Publication Type

Journal Article

Version

Postprint

Publication Date

9-2015

Abstract

Prior studies show that equity value has convex relations with earnings and book value of equity, respectively, due to growth and adaptation options (Burgstahler and Dichev 1997a; Zhang 2000). These studies, however, do not consider the role of institutions in affecting firms' ability to exercise growth and adaptation options. In this study, we investigate whether these convex relations vary with the degree of a country's economic freedom, which may influence the frictions and costs of exercising these options. We develop four hypotheses: In countries with greater economic freedom, (1) a firm's capital investment in response to profitability is greater; (2) the relation between equity value and earnings, given equity book value, is more convex; (3) the relation between equity value and equity book value, given earnings, is more convex; and (4) the relation between stock return and profitability change is more convex. Using the index of economic freedom from the Fraser Institute, we test our hypotheses with data from 30 countries during the 2000-2010 period. The empirical results are consistent with these hypotheses. The effect of economic freedom that we document is distinct from the effects of GDP level and growth, legal origin, law enforcement, investor protection, and quality of accounting standards. Our results suggest that greater economic freedom enhances equity value through more efficient management of investment options.

Keywords

economic freedom, investment flexibility, real options, equity value

Discipline

Accounting | Corporate Finance | International Business

Research Areas

Corporate Governance, Auditing and Risk Management

Publication

Accounting Review

Volume

90

Issue

5

First Page

1839

Last Page

1870

ISSN

0001-4826

Identifier

10.2308/accr-51034

Publisher

American Accounting Association

Copyright Owner and License

Authors

Creative Commons License

Creative Commons Attribution-Noncommercial-No Derivative Works 4.0 License
This work is licensed under a Creative Commons Attribution-Noncommercial-No Derivative Works 4.0 License.

Additional URL

http://dx.doi.org/10.2308/accr-51034

Share

COinS