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O R I G I N A L R E S E A R C H

Corporate governance and the stock market reaction

to new product announcements

Wen-Chun Lin • Shao-Chi Chang

Published online: 21 July 2011 Springer Science+Business Media, LLC 2011

Abstract This study examines the explanatory power of corporate governance mecha-

nisms on the wealth effect of firms’ new product strategies. We show that board size, board

independence, audit committee independence, CEO equity-based pay, analyst following

and shareholder rights are all of significance in explaining the variations in the wealth

effect of new product introductions. Our results reveal that the new product strategies

announced by firms with better corporate governance mechanisms tend to receive higher

stock market valuations than those of firms with poorer governance mechanisms. Thisstudy provides empirical support for the notion that enhanced governance mechanisms can

reduce both agency and information asymmetry problems for firms announcing new

products.

Keywords Corporate governance New product introduction Wealth effect

JEL Classification G14 G30

1 Introduction

In this study, we set out to explore the impact of corporate governance on the wealth effect

of firms’ new product introductions, arguing that corporate governance mechanisms can

reduce agency costs and provide certification of the quality of information contained

in new product announcements, and propose that new product announcements by firms

W.-C. Lin (&)

Department of Finance, College of Management, Providence University, No. 200, Chungchi Road,Taichung, Taiwan

e-mail: [email protected]

S.-C. Chang

Department of Business Administration, College of Management, National Cheng Kung University,

No. 1, University Road, Tainan, Taiwan

e-mail: [email protected]

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Rev Quant Finan Acc (2012) 39:273–291

DOI 10.1007/s11156-011-0248-x


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with better corporate governance mechanisms are likely to receive a more positive stock

market reaction.

New product introductions play a crucial role in developing and maintaining the

competitive advantage of a company. Firms that are able to deliver more new products to

the market generally create better opportunities for differentiation and competitiveadvantage. However, new product introductions do not necessarily create firm value, per

se, as the development of new products is often risky, with failure rates reaching as high as

60 per cent (Pauwels et al. 2004). In addition, the commercialization of new products does

not guarantee financial success, as the additional sales revenues from new products may be

insufficient to cover the significant development and launch costs (Chaney et al. 1991).

Furthermore, the competitive advantage from new products may quickly disappear, largely

as a result of the rapid imitation of such products by competitors, or the effects of short

product life cycles.

Although prior studies generally document positive stock market reactions to

announcements of new product introductions (Woolridge 1988; Kelm et al. 1995; Chen

and Ho 1997), considerable variations are found in terms of individual announcing firms.

Chen (2008) finds that new product announcements provide only about 58 per cent of US

firms with positive abnormal returns, whilst Chen and Ho (1997) report similar evidence

for Singaporean firms. Determining why there are discrepancies in how investors perceive

and evaluate new products based upon their initial announcements would seem to be of

considerable interest to both academics and business professionals alike. This study

investigates the issue from the perspective of the impact a firm’s corporate governance

mechanisms may have on this.

As new product development generally involves greater information asymmetrybetween managers and external—and potentially adversarial—parties such as investors,

analysts, suppliers, employees, unions and competitors, it is difficult for outsiders to make

effective valuations of new product announcements. One reason is that new products are

usually unique to the developing firms, making it extremely difficult to assess their value

based upon observations of the performance of similar products in other comparable firms.

Furthermore, information disclosure of new product introductions is not mandatory (Eccles

and Kahn 1998), causing disclosure incentives for different firms to be quite diverse:

Whilst some firms may provide information on a voluntary basis in order to reduce

information asymmetry, other firms may disclose quite specific information to deliberately

overstate the value of their products (Eagly et al. 1978; Frost 1997; Koch 2002; Mercer2004). Thus, outsiders evaluating a new product announcement are not only facing the

issue of information asymmetry, but must also attempt to identify the underlying motives

of those firms that do voluntarily disclose information. As such, the quality of corporate

governance may convey important signals of the underlying motives of new product

investments and may provide important certification effects on information that is vol-

untarily disclosed as well as on new product announcements.

Agency problems may further complicate the valuation of new product introductions

(Wu 2008); indeed, it has been demonstrated within the prior literature that with the sep-

aration of ownership and control, managers may make capital and human resourceinvestment decisions for their private interests at the expense of shareholder wealth (Wei

and Zhang 2008). For example, managers cannot hedge their investment risk as easily as

risk-neutral shareholders can, who can diversify their risk by holding diversified portfolios.

As a result, they may reduce such risks by investing in projects which are less risky, but

which also yield lower returns. Another agency issue is that of poorly functioning internal

274 W.-C. Lin, S.-C. Chang

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control, which Jensen (1993) argues is the reason why R&D investments in many large firms

fail to lead to any increase in firm value.

Thus, well-functioning corporate governance mechanisms play crucial roles in miti-

gating agency costs (Claessens et al. 2002; Brunello et al. 2003; Singh and Davidson

2003). Firstly, such mechanisms provide internal and external monitoring which dis-courages the pursuit of private interests by managers, thereby maintaining management

discipline. Several studies find that firms with boards and audit committees that are more

independent than otherwise similar firms—where such independence is measured by the

number of outside directors—demonstrate less earnings management and higher quality

disclosures (Beasley 1996; Fama and Jensen 1983; Gibbs 1993; Klein 2002; Wild 1996).

This is because the board of directors is the highest internal control mechanism responsible

for monitoring the actions of senior managers. Klein (2002) further states that the struc-

turing of boards with greater independence from the CEO will be more effective in

monitoring the corporate financial accounting process. Furthermore, less earnings man-

agement is also discernible amongst firms with boards and audit committees which possess

greater financial expertise, and which meet more frequently (Xie et al. 2003). Kim et al.

