ACADEMIA ECONOMIC PAPERS
31 : 3 (September 2003), 301–331
When Will the Controlling Shareholder
Expropriate Investors? Cash Flow Right and
Investment Opportunity Perspectives
Konan Chan
Department of Finance
National Taiwan University
Shing-yang Hu
Department of Finance
National Taiwan University
Yan-zhi Wang ∗
Department of Finance
National Taiwan University
Keywords: Corporate governance, Investment opportunity
JEL classification: G34
∗
Correspondence: Yan-zhi Wang, Ph. D. Student of the Department of Finance, National Taiwan University, Taipei 106, Taiwan. Tel: (02) 2368-5846; Fax: (02) 2366-0764; E-mail: D89723007@ms89.ntu.
edu.tw. We acknowledge Yeh-ning Chen and two anonymous referees for their insightful comments to
this paper.
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ABSTRACT
In this paper, we examine how investment opportunities influence the impact of cash
flow rights on a firm value. Previous papers argue that cash flow rights serve as the
incentives of a controlling shareholder to expropriate outside investors, and document that
cash flow rights increase firm value. We find that when firms have opportunities to invest
in positive NPV projects, cash flow rights do not increase firm value. However, when there
exist investment opportunities and cash flow rights are relatively low, cash flow rights still
increase firm value. Only when cash flow rights are relatively high, will firm value not be
affected by cash flow rights, given the potential investment gains. Hence, in the presence
of profitable projects, whether cash flow rights increase firm value depends on the level of
cash flow rights. These results suggest a non-linear relationship between cash flow right of
the controlling shareholder and firm valuation.
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1. INTRODUCTION
Corporate governance is an important issue in corporate finance, and modern corporate governance theories focus on the effect of cash flow rights held by the ultimate
controlling shareholder.1 Past studies argue that the cash flow rights reflect incentives
of the controlling shareholders to expropriate outside investors. Large cash flow rights
reduce incentives of the controlling shareholder to transfer firm resources to private
benefits. For example, La Porta et al. (2002) and Claessens et al. (2002) find that there
exists a cash flow right effect where firm value are positively associated with cash flow
rights.
The literature presents two important factors which determine how cash flow
rights affect firm value. One is investor protection mechanisms, and the other is investment opportunity. Investor protection mechanisms were first documented by La
Porta et al. (2002), which follows their path-breaking papers about the impact of investor protection on financial development (La Porta et al. (1999, 2000)). They argue
that when laws and government policy are advantageous to outside investors and well
enforced, the controlling shareholder has huge costs to expropriate firm resources, and
the cash flow right is not important to firm value. As a result, the cash flow right effect
decreases with the level of law protection to investors. This result is further supported
in recent studies (e.g., Volpin (2002), Lemmon and Lins (2003), and Nenova (2003)).
As for the other factor, Lemmon and Lins (2003) argue that when there exist
investment opportunities, cash flow rights do not increase firm value. Treating the
Asian financial crisis as a negative impact on investment opportunities, they examine
the relationship between stock returns and cash flow rights during and before the crisis.
They find that cash flow rights did not affect stock returns before the crisis, but did have
a strong positive impact during the crisis for East Asian countries.
However, how do investment opportunities influence the positive relationship between cash flow rights and firm value in general? Although Lemmon and Lins (2003)
argue that this positive relationship will vanish when there exist profitable projects, it
is not evident whether this phenomenon exists outside of the financial crisis. Moreover, whether the impact of investment opportunities on this positive relationship is
1
Shleifer and Vishny (1997) survey the literature on corporate governance. Since then researchers
have focused on the issue of the effect of cash flow rights (see a further survey of Becht et al. (2002)).
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related to the cash flow right level is unclear. Thus, the purpose of this paper is to
give a thorough examination of the relationship among firm value, cash flow rights
and investment opportunities.
In this paper, we argue that as investment opportunities exist, cash flow rights do
not increase firm value. When investing resources into positive NPV projects rather
than transferring resources, the controlling shareholder has chances to increase future
wealth in proportion to future cash flows. Thus, the controlling shareholder will wait
for future benefits and expropriate less now. Moreover, the investment opportunity can
be treated as an opportunity cost of expropriation. When an investment opportunity
is present, the cash flow right does not matter so much because the controlling shareholder has more opportunity costs in expropriation. Therefore, the positive relationship
between cash flow rights and firm value exists only when investment opportunities are
not available.
In addition, we propose that when firms have positive NPV projects and cash flow
rights are relatively low, cash flow rights still increase firm value. This argument is different from Lemmon and Lins (2003). In particular, given the presence of investment
opportunities, if a controlling shareholder has tiny cash flow ownership, she will get
nearly no profits from future investment gains due to her small cash flow right.2 As a
result, she tends to expropriate rather than invest resources into positive NPV projects
even when there exist investment opportunities. On the contrary, if a controlling shareholder has more cash flow ownership, she will wait for the future investment gains,
and expropriate less now. Accordingly, under the presence of investment opportunities, whether cash flow rights raise firm value is dependent on the level of cash flow
rights.
In this paper, we employ the long-run industry sales growth as a measure of investment opportunity. This measure is designed to assess how investment opportunities alter the positive relationship between cash flow rights and firm value over time.
In particular, Lemmon and Lins (2003) emphasize that there exists a severe endogenous problem between the firm’s investment decisions and firm value. A number of
past studies also document that the firm value and investment opportunity are jointly
determined (e.g., McConnell and Muscarella (1985), Fazzari and Petersen (1993), and
Cho (1998)). In our paper, since a single firm’s decision will hardly affect the industry equilibrium in a competitive market, industry characteristics like concentration and
2
Theoretically, a controlling shareholder can control a firm with zero cash flow ownership through
pyramid ownership structure and cross holding (Bebchuk et al. (1999)).
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industry growth will not be changed by a firm. Therefore, the industry sales growth is
almost an exogenous variable to individual firms, and can avoid the endogeneity problem mentioned in Lemmon and Lins (2003). We choose the third quartile as the critical
value to divide firms into high and low growth industries. This methodology makes
sure that investment opportunity shocks are significant enough. When the investment
opportunity shock is large, the impacts of investment gains on reducing incentives to
expropriate will be significant as well. In addition, we use capital expenditure and
R&D expenditure as alternative measures of investment opportunities to check the robustness of our results.
