ballesta, 2014) also suggests that investment efficiency (IE) is
associated with lower information asymmetry which in turn leads toward lower level of moral
VOL. 12 NO. 1, 2018, pp. 44-59, © Emerald Publishing Limited, ISSN 1558-7894 DOI 10.1108/JABS-09-2015-0163
 hazards and adverse selection problem. Biddle et al. (2009) suggested that firms with
higher financial reporting quality are associated with lower level of underinvestment and
(or) overinvestment. They further argued that firms with higher financial reporting quality do
not deviate from predicted investment level. They also found that a firm’s deviation from
predicted level is less sensitive to macro-economic conditions if it has higher financial
reporting quality. Biddle et al. (2009) argued that the reason behind this association
between financial reporting quality and IE is lower information asymmetry and reduced
agency risk because of fewer incentives for managerial opportunism in the presence of
higher reporting quality. Similarly, Chen et al. (2011) argued that financial reporting quality
reduces agency cost by improving IE in private firms, and Cutillas Gomariz and Sánchez
Ballesta (2014) proposed that not only financial reporting quality but debt maturity also
plays an important role in controlling managerial opportunism and hence improves IE.
These arguments suggest that any mechanism which reduces managerial opportunism
(agency risk) and informational risk would reduce inefficient investment. These studies also
suggest that there is lower agency risk and lower information asymmetry when IE is higher. This
implies that the firms with higher level of IE would have lower agency problems caused by
opportunistic behavior of the management. Based on this discussion, two viewpoints can be
extracted. First, IE is associated with lower information asymmetry and lower agency risk.
Second, lower informational risk and agency conflict can reduce CoE. This study links these
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two viewpoints and examines whether IE leads to lower CoE. This study seeks to answer the
question: Is there a link between IE and CoE capital? Or, does IE which is a result of lower level
of agency conflict leads to lower CoE? What is the impact of state ownership on the relationship
between IE and CoE? What is the effect of overinvestment (underinvestment) on the CoE?
IE is an important concept in this study. In perfect financial markets, firms invest efficiently
if they carry out all the projects with positive net present value (NPV) and reject those with
negative NPV. However, prior literature (Hubbard, 1998; Bertrand and Mullainathan, 2003)
refutes this assumption, as the world is not without frictions. Hence, the market
imperfections along with information asymmetries and agency conflicts can potentially lead
to accepting the projects with negative NPV (overinvestment) and rejection of projects with
positive NPV (underinvestment). Following earlier literature (e.g. Biddle et al., 2009; Chen
et al., 2011; Cheng et al., 2013), IE is defined as expected level of investment which is
measured as predicted investment level based on sales growth opportunities. A positive
deviation from expected level (i.e. investment higher than predicted level) is considered as
overinvestment, and negative deviation from expected level (i.e. investment lower than
predicted level) is regarded as underinvestment, while both (i.e. overinvestment and
underinvestment) constitute inefficient investment.
This study is based on the sample of A-listed Chinese firms for the period spanning
2000-2013. We document that IE is negatively associated with CoE. Notably, the results
show that higher IE leads toward lower CoE, which suggests that investors take into
account the investment decisions made by the firms and also confirms the proposition of
Lambert et al. (2007) that decisions like investment influence the cost of capital. We further
extend our analysis by examining the impact of IE on CoE for state-owned enterprises
(SOEs) and non-state-owned enterprises (NSOEs). Chinese institutional environment offers
a unique research opportunity because of large number of SOEs. SOEs and NSOEs differ
in the nature of their ownership structure, agency conflict and bankruptcy risk. The main
objective of SOEs is not profit maximization but they pursue other social objectives like
employment of the region and political objectives of the state which makes them quite
different from NSOEs. In case these SOEs face financial distress, they are bailed out by the
government (Faccio, 2006). This study hypothesizes and documents that effect of IE on
CoE capital is only pronounced for NSOEs, while we do not find any statistically significant
between IE and CoE for SOEs. This association is expected because of lower risk
associated with SOEs as argued by Chen et al. (2010) and potential support from the state

VOL. 12 NO. 1 2018 JOURNAL OF ASIA BUSINESS STUDIES PAGE 45

 (in case of distress) which makes SOEs more lucrative investment avenue and hence
results in lower rate of return demanded by the investors. This may also be because of
the reason that investment decisions of SOEs are not for profit maximization but to
achieve political and social goals so their investment decisions are evaluated quite
differently. Moreover, the support of the government to the SOEs is considered to
surpass the risk of loss from bad investment decisions. This study would help to
understand how IE influences the CoE with the variations in ownership structure,
agency risk and bankruptcy risk.
The study also examines the impact of two inefficient scenarios, i.e. overinvestment and
underinvestment on CoE, to understand which scenario has (more pronounced) effect on
CoE. Underinvestment represents lost opportunity, which may be availed by competitors,
while overinvestment is an agency issue, which may arise due to availability of free cash
flows (Richardson, 2006). We hypothesize that overinvestment (or underinvestment) is
associated with higher CoE. However, our results show that there is negative association
between overinvestment and CoE but we do not find any statistically significant relationship
between underinvestment and CoE. The negative association between overinvestment and
CoE may be because of the reason that investment expenditure results in lower future
operating performance (Li, 2004) and negative stock returns (Titman et al., 2004), which
implies that investors do not consider higher investment as positive sign and hence require
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higher rate of return.

This study makes several contributions to the literature by providing evidence of IE on cost
of capital. Studies (Biddle et al., 2009; Chen et al., 2011; Cheng et al., 2013) show that IE
is associated with lower information asymmetry and (or) agency cost. Preceding research
also shows that lower level of information asymmetry and agency conflict reduces CoE.
First, this study links these two viewpoints to examine whether IE leads to lower CoE.
Second, our study contributes by providing empirical evidence to the argument of Lambert
et al. (2007) that managerial decisions like investment effect cost of capital. Third, how IE
influences the CoE with the variations in ownership structure, agency risk and bankruptcy
risk by examining the impact of IE on CoE for SOEs and NSOEs. By examining the impact
of IE for SOEs and NSOEs, this study would improve our understanding how real decisions
(like investments) of two different types of firms, i.e. one with only objective of profit
maximization (NSOEs) and others with objective of social and political gains, are perceived
by equity market. Our study also helps in understanding how insurer role played by the
government shapes the investors’ perception of managerial opportunism (which results in
inefficient investment). Fourth, we document the impact of overinvestment (or
underinvestment) on the CoE. It would help to understand how two different scenarios, i.e.
overinvestment and underinvestment, are perceived by investors. Fifth, China offers a
unique institutional and economic environment, which makes it an interesting setting to
study. China has a large number of SOEs that can get financial support from the
government in case of distress along with preferential treatment like reduction in tax burden
and subsidized loans. Chinese corporate sector is mainly dependent on banking sector for
their financing needs. Despite being the second largest economy of the world, Chinese
equity market is less developed, has higher information asymmetry and lower investor
sophistication as compared to developed economies like the USA and the UK. In such a
unique institutional environment having different aspects at the same time, examining the
impact of IE on CoE would contribute to the growing body of literature.
The remainder of the paper is organized as follows. Section 2 reviews the literature and
develops hypotheses. Section 3 discusses the research design and variable
measurements. Section 4 describes sample and descriptive statistics. Section 5 details
results and robustness check, which is followed by Section 6, which concludes the
paper.

