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CORPORATE OWNERSHIP & CONTROL Volume 11, Issue 2, 2014, Continued - 1
CONTENTS
DOES ANALYST FOLLOWING IMPROVE FIRM PERFORMANCE? EVIDENCE FROM THE MENA REGION 157 Omar Farooq, Harit Satt ENHANCING THE CORPORATE PERFORMANCE THROUGH SYSTEM DYNAMICS MODELLING 167 Mridula Sahay, Kuldeep Kumar THE EFFECT OF CORPORATE GOVERNANCE ON BANK FINANCIAL PERFORMANCE: EVIDENCE FROM THE ARABIAN PENINSULA 178 Mohamed A. Basuony, Ehab K. A. Mohamed, Ahmed M Al-Baidhani DEBT, GOVERNANCE AND THE VALUE OF A FIRM 192 K. Rashid, S. M. N. Islam, S. Nuryanah LINK BETWEEN MARKET RETURN, GOVERNANCE AND EARNINGS MANAGEMENT: AN EMERGING MARKET PERSPECTIVE 203 Omar Al Farooque, Eko Suyono, Uke Rosita THE LIFECYCLE OF THE FIRM, CORPORATE GOVERNANCE AND INVESTMENT PERFORMANCE 224 Jimmy A. Saravia EXECUTIVE COMPENSATION, ORGANIZATIONAL CULTURE AND THE GLASS CEILING 239 Michael Dewally, Susan Flaherty, Daniel D. Singer
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DOES ANALYST FOLLOWING IMPROVE FIRM PERFORMANCE? EVIDENCE FROM THE MENA REGION
Omar Farooq*, Harit Satt**
Abstract
Given ineffective disclosure and governance mechanisms, are there any mechanisms that can help improve performance of firms in the MENA region? This paper aims to answer the above question by documenting the effect of analyst following on firm performance during the period between 2005 and 2009. Our results show that the extent of analyst following does positively affect firm performance. However, this beneficial impact exists only at high level of analyst following. At lower levels of analysts following, our results show negative relationship between the two. We argue that high levels of analyst following, it becomes hard for insiders to evade effective disclosure of firm value. It, therefore, leads to lower agency problems and, eventually, to better performance. We also show that high levels of analyst following, partly, improve the informativeness of reported earnings. However, it does not improve the informativeness to an extent that the information contained in reported earnings is positively reflected in stock prices. JEL classification: G32 Keywords: Analyst Following, Corporate Governance, Firm Performance, Earnings Informativeness, Emerging Markets * Department of Management, American University in Cairo, Cairo, Egypt Tel.: 20 102 376 0037 Email: [email protected] ** School of Business Administration, Al Akhawayn University in Ifrane, Ifrane, Morocco
1. Introduction
Information is the key to efficient functioning of the
stock markets. Securities get priced correctly when
the relevant information about firms get incorporated
into the prices. Financial analysts play an important
role in this process by bringing out new information
about firms. Under normal circumstances, stock
market participants view analysts’ research reports,
forecasts, and recommendations as relatively accurate
sources of information and use them in their
investment decisions. Jensen and Meckling (1976)
suggest that, as information intermediaries, financial
analysts are able to mitigate the agency problems
present within firms. Merton (1987) argues that the
market value of a firm is an increasing function of the
breadth of investor awareness. Conventional wisdom
suggests that one of the ways to increase awareness of
an investor regarding a certain firm is by increasing
the extent of analyst following. Chung and Jo (1996)
argue that the value of a firm is a positive function of
number of analysts following a firm. In addition to
increasing awareness, analyst following may also
effect firm valuation by reducing information
asymmetries and agency problems. Analysts perform
the task of discovering any information that firm
decides to hide. In doing so, they act as a device that
ensures that all information is presented to stock
market participants. As a result, they help reduce
information asymmetries and positively impact firm
valuation. Furthermore, greater the extent of analyst
following, greater is the amount of information that
gets discovered. The extent of analyst following,
therefore, should be an important determinant of the
relationship between analyst following and firm
valuation.
In this paper, we aim to extend the above strand
of literature by documenting whether the extent of
analyst following improves firm performance, an
important proxy for firm valuation, in the previously
unexplored region of the Middle East and North
Africa (MENA). To the best of our knowledge, this is
the first attempt to relate the two in the MENA region.
Given the ability of analysts to uncover new
information, it is intuitive to argue that they are able
to reduce information asymmetries between outsiders
and insiders. Reduction in information asymmetries
makes expropriation technology costly and results in
disciplining the managers by reducing agency
problems. Therefore, analyst following is an obvious
determinant of firm performance. Furthermore,
conventional wisdom suggests that greater is the
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158
extent of analyst following for a certain firm, higher is
the reduction in information asymmetries. As a result,
greater is the extent of analyst following, better
should be firm performance. Consistent with our
expectations, our results show that analyst following
does positively affect firm performance in the MENA
region (Morocco, Egypt, Saudi Arabia, United Arab
Emirates, Jordan, Kuwait, and Bahrain) during the
period between 2005 and 2009. However, this
positive impact exists only at high levels of analyst
following. At lower levels of analyst following, we
report a negative impact of analyst following on firm
performance – an unexpected finding. Our results are,
partly, consistent with prior literature that considers
any mechanism that helps resolve information
asymmetries between insiders and outsiders as value
relevant for stock market participants. As an example,
consider Lang et al. (2004) who document a positive
valuation effect of analyst following in emerging
markets. They argue that emerging markets have
scarcity of information, thereby enhancing the value
relevance of any mechanism that provides valuable
information to investors. Our results are partly
consistent because at the lower levels of analyst
following, our results show that the extent of analyst
following negatively impacts firm performance. This
is surprising because, at most, low analyst following
should result in no impact on firm performance.
Negative association between the two is counter
intuitive.
Another surprising finding of our analysis is the
negative relationship between firm performance and
earnings per share. This relationship is also robust
across different sub-samples. One reason for this
negative impact is the low information content of
reported earnings. Investors, aware of the fact that
firms in the emerging markets misreport information,
have little faith on reported information. Therefore,
they discount earnings per share. In order to see
whether the extent of analyst following improves the
infomativeness of reported earnings, this paper also
documents the impact of analyst following on the
informativeness of reported earnings. Our results
show that analyst following does improve the
informativeness of reported earnings, but it does not
completely offset the lower faith that investors have
on reported information. Our results show that the
magnitude of negative relationship between earnings
per share and firm performance reduce significantly
as the extent of analyst following goes up.
Our results are important for investors investing
in the MENA region. One of the main problems faced
by these investors is that it is almost impossible for
them to differentiate between good and bad firms.
However, our results show that investors can use
analyst following to infer which firm is expected to do
good and which firm is expected to do bad.
Furthermore, our results also indicate that analyst
following can also be used to improve the
informativeness of reported earnings. Our results
show that investors can complement accounting
information with analyst following to distinguish
between true and manipulated accounting
information. It is important to mention here that our
paper adds to the debate on the effectiveness of
alternate/external governance mechanisms in the
MENA region. Unlike the developed markets,
analysts are not considered very important monitoring
mechanisms in the MENA region. Farooq and Id Ali
(2012) show no value in analysts’ recommendation in
the MENA region. They consider lower demand for
analyst services and relatively low market for
reputation in the MENA region for their result.
However, our results indicate that analysts do have
some value for stock market participants. The
increased scrutiny provided by them helps in reducing
information asymmetries, thereby improving firm
performance.
The remainder of the paper is structured as
follows: Section 2 briefly discusses motivation and
background for this study. Section 3 summarizes the
data and Section 4 presents assessment of our
hypothesis. Section 5 discusses implications of our
findings and the paper concludes with Section 6.
2. Motivation and background
Prior literature characterizes emerging markets with
ineffective and weak corporate governance
mechanisms. Claessens and Fan (2003), for instance,
note that traditional governance mechanisms are weak
in emerging markets. In another related study, Farooq
and Kacemi (2011) document that an average firm in
the Middle East and North Africa is owned and
controlled by a single entity. They argue that
concentration of ownership in the hands of a few
gives rise to many of the agency problems. These and
numerous other studies argue that weak enforcement
of investor protection laws, presence of family
control, and lax implementation of anti-director rights
contribute to ineffectiveness of corporate governance
mechanisms in emerging markets. Prior literature
suggests that ineffective governance mechanisms
result in poor information disclosure. Leuz et al.
(2003), for instance, document that managers and
insiders do not disclose true information about their
firms in emerging markets. As a result, agency
problems are exacerbated, thereby causing adverse
impact on firm performance. Dowell et al. (2000)
argue that firms with no or little adaptation to global
governance standards have lesser market value. In
another related study, Black (2001) shows that
ineffective corporate governance mechanisms
adversely affect firm valuations in emerging markets.
This strand of literature argues that higher information
asymmetries in poorly governed firms provide
incentives to managers/controlling shareholders to
expropriate resources, thereby negatively affecting
firm performance.
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Given that financial analysts can help resolve
some of the inefficiencies in corporate governance
mechanisms, this paper argues that analyst following
is a value enhancing mechanism in emerging markets.
Analysts resolve inefficiencies in governance
mechanisms by bringing out new information to stock
market participants. Michaely and Womack (1999)
note that analysts are the agents that collect, interpret,
and disseminate public and private information to
stock market participants. By disseminating valuable
information, analysts are able to resolve information
asymmetries. Amir et al. (1999) also suggest that
analysts’ research mitigate information deficiencies
present in financial statements. This paper argues that
analysts’ role as information providers is of
paramount importance in emerging markets
(Claessens et al., 2002; Lins, 2003; Dyck and
Zingales, 2004; Nenova, 2003). Nenova (2003) argues
that investors discount firms with high information
asymmetries. Information asymmetries introduce
agency problems within firms and expose investors to
excessive risk. Therefore, any mechanism that can
help in reducing information asymmetries is of great
importance to stock market participants.
Our arguments are consistent with prior
literature that considers financial analysts to substitute
for corporate governance mechanisms in emerging
markets. Lang et al. (2004), for example, document
the substitution effect of analysts by showing that the
extent of analyst following mitigates the negative
effect of lower investor protection on valuation in
emerging markets. In another related study, Knyazeva
(2007) documents that analyst following improves
firm performance by substituting for corporate
governance. Main argument in this strand of literature
is that analysts’ role as information providers allow
investors to offset any information misreported by
firms. This strand of literature also argues that the
nature of analyst’s job is such that he has to make
every effort to bring to light any information
misreported or not disclosed by firms.1 Conventional
wisdom suggests that more is the number of analysts
looking out for information, greater is the chances that
no information remains misreported or undisclosed.
As a result, higher analyst following should affect
firm performance more than lower analyst following.
At a lower level of analyst following, the information
asymmetries are not resolved to an extent that analyst
following becomes valuable for stock market
participants. It, therefore, leads us to hypothesis a
positive but a nonlinear relationship between analyst
following and firm performance.
1 Plentiful of prior literature suggests that the compensation
of analysts depend on their accuracy (Stickel, 1992; Hong and Kubik, 2003). Therefore, it is intuitive to argue that analysts strive for gathering as much value relevant information as possible.
H1a: There is a positive, but nonlinear, relationship
between analyst following and firm performance in
emerging markets
However, a second school of thought contests the
value enhancing impact of analyst following in
emerging markets.2 This school of thought cites
several reasons behind no impact of analyst following
in emerging markets. Most important of them are: (1)
Lower market for reputation, (2) Less demand for
analyst services, and (3) Unscrupulous behavior of
brokerage houses. All of these factors are expected to
affect value enhancing role of analysts to a varying
degree.
The first issue that arises in emerging
markets is the absence of market for reputation.
Anecdotal evidence suggests that there are no rating
agencies like “Institutional Investor (publisher of All-
American Research Team)” or “The Wall Street
Journal (publisher of Best on the Street)” in most of
the emerging markets. Therefore, there is little
incentive for analysts to improve their rankings or
reputation. In the absence of market for reputation, it
is not entirely clear why analysts would compete for
quality. In addition, evidence also suggests lower
development of financial press or financial media in
these markets. For instance, there are no well-
developed TV channels are that specifically related to
financial news. If there were such TV channels, it
would have been possible for some analysts to
develop reputation of being accurate and it would
have pushed the others to be accurate as well. Lower
market for reputation should lower the pressures that
analysts may face to improve value of their research.
As a result, value enhancing role analysts is expected
to be less pronounced in emerging markets.
Another issue that often arises in emerging
stock markets is the lower demand for analyst
services. Prior literature suggests limited participation
of local populations in emerging stock markets.
Giannetti and Koskinen (2005), for example,
document that only 3.3% of Indian population invests
in stock market, while this statistics is 1.2% for
Turkey and 2.3% for Sri Lanka. They also show that,
in contrast to emerging markets, 40.4% of Australian
population, 26.0% of the US populations, and 31.0%
of New Zealand population invests in stock markets.
We argue that limited participation of local
populations in stock markets lowers the demand for
analyst services in emerging markets. Lower demand
of analyst services should reduce the incentives for
analysts to improve their research, thereby resulting in
a weaker relationship between analyst following and
firm performance.
2 There is not enough evidence on how valuable analyst
research is in most of the emerging markets. Erdogan et al. (2011), for instance, document that analysts are not able to distinguish well performing and poorly performing firms in Turkey. In another related study, Farooq and Ahmed (2013) report low value of analyst recommendations in Pakistan.
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In addition to the above two factors,
inadequate regulations pertaining to brokerage houses
may also result in lowering the value of analyst
research. Prior literature documents that brokerage
houses collude to manipulate stock prices in emerging
markets. Khwaja and Mian (2006) document that
“when brokers trade on their own behalf, they earn at
least 50 to 90 percentage points higher annual returns
and these abnormal returns are earned at the expense
of outside investors”. In another related study,
Khanna and Sunder (1999) argue that “brokers were
often accused of collaborating with the company
owners to rig share prices in pump and dump
schemes”. Farooq and Ahmed (2013) argue that one
of the channels via which brokerage houses
manipulate prices is by using financial analysts
employed by them. They explain a scenario where a
brokerage house starts accumulating stocks at a lower
price. It gradually pushes the stock price up until it
reaches a level where brokerage houses ask their
analysts to issue buy recommendations. Naive
investors, anticipating stock prices to go up further,
keep on buying in response to analysts’ buy
recommendations. At this high price, brokerage
houses start disposing off their accumulated stocks.
An outcome of such behavior is the decline in value
enhancing role analysts in emerging markets.
All of the above mentioned factors may result in
insignificant relationship between analyst following
and firm performance.
H1b: There is no relationship between analyst
following and firm performance in emerging markets
3. Data
This paper examines how the extent of analyst
following affects firm performance in the MENA
region. We select Morocco, Egypt, Saudi Arabia,
United Arab Emirates, Jordan, Kuwait, and Bahrain
as the representative stock markets for the MENA
region because of their relatively more development.
The sample period is between 2005 and 2009. The
following sub-sections will explain the data in greater
detail.
3.1 Analyst following
We define analyst following by the maximum number
of analysts issuing annual earnings forecasts in a
given year. Greater the number of analysts following
a firm, the better is its information environment and
lower is information asymmetry. Data for analyst
following is obtained from the I/B/E/S.3 Table 1
3 The Institutional Brokers' Estimate System (I/B/E/S) is a
database owned by Thomson Financials and provides data on analyst activities, such as earnings forecasts and stock recommendations issued by them. The IBES provides a data entry for each forecast and each recommendation announcement by each analyst whose brokerage house contributes to the database. Each observation in the file
documents the descriptive statistics for analyst
following during our sample period. Panel A presents
descriptive statistics for each year, while Panel B and
Panel C presents similar statistics for each country
and each industry respectively. Our results in Table 1,
Panel A, show that analyst following gradually
increased from 0.8497 in 2005 to 2.8732 in 2009. It
shows gradual improvement in analyst industry in the
MENA region. It also shows that maximum analyst
following that a firm generated was 11 analysts in
2005. It also gradually increased to 20 analysts by
2009. Furthermore, Table 1, Panel B, shows that firms
headquartered in United Arab Emirates, Morocco, and
Egypt have the highest level of analyst following in
the region. We report average analyst following of
1.6780 in United Arab Emirates, 1.6238 in Morocco,
and 1.3145 in Egypt. Table 1, Panel B, also reports
that firms headquartered in Kuwait have the least
level of analyst following in the region. The results in
Table 1, Panel C, show that firms belonging to
Telecommunication sector have the highest level of
analyst following. It is intuitive because most of
Telecommunication firms are large and very
profitable firms in the region.
Table 1 documents the descriptive statistics for
analyst following in the MENA region, i.e. Morocco,
Jordan, Bahrain, Egypt, Kuwait, United Arab of
Emirates, Saudi Arabia, and Qatar. The sample period
is from 2005 to 2009. Panel A document descriptive
statistics for each year, while Panel B and Panel C
document similar statistics for each country and each
industry respectively.
3.2 Firm performance
This paper measures firm performance by market-
adjusted returns (RET). We define RET as the
difference between stock returns and market returns.
Stock prices and market index are obtained from the
Datastream. The stock price data and the market index
data was obtained for the first and the last day of a
given year to compute RET.
3.3 Control variables This paper uses the following firm-specific
characteristics as control variables. The data for
control variables is obtained from the Worldscope.
SIZE: We measure size by log of market
capitalization. Conventional wisdom suggests that
large firms have lower agency problems due to
increased interest from stock market participants
(investors and analysts). Lower agency problems
should lead to better performance of large firms (Fang
represents the issuance of a forecast or a recommendation by a particular brokerage house for a specific firm. For instance, one observation would be a forecast or a recommendation by Brokerage House ABC regarding Firm XYZ.
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161
et al., 2009). Furthermore, Bhattacharyya and Saxena
(2009) argue that larger firms have more bargaining
power over their suppliers and competitors, thereby
improving their performance.
Table 1. Descriptive statistics for analyst following
Panel A. Analyst following in different years
Years Average Standard Deviation Maximum Minimum
2005 0.2621 0.8497 11 0
2006 0.4681 1.1791 13 0
2007 0.6909 1.4454 13 0
2008 1.0439 2.1206 14 0
2009 1.4015 2.8732 20 0
Panel B. Analyst following in different countries
Countries Average Standard Deviation Maximum Minimum
Bahrain 0.3095 0.6220 3 0
Egypt 1.3145 2.3932 14 0
Jordan 0.3102 0.7532 5 0
Kuwait 0.2415 0.9515 12 0
Morocco 1.6238 1.1392 8 0
Qatar 0.6487 1.8132 13 0
Saudi Arabia 0.6352 1.6066 14 0
United Arab of Emirates 1.6780 3.2715 20 0
Panel C. Analyst following in different industries
Industry Average Standard Deviation Maximum Minimum
Oil and Gas 0.3647 0.9238 5 0
Basic Materials 0.9000 1.5137 10 0
Industrials 0.7870 1.6066 14 0
Consumer Goods 0.4603 0.9242 5 0
Healthcare 0.6000 0.8329 3 0
Consumer Services 0.4240 1.4241 15 0
Telecommunication 4.7600 4.6319 14 0
Utilities 1.6285 1.7836 6 0
Financials 0.7851 1.9637 20 0
Technology 1.1428 2.3904 11 0
LEVERAGE: We measure leverage by total
debt to total asset ratio. High leverage exposes firms
to greater financial risk. High risk should result in
lower performance (Mitton, 2002).
EPS: This paper defines EPS as earnings per
share. EPS is an important variable that measures
investor interest in a firm (Chang et al., 2008). It also
measures accounting performance of a firm. Higher
investor interest and superior accounting performance
is expected to translate into better stock price
performance.
GROWTH: This paper measures GROWTH
by growth in earnings per share. Jegadeesh and Livnat
(2006) document that firms with higher growth have
better stock price performance.
PoR: It is defined as percentage of earnings
paid as dividends. Prior literature considers dividends
as a tool via which firms can reduce information
asymmetries (Grossman and Hart, 1980; Jensen,
1986; La Porta et al., 2000). Lower information
asymmetries should lead to better stock price
performance.
VOLATILITY: It is the measure of a stock's
average annual price movement to a high and low
from a mean price for each year. For example, a
stock's price volatility of 20% indicates that the
stock's annual high and low price has shown a
historical variation of +20% to -20% from its annual
average price. We expect firms with high volatility to
exhibit low stock price performance.