Our empirical results are consistent with the notion that cash flow rights are independent of firm value with the presence of investment opportunities. However, when
firms have positive NPV projects and cash flow rights are low, cash flow rights still
increase firm value. For example, for industries with high sales growth, the Tobin’s q
is not associated with cash flow rights. On the contrary, for industries with low sales
growth, the Tobin’s q increases in cash flow rights. Besides, for industries with high
sales growth, the positive relationship between Tobin’s q and cash flow rights exists
when cash flow rights are relatively low, but disappears when cash flow rights are relatively high. These results suggest a non-linear relationship between the cash flow right
and firm value.
This paper contributes to the corporate governance literature in two ways. First,
we extend La Porta et al. (2002) and Lemmon and Lins (2003) to give an in-depth
examination of the relationship among cash flow rights, investment opportunities and
firm value. By our methodology, we can investigate the impact of investment opportunities on the cash flow right effect in cross-sectional analyses. Second, our research
relates to the literature examining the impact of corporate ownership structure on firm
valuation.3 Previous studies suggest a non-linear relationship between ownership and
firm valuation. We also find a non-linear relationship between the cash flow right and
firm value depending on investment opportunities. To our knowledge, this is the first
study to document this non-linear relationship.
The paper is organized as follows. Section 1 is the introduction. Section 2
3
Early studies focus on the non-linear relationship between firm value and ownership, rather than the
cash flow right by the ultimate controlling shareholder. The ownership in these papers is usually defined
as the shareholding of the five largest shareholders, or by management board (e.g., Demsetz and Lehn
(1985), Morck et al. (1988), McConnell and Servaes (1990), Cho (1998), and Demsetz and Villalonga
(2001)). Instead, subsequent papers after Shleifer and Vishny (1997) examine the relationship between
cash flow rights and firm performance (e.g., La Porta et al. (2002), Claessens et al. (2002), and Lemmon
and Lins (2003)).
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presents a simple model. Section 3 describes the data. Section 4 presents the empirical
findings. Section 5 shows the industry effect. Section 6 discusses the robustness of
results and Section 7 concludes.
2. A SIMPLE MODEL
In this section, we introduce a simple model, which is similar to Johnson et al. (2000)
and La Porta et al. (2002). The hypothesis settings in our model follow assumptions of
these two papers. Although we follow some of their assumptions, it is emphasized that
we present a non-linear relationship between cash flow rights and firm value, which
has never been documented in the literature. Here we describe our main hypotheses as
follows.
We assume that the unique controlling shareholder is an entrepreneur who has
the cash flow right α of the firm, and α is exogenously determined. The firm has the
amount of cash I, which is invested in a project with the gross rate of return R, and
the firm has no cost in the investment. Besides, as a private benefit of controlling the
firm, the entrepreneur can divert a share of the firm resources to herself. The diversion
can take the form of salary, transfer pricing, or subsidized personal loans, etc. We
further assume s ≥ 0 to avoid the problem of negative expropriation. For the case
of negative s, it means that the entrepreneur will invest in the project with her own
money due to good timing. If she would like to finance the project with additional
money, then the firm needs to issue SEO. However, the entrepreneur could not buy all
of the shares newly issued, since the other shareholders also have the right to take the
offering. Thus, it is less meaningful and more complicated for negative s.
Moreover, when the controlling shareholder diverts share s from firm resources,
she faces a cost function c(s),
c(s) =
s2
,
2
(1)
where c is the share of resources that a controlling shareholder wastes when s is diverted.4 We assume the cost c to be borne by the entrepreneur rather than by all the
4
La Porta et al. (2002) considers c as a function of s and k, which is the level of law protection.
However, we do not discuss law protection in our paper and omit it.
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shareholders.
Using these assumptions, the entrepreneur maximizes:
α(1 − s)RI + sI − c(s)I,
(2)
where the first term is the gain from investments after diverting, and the remaining
terms are the benefit from expropriation. Notice that the entrepreneur only can divert
the original resources of the firm, so R is absent in the last two terms. Since the
solution for optimal s is independent of I, the objective function becomes:
α(1 − s)R + s −
s2
.
2
(3)
The first order condition is:
s∗ = 1 − αR
=0
if
if
αR < 1
αR ≥ 1.
(4)
By optimization of s to the entrepreneur, called s∗ , an entrepreneur can maximize the
utility. Besides, the firm value is defined by (1 − s∗ )RI ≡ q, so firm value is nondecreasing in α from equation (4). We call the positive relationship between cash flow
rights and firm value, the cash flow right effect. From equation (4), we find there exists
a non-linear relation, and it leads a non-linear relationship between cash flow rights
and firm value. Such a non-linear relation is due to the assumption of non-negative s,
which has been mentioned above.
Based on the equation (4), s∗ would be larger than zero if and only if R < 1/α.
This means that if R is lower than 1/α, the controlling shareholder will expropriate the
firm value. Since future investment opportunities can be treated as opportunity costs
of expropriation to the controlling shareholder, when opportunity costs are higher, the
controlling shareholder will not divert firm resources and profits. Johnson et al. (2000)
also mention this pattern in their model, and suggest that the controlling shareholder
will not expropriate firm value if αR ≥ 1.5 Furthermore, when firms have gainful
5
Although they also argue the same pattern, we discuss different phenomena. They focus on how the
investor protection mechanism affects the firm value with investment opportunity shocks, while we focus
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projects in which to invest, the cash flow right does not matter so much. Hence, the
positive relationship between cash flow rights and firm value will vanish due to gains
from investments. In contrast, the firm is increasing with the cash flow right, ie., the
cash flow right effect is present. Therefore, we have the following testing hypothesis.
H1 For firms with enough investment opportunity shocks, cash flow rights of the
controlling shareholder do not influence the firm value in general.