PAGE 46 JOURNAL OF ASIA BUSINESS STUDIES VOL. 12 NO. 1 2018

 2. Review of literature and hypotheses development
All the firms need capital for their operations and expansion, which is provided by investors
(shareholders and lenders). However, a return is demanded by the providers of the capital,
but due to the separation of ownership and control, there are agency problems resulting
from opportunistic behavior of the management (Jensen and Meckling, 1976). In case of
higher agency risk, investors demand higher return to cover the default risk and monitoring
cost (Stulz, 2014; Lombardo and Pagano, 1999; Botosan and Plumlee, 2002; Sanjeev and
Sengupta, 2003; Chen et al., 2009; Francis et al., 2005).
Stulz (2014) and Lombardo and Pagano (1999) suggested that higher rate of return is required
when agency conflict is higher to mitigate default risk. According to Healy and Palepu (2001),
information asymmetry and agency conflict give rise to the financial disclosure and reporting.
According to them, accounting information reduces information asymmetry and agency
conflict. This argument was supported by Botosan and Plumlee (2002) who reported that
greater disclosure in annual reports results in lower CoE. Similar relationship was found by
Francis et al. (2005) who argued that financial reporting quality was negatively associated with
CoE. These arguments suggest that when the managerial interests are aligned with the interest
of the shareholders, then CoE reduces because of lower agency risk. Huang et al. (2009)
reported managerial ownership lowers CoE, as managerial ownership aligns managerial
interests with shareholders which reduce agency conflicts. Similarly, Chen et al. (2011)
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reported lower CoE when audit quality is high, which implies that audit function acts as
monitoring mechanism which reduces managerial opportunism and hence reduces CoE. Fu et
al. (2012) suggested that higher reporting frequency decreases information asymmetry and
resultantly CoE. Ashbaugh-Skaife et al. (2009) also reported that alignment of interest by
improving the internal control mechanism would result in lower CoE. Thus, any mechanism
whether information quality (Easley and Hara, 2004), multiple large shareholdings (Attig et al.,
2008; Guedhami and Mishra, 2009) or management entrenchment (Collins and Huang, 2011)
which reduces agency conflict or decreases monitoring cost by aligning managerial interests
would decrease CoE. We argue that IE is representative of such governance mechanism which
lowers agency conflict. Prior literature (Biddle et al., 2009; Chen et al., 2011; Cheng et al., 2013;
Cutillas Gomariz and Sánchez Ballesta, 2014) suggests IE is the consequence of lower level of
information asymmetry which means lower level of adverse selection and moral hazards. These
arguments imply that efficient investment means lower level of agency risk in the firm. We argue
that if efficient investment means lower level of agency problem, then it should have an impact
on cost of capital. Another line of inquiry is proposed by Lambert et al. (2007) who argued that
information disclosure has an effect on cost of capital in two ways, first by improving the
perception of the firms and second by influencing the real decisions (like production and
investment). So, another channel through which CoE is influenced is the real decisions (related
to investment) which affect the investor’s risk perception and consequently required rate of
return. If it is so, then IE should affect the cost of capital directly. Our study explores this channel
by providing empirical evidence that real investment decisions affect CoE. Based on these
premises, we argue that there is negative association between IE and CoE. So, our first
hypothesis is:

H1. IE is negatively associated with CoE capital.

Chinese institutional environment offers a unique environment to study agency issues
(Radhakrishnan, 2014). Agency issues arise first because of separation of ownership and
control (Jensen and Meckling, 1976) and second because of conflict of interests between
controlling and non-controlling shareholders (Ali et al., 2007). The presence of SOEs and
NSOEs provides an excellent opportunity to study second type of agency issue, i.e. agency
conflict between majority shareholders and minority shareholders. A large number of
Chinese firms are controlled by state which would be interesting to study because these
SOEs differ from NSOEs in their objectives and riskiness. China is an economy in transition
and main source of finance is not the equity market but banking sector (Allen et al., 2012).

VOL. 12 NO. 1 2018 JOURNAL OF ASIA BUSINESS STUDIES PAGE 47

 Allen et al. (2012) further argued that majority of the funds from banking sector go to SOEs
in manufacturing sector. Byun et al. (2013) argue that business group affiliation has
co-insurance effect which reduces the bankruptcy risk and a similar role is played by the
government in China. This study argues that SOEs face lower bankruptcy risk as compared
to NSOEs because government plays the role of insurer for SOEs as in case of financial
distress, they are bailed out by the government (Faccio, 2006). These SOEs are considered
to have lower risk by lenders (Chen et al., 2010) for the same reason. These SOEs are given
preferential treatment like reducing tax burden and capital injections from the government.
The main reason for these concessions to these SOEs is that their main objective is not
financial performance only but various other social and political objectives like improving
employment level and financial condition of the region. Chen et al. (2011) argued that the
effect of audit quality is more evident for NSOEs than for SOEs because the role of audit
function as monitoring mechanism is less pronounced for SOEs. Based on these
arguments, we postulate that the association between IE and CoE is less pronounced for
SOEs because of two reasons. First, SOEs have lower risk associated with them and that
is why investors demand lower return for them. Second, SOEs differ from NSOEs in their
objectives, and monitoring mechanisms play less distinct role in reducing CoE. Based on
this discussion, our second hypothesis is as follows:
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H2. The negative relationship between IE and CoE capital is weaker for SOEs than
for NSOEs.
Following Cutillas Gomariz and Sánchez Ballesta (2014), we further divide the sample
into underinvestment and overinvestment. Although both underinvestment and
overinvestment represent inefficient investment and may cause value destruction.
However, both underinvestment and overinvestment affect firm values in different ways.
On one side, underinvestment may be considered as value-destroying activities and
may result in future loss because in case of underinvestment, firm may be out of
competition and lose business to its competitors, as it will not be able to meet the
increasing market demand. Hence, the underinvestment may result in predation risk,
i.e. a risk of losing profitable investment opportunity and market share to the
competitors. After losing market share to the competitors, the firm may not be able to
achieve even industry average profits. Consequently, performance of the firm below
industry average would give negative impression of the firm to the investors and they
may demand higher rate of return. Losing business to competitors and lower profits as
compared to other firms in industry would also signal poor management of the affairs
of the firm and may raise concerns regarding the survival of the firm. On the other hand,
Richardson (2006) reported overinvestment of free cash flows as “common problem”
and found weak evidence that governance mechanisms can prevent overinvestment
problem. These arguments suggest that overinvestment is difficult to control even in the
presence of governance mechanism. Li (2004) reported negative association between
investment expenditure and future operating performance. This poor performance may
be attributed to agency cost. Similarly, stock returns have been found to be negatively
associated with investment (Titman et al., 2004) which means investors negatively react
to investment, as higher investment reduces efficiency of the firm. So, we argue that
investors in the equity market react negatively to the investment decisions and demand
higher rate of return. Base on this discussion, we propose that both underinvestment
and overinvestment are value-destroying activities and consequently increase the CoE
of the firms. This discussion provides basis for our following hypotheses:

