What Gets Measured Gets Managed: Investment and the Cost of Capital

Abstract

We study the impact of government-led incentive systems by examining a staggered reform in the Chinese state-owned enterprise (SOE) performance evaluation policy. To improve capital allocative efficiency, regulators switched from using return on equity (ROE) to economic value added (EVA). However, this EVA policy takes a one-size-fits-all approach by stipulating a fixed cost of capital for virtually all SOEs, neglecting the potential heterogeneity of firm-specific costs of capital. We show that SOEs responded to the evaluation reform by altering their investment decisions, particularly when the actual borrowing rate deviated further from the stipulated rate. Besides providing an estimate of the cost of capital's impact on investment, our paper offers causal evidence that incentive schemes affect real investment and sheds new light on economic reform challenges in China.

Keywords: CEO compensation, Capital budgeting, Cost of Capital, Corporate governance, Economic reform, Transition economy

JEL Classification: G31, G34, M12, M52, P31