In this paper, we also argue that there is a non-linear relationship between cash
flow rights and firm value. When α is greater than 1/R, the controlling shareholder
will not divert the firm value from equation (4). Given R greater than one, the entrepreneur need not own 100% cash flow right to prevent expropriation. Thus, given
investment opportunities, we separate firms into two groups, one with larger cash flow
rights (α ≥ 1/R), the other with lower cash flow right (α < 1/R). For the first
group, investment opportunities eliminate the cash flow right effect. Firm value are
independent of cash flow rights if firms have positive NPV projects. However, for the
second group, the impact from investment opportunities is so small that firm value still
increase with cash flow rights. Thus, whether investment opportunities influence the
positive relationship between cash flow rights and firm value depends on the level of
cash flow rights. The theoretical model is presented in the following figures.
For Figures 1 and 2, we draw the relationship between firm value and expropriation given investment opportunities in a bold line (the line with R > 1). The other
notations are the same as the model. When the firm has profitable projects, incentives of the controlling shareholder to expropriate become lower. For the cash flow
right higher than 1/R, the impact of cash flow rights on firm value is eliminated by
investment opportunities, so the bold line with high α is horizontal. On the other hand,
when cash flow rights are low, the cash flow right still positively influences the firm
value. Thus, the slope is positive in the left-hand side of the bold line in Figure 2. This
implies that the firm value has a non-linear relationship with the cash flow right.
Therefore, we propose our second testing hypothesis.
H2 For firms with investment opportunities but low (high) cash flow rights, firm
value are (not) increasing along with cash flow rights.
on the impact of investment opportunities on the cash flow right effect.
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s
R=1
R>1
1/R
low Å
1
Å
high Å
Figure 1 Relationship between α and s
q
R=1
R>1
1
1/R
low Å
high Å
Figure 2 Relationship between α and q
309
Å
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3. DATA
Our initial sample contains listed Taiwanese companies during the period of 1987 to
2000 from the Taiwan Economic Journal (TEJ) database. We obtained the information
of family groups from China Credit Information Service from 1987 to 1998 in order
to calculate the cross-holding ownership in each of the family groups. For firms not
owned by family groups, we calculate the cash flow right and voting right of the ultimate controlling shareholder based on La Porta et al. (1999, 2000 and 2002). Since
we don’t have family group data for 1999 and 2000, we collect only non-family firms
in these two years. Moreover, we exclude financial firms, observations within one year
of IPO, and sample firms without ownership information.6 We also follow La Porta et
al. (2002) to require that the controlling shareholder who has the largest shareholding
through pyramid or cross-ownership controls have at least 10% of the voting rights. We
delete firms with dispersed ownership structure because even the largest shareholder
in these firms may have only limited ability to expropriate. Finally, in order to reduce
the impact of outliers, we delete the top and bottom 2% observations based on Tobin’s
q, cash flow rights and R&D expenditure ratios. As a result, our final sample contains
918 firm-year observations for 178 firms.
The variables we use in the paper are defined as follows:
Tobin’s q = the book value of debt plus the market value of common equity divided
by the book value of assets.
CF right = The cash flow right held by the controlling shareholder.
R&D expenditure = R&D and advertisement expenditures divided by annual sales minus the industry median.
Sales growth = the geometric average of sales growth over the past three years.
We follow previous literature to compute the cash flow right and voting right
through pyramid or cross-holding ownership (e.g., Bebchuk (1999), La Porta et al.
6
The reason for excluding data within one year of IPO is that the firm value of IPO tends to be high,
and the ownership tends to be concentrated. Thus, we delete these observations to ensure that results are
not due to the features of IPOs.
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(year 1995)
Ritek Corp
CDIB
10.54%
Cho-kai VC
4.37%
Cho-ou VC
7.03%
China VC
3.51%
Cho-ou VC
China VC
62.5%
37.13%
Note: CDIB is China Development Industrial Bank; VC means venture capital company.
Figure 3 Ownership Structure of Ritek Corp
(1999, 2000, 2002)). We first identify the ultimate controlling shareholder of a firm,
and then compute his/her cash flow right and voting right.7 For example, we illustrate
the ownership structure of Ritek Corp in Figure 3. In this case, we have a two-tier
pyramid ownership structure, and the cash flow right and the voting right are 13.62%
(0.625 × 10.54% + 7.03%) and 17.57% (10.54% + 7.03%), respectively, for the ultimate controlling shareholder, Cho-ou VC. As for the calculation of the cash flow right
and voting right, we have more detailed information in the Appendix.
In this paper, we use the portfolio test to check our hypotheses. We categorize
the sample based on cash flow rights and industry sales growth, respectively. First,
high and low cash flow right groups are separated by the median cash flow right of
the controlling shareholder. Second, high and low industry sales growth groups are
classified by the 3rd quartile of the long-run industry sales growth. Long-run industry
sales growth is the geometric average of annual industry sales growth rates during the
past three years (called industry sales growth hereafter). Annual industry sales growth
is the simple average of individual firms’ sales growth in each industry. Over our
sample period, we have 335 industry-year observations for three-year industry sales
growth, and the third quartile of these industry-year observations is 17.3%. We use the
17.3% to separate the sample into high and low growth groups. If an industry sales
growth rate is higher than 17.3%, all firms in the industry in that year will be classified
in the high growth group.8
7
The controlling shareholder can be a family, state, financial institution or a corporation.
8
For example, the electronic industry sales growth of 31.4% in the year 2000 is computed based on
the following steps. First, we obtain sales growth rates for individual firms (e.g., TSMC’s annual sales
growth rates are 14.3%, 45.6% and 127.3% from 1998 to 2000; UMC’s annual sales growth rates are
−26.5%, 58.1% and 260.5% from 1998 to 2000). Second, we compute the simple average of annual
sales growth for three years, which are 31.8%, 27.2% and 35.5% during 1998 to 2000, respectively. Then
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One may have two questions regarding our industry sales growth grouping. The
first one is why we use past three-year industry sales growth as a proxy for future
growth. We assume past sales growth is a reasonable proxy for future growth because
using industry level characteristic avoids the problem of endogeneity. In particular,
Lemmon and Lins (2003) emphasize that there exists a severe endogenous problem
between the firm’s investment decisions and firm value. A number of past studies also
document that the firm value and investment opportunity are jointly determined (e.g.,
McConnell and Muscarella (1985), Fazzari and Petersen (1993), and Cho (1998)). In
our opinion, since a single firm’s decision will hardly affect the industry equilibrium in
a competitive market, industry characteristics like concentration and industry growth
will not be changed by a firm. Therefore, the industry sales growth is almost an exogenous variable to individual firms, and its use as proxy can avoid the endogeneity
problem mentioned in Lemmon and Lins (2003).