H3a. There is positive relationship between overinvestment and CoE capital.

H3b. There is positive relationship between underinvestment and CoE capital.

PAGE 48 JOURNAL OF ASIA BUSINESS STUDIES VOL. 12 NO. 1 2018

 3. Research design
3.1 Model specification
This study proposes the following models to test the hypotheses. We use fixed effect
(FE) regression and two-stage least square (2SLS) regression to test hypotheses for
CoE following prior studies (Fu et al., 2012). In FE regression model, we use
province-year FEs, as provinces may be developing at varied growth rates. We use
industry and year FE in 2SLS regression. Both techniques, i.e. FE regression and 2SLS,
have been employed extensively in prior literature (Fu et al., 2012; Chen et al., 2009;
Huang et al., 2009). In panel data, FE regression models are used for controlling
omitted variables. FE methods are used for controlling omitted variables when such
variables change over entities but do not changes over time. In FE regression method,
there are n different intercepts, one intercept for each entity or group. These intercepts
can be characterized by a set of binary variables. The effects of all such omitted
variables, which differ from one entity (or group) to another, would be absorbed by such
binary variables. FE model is particularly popular, as it makes possible to control for all
stable characteristics of an entity even when such characteristics could not be
measured (Halaby, 2004). Province FEs would generate unbiased estimates under the
assumption that certain unobservable characteristics of the province which influence
both IE and CoE are constant over the period of time. For 2SLS model predicted values
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of IE/Overinvest/Underinvest are calculated. For this purpose, in first-stage regression,

dependent variable is IE/Overinvest/Underinvest and independent variables include all
control variables. The IE/Overinvest/Underinvest values are calculated by using
industry FE as described by Gormley and Matsa (2014). The values of IE/Overinvest/
Underinvest, calculated in the first stage, are used in second-stage regression.
CoEit ⫽ ␤0 ⫹ ␤1IEit ⫹ ␤2SOEit ⫹ ␤3IE_SOEit ⫹ ␤4Betait ⫹ ␤5BMit
⫹ ␤6Sizeit ⫹ ␤7Levit ⫹ ␤8CFOit ⫹ ␤9Tangit ⫹ ␤10Growthit ⫹ ␤11IOit
⫹ ␤12ROAit ⫹ FixedEffects ⫹ ␧it
CoEit ⫽ ␤0 ⫹ ␤1Overinvestit ⫹ ␤2Betait ⫹ ␤3BMit ⫹ ␤4Sizeit
⫹ ␤5Levit ⫹ ␤6CFOit ⫹ ␤7Tangit ⫹ ␤8Growthit ⫹ ␤9IOit
⫹ ␤10ROAit ⫹ FixedEffects ⫹ ␧it
CoEit ⫽ ␤0 ⫹ ␤1Underinvestit ⫹ ␤2Betait ⫹ ␤3BMit ⫹ ␤4Sizeit
⫹ ␤5Levit ⫹ ␤6CFOit ⫹ ␤7Tangit ⫹ ␤8Growthit ⫹ ␤9IOit
⫹ ␤10ROAit ⫹ FixedEffects ⫹ ␧it
Where IEit represents IE calculated following Biddle et al. (2009). Following prior literature
(Botosan and Plumlee, 2005; Chen et al., 2009; Huang et al., 2009), we control for several
variables. SOE is dummy variable, which is one for SOEs and zero otherwise. BMit is the
book to market value, Sizeit is the log of total assets, Levit is the leverage ratio, IOit is the
institutional ownership, Growthit is the average growth sales, Betait is the market risk, Tangit
represents tangibility of assets is the ratio of fixed assets to total assets, ROA is return on
assets and CFOit is cash flow from operations scaled by total assets.

3.2 Variable measurement

3.2.1 Measurement of investment efficiency. Following Biddle et al. (2009), the measure of
IE used in this study is based on expected level of investment by specifying the following
model which measure predicted level of investment based on sales growth opportunities.
Investmentit ⫽ ␤0 ⫹ ␤SalesGrowthit⫺1 ⫹ ␧it
Where Investmentit is the total investment in the firm “i” in year “t” which is defined as net
increase in tangible and intangible assets scaled by total assets, while SalesGrowthit-1 is
the rate of change in sales from year t-2 to t-1. The model is estimated cross-sectionally for
each year and industry and residual represents the deviation from expected level. A

VOL. 12 NO. 1 2018 JOURNAL OF ASIA BUSINESS STUDIES PAGE 49

 positive residual means investment is more than expected level as per sales growth which
is classified overinvestment. While a negative residual means investment is lower than
expected level and so it is classified underinvestment. So, the test variable, i.e. IE, is
absolute value of residual which represents inefficient investment. This implies higher value
of residual represent higher level of inefficiency.
3.2.2 Measurement of cost of equity.
3.2.2.1 Price earning growth ratio. Although Botosan and Plumlee (2002) suggested price
earning growth (PEG) ratio (Easton, 2004) to be the robust measure of CoE capital, it has
not been established yet that PEG ratio is also most robust measure for Chinese market as
well. However, following prior studies on Chinese settings like Chen et al. (2011), this study
also uses PEG ratio to measure ex ante CoE capital. In the PEG ratio model, the CoE capital
is calculated by using following model.

