FINANCE

Finance

Finance

Capital expenditures refer to important capital budgeting decisions such as plant expansion or equipment replacement. These expenditures are generally linked to strategic decisions of firms. Presumably, firms should undertake investment projects that will generate positive net present value. If so, capital expenditures in the current period should be positively associated with future corporate earnings.

Previous empirical results on the association between current capital expenditures and corporate earnings are not conclusive.

More recently, Kim (2001) examines the financial performance of manufacturing firms in the USA. Based on a sample of an average of 515 observations per year over the sample period 1976-1989, Kim reports no linear association between capital expenditures and future earnings for the overall sample (after controlling for current earnings). However, when the sample firms are partitioned into winners and losers, Kim finds that winner firms exhibit a positive association between capital expenditures and future earnings while loser firms exhibit a negative association between capital expenditures and future earnings. When losers are excluded from the sample, Kim finds that capital expenditures generally provide positive information about future earnings.

Several theorems are available for explaining the observed empirical evidence. The traditional view suggests that managers, acting in the best interest of stockholders, seek to maximize stockholder wealth by undertaking capital projects that are expected to create positive net present value. Thus, this traditional view predicts a positive association between capital expenditures and future earnings.

However, the agency theory (Jensen and Meckling, 1976; Jensen, 1986) suggests that agency costs may occur when managers and owners hold conflict interests. To fulfill self-interest, managers may make investment decisions to expand the resources under their control. These investment projects need not generate positive net present value. The issue of agency costs is more severe when the firm has excess free cash flow under management's discretion. Thus, the agency hypothesis suggests that the association between capital expenditures and future corporate earnings need not be positive.

Aside from the agency theory, Echevarria (1997) notes that several other factors may also lead to unsuccessful investments. Unexpected market conditions such as changes in tastes and preferences of consumers may affect the demand conditions. Similarly, unexpected changes in competitors may affect the supply conditions. These unexpected factors may contribute to the failure of investment projects.

Previous studies on the relationship between capital expenditures and corporate earnings are based mainly on developed countries. The purpose of this paper is to examine the association between capital expenditures and corporate earnings using data from the manufacturing firms listed on the Taiwan Stock Exchange. Empirical evidence from the Taiwan Stock Exchange would provide further insights regarding this important issue. The next section of the paper describes the research design including the sample selection and the research methodology. Section 3 of the paper reports empirical results. The last section provides a brief conclusion.

Research design 2.

To examine the relationship between capital expenditures and corporate earnings, the data of all manufacturing firms listed on the Taiwan Stock Exchange over the period of 1992-2002 were ...