The other question is why we choose the 3rd quartile to be the critical value in
the proxy of the investment opportunity. In the case of Lemmon and Lins (2003), they
select the Asian financial crisis as an investment opportunity shock. Since the shock
is so large that controlling shareholders lose their incentive to run the business, firm
value would increase with cash flow rights due to the cash flow right effect. Therefore,
we choose the 3rd quartile of the investment opportunity proxy in classifying groups to
make sure that investment opportunity shocks are large enough to obtain meaningful
and significant results.
4. EMPIRICAL RESULTS
Our primary valuation measure is the Tobin’s q. Panel A in Table 1 presents the summary statistics. Panel B shows the difference between groups.
In panel B of Table 1, we find that Tobin’s q for high and low cash flow rights are
1.947 and 1.772, respectively. The difference is 0.175, which is significant. This result
supports the cash flow right effect of La Porta et al. (2002), where cash flow rights
increase firm value.
we get the (long-run) industry sales growth of 31.4% ( 3 (1 + 31.8%)(1 + 27.2%)(1 + 35.5%) − 1). All
firms in the electronics industry in year the 2000 are classified as high growth since 31.4% is greater than
17.3%.
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Table 1
Summary Statistics
Panel A: Summary statistics
Mean
S.D.
Min.
Max. Median
Q1
Q3
Skew Kurtosis
Tobin’s q
1.8595 0.9407
0.6699 7.7748 1.6392
1.2402 2.1874 2.1669 6.9201
CF right
0.1942 0.1085
0.0288 0.5100 0.1719
0.1146 0.2478 1.0506 0.7167
R&D exp.
0.0029 0.0130 −0.0223 0.0763 0.0000 −0.0031 0.0051 2.0654 6.6292
Sales growth 0.0997 0.2647 −0.5005 3.6941 0.0545 −0.0112 0.1335 5.2421 49.6485
Panel B: Tobin’s q by grouping
CF right
Industry sales growth
High
Low
Diff.
1.947
1.772
0.175**
(1.05)
(0.81)
t = 3.06
N = 459
N = 459
2.039
1.810
0.237**
(0.99)
(0.92)
t = 3.22
N = 200
N = 718
Note: Panel A in the Table shows the summary statistics. Panel B presents the average Tobin’s q by cash flow rights and industry sales growth. Tobin’s q is the book value of
debt plus the market value of common equity divided by the book value of assets. CF
right is the cash flow right held by the controlling shareholder. R&D expenditure is
the R&D and advertisement expenditures divided by annual sales minus the industry
median. Sales growth is the geometric average of the past three years’ sales growth.
Industry sales growth is the geometric average of annual industry sales growth for
the past three years. Annual industry sales growth is the simple average of individual
firms’ sales growth in each industry. CF right groups are divided by the median CF
right. Industry sales groups are divided by the 75th percentile of industry-year observations. Numbers in the parentheses are standard deviations, and N is the number of
observations in each cell. * and ** represent the significance levels of 5% and 1%,
respectively, based on a two-tailed t-test.
The difference of Tobin’s q between high and low industry sales growth groups
is 0.237, which is significant. Although we find a positive relationship here, there are
two ways of investment opportunities can increase firm value. One is the direct effect
of investment opportunities creating profits from projects. The other is the indirect
effect in which investment opportunities eliminate expropriation incentives of the controlling shareholder (Johnson et al., 2000). Therefore, we need the following empirical
analyses for the indirect effect.
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4.1 Impact of investment opportunities on the cash flow right effect
Our first hypothesis is that for firms with enough investment opportunities, cash flow
rights of the controlling shareholder do not influence firm value in general. We divide observations by a two-way independent sort for cash flow rights and investment
opportunities, and present the results in Table 2.
In panel A of Table 2, when the industry sales growth is higher then the 3rd quartile, the difference across high and low cash flow rights is only 0.06, which is not significant. In contrast, as the industry sales growth is lower, the difference between high
and low cash flow rights is 0.192, which is significantly different from zero. Therefore,
the cash flow right of the controlling shareholder positively influences the firm value if
investment opportunities are absent. In addition, the cash flow rights do not affect firm
value in the presence of investment opportunities.9
Moreover, our paper uses regression to check our findings by controlling time
effect. Because our samples are from 1987 to 2000, we need to control time effects to
ensure that the findings in Table 2 are reliable. Pooling 918 observations, we regress
the Tobin’s q on the cash flow right with year random effect. The regression results are
presented in Table 3.
First, models I and II in Table 3 show the simple analyses similar to La Porta
et al. (2002), which present a positive relationship between cash flow rights and firm
value. Second, model III and IV regress the Tobin’s q on the cash flow right in high and
low industry sales growth groups, respectively. As a result, the coefficient of the cash
flow right in model III is significant, but it is insignificant in model IV. This finding
suggests that investment opportunities eliminate the effect of cash flow rights on firm
value. When a firm has profitable projects in which to invest, whether cash flow rights
are high or low is not vital. The firm value will be independent of the cash flow right.
Therefore, the coefficient of cash flow rights is insignificant in model IV.10
9
We also test the hypothesis by comparing the first and the last quartile, since the use of the symmetric
sub-sample can avoid estimation biases. Consequently, the differences between high and low cash flow
rights are 0.06 (t = 0.42) and 0.378 (t = 2.18) for high and low industry sales growth, respectively.
This result still supports our first hypothesis. We thank one referee for this insightful suggestion.
10
Although not reported in the paper, we did try various firm characteristics, such as the firm size and
R&D expenditure as control variables in the regression. Coefficients of cash flow rights with and without
industrial sales growths are 0.7255 (t = 1.16) and 0.9845 (t = 3.98), respectively. Accordingly, our
main result still holds in this robustness check.
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Table 2
Tobin’s q Ranked by Cash Flow Rights and Investment Opportunities
Industry sales growth
High
Low
High CF right
Low CF right
Diff.