(2006) find that firms with an audit committee and/or a larger percentage of outside

directors command higher market valuations, arguing that these effects occur because

investors place a higher valuation on the same earnings stream for such firms.

Other studies suggest that corporate governance mechanisms help to deal with agency

problems and the subsequent implementation of efficient investment decisions through

aligning the interests of managers and shareholders (Cornett et al. 2003; Gompers et al.

2003; Pantzalis et al. 1998; Luo and Hachiya 2005). This can be achieved through sub-

stantial stock concentrations and management stockholdings (Hill and Snell 1988) andeffective incentive contracts that include the appropriate compensation of managers rela-

tive to the performance of the firm—such as through equity-based compensation plans

(Bizjak et al.1993; Coles et al. 2001). These mechanisms are effective as they cause the

personal wealth of a CEO to be increasingly dependent on the value of the firm. For

example, if compensation plans place significant emphasis on short-term stock returns, and

little or no emphasis on future performance, managers may exhibit prejudiced behavior

towards either over- or under-investment, while by implementing the above corporate

government mechanisms the CEO will have less incentive to pursue investments in pro-

jects which do not increase shareholder value.

Prior studies argue that corporate governance is an important consideration in cor-porate investment, including mergers and acquisitions (Agrawal and Mandelker 1987;

Datta et al. 2001), corporate diversification (Hill and Snell 1988; Denis et al. 1997;

Anderson et al. 2000) and firm restructuring (Gibbs 1993; Hoskisson et al. 1994).

However, to the best of our knowledge, no previous study has investigated the influ-

ence of corporate governance on the reaction by the stock market to new product

introductions. We therefore examine the relationship between corporate governance

mechanisms (specifically board size and independence, audit committee independence,

CEO equity-based compensation, analysts’ following, and shareholder rights) and the

announcement effects on stock prices of announcing firms using a sample of newproducts announcements by US firms.

The remainder of this paper is organized as follows: Sect. 2 provides the development of

our hypotheses. The sample selection and variable measure are presented in Sect. 3,

followed in Sect. 4 by the analysis of our empirical results. Finally, the conclusions drawn

from this study are discussed in the closing section.

Corporate governance and the stock market reaction 275

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2 Hypothesis development

According to agency theory, boards of directors exist to ensure that shareholder interests

are appropriately pursued and to monitor managers on behalf of shareholders. This is

necessary because the relationships between managers and shareholders with regard to theorganizational processes and outcomes are fundamentally different (Daily et al. 2003;

Jensen and Meckling 1976). While ordinary shareholders may be considered risk neutral,

as they can diversify their risks through their portfolios (Wiseman and Gomez-Mejia

1998), managers are more likely to be risk-averse, as they cannot diversify their risks so

easily. For example, in terms of innovations, failures will not only reduce a firm’s short-

term performance and thereby lower management compensation, but they can also damage

the reputation of the executives involved and thereby increase their risk of unemployment.

To counter such risk aversion, stakeholders may be heavily reliant on corporate gov-

ernance mechanisms, using monitoring or incentives to align their risk differentials.

However, whilst increased monitoring can, to some degree, help to resolve agency con-

flicts, its effectiveness is also limited by potential information asymmetry. In this study, we

examine specific governance mechanism characteristics, discussing the relationship

between the monitoring and information certification effects of governance and the stock

market reaction to new product introductions.

2.1 Board size

A corporate board improves the performance of a firm by monitoring the quality of

managerial decisions and providing specialized resources (Monks and Minow 1995). Theeffect of board size on firm performance is, however, inconclusive. A larger board is

valuable for the breadth of its services, and often shows that a firm has directors from a

wide variety of backgrounds (Chaganti et al. 1985). Furthermore, since innovation projects

usually involve greater uncertainty in the development and commercialization stages, the

wider range of knowledge and services offered by a larger board could be of considerable

benefit in guiding investment decisions. Nevertheless, Lipton and Lorsch (1992) and

Jensen (1993) argue that large boards are more difficult to coordinate, and can be less

effective as a controlling body, whilst Yermack (1996) and Lee and Lee (2009) also argues

that board size is inversely related with firm value. Thus, as the impact of board size on the

reaction by the stock market to new product introductions remains ambiguous, we proposethe following two alternative hypotheses:

Hypothesis 1a: board size is positively associated with stock market reaction to new

product introductions.

Hypothesis 1b: board size is negatively associated with stock market reaction to new

product introductions.

2.2 Board independence

The second corporate mechanism we examine in this study is board independence. Notonly do independent directors provide professional expertise, but they can also indepen-

dently oversee and monitor senior management. Therefore, it is argued in numerous studies

that the effectiveness of corporate governance is positively associated with board inde-

pendence. For example, both Fama (1980) and Fama and Jensen (1983) argue that inde-

pendent boards are more likely to make decisions that are consistent with the maximization

of shareholder wealth. Weisbach (1988) and Lee and Lee (2009) suggests that a board


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which is dominated by independent directors is more likely to respond to poor performance

by dismissing the CEO;. Weisbach (1993) goes on to argue that independent directors are

effective in monitoring the decisions taken by managers, suggesting that with a rise in the

number of independent directors, there is a corresponding reduction in the probability of a

hostile takeover.Furthermore, the independence of the board has been found to have a positive correlation

with the quality of the information disclosed by a firm, where Farber (2005) and Beasley et al.

(2000) show that firms which fraudulently manipulate their financial statements have fewer

independent board members. Klein (2002) also suggests that firms which have more inde-

pendent board members are less likely to encounter earnings management problems.