Table 2 documents the statistics for our control
variables during our sample period. Panel A
documents the descriptive statistics for control
variables used in our analysis and Panel B documents
the correlation between different control variables. As
is expected, Table 2, Panel A, shows that firms in the
MENA region pay low fraction of their earnings as
dividends. Our results show that the PoR is 30.3736%
for our sample firms. This observation is in contrast to
the PoR in the developed countries where almost 80%
of earnings are distributed to shareholders as
dividends. Table 2, Panel A, also shows that firms in
the MENA region have very low leverage. This
observation is consistent with prior literature that
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162
shows that firms in the MENA region rely on their
retained earnings for their long-term financial needs
(Achy, 2009). Furthermore, Table 2, Panel B, shows
low correlation between our control variables, thereby
allowing us to include these variables in regression
analysis.
The following table documents the statistics for
control variables used in regression. The sample
comprise of firms from Morocco, Jordan, Bahrain,
Egypt, Kuwait, United Arab of Emirates, Saudi
Arabia, and Qatar. The period of analysis is from
2005 to 2009. Panel A document descriptive statistics
for control variables, while Panel B document
correlation between different control variables.
Table 2. Statistics for control variables
Panel A. Descriptive statistics
Mean Median Standard Deviation
EPS 3.8409 0.1760 17.8059
SIZE 6.3646 6.3966 2.3453
LEVERAGE 18.7935 13.5730 18.6983
VOLATILITY 30.7110 29.9760 10.8343
PoR 30.3736 21.5045 29.0761
GROWTH 11.8849 7.6535 64.1726
Panel B. Correlation matrix
EPS SIZE LEVERAGE VOLATILITY PoR GROWTH
EPS 1.0000
SIZE 0.2425 1.0000
LEVERAGE 0.0337 -0.0086 1.0000
VOLATILITY -0.1553 0.3339 0.0135 1.0000
PoR 0.1398 0.0512 -0.0708 -0.1815 1.0000
GROWTH -0.0130 -0.0375 0.0062 -0.0827 -0.1560 1.0000
4. Methodology
This paper aims to document the effect of analyst
following on firm performance in the MENA region.
In order to test this hypothesis, we estimate a
regression equation with market-adjusted returns
(RET) as a dependent variable and two variables
representing analyst following (ANALYST) and
square of analyst following (ANALYST*ANALYST)
as independent variables. Furthermore, as mentioned
above, we also include a number of control variables
in our regression equation. These variables are
earnings per share (EPS), log of market capitalization
(SIZE), total debt to total asset ratio (LEVERAGE),
stock price volatility (VOLATILITY), dividend
payout ratio (PoR), growth in earnings per share
(GROWTH), and year dummies (YDUM). Our basic
regression takes the following form. It is important to
mention here that we use panel data regression with
fixed effects for our analysis. Hausman test was used
to decide between fixed effect and random effects.
εYDUMβGROWTHβPoRβ
VOLATILITYβLEVERAGEβSIZEβEPSβ
ANALYST*ANALYSTβANALYSTβαRET
Yr
Yr
87
6543
21
(1)
The results of our analysis are reported in Table
3. Our results show that the extent of analysts
following improves firm performance only at high
levels. We report significant and positive coefficient
of ANALYST*ANALYST. At low levels of analyst
following, our results indicate a negative relationship
between analyst following and firm performance. We
report significantly negative coefficient of
ANALYST. Our results indicate that high analyst
following is associated with lower information
asymmetries in the MENA region. Lower information
asymmetries lead to lower agency problems, thereby
positively influencing firm performance. However, at
low level of analyst following, information
asymmetries do not get resolved to an extent that it
influences firm performance positively. Surprisingly,
our results also show that there is a negative
relationship between earnings per share and firm
performance. We report significant and negative
coefficient of EPS. It indicates that stock market
participants do not value the reported earnings on
their face value.
Table 3 documents the effect of analyst
following on firm performance in the MENA region
(Morocco, Egypt, Saudi Arabia, United Arab
Emirates, Jordan, Kuwait, and Bahrain). The period of
analysis is from 2005 to 2009. The panel data
regression with fixed effects is performed using
Equation (1). The coefficients with 1% significance
are followed by ***, coefficient with 5% by **, and
coefficients with 10% by *.
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163
Table 3. Effect of analyst following on firm performance
Equation (1)
ANALYST -0.0901***
ANALYST*ANALYST 0.0069***
EPS -0.0150***
SIZE 0.6773***
LEVERAGE 0.0063
VOLATILITY -0.0296**
PoR 0.0022**
GROWTH 0.0026***
Year Dummies Yes
No. of Observations 974
F-Value 47.32
R2 within 0.4022
There may be concerns that the results obtained
above are confined to certain sub-sets of stocks. For
instance, smaller firms have higher information
asymmetries and analysts’ role to reduce these
asymmetries should be more pronounced in these
firms relative to larger firms. As a result, analyst
following should be more value relevant for small
firms. Lang et al. (2004) argue that increased analyst
following is associated with higher valuations,
particularly for firms likely to have higher
information asymmetries. In order to overcome these
concerns, we divide our sample into different groups
– large / small firms, firms with high / low debt, and
firms from common law / civil law countries. All of
these groups are characterized by different levels of
information asymmetries. Large firms, firms with
high debt, and firms from common law countries have
better information environment relative to small
firms, firms with low debt, and firms from civil law
countries, respectively. We re-estimate Equation (1)
for each group. Results of our analysis are reported in
Table 4. We report that our results hold true in both
civil law and common law countries. Interestingly,
our results also show that our results hold in a sub-
sample of large firms and in a sub-sample of firms
with high leverage. We report negative and significant
coefficient of ANALYST and positive and significant
coefficient of ANALYST*ANALYST for these
groups. Both of these groups have lower information
asymmetries. Larger firms enjoy more interests from
investors and analysts, while firms with high debt
command more scrutiny from creditors. As a result,
the incremental value of analysts should be less
pronounced in these sub-samples. We report
insignificant impact of analyst following in sub-
samples characterized by high information
asymmetries – small firms and firms with low debt.
This finding is in contrast with Lang et al. (2004) who
document that analyst following is more value
relevant in asymmetric information environments.
The following table documents the effect of
analyst following on firm performance in different
sub-samples (Large/Small, High Leverage/Low
Leverage, Common Law/Civil Law). The sample
comprise of firms from the MENA region (Morocco,
Egypt, Saudi Arabia, United Arab Emirates, Jordan,
Kuwait, and Bahrain). The period of analysis is from
2005 to 2009. The panel data regression with fixed
effects is performed using Equation (1). The
coefficients with 1% significance are followed by
***, coefficient with 5% by **, and coefficients with
10% by *.
Table 4. Effect of analyst following on firm performance in different sub-samples
Size Leverage Legal Traditions
Large Small High Low
Common
Law Civil Law
ANALYST -0.0875** -0.0614 -0.1017*** -0.0516 -0.0282 -0.0988**
ANALYST*ANALYST 0.0063** -0.0175 0.0071*** 0.0060 0.0041** 0.0065*
EPS -0.0167*** -0.1194*** -0.0110* -0.0167*** -0.0620*** -0.0066**
SIZE 0.719*** 0.6222*** 0.7515*** 0.7281*** 1.1338*** 0.3967***
LEVERAGE 0.0029 -0.0054** 0.0012 -0.0099 0.01410* 0.0031
VOLATILITY -0.0411** -0.0249** -0.0183 -0.0475** -0.0592*** 0.0038
PoR 0.0041*** -0.0008 0.0018 0.0025* 0.0038** 0.0015
GROWTH 0.0038*** 0.0011*** 0.0031*** 0.0018*** 0.0017** 0.0030***
Year Dummies Yes Yes Yes Yes Yes Yes
No. of Observations 554 420 462 512 320 654
F-Value 41.10 19.61 17.24 37.45 65.80 16.33
R2 within 0.4518 0.3532 0.4208 0.4584 0.7128 0.3117
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5. Discussion of results
Our results have shown that high level of analyst
following has a positive impact on firm performance.
We argue that at high level of analyst following,
information asymmetries are reduced to a significant
level and therefore cause firm performance to
improve. One implication of our argument is that, at
high level of analyst following, firms should be
unable to manipulate their financial statements. As a
result, we should expect a positive impact of high
analyst following on the informativeness of reported
earnings. In order to test our conjecture, we introduce
two more variables in Equation (1). These variables
represent interaction between analyst following and
earnings per share (ANALYST*EPS) and interaction
between square of analyst following and earnings per
share (ANALYST*ANALYST*EPS). Our modified
equation takes the following form:
εYDUMβGROWTHβPoRβ
VOLATILITYβLEVERAGEβSIZEβ
EPS*ANALYST*ANALYSTβEPS*ANALYSTβEPSβ
ANALYST*ANALYSTβANALYSTβαRET
Yr
Yr
109
876
543
21
(2)
The results of our analysis are reported in Table
5. Contrary to our expectations, our results report
negative and significant coefficient of
ANALYST*EPS and of
ANALYST*ANALYST*EPS. However, we show
that the magnitude of coefficient of
ANALYST*ANALYST*EPS is significantly less
than coefficient of ANALYST*EPS. It shows that
higher level of analyst following does have, at least,
some beneficial impact on the informativeness of
reported earnings. However, the beneficial impact is
not to an extent that it results in completely restoring
the credibility of reported earnings. Our findings,
partly, support Farooq (2013) who document positive
impact of analyst following on informativeness of
reported earnings in the MENA region.
The following table documents the effect of
analyst following on informativeness of earnings in
the MENA region (Morocco, Egypt, Saudi Arabia,
United Arab Emirates, Jordan, Kuwait, and Bahrain).
The period of analysis is from 2005 to 2009. The
panel data regression with fixed effects is performed
using Equation (2). The coefficients with 1%
significance are followed by ***, coefficient with 5%
by **, and coefficients with 10% by *.
Table 5. Effect of analyst following on informativeness of earnings
Equation (2)
ANALYST -0.1044***
ANALYST*ANALYST 0.0087***
EPS -2.3700***
ANALYST*EPS -0.2419**
ANALYST*ANALYST*EPS -0.0005**
SIZE 0.6756***
LEVERAGE 0.0062
VOLATILITY -0.0300**
PoR 0.0023**
GROWTH 0.0027***
Year Dummies Yes
No. of Observations 974
F-Value 40.01
R2 within 0.4034
6. Conclusion
This paper documents the impact of analyst following
on firm performance in the MENA region during the
period between 2005 and 2009. The results of our
analysis show that higher analyst following, indeed,
leads to better performance. We argue that lower
information asymmetries that arise as a result of high
analyst following reduce agency problems and result
in improving stock price performance of firms. We
also show that our results hold across different sub-
samples characterized by different characteristics. For
instance, we show that our results are qualitatively the
same in the common law as well as the civil law
countries. We also show that our results hold in a sub-
sample of large firms and in a sub-sample of firms
with high leverage. Interestingly, in the sub-samples
where analysts are needed the most – small firms and
firms with low leverage – our results do not hold. We
report insignificant relationship between analyst
following and firm performance in these sub-samples.
These sub-samples are characterized by higher agency
problems and therefore incremental value of analysts
should be higher in these sub-samples. Surprisingly,
we also show that low level of analyst following is
associated with lower stock price performance. It
shows that lower analyst following does not resolve
information asymmetries and agency problems.
Our results also show negative association
between earnings per share and firm performance. It
indicates low informativeness of reported earnings.
Given that higher analyst following lowers
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165
information asymmetries, this paper also tests whether
analyst following improves informativeness of
reported earnings or not. Our results show that high
level of analyst following does improve the quality of
reported earnings, but not to a level that it is
positively reflected in stock prices. Our results have
implications for investors, regulators, and policy
makers in a way that we show misleading information
in reported earnings. Our results indicate that earnings
alone do not convey much information to stock
market participants. Only those reported earnings that
are complemented by high analyst coverage may have
some information value.
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ENHANCING THE CORPORATE PERFORMANCE THROUGH SYSTEM DYNAMICS MODELLING
Mridula Sahay*, Kuldeep Kumar**
Abstract
The aim of the current study is to improve the performance of corporate through application of System Dynamics (SD) methodology. The paper discusses the importance of system dynamics modelling in enhancing corporate performance and how it shows the dynamic behaviour of the system. For this purpose a system dynamics model for an Indian Steel company has been prepared. The paper also covers a brief introduction of the system dynamics modelling, a brief narration of Steel Sector and the process adopted in modelling. Some of the important corporate performance parameters such as market share, revenue, employee’s strength, number of shareholders, installed capacity have been taken to reflect corporate behaviour. The behaviour of these performance parameters over time is used for both validation of the model as well as for reflecting their future pattern. The paper concludes that the SD modelling approach has high potential in understanding corporate performance behaviour and their by gaining insight into the corporate functioning and taking appropriate remedial steps for improving its performance. Keywords: Corporate Performance, System Dynamics, Dynamics Behaviour * Associate Professor, Amrita Business School, Amrita University, India ** Professor, Faculty of Business, Bond University, Australia
1. Introduction
Corporate performance is a very actual output or
result of a corporation as measured against its
intended outputs, which can be reflected in many
ways. Corporate performances build the image of the
corporation in front of shareholders, investors,
funding agencies, competitors; fulfil the goal of the
company etc. It also effects on the image of the board
of the corporation and their governance. It’s related to
revenue, return on investment, overhead and
operational costs. Many companies strive to be the
best in their market and most never succeed. Many of
the ones that do, so only temporarily and subsequently
lose their position through misunderstanding how
they got there and what is needed to stay there. Very
few, as Collins (2001) has stated, are capable to going
from “good to great”.
Corporate performance is viewed from the
perspective of different stakeholders as businesses
respond to contemporary developments and broader
strategic, commercial and social consideration.
Dahya, et. al. (2002), In 1992, the Cadbury
Committee issued the Code of Best Practice which
recommends that boards of U.K. corporations include
at least three outside directors and that the positions of
chairman and CEO be held by different individuals.
The underlying presumption was that these
recommendations would lead to improved board
oversight. They empirically analyse the relationship
between CEO turnover and corporate performance.
CEO turnover increased following issuance of the
Code; the negative relationship between CEO
turnover and performance became stronger following
the Code’s issuance; and the increase in sensitivity of
turnover to performance was concentrated among
firms that adopted the Code.
Richard et al. (2009) states that organizational
performance encompasses three specific areas of firm
outcomes: (a) financial performance (profits, return
on assets, return on investment, etc.); (b) product
market performance (sales, market share, etc.); and (c)
shareholder return (total shareholder return, economic
value added, etc.
Beaver (2000) states that performance appraisal
is a serious business and not some academic fad that
will fade like so much of the indulgent language and
management tools and techniques currently in vogue
at its most fundamental. Performance appraisal is the
principal means for an organization to assess the
effectiveness of its decision making. In doing this,
judgements can be made about the success or failure
of its strategic management in the context of its
organizational paradigm. The notion of corporate
success is a natural derivative of a firm’s
achievements which is in turn a reflection of the
quality of its management decisions in relation of the
quality of its management decisions in relation to
strategic objectives, market and a whole range of
internal and external circumstances. Given the
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168
unpredictability of these circumstances, many of the
current methods of measuring corporate performance
effectively, realistically and consistently appear to be
facile and inappropriate and subject to imaginative
financial engineering and plain management abuse.
Based upon the explanation of Majumdar (1997)
whether larger firms are superior in performance to
smaller firms, or vice-versa and whether older firms
are superior in performance to younger firms, or vice-
versa, have generated large amount of theoretical and
empirical research in the economics, management and
sociology disciplines. Cheng (2008) provides
empirical evidence that firms with larger boards have
lower variability of corporate performance. The
results indicate that board size is negatively associated
with the variability of monthly stock returns, annual
accounting return on assets, Tobin's Q, accounting
accruals, extraordinary items, analyst forecast
inaccuracy, and R&D spending, the level of R&D
expenditures, and the frequency of acquisition and
restructuring activities. The results are consistent with
the view that it takes more compromises for a larger
board to reach consensus, and consequently, decisions
of larger boards are less extreme, leading to less
variable corporate performance.
Prasetyantoko and Parmono (2008) disused that
firm size is positively related to firm profitability, but
it is not related to market capitalization and ownership
factors matters on firm performance.
Wheelen & Hunger (2002) pointed that
businesses are tending to rely less on financial
measures (which are based on Accounting Standards)
such as, profit, return on investment, and return on
assets, alone to assess over all corporate performance
Wheelen and Hunger (2002), defined
performance simply as the end result of activity. At
one level, it maybe as simple and mundane as this
definition, although at another level the notion of a
general measure of performance is both intriguing yet
continually disappointing (Bonoma & Clark 1988).
Choosing a performance measure is one of the
most critical challenges facing organizations (Ittner &
Larcker 1998). It is common for corporations to have
numerous performance measures (Neely, Adams &
Kennerley 2002), though financial measures dominate
for Autralian, UK and US executives (Phillips &
Shanak 2002; Clark 1999; Kokkinaki & Ambler
1999).
Irala (2007) states that traditionally periodic
corporate performance is most often measured using
some variant of historical accounting income (eg. Net
Profit, EPS) or some measures based on the
accounting income (eg. ROI/ ROCE). And he also
examines whether Economic Value Added has got a
better predictive power relative to the traditional
accounting measures such as EPS, ROCE, RONW,
FCF, Capital Productivity (Kp) and Labor
Productivity (Lp)
Harols and Belen (2001) investigate the relation
between the ownership structure and the performance
of corporations if ownership is made multi-
dimensional and also is treated as an endogenous
variable.
Qi, Wu, Zhang (2000), investigate whether and
how the corporate performance of listed Chinese
firms is affected by their shareholding structure.
Adams et al (2005) develop and test the hypothesis
that firms whose CEOs have more decision-making
power should experience more variability in
performance. They suggest that the interaction
between executive characteristics and organizational
variables has important consequences for firm
performance
Joy et al (2007) has shown in their research that
women representation on board increase return on
equity (ROE), return on sales (ROS), return on
investment (ROI) corporate performance. Bryan
(2007) state that companies should redesign their
financial-performance metrics for this new age.
Normally companies focus far too much on measuring
returns on invested capital (ROIC) rather than on
measuring the contributions made by their talented
people. Times have changed. Metrics must change as
well.
During the 1990s and beyond, countries around
the world witnessed calls and/or mandates for more
outside directors on publicly traded companies' boards
even though extant studies find no significant
correlation between outside directors and corporate
performance. Dahya
et. al (2007) examine the
connection between changes in board composition
and corporate performance in the U.K. over the
interval 1989–1996, a period that surrounds
publication of the Cadbury Report, which calls for at
least three outside directors for publicly traded
corporations. They find that companies that add
directors to conform to this standard exhibit a
significant improvement in operating performance
both in absolute terms and relative to various peer
group benchmarks. They also find a statistically
significant increase in stock prices around
announcements that outside directors were added in
conformance with this recommendation. They do not
endorse mandated board structures, but the evidence
appears to be that such a mandate is associated with
an improvement in performance in U.K. companies.
Norburn, and Birley, (1998) tested the
relationship between the characteristics and
background of U.S. top executives, and measures of
corporate performance. Results were generally
positive: managerial characteristics not only predicted
performance variations within industries—the top
performers having significantly different managerial
profiles than poorly performing companies—but also
that the characteristics of managers within high-
performing companies were similar across the five
industries.
Firth et al. (2006) has examined the
compensation of CEOs in China's listed firms. First,
they discuss what is known about the setting of CEO
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169
compensation and then we go on to examine factors
that may help explain variations in the use of
performance related pay. In China, listed firms have a
dominant or controlling shareholder. Firth et al.
(2006) argue that the distinct types of controlling
shareholder have different impacts on the use of
incentive pay. We find that firms that have a State
agency as the major shareholder do not appear to use
performance related pay. In contrast, firms those have
private block holders or SOEs as their major
shareholders relate the CEO's pay to increases in
stockholders' wealth or increases in profitability.
However the pay–performance sensitivities for CEOs
are low and this raises questions about the
effectiveness of firms' incentive systems.
Above discussion shows that corporate
performance as a whole is missing. Most of them
have worked on composition of the committee,
financial aspect of the company etc., but corporate
performance as a whole like operational performance,
financial performance has not been combined
together. The purpose of this paper is to combine both
operational as well as financial performance together
to measures the performance of the company with
using management science tools like system dynamics
(SD).
2. System Dynamics: principles and concepts
The system dynamics (SD) has been developed as
industrial dynamics approach has at MIT by Prof. J.