2.065
2.005
0.060
(1.02)
(0.96)
t = 0.42
N = 113
N = 87
1.909
1.717
(1.06)
(0.76)
N = 346
N = 372
0.192**
t = 2.77
Note: This Table shows the Tobin’s q under a two-way independent sort of cash flow rights
and investment opportunities. The investment opportunity is measured by industry
sales growth in this table. Numbers in the parentheses are standard deviations, and N
is the number of observations in each cell. * and ** represent the significance levels
of 5% and 1%, respectively, based on a two-tailed t-test.
Table 3
Random Effect Regressions of Tobin’s q
Model I
Intercept
1.872**
(9.73)
N
1.841**
(9.47)
0.189
(1.61)
Sales growth
CF right
Model II
0.832**
(3.38)
918
0.847**
(3.44)
918
Model IIIlow industry sales
growth group
Model IVhigh industry sales
growth group
1.856
(9.06)
1.874
(10.03)
−0.598**
(−2.87)
0.317
(1.93)
1.088**
(4.17)
0.684
(1.12)
718
200
Note: This Table presents random effect regressions. The dependent variable is Tobin’s q.
Models I and II use the full sample to run regressions, where CF right is cash flow right
held by the controlling shareholder, and sales growth is the geometric average of threeyear individual sales growth. Model III uses the low industry growth sub-sample, and
model IV uses the high industry growth sub-sample. The correlation coefficient of CF
right and sales growth is −0.025. Parameter estimations are based on regressions with
year random effects. Numbers in the parentheses are t-statistics. * and ** represent
the significance levels of 5% and 1%, respectively, based on a two-tailed t-test.
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Rather than year random effect regressions, we also regress Tobin’s q on the cash
flow right with ordinary least square method (OLS). The empirical findings are the
same as random effect regressions, and we do not present them here.
As we mention above, the selection of the 3rd quartile of industry sales growth
makes the investment opportunity shock large enough. We also employ different cutoff points as the standard of the investment opportunity but do not present these in the
paper. In addition to the 75% cut-off point, the median, 60%, 70%, 80% and 90%
critical values are employed. As a result, the impact of investment opportunities is
insignificant until the cut-off point of 70% for regression results. However, portfolio
tests for all classifications support our first hypothesis. Therefore, we believe that the
investment opportunity shock is large enough when the industry sales growth is greater
than the third quartile.
Our findings are similar to those of Lemmon and Lins (2003). However, we employ industry sales growth as investment opportunities, which can be applied to crosssectional analyses. Hence, the methodology in our paper does not rely on particular
events or timing, and is more general, too.
4.2 Precise relationship among variables
Our second hypothesis is that for firms with investment opportunities but low (high)
cash flow rights, firm value are (not) increasing along with cash flow rights. In the other
words, the impact of investment opportunities on the cash flow right effect depends on
the level of cash flow rights. Table 4 presents the Tobin’s q of firms in the high industry
sales growth group. In order to analyze this non-linear relationship, we divide the full
sample into low CF right, middle CF right and high CF right groups. Low, middle and
high CF right groups are divided by the lowest, the middle, and the highest cash flow
right tercile, respectively. As a result, we find that the average Tobin’s q in the low and
middle CF right groups are 1.852 and 2.264. The difference across these two levels is
0.412, which is significant differently from zero. In contrast, the average Tobin’s q in
the high CF right groups is 2.025, and the difference between the middle and high CF
right groups is insignificant. Therefore, given high industry sales growth but low cash
flow rights of the controlling shareholder, cash flow rights still have a positive effect on
firm value. On the contrary, when firms have high industry sales growth and relatively
high cash flow rights, cash flow rights are independent of firm value. This suggests
that whether investment opportunities alter the positive relationship between cash flow
rights and firm value depends on the level of cash flow rights.
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Table 4
Tobin’s q Ranked by Cash Flow Rights for High Industry Sales Growth
Low CF right
Middle CF right
Diff.
1.852
2.264
−0.412*
(0.89)
(1.02)
t = −2.27
N = 58
N = 53
Middle CF right
High CF right
Diff.
2.264
2.025
0.239
(1.02)
(1.03)
t = 1.34
N = 53
N = 89
Note: This Table shows Tobin’s q sorted by cash flow rights for the high industry sales
growth group. Low, middle and high CF right are the lowest, the middle, and the
highest cash flow right tercile respectively. Numbers in the parentheses are standard
deviations, and N is the number of observations in each cell. * and ** represent the
significance levels of 5% and 1%, respectively, based on a two-tailed t-test.
Furthermore, the empirical result above presents a non-linear relationship between cash flow rights and firm valuation. When the cash flow right is relatively low,
there is a significant effect of the cash flow right on Tobin’s q. When the cash flow
right is relatively high, there is no difference between different levels of cash flow
rights. Consequently, there is a non-linear relationship here, as shown in Figure 2.
Because the sample in this paper contains a time trend from 1987 to 2000, we
test the second hypothesis with year random effect regression. In the models, we
regress the Tobin’s q on cash flow rights, and the empirical results are presented in
Table 5. Models I and II both use observations in the high industry sales growth group.
Model I contains a sample from low CF right and middle CF right groups, and model
II contains a sample with middle and high CF right groups. Corresponding to the
grouping in Table 4, the sample of model I comes from the first row, and the sample
of model II comes from the second row in panel A of Table 5. Thus, model I contains
111 observations with relatively low cash flow rights and high industry sales growth.
Model II has 142 observations with relatively high cash flow rights and high industry
sales growth.
As a result, the coefficient of the cash flow right in model I is 5.245, which is
significant. In contrast, the coefficient of the cash flow right in model II is statistically
zero. Therefore, this result also confirms our testing hypothesis. When cash flow rights
are relatively low, cash flow rights still increase the firm value even in the presence of
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Table 5
Regressions of Tobin’s q for High Industry Sales Growth
Model I-
Model II-
low and middle CF right groups
middle, high CF right groups
Intercept
1.379**
(5.48)
2.403**
(8.23)
Sales growth
0.090
(0.53)
0.271
(1.46)
CF right
5.245**
(2.84)
N
−0.848
(−0.96)
111
142
Note: Only firms with high sales growth are included in this Table. Model I contains observations in the low and middle CF right groups. Model II has observations in the
middle and high CF right groups. Parameter estimations are based on regressions with
the year random effect. Numbers in the parentheses are t-statistics. * and ** represent
the significance levels of 5% and 1%, respectively, based on a two-tailed t-test.
investment opportunities. On the contrary, this pattern will disappear if cash flow rights
are relatively high. Furthermore, this finding shows strong evidence on the non-linear
relationship between cash flow rights and firm valuation. Though not reported here,
we also run OLS regressions by model I and II, and the results are similar.