However, Hermalin and Weisbach (1991) argue that it may be difficult for independent

directors to monitor senior management officials since they can often control the board-

selection process, whilst independent directors may have problems in ascertaining the

value of the day-to-day operations of the company. Hermalin and Weisbach ( 1991) also

argue that an independent board only affects extraordinary events, such as unusually poor

performance. The net effect of board independence is therefore ambiguous. Therefore, we

follow the prior studies to hypothesize that:

Hypothesis 2a: board independence is positively associated with stock market reaction

to new product introductions.

Hypothesis 2b: board independence is negatively associated with stock market reaction

to new product introductions.

2.3 Audit committee independence

An audit committee is a sub-committee of a company’s main board of directors which is

established to increase the credibility of audited financial statements as well as to help the

board meet its responsibilities. The members of the audit committee meetg regularly to

review the company’s financial statements and to audit its processes and internal control

systems. Independent directors are expected to improve the effectiveness of the audit board as

a monitoring device, for example by making it more difficult for departing CEOs to

manipulate accruals (Reitenga and Tearney 2003), thus reducing the likelihood of fraudulent

financial reporting (Beasley 1996; Beasley et al. 2000). As such, we expect to find a positive

relationship between independent directors on the audit committee, along with increases in

both the monitoring effect and the wealth effect of firms announcing new product strategies:Hypothesis 3: audit committee independence is positively associated with stock market

reaction to new product introductions.

2.4 CEO equity-based pay

Well-designed executive compensation plans, which include equity ownership, can help to

align the interests of managers and shareholders (Datta et al. 2001; Masulis et al. 2007;

Bauman and Shaw 2006). The alignment of shareholder interests with managerial incen-

tives suggests a positive relationship between a firm’s performance and its governancestructure, essentially because the latter is designed to reduce the agency costs arising from

the separation of ownership and control. Murphy and Dial (1995) show that stock-based

compensation is important in executing corporate downsizing, resulting in the transference

of resources to higher-valued opportunities, whilst Datta et al. (2001) show that an

acquiring firm’s compensation structure influences both the stock price and responses to

acquisition announcements by the bidding firms.


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Based on the above, investors can assume that firms whose CEOs’ pay is equity-based

will pursue new product innovations that are expected to increase firm value (and thus

CEO wealth). We therefore construct the following hypothesis:

Hypothesis 4: CEO equity-based pay is positively associated with the stock market

reaction to new product introductions.

2.5 Analyst following

By collecting, analyzing and disseminating information on a firm, analysts play a crucial

role in helping to the reduce agency costs associated with the separation of ownership and

control (Jensen and Meckling 1976) as they are seen as vital instruments of an efficient and

secure informational marketplace through both providing market information and effec-

tively monitoring and disciplining managerial behavior (Healy and Palepu 2001; Best et al.

2003). As such, analysts may elicit managerial responsiveness, and thereby reduce the

probability of resource-wasting investments (Moyer et al. 1989). For example, the results

presented by Yu (2008) show that more comprehensive analyst coverage is consistent with

less earnings management, and that changes in analyst coverage are inversely related to

changes in earnings management. This leads us to our fifth hypothesis:

Hypothesis 5: analyst following is positively associated with stock market reaction to

new product introductions.

2.6 Shareholder rights

The shareholder rights can restrain management empire building, in that firms that makevalue-destroying investment (Mitchell and Lehn 1990). Furthermore, the ability of

shareholder rights can provide managers with the appropriate incentives to maximize

shareholder wealth (Cheng et al. 2006; Masulis et al. 2007). We use Gompers et al.’s

(2003) G-index to proxy for the shareholder rights of corporate governance. The index is

based on 24 antitakeover provisions and measures the power-sharing relationship between

investors and management. A higher G-index score indicates lower shareholder rights and

greater management power. Based on agency theory, a new product announcement by a

firm with a higher G-index score (less shareholder rights) is expected to exhibit a lower

wealth effect as it is thus more difficult or costly to remove management that is acting

opportunistically. On the other hand, a firm with stronger shareholder rights (a lowerG-index score) is more likely to have stronger monitoring and control processes in place,

leading to more effective and efficient managerial decision making. Accordingly, the sixth

hypothesis proposed in this study is:

Hypothesis 6: G-index scores are negatively associated with stock market reaction to

new product introductions.

3 Sample and variables

3.1 Data sample

This study collects an initial sample of announcements of new product introductions by

firms listed on the New York Stock Exchange (NYSE) or the American Stock Exchange

(AMEX), covering the 8 year period from 1997 to 2004; the data is collected from the


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LexisNexis Academic NEWS database. In order to be included in the final sample, the new

product announcements have to meet specific criteria, as follows: In order to avoid any

confounding events which might distort the measurement of announcement returns, we

exclude those announcements by firms that made other major announcements—such as

announcements of quarterly earnings, mergers and acquisitions or changes in dividends—either 5 days before or 5 days after the announcement of the new product. Furthermore, in

order to ensure that the new product announcements are not affected by information leaked

ahead of time, we discard any new product announcements if there has been news items

reported in major newspapers up to 1 year prior to the announcement date. We also

exclude the announcing firms if no data is available on the firms from the return files of the

Center for Research in Securities Prices (CRSP). Finally, we exclude those announcements

where the corporate governance measures (to be described below) are unavailable. Our

final sample is comprised of 1,945 new product announcements made by 341 different

firms.

