The market reaction to capital expenditure announcements

Abstract

The theory of the firm regards investment decisions as one of the fundamental and central activities of the modern firm. The normative aspect of the theory claims that firm resources should be allocated to value-creating positive NPV projects. The current literature has mostly focused on managerial behaviour in advanced economies and has reported evidence that shareholder wealth is positively affected when firms make capital spending decisions (Woolridge (1988) and McConnell and Muscarella (1985)). Recent work by La Porta, Lopez-de-Silanes, Shleifer and Vishney (2002) and Shleifer and Vishney (1997) document that corporate environments in emerging economies differ quite significantly from those in advanced economies. Claessens, Djankov, and Lang (2000) also report that many emerging markets are dominated by companies which have high ownership / asset concentration, and which are large in size and function as conglomerates. Berger and Ofek (1995) suggest that greater agency costs are incurred when firms engage in conglomeration. Accepting negative net present value projects and misallocating resources toward inefficient divisions are a manifestation of these agency costs, which negatively impact firm value (Jensen and Meckling (1976) and Mansi and Reeb (2002)). Insights from the published literature imply that these problems are likely to be more severe for firms that are operating in countries with majority share ownership and asset concentration, suggesting that the nature of managerial decisions made in emerging economies require empirical examination. This paper has three aims. The first is to conduct an event study of capital investment announcements to measure whether the investment decisions of South African companies are consistent with the goal of maximizing shareholder wealth. The second aim is motivated by a unique attribute of the South African economy. In addition to being classified as an emerging market, the South African economy is also dominated by large groups of holding companies, which are highly diversified (Castle and Kantor, 2000). Many of these conglomerates are managed by founding families and their descendents (Kantor, 2001). It has been reported that many local companies stray from their core activities into diversifications that lack any business logic (Gerson, 1992). In light of these important characteristics of the South African business structure, this paper also examines whether the wealth effects of capital expenditure announcements differ between diversified firms and focused firms. The third aim of this paper is to investigate whether the market reaction to capital expenditure announcements varies with the category of projects being announced, as well as other characteristics of the investment and the company making the announcement.