5. INDUSTRY EFFECTS ON THE TESTING HYPOTHESES
In previous section, we document the impact of investment opportunity on the positive
cash flow right effect. The impact will decrease the incentive of the controlling shareholder to expropriate the firm value, and reduce the effect of cash flow rights on firm
value. Moreover, the magnitude of the impact also depends on the level of the cash
flow right. When the cash flow right is tiny, the impact of the investment opportunity
will be absent.
However, we cannot rule out the possibility that the industry effect could explain
why there exists a positive relationship between cash flow rights and firm value. It is
very likely that industries have higher cash flow rights as well as higher firm value,
thus we can observe the positive relationship. Besides, it is possible that our results
are a consequence of the industry effect. The firm might have a strong relationship
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between cash flow rights and firm value just because the industry declines, and have
an insignificant relationship when the industry grows. This suggests that the impact
of investment opportunities on the cash flow right effect is due to the industry effect,
rather than expropriation incentives. In this section, we address these concerns by the
following three tests.11
First, we list the Tobin’s q and the cash flow right for each industry and present
the result in Table 6. In the table, we could not find an obvious relationship between
cash flow rights and firm value. For example, the electronics industry in Taiwan has a
high Tobin’s q (2.297). However, the cash flow right is not high (0.182), and is even
less than the mean cash flow right of the sample (0.194). Thus, the positive relationship
doesn’t seem to come from the industry effect.
Second, we test our hypotheses by carefully controlling the industry effect. In
particular, we use the excess Tobin’s q as the proxy for the firm value to eliminate
any potential impact from the industry level. The excess Tobin’s q is defined as the
firm’s Tobin’s q minus its industry median. Though not reported here, our results are
consistent with what we show in the previous tables.
For the first hypothesis, the difference of excess q between high and low cash
flow right is significant for the high industry sales growth group, but the difference is
insignificant for the low growth group. This suggests that the cash flow right increases
the excess q in the absence of investment opportunities, but the positive relation disappears with the appearance of investment opportunities. Moreover, the empirical results
are also consistent with our second hypothesis, given investment opportunities. The
difference of excess q between high and middle cash flow right groups is significantly
different from zero, but insignificant between middle and high cash flow right groups.
As a result, the cash flow right effect may still exist depending on the level of cash flow
rights by the proxy of excess Tobin’s q.
Finally, we use industry fixed and random effect regressions to check our results.
Even controlling the industry fixed and random effects, we still find strong evidence
supporting our testing hypotheses. Again, we don’t report the table here to save space.
Overall, we don’t find any evidence that our results are due to the industry effect.
This shows that investment opportunities influence the firm’s decision on expropriation. So, there exists no difference between the levels of cash flow rights with the
presence of investment opportunities,whereas there is significant difference without
11
We appreciate that one referee kindly points out this concern.
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Table 6
Industry
Cement
Food
Plastics
Textiles
Electric, Machinery
Appliance, Cable
Chemical
Glass, Ceramics
Paper, Pulp
Steel, Iron
Rubber
Automobile
Electronic
Construction
Transportation
Tourism
Department Stores
Other
Average
Industry Tobin’s q and the Cash Flow Right
Industry
code
11
12
13
14
15
16
17
18
19
20
21
22
23
25
26
27
29
99
N
32
89
115
176
14
23
37
24
44
50
7
21
73
51
39
29
52
37
50.72
Tobin’s q
Mean
1.968
1.590
2.122
1.695
1.234
1.442
1.949
2.044
2.091
1.327
1.553
1.692
2.297
1.352
1.551
2.760
2.187
2.000
1.825
S.D.
1.291
0.529
0.884
0.778
0.393
0.493
0.705
0.894
1.134
0.399
0.520
0.352
0.995
0.567
0.461
1.422
1.183
0.987
CF right
Mean
0.126
0.161
0.283
0.173
0.205
0.184
0.163
0.194
0.229
0.187
0.127
0.124
0.182
0.172
0.227
0.227
0.180
0.230
0.187
S.D.
0.078
0.066
0.137
0.084
0.109
0.073
0.073
0.091
0.134
0.097
0.043
0.031
0.090
0.060
0.136
0.104
0.140
0.112
Note: This Table shows the Tobin’s q and the cash flow right for each industry. Industry
classification codes are from Taiwan Stock Exchange. Correlation coefficient between
q and CF right for industry level is 0.315.
the investment opportunity. Besides, the impact coming from the investment opportunity will vanish when the cash flow right is relatively small, suggesting a non-linear
relationship between cash flow rights and firm value here.
6. ROBUSTNESS OF THE RESULTS
In this section, we discuss four issues of robustness. First of all, we use industry
capital expenditure and R&D expenditure ratio of a firm as investment opportunities.12
12
We acknowledge that one referee suggests we employ the capital expenditure for the measurement
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Second, we employ panel data regressions in empirical analyses. Third, we divide the
sample into two different groups by the median of cash flow rights, and analyze them
by regression to robustly check. Fourth, we try to explain what can be done about the
endogeneity of ownership.
The reason for treating industry capital expenditure as the investment opportunity
is as follows. A firm with more positive NPV projects in which to invest will buy more
plants, machines and other equipment. Thus, increases in fixed assets can serve as
proxy for the investment opportunity in the future. As with the rule of industry sales
growth, we use the 3rd quartile for industry capital expenditure as the critical point
of the investment opportunity. Industry capital expenditure is defined as the change
in total industry fixed assets to the total industry assets. The empirical results are
presented in Table 7. In panel A and B, when the industry capital expenditure is high,
the difference between high and low cash flow rights is insignificant. In contrast, there
exists reasonable difference between high and low cash flow right if the industry capital
expenditure is low. Besides, in panel C and D, there is no significant difference when
cash flow rights are relatively high, but a significant difference when cash flow rights
are relatively low with high industry capital expenditure. All these results support our
main arguments.