3.2 Stock market reaction

We employ standard event-study methodology to examine the response in stock prices to

announcements of new product introductions, with Day 0 being defined as the day on

which the announcement first appears in any major publication. The abnormal return is

calculated as the difference between the actual return and the expected return generated by

the market model, with the value-weighted CRSP index being used as a proxy for market

returns. The estimation of the parameters of the market model is based upon data covering

the period from 200 to 60 days prior to the initial announcement date.Abnormal returns and cumulative abnormal returns are generated for each announcing

firm over the period from 10 days before to 10 days after the initial announcement date.

Cumulative abnormal returns over different event windows are then calculated by sum-

ming the daily abnormal returns during the event periods. We calculate the 2 day period

abnormal returns (–1, 0)1 by summing the abnormal returns on the announcement day, and

1 day prior to the announcement date, in order to estimate the wealth effect of new product

introductions.

3.3 Measuring corporate governance

Our analysis of corporate governance is undertaken using the six different measures of

Board Size, Board Independence, Audit Committee Independence, CEO Equity-based Pay,

Analyst Following and G-index Score. The corporate governance data are obtained from

the IRRC Board datasets, Compustat ExecComp and the I/B/E/S database, with the mea-

sures being estimated as at the end of the fiscal year prior to the new product

announcements.

We follow prior studies and measure Board Size as the number of directors on the board

during the fiscal year preceding the new product announcement (Lehn and Zhao 2006;

Masulis et al. 2007). Independent directors are defined as those who hold no executiveposition, have held no such position in the past, and are unrelated to any executive or

1 If such announcements occur after the close of trading on the previous day, then the impact on share prices

will be felt on the day in which the announcements appear in the publication. If the announcements are

released prior to the close of trading hours, any immediate valuation effect will be reflected in the share

prices on the day prior to the announcement appearing in print.


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director in the announcing firm. Board Independence is measured as the ratio of inde-

pendent directors on the board for the fiscal year preceding the new product announcement,

and following Klein (2002), we measure Audit Committee Independence as the ratio of the

number of independent directors to the number of directors on the audit committee. CEO

Equity-based Pay is measured, following Datta et al. (2001) and Masulis et al. (2007), asthe ratio of equity-based compensation within the overall compensation package, with

equity-based pay being defined specifically as the value of all stock options and restricted

stock grants. Analyst Following is a measure of external monitoring which is defined as the

average number of analyst forecasts taking place during the fiscal year prior to the new

product announcement. Finally, we use Gompers et al.’s (2003) G-index as a proxy to

measure the power-sharing relationship between investors and management. Each firm’s

G-index Score is the sum of points, where one point is awarded for the presence of each of

the 24 provisions included.

3.4 Measuring control variables

The control variables included in the regression analyses are a firm’s Investment Oppor-

tunities (where Tobin’s Q is used as a proxy), Free Cash Flow, Debt Ratio, Firm Size,

Relative R&D Intensity and Industry Competitiveness (where the Herfindahl Index, is used

as a proxy), all of which have been found within the prior literature to be important in

explaining the stock market reaction to new product announcements. All of the data on

these control variables are obtained from the Compustat files.

Investment Opportunities. The degree of availability of investment opportunities can be

an important consideration in assessing the value of corporate innovations. Innovations byfirms with good investment opportunities are generally regarded as worthwhile, whereas

those by firms with poor investment opportunities are not. Therefore, share price responses

to new product announcements are expected to have a positive correlation with a firm’s

investment opportunities.

Investment opportunities are estimated in this study using a firm measure of Tobin’s Q,

where a high Tobin’s Q represents a high degree of investment opportunities. Given a lack

of availability of data,2 we estimate Tobin’s Q as the ratio of the market-to-book value of

the firm’s assets, where the market value of assets is the book value of assets minus the

book value of common equity plus the market value of common equity. This measure has

been widely used in many of the prior studies as a means of estimating growth opportu-nities (Agrawal and Knoeber 1996; Barclay and Smith 1995a, 1995b; Denis 1994;

Holderness et al. 1999; Kang and Stulz 1996). Our Tobin’s Q variable is calculated as the

average ratio for the three fiscal years prior to the announcement date.

Free Cash Flow. The degree of availability of free cash flow can also be an important

consideration in determining the value-enhancing potential of corporate innovations.

Jensen (1986) argues that managers endowed with higher free cash flow will invest

wastefully, as opposed to ensuring that it is returned to shareholders. Therefore, the

potential agency costs of innovations can be higher for firms with higher free cash flow.

2 Tobin’s Q is technically defined as the ratio of the market value of a firm to the replacement cost of its

assets, as the difference between market value and replacement value is dependent upon the profitability of

both the firm’s assets in place and its expected investment opportunities. If the profitability of the firm’s

assets in place is high, its investment opportunities will also be expected to earn a high rate of return; thus,

the firm will have a high Tobin’s Q (Lang and Litzenberger 1989).


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On the other hand, innovations by firms with lower free cash flow raise the likelihood of

the firm seeking new external financing. As free cash flow theory predicts that the market

response to a new product will be inversely related to the firm’s free cash flow, any new

external financing provides a monitoring function, and the firm’s willingness to undergo

such monitoring can be seen as providing a favorable signal (Szewczyk et al. 1996). In thisstudy, Free Cash Flow is defined as operating income before depreciation minus interest

expense, taxes, preferred dividends and common dividends divided by the book value of

total assets for the fiscal year preceding the announcement (Lang et al. 1991; Lehn and

Poulsen 1989).