冪
epst⫹2 ⫺ epst⫹1
RPEG ⫽
Pit
Where RPEG is the implied CoE and epst⫹1 and epst⫹2 represent the earning per share one
year ahead and two years ahead, respectively, while Pit is the year-end share price. This
model requires forecasted earnings per share but analyst forecasts are not available for
whole period of study. Therefore, following prior studies (e.g. Chen et al., 2011), we use
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realized earnings per share. Another important point is that PEG ratio requires epst⫹2 ⬎
epst⫹1 ⬎ 0. However, several observations are lost to fulfill this assumption.
3.2.2.2 Cost of equity using Ohlson and Juettner-Nauroth (2005). Following Chen et al.
(2009), we use Ohlson and Juettner-Nauroth (2005) model (OJ model) for the measurement
of CoE as described by Gode and Mohanram (2003) and defined in the following equation:
epst⫹1 [epst⫹2 ⫺ epst⫹1 ⫺ ROJ ⫻ epst⫹1(1 ⫺ Pout)]
ROJ ⫽ ⫹
ROJ ROJ(ROJ ⫺ git)

ROJ ⫽ A ⫹
冪A2
epst⫹1
Pit
⫹ 共
epst⫹2 ⫺ epst⫹1
epst⫹1
⫺ git兲
Where:
1
A⫽
共
2 git ⫹
Pout ⫻ epst⫹1
Pit 兲
Where git is long-term earning growth rate which is proxied by inflation rate, and epst⫹1 and
epst⫹2 represent the earning per share one year ahead and two years ahead, respectively,
while Pit is the year-end share price. Just like in the PEG ratio model, realized earning per
share is used here instead of forecasted values, and Pout is dividend payout for the year.
Both models are a little different, but the basic concept is the same and both provide
implied CoE. However, the analyst forecasts required for both models are not available for
the whole period of studies; so, following Chen et al. (2011), actual values for “eps” are
used for the calculation of both models. Both models have their own pros and cons.
Kitagawa and Gotoh (2011) conclude that the PEG (price earnings growth) ratio reflects the
risk factors most suitably and it is superior to other models. According to them, estimated
CoE capital can be used for the valuation and forecast of risks associated with capital
investment. Similarly, Botosan and Plumlee (2005) argued that PEG ratio is the robust
measure of CoE for US market. However, this methodology is not without disadvantages.
The PEG ratio causes a downward bias in general because it assumes there is no abnormal
earnings growth and dividends are zero (Kitagawa and Gotoh, 2011). Moreover, the main
assumption here is it requires epst⫹2 ⬎ epst⫹1 ⬎ 0. Due to this restriction that earnings are
consistently growing, many observations are lost, which reduces the power of test to some
extent. OJ model on the other hand overcomes some of the disadvantages of the PEG ratio.
The main advantage of this model is that it is parsimonious and does not require any

PAGE 50 JOURNAL OF ASIA BUSINESS STUDIES VOL. 12 NO. 1 2018

 assumption regarding dividend payment policy. Furthermore, OJ model, contrary to PEG
ratio, does not assume continuous earnings growth. The downward bias of PEG ratio which
is due to the assumption of zero dividend and consent growth can be avoided in OJ model.
However, OJ model is also not without flaws. Kitagawa and Gotoh (2011) and Tran (2014)
concluded that PEG ratio is superior model as compared to OJ model. No preceding study
has documented which model is best for Chinese institutional settings although both
models have been used in prior research (Chen et al., 2011; Huang et al., 2009).
3.2.3 Control variables. This study employs several control variables. Following Fu et al.
(2012), beta, size, book-to-market (BM) value have been controlled. We control for size
because size affects agency cost (Chiang and Ko, 2009; Jensen and Meckling, 1976). We
also control for leverage, as debt financing may reduce the agency cost because of
monitoring role played by lenders (Agrawal and Knoeber, 1996). Moreover, higher debt
financing shrinks cash flows and reduces the likelihood of managerial benefits for investing
in projects with negative NPV (Jensen, 1986). According to active monitoring hypothesis,
active monitoring as a result of higher institutional ownership increases the firm value
(Agrawal and Mandelker, 1990). Following Huang et al. (2009), who argued that higher
institutional ownership reduces CoE, this study also controls for institutional ownership. Our
study also controls for BM ratio, as there is positive association between BM ratio and
expected returns, while market model beta is incorporated to control for systematic risk.
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Gode and Mohanram (2003) reported firm’s growth rate (average sales growth of past three
years) also influence the CoE, as it influences the risk perception of the firm. We also
include ROA as control variable, as more profitable firms have low default risk. To control
for the riskiness of the firms, we also control for tangibility and cash flows from operations
following Valta (2012) and Kabir et al. (2013).

4. Sample and descriptive statistics

4.1 Sample
This study includes all the A-listed non-financial firms of both stock markets (Shanghai and
Shenzhen) of China for the years 2000 to 2013 which are included in RESSET (www1.
resset.cn) database. But two important points need attention here. First, as IE measure
needs sales growth rates of the previous year, so the observations from the first year of
every firm in the period are lost. Second, the ex ante CoE measure requires at least two
years ahead earning per share so we lose the observations for last two years for every firm.
As the measure of IE is estimated cross-sectionally for each year and industry, this study
uses second-level industry code of CSRC for the purpose of industry classification and
drop the industries which have less than ten observations. All the variables have been
winsorized at 1 per cent and 99 per cent. Table I provides definition of all variables used
in this study and descriptive statistics.

4.2 Descriptive statistics and correlation matrix

Table I presents the descriptive statistics for variables including mean, median and
slandered deviation. IE has mean value of 1.57 and a median of 0.1047.
The overinvestment (Overinvest) and underinvestment (Underinvest) have mean and
median of 2.55, 1.1383 and 0.1086, 0.1035, respectively. It is important to note that all the
values of investment, under/overinvestment are absolute values. Table II represents serial
correlation. Similarly, out of two measures of CoE, PEG ratio is significantly positively
associated with our measure of inefficiency.
This is consistent with the preceding studies that any mechanism which reduces the agency
conflict reduces the cost of capital and vice versa. Although OJ measure of CoE is negatively
correlated, this correlation is insignificant at conventional level. Correlations between our
independent variables are not high, and so, collinearity is not likely to be an issue.