In addition, we also use the R&D expenditure as the proxy of the investment
opportunity. Although the R&D expenditure ratio is endogenous to the firm, it still
presents some kinds of investment opportunities. Firms who have high R&D and advertising expenditures hold more profitable projects, and have more chances to increase
firm valuation. Thus, we also employ the R&D expenditure and advertising expenditure ratio as the proxy of the investment opportunity. Dividing data into the high and
low R&D expenditure ratio by 3rd quartile, we show the empirical results in Table 8.
Panels A and B in Tables 7 and 8 are to test the first hypothesis (H1), and the panels
C and D test the second hypothesis (H2). The empirical results are consistent with the
findings of using industry grouping, and accept our two hypotheses.
Since we have the sample from 1987 to 2000, we use the panel regression to check
empirical results. When firms have low industry sales growths, the panel regressions
show that the coefficient of the cash flow right is significant at 1% level. In contrast, the
coefficient is not significant when firms have high industry sales growths. In addition,
for firms in the high industry sales growth group, the coefficient of the cash flow right
is significant when the cash flow right is relatively low. However, the coefficient is
of investment opportunity.
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Table 7 Robustness Check of Using Capital Expenditure As Investment Opportunities
Panel A: Tobin’s q by capital expenditure and CF right
Industry capital
expenditure
High
Low
High CF right
Low CF right
Diff.
2.196
(0.92)
N = 80
1.894
(1.07)
N = 382
1.959
(0.82)
N = 69
1.740
(0.80)
N = 387
0.237
t = 1.64
0.154*
t = 2.25
Panel B: Regressions of Tobin’s q
Intercept
Sales growth
CF right
Model Ilow capital expenditure group
1.848**
(8.93)
0.081
(0.63)
0.814**
(2.98)
Model IIhigh capital expenditure group
1.861**
(9.56)
0.366
(1.32)
0.873
(1.55)
Panel C: Tobin’s q for high industry capital expenditure
Low CF right
1.746
(0.58)
N = 42
Middle CF right
2.307
(1.01)
N = 47
Middle CF right
2.307
(1.01)
N = 47
High CF right
2.152
(0.90)
N = 60
Diff.
−0.561**
t = −3.25
Diff.
0.154
t = 0.84
Panel D: Regressions of Tobin’s q for high industry capital expenditure groups
Intercept
Sales growth
CF right
Model IIIlow, middle CF right group
1.312**
(5.06)
0.131
(0.41)
6.12**
(3.71)
Model IVmiddle, high CF right group
2.429**
(8.72)
0.322
(0.96)
−0.862
(−1.02)
Note: This Table presents the robustness checks by using industry capital expenditure as investment
opportunities. The high and low industry capital expenditures are divided by the 3rd quartile.
The finding of panel A is similar to the result in Table 2. Panel B lists the regression results like
Table 3. Panel C is similar to Table 4. Panel D is the regression results corresponding to panel C.
Models I and II in panel B contain 769 and 149 observations respectively. The sample in panel
D comes from the group with high industry capital expenditure. Model III in panel D has 89
observations in low and middle CF right groups and, Model IV in panel D has 107 observations
in middle and high CF right groups. Regression results are estimated by year random effect.
Numbers in the parentheses are t-statistics. * and ** represent the significance levels of 5% and
1%, respectively, based on a two-tailed t-test.
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Table 8 Robustness Check of Using R&D Expenditure Ratios As Investment Opportunities
Panel A: Tobin’s q by R&D expenditure and CF right
R&D expenditure
High CF right
2.002
(1.17)
N = 113
1.929
(1.01)
N = 346
High
Low
Low CF right
1.928
(0.84)
N = 117
1.718
(0.79)
N = 342
Diff.
0.074
t = 0.55
0.211*
t = 3.06
Panel B: Regressions of Tobin’s q
Intercept
Sales growth
CF right
Model Ilow R&D expenditure ratio group
1.761**
(9.35)
0.176
(1.49)
0.972**
(3.74)
Model IIhigh R&D expenditure ratio group
1.933**
(7.81)
0.457
(1.10)
0.874
(1.10)
Panel C: Tobin’s q for high R&D group
Low CF right
1.871
(0.74)
N = 74
Middle CF right
2.035
(1.01)
N = 88
Middle CF right
2.035
(1.01)
N = 88
High CF right
1.976
(1.26)
N = 68
Diff.
−0.164**
t = −1.19
Diff.
0.059
t = 0.32
Panel D: Regressions of Tobin’s q for high R&D groups
Intercept
Sales growth
CF right
Model IIIlow, middle CF right group
1.521**
(6.41)
0.444
(1.07)
3.086*
(2.17)
Model IVmiddle, high CF right group
2.035**
(6.59)
0.843
(1.58)
0.199
(0.19)
Note: This Table presents the robustness checks by using R&D expenditure ratios as investment opportunities. The high and low R&D expenditure are divided by the 3rd quartile. The finding of panel
A is similar to the result in Table 2. Panel B lists the regression results like Table 3. Panel C
is similar to Table 4. Panel D is the regression results corresponding to panel C. The sample in
panel D comes from the group with high R&D expenditure. Model III in panel D contains 162
observations in low and middle CF right groups, and Model IV in panel D has 156 observations
in middle and high CF right groups. Regression results are estimated by year random effect.
Numbers in the parentheses are t-statistics. * and ** represent the significance levels of 5% and
1%, respectively, based on a two-tailed t-test.
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insignificant when the cash flow right is relatively high. Consequently, these findings
are consistent with the findings above, and we do not show them here.
We also divide observations with high industry sales growth into two groups by
the median of cash flow right with independent sort. Corresponding to Table 5, we
regress the Tobin’s q on the cash flow rights by these two groups respectively. Given
firms with high industry sales growth, we find that the coefficient of the cash flow right
is significant before the median of cash flow rights, but the coefficient is insignificant
after the median. This also supports our results above, but we also do not show them
in the paper.