Debt Ratio. Jensen (1986) suggests that a firm’s debt ratio can be regarded as an

alternative measure of free cash flow. Firms with greater free cash flow will invariably opt

for higher levels of debt within their overall capital structure since this provides a credible

pre-commitment to paying out their excess cash flow, thereby lowering the expected costs

of such free cash flow. The Jensen theory thus suggests a positive relationship between the

market response to corporate announcements of new products and the debt ratio of the

announcing firm. The Debt Ratio is measured in the present study as the ratio of the book

value of long-term debt to the book value of total assets for the fiscal year prior to the

announcement (Lang and Stulz 1992).

Firm Size. Innovations by larger firms have less unanticipated information than those of

smaller firms, essentially because information production and dissemination is a positive

function of firm size (Atiase 1985; Hertzel and Smith 1993; Kang and Stulz 1996); we

therefore expect to find an inverse relationship between firm size and the evaluation by the

market of a firm’s new product. In the present study, Firm Size is measured as the natural

logarithm of the book value of total assets for the fiscal year preceding the announcement(Chen et al. 2002).

Relative R&D Intensity. Since firms with greater relative R&D intensity may occupy

leading positions in technological advances (Baysinger and Hoskisson 1989; Kelm et al.

1995), we expected to find a positive correlation between a firm’s relative R&D intensity

and the wealth effect of stockholders when firms announce new products. Following Chan

et al. (1990) and Szewczyk et al. (1996), we measure the R&D intensity of a firm as the

ratio of its R&D expenditure to sales in the fiscal year –1. We then estimate the R&D

intensity of the industry as the ratio of R&D expenditure to the net sales of all firms with

the same primary Compustat four-digit SIC code. Finally, a firm’s Relative R&D Intensity,

which is a measure of the firm’s financial resources allocated to R&D relative to that of itspeers, is calculated as the ratio of the firm’s R&D intensity to the R&D intensity of the

industry in which the firm is located.

Industry Competitiveness. Woolridge and Snow (1990) present that the announcement

of strategic investment decisions may release an unexpected improvement in the investing

firm’s cash flow that derives from an increase in its market share. The investing firm within

an imperfect competitive environment may gain at the expense of rival firms. As such, this

study expects that the stock price reaction to new product announcements will be more

positive in industries with a lower degree of competition. The level of industry competi-

tiveness is represented in this study by the Herfindahl Index

, which is measured as the sumof the squared proportion of industry sales. The data is collected from Compustat for a total

of 48 industries based upon the industry classification of Fama and French (1997).3

Although this index is essentially a measure of concentration, it has, nevertheless, been

3 This follows the approach used in Masulis et al. (2007), Giroud and Mueller (2011), and Chen et al.

(2010).


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widely used as a proxy for competitiveness largely because of the inverse relationship

generally found between the degree of concentration and the degree of competition.

4 Empirical results

Table 1 presents the sample distribution, by year of announcement, which shows that about

33 per cent of the sample announcements occurred in 2003 and 2004.

Table 2 provides the descriptive statistics and Pearson’s correlation coefficients for all

of the corporate governance and control variables adopted in this study. Our sample firms

have an average of ten directors on their boards, with a mean proportion of independent

directors of 71 per cent, and about 88 per cent of all directors on the audit committees

being totally independent. The mean ratio of equity-based compensation is 0.59 and the

average number of analyst following is 18.58.

4.1 Overall sample

The abnormal returns for new product announcements are presented in Table 3, which

shows that the average 2 day announcement period abnormal return is 0.54 per cent

(t = 7.02), with a statistical significance at the 0.1 per cent level. We also calculate the

median abnormal returns of each window and conduct significance tests using the non-

parametric Wilcoxon z-statistic, and the results are very similar. This finding is consistent

with Woolridge (1988) and Chen et al. (2002).4 Our results also indicate, however, that

there is a particularly high variation in the announcement effect amongst our sample firms;the proportion of firms receiving positive market reactions is only 51 per cent. We find no

significant abnormal returns for other days surrounding the announcements. This suggests

that the impact of new product announcements is captured in the CAR (–1, 0).

4.2 Analysis of subsamples based on the governance mechanism

To test the impact of the corporate governance mechanism on the stock price response of

new product announcement, we divide the sample firms into two governance sub-groups

based upon their ‘better’ or ‘poorer’ corporate governance levels. We then calculate the

4 Woolridge (1988) demonstrates that between 1972 and 1984, the 2 day (–1, 0) average cumulative

market-adjusted return for a sample of product-announcing firms is 0.84 per cent, whilst Chen et al. (2002)

show that for a sample of firms announcing new product introductions between 1991 and 1995, the two-day

(–1, 0) average cumulative abnormal return is 0.59 per cent, with significance at the 1 per cent level; our

mean two-day abnormal return is 0.54 per cent, with significance at the 1 per cent level. The magnitude of

the abnormal return found in this study is therefore very much in line with those found in prior studies.

Table 1 Sample distribution

Year

1997 1998 1999 2000 2001 2002 2003 2004 Total

No. of announcements 282 229 288 212 128 169 259 378 1,945

Share of sample (%) 14.5 11.8 14.8 10.9 6.6 8.7 13.3 19.4 100.0

Our study sample is comprised of a total of 1,945 new product announcements made between 1997 and 2004

by 341 firms listed on either the NYSE or the AMEX


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stock market reaction to the new product introduction and examine the mean and median

difference in the stock market reaction between the groups with these ‘better’ and ‘poorer’

governance levels. We expect to find a more positive market reaction to new product

introductions by the better governance group than those by the poorer governance group.