VOL. 12 NO. 1 2018 JOURNAL OF ASIA BUSINESS STUDIES PAGE 51

 Table I Descriptive statistics
Variable Variable definition Mean Median Min Max SD N

IE IE is the level of inefficiency, i.e. investment 1.574 0.1047 0.0124 11,013.37 85.4249 18,460
efficiency measure
Overinvest Overinvest represents overinvestment 2.5559 0.1086 0.0124 1,114.565 46.8738 5,672
Underinvest Underinvest represents underinvestment 1.1385 0.1035 0.0231 11,013.37 97.7718 12,788
PEG Ex ante cost of equity calculated following 0.1086 0.0882 0.000 1.3318 0.0918 7,635
Easton (2004)
OJ Measure of cost of equity following Ohlson & 4.7258 4.7493 0.0017 131.0788 3.6607 5,456
Juettner-nauroth (2005) according to the
Gode and Mohanram (2003)
BM Book value to market value of equity 0.428 0.374 ⫺4.9838 5.2099 0.3252 16,872
CFO Cash flow from operations divided by total 0.0503 0.0475 ⫺0.2058 0.3293 0.0861 18,431
assets
IO Percentage of institutional ownership 26.9889 21.4636 0.0015 85.1206 23.5192 15,006
Lev Leverage ratio 47.4835 47.9606 5.0204 115.742 21.8872 18,457
Size Size is the log of total assets 21.3986 21.271 18.2603 25.0628 1.2435 18,459
TANG Ratio of fixed assets (property, plant and 0.4277 0.412 0.0289 0.9093 0.2148 18,454
equipment) to total assets
Beta Beta is the systematic risk factor 1.1034 1.0835 ⫺41.5657 56.1421 1.1748 18,598
ROA Return on assets 4.8297 4.1842 ⫺22.5595 33.119 7.5179 18,460
Growth Average sales growth 23.2041 16.9211 ⫺44.2849 269.383 39.1133 18,471
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Table II Correlation matrix

Variable IE PEG OJ BM CFO IO LEV Size TANG Beta ROA Growth

IE 1
PEG 0.143*** 1
OJ ⫺0.031 0.228*** 1
BM 0.037** 0.138*** 0.326*** 1
CFO 0.012 0.025* 0.009 ⫺0.017*** 1
IO ⫺0.009** ⫺0.070*** 0.062*** ⫺0.057*** 0.10*** 1
LEV ⫺0.002*** 0.235*** 0.029* ⫺0.078*** ⫺0.118*** 0.061*** 1
Size 0.071 0.077*** 0.127*** 0.417*** ⫺0.05*** 0.40*** 0.427*** 1
TANG 0.073 0.111*** 0.001 0.124*** 0.171*** 0.010 0.102*** 0.149*** 1
Beta ⫺0.007 0.023 0.0169 0.384*** ⫺0.019*** ⫺0.17* ⫺0.008 ⫺0.002 ⫺0.013 1
ROA ⫺0.028*** ⫺0.137*** ⫺0.023 ⫺0.045** 0.275** 0.218** ⫺0.377*** ⫺0.070** ⫺0.20*** 0.001 1
Growth ⫺0.012* 0.035*** 0.022 ⫺0.044*** 0.058*** 0.0086 0.304*** ⫺0.013* ⫺0.119*** 0.012 0.235*** 1
Notes: ***Represents significant at 1%; **represents significant at 5%; *represents significant at 10%; where IE is the investment
efficiency, PEG is ex ante cost of equity calculated following Easton (2004), OJ is also proxy for cost of equity following Ohlson and
Juettner-Nauroth (2005) according to the Gode and Mohanram (2003), BM is book-to-market value of equity, CFO is cash flow from
operations divided by total assets, IO is percentage of institutional ownership, Lev is leverage ratio, Size is the log of total assets, TANG
is ratio of fixed assets(property, plant and equipment) to total assets, Beta is the systematic risk factor, ROA is return on assets and
Growth is average sales growth

5. Results
5.1 Regression results
Table III reports regression results which show significant negative association between IE
and CoE as CoE increases with the increase in inefficient investment which means as
investment will become more efficient, the CoE will decrease. These results from both FE
and 2SLS show negative association between IE and CoE. The coefficient values for FE
regression range from 0.0011 to 0.0031, suggesting CoE decreases by between 0.11 and
0.31 basis point when IE increases by 1 point. The coefficient values for 2SLS range from
0.0006 to 0.0024.
With both measures of CoE, our results are statistically significant and support our first
hypothesis. The results provide evidence in favor of our argument that efficient investment
signals the presence of such governance mechanism which results from lower agency

PAGE 52 JOURNAL OF ASIA BUSINESS STUDIES VOL. 12 NO. 1 2018

 Table III Investment efficiency and cost of equity
Fixed effect Two-stage least square (2SLS)
Variable PEG OJ PEG OJ

IE 0.0011*** (7.89) 0.0031** (2.25) 0.0006*** (8.55) 0.0024** (2.28)

SOE ⫺0.0147 (⫺1.04) ⫺0.1051 (⫺0.59) ⫺0.0048*** (⫺2.95) ⫺0.1714 (⫺1.01)
IE_SOE 0.0008 (0.77) 0.0711 (0.68) 0.0017 (0.82) 0.0312 (0.51)
CFO 0.0319 (0.61) 3.4160* (1.74) 0.0253*** (3.96) 1.0178*1.81
Size ⫺0.0198*** (⫺6.10) ⫺0.5341*** (⫺3.11) ⫺0.0197*** (⫺2.79) ⫺0.1706** (⫺2.25)
TANG 0.0710*** (2.91) ⫺1.3591* (⫺1.90) 0.0199*** (4.18) ⫺0.8417*** (⫺2.69)
ROA ⫺0.0171*** (⫺3.43) ⫺0.1053** (⫺2.13) 0.0042*** (3.57) ⫺0.0829*** (⫺4.19)
Lev 0.0029*** (5.13) ⫺0.0329 (⫺0.53) 0.0041*** (13.42) 0.0096* (1.77)
BM 0.0271* (1.88) 2.8361** (2.07) 0.0619*** (6.32) 4.0149*** (4.63)
Beta ⫺0.0042 (⫺1.20) ⫺0.0248 (⫺0.27) 0.0018 (0.91) ⫺0.0171 (⫺0.41)
Growth ⫺0.0003 (⫺1.13) ⫺0.0001 (⫺0.41) ⫺0.0001 (⫺1.11) 0.0004 (1.17)
IO ⫺0.0011*** (⫺2.97) 0.0084* (1.81) ⫺0.0017*** (⫺2.71) ⫺0.0199*** (⫺4.53)
Intercept 0.9527*** (6.93) 9.1720*** (3.41) 0.0159*** (5.25) 7.2501*** (3.13)
Fixed effects Province-year Province-year Industry Industry
Fixed effects – – Year Year
R2 14.31 46.69 11.82 18.41
F 492.17*** 393.21*** 84.06*** 98.19***
Notes: ***Represents significance level at 1%; **represents significance level at 5%; *represents
significance level at 10%; this table reports fixed effect and 2SLS results examining the impact of
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investment efficiency on cost of equity for the sample firms spanning 2001-2013 that meet data
requirements. Dependent variable is cost of equity measured by PEG ratio model (Easton, 2004) and
OJ model (Ohlson and Juettner-Nauroth, 2005); beneath each coefficient is the t-statistic robust to
both heteroskedasticity and serial correlation