Finally, it is reasonable to suspect that the ownership is endogenous. Our defense
of this argument is that, generally speaking, ownership structures are extremely stable.
In the over 10-year time series, the cash flow right of the firm changes a little. For
example, we compute the standard deviation of the cash flow right for each firm in
time series, and the average of these standard deviations is only 3.23%. According
to La Porta et al. (2002), they also defend the problem of endogeneity by the same
reason. Therefore, we assume the ownership of the firm to be exogenous only in this
paper.
7. CONCLUSION
One popular issue raised recently in corporate finance is the impact of the cash flow
right held by the controlling shareholder. Past studies document a positive cash flow
right effect, wherein cash flow rights increase firm’s value, and argue that this effect
is related to investment opportunities. In this paper, we examine how investment opportunities influence the cash flow right effect, and study the relationship among cash
flow rights, investment opportunities and firm value.
We argue that the positive relationship between cash flow rights and firm value
does not exist when investment opportunities are available. When there exist profitable
projects, the controlling shareholder will expropriate less, and the firm’s value is independent of the cash flow right. However, when firms have positive NPV projects
and cash flow rights are relatively low, cash flow rights still increase firm value. Only
when cash flow rights are relatively high, will cash flow rights be independent of firm
value given the investment opportunities. This result suggests a non-linear relationship
between cash flow rights and firm valuation. To our knowledge, our paper is the first
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study to document this non-linear relationship.
One major implication of our paper is that a firm with weak legal protection of
investors tends to perform well if the firm has profitable projects. Since investment
opportunities will eliminate expropriation, under a weak investor protection mechanism, the controlling shareholder has less incentive to expropriate outside investors
given investment opportunities. For example, although the investor protection mechanism of East-Asian countries is relatively weak, the performance of firms in these
countries was outstanding in the early 1990s. Foreign investors and governments invest lots of capital in these emerging markets, and controlling shareholders prefer to
invest resources into profitable projects rather than expropriate firm value. Therefore,
we can treat investment opportunity as a substitute for legal protection to investors.
When laws are disadvantageous to investors, good timing or industry perspectives can
lead to less expropriation.
However, we also find that when cash flow rights are relatively low, investment
opportunities are not effective in eliminating expropriation. Given the presence of
investment opportunities, the low cash flow right still raises entrenchment, transferring
and expropriation of outside investors. These are consistent with some cases of milking
properties in East Asian countries during the 1990s. Therefore, whether the investment
opportunity can be a substitute for legal protection is dependent on the level of cash
flow rights of the controlling shareholder.
In conclusion, when the cash flow right is not tiny, we can treat the investment
opportunity as a substitute for investor protection mechanisms. Hence, low cash flow
rights will not result in low firm value. Nevertheless, when cash flow rights are very
small, low cash flow rights raise more expropriation and decrease firm value in the
presence of investment opportunities. In this case, we still need strong investor protection mechanisms to prevent expropriation of outside investors.
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APPENDIX
La Porta et al. (1999) presents the calculation of cash flow rights and voting rights
through pyramid ownership, and we follow their approach to compute the cash flow
right and voting right. Here, the cash flow right is the right of the shareholder to get
the distributed earnings of the firm. Let’s take the following example to show how we
get the cash flow right of the controlling shareholder.
Firm A
(S holds 5% ownership)
20%
25%
Firm B
(S holds 10% ownership)
Firm C
(S holds 20% ownership)
Assume there is a shareholder S, who holds 5%, 10% and 20% ownership of firms A,
B and C, respectively. Firms B and C also have 20% and 25% ownership of firm A,
respectively. Since S has 5% direct ownership, and 0.07% indirect ownership (0.1 ×
0.2 + 0.2 × 0.25 = 0.07) through the shareholding of firms B and C, the total cash
flow right of S for firm A is 0.05 + 0.1 × 0.2 + 0.2 × 0.25 = 0.12.
Moreover, we also use cross ownership to find the cash flow right in family
groups. We present another simple case here, where there are firms A, B and C in
a family group S.
Firm A
(S holds 5% ownership)
10%
5%
20%
Firm B
(S holds 10% ownership)
25%
10%
15%
326
Firm C
(S holds 20% ownership)
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In this case, the family S owns 5%, 10% and 20% of firms A, B and C, respectively.
Besides, Firm A owns 10% and 5% of firms B and C. Firm B owns 20% and 10% of
firms A and C. Firm C owns 25% and 15% of firms A and B. We denote the following
notation to calculate cash flow rights in cross ownership:

0

Σ =  0.1
0.05
0.2
0
0.1

0.25

0.15  ,
0
Φ = [0.05 0.1 0.2].
The first column of S is the shareholding of A in B and C. The second column of S is
the shareholding of B in A and C. The remaining is the shareholding of C in A and B.
Φ is the shareholding of S in A, B and C. Based on Bebchuk et al. (1999), we have the
formula:
Cash flow rights = Φ[I − Σ]−1 = [0.076 0.139 0.24], where each element presents
the cash flow right of firms A, B and C.
Rather than the cash flow right, the voting right is the votes held by the shareholders. In the other words, voting rights measure the control right on the firm’s decisions.
Referring to La Porta et al. (1999), the voting right is computed as follows. We find
the minimum in each “control chain” of the ownership structure, and the voting right
is the sum of the minimum ownership. For example, the voting right of firm A is 0.35
(0.05 + 0.10 + 0.2) in the cases above. Here, 0.05 is the direct ownership of firm
A. The indirect vote through the “control chain” of firm B controlling firm A is 0.1
(min[0.1, 0.2]). The indirect vote through the “control chain” of firm C controlling
firm A is 0.2 (min[0.2, 0.25]). The reason why we choose the minimum ownership for
each “control chain” is to ensure the lowest voting right that the controlling shareholder
could have. So, we calculate voting rights for the cases above:
Voting rights of firm A = 0.05 + min[0.1, 0.2] + min[0.2, 0.25] = 0.35,
Voting rights of firm B = 0.1 + min[0.05, 0.1] + min[0.2, 0.15] = 0.3,
Voting rights of firm C = 0.2 + min[0.05, 0.05] + min[0.1, 0.1] = 0.35.
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