To examine the effects of Board Size, we separate the firms into smaller or larger boards

(Panel A of Table 4) based upon the sample median size of ten board members. The results

show that firms with smaller boards experience a significantly positive mean announce-

ment effect of 0.86 per cent (t = 7.78), whilst the mean announcement effect of firms with

larger boards is 0.30 per cent (t = 3.12). The mean difference in CAR between firms with

smaller and larger boards is 0.56 per cent (t = 3.80). The results suggest that corporate

governance is more effective in firms with small boards, and that this may provide

investors with a more positive signal on the valuation of new products. Our finding is

consistent with the argument of Yermack (1996), which small boards can more effectively

monitor the investment decisions taken by managers.

The effect of Board Independence, measured by the ratio of independent board mem-bers, is examined in Panel B of Table 4. The sub-samples of greater (lesser) independence

contain firms with ratios of independent board members higher (lower) than the sample

median of 75 per cent. The results show that following the announcement of new product

introductions, firms with a greater number of independent members experience a signifi-

cantly positive mean abnormal return of 0.75 per cent (t = 7.66), whilst the return for firms

with less independent directors is 0.36 per cent (t = 3.64). The mean difference between

the sub-groups is 0.39 per cent (t = 2.79), which is found to have statistical significance at

the 1 per cent level.

The effects of Audit Committee Independence are examined in Panel C of Table 4,

which shows that whilst firms in both sub-samples receive a significantly positive stock

market reaction, the mean abnormal return is significantly greater for firms with greater

audit committee independence than for those firms with less audit committee indepen-

dence. The evidence is consistent with the results presented in Panels A and B of Table 4,

and suggests that the independence of directors is an important consideration in investors’

value assessment of new product introductions.

Table 3 Cumulative abnormal returns for firms making new product announcements

Period relative

to announcement

Cumulative abnormal returnsa Proportion of positive

abnormal returns (%)Mean (%) t -statisticb Median (%) p-value for the

Wilcoxon z-statistic

(–10, –4) –0.15 –0.94 –0.11 0.412 49

(–3) 0.05 0.74 –0.03 0.888 49

(–2) –0.06 –0.92 –0.14 0.098 47

(–1, 0) 0.54 7.02*** 0.08 0.000 51

(1) –0.01 –0.09 –0.06 0.438 49

(2) 0.04 0.61 –0.12 0.462 47

(3) –0.06 –0.94 –0.18 0.006 46

(4, 10) –0.25 –1.56 –0.07 0.238 49

a This table examines the cumulative abnormal returns surrounding the announcements of 1,945 new

product introductions which took place between 1997 and 2004b The p-value refers to the t -statistic

*** indicates p\0.01


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Table 4 Announcement period

abnormal returns of announcers,

by corporate governance

mechanisms

The analysis of the sub-samples

is undertaken based upon the

relative corporate governance

variables from Panels A to E,

with the 2 day (–1, 0) average

announcement period abnormal

returns being generated for each

announcing firm over the period

1 day prior to the initial

announcement datea The number of observations

varies across panels as a resultof the unavailability of certain

governance variablesb For the comparison of the

means, we report the mean

difference and the t -statistic

under the assumption of unequal

variances; the results are similar

to those obtained under the

assumption of equal variance.

The non-parametric Wilcoxon

z-statistic is employed to test the

median difference

* indicates p\0.1

** indicates p\0.05

*** indicates p\0.01

Panel A: board size (median = 10)

Small Large Difference

Mean 0.86 0.30 0.56

t -statisticb (7.78)*** (3.12)*** (3.80)***

Median 0.22*** –0.06 0.28**

No. of observationsa 1,051 867

Panel B: board independence (median = 75%)

Greater Less Difference

Mean 0.75 0.36 0.39

t -statisticb (7.66)*** (3.64)*** (2.79)***

Median 0.27*** 0.02* 0.25**

No. of observationsa 954 914

Panel C: audit committee independence (median = 1)


Mean 0.82 0.36 0.46

t -statisticb (8.77)*** (3.27)*** (3.18)***

Median 0.21*** 0.05** 0.17*


Panel D: CEO equity-based pay (median = 0.65)

High Low Difference

Mean 0.84 0.34 0.51

t -statisticb (7.51)*** (3.82)*** (3.56)***

Median 0.25*** 0.01* 0.24**

No. of observationsa 933 966

Panel E: analyst following (median = 17.33)


Mean 0.74 0.41 0.33

t -statisticb (6.66)*** (4.45)*** (2.20)**

Median 0.27*** –0.04 0.32**

No. of Observationsa 954 970

Panel F: G-index score (median = 9.00)

Low High Difference

Mean 0.63 0.30 0.33

t -statisticb (6.48)*** (2.48)** (2.15)**

Median 0.26*** –0.16 0.42**



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The impact of CEO Equity-based Pay is examined in Panel D of Table 4, from which

we can see that the mean abnormal return for those firms whose CEOs received high

proportions of equity-based compensation (0.84 per cent) is significantly greater than the

mean for firms with low proportions of CEO equity-based compensation (0.34 per cent).

This result highlights the importance of equity-based compensation in mitigating theagency problem.

The impact of Analyst Following on the announcement effect of new product intro-

ductions is examined in Panel E of Table 4. Those firms described as having a greater

analyst following were those with a greater number of analyst reports than the sample

median of 17.33 during the fiscal year prior to the announcement of the new product

introduction. As shown in the table, the mean abnormal returns for firms with greater

(lesser) analyst following are 0.74 per cent (0.41 per cent), with the difference being found

to be statistically significant at the 5 per cent level.

Finally, we use the G-index Score as a proxy for shareholder rights, and use it to

examine the impact of governance on the wealth effect of new product announcing firms.