W. Forrester in late sixties. It amalgamates ideas
developed in various system theories. It is a branch of
control theory, which deals with socio-economic
systems and also a branch of management science,
which deals with the problems of controllability. It is
a way of studying the behaviour of any systems to
show how policies, decisions, structure and delays are
inter-related to influence growth and stability. It
integrates the separate functional areas of
management – marketing, investment, research,
personnel, production, accounting etc. Each of these
functions is reduced to a common basis by
recognizing that any economic or corporate
(candidates, instructed) activities consists of flows of
money, orders, materials, personnel, and capital
equipment. These five flows are integrated by an
information network. Industrial dynamics recognizes
the critical importance of this information network in
giving the system its own dynamics characteristics.
It combines both qualitative and quantitative
aspects to explore, realize and communicate complex
ideas. The qualitative part entails the creation of
causal relationship, in which variables are mapped in
a cause and effect relationship pattern.
The quantitative aspect involves the
development of a computer model based upon a
“stock and flow diagram, and equations which depict
interrelated variables in the system. Stock variable
(rectangles) represents the state variables and are the
accumulations in the system. Flow variables (valves)
alter the stocks by filling or draining the stocks.
Arrows point the causal relation between two
variables and also reflects the flow of information
within the model structure.
System dynamics models, however, have two
important differences which are major advantages:
1. They allow for far more complex multiple
interrelationships of variables over time, and
outcomes of those relationships are calculated by the
model rather than being done externally and inputted
in advance.
2. They can include the impact of variables
which are not normally subject to quantification. This
is done by arbitrarily assigning a value of 1.00 to a
subjective variable, and allowing it to vary based on
the management group’s expectations of what would
happen under certain conditions.
System thinking and dynamics plays an
important role in understanding the relationship
between strategic choices and its outcomes. Five
decades ago, Jay Forrester, regarded as the father of
SD, started to advocate for the application of systems
and feedback theory to the formulation of
organizational and social policies (Forrester, 1961).
Peter Senge’s The Fifth Discipline (1990) has been an
important source for understanding system thinking
and dynamics to a wide audience. SD importance is
rooted on the decision-makers limitations to fully
understand their environment and business system
realities due to three main conditions: complexity,
uncertainty, and cognition limitations (Folke, 2006).
Rather than try to optimize for a solution, the
decision-maker choose for satisfying explanations.
This is the groundwork of Simon’s “theory of
bounded rationality”, the type of rationality that a
decision-maker draws on when the situation is too
complex relative to their limited rational abilities
(Simon, 1979). He reasons that decision-making in
practice challenge existing assumptions that
“…decision-makers pursuit optimal choices in all
conditions.” For the operational strategist this
discussion implies that he/she will be only somewhat
capable of retaining and manipulating sufficiently
representative information and structural relations
during the process of strategy formulation due to the
steering of intermediaries, which may be particularly
difficult to anticipate and control (Nobs, Minkus, &
Rummert, 2007).
In SD, a system is a way of understanding any
dynamic process and many complex relations in the
organizations. SD creates a representation of the
operations choices and studies their dynamics,
facilitating the understanding of the relation between
the behavior of a system over time and its underlying
structure and decision rules. Better performing
organizations attempted to gain an understanding of
the system structure before they proceeded to develop
strategies and take action. Concisely, SD is based on a
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170
structural theory that offers a panorama on operations
strategy issue
Rahdari and et.al (2007) discussed the model the
effects of fluctuations in world steel price on
stockprice of one of Iranian steel producers. They also
offer some policies to mitigate the global fluctuation
effects on stock price of steel-makers in Iran
Sahay (2011) highlighted an application system
dynamics methodology and develop a cause and
effect relationship model for corporate strategy, which
has potential of integrating board parameters/variables
significant in corporate strategy development.
Kumar and Vrat (1989) discussed the application
of system dynamics to simulate the production flow in
a steel plant. The feedback concepts underlying the
model of a production shop were discussed. Models
of various shops were assembled to construct the
entire flow of the steel production system. The
applications of the model in the area of corporate
planning were discussed.
Sahay (1984) stated that system dynamics model
validation is a systematic trial-search process. He
emphasized the use of both qualitative and
quantitative criteria for model validation followed by
sensitivity testing for monitoring information
economically for the purpose of exercising desired
controls in organizational functions to achieve its
goals.
King et al (1983) conceptualized an integrated
general model of business performance that combined
the individual management disciplines of industrial
economics, reenfield theory and business policy
within the framework of a dynamics feedback model.
Measures to assess the position of a company in its
business environment and the process of strategic
choice were discussed.
King et al (1983) conceptualized an integrated
general model of business performance that combined
the individual management disciplines of industrial
economics, organisation theory and business policy
within the framework of a dynamics feedback model.
Measures to assess the position of a company in its
business environment and the process of strategic
choice were discussed.
Brugnoli (1999) states that Trainers can improve
the evaluation-decision process of management
through improving its system thinking capabilities.
Gary et al (2008) have found that there is
opportunity for system dynamics research to develop
explanations for the observed longitudinal patterns of
performance differences among firms. Such work
addresses an important issue for policy makers,
shareholders, and general managers, and would make
enormous contributions to the strategy field.
3. Objectives of the Paper
Objective of this research paper is to prepare an
integrated dynamic model for improving the
performance of Indian steel company both in its
operational performance (installed capacity actual
production, market share, manpower involved etc.) as
well as financial performance (return on investment,
expenditure and revenue etc.). Authors have chosen
system dynamics techniques for developing a model
among the availability of number of management
science tools and techniques due to its effective and
dynamics behavioural pattern.
4. Steel Industry
Steel industry is a booming industry in the whole
world. The increasing demand for it was mainly
generated by the development project that has been
going on along the world, especially the
infrastructural works and real estate projects that has
been on the boom around the developing countries.
Steel industry was till recently dominated by the
United Sates of America but this scenario is changing
with a rapid pace with the Indian steel companies on
an acquisition spree.
Steel Industry has grown tremendously in the last one
and a half decade with a strong financial condition.
The increasing needs of steel by the developing
countries for its infrastructural projects have pushed
the companies in this industry near their operative
capacity.
The main demand creators for Steel industry are
Automobile industry, Construction Industry,
Infrastructure Industry, Oil and Gas Industry, and
Container Industry.
The Steel industry has enough potential to grow
at a much accelerated pace in the coming future due to
the continuity of the developmental projects around
the world. This industry is at present working near its
productive capacity which needs to be increased with
increasing demand.
It is common today to talk about "the iron and
steel industry" as if it were a single entity, but
historically they were separate products. The steel
industry is often considered to be an indicator of
economic progress, because of the critical role played
by steel in infrastructural and overall ("Steel
Industry". Retrieved 2009-07-12.)
The economic boom in China and India has
caused a massive increase in the demand for steel in
recent years. Between 2000 and 2005, world steel
demand increased by 6%. Since 2000, several Indian
and Chinese steel firms have risen to prominence like
Tata Steel (which bought Corus Group in 2007),
Shanghai Baosteel Group Corporation and Shagang
Group. ArcelorMittal is however the world's largest
steel producer.
In 2008, steel began trading as a commodity on
the London Metal Exchange. At the end of 2008, the
steel industry faced a sharp downturn that led to many
cut-backs. (Unchiselled, Louis (2009-01-01). "Steel
Industry, in Slump, Looks to Federal Stimulus". The
New York Times. Retrieved 2012-04-15)
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Corporate Ownership & Control / Volume 11, Issue 2, 2014, Continued - 1
171
Iron and steel are used widely in the construction
of roads, railways, other infrastructure, appliances,
and buildings. Most large modern structures, such as
stadiums and skyscrapers, bridges, and airports, are
supported by a steel skeleton. Even those with a
concrete structure will employ steel for reinforcing. In
addition, it sees widespread use in major appliances
and cars. Despite growth in usage of aluminium, it is
still the main material for car bodies. Steel is used in a
variety of other construction materials, such as bolts,
nails, and screws (Ochshorn, Jonathan (2002-06-11).
"Steel in 20th Century Architecture". Encyclopedia of
Twentieth Century Architecture. Retrieved 2010-04-
26.) Other common applications include shipbuilding,
pipeline transport, mining, offshore construction,
aerospace, white goods (e.g. washing machines),
heavy equipment such as bulldozers, office furniture,
steel wool, tools, and armour in the form of personal
vests or vehicle armour (better known as rolled
homogeneous armour in this role).
Authors have chosen the field of steel sector for
the study because Indian Steel sector has large
contribution in development of economic base and
industrialization in India. The demand of steel is
growing day by day due to its need in rapid
development of infrastructure, Construction
Company, power sector, telecommunication,
railways, etc.
In India both public and private sector
companies are involved in producing steel. Steel
Authority of India (SAIL), Rashtriya Ispat Nigam Ltd.
(RINL), NMDC Ltd., Maganese Ore (India) Ltd.,
MSTC Ltd., Hindustan Steel works Construction Ltd,
MECON Ltd., Bharat Regrafactories Ltd., Sponge
Iron India Ltd., Kundremukh Iron Ore Company Ltd.
are the Indian government undertaking public sector’s
steel plants and Tata Steel Ltd., Essar Steel Ltd., JSW
Steel Ltd., Jindal Steel & Power Ltd., Spat Industries
Ltd. Bhusan Power & Steel Ltd., Monnet Ispat &
Energy Ltd., Sponge Iron Industry, Pig Iron Industry,
Electric Arc Furnace Industry, Induction Furnance
Industry, Hot Rolled Long Products Units, Steel Wire
Drawing Units, Hot Rolled Steel Sheets/Strips/Plates
Units, Cold Rolled Steel Sheets/Strips Units,
Galvanised and Color Coated Sheets/strips Units, Tin
Plate Units are private sectors companies
Steel production in India has increased by a
compounded annual growth rate (CAGR) of 8 percent
over the period 2002-03 to 2006-07. Going forward,
growth in India is projected to be higher than the
world average, as the per capita consumption of steel
in India, at around 46 kg, is well below the world
average (150 kg) and that of developed countries (400
kg). Indian demand is projected to rise to 200 million
tonnes by 2015. Given the strong demand scenario,
most global steel players are into a massive capacity
expansion mode, either through brownfield or
greenfield route. By 2012, the steel production
capacity in India is expected to touch 124 million
tonnes and 275 million tonnes by 2020. While
greenfield projects are slated to add 28.7 million
tonnes, brownfield expansions are estimated to add
40.5 million tonnes to the existing capacity of 55
million tonnes.
5. System Dynamics Modelling for Corporate Performance of Indian Steel Company
Improvement in corporate performance in traditional
way primarily made through the decision makers at
various levels such as board of the corporation and the
managers of the works based on comparing and
judging various identifies factors and the corporate
performance empirically; or through factor analysis
combining methods of investigating exceptions and
drawing commonality in the pattern of the outcome
and the behaviour; or using regression analysis/multi-
variant analysis or econometric model.
These approaches provide very broadly the
future course of action without understanding intrinsic
causes. They are piece meal approach and laps
coherence and system thinking and dynamics of the
system. The application of system dynamics
methodology attempts on improvement intervention
based on system thinking and has potential to solve
complex problem. Sector-wise simulated results are
discussed below.
5.1Demand and capacity
Here, demand of product and installed capacity are
considered as a level variable. Demand of product is
31000 MT and installed capacity is 3500 MT/year in
the reference year 2001.
Figure 1 show that demand of product is
increases with demand of product increasing rate and
demand of product increasing rate is calculated by
demand rising fraction multiply by demand of product
and divided by year. Installed capacity is depend on
installation time and additional capacity multiplier.
Market share is an auxiliary variable and it has
calculated by demand of product, sales and demand
fulfilling factor.
We can see in figure 2 that demand of product in
the country and installed capacity increases every
year. It has rise from 31000 MT to 51000 MT
(64.5%) and installed capacity of the company has
increased 3500 MT to 6000 MT (71.4%) in six year.
5.2 Revenue and Expenses
In this sector, manufacturing cost, other expenses,
loans & advances are considered as level variables.
Manufacturing cost changes over the time with the
help of increase in manufacturing cost rate and
manufacturing cost rate is effected and percentage
increase in manufacturing cost per year. Similarly
other expense also changes with other expenses
increasing rate and inflation rate of general
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Corporate Ownership & Control / Volume 11, Issue 2, 2014, Continued - 1
172
commodity per year. loans & advances changes.
Revenue is calculated with sales and price per TMT
and for the calculation of price per TMT, selling price
in ref year, product mix factor and ratio of current
inflation index to normal index have taken.
Board members salary and compensation, salary of
employee, annual manufacturing cost, annual other
expenses, S&A expenses, interest payment have
considered to calculated expenditure.
5.3 Corporate Performance
In this sector, authors have assumed that desired
corporate performance level should be minimum 60 in
the reference year 2001 and for the result of corporate
performance index; they also have calculated total
corporate performance with market share, profit,
installed capacity, employee, shareholders etc. and for
each variables, there is some weigthages point.
5.4 Validated criteria for the developed model
For validation, very few selected performance
indicators for enhancing the performance of corporate
has taken like employee’s strength, no. of
shareholders, installed capacity, return on investment,
market share, expenditure, revenue etc.
The validation in the system dynamics
modelling means behaviour of the model is resembles
the actual behaviour of the system. This means from
the model, some important variables are chosen and
their simulated behaviour is compared with actual
values for the reference period.
The SD model with the data collected from the
company’s report of the reference year 2001 has been
simulated. The results are observed both in the tabular
and graphical form for important variables from each
sector. By modifying some of the structural
relationships, values of some multipliers and graph
functions and simulated till acceptable model output
is obtained.
Figure 1. Demand and Capacity Stock- flow diagram
MARKET SHARE
DEMAND RISING FRACTION
ACTUAL FUND AVAILABLE
FOR INVESTMENT
DEMAND OF PRODUCT
DEMAND OF PRODUCT
INCREASING RATE
INSTALLED CAPACITY
CAPACITY INCREASING RATE DECREASE IN INSTALLED
PRODUCTION
CAPACITY RATE
ACTUAL
PRODUCTION
DESIRED PRODUCTION
CAPACITY
UTILIZATION
ANTICIPATED MARKET SHARE
SALES
INCREASE IN INSTALLED
CAPACITY DESIRED
AVERAGE CAPACITY UTILIZATION
RETAINED EARNING FOR
INVESTMENT
YEAR
SALES
INCREASE IN INSTALLED
CAPACITY DESIRED
INSTALLATION TIME
INSTALLATION COSTPER TMT
RE USE FRACTION
DEMAND FULFILLING FACTOR
INVESTMENT NEED TO INSTALLE
ADDITIONAL CAPACITY
CAPACITY ADDITION
MULTIPLIER
LOANS & ADVANCES
PROCUREMENT RATE
FINALISATION OF
CAPACITY ADDITION
DEMAND FULFILLING FACTOR
PROFIT AFTER TAX
RE INVESTMENT FRACTION
PERIOD
NORMAL CU
LOANS &ADVANCES
REQUIRED
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Corporate Ownership & Control / Volume 11, Issue 2, 2014, Continued - 1
173
Figure 2. Standard run of demand of product and installed capacity of the company
Figure 3. Demand and Capacity Stock- flow diagram
9:41 PM Tue, Oct 22, 2013
Untitled
Page 1
1.00 2.25 3.50 4.75 6.00
Years
1:
1:
1:
2:
2:
2:
30
45
60
3
5
6
1: DEMAND OF PRODUCT 2: INSTALLED CAPACITY
1
1
1
1
2
2
2
2
SALES
SALES
TOTAL CORPORATE
PERFORMANCE
CORPORATE PERFORMANCE
INDEX
WEIGHTAGE ON INSTALLED CAPACITY
DESIRABLE CORPORATE
PERFORMANCE
INSTALLED CAPACITY
~
CP POINT IN % DUE TO
INSTALLED CAPACITY
INSTALLED CAPACITY
WEIGHTED POINT ON CP
NO OF EMPLOYEE
~
CP POINT IN % DUE
TO EMPLOYEE
EMPLOYEE WEIGHTED
POINT ON CP
WEIGHTAGE ON NO
OF EMPLOYEE
NO OF SHAREHOLDERS
SHAREHOLDERS
WEIGHTED POINT ON CP
~
CP POINT IN %DUE
TO SHAREHOLDERS
WEIGHTAGE ON NO
OF SHREHOLDERS 2
PROFIT AFTER TAX
WEIGHTED POINT ON CP
PROFIT AFTER TAXMARKET SHARE
MARKET SHARE
WEIGHTED POINT ON CP
WEIGTHAGE ON
MARKET SHARE
~
CP POINT IN % DUE
TO MARKET SHARE
WEIGHTAGE ON PROFIT
AFTER TAX
~
CP POINT IN % DUE
TO PROFIT AFTER TAX
PERCENT INCREASE IN
MARKET SHARE
PROFIT AFTER TAX PER TMT
EMPLOYEE PER TMT
SHAREHOLDERS PER TMT
PERCENTAGE INCREASE
IN INSTALLED CAPACITY
IC IN RY
MS IN RY
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Corporate Ownership & Control / Volume 11, Issue 2, 2014, Continued - 1
174
Figure 4. Standard run of demand of product and installed capacity of the company
The process of validation progresses after having
the initial run often, if modeller finds some erroneous
and implausible results, by modifying some of the
erroneous structural relationships included in the
model by mistake or wrong assumptions or assumed
values, of some multipliers, or graph functions etc
(taken earlier with some assumptions) The model is
run for simulation again and again incorporating some
modifications each time, till valid output is obtained.
An attempt has been made to compare the model
behaviour with that of the actual data for employee,
shareholders, installed capacity, production capacity,
revenue, expenditure, return on investment, market
share etc as depicted in figures they show close
resemblance.
In the reference year installed capacity of the
company is 3500 MT and it increases year by year.
This table shows the comparison of actual vs.
simulated result.
Figure 5. The comparison of actual vs. simulated result
9:43 PM Tue, Oct 22, 2013
Untitled
Page 1
1.00 2.25 3.50 4.75 6.00
Years
1:
1:
1:
2:
2:
2:
2500
5000
7500
1500
5000
8500
1: EXPENDITURE 2: PROFIT AFTER TAX
1
1
1
1
2
2
2
2
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175
5.5 Future Projection
For knowing the corporate performance in future
years say (2008 to 2017), reference year has been
changed to the year 2006-2007 and initial values of
variables and some other values taken accordingly,
keeping other values and relationships is structure of
the model unchanged for simulation. This means
without modify the structure of the model, the model
is run for simulation for next ten years.
The projected result shows for next ten years i.e.
2017, in 2007 installed capacity of the company is
6,000 MT/ year and it shall be double after 3 years
(2010) and in 2017 it shall be 22,950 MT. Even
company wants to double its capacity by 2010.
Demand of product in the country is shall be
from 51,000 MT to 110,000 MT from 2007 to 2017.
11th
Five Year Plan of India (ministry of steel) and
National Steel Policy of India indicated the demand
growth will be 121,000 MT by 2019.
Figure 6. Future projected result of demand of product, installed capacity and actual production of the
company
6. Conclusion
System Dynamics is a powerful method to gain useful
insight into situations of dynamic complexity and
policy resistance. It is increasingly used to design
successful policies in companies and public policy
settings. In this paper we reported an ongoing
research effort to study the performance of corporate.
iThink©
software has been extensively used to
develop a comprehensive system dynamics model of
corporate performance. We have also utilised the
computer simulation tools of the software to handle
the high complexity of the resulting feedback model.
System dynamics model for the corporate
performance developed has been put to generate
model behaviour by simulating using solution interval
1 year and 6 years as simulation run length with initial
values for the year 2001. For future projection,
solution interval is 1 and simulation length is 10 yrs
with initial value for the year 2007.
The performance of corporate lies not only in
having efficient plan but by implementing the plan
efficiently to enhance the desired performance
without much of deviations.
