A Revealed Preference Approach. To Understanding Corporate Governance Problems: Evidence From Canada

Empire-building by managers implies that they use a lower effective discount rate in making investment decisions. We use actual investment decisions to measure the gap between the manager’s effective discount rate and the market rate. Our empirical work is based on panel data for 193 Canadian firms. Distinctive institutional features, such as interrelated groups of Canadian firms and concentrated share ownership, allow us to quantify the sensitivity of effective discount rates and governance problems to these institutional control mechanisms. For the firms most likely to be affected by the agency problems highlighted by Jensen (1986), estimated discount rates are 350-400 basis points less than the market rate, supporting the Free Cash Flow view that unresolved corporate governance problems distort firm behavior. Firms in our sample that face Free Cash Flow problems have a stock of fixed capital approximately 7% to 22% higher than would prevail under value maximizing behavior.