problem and alignment of interests of the management and shareholders and reduce the CoE.
This argument and evidence is consistent with prior research (Easley and Hara, 2004; Attig
et al., 2008; Guedhami and Mishra, 2009) that various governance mechanisms reduce
agency conflict and resultantly CoE. The results also provide argument of Lambert et al. (2007)
that real decisions like investment affects CoE capital.

Similarly, the control variables have signs consistent with prior research. We document that
firms that are larger in size have lower CoE, as larger firms are considered more established
and stable, which makes them less risky. Furthermore, firms with higher leverage ratio have
higher CoE, and firms with higher growth have lower CoE. Moreover, our results for other control
variables like ROA and BM are also in accordance with expectations. There is negative and
insignificant relationship (except in one case) between SOE and CoE measures. The results,
though insignificant at conventional levels, also signal in favor of our argument that SOEs have
lower risk and so have lower CoE as compared to NSOEs.

The interaction term IE_SOE shows the results for SOEs with inefficient investment. The results
for SOEs are not statistically significant at conventional levels and with mixed signs. These
results support our second hypothesis that IE in significant and relevant factor in determining
the required rate of return for NSOEs and is less pronounced in case of SOEs. These results
support our argument that SOEs are perceived less risky because of higher likelihood of bailout
by the government in case of financial distress (Faccio, 2006), and hence, investors do not care
about the efficiency of these firms nor do they take into account the value-destroying activities
in the same way as they perceive in NSOEs. These results also support the argument that
government plays co-insurer role for SOEs as argued by Byun et al. (2013) for Korean Chaebols
(Business Groups).
We further divide the sample into two categories of inefficient investment, i.e.
underinvestment and overinvestment. Table IV reports the results for overinvestment and
underinvestment.

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Table IV Investment efficiency and cost of equity
Overinvest Underinvest
Fixed effects Two-stage least square Fixed effects Two stage least square
Variable PEG OJ PEG OJ PEG OJ PEG OJ

VOL. 12 NO. 1 2018

IE 0.0004*** (3.18) 0.0058** (2.07) 0.0003*** (2.89) 0.0017 (0.61) ⫺0.0021 (⫺0.83) 0.1593 (0.91) 0.0023 (1.36) 0.1462 (0.69)
SOE ⫺0.0251** (⫺2.09) ⫺0.6721 (⫺0.98) ⫺0.0012 (⫺0.29) ⫺0.1614 (⫺1.08) ⫺0.0408 (⫺1.24) ⫺0.4130 (⫺0.65) ⫺0.0143*** (⫺4.19) ⫺0.2132 (⫺0.80)
CFO 0.1290 (1.14) 2.2813* (1.88) 0.0914*** (3.17) 0.7131 (0.55) 0.0243 (0.96) 3.7805 (1.07) 0.1862*** (3.42) 0.1354 (1.13)
Size ⫺0.017 (⫺1.52) ⫺0.5630* (⫺1.82) ⫺0.0031 (⫺1.32) ⫺0.1852 (⫺1.54) ⫺0.1149*** (⫺5.47) ⫺0.2917* (⫺1.73) ⫺0.0416** (⫺2.05) ⫺0.1425* (⫺1.79)
TANG ⫺0.0424 (⫺1.41) ⫺2.4805** (⫺1.98) 0.0240 (0.68) ⫺0.4830 (⫺1.41) 0.0611 (1.34) ⫺1.7384 (⫺1.45) 0.0357** (2.31) ⫺0.5173*** (⫺3.39)
ROA ⫺0.0038*** (⫺3.53) ⫺0.1242* (⫺1.87) ⫺0.0021** (⫺2.11) 0.0719* (1.69) ⫺0.0214*** (⫺3.70) ⫺0.0521*** (⫺3.27) 0.0016*** (3.37) 0.1179** (4.87)
Lev 0.0011* (1.71) ⫺0.0431*** (⫺3.11) 0.0029*** (5.41) 0.0179** (2.16) 0.0415*** (3.19) ⫺0.0049*** (⫺2.65) 0.0016*** (11.01) ⫺0.0013*** (⫺3.39)
BM 0.0051 (0.41) 2.1360** (2.11) 0.0430*** (5.41) 3.0180*** (8.40) 0.0380*** (3.75) 2.1634* (1.81) 0.0174*** (9.54) 3.3470* (1.78)
Beta 0.0066** (2.19) 0.0857 (0.67) 0.0018 (0.51) ⫺0.1271 (⫺1.30) 0.0056 (0.92) 0.0529* (1.71) 0.0072 (0.83) 0.0473 (0.59)
Growth ⫺0.0001 (⫺0.68) ⫺0.0014 (⫺0.40) 0.0002 (⫺0.46) 0.0011 (0.61) 0.0001 (⫺0.49) ⫺0.0029 (⫺1.02) ⫺0.0001 (⫺1.07) ⫺0.0009 (⫺0.29)
IO ⫺0.0007*** (⫺2.93) ⫺0.0002 (⫺0.78) 0.0002 (0.23) ⫺0.0164*** (⫺3.57) ⫺0.0013*** (⫺2.71) 0.0077 (1.86) ⫺0.0019*** (⫺3.17) ⫺0.0247*** (⫺3.91)
Intercept 0.3938* (1.79) 12.1317*** (3.54) 0.1146** (2.28) 5.1440*** (2.92) 1.1410*** (7.14) 5.281*** (3.85) 0.0921*** (2.76) 4.1307*** (2.82)
Fixed effects Province-year Province-year Industry Industry Province-year Province-year Industry Industry
Fixed effects – – Year Year – – Year Year
R2 9.13 21.49 11.69 29.70 8.95 27.93 13.67 21.71
F 621.44*** 81.49*** 41.10*** 19.47*** 311.91*** 79.13*** 60.24*** 52.18***