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THE EFFECT OF CORPORATE GOVERNANCE ON BANK FINANCIAL PERFORMANCE: EVIDENCE FROM THE
ARABIAN PENINSULA
Mohamed A. Basuony*, Ehab K. A. Mohamed**, Ahmed M Al-Baidhani***
Abstract
This paper investigates the effect of internal corporate governance mechanisms and control variables, such as bank size and bank age on bank financial performance. The sample of this study comprises of both conventional and Islamic banks operating in the seven Arabian Peninsula countries, namely Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, United Arab Emirates, and Yemen. Regression analysis (OLS) is used to test the effect of corporate governance mechanisms on bank financial performance. The results of this study reveal that there is a significant relationship between corporate governance and bank profitability. Board size, board activism, number of outside directors, and bank age significantly affect Tobin’s Q. Meanwhile, ROA and PM are affected by ownership concentration, audit committee, audit committee meetings, and the age & size of the bank. The results are consistent with previous literature that the correlation between corporate governance and firm performance is still not clearly established and that impact of corporate governance on bank financial performance in developing countries is still relatively limited. Keywords: Board Structure, Ownership Structure, Audit Committee, Corporate Governance Mechanisms, Bank Performance, GCC, Yemen * American University in Cairo, Egypt ** Professor of Accounting & Vice of Academic Affairs, Faculty of Management Technology, German University in Cairo, New Cairo, Post Code: 11835, Cairo, Egypt Tel.: 20 227590764 Fax: 20 227581041 Email: [email protected] *** German University in Cairo, Egypt
1. Introduction
Corporate governance has become one of the most
topical issues in the modern business world today.
Spectacular corporate failures, such as those of Enron,
Worldcom, Barlow Clows and Levitt, the Bank of
Credit and Commerce International (BCCI), Polly
Peck International and Baring Bank, have made it a
central issue, with various governments and
regulatory authorities making efforts to install
stringent governance regimes to ensure the smooth
running of corporate organizations, and prevent such
failures. A corporate governance system is defined as
a more-or-less country-specific framework of legal,
institutional and cultural factors shaping the patterns
of influence that shareholders (or stakeholders) exert
on managerial decision-making. Corporate
governance mechanisms are the methods employed, at
the firm level, to solve corporate governance
problems.
Corporate governance is viewed as an
indispensable element of market discipline (Levitt
1999) and this is fuelling demands for strong
corporate governance mechanisms by investors and
other financial market participants (Blue Ribbon
Committee 1999; Ramsay 2001). Regulators have
enacted corporate governance reforms into law in
many countries such as the USA (Sarbanes-Oxley
Act, 2002). In other countries such UK (Combined
Code of Corporate Governance, 2003) the corporate
governance codes are principles of best practice with
some indirect element of legislature operating through
the respective stock exchange listing rules. For the
banking sector, Basel II is widely adopted by
developing and emerging market economies to
enhance their CG codes.
Bank governance was altered tremendously
during the 1990s and early 2000s, principally due to
bank ownership changes, such as mergers and
acquisitions (Berger et al. 2005; and Arouri et al.
2011). The worldwide financial crisis of 2008, which
started in the United States, was attributable to U.S.
banks’ excessive risk-taking. Consequently, in order
to control such risk and draw people’s attention to the
agency problem within banks, there are statements
made by bankers, central bank officials, and other
related authorities, emphasizing the importance of
effective corporate governance in the banking
industry since 2008 and until now (Beltratti and Stulz
2009; and Peni and Vahamaa 2011). Therefore, any
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similar crisis occurred or may occur in the future
might be explained as a result of bank governance
failure. Few studies have focused on banks’ corporate
governance (see Macey and O’Hara, 2003; Levine,
2004; Adams and Mehran, 2005; Capiro et al. 2007;
Bokpin, 2013; Nyamongo and Temesgen, 2013).
This study focuses on banks operating in Yemen
and the GCC countries in order to provide empirical
evidence on the effects of corporate governance on
bank performance. The rest of the paper is organised
as follows: the following section provides a
theoretical background and hypotheses development.
The research methodology is provided in section 3,
followed by the findings and analysis in section 4; and
finally summary & conclusion are provided in
section 5.
2. Theoretical Background and Hypotheses Development
2.1 Background
Traditional finance literature has indicated several
mechanisms that help solve corporate governance
problems (Jensen and Meckling (1976); Fama (1980);
Fama and Jensen (1983); Jensen (1986); Jensen
(1993); and Turnbull (1997). There is a consensus on
the classification of corporate governance
mechanisms to two categories: internal and external
mechanisms. However, there is a dissension on the
contents of each category and the effectiveness of
each mechanism. In addition, the topic of corporate
governance mechanisms is too vast and rich research
area to the extent that no single paper can survey all
the corporate governance mechanisms developed in
the literature and instead the papers try to focus on
some particular governance mechanisms.
Jensen (1993) outlines four basic categories of
individual corporate governance mechanisms: (1)
legal and regulatory mechanisms; (2) internal control
mechanisms; (3) External control mechanisms; and
(4) product market competition. Shleifer and Vishny
(1997) concentrate on: incentive contracts, legal
protection for the investors against the managerial
self-dealing, and the ownership by large investors;
they point out the costs and benefits of each
governance mechanism. Denis and McConnell (2003)
use a dual classification of corporate governance
mechanisms (They use systems as synonym to
mechanisms) as follows: (1) internal governance
mechanisms including: boards of directors and
ownership structure and (2) external ones including:
the takeover market and the legal regulatory system.
Farinha (2003) surveys two categories of
governance (or disciplining) mechanisms, the first one
is the external disciplining mechanisms including:
takeovers threat; product market competition;
managerial labour market and mutual monitoring by
managers; security analysts; the legal environment;
and the role of reputation. The other category is the
internal disciplining mechanisms which include: large
and institutional shareholders; board of directors;
insider ownership; compensation packages; debt
policy; and dividend policy.
Despite the existence of different corporate
governance structures, the basic building blocks of the
structures are similar. They include the existence of a
Company, Directors, Accountability and Audit,
Directors’ Remuneration, Shareholders and the AGM.
Cadbury (1992), Greenbury (1995) and Hampel
(1998) called for greater transparency and
accountability in areas such as board structure and
operation, directors’ contracts and the establishment
of board monitoring committees. In addition, they all
stressed the importance of the non-executive
directors’ monitoring role. The relationship between
corporate performance and corporate governance is
measured using only one of the two variables:
ownership structure and board structure (Krivogorsky,
2006).
Much of the empirical findings on corporate
governance and performance in non-financial
institutions are also applicable to financial
institutions. However, the optimal designing of bank
governance structure is very complex and important
relative to unregulated, non-financial firms for several
reasons. Mullineux (2006) argues that good CG of
banks requires prudential risk-related regulation and
attention to conflicts of interest and competition
issues, particularly given the clear information
advantage of banks over their retail customers. Banks
are prudentially regulated and highly levered
compared to other companies and hence bank
governance deserves special attention (Adams and
Mehran 2003).
Moreover, the stakeholders’ interests at banks
extend beyond the shareholders’ interests since the
bank depositors, creditors, and regulators have stakes
in the banks as well. In addition to shareholders and
managers, depositors and regulators have a straight
stake in bank performance. Griffiths (2007) argues
that borrowers have a legitimate claim on banks by
entering in lending agreements, acquire power and
urgency through their cause being adopted by other
stakeholders such as regulators and consumer
organisations. These stakeholders enjoy all three of
Mitchell et al. (1997) stakeholder attributes: power,
legitimacy and urgency (Yamak and Su¨er, 2005;
Griffiths, 2007). Governments are also worried about
banks reputations, and consequently regulate their
governance, because a bank’s failure negatively
affects the respective country’s economy, and may
even spread globally, similar to what happened during
the 1997 Asian financial crisis (Pathan et al. 2008)
and the 2008 U.S. financial crisis (Peni and Vahamaa
2011).
Abu-Tapanjeh (2009) compares the OECD
corporate governance principles with principles from
Islam and declares them compatible; he points out
that Islam as applied to business is entirely
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compatible with corporate governance. Honesty and
trust that are key ingredients of an effective
governance framework (OECD, 2004) are also basic
to ethical behaviour in the Islamic Sharia (Gambling
and Karim, 1991; Tan, 2006; Taylor, 2008;
Mohammed, 2009). Hence the first research
hypothesis is:
H1: There is no difference in adopting CG
mechanisms between Islamic banks and
conventional banks.
2.2 Board Structure
The board of directors is typically the governing body
of the organization. Its primary responsibility is to
make sure that the organization achieves the
shareholders’ goal. The board of directors has the
power to hire, terminate, and compensate top
management (Johnson et al. 2008). Therefore, it
safeguards the organization’s assets and invested
capital. In addition to setting the bank’s objectives
(including generating returns to shareholders), the
board of directors and senior management affect how
banks run their daily operations, meet the obligation
of accountability to bank’s shareholders, and consider
the interests of other recognized stakeholders (Basel
Committee, 2004).
Nonetheless, there is a debate regarding the
effect of board composition on firm performance
(Dulewicz and Herbert, 2004; De Andres et al., 2005;
Ehikioya, 2009; Mohamed et al., 2013). Bhagat and
Black (2002) find a negative relationship between the
proportion of outside directors and corporate
performance. Moreover, Yermack (1996) reported
evidence that a higher percentage of independent
directors leads to worse performance. In addition,
Klein (2002) suggests that high percentage of outside
directors will have the same negative effect. On the
other hand, several studies do not show any evidence
of an existing relationship between the proportion of
non-executive directors and firm performance (Dalton
et al., 1998; Vafeas and Theodorou 1998; Laing and
Weir, 1999). Pi and Timme (1993) find that banks
cost efficiency and return on assets are not
significantly related to the proportion of inside
(outside) directors. While Alonso and Gonzalez
(2006) document a positive relation between the
proportion of non-executive directors and bank
performance.
Moreover, several studies reveal that there is
negative relation between the size of the board and
performance (Hermalin and Weisbach, 1991;
Eisenberg et al, 1998; Carline et al, 2002; Mak and
Yuanto, 2003). Larger boards seems to be less
efficient due to the slow pace of decision making and
the difficulty in both arranging board meeting and
reaching consensus. It is also argued that the CEO
seems to have more dominant power when the board
size is too large (Jensen, 1993; Yermack, 1996;
Eisenberg et al, 1998; Singh and Davidson, 2003;
Cheng, 2008). Staikouras et al. (2007) report ROA
and ROE are statistically significant and negatively
related to board size in European Banks. However,
Huang (2010) finds positive significant relationship
between the size of the board and bank performance
in Taiwan.
It is not only the size of the board that seems to
have a governing effect on firm performance, it is
argued that the board composition in terms of the
number of outside directors versus inside directors
results in better performance through better
monitoring. This argument is mainly based on the
agency theory (Fama 1980; Demsetz and Lehn, 1985).
Several studies find that the larger the number of
outside directors on the board, the better the firm
performance (Rosenstein and Wyatt, 1990; Weisbach,
1988; Huson, 2001; Mohamed et al., 2013). Huang
(2010) finds positive significant relationship between
the number of outside directors and bank performance
in Taiwan.
On the other hand, some argue that based on the
stewardship theory executive directors have a positive
effect on corporate R&D costs and better performance
based on improved strategic innovation (Donaldson,
1990; Kochar and David, 1996; Davis et al, 1997).
Several studies reveal negative relation between the
number of outside directors and firm performance
(Agrawal and Knoeber, 1996; Kochar and David,
1996; Bhagat and Black, 2002). Meanwhile, several
other studies find no significant relation between the
number of outside directors and corporate
performance (Hermalin and Weibach, 1991; Dalton et
al, 1998; Vafeas and Theodorou, 1998; Laing and
Weir, 1999; Lam and Lee, 2012). Further explanation
is provided by Adams and Ferreira (2007) who
suggest that CEOs may be reluctant to share
information with more independent boards, thereby
decreasing shareholder value.
Based on the agency perspective the separation
of the roles of CEO from chairman is another crucial
monitoring mechanism. CEO duality is problematic
from an agency perspective as the CEO seems to get
dominant influence on board decisions by chairing the
group of people in charge of monitoring and
evaluating his performance. This in effect results in
weakening the board's independency and may result
in ineffective monitoring of management. Therefore
good governance will occur when the two roles of
Chairman and CEO are separated (Baliga and Rao,
1996; Brickley et al, 1997; Coles and Hesterly, 2000;
Weir and Laing, 2001; William et al. 2003).
Rechner and Dalton (1989) find no significant
differences in firm performance between separated
leadership structure firms and combined leadership
structure firms over a five year period. However,
further study of the same sample reveal that firms
with separated leadership structure have higher
performance than the firms with combined leadership
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structure measured with ROE, ROI and profit margin
(Rechner and Dalton, 1991).
Saundaramurthy et al. (1997) provide evidence
that separating the positions will affect the
shareholder wealth positively. Moreover, Coles and
Hesterly (2000) find that firms that separate CEOs
and board chairs will have better stock returns than
firms that do not separate the two roles. On the other
hand, Baliga and Rao (1996) do not find sufficient
evidence to support a performance distinction
between separated and combined leadership firms
when the performance was measured using the market
value added (MVA) and economic value added
(EVA) as performance indicators.
Audit committees are identified as effective
means for corporate governance that reduce the
potential for fraudulent financial reporting (NCFFR,
1987). Audit committees oversee the organization’s
management, internal and external auditors to protect
and preserve the shareholders’ equity and interests.
To ensure effective corporate governance, the audit
committee report should be included annually in the
organization’s proxy statement, stating whether the
audit committee has reviewed and discussed the
financial statements with the management and the
internal auditors. As a corporate governance monitor,
the audit committee should provide the public with
correct, accurate, complete, and reliable information,
and it should not leave a gap for predictions or
uninformed expectations (BRC, 1999). The BRC
report provides recommendations and guiding
principles for improving the performance of audit
committees that should ultimately result in better
corporate governance. The importance of the audit
function in terms of the audit committee and audit
firm is further strengthened by the Sarbanes-Oxley
Act of 2002. The discussion above leads us to the
second research hypothesis:
H2: There is a significant relationship between board
structure and bank performance.
5.3 Ownership Structure
Cole and Mehran (1998) find that changes in
performance are significantly associated with changes
in insider ownership. They document that the greater
the increase in insider ownership, the greater the
performance improvement, which is consistent with
the alignment of interests hypothesis arising from a
larger insider ownership. Also consistent with that
hypothesis of Subrahmanyam et al (1997) who find
evidence, in a sample of successful bidders in bank
acquisitions, of a positive association between bidder
returns and the level of insider ownership when the
latter exceeds 6%.
Large shareholders and institutional investors
can be seen as potential controllers of equity agency
problems as their increased shareholdings can give
them a stronger incentive to monitor firm
performance and managerial behavior (Demsetz,
1983; Demsetz and Lehn 1985; and Shleifer and
Vishny, 1986; Shleifer and Vishny, 1997, La Porta et
al, 1998; La Porta et al, 1999; Claessens et al, 2000,
and Denis and McConnell, 2003). This potentially
helps to circumvent the free rider-problem associated
with ownership dispersion.
Equity agency costs can be reduced by
increasing the level of managers' stock ownership,
which may permit a better alignment of their interests
with those of shareholders. In fact, in the extreme case
where the manager's share ownership is 100%, equity
agency costs are reduced to zero (Jensen and
Meckling, 1976). As managerial ownership increases,
managers bear a large fraction of the costs of shirking,
perquisite consumption and other value-destroying
actions. Further, larger share ownership by managers
reduces the problem of different horizons between
shareholders and managers if share prices adjust
rapidly to changes in firm’s intrinsic value.
A limitation, however, of this mechanism as a
tool for reducing agency costs is that managers may
not be willing to increase their ownership of the firm
because of constraints on their personal wealth.
Additionally, personal risk aversion also limits the
extension of this monitoring device as the allocation
of a large portion of the manager's wealth to a single
firm is likely to translate into a badly diversified
portfolio (Beck and Zorn, 1982).
In accordance with the proposition that larger
managerial ownership reduce agency costs, Kaplan
(1989) finds that following large management
buyouts, firms experience significant improvements
in operating performance. He interprets this evidence
as suggesting that operating changes were due to
improved management incentives instead of layoffs or
managerial exploitation of shareholders through
inside information. Smith (1990) reports similar
results and notes that the amelioration observed in
operating performance is not due to reductions in
discretionary expenditures such as research and
development, advertising, maintenance or property,
plant and equipment. Macus (2008) argues that the
basic issue from an agency perspective is how to
avoid such opportunistic behaviour. Previous studies
suggest that corporate governance is an effective tool
to control the opportunistic behaviour of management
(Denis and McConnell, 2003; Bhagat and Bolton,
2008; Chen et al., 2009).
Research by Morck et al (1988), McConnell and
Servaes (1990) and Hermalin and Weisbach (1991) is
also consistent with the view that insider ownership
can be an effective tool in reducing agency costs,
although they report a non- monotonic relation. This
functional form has been related to the observation
that, within a certain ownership range, managers may
use their equity position to entrench themselves
against any disciplining attempts from other
monitoring mechanisms. Spong and Sullivan (2007)
reveal that boards of directors are likely to have a
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more positive effect on community bank performance
when directors have a significant financial interest in
the bank. However, some other studies find no
evidence of a positive relationship between insider
ownership and performance (see, for instance,
Demsetz and Lehn, 1985; Loderer and Sheehan, 1989;
Holderness and Sheehan, 1988; Denis and Denis,
1994; and Loderer and Martin, 1997).
A possible explanation for these mixed results is
that many of the studies do not properly distinguish
the possibility of alignment of interests across a
certain range of ownership values and of
entrenchment over another range. Furthermore, these
analyses usually do not take into account the
possibility that several different mechanisms for
alignment of interests can be used simultaneously,
with substitution effects with insider ownership. It is
quite conceivable that different firms may use
different mixes of corporate governance devices
(Rediker and Seth, 1995). These different mixes can,
however, all be optimal as a result of varying
marginal costs and benefits of the several monitoring
instruments available for each firm. If so, then one
would not be able to observe a relationship between
performance and any of these particular mechanisms.
It appears that the main conflict is between owners
and managers in common law countries due to the
existence of dispersed control and ownership
structures. While, in civil law countries the control
and ownership structures are concentrated, thus the
main governance problem arises between minority
and controlling shareholders. Therefore, ownership
structure has greater importance in civil law countries
where protection of shareholders right is weak (La
Porta et al., 1998; Beck et al., 2003). The situation is
more prevalent in developing countries where large
concentration of ownership is more evident while the
stock markets are weak. In those countries there is a
higher degree of economic uncertainties coupled with
weak legal controls and investor protection, and
frequent government intervention; all resulting in
poor performance (Ahunwan, 2002; Rabelo and
Vasconcelos, 2002; Tsamenyi et al; 2007).
Similar results are prevalent in the banking
sector in the GCC countries where most ownership
and control in substantial family corporate holdings
and boards of directors are largely dominated by
controlling shareholders, their friends and relatives.
There are few independent directors on boards and
shareholders dominate the decision-making process as
there is rarely any separation between ownership and
management. In most cases the chairman of the board
is also the CEO; and there is a general lack of
transparency and disclosure which leads to the
conclusion that a high concentration of corporate
ownership undermines the principles of good
corporate governance (The Union of Arab Banks,
2003; Yasin and Shehab, 2004). Based on the above
discussion, the third research hypothesis is:
H3: There is a significant relationship between
ownership structure and bank performance.
3. Research Methodology 3.1 The method
In order to test the hypotheses, quantitative method is
used to investigate the effects of corporate governance
mechanisms on bank performance. CG mechanisms
include (ownership concentration, director ownership,
duality, board size, board non-executives, board
activism, audit committee and audit committee
meetings), and other control variables, such as bank
size, age and type of banks. The bank performance is
measured by Tobin’s Q, ROA, and Profit Margin.
Bankscope database is used to select the country,
Yemen and six GCC countries, and selected the top
fifty banks from the above seven countries, as shown
in table (1). It is also used the respective banks’
websites and other websites to extract the relevant
financial and non-financial information about each
bank from its published audited financial statements,
annual reports, and other relevant information.
3.2 Sampling and data collection
The sample includes conventional and Islamic banks
operating in Yemen and the six GCC countries using
the data for the year 2011. Excluded from the sample
are banks that do not have audited financial
statements. Financing, insurance, or non-bank
institutions are excluded since they are different from
banks with respect to their specific characteristics,
management structures, accounting procedures, and
audit functions. Table (1) below shows the population
and samples selected per country.
The final sample consists of the largest 50
conventional and Islamic banks operating in Yemen
and the six GCC countries. The process of selecting
this sample is based on the values of these banks’
total assets and the consequent ranking stated by
Bankscope database. Any bank excluded due to any
of the above reasons has been replaced with the next
immediate bank in ranking. Table (2) summarizes the
sample selection.