The results presented in Panel F of Table 4 show that the group with lower G-index scores

experiences a significantly positive mean announcement effect (0.63 per cent), while the

mean announcement effect for the group with a greater G-index score is positive (0.30 per

cent).5 The mean difference in abnormal returns between the two groups is 0.33 per cent

and significant at the 5 per cent level. We further calculate the median CARs of the

subsamples in each panel, and find very similar results.

In summary, the results in Table 4 provide clear support for our hypotheses that cor-

porate governance measures are generally of significance in explaining the stock market

reaction to new product announcements. However, it is important to note that we did notcontrol for other potential factors that may also influence stock market responses.

4.3 Cross-sectional regression analyses

In order to further examine the impact of corporate governance on the stock market

reaction to the new product introductions, we employed the following cross-sectional

regression model:

CARi ¼ aþ b1CGi þ b2CG High HHI þ b3Tobin0s Qi þ b4Free Cash Flowi

þ b5 Debt Ratioi þ b6Firm Sizei þ b7 Relative R& D Intensityi

þ b8 Herfindahl Indexi þ ei

where CAR refers to the 2 day (–1, 0) announcement-period abnormal returns for a firm

introducing a new product; CG refers to the corporate governance variable; High_HHI is

equal to 1 if the industry’s Herfindahl index is in the top quartile of all industries;6 Tobin’s

Q refers to the ratio of the market-to-book value of the firm’s assets; Free Cash Flow is the

free cash flow of the firm; Debt Ratio is the ratio of the book value of long-term debt to the

book value of total assets; Firm Size refers to the natural logarithm of the book value of

total assets; Relative R&D Intensity is the ratio of the firm’s R&D intensity to the R&D

5 Other studies, such as Gompers et al. (2003), Masulis et al. (2007) and Giroud and Mueller (2011), refer to

companies with a G-index score of 5 or less as democracies and to companies with a G-index score of 14 or

greater as dictatorships. We have also used 5 and 14 as the cut-off G-index scores in our sensitivity analysis.

The conclusions in our study remain unchanged.6 We have also used median and top tercile as the cut-off Herfindahl index values in our sensitivity analysis.

The conclusions in our study remain unchanged.


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intensity within the industry in which the firm is located; and Herfindahl Index refers to the

Herfindahl index7 of the firm.

The literature suggests that industry competition could also influence the impact of

corporate governance on abnormal returns (Giroud and Mueller 2011). Shleifer and Vishny

(1997) present that managers of firms in competitive industries are likely to reduce slack and put valuable resources into efficient uses. Giroud and Mueller ( 2011) argue that firms

in noncompetitive industries, where low competitive pressure results in managers reducing

their effort, corporate governance plays a relatively more important role. To consider the

mediation effect of product market competition,8 we included the interaction term

(CG 9 High_HHI ) in the regressions.

The results of the multivariate cross-sectional regression analyses of the 2 day (–1, 0)

announcement-period abnormal returns are presented in Table 5, for both the corporate

governance measures and the control variables. It is important to note that the observations

are found to vary across regression models, essentially due to data availability limitations.

The effects of the size of the board are tested in Model 1, with the results showing that

the coefficient of Board Size is –1.438 (t = –3.96), which is negatively and statistically

significant at the 1 per cent level. This result suggests that the announcement effect is more

favorable for firms with a smaller board size. The coefficient of Board Independence in

Model 2 is 0.010 (t = 1.93), which indicates that the number of independent directors has a

positive correlation with the stock market reaction to new product announcements. The

importance of Audit Committee Independence is examined in Model 3, with the findings

suggesting a strong positive relationship between the independence of the audit committee

and the reaction by the market to new product introductions. The influence of CEO Equity-

based Pay is tested in Model 4, with the results revealing a positive effect. Model 5examines the influence of analyst reports, with the coefficient on Analyst Following being

found to be 0.863 (t = 5.08) and demonstrating a significantly positive correlation with the

wealth effect of new product announcements. Model 6 shows that the G-index Score is

significantly negatively related to the announcement of firms’ cumulative abnormal

returns. That is, the announcement effect is significantly more favorable for announcing

firms with greater shareholder rights. The results are again consistent with the prediction

for the role of corporate governance in explaining the wealth effects of new product

introductions.

The control variables in the models show signs that are generally consistent with the

prior studies. However, all except Firm Size are found to be insignificant in the presentstudy, while Firm Size is found to be statistically significant with and a negative correlation

with abnormal returns during the announcement period of new product introductions.9 This

indicates that new product introductions by larger firms may contain less unanticipated

information than those of smaller firms, and. This is essentially attributable to the fact that

information production and dissemination remains a positive function of firm size (Hertzel

and Smith 1993; Kang and Stulz 1996).

7 Qualitatively similar results are obtained if the Herfindahl index is measured by the sum of the squared

market shares of all Compustat firms based on the industry classification of their Compustat four-digit SIC

code (as in Lang and Stulz 1992, and Song and Walkling 2000).8 Our results are similar when the competitive structure of an industry is measured by the product

uniqueness (as in Masulis et al. 2007 and Chen et al. 2010).9 We also obtained similar results when we used net sales and the number of employees to measure the size

of the firm.


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T a b l e 5

C r o s s - s e c t i o n a l r e g r e s s i o n a n a l y s e s o f a n n o u n c e m e n t - p e r i o d a b n o r m a l r e t u r n s

V a r i a b l e s

M o d e l 1

M o d e l 2

M o d e l 3

M o d e l 4

M o d e l 5

M o d e l

6

C o e f f .

t - s t a t .

C o e f f .

t - s t a t .

C o e f f .

t - s t a t .

C o e f f .

t - s t a t .

C o e f f .

t - s t a t .

C o e f f .

t - s t a t .

