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Investment decisions and bank loan contracting

Wenxia Ge ( University of Manitoba , Winnipeg, Canada)
Tony Kang ( McMaster University , Hamilton, Canada)
Gerald J. Lobo (Bauer College of Business, University of Houston , Houston, Texas, USA)
Byron Y. Song ( Hong Kong Baptist University , Kowloon, Hong Kong)

Asian Review of Accounting

ISSN: 1321-7348

Article publication date: 2 May 2017

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Abstract

Purpose

The purpose of this paper is to examine how a firm’s investment behavior relates to its subsequent bank loan contracting.

Design/methodology/approach

Using a sample of US firms during the period 1992-2011, the authors examine the association between overinvestment (underinvestment) and three characteristics of bank loan contracts: loan spread, collateral requirement, and loan maturity.

Findings

The authors find that overinvesting firms obtain loans with higher loan spreads. Additional tests show that the effect of overinvestment on loan spreads is generally more pronounced in firms with lower reputation, weaker shareholder rights, and lower institutional ownership. The effect of overinvestment on collateral requirement is mixed, and investment efficiency has no significant relation to loan maturity.

Research limitations/implications

The results are subject to the following caveats. First, while the study provides empirical evidence that investment efficiency affects bank loan contracting terms, especially the cost of bank loans, the underlying theory is not well-developed. The authors leave it up to future research to provide a theoretical framework to clearly distinguish the cash flow and credit risk effects of past investment behavior from those of existing agency conflicts. Second, due to data limitation, the sample size is small, especially when the authors control for corporate governance measured by G-index and institutional ownership.

Practical implications

The finding that overinvestment is costly to corporations suggests that managers should consider the potential trade-offs from such investment decisions carefully. The evidence also alerts shareholders and board members to the importance of monitoring management investment decisions. In addition, the authors find that corporate governance moderates the relationship between investment decisions and cost of bank loans, suggesting that it would be beneficial to design effective governance mechanisms to prevent management from empire building and motivate managers to pursue efficient investment strategies.

Originality/value

First, the findings enhance understanding of the potential economic consequences of overinvestment decisions in the context of a firm’s private debt contracting. The evidence suggests that lenders perceive higher credit risk from overinvestment than from underinvestment, likely because firms squander cash in the current period by investing in (negative net present value) projects that are likely to result in future cash flow problems. Second, the study contributes to the literature on the determinants of bank loans by identifying an observable empirical proxy for uncertainty in future cash flows that increases credit risk.

Keywords

Acknowledgements

The authors appreciate the helpful comments from the editor, two anonymous reviewers, Bilal Ertruk, Usha Mittoo, Daniel Jiang, Yaxuan Qi, Steven Zheng and the workshop participants at the City University of Hong Kong, the 2012 Certified General Accountants of Manitoba/University of Manitoba Accounting Research Conference, the 2015 CAAA Annual Conference and the 2015 AAA Annual Meeting. Wenxia Ge acknowledges funding support from the CPA Manitoba and a start-up grant from the University of Manitoba. The usual disclaimer applies.

Citation

Ge, W., Kang, T., Lobo, G.J. and Song, B.Y. (2017), "Investment decisions and bank loan contracting", Asian Review of Accounting, Vol. 25 No. 2, pp. 262-287. https://doi.org/10.1108/ARA-03-2016-0027

Publisher

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Emerald Publishing Limited

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