3.3 Measurement of variables
For bank performance measurement, the dependent
variables used are Tobin’s Q, ROA, and Profit
Margin. Meanwhile, the independent variables used in
regard to corporate governance mechanisms are
ownership concentration, director ownership, duality,
board size, board non executive, board activism, audit
committee and audit committee meetings. Other
control variables include bank type, bank age, and
bank size. Table (3) shows the definition and
measurement of these variables.
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Table 1. Population and samples per country
Country Population* (Banks only) Sample Size Sample Size (%)
Bahrain 29 14 48%
Kuwait 10 7 70%
Oman 7 7 100%
Qatar 7 7 100%
Saudi Arabia 12 9 75%
United Arab Emirates 19 7 37%
Yemen 11 8 73%
Total 95 59 62% *Information from Bankscope Database
Table 2. Sample selection
Number of banks selected from Bankscope Database based on its ranking for 2011 and the number of
banks in each country
59
No annual reports available for 2011 (3)
No sufficient data about bank (6)
Final sample
Final sample (%)
50
53%
Table 3. Definition and measurement of variables
Variable Symbol Definition Measurement
Dependent Variables
TobinQ Tobin’s Q MVE + PS + Debt / TA (as per Chung and Pruitt,
1994)
ROA Return on Assets Net Income / Total Assets
PM Profit Margin Net Income / Revenues
Independent Variables
OwnCon Ownership Concentration Adding up all shareholding of 5% or more
DirOwn Director Ownership Director ownership = 1; otherwise = 0
Brdsize Board Size Total number of board members during 2011
Duality CEO Duality If the CEO and Chairman are the same person = 0;
otherwise = 1
BrdNonEx
Number of Non-Executives
on Board
Number of non-executive members on the board
during 2011
BrdActivism Board Activism Number of board meetings held during 2011
AC Audit Committee If Audit Committee exists = 1; otherwise = 0
ACmeetings Number of Audit Committee
Meetings per Year
Number of audit committee meetings during 2011
Control Variables
TYPE Bank Type Conventional bank = 1; Islamic = 0
AGE Age of Bank In years: 10 or more = 1; less than 10 = 0
SIZE Bank Size Natural log of total assets
4. Data Analysis and Discussion 4.1 Descriptive Analysis
Table (4) illustrates the minimum and maximum
values for the variables. The descriptive findings
show the central tendency and dispersion of the
indicators as shown in table (4). The study focuses on
conventional and Islamic banks operating in Yemen
and the six GCC countries.
Table (5) shows the frequency of the banks
based on the GCC countries and Yemen.
Figure (1) shows the description of the sample
based on number of banks on the six GCC countries
and Yemen.
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Table 4. Descriptive Statistics
Variables Minimum Maximum Mean Std. Deviation
OwnCon 0.05 1.0000 .62 .28
DirOwn .00 1.00 .16 .37
Duality .00 1.00 .92 .27
Brdsize 6.00 19.00 9.48 2.22
BrdNonEx 4.00 13.00 8.46 2.04
BrdActivisim .00 9.00 4.96 1.67
AC .00 1.00 .86 .35
ACmeetings .00 11.00 4.08 2.41
Age 4.00 75.00 29.74 15.45
Size 6.21 11.33 8.91 1.52
TobinQ .1300 3.2600 .94 .38
ROA -.0090 .0491 .02 .01
PM -.3700 .7500 .37 .22
Table 5. Frequency of the sample
Country Frequency Percent Cumulative Percent
Bahrain 14 28.0 28.0
Kuwait 4 8.0 36.0
Oman 7 14.0 50.0
Qatar 6 12.0 62.0
KSA 9 18.0 80.0
UAE 7 14.0 94.0
Yemen 3 6.0 100.0
Total 50 100.0
Figure 1. Description of the sample
4.2 Hypotheses Testing
For testing the first hypothesis, two-independent
samples t-test is adopted. Finally, multiple regressions
models are used to test the second and third
hypotheses.
4.2.2 The difference between Islamic and
conventional banks in using CG mechanisms
This hypothesis is concerned with the difference
between CG practices in conventional and Islamic
banks.
The two groups that are used in this hypothesis
are: Islamic and conventional banks which use CG
mechanisms. The independent-samples T-test is used
to test this hypothesis as shown in table (6). For the
ownership concentration as a CG mechanism, the
interpretation of the independent t-test result is a two-
stage process. The first stage is to examine the
homogeneity of the variance between the two groups
using Levene’s Test for Equality of Variances, where
(F = 8.953, P = 0.004). This is considerably less than
0.01 (thus significant), indicating that equal variances
cannot be assumed. The second stage is to use the t-
test row of results labelled equal variance not
assumed. This provides the t-value (t = -.420), the
degree of freedom (df = 16.186), and the sig. (2-
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tailed) is .680, where (P > 0.05). Thus, the result is
not significant which means that Islamic banks are not
significantly different from conventional banks in
using CG mechanism as in table (6).
For the other CG mechanisms (director
ownership, duality, board size, board non-executives,
board activism, audit committee and audit committee
meetings), the interpretation of the independent t-test
result is a two-stage process. The first stage is to
examine the homogeneity of the variance between the
two groups using Levene’s Test for Equality of
Variances, where (P-value for F-test > 0.05). This is
considerably less than 0.05 (thus not significant),
indicating that equal variances can be assumed. The
second stage is to use the t-test row of results labelled
equal variance assumed. Where (P-value for T-test >
0.05) for director ownership, duality, board non-
executives, board activism, audit committee and audit
committee meetings. Thus, the result is not significant
except for board size where (P-value for T-test <
0.05) which means that there is a significant
difference. Finally, it can be said that Islamic banks
are not significantly different from conventional
banks in using CG mechanism except for board size
as in table (6). The results agree to great extent with
the findings of Al-Tamimi (2012) that there is no
significant difference between the UAE national
conventional and Islamic banks regarding CG
practices
Table 6. Independent-Samples T-test
F Sig. t df Sig.
(2-tailed)
OwnCon Equal variances assumed 8.953 .004 -.501 48 .618
Equal variances not assumed -.420 16.186 .680
DirOwn Equal variances assumed 2.286 .137 .798 48 .429
Equal variances not assumed .712 17.563 .486
Duality Equal variances assumed .009 .926 .047 48 .963
Equal variances not assumed .047 21.006 .963
Brdsize Equal variances assumed .007 .932 2.563 48 .014
Equal variances not assumed 2.163 16.330 .046
BrdNonEx Equal variances assumed .091 .764 .316 48 .753
Equal variances not assumed .294 18.675 .772
BrdActivisim Equal variances assumed .044 .835 -.865 48 .391
Equal variances not assumed -.807 18.749 .430
AC Equal variances assumed .105 .747 -.164 48 .870
Equal variances not assumed -.158 19.670 .876
ACmeetings Equal variances assumed .761 .387 -.402 48 .689
Equal variances not assumed -.356 17.335 .726
4.2.3 Testing the effect CG mechanisms on firm
performance
The second and third research hypotheses are
concerned with studying the effect of CG mechanisms
on firm performance.
Three equations are used to test these hypotheses are
presented in the formulars 1, 2, 3.
This hypothesis concerns with investigating the
effect of firm size, firm age, and CG variables on firm
performance by using OLS analysis. Table (7)
provides the results for the multivariate regression
models.
Tobin’s Q = α + β1 OwnCon +β2 DirOwn + β3 Duality + β4 Brdsize + β5 Brdnonex + β6
Brdativism + β7 Ac + β8 Acmeeting + β9 Age + β10 Size + ε (1)
ROA = α + β1 OwnCon +β2 DirOwn + β3 Duality + β4 Brdsize + β5 Brdnonex + β6 Brdativism
+ β7 Ac + β8 Acmeeting + β9 Age + β10 Size + ε (2)
PM = α + β1 OwnCon +β2 DirOwn + β3 Duality + β4 Brdsize + β5 Brdnonex + β6 Brdativism
+ β7 Ac + β8 Acmeeting + β9 Age + β10 Size + ε (3)
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Corporate Ownership & Control / Volume 11, Issue 2, 2014, Continued - 1
186
Table 7. OLS regression results
*Statistically significant at the 0.10 level
** Statistically significant at the 0.05 level
*** Statistically significant at the 0.01 level
Model 1 investigates the relationships between
firm performance (Tobin’s Q) and the variables of
interest. The R2
is 0.474 and the model appears highly
significant (F = 3.508, p = 0.001). As regards our
variables of interest, firm age, board size and board
activism appear to have an effect on Tobin’s Q, where
the estimated coefficients are positive and statistically
significant at 10%, 1% and 5% respectively. These
results on board size are consistent with the results of
Huang (2010) in Banks in Taiwan, however they are
inconsistent with previous studies (Jensen 1993;
Yermack 1996; Eisenberg et al, 1998; Singh and
Davidson, 2003; Staikouras et al., 2007; Cheng,
2008). Board non-executives has an effect on Tobin’s
Q, where the estimated coefficient is negative and
statistically significant at 1% level. This result is
consistent with the finding of Agrawal and Knoeber
(1996), Kochar and David (1996) and Bhagat and
Black (2002). The variance inflation factor (VIF)
score was calculated for each independent variable, in
order to evaluate whether multicollinearity may be a
cause of concern. VIF scores higher than 10 are likely
to cause a multicollinearity problem (Gujarati, 2004).
The highest VIF obtained is 3.210.
Regarding model 2, it examines the relationships
between firm performance (ROA) and firm size, firm
age, and CG variables. The R2
is 0.376 and the model
appears significant (F = 2.345, p = 0.028). As regards
our variables of interest, audit committee appears to
have an effect on ROA, where the estimated
coefficients are positive and statistically significant at
5% level. Ownership concentration and audit
committee meetings have an effect on ROA, where
the estimated coefficient is negative and statistically
significant at 10% level. These results are consistent
with previous studies (Ahunwan, 2002; Rabelo and
Vasconcelos, 2002; Tsamenyi et al; 2007). It seems
that in GCC banks most ownership and control are in
substantial family holdings and boards of directors are
largely dominated by controlling shareholders. Thus
the effect of the weak professional control results in
poor performance. The highest VIF obtained is 3.210.
Regarding model 3, it examines the relationships
between profit margin (PM) and firm size, firm age,
and CG variables. The R2 is 0.423 and the model
appears significant (F = 2.853, p = 0.009). As regards
our variables of interest, only firm age and firm size
appear to have an effect on PM, where the estimated
coefficients are positive and statistically significant at
10% and 5% level respectively. The results are
consistent with the findings of Klapper and Love
(2004) and Odegaard and Bohren (2003). This result
may reflect an independent source of value creation,
possibly due to market power and economies of scale
and scope (Odegaard and Bohren, 2003). Moreover,
large banks in the Middle East have more resources
(e.g., more skilled managers) compared to medium
and small banks which may help them to be more
efficient and attract more investors and increase their
firms' values. The highest VIF obtained is 3.210.
5. Summary and conclusion This paper investigates the effect of corporate
governance mechanisms on bank financial
performance in seven Middle Eastern countries. The
Model 3
(Dependent Variable
PM)
Model 2
(Dependent Variable
ROA)
Model 1
(Dependent Variable Tobin Q)
t-statistics Coeff. t-statistics Coeff. t-statistics Coeff.
.205
1.847*
2.050**
-1.385
-1.047
-.317
-1.051
.435
1.103
1.162
-.825
2.853
0.009
0.423
0.274
3.210
.069
.004
.049
-.156
-.111
-.214
-.021
.009
.025
.146
-.016
.720
1.098
-.220
-1.940*
-.896
-.884
-.343
1.443
.567
2.167**
-1.754*
2.345
0.028
0.376
0.215
3.210
.012
.000
.000
-.011
-.005
-.007
.000
.002
.001
.014
-.002
.153
1.765*
-.102
-.649
.650
-.149
4.391***
-3.020***
2.119**
.239
-.716
.085
.006
-.004
-.120
.114
-.040
.141
-.103
.078
.049
-.023
3.508
0.002
0.474
0.339
3.210
Const.
Age
Size
OwnCon
DirOwn
Duality
BrdSize
BrdNonEx
Brdactivism
AC
ACmeetings
F-statistics
p-value for F- test
R-squared
adjusted R2
Max VIF
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Corporate Ownership & Control / Volume 11, Issue 2, 2014, Continued - 1
187
paper provides an insight into the corporate
governance practices in 50 conventional and Islamic
banks operating in Yemen and the six GCC countries
and the effect of such practices on Tobin’s Q, ROA
and PM. Corporate governance of banks in emerging
economies is of crucial importance as banks hold an
overwhelmingly dominant position in the financial
systems of these countries. Moreover, banks are
extremely important engines of growth in such
countries as they are typically the most important
source of finance for the majority of firms, in addition
to playing a major role in the payment & saving
system. Therefore, bank governance is of crucial
importance as the reduced role of economic regulation
has resulted in the managers of banks having greater
freedom on how they run their banks.
Emerging economies are likely to require more
effective and stronger governance mechanisms than
their western developed counterparts if they are to
become equal, full, and active participants in the
global financial marketplace. The governments of
most GCC countries have taken the necessary actions
to have a strong financial sector based on well-
established financial companies, in order to keep pace
with international developments and enable the vision
of a solid economy that will be recognized
internationally. While the corporate governance codes
and regulations in the GCC might not be as elaborate
as corporate governance regimes in western countries,
they can be said to provide adequate coverage of the
key disclosure issues of relevance in a market with a
nascent disclosure culture. Nonetheless, policy
makers in GCC countries need to ensure that firms
implement effective corporate governance
mechanisms. This implementation should be
appropriate for the GCC business environment while
embracing international corporate governance
standards.
The results reveal that certain corporate
governance mechanisms have impact on market value
performance. Meanwhile, book value performance is
affected by different corporate governance
mechanisms. The study results are consistent with
previous literature that the correlation between
corporate governance and performance is still not
clearly established and that financial impact on
corporate governance on performance in emerging
economies is still relatively scarce. The results reveal
that corporate governance practices do not differ
between conventional and Islamic banks in the
Middle East.
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Vol. 30, pp. 383-407.
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pp. 431–460.
109. Weir, C. and Laing, D. (2001), "Governance
structures, director independence and corporate
performance in the UK", European Business Review,
Vol. 13 No. 2, pp. 86-94.
110. William, Q., Naoumova I., and Koutzevol, N. (2003),
"Corporate governance and firm performance in
Russia: An empirical study", Journal of World
Business, Vol. 38, pp. 385–396.
111. Yermack, D. (1996), "Higher market valuation for
firms with a small board of directors", Journal of
Financial Economics, Vol. 40, pp. 185-211.
112. Yamak, S. and Su¨er, O. (2005), ‘‘State as a
stakeholder’’, Corporate Governance, Vol. 5 No. 2,
pp. 111-20.
113. Yasin, H. and Shehab, I. (2004), “Monitoring and
overseeing disclosure”, in Saidi, N. (Ed.),
paperpresented at the Corporate Governance in
MENA Countries: Improving Transparency and
Disclosure, the Second Middle East and North Africa
Regional Corporate Governance Forum, Beirut, June
3-5.
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Corporate Ownership & Control / Volume 11, Issue 2, 2014, Continued - 1
191
Appendix 1. List of Banks
Bahrain: Kuwait: Oman: Qatar: Saudi
Arabia: UAE: Yemen:
1 Ahli United
Bank BSC
National
Bank of
Kuwait
S.A.K.
Bank
Muscat
SAOG
Qatar National
Bank
National
Commercial
Bank (The)
Emirates
NBD PJSC
Tadhamon
International
Islamic Bank
2
Albaraka
Banking
Group
B.S.C.
Al Ahli
Bank of
Kuwait
(KSC)
National
Bank of
Oman
(SAOG)
Commercial
Bank of Qatar
(The) QSC
Al Rajhi
Banking &
Investment
Corporation-
Al Rajhi
Bank
Natiional
Bank of Abu
Dhabi
Yemen Bank
for
Reconstruction
and
Development
3
Gulf
International
Bank BSC
Jordan
Kuwait
Bank
Bank
Dhofar
SAOG
International
Bank of Qatar
Q.S.C.
Riyad Bank Abu Dhabi
Commercial
Bank
National Bank
of Yemen
4 BBK B.S.C.
Industrial
Bank of
Kuwait
K.S.C.
Bank
Sohar
SAOG
Qatar
International
Islamic Bank
Banque Saudi
Fransi
First Gulf
Bank
5 Ithmaar
Bank B.S.C.
HSBC
Bank
Oman
Qatar
Development
Bank Q.S.C.C.
Saudi British
Bank (The)
Dubai
Islamic Bank
plc
6
National
Bank of
Bahrain
Oman
Arab
Bank
SAOG
Qatar First
Investment
Bank
Arab
National
Bank
Union
National
Bank
7
Al-Baraka
Islamic
Bank
Ahli Bank
SAOG
Islamic
Development
Bank
Mashreqbank
8 Arcapita
Bank
Saudi
Hollandi
Bank
9
Al-Salam
Bank
Bahrain
Bank Al-
Jazira
10 Investcorp.
Bank
11
Bahrain
Islamic
Bank
12 United Gulf
Bank
13 BMI Bank
14 Future Bank
Page 38
Corporate Ownership & Control / Volume 11, Issue 2, 2014, Continued - 1
192
DEBT, GOVERNANCE AND THE VALUE OF A FIRM
K. Rashid*, S. M. N. Islam**, S. Nuryanah***
Abstract
This paper examines the role of debt in affecting the value of a firm in the developing and the developed financial markets. The study uses panel data of 120 companies for the years 2000 to 2003 from the selected financial markets. The paper extends the literature by performing a comprehensive analysis of the relationship between debt and the value of a firm, by using a correct proxy to value a firm. Furthermore, the results are interpreted by taking into account the foundations of the developing and developed markets and different financial theories are ranked on the basis of these results of the study. The findings of the study suggest that higher debt plays a negative role in affecting the value of a firm in the selected markets showing the effect of market imperfections in the developing market. The result supports the second trade off theory and the foundation of the developed financial market. An efficient regulatory authority improves the firm’s performance by defending the rights of shareholders and reducing principal and agent conflicts. Similarly, the dual leadership structure, investors’ confidence and optimal utilization of assets improve shareholders’ value in these markets. The results are valuable to academics and policy makers as these results suggest an optimal capital structure for the firms of the selected financial markets. Keywords: Corporate Governance, Debt, Firm Performance, Board Size and CEO Duality ** Department of Accounting, Faculty of Economics, Universitas Indonesia Email: [email protected]
Acknowledgements This paper is adapted from Rashid, K. and Islam, S. (2008) Corporate Governance and Firm Value: Econometric Modelling and Analysis of Emerging and Developed Financial Markets, Emerald, UK, and is reproduced with the permission of Emerald. The authors thank Emerald for giving permission to publish this paper. The authors are thankful to Ms Siti Nuryanah and Ms Margarita Kumnick for their help in proof reading the document.
1. Introduction
Debt is an important tool in minimizing the principal
(shareholder) and agent (manager) divergences and
improving the firms’ performance in a financial
market (Heinrich, 2002; Abor, 2005). Previous studies
have focused on the relationship between the debt and
equity structure in affecting the value of a firm, but
have overlooked the role of additional factors
affecting the nature of this relationship, particularly in
a developing financial market. Furthermore, the
results of these other studies were not interpreted by
taking into account the foundations of developing and
developed markets. Finally, the literature lacks a
comprehensive study based on a robust data set and a
correct proxy to value a firm, to test its relationship
with the role of debt in developing and developed
financial markets.
The literature concerning the role of debt in
affecting firms’ performance suggests a mixed
relationship between both the variables. Nerlove
(1968), Petersen and Rajan (1994) and Hutchinson
(1995) find a positive relationship between higher
debt and the value of a firm in the financial market.
Similarly, Taub (1975) advocates for a positive
relationship between the different measures of
profitability and the debt to equity ratio. The effective
role of debt in corporate governance and hence
increasing firm value are also confirmed in the current
studies conducted by Ivashina et al. (2009), Altan and
Arkan (2011), and Ben Moussa and Chichti (2011).
On the other hand, Fama and French (1998),
Gleason et al. (2000) and Hammes (2003) argue that
higher debt deteriorates the value of a firm in
financial markets. Similarly, Berger and Patti (2006)
in their research conducted on banking sector and
Majumdar and Chhibber (1999) in their study related
to the DVF relationship pertinent to an emerging
market, find that higher debt deteriorates the value of
a firm. Sarkar and Sarkar (2008) found that debt
cannot play its disciplinary role as a corporate
governance instrument. The current study conducted
by Sadeghian et al. (2012) confirms further that the
debt increase has a negative influence on the
company’s performance.
