Free cash flow, over-investment and corporate governance in China

Abstract

We investigate whether and how free cash flow and corporate governance characteristics affect firm level investments, using a sample of 865 Chinese listed firms. Consistent with the agency cost explanation, we find that firms' over-investment is more sensitive to current free cash flow and that over-investment is more pronounced in firms with positive free cash flows. Also, we find that certain corporate governance characteristics are significantly related to firm level investment. Further, we divide the full sample into two subsamples: over-investment firms and under-investment firms. For over-investment firms, our evidence indicates that higher state-ownership concentration boosts over-investment, while firms with higher proportion of tradable shares, larger board size of supervisors or higher leverage mitigate over-investment. For under-investment firms, our evidence shows that firms with higher state-ownership concentration, larger board size of directors or higher proportion of outside directors are associated with severer under-investment, while firms with higher leverage or higher proportion of tradable shares alleviate under-investment.