State ownership and investor protection: Dynamic model of the cost of capital; empirical investigation of a worldwide panel of firms.

Abstract

The empirical part of this work uses a worldwide panel dataset to document the effect of state and insider ownership on the firm's cost of capital. Using panel data allows me to resolve some of the econometric problems with cross-section studies. Further my treatment of state ownership is unique in the literature.

This paper incorporates the effect of the state in a theoretical model for the cost of capital. The mathematical results show why it might be possible for some degree of state ownership to be efficient under poor investor protection and weak institutions. I introduce the source of inefficiency through the decision of the manager to divert resources from the firm due to poor legal preventive mechanisms. Further, I claim that under some degree of state ownership it is more costly for the manager to steal, because he might be compelled to share benefits with the politicians or it might be too costly to hide from them. Additionally the politicians impose a degree of over-employment on the firm to secure votes, which leads to a decrease in company profits. Consequently, state ownership acts as a monitoring mechanism that limits diversion but imposes a cost. When the manager makes the decision to finance investment with new equity, he has to signal to the market---characterized by poor investor protection---his commitment to limit diversion by retaining some share ownership for himself. In this way he cannot diversify his idiosyncratic risk and assigns a higher cost of capital than the optimal rate assigned by the market. Ultimately diversion and over-employment result in higher cost of capital and passing up profitable investment opportunities. Interestingly in some cases the cost of capital might be reduced when the state owns part of the company. This happens under very poor investor protection when the managers would otherwise choose very high levels of diversion, they limit stealing due to their own share ownership, as well as due to state ownership.