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193
In spite of the mixed results in the DVF
relationship, an advanced panel threshold regression
model conducted by Feng-Li and Tsangyao (2011)
shows that, for Taiwan case study, there are two
threshold effects between debt ratio and firm value,
which are 9.86% and 33.33%. Firm value will
increase much higher if the debt ratio is less than
9.86%. The increase will be slower as the debt ratio
increases up to 33.33% and finally if the debt ratio is
greater than 33.33% there will be no relationship
between debt ratio and firm value.
This paper argues that the mixed results in the
DVF relationship indicates the limitations of the
previous studies as, for example, the studies
conducted by Kyereboah-Coleman and Biekpe (2005)
and Chang and Mansor (2005) have tested the
relationship between the level of debt and the value of
a firm as a control variable in a developing market but
have not incorporated the important factors affecting
debt and the value of a firm (DVF) relationship.
Similarly, Myers and Majluf (1984), Zwiebel (1996),
Berglof (1997), Hadlock and James (2002), Suto
(2003) and Rashid and Islam (2009) have not
performed the study to test the role of debt in
combined markets (developing and developed
financial markets). This research addresses the above-
mentioned gap in the literature and extends the recent
paper by Rashid and Islam (2009) by using a correct
proxy to value a firm and by performing a
comprehensive study to analyze the role of debt in
affecting the firm’s performance. Based on the panel
data of 120 publicly listed companies, this paper
depicts that debt plays an unhealthy role in managing
the conflicts between shareholders and managers. On
the contrary, the external regulatory regime defends
the rights of shareholders in the selected markets.
Finally, the results for the control variables suggest
that dual leadership structure, efficient utilization and
investors’ confidence lead to the improved value of a
firm in these markets. The results of this study are
valid, as an additional test of robustness is also
performed.
Following the introduction, the paper is further
structured as follows. Section 2 presents the literature
review which is followed by the hypothesis
development in Section 3. Section 4 describes the
methodology for the model. Similarly, Section 5
discusses the econometric results for the study.
Section 6 presents the explanation of the results and
finally, Section 7 concludes the paper.
2. Literature review 2.1 Corporate governance
Corporate governance in the literature is defined as
the mechanism used to protect the interests and rights
of shareholders in the market (Gompers et al., 2003).
The concept of corporate governance is also related to
the fair returns on the investment made by the
shareholders, because they are the providers of capital
(funds) to organizations as defined by Shleifer and
Vishny (1997). Similarly, a corporate governance
framework defends the rights of different stakeholders
which include management, customers, suppliers,
creditors and other associated parties related to the
operations of a firm (Dallas, 2004; Black et al., 2006).
Financial markets can be divided into two types:
developing and developed markets. These markets are
categorized on the basis of the sophistication of the
financial instruments used in these countries. The
developing financial market uses less sophisticated
instruments compared to the developed market. These
instruments are used to manage risk by hedging the
investors’ portfolios, ultimately improving the returns
for shareholders in the financial market (Hunt and
Terry, 2005). Shareholders in a developed market
earn higher returns due to the developed instruments
used in this market.
The literature related to corporate governance
suggests that different mechanisms of corporate
governance incorporate democratic (investor friendly)
provisions in both developing and developed financial
markets (Black, 2001; Black et al., 2003). The
instruments of corporate governance mechanisms
include shareholders, managers, board, executive
management, suppliers, customers, regulatory
authorities and judiciary as argued by Morin and
Jarrell (2001) and Dittmar et al. (2003).
The two important types of corporate
governance mechanisms include external and internal
corporate governance instruments. The latter refers to
the internal corporate governance regime and includes
board, size of board, mix in the board, leadership
structure of a firm (CEO duality) and the role of debt
in financial markets (Nam and Nam, 2004). These
instruments can improve the level of corporate
governance as argued by Gompers et al. (2003) and
Bebchuk et al. (2004). On the other hand, the former
are the external regulators in the financial market and
include a regulatory authority, judiciary, central bank
and a securities and investment commission
(Ahunwan, 2003).
2.2 Theories about capital structure
Debt has an important role in affecting the value of a
firm. There are different theories related to this. The
first school of thought in this regard is the Modigliani
and Miller hypothesis (1958, 1963). This theory
suggests that capital structure or the debt equity mix
does not affect the shareholders’ value significantly.
Modigliani and Miller hypothesis further suggests that
a firm operates in a perfect market as there is no
interest rate, agency cost of debt and the cost of
financial distress which makes the debt and equity
structure irrelevant in the market.
The second theory, which deals with the role of
capital structure, discusses the trade-off that exists
between the advantages and disadvantages of debt.
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194
This is the trade-off theory and suggests that financial
benefits of debt are offset by the disadvantages such
as the agency cost of debt and the cost of financial
distress (Copeland et al., 2005). The theory further
suggests that the benefits of debt, such as reduction in
the individual’s tax payment, are offset by the
additional amount of tax paid by the corporation.
Another theory relevant to the role of capital
structure is the second trade-off theory and suggests
that benefits of debt such as minimizing the amount
paid by an individual is equalized by the cost of
bankruptcy and the agency cost between creditors and
managers in the market.
Finally, the theory relevant to the role of capital
structure in affecting the value of a firm is the pecking
order theory. This theory ranks the methods or modes
of financing available to the firm on the basis of the
cost related to the execution of an individual option of
financing. The theory suggests that the firm will use
the cheapest source of financing on a priority basis,
which makes internal equity a highly preferable
source (Brealey and Myers, 2000). The second option
of raising funds is by issuing debt. Finally, the firm
can acquire finances by using the option of an
external equity. The theory further suggests that
issuance of debt conveys a positive signal to investors
as they realize that the management of a firm invests
in healthy projects. Furthermore, it also shows that the
firm has higher investment opportunities compared to
internally generated finances. The management of a
firm meets this short fall by issuing additional debt.
3.3 Other corporate governance instruments which increase the value of a firm
In addition to debt, majority shareholders, as an
external monitor, can also play an important role in
checking the internal corporate governance
mechanisms by defending the shareholders rights in
the financial markets (Franks and Mayer, 1994;
Kaplan and Minton, 1994).
Similarly, an internal mechanism such as the
board mix is also important, as it can affect the
shareholders’ value in the market (Abdullah, 2002;
Coles et al., 2008). The composition of the board is
vital in reducing the agency cost from the market. The
board of directors consists of a combination of inside
and outside directors (Wei, 2003). Inside directors are
the employees of a firm and have related financial
interests with the firm’s performance. These directors
can pursue their own benefits at the expense of the
shareholders (principal). Inside directors also
command the flow of important financial and strategic
information in affecting the shareholders’ value
(Stiles and Taylor, 1993). The convergence of
interests between shareholders and inside directors
can push the insiders to improve the value of a firm in
the financial market.
On the contrary, outside (independent) directors
are not the employees of a firm and can monitor the
organization on an independent basis (Bhagat and
Jefferis, 2002). This can improve the shareholders’
value, as the chances of expropriation of the minority
shareholders are reduced due to their (shareholders)
lower level of conflicts with the independent
directors. The combination of inside and outside
directors can be optimal to improve a firm’s
performance (Nam and Nam, 2004).
Similar to the board mix, board size is an
important corporate governance instrument in
affecting shareholders’ value (Loderer and Peyer,
2002). There are two schools of thought in this regard.
Zahra and Pearce (1989) and Kyereboah-Coleman and
Biekpe (2005) argue that a bigger board is better for
the firm’s performance, as it provides higher level of
strategic, planning and conceptual skills. The larger
board also creates value, as it is difficult for the
independent CEO (dual leadership) to dominate the
rational decisions of a board. There are functional
conflicts (healthy divergences) among the members of
the board which reduces the agency cost of the firm
(Linck et al., 2008).
On the other hand, Mak and Kusnadi (2005)
suggest that the bigger board does not add value for
the shareholders due to unhealthy conflicts among the
board members. Furthermore, the members of a larger
board often do not monitor the firm properly and are
involved in delayed decision making and free riding.
Free riding refers to the phenomena where the board
members do not perform their fiduciaries, but depend
on the monitoring done by other members of the
board. This deteriorates the value of a firm in the
financial market (Jensen, 1993).
The management and the board of directors can
also force the CEO to work for the benefits of all the
shareholders (the minority and the majority), by
relating the incentives of the CEO with its
performance. The management, including the board,
can also give proper remuneration to the CEO when
he/she meets both the long and short-term goals of a
firm (Bhagat and Jefferis, 2002).
The role of leadership structure is an important
component of corporate governance. The two main
types of leadership structures include dual and non-
dual leadership. Dual structure refers to a single
person performing both the tasks of CEO and the
chairman (Lam and Lee, 2008). This leads to the
dominance of the CEO, hence threatening the
independence of the board, as the board members
cannot discipline the CEO who is also the chairman of
board (Higgs, 2003: 23). On the contrary, non-dual
leadership refers to two different individuals holding
the job of CEO and chairman. This leads to the
independence of decision making by the board, hence
safeguarding the shareholders’ rights in a market.
In addition to all the instruments above, efficient
utilization of assets, as for example proxied by return
to total assets is an important aspect of corporate
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195
governance, since it creates returns for shareholders
and stakeholders. Firms in financial markets should
optimally utilize their assets to create shareholders’
returns (Capulong et al., 2000). The assets of these
firms should not be over and under-utilized by the
management to derive private gains from the financial
market.
The next section deals with the discussion
related to the role of business and management
theories. The first theory in this regard is the
stewardship theory. This theory suggests that the
manager, as an agent, looks after the interests of
shareholders (Davis et al., 1997). On the contrary, the
second theory is the agency theory and suggests that
the manager, as an agent, does not create value for
shareholders, deteriorating the firm’s performance
(Jensen and Meckling, 1976).
The figure below shows that in the presence of
an effective regulatory regime, debt can be used as a
powerful tool to reduce the misuse of cash flow and
discipline management, which improves the value of
a firm in a financial market.
Figure 1. The Relationship between Debt, Governance and the Value of a Firm
3. Hypohesis development
Jensen and Meckling (1976) and Jensen (1986) argue
that capital structure is of vital importance in affecting
the value of a firm. The free cash flow at the
discretion of managers is reduced in the indebted
firm, because it is utilized as a debt re-installment to
the creditor. The free cash flow is usually misused in
the forms of under and over investment by the
managers in a market. Under investment occurs when
managers do not invest in the profitable opportunities,
as the creditors share the part of profit from the
valuable investments. On the contrary, over
investment takes place when managers have
incentives to invest in projects due to their related
private benefits attached to the success of these
projects (Bebchuk et al., 2004). Shareholders pay
higher costs in monitoring and disciplining the
managers who deteriorates the value of a firm.
As discussed, the role of debt is important in
reducing the agency conflicts between managers and
shareholders, as the free cash flow problem is
resolved. The debt, in combination with other
instruments such as majority shareholders, can also
improve the value of a firm (Berglof, 1997). The
literature suggests that the use of corporate
governance instruments resolves the agency conflicts,
but an excessive use of a single instrument also
creates an additional agency cost in the market. This
leads to the need for other instruments, which reduce
the marginal cost and improve the marginal benefits
of each other to create real value for shareholders. The
combination of these instruments is called Edgeworth
complements. An instrument is Edgeworth
complementary if the marginal benefit of using
combined complementary instruments improves by an
additional use of each instrument in combination
(Heinrich, 2002).
The foundation of the developing financial
market suggests that the agency cost between
creditors and managers is governed properly
compared to the same cost between the managers and
shareholders. This suggests that higher debt creates
value in developing markets due to a better
management of the agency cost between the relevant
players of corporate governance (Berglof, 1997). The
majority shareholders also act as a better debt monitor
in the developing market, due to their higher financial
stakes related to the firms’ performance, compared to
the minority shareholders.
On the contrary, the agency cost between
managers and equity holders is handled properly in
the developed financial market. This feature of the
developed market advocates for the lower level of
debt as the shareholding is dispersed in this market.
Dispersed shareholding also justifies lower debt,
because the majority shareholders as external
monitors are absent (Rashid and Islam, 2008). This
feature of the developed market restricts higher debt
to be used as a better option for the value creation of
shareholders.
The level of financial benefits derived by
creditors in developing markets can be magnified by
linking them with the incentives to management
(Heinrich, 2002). This will force management to work
for all the stakeholders in these markets. Higher debt
in the hybrid system controls the adverse actions of
managers as it introduces efficient monitors
(blockholders) in the market. On the contrary, greater
debt also triggers a bankruptcy risk in the system
(Copeland et al., 2005). These advantages and
disadvantages should be considered to make optimal
financing decisions in the financial market.
The majority shareholders can monitor the firm
as they have higher financial interests related to the
firms’ performance. This related financial interest can
also reduce the free riding and wasteful duplication of
efforts by all the shareholders. Free riding prevails in
dispersed shareholding, when all the shareholders do
not keep a check on the management of the firm
properly, as most of them prefer not to pay any
monitoring cost. Secondly, wasteful duplication of
External
Corporate
Governance
Instruments
Debt and Other Governance
Instruments (agency cost
between managers and
creditors)
Management (control
under and over
investment of the free
cash flow)
Value of a
Firm
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Corporate Ownership & Control / Volume 11, Issue 2, 2014, Continued - 1
196
effort occurs in financial markets when the majority
of the shareholders waste their efforts in doing the
similar job of monitoring as performed by all of them
(Diamond, 1984).
There are additional imperfections (inflation,
political turmoil, under-resourced and rudimentary
regulatory institutions, and expropriation of minority
shareholders) in the developing financial market
(Ahunwan, 2003). Higher inflation leads to an intense
depreciation and a loss of investors’ confidence.
Similarly, the political unsteadiness makes the market
unstable, leading to the deteriorating performance of a
firm. The weak regulatory institutions cannot align
the interests of the principal and agent which results
in a higher agency cost in the developing market.
Finally, the rights of minority shareholders are not
safeguarded, as cash flow in the firm is not used in a
positive manner in this market. These imperfections
affect the strength of individual instruments in the
Edgeworth combination to improve the marginal
benefits of each other.
The abovementioned discussion related to the
role of debt in affecting the value of a firm can be
summarized by suggesting that lower debt is
beneficial for firms in the developed market due to an
absence of majority shareholders as external monitors.
Similarly, due to the presence of additional
imperfections in the developing market, the higher
debt in combination with blockholding is not
beneficial to firms of this market. This discussion
leads to the following hypothesis.
H1: There is a negative relationship between higher
debt and the value of a firm in the selected financial
markets.
4. Methodology
The current section consists of the data collection
methods, methodology of construction of the
variables, econometrics relevant for the study and a
multifactor model used to test the relationship among
the dependent and independent variables.
4.1 Data collection methods The data set for sixty companies from each market is
collected for the firms listed at Kuala Lumpur and
Australian securities exchanges and is secondary in
nature. The study used simple random sampling as the
sample companies for this study are selected purely
on random basis. The data for the study is collected
for control variables and external and internal
corporate governance instruments. The data for
control variables (CEO duality, board size, price to
book value ratio and return on total assets) is collected
by using an OSIRIS database. The collected data is
also crossed-checked with financial information
available on the websites of companies listed at
respective securities exchanges. The data for the
external corporate governance instrument (regulatory
authority and judicial efficiency index) is collected
from the World Bank and International Monetary
Fund websites. Finally, the data set for the internal
corporate governance instrument (debt to equity ratio)
is collected by using the stock exchanges books in
these financial markets.
4.2 Methodology of the variables
The dependent and independent variables used in this
study are listed in table 1 and their methodology of
construction is as follows. Tobin’s Q is used as a
dependent variable for the study (Bhagat and Jefferis,
2002; Gompers et al., 2003). The proxy for the
dependent variable (Tobin’s Q) in this study is
calculated by adding market capitalization and total
assets. In the second step, the shareholders’ fund is
subtracted from the added value calculated in the first
step. The residual value is divided by the total assets
to get the proxy for the Tobin’s Q. The calculation for
the proxy by using the above-mentioned methodology
contributes to the literature as the replacement value
of institutional debt does not comprise the formula to
calculate the proxy for Tobin’s Q. The correct proxy
to value a firm used in developing and developed
financial markets enables us to find the real
relationship between the independent variables and
the firms’ performance.
The independent variables relevant for the study
which are used to test their relationship with the value
of a firm are constructed as follows. The internal
corporate governance instrument on which the study
is based is the debt to equity ratio of firms
(Kyereboah-Coleman and Biekpe, 2005). The variable
is directly extracted from the balance sheets of the
companies listed at the securities exchanges of the
selected markets. We expect a negative relationship
between the variable and the value of a firm in these
markets.
The next independent variable in this study is the
role of board size in affecting the firm’s performance.
The board size in the model for DVF relationship is
calculated by counting the number of directors on the
board (Kyereboah-Coleman and Biekpe, 2005). We
expect a negative relationship between the board size
and the value of a firm as we support the agency
theory in the selected financial markets.
CEO duality is used in the model for DVF
relationship to testify the role of leadership structure
in affecting the value of a firm (Haniffa and Cooke,
2000). This variable is measured with the help of a
dummy variable. The value of this variable is 1 when
a single person holds both the positions of CEO and
chairman. On the contrary, the value of the variable is
0 when both the roles (CEO and chairman) are
separated i.e performed by two different persons
(Kyereboah-Coleman and Biekpe, 2005). We expect a
negative relationship between the CEO duality and
the value of a firm as a single person holding both the
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Corporate Ownership & Control / Volume 11, Issue 2, 2014, Continued - 1
197
important positions is against the corporate
governance principles in the selected markets.
The role of the external corporate governance
instrument (regulatory authority efficiency) is
measured by regulatory efficiency index (Klapper and
Love, 2004). This index is constructed by taking into
account the time and cost involved in the settlement
of corporate disputes in the judicial system
.
Table 1. Variables used for DVF Relationship Model
Variables Proxied by Symbol Expected Sign
Dependent variable
Value of a firm Tobin’s Q Mkt Cap+ TA- ShF/TA TQ
Independent variables
Return on total assets Returns generated by all assets of firm ROTA Positive
Gearing Percentage of debt used to finance the firm Gr Negative
Size Number of directors in the board Log Size Negative
Duality Dummy variable: Can take the values
between 1 and 0
Duality Negative
Price to book value ratio Ratio between price and book value of the
assets of a firm
Pb Positive
Regulatory regime Procedures involved in the settlement of the
disputes
Log Pro Negative
Notes: Mkt Cap = Market capitalization.
TA = Total assets.
Sh F = Shareholders’ funds.
The higher value on the index shows more cost
and time consumed in a court depicting the
inefficiency of a regulatory regime. We expect a
negative relationship between the inefficient
regulatory authority and the value of a firm.
The next variable used in this study is the return
on total assets. The validity of the test related to the
relationship between return on total assets and the
value of a firm will show the role of allocation and
dynamic efficiency in affecting the firms’
performance (Chen et al., 2005).
Price to book value ratio in this study is used to
test the role of investors’ confidence in affecting the
shareholders’ value in developing and developed
financial markets. The positive value will depict that
the investors are willing to pay a higher premium for
the assets of the organization in the market creating
value for the shareholders.
4.3 Econometric testing Multiple regression analysis is used as a tool for
hypothesis testing and to analyze the relationship
between corporate governance instruments, control
variables and the value of a firm. The general
representation of the DVF relationship model is given
in the equation below.
Yt = C + 1t X1t + 2t X2t + ……….. + nt Xnt + Ut (1)
where:
Yt = dependent variable (value of a firm);
C = intercept;
t = slope of the independent variables of the model
(internal, external and control variables);
Xt = independent variables; and
Ut = error term (residual).
The ordinary least square (OLS) estimation will
be used to minimize the error terms of the DVF
relationship model. This type of estimation improves
the power of the sample regression function to explain
the major portion of the population regression
function (Cuthbertson, 1996).
4.4 Multifactor model
The multifactor DVF relationship model is used to
analyze the properties of the individual corporate
governance mechanism and testify its role in affecting
the value of a firm in developing and developed
markets.
The multifactor model for this study is shown as
follows:
Yt = C + 1t X1t + 2t X2t + 3t log X3t + 4t X4t +
5t X5t + 6 log X6t + Ut
(2)
where.