I n t e r c e p t

3 . 7

5 1

5 . 4

8 * * *

0 . 4

8 5

0 . 8

8

1 . 0

4 4

1 . 6

9 *

0 . 9

8 1

2 . 0

2 * *

1 . 6

6 5

3 . 2

8 * * *

2 . 5

7 7

4 . 0

5 * * *

L o g ( b o a r d s i z e )

– 1 . 4

3 8

– 3 . 9

6 * * *

B o a r d i n d e p e n d e n c e

0 . 0

1 0

1 . 9

3 *

A u d i t c o m m i t t e e

i n d e p e n d e n c e

0 . 0

0 9

2 . 2

6 * *

C E O e q u i t y - b a s e d p a

y

0 . 6

2 4

2 . 3

2 * *

L o g ( a n a l y s t f o l l o w i n g )

0 . 8

6 3

5 . 0

8 * * *

G - I n d e x

– 0 . 0

7 8

– 2 . 3

7 * *

C G 9

H i g h_

H H I

– 0 . 0

1 6

– 0 . 1

7

– 0 . 0

0 2

– 0 . 7

9

– 0 . 0

0 2

– 0 . 8

0

– 0 . 4

0 1

– 1 . 4

0

0 . 0

5 3

0 . 6

9

– 0 . 0

0 1

– 0 . 0

5

T o b i n ’ s Q

– 0 . 0

3 0

– 0 . 4

9

– 0 . 0

0 6

– 0 . 1

0

– 0 . 0

3 3

– 0 . 5

5

– 0 . 0

2 0

– 0 . 3

3

0 . 1

3 5

2 . 0

7 * *

– 0 . 0

1 8

– 0 . 2

5

F r e e c a s h fl o w

0 . 6

1 6

0 . 5

2

– 0 . 4

6 0

– 0 . 4

1

– 1 . 0

8 6

– 0 . 9

3

– 0 . 2

5 8

– 0 . 2

3

– 0 . 7

7 3

– 0 . 6

5

– 0 . 4

2 2

– 0 . 3

0

D e b t r a t i o

– 0 . 0

0 8

– 0 . 0

5

– 0 . 0

6 9

– 0 . 5

2

– 0 . 0

5 1

– 0 . 3

8

– 0 . 0

2 6

– 0 . 1

9

0 . 0

8 1

0 . 5

7

0 . 0

3 0

0 . 2

0

F i r m s i z e

0 . 0

2 1

0 . 3

5

– 0 . 0

5 0

– 1 . 0

5

– 0 . 0

8 8

– 1 . 8

5 *

– 0 . 0

6 4

– 1 . 3

3

– 0 . 3

3 8

– 4 . 6

8 * * *

– 0 . 1

3 4

– 2 . 5

9 * * *

R e l a t i v e R & D i n t e n s i t y

0 . 0

0 3

0 . 1

3

– 0 . 0

1 6

– 0 . 7

1

– 0 . 0

2 2

– 0 . 9

4

– 0 . 0

1 7

– 0 . 7

1

– 0 . 0

1 7

– 0 . 6

7

– 0 . 0

2 0

– 0 . 8

2

H e r fi n d a h l i n d e x

– 0 . 2

0 9

– 0 . 0

9

– 0 . 5

5 3

– 0 . 2

7

– 2 . 8

4 7

– 1 . 3

1

– 0 . 5

6 8

– 0 . 3

0

– 1 . 8

7 9

– 0 . 8

7

– 1 . 3

9 2

– 0 . 6

0

A d j u s t e d R 2

0 . 0

0 8

0 . 0

0 1

0 . 0

0 5

0 . 0

0 1

0 . 0

1 2

0 . 0

0 2

N o . o f o b s e r v a t i o n s

a

1 , 9

1 8

1 , 8

6 8

1 , 8

4 7

1 , 8

9 9

1 , 9

2 4

1 , 8

8 0

T h e d e p e n d e n t v a r i a b l e i s t h e 2 d a y ( – 1 ,

0 ) a n n o u n c e m

e n t p e r i o d c u m u l a t i v e a b n o r m a l

r e t u r n ( C A R )

a

T h e n u m b e r o f o b

s e r v a t i o n s v a r i e s a c r o s s r e g r e s s i o n s a s a r e s u l t o f t h e n o n - a v a i l a b i l i t y o f c e r t a i n g o v e r n a n c e v a r i a b l e s

* i n d i c a t e s p \

0 . 1 0

* * i n d i c a t e s p \

0 . 0 5

* * * i n d i c a t e s p \ 0 . 0 1


1 3


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5 Conclusions

This study examines the relationship between corporate governance and the market

reaction to new product announcements. We investigate a sample of US firms announcing

new product introductions between 1997 and 2004, with the results revealing that newproduct announcements are generally associated with significantly positive abnormal

returns. The results further indicate that those firms with a small board size, greater board

independence, a more independent audit committee, higher CEO equity incentives, more

analyst coverage and greater shareholder rights (represented by a lower G-index score) see

greater announcement effects. The evidence is consistent with the hypothesis that better

corporate governance mechanisms reduce agency costs, whilst also increasing the value

creation of new product introductions through monitoring and alignment mechanisms.

Our findings suggest that corporate governance factors are important for investors in

assessing the valuation effect of innovation. Financial markets consider not only innova-

tion-specific information, but also factors relating to managerial incentives. Better gov-

ernance mechanisms convey positive information to investors that investments are not

being made for the personal interests of managers. This is an effect which is expected to be

of greater importance in cases where there is strong information asymmetry between firms

and investors. Managers are advised to take this signaling effect of corporate governance

into consideration in all areas relating to information disclosure.

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