Notes: ***Represents significance at 1%; **represents significance level at 5%; *represents significance level at 10%; this table reports fixed effect and 2SLS results examining the impact of investment
efficiency on cost of equity for the sample firms spanning 2001-20013 that meet data requirements. Dependent variable is cost of equity measured by PEG ratio model (Easton, 2004) and OJ model (Ohlson
and Juettner-Nauroth, 2005). Beneath each coefficient is the t-statistic robust to both heteroskedasticity and serial correlation
 The results are insignificant for underinvestment. However, the results are significant for
overinvestment. The overinvestment, for FE regression model, is highly significant and the
coefficient ranges from 0.0004 to 0.0058, thereby suggesting that CoE increases by between
0.04 and 0.58 basis point with 1 point increase in overinvestment. The results remain consistent
when 2SLS method is used. These results support our H3a hypothesis, which suggests that
overinvestment is positively associated with CoE. So, the overinvestment is considered a more
serious problem as compared to underinvestment. These results are in line with Cutillas
Gomariz and Sánchez Ballesta (2014) who argued that it is through overinvestment that
managers tend to “expropriate creditors and minority shareholders”. These results are also in
accordance with Li (2004) and Titman et al. (2004). Li (2004) reported lower future operating
performance for firms engaged in investment expenditure, which may be due to lower
operating efficiency or agency issues. Titman et al. (2004) also reported negative future returns
from capital investment. We argue, as lower future operating performance of the brands makes
firms more risky and results in investors demanding higher rate of return, overinvestment is
associated with higher cost of capital.

5.2 Robustness check

We re-estimate our measure of IE following Chen et al. (2013) by using sales growth and
Tobin’s Q to predict the optimal level of investment. They argued that “this approach does
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not rely on the assumption that cash balance and leverage are exogenous factors
predicting the propensity to underinvestment or overinvestment”.
Investmentit ⫽ ␤0 ⫹ ␤1SalesGrowthit⫺1 ⫹ ␤2Qit ⫹ ␧it
Where Investmentit is the total investment in the firm “i” in year “t”, which is defined as net
increase in tangible and intangible assets scaled by total assets, and SalesGrowthit-1 is the
rate of change in sales from year t-2 to t-1 while Qit is the lagged Tobin Q, measured as sum
of market value of shareholders’ equity and book value of liabilities divided by total assets.
The results as shown in Tables V and VI are similar to those as previously reported in
Tables III and IV. IE is significantly associated with lower CoE in overall sample. Moreover,

Table V Investment efficiency and cost of equity

Fixed effect Two-stage least square
Variable PEG OJ PEG OJ

IE 0.0004*** (11.52) 0.0036*** (3.57) 0.00013*** (7.48) ⫺0.0021** (⫺2.14)

SOE ⫺0.046 (⫺1.12) ⫺0.0681 (⫺0.67) ⫺0.0107*** (⫺3.13) ⫺0.1431 (⫺0.91)
IE_SOE 0.0010 (0.91) 0.0743* (1.81) ⫺0.0014 (⫺0.78) ⫺0.0471 (⫺0.67)
CFO 0.0317 (0.79) 3.1519 (1.33) 0.0641*** (5.13) 0.7619 (0.79)
Size ⫺0.0571*** (⫺9.17) ⫺0.4689*** (⫺2.71) ⫺0.0019*** (⫺2.93) ⫺0.0652*** (⫺3.81)
TANG 0.0412*** (3.31) ⫺0.7732 (⫺1.13) 0.0319*** (3.49) ⫺0.6267*** (⫺2.79)
ROA ⫺0.0031*** (⫺4.28) ⫺0.0683** (⫺2.11) 0.0021 (0.69) ⫺0.0853*** (⫺3.61)
Lev 0.0020*** (6.51) 0.0251 (0.79) 0.0041*** (9.45) 0.0007 (0.76)
BM 0.0497* (1.81) 1.3472*** (2.98) 0.0619*** (12.57) 3.5419*** (8.97)
Beta 0.0024 (1.16) 0.0434 (0.63) 0.0019 (0.48) 0.0154 (0.59)
Growth ⫺0.0020 (⫺1.06) ⫺0.0012 (⫺0.12) ⫺0.0010 (⫺1.31) 0.0019 (1.19)
IO ⫺0.0028*** (⫺2.97) ⫺0.0034 (⫺3.40) ⫺0.0009** (⫺2.16) ⫺0.0417*** (⫺4.76)
Intercept 0.8716*** (7.83) 2.6769** (2.11) 0.1421*** (3.79) 1.4837*** (3.47)
Fixed effects Province-year Province-year Industry Industry
Fixed effects – – Year Year
R2 8.39 29.77 13.73 11.19
F 861.63*** 226.87*** 92.12*** 49.16***
Notes: ***Represents significance level at 1%; **represents significance level at 5%; *represents
significance level at 10%; this table reports fixed effect and 2SLS results examining the impact of
investment efficiency on cost of equity for the sample firms spanning 2001-20013 that meet data
requirements. Dependent variable is cost of equity measured by PEG ratio model (Easton, 2004) and
OJ model (Ohlson and Juettner-Nauroth, 2005); beneath each coefficient is the t-statistic robust to
both heteroskedasticity and serial correlation

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Table VI Investment efficiency and cost of equity
Overinvest Underinvest
Fixed effects Two-stage least square Fixed effects Two stage least square
Variable PEG OJ PEG OJ PEG OJ PEG OJ

IE 0.0003*** (5.13) 0.0019*** (3.57) 0.0003*** (2.91) 0.0034** (2.11) ⫺0.0027 (⫺0.49) ⫺0.1515 (⫺1.21) ⫺0.0013 (⫺1.14) ⫺0.0735 (⫺0.58)