X1t = CEO duality;
X2t = Gearing ratio;
X3t = Regulatory authority efficiency index;
X4t = Price to book value ratio;
X5t = Return on total assets; and
X6t = Board size
The above-mentioned equation shows the
relationship between the value of a firm, corporate
governance instruments and control variables in the
selected markets.
5. Econometric Results
The discussion relevant for this section deals with the
regression analysis and a robustness test. The details
of these tests are presented below.
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198
5.1 Multiple regression analysis
As discussed, multiple regression analysis is
performed to testify the role of debt in affecting the
value of a firm. Models with varying functional forms
and alternative specifications are tried and the model
with the best functional form and strong diagnostics is
selected for the study. The variables in the selected
model are given an appropriate treatment by
transforming independent variables (price to book
value ratio, return on total assets and shareholders
concentration) into percentage form. Similarly, the
other independent variables such as the regulatory
authority efficiency and board size, are transformed
into non linear form by taking the natural logarithm,
removing the potential disorder of the OLS
assumptions. This treatment is similar to that of
Sridharan and Marsinko (1997) and Kyereboah-
Coleman and Biekpe (2005), in their studies related to
role of corporate governance in the financial market.
Furthermore, the OLS assumptions followed by
the estimators in the current model are endorsed by
giving the white diagonal treatment to the variables as
the variance of the error term of the model is unequal.
This unequal variance of the error term leads to the
existence of the heteroscedasticity (Gujarati, 2003).
White diagonal treatment corrected the variance of the
error term by transforming the ordinary least square
(OLS) method of estimation into the generalized least
square estimation method (GLS) (Maddala, 2001).
The results are also made robust by performing
the tests to detect multicollinearity in the model. The
results are presented in table 2 and include the tests
for variance inflation factors (VIF) for the variables
relevant for the selected financial markets. The value
(VIF) is calculated by making the independent
variables as the dependent variable and calculating the
value for the R squared. This calculated R squared is
subtracted from one and is lastly divided by one to get
the value for the variance inflation factor (Gujarati,
2003). The formula below is used to calculate the
value for variance inflation factor.
VIF = 1/1 - R2 (3)
The range of the values for the VIF for the
variables varies from 1.06 to 1.35, which shows the
absence of the multicollinearity from the model for
DVF relationship.
Table 2. Values for Variance Inflation Factor for the Selected Markets
Variables Variance Inflation Factor
Gearing 1.06
Procedures 1.35
CEO Duality 1.14
Return on Total Assets 1.19
Board Size 1.09
Price to Book Value Ratio 1.16
Table 3. Results of the Model for DVF relationship for the Selected Markets
Variables Model
Constant 0.54
(3.09)**
Log Board Size 0.20
(1.25)
CEO Duality 0.14
(2.72)**
Gearing -0.07
(-4.36)**
Price to Book Value Ratio 49.03
(13.56)**
Return on Total Assets 0.93
(1.78)*
Log Procedures -0.15
(-2.31)**
R-Squared 0.77
Mean Dependent Variable 1.42
F-Statistic (276.93)**
Notes: The values of the coefficients are in the first row.
Below are the values of T-Statistics in parenthesis.
Total number of observation for combined model= 480.
* Represents the significance of a variable at 10% significance level.
** Represents the significance of a variable at 5% significance level.
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199
5.2 Results of the model The quantitative form of the estimated model
presented in table 3 is explained below.
Yit = 0.54 + 0.14 Duality - 0.07 Gr - 0.15 Pro +
49.03 Pb + 0.93 Rota + 0.20 Size (4)
(3.09)** (2.72) ** (-4.36) ** (-2.31) ** (13.56) **
(1.78)* (1.25)
R2 = 0.77
In the equation above, the values for the
coefficients are in the first row. The values for t-
statistics are in the parenthesis below. The single
asterisk (*) and double asterisk (**) show that the
variable is significant at 10% and 5% level of
significance respectively.
The diagnostics of the model show that the value
for the R squared is 77%. This value shows that 77%
variation in the dependent variable is explained by the
independent variables of the model. The 23%
variation remains unexplained by these independent
variables. The value for the F-statistic is high (276.93)
and is significant depicting that the model is stable
and reliable. The mean value for the dependent
variable (Tobin’s Q) is 1.42, endorsing that firms in
the selected markets are healthy and create value for
shareholders.
5.3 Robustness test
The robustness test (factor analysis) in this study is
performed to confirm the validity of the alternate
hypothesis relevant for the model and is presented in
table 4 below. The result for the factor analysis shows
that price to book value ratio has the highest
correlation (loading) with the Tobin’s Q (0.87). This
result suggests that the higher investors’ confidence
leads to the improved value of a firm to a greater
magnitude. On the other hand, return on total assets
has a least correlation with the price to book value
ratio (0.33) showing that the optimal utilization of
assets does not lead to a significant change in the
willingness of the investors’ to pay a higher premium
in these markets.
Table 4. Factor Analysis: Results about Highly Correlated Variables in the Models
Variables of Cross-market Analysis Correlation Coefficient
PB and ROTA 0.33
TQ and AC 0.35
TQ and PB 0.87
MC and CF 0.49
AC and Log Pro 0.34
6. Explanation of the Results
The results of the model relevant for the study are
presented in table 3 and their detail is as follows. The
result explaining the role of debt in affecting the value
of a firm shows that there is a negative relationship
between the variable (gearing ratio) and the firms’
performance. This confirms our hypothesis (H1) for
the study. The result is consistent with the foundation
of the outsider system of corporate governance as
dispersed shareholding and lower debt reinforce the
positive effects of each other. Furthermore, the
agency cost between creditors and managers is not
handled properly in the selected financial markets.
Tunneling (under and over investment of the free cash
flow) takes place as the excessive cash flow is not
invested in the healthy projects improving the agency
cost in the firms of these markets. The detrimental
activities of agents limit the constructive role of the
majority shareholders to improve the marginal
benefits of higher debt in the developing market. The
government of the developing market does not make
tough regulations to reduce the agency cost of debt
and protect the rights of shareholders.
The result is consistent with the findings of
Zingales (1995) and Chang and Mansor (2005) as the
majority shareholders do not perform a healthy role of
monitoring the debt. Furthermore, the financial
advantages of debt in the selected markets are lower
compared to the potential disadvantages associated
with it. These benefits include the tax shield which
minimizes the amount of tax paid to the government
at both corporate and individual levels. Similarly, the
disadvantages associated with debt include the agency
cost between creditors and managers and the cost of
financial distress. The result supports the agency
theory and the second trade off theory in these
markets. On the contrary, the result contradicts the
Modigliani and Miller hypothesis (1958, 1963) as
debt and equity structure has relevance in the selected
markets (Copeland et al., 2005).
There is a positive relationship between the CEO
duality and the value of a firm with the value of
coefficient as 0.14. The result shows that dual
leadership structure creates value for shareholders in
developing and developed markets (Haniffa and
Cooke, 2000). The implication of the result suggests
that debt in the firm disciplines the CEO and makes
him a steward working for shareholders. Finally, the
representatives of creditors on the board converge the
interests of the CEO and shareholders, which also
improves the value of a firm in these markets. The
result is consistent with the findings of Brickley et al.
(1997).
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200
The role of external corporate governance
instrument in affecting the value of a firm is endorsed
at a 5% significance level with a value of coefficient
of -0.15. The value for coefficient shows that a 1%
increase in the regulatory authority inefficiency
decreases the value of a firm by 0.15 units.
Alternatively, regulatory authority efficiency
improves the firms’ performance by restraining the
majority shareholders and managers from tunneling in
the selected financial markets. The agency cost is
reduced by protecting the rights of shareholders in
these markets as suggested by Nenova (2003).
There is a positive relationship between the price
to book value ratio and the value of a firm. The value
for the coefficient is 49.03. This shows that higher
investors’ confidence leads to an intense level of
investment in the selected financial markets. The
highest coefficient of the variable among all the
independent variables reflects its relative importance
in the DVF relationship model.
Finally, a positive relationship between the
return on total assets and the value of a firm is
confirmed at a 10% significance level with the value
of coefficient being 0.93. The result shows that the
optimal utilization of assets leads to the improvement
in the value of a firm as found by Chen et al. (2005)
in their studies about corporate governance in the
financial market.
7. Conclusion
The current paper has investigated the role of debt in
affecting the firms’ performance in the developing
and developed financial markets. The result shows
that debt cannot be used as an effective tool to control
the free cash flow and reduce the agency cost between
creditors and managers in these markets. In addition,
majority shareholders do not govern the agency cost
of debt properly. Similarly, the laws concerning the
governance of debt do not address the incomplete
contracting improving the level of divergence of
interests among the different players of corporate
governance.
The firms of the selected financial markets
should consider alternate options to raise the funds
compared to debt financing. Due to additional
imperfections in the developing financial market, the
conflicts between creditors and managers are not
governed properly. The results related to the role of
control variables suggest that an efficient regulatory
authority, dual leadership structure, investors’
confidence and an effective utilization of assets
improve the value of a firm in these markets. In
future, these factors should be considered by
governments of these countries in making corporate
governance policies. The limitations of the study
suggest that the role of debt in disciplining the
principal and agent conflicts in the insider system of
corporate governance and under recession or boom in
the economy can give us a different nature of the
DVF relationship, with a new policy implication.
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LINK BETWEEN MARKET RETURN, GOVERNANCE AND EARNINGS MANAGEMENT: AN EMERGING MARKET
PERSPECTIVE
Omar Al Farooque*, Eko Suyono**, Uke Rosita***
Abstract
This paper investigates the impact of earnings management on market return (by the proxies of discretionary accruals and earnings response coefficient/CAR regarded as accounting and market based earnings quality, respectively) along with a number of moderating (both governance and financial) variables in an emerging market context. Indonesia. Building on extant literature and using panel data approach, it examines 52 manufacturing firms listed on the Indonesia stock exchange during 2007 to 2010 periods. Applying Modified Jones Model to measure earnings management, our regression analysis reveals that earnings management has significant negative influence of market return. Of the moderating variables, board size, leverage and firm size are showing significant effects on market return, but not the institutional ownership. Again, observing the use of moderator effects on earnings management, our findings confirm that board size has more predictive power than institutional ownership in deterring earnings management and weaken the association between earnings management and market return. Similarly, leverage has strengthened the relation between earnings management and market return showing more exposure to earnings management while firm size showing a tendency to weakening earnings management, on the contrary. These results have enormous implications for Indonesian corporate sector and policy makers in adopting appropriate governance measures to constrain earnings management and improve quality of earnings. Keywords: Earnings Management, Earnings Quality, Corporate Governance, Indonesia. GEL Classification: G32, G34, M41, M48 * UNE Business School, University of New England, Australia Tel.: +61(0)2 67723920 Email: [email protected] **Faculty of Economics and Business, Jenderal Soedirman University, Indonesia Email: [email protected] *** Faculty of Economics and Business, Jenderal Soedirman University, Indonesia Email: [email protected]
1. Introduction
High quality earning whether market or accounting
oriented is important in modern corporate
environment in which equity ownership is separated
from control of corporate decisions. Agency theory
explains the conflict of interests which are the effect
of separation between ownership and control (Jensen
and Meckling, 1976 and Fama and Jensen, 1983b).
Moreover, the separation between ownership and
control also results in an asymmetric information
problem between executives and shareholders. An
information asymmetry usually appears when
information is not equally available to all participants.
In effect, managers have more information than
owners to pursue their own interests at the cost of
owners, and sometimes they prefer to distort
information in their interests. Gitman and Madura
(2001) contend that some executives may try to
access some information about the firm which makes
them getting more benefits than shareholders. As
agents, the executives prepare financial statements to
discharge their stewardship and principals reward the
agents using the information provided. Earning is one
of the important information in the financial
statement. Earning should represent actual condition
of the firm to increase or decrease economics value
for the investors. Moreover, earning is used as a tool
to predict the management performance in using
company resources and the future company prospect
as well. Therefore, the occurrence of earning
manipulation in the financial statement may arise to
protect the interest of the executives at the cost of the
firm. If earning as a part of financial statement does
not represent the real economics condition of the
company, earning quality whether accounting and
market based becomes weak to support investors’
decision making process. This is, however, considered
as a failure of financial reporting system to protect the
interest of investors and other stakeholders.
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204
Although stewardship theory suggests that
executives’ behaviour does not depart from the
interests of the principals even when the interests of
the executives do not coincide with the interests of the
owners (Davis et al., 1997), it is evident that the use
of financial information, such as earnings, in many
contractual agreements might provide the executives’
an incentive for earnings management which
ultimately leads to lower quality of earnings,
irrespective of market or accounting oriented.
Because, the usage of accrual based accounting
contributes to the propensity of earning management
as it does not require the physical evidence of cash in
recording the transactions (Sulistyanto, 2008). The
assumption that earnings management is an
opportunistic behaviour of managers as indicated in
Healy and Wahlen (1999) that when managers use
judgement in financial reporting and in structuring
transactions to alter financial reports to either mislead
some stakeholders about the underlying economic
performance of the company or to influence
contractual outcomes that depend on reported
accounting numbers, it can be argued in line with
agency theory that earnings management is an agency
cost detrimental to shareholders as well as other
stakeholders. To mitigate this problem and ensure that
alignment of interests exists between executives and
shareholders, significant monitoring mechanisms such
as corporate governance are installed within the firm
(Shleifer and Vishny, 1986). Because, corporate
governance is a set of mechanisms to monitor and
ratify managerial decisions and ensure the efficient
operation of a corporation on behalf of its
stakeholders (Donelly and Mulcahy, 2008). It is the
subset of a firm’s contracts that help align the actions
and choices of managers with the interest of
shareholders (Armstrong et al., 2011). Boediono
(2005) document that earning quality is influenced by
the occurrence of earning management and corporate
governance mechanisms, particularly managerial
ownership, institutional ownership and board size
mechanisms. Good corporate governance system is
very useful to protect the stakeholder interest in the
company which consists of institutional ownership
and board of director.
Given the above mentioned context, this study is
motivated to investigates the impact of earnings
management on market return along with a number of
moderating (both governance and financial) variables
in an emerging market context. Indonesia. In this
case, we use discretionary accruals and earnings
response coefficient/CAR as the proxies for,
respectively, earnings management and market return
(for market-oriented earnings quality). Our specific
research questions are whether earnings management
affect significantly market return (earning quality);
whether corporate governance mechanisms and firm
financials have significant impact on market return
(earning quality) and finally whether corporate
governance mechanisms and firm financials can
effectively mediate or not the effect of earning
management on market return (earning quality) by
constraining earnings management behaviour.
The remainder of this paper is divided into five
sections. Section 2 considers literature review,
conceptual framework and hypotheses development,
section 3 describes research method for data sources
and sample selection, variable measurement and
operation, and data analysis and model development.
Results and discussion are addressed in section 4 and
section 5 denotes conclusion and implication of the
study.
2. Literature Review and Hypotheses Development
The relationship between market return (i.e. earnings
quality), governance and earnings management can be
explained by agency theory. The agency relationship
contributes to the problems of conflict of interest for
the separation of ownership and control and
information asymmetry. Conflict of interest occurs
when an agent acts to fulfill their own personal
interest when making economic decisions while
ignoring the implications for shareholders. It is based
on the idea that managers who are not owners will not
watch over the affairs of a firm as diligently as the
owners (Chrisman, Chua, and Litz, 2004). Moreover,
the agents have the advantage of having more or
better information than the principal does (Ross,
1973). Information asymmetry represents the gap
between the amounts of information held by
management and that held by market participants
(Fields et al., 2001). Therefore, the degree of
information asymmetry will be higher if the quality of
information is low and stakeholders will be poorly
informed about the business. So, managers tend to
become involved in opportunistic behaviour (i.e.
earnings management and flawed disclosure) that
potentially increases a firm’s agency cost. In other
words, the asymmetric information between the agent
and principals give an opportunity to the managers
maximizing their interest by conducting earning
management. Eisenhardt (1989) stated that the agency
theory uses three human characteristic assumptions,
that is : (1) human has a self interest, (2) human has a
limited thought about the future perception (bounded
rationality), and (3) human generally tries to averse
the risk (risk averse). Healy and Palepu (2001) outline
several solutions to the agency problem, such as
appropriate contractual incentives, effective
monitoring function of the board of directors and
capital market players etc. to reduce conflict of
interests by controlling managerial behaviour. This
implies that both internal and external governance
processes are important in solving agency problems.
The extant literature emphasizes that the quality
of earnings is very important to users of financial
information because reported earnings are considered
to be the premier information in financial statements.
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Salvato and Moores (2010) confer that high quality
accounting information on attributes such as earnings
is essential for firms to access equity and debt
markets. The informative function of earnings means
that it is often used as a basis to describe the financial
performance of a firm. Earnings quality can be
observed where earnings are regarded as having high
in quality, i.e. the more accurate and timely that
reported earnings reflect expected future dividends,
the higher the quality of earnings. Dechow and
Schrand (2004) contend earnings to be high in quality
when they accurately reflect the company’s current
operating performance, are good indicators of future
operating performance and are a good summary
measure for assessing firm value. This is consistent
with the objectives of financial analysts and investors
to evaluate the performance of the company, to assess
the extent to which current earnings indicates future
performance and determine whether current stock
price reflects intrinsic firm value (Dechow and
Schrand, 2004). Again, financial information users
consider earnings quality as the absence of earnings
management, because intentional manipulation of
earnings by managers may distort the usefulness of
earnings to users. Managers may manage earnings for
a number of reasons relating to capital market
motivations, compensation and bonus as well as debt
contracts, which might result in low quality of
earnings. This implies earnings that are persistent and
predictable may not be of high quality if it is a result
of earnings management. That is, the lower the
earnings management, the higher the earnings quality
and vice versa. According to Schipper and Vincent
(2003), the importance of earning quality can be
explained from two perspectives, first, the contracting
perspective and second, investment perspective. From
the former perspective, low quality of earnings may
result in unintentional wealth transfers, i.e.
overcompensation to the managers if earnings are
overstated. From the latter perspective, poor quality of
earnings is problematic as it can mislead investors,
resulting in misallocation of resources (Myers et al.,
2003; Schipper and Vincent, 2003). Therefore, it is
very important for the reported earnings to be of high
quality. Because, prior literature documents that high
earnings quality would ultimately increase market
liquidity (Young and Guenther, 2003), attractiveness
of stocks to outside investors, lower cost of debt
(Salvato and Moores, 2010) and cost of capital (Leuz
and Verrecchia, 2000; Salvato and Moores, 2010).
2.1 Earning Management and Earning Quality
Within the framework of agency theory, earnings
management has been viewed as a form of agency
cost as it causes information asymmetry and reduces
principals’ understanding of a firm’s performance
which subsequently influences their investment
decisions (Davidson et al., 2004). It views earnings
management activity as a result of the misalignment
of interest between agent and principal that ultimately
leads to the agency cost (Davidson et al., 2004). Most
prior studies acknowledge that earnings management
is opportunistic rather than beneficial (e.g. Siregar and
Utama, 2008; Burgstahler and Dichev, 1997; Balsam
et al., 2002; Yu, 2008). To date, numerous examples
in the literature support the notion that earnings
management is opportunistic (e.g. Jones, 1991; Teoh
et al., 1998; Healy and Wahlen, 1999). Managers are
motivated to manipulate earnings for a number of
reasons as identified in prior literature, such as to
hype the stock price especially before initial public
offerings (Friedlan, 1994) and prior to seasoned
equity offerings (Jo and Kim, 2007; DuCharme et al.,
2004; Teoh et al., 1998; Rangan, 1998), to avoid
reporting losses (Bustaghlar and Dichev, 1997;
Degeorge et al., 1999; Charoenwong and Jiraporn,
2009), to smooth earnings volatility (Cormier et al.,
2000) and to influence contractual outcomes from
import relief (Jones, 1991). In contrast, a smaller body
of literature claims that earnings management is
beneficial because it is not harmful to a firm’s value
(e.g. Jiraporn et al., 2008). Prior literature argues that
inflated earnings potentially reduce the earnings
informativeness, impairing the earnings and stock
price correlation. Earnings management leads to
earnings mispricing by the market players and,
consequently, distorts the capital market’s
information and system. Given that the earnings are
correlated to the share price (Su, 2003; Easton and
Harris, 1991; Chan and Seow, 1996; Alford et al.,
1993; Easton and Zmijewski, 1989), inflating
earnings will result in an incremental increase in the
share price (Healy and Wahlen, 1999). Consequently,
investor’s decision making is influenced by inaccurate
earnings; stock price may be overvalued. Therefore,
most literature assumes that earnings management is
detrimental to firm value as well as earnings quality.