VOL. 12 NO. 1 2018

SOE ⫺0.0719 (⫺1.17) ⫺0.4161 (⫺0.72) ⫺0.0045 (⫺0.59) ⫺0.2683 (⫺0.79) ⫺0.0341 (⫺0.92) ⫺0.2512 (⫺0.62) ⫺0.0623*** (⫺3.51) ⫺0.1371 (⫺0.26)
CFO 0.0534 (1.21) 1.6843* (1.79) 0.0615*** (3.73) 0.5831 (0.93) 0.0735 (1.12) 5.3519* (1.74) 0.0481*** (2.99) 0.6483 (0.96)
Size ⫺0.0537*** (⫺3.94) ⫺1.1541*** (⫺3.64) ⫺0.0421** (⫺2.26) ⫺0.0175*** (⫺2.82) ⫺0.1543*** (⫺5.67) ⫺0.1498 (⫺0.79) ⫺0.0034* (⫺1.71) ⫺0.2513* (⫺1.77)
TANG ⫺0.0317 (⫺0.85) ⫺2.1493** (⫺2.13) 0.0413** (2.17) ⫺1.4248** (⫺2.15) 0.0455* (1.78) ⫺2.4190* (⫺1.71) ⫺0.0243*** (⫺3.16) ⫺0.8551** (⫺2.15)
ROA ⫺0.0046*** (⫺3.67) ⫺0.0258 (⫺1.22) 0.0125 (1.19) ⫺0.0342 (⫺0.86) ⫺0.0343*** (⫺2.64) ⫺0.0315 (⫺1.21) 0.0045 (0.69) ⫺0.1573*** (⫺4.79)
Lev 0.0017* (1.71) ⫺0.0051 (⫺0.54) 0.0027*** (5.19) 0.0342 (1.24) 0.0216*** (4.45) ⫺0.0192* (⫺1.91) 0.0541*** (9.49) ⫺0.0317* (⫺1.89)
BM 0.0470 (0.64) 0.0927 (1.24) 0.0371*** (11.21) 0.8617*** (5.14) 0.0178*** (6.16) 2.345* (1.70) 0.0428*** (6.51) 3.3581*** (6.53)
Beta 0.0137 (1.19) 0.0452 (0.78) 0.0016 (0.32) 0.0518 (0.83) 0.0017 (1.15) 0.0751* (1.77) 0.0214* (1.71) 0.0321 (0.73)
Growth ⫺0.0021 (⫺1.22) 0.0014 (0.79) 0.0001 (0.47) 0.0035 (1.16) ⫺0.0010 (⫺0.83) ⫺0.0185 (⫺1.12) ⫺0.0022** (⫺2.09) ⫺0.0184 (⫺0.81)
IO ⫺0.0015** (⫺2.19) ⫺0.0048 (⫺2.11) ⫺0.0031 (⫺0.95) ⫺0.0317*** (⫺3.69) ⫺0.0013** (⫺2.10) 0.0059*** (2.79) ⫺0.0032** (⫺2.24) ⫺0.0713*** (⫺4.54)
Intercept 0.6813*** (3.57) 13.0118*** (2.99) 0.1646*** (3.85) 3.1482** (2.13) 1.1230*** (6.21) 5.2531 (0.73) 0.0931** (2.34) 5.1347*** (3.35)
Fixed effects Province-year Province-year Industry Industry Province-year Province-year Industry Industry
Fixed effects – – Year Year – – Year Year
R2 6.98 4.61 12.71 11.86 7.90 29.68 14.55 22.56
F 219.69*** 144.49*** 48.95*** 31.17*** 24.61*** 123.18*** 55.43*** 36.35***
Notes: ***Represents significance level at 1%; **represents significance level at 5%; *represents significance level at 10%; this table reports fixed effect and 2SLS results examining
the impact of investment efficiency on cost of equity for the sample firms spanning 2001-20013 that meet data requirements. Dependent variable is cost of equity measured by
PEG ratio model (Easton, 2004) and OJ model (Ohlson and Juettner-Nauroth, 2005); beneath each coefficient is the t-statistic robust to both heteroskedasticity and serial correlation
 unlike NSOEs, IE is not significantly associated with lower CoE for SOEs. The results for
overinvestment and underinvestment are also similar as previously reported in Tables III
and IV where in case of overinvestment there is negative association between IE and CoE
and underinvestment is not significant at conventional level.
Furthermore, the control variables are also consistent as reported previously. To mitigate the
measurement problem, we also take average of both measures of IE, and (un-tabulated) results
confirm previously reported results. These results are robust when financial risk factors like
leverage and growth rate are excluded. The results of this study also remain same when the
sample is divided into SOEs and NSOEs to test second hypothesis.

6. Conclusion
This study analyzes the effect of IE on CoE capital. We find robust evidence that IE in negatively
associated with CoE. These results suggest that investors value IE as a mechanism that signals the
managerial behavior. The results also show that investment inefficiency is considered a more
pronounced issue in NSOEs, as CoE for inefficient NSOEs is higher. However, inefficiency is not
significantly associated with CoE in case of SOEs, which can be attributed to lower risk associated
with SOEs. These results are supported by preceding studies like Chen et al. (2011) who argued
that SOEs face lower bankruptcy risk because of support from government, and investors expect
financial support from government in case of financial trouble, as the government acts as “deep
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pocket” for SOEs. Our study also documents that overinvestment is considered a more severe issue
by investors, as investment will reduce future operating performance (Li, 2004), which results in
higher return demanded from investors.
We contribute to the IE literature by documenting that IE is a relevant factor to control the
managerial behavior. These results also provide an empirical evidence for the argument that
the real decisions like investment play a crucial role in reducing the cost of capital as proposed
by Lambert et al. (2007). These findings have some significant policy implications for investors,
creditors, researchers and society as well. Our study suggests that market participants give
importance to efficient investment, so investment professionals and analyst would give
importance to this factor while making their assessments regarding firms. Corporate sector
would realize the benefits of efficient investment and the price it would have to pay for inefficient
investment which may result in firms pursuing optimal investment levels. This study also holds
its value for the private firms aspiring to go public, as such firms would realize the costs associated
with inefficient investments and benefits they would reap from IE and it could invariably result in
better investment decisions in private firms as well. These optimal investment decisions would lead
toward efficient utilization of scare resources which can potentially benefit the society as whole.
Our study has some limitations as well. First, as in other studies on CoE and IE, the proxies
used here are subjected to measurement errors along with the fact that each proxy has its
own certain advantages and disadvantages. Second, this study does not differentiate
SOEs on the basis of ownership by central government and ownership by local
government. However, such firms may be perceived differently by the investors. Third, the
role of IE may differ according to the institutional environment. More developed market,
higher level of investor protection and higher level of creditor protection may lead to
different results. So, the results may not be generalized to other contexts. However, these
limitations also offer an opportunity to extend our research. In this sense, the effect of IE on
cost of capital can be studied in different framework and legal settings. These limitations
may offer an interesting opportunity for future research.

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Corresponding author
Muhammad Ansar Majeed can be contacted at: ansarmajeed5@gmail.com

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