Some studies find that firms which alter discretionary
accruals before security offerings eventually suffer a
lower and abnormal stock return (e.g. Teoh et al.,
1998; Rangan, 1998).
Earning quality could be defined as the ability of
earning information in giving response to the market.
In other words, the reported earning has a response
power. The power of market reaction to the earning
information is reflected on the degree of earnings
response coefficients (ERC). High ERC means the
reported earning has high quality. In the context of
agency theory, managers choose certain accounting
methods to get the earning that is suitable to their
motivation. Of course, this condition affects the
quality of reported earning, because earning may not
necessarily reflect the real economic performance.
Thus, the first hypothesis is formulated as follow :
H1: Earnings management significantly affects
earning quality.
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2.2 Corporate Governance and Earning Quality
The importance of corporate governance to ensuring
effective monitoring has been widely discussed in the
prior literature. Corporate governance is the system
through which the behavior of a company is
monitored and controlled (Cheung and Chan, 2004).
Corporate governance structures aim to mitigate the
agency problem. Baek et al. (2009) point out that
sound governance processes are one of the
mechanisms that are potentially relevant to reducing
agency cost. John and Senbet (1998) state that
corporate governance encompasses a set of
mechanisms by which shareholders’ exercise control
over corporate insiders and management to protect
their interests. Corporate governance acts as a set of
controls that govern the behavior of managers, define
their discretionary powers, and serve to offset
potential losses due to the conflict of interest between
shareholders and managers (Bozec and Bozec, 2007).
According to Ho and Wong (2001), the adoption
of good governance mechanisms provides an
“intensive monitoring package” for a firm to reduce
opportunistic behaviors and information asymmetry
(Leftwich, Watts, and Zimmerman, 1981; Welker,
1995). Having good corporate governance promotes
transparency and accountability in the firm’s
information; which subsequently has a positive
impact on the level of earnings quality (Johnson et al.,
2002). Strong corporate governance is expected to be
able to protect stakeholders interests, curb agency
conflicts and limit agency costs (Haniffa and Hudaib,
2006). Bathala and Rao (1995) state that corporate
governance could act to reduce a manager’s self-
interest in the principal-agent relationship. Low self
interest will increase the likelihood of a manager
giving high quality disclosures to shareholders in
order to reduce information asymmetry
(Kanagaretnam et al. 2007).
There are numerous studies on earnings quality
and corporate governance in the academic journals.
Such studies become sufficiently robust corporate
governance to ensure high quality of corporate
financial reports. Prior studies document that low
quality of earnings is systematically related to
weaknesses in the oversight of management. A firm’s
governance attributes are supposed to be effective in
enhancing the quality of earnings as a monitoring
mechanism. To overcome the problem of earnings
management, some studies (e.g., Xie et al. 2003; Kent
et al. 2010) view internal corporate governance as a
credible tool for deterring earnings management.
Dechow, Sloan and Sweeney (1996) highlight that the
establishment of governance processes is essential to
maintain the credibility of firms’ financial statements
and safeguard against earnings manipulation. This
study assumes that as part of firm’s governance
practices, both internal and external monitoring
effects, respectively, by institutional ownership and
board of directors are effective in reducing earnings
management and improving earnings quality.
2.2.1 Institutional Ownership and Earning Quality
Institutional ownership has the ability to control
management through an effective monitoring process,
therefore it can constrain earning management by
supporting management to report the real financial
condition. Institutional monitoring process supports
the company to report good quality of income. The
percentage of stock ownership by institutions affects
the financial reporting process which enable the
management team making acrualistion in accordance
with their interest (Boediono, 2005).
Osma and Noguer’s (2007) find that institutional
investors are more influential in reducing earnings
management. Hashim (2004) find evidence that
institutional ownership affect eraning quality
positively. It implies that more concentrated
ownership in the hands of institutional investors has
more incentive to monitor company activities. The
involvement of institutional investor not only improve
good corporate governance practices, but also
contribute to the better quality of reporting
mechanism. Thus, the second hypothesis could be
formulated as follow:
H2a: Institutional ownership significantly affects
earning quality.
2.2.2 Board of Director Size and Earning Quality
The managers’ conflicts of interest are mitigated
through governance attributes, which have the
potential to control and monitor by the board. Boards
of directors play important roles in monitoring.
“Broadly speaking, the monitoring function requires
directors to scrutinize management to guard against
harmful behaviour, ranging from shirking to fraud”
(Linck et al., 2008, p. 311). According to García Lara
et al. (2007) strong corporate governance promotes
efficient monitoring by the board of directors, those
results in higher financial statement transparency and
lower accounting manipulation. The board of
directors receives authority over the internal control
of the firm from shareholders. They are responsible
for monitoring management to ensure that it acts in
the shareholders’ best interests. Although the board
delegates most decision and control functions to top
management, the board retains ultimate control
(Beasley, 1996). Thus, the board of directors plays an
important role in monitoring the quality of earnings
reported to the public.
Linck et al. (2008, p. 311) point out that “[a]
firm’s optimal board structure is a function of the
costs and benefits of monitoring and advising given
the firm’s characteristics, including its other
governance mechanisms”. The size of boards is
important in determining the effectiveness of board
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monitoring function. The board of directors should
carefully determine the optimum number of board
members to ensure that there are enough members to
discharge responsibilities and perform related duties.
The studies show that firms that report high quality
earnings are more likely to have smaller board
(Eisenberg, Sundgren, and Wells, 1998; Mak and
Kusnadi, 2005; Vafeas, 2000; Yermack, 1996).
Although some studies argue that larger boards are
better as they have greater capability to safeguard
shareholder interest (Zahra and Pearce II, 1989), a
broader range of experience (Xie et al., 2003), and
varied expertise (Rahman and Ali, 2006), there are
also empirical studies that show that smaller boards
are more effective than large boards ensuring higher
firm value (Eisenberg et al., 1998), more informative
(Vafeas, 2000), better communication and more
timely decision-making (Karamanou and Vafeas,
2005), more coordinating directors efforts (Eisenberg
et al., 1998; Jensen, 1993; Yermack, 1996).
The board of director is appointed by
stockholders as their representative to manage the
company. Board composition and size have relation
with earning management practice. It is because of the
earning management practice has relation with
financial statement that present useful earning for the
investors on investment decision making. Therefore,
in order to get the best decision, earning should be
qualified. Kao and Chen (2004) report that large
board size is associated with higher earnings
management, and small board size is associated with
lower earnings management. Ismail et al. (2008) find
evidence that board of director size positively affect
earning quality. It is because the board of director has
an important role to monitor the earning reporting
mechanism. Based on this finding, the third
hypothesis is formulated as follow :
H2b: Board of director size significantly affects
earning quality.
2.3 Firm-specific Attributes and Earning Quality
2.3.1 Financial Leverage and Earning Quality
Leverage is a ratio that is derived from total liabilities
devided by total assets. This ratio shows the amount
of company assets that is funded by liabilities. The
higher leverage, the higher is the risk for investors.
So, investors demand more return from highly levered
firms. Therefore, it can be concluded that higher ratio
of leverage tends to push to more practices in earning
management (Herawati, 2008). Moradi (2010)
document that the volatility of earning response
coefficient (ERC) as a proxy of earning quality,
depends on the volatiliy of financial leverage.
Financial leverage is assumed as a relevant
information on unpredicted market reaction to the
company earning. Thus, the fourth hypothesis could
be formulated as follow :
H2c: Financial leverage significantly affects earning
quality.
2.3.2 Company Size with Earning Quality
Company size is a basis that shows the company’s
ability in managing the business. The higher company
size is, the more capable the company is in managing
business activities. In relation to agency theory,
managers have more information than the owners.
Therefore, managers try to show good performance to
the owners to maintain their position. This condition
encourages managers to do more earning
management. Thus, high company size tends to push
to more earning management, in which will gear the
low earning quality.
Pagulung (2006) found that leverage has
significant relationship with 5 atributes of earning
quality. Then, sales and company size has significant
relationship with 5 atributes of earning quality. Other
variables, such as : operating cycle, performance, and
industries clasification show the atributes of earning
quality that has relationship with acrual quality,
iquidity, and factorial earning quality. Thus, the fifth
hypothesis could be formuleted as follow :
H2d: Company size significantly affects earning
quality.
2.4 Good Corporate Governance can Weaken the Effect of Earning Management on Earning Quality
Previous research supports the proposition that
corporate governance is beneficial in reducing
managers’ propensity to manipulate earnings. Bedard
et al. (2004) study reports that board size and
ownership by non-executive directors reduce
downward earnings management. Zhang et al. (2007)
report a positive association between blockholder
ownership and earnings management. Heflin and
Shaw (2000), however, document that both internal
and external blockholders are effective in reducing
information asymmetry and market liquidity in a firm,
thus suggesting that blockholders, regardless of type,
have the effect of improving disclosure quality.
It is widely believed that a small board is more
effective in monitoring a firm’s activity (Coles et al.,
2008). Board size is an important determinant of
earnings management in Taiwan (Kao and Chen,
2004), it has no significant effect in Malaysian firms
(Rahman and Ali, 2006). A higher number of board
members will stimulate a higher number of
independent directors on the board, with vast range of
experience and knowledge (e.g. Linck et al., 2008;
Xie et al., 2003; Dalton et al., 1999) and, thereby,
increase the board’s capability in constraining
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earnings management. On the contrary, Zhao and
Chen (2008) document that lower fraud and accruals
are associated with a staggered board (which is a
proxy for weak governance), thus suggesting that
strong board governance is not always effective in
constraining managers’ propensity to manipulate
earnings.
The qualified earning is an earning from
reporting mechanism that earning management does
not occur. Good corporate governance can minimize
the earning management practice in the company.
Chtourou and Bedard (2001) report that the
characteristic of board of director has an important
effect to the quality of financial statement. Basically,
experienced and independent board of director can
reduce the earning management practice. Beside that,
the institutional investor has a right to control the
company managers. This condition is expected to
improve the quality of reporting process on earning,
which in turn reduce the extent of earning
management (Moradi and Nezami, 2011). Thus, the
hypotheses could be formulated as:
H3a: Institutional ownership can weaken the effect
of earnings management on earning quality.
H3b: Board of director size can weaken the effect
of earning management on earning quality.
2.5 Firm-specific Attributes can Strengthen the Effect of Earning Management on Earning Quality performance
A financial statement is a tool for analyzing company
performance and result of operation. This information
is very useful to the user’s in decision making
process. From different types of information in the
financial statement, earning information is very
important for users (Beattie et al. 1994). Financial
statement analysis could be done by evaluating the
financial ratios to the earning quality. Pedwell et al.
(1994) argue that large company has more predictable
permanent earning process and has more resources to
make good estimation on high earning quality. Many
previous studies document evidence that there are
significant relationship between earning management,
estimation of earning quality and company size in
Australia (Anis, 2010). Astuti (2002) find that
financial leverage positively affect earning
management. According to Astuti (2002) managers
conduct earning management aiming to avoid breach
of debt covenant, which intern impacts on earning
quality. Therefore, high leverage tend to motivate
managers to engage in earning management which
ultimately affect earning quality. Thus, the
hypotheses could be formulated as:
H4a: Financial leverage can strengthen the effect of
earning management on earning quality.
H4b: Size of the company can strengthen the effect of
earning management on earning quality.
2.6 Conceptual Framework
The conceptual framework of this research is
displayed in the following 3 figures. The main
variables of interest are the relationship between
market return as the proxy for earning quality and
earning management. In this process, considering the
importance of corporate governance and firm-specific
attributes, moderating effects of them are taken into
account separately. Figure-1 shows the total structure
of the regression model while Figure-2 and Figure-3
indicate mediating effect of specific variables for
corporate governance and firm-specific attributes,
respectively. In regards to corporate governance,
institutional ownership and board of director size are
adopted in the model to observe their effects on
earning quality through earnings management
(Figure-2). Again, financial leverage and firm size are
considered as important firm-specific attributes to
detect their effects on earning quality through
earnings management (Figure-3).
Figure 1. Relationship between market return (i.e. earning quality), corporate governance, earning management
and firm-specific attributes
Earning management
Good corporate governance:
- Institutional ownership
- Board of director size
Firm-specific attributes:
- Financial leverage
- Company size
Market return
(Earning quality)
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Figure 2. Moderating good corporate governance in the effect of earning management on
earning quality
Figure 3. Moderating firm-specific attributes in the effect of earning management on earning quality.
3. Research Method 3.1 Sampling Method and Data Sources
The sampling method is purposive sampling with the
criteria as follow: (1) manufacturing firms listed on
the Indonesian Stock Exchange during the period of
2007-2010; (2) issue of audited annual report with 31
December year-end and (3) reported earning during
that period. In regards to data sources, this research
has used secondary data that could be accessed from
Indonesian capital market linked websites, such as:
www.idx.co.id., www.yahoofinance.com and
www.duniainvestasi.com.
3.2 Variables Operation and Measurement a. Dependent Variable (Y):
The dependent variable of this research is earning
quality. Scott (2003) explained that Earnings
Response Coefficient (ERC) could be proxy for
earning quality, which is a measurement of market
return based on available market data. ERC is a
coefficient gathered from the regression between the
proxy of stock price and accounting earning after
controlling annual return.
ERC is calculated with the formula as follow :
∑
where:
: Commulative abnormal return of the company
i in 5 days after publication of accounting earning;
: Individual abnormal return of the company on
period t-day
where:
: Individual return of the company on period t-
day
: Individual actual return of the company on period
t-day
: Market return on period t-day
where:
: Individual actual return of the company on period
t-day
: Stock closing price of the company on period t-
day
: Stock closing price of the company on period t-
1 day
where:
: Market return on the day of t
: Composite stock price index on the day of t
: Composite stock price index on the day of
t-1
| |
where:
: Unexpected EAT of the company i at the eriod
of t
: EAT (Earning after tax) of the company i at
the eriod of t
Good Corporate Governance:
Institutional Ownership
Board of Director Size
Earning Quality Earning Management
Firm-specific Attributes:
Financial Leverage
Company Size
Earning Management
Earning Quality
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: EAT (Earning after tax) of the company i at
the eriod of t-1
where:
: Annual return of the company i at the period of
year t
: Stock closing price of the company i at the period
of year t
: Stock closing price of the company i at the
period of year t-1
where:
: Cummultive abnormal return of the company i
during 5 days before and after the publication of
financial statement
: Unexpected earnings on the company i on the
period of t
: Annual return of the company i on the period of
t
: The value of earning response coefficient (ERC)
b. Independent Variables (X):
1) Earning Management (X1)
Discretionary accruals as a proxy of earning
management was calculated by Modified Jones Model
(Dechow et al., 1995) with the formula as follow:
TAC = NIit – CFOit (1)
Total accrual (TA) that is estimated with Ordinary
Least Square as follow:
(
) (
) (
) (2)
With the regression coefficient as above,
nondiscretionary accruals (NDA) is as
follow:
(
) (
)
(
)
(3)
Then discretionary accruals (DA) could be calculated
as follow:
(4)
where:
Dait: Discretionary accruals of the company i at the
period of t
NDAit: Nondiscretionary accruals of the company i at
the period of t
TAit: Total acrual of the company i at the period of t
NIit: Net earning of the company i at the period of t
CFOit: Cash flow from operating activities of the
company i at the period of t
Ait-1: Total assets of the company i at the period of t-1
Revit: Income alteration of the company i at the
period of t
PPEit: Fixed assets of the company i at the period of t
Recit: Alteration of receivables company i at the
period of t
ε: Error term
c. Moderating Variables:
Moderating variable is a variable that strengthen or
weaken the relationship between one variable to
another variable. The moderating variables on this
research are:
a) )
a) Institutional ownership is a percentage of voting
right owned by the institutions. According to
Suyono (2011), institutional ownership is
measured by:
% Institutional Ownership
=
x 100%
b) Board of Director Size (X3)
Board of diretor size is measured by the number
of board of director members on the company
(Boediono, 2005).
c) Financial Leverage (X4)
Financial leverage is measured by Debt Ratio,
with the formula as follow:
Debt Ratio =
d) Company Size (X5)
Company size is an indication of the company
capabilities to manage the stockholders
investment by improving their welfare. The
logaritm of total assets can be used as a proxy
for company size (Pagulung, 2006).
Company Size = Ln_Total asstes
3.3 Data Analysis The data analysis is consisted of descriptive statistic
(i.e. mean, maximum, minimum, and deviation
standard of the variables), classical assumption test
for multiple regression (i.e. normality,
multicollinearity, heteroskedasticity and
autocorelation) and regression for moderation
absolute difference. The test of hypotheses 1 and 2 is
done with multiple linear regression, meanwhile
hypotheses 3 and 4 with regression for moderation
absolute difference.
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211
Regression equation model for hypotheses 1 and
2 is as follows:
where:
Y = Earning quality
α = Constant
EM = Earnings management
IO = Institutional ownership
BDS = Board of director size
FL = Financial leverage
CS = Company size
Regression equation model for hypothesis 3 is as
follows:
| | | |
Regression equation model for hypothesis 4 is as
follows:
| | | |
where:
Y1 = Earning quality
Y2 = Earning quality
α = Constant
EM = Earnings management
IO = Institutional ownership
BDS = Board of director size
FL = Financial leverage
CS = Company size
ZEM = Variable of earnings management from the
result of standard value
ZIO = Variable of institutional ownership from the
result of standard value
ZBDS = Variable board of director size from the
result of standard value
ZFL = Variable of financial leverage from the result
of standard value
ZCS = Variable company size from the result of
standard value | | = The different of absolute value
between institutional ownership and earnings
management (measured by absolute value from the
deviation between EM and IO)
| | = The different of absolute value
between board of director size and earnings
management (measured by absolute value from the
deviation between EM and BDS)
| | = The different of absolute value
between financial leverage and earnings management
(measured by absolute value from the deviation
between EM and FL)
| | = The different of absolute value
between company size and earnings management
(measured by absolute value from the deviation
between EM and CS)
4. Results and Discussion
4.1 Sampling Procedure and Statistical Descriptive
The purposive sampling of this research are based on
the following criterias: (1) the number of
manufacturing companies listed on Indonesian Stock
Exchange (IDX) in 2007-2010 periods were 145
companies, (2) 17 companies were delisted during
these periods, (3) 23 companies did not issue the
annual report for the year-end 31 December, (4) 45
companies did not report earning, and (5) 8
companies did not have sufficient data for this
research. Therefore, final sample size of the study
reduced to 52 companies or 208 firm years for 4-year
periods.
The result of descriptive analysis that includes
minimum value, maximum value, mean, standard
deviation of the variables of earning quality (ERC),
earnings management, institutional ownership, board
of director size, financial leverage, and company size
arepresented in Table 1 as follows:
Table 1. Descriptive Statistics
N Mean
Std.
Deviation Minimum Maximum
EM 208 0.1241 0.14003 -0.66 0.80
IO 208 0.7076 0.19775 0.03 0.98
BDS 208 4.7019 2.00425 2.00 10.00
FL 208 0.3981 0.19417 0.05 0.97
CS 208 27.6074 1.35027 24.85 31.49
EQ (ERC) 208 0.0701 0.10383 -0.17 0.77
Valid N
(listwise) 208
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212
Table-1 shows average earnings management in
Indonesian companies is around 12% which is much
higher than the developed economies, but similar to
other emerging countries in Asian region. Mean value
of market return (ERC) as proxy for earnings quality
is 7% which is quite low as compared to developed
economies. This implies that stock market in
Indonesia is not adequately developed yet to ensure
symmetric information flow in the market. As a
result, there remains incentive for company managers
to use information for their own interest as reflected
in high levels of earnings management, an indicator of
agency costs. In regards to governance variables,
average institutional ownership is 71% which indicate
high concentration of ownership and average board of
director size is 5 which a minimum of 2 and
maximum of 10 members. The mean value of
financial leverage is 40% indicating that firms are not
highly levered. Similarly, mean company size is 28%
(log of total assets) which suggest that Indonesian
companies are not large scale companies in size with
the exception of a few companies.
4.2 Classical Assumption Test for Multiple Regression
As mentioned earlier, these tests are consisted of
normality, heteroskedasticity, multicollinearity and
autocorrelation (These results are not shown here for
brevity, but will available from the authors when
requested. See Appendix 1). Normality test with the
value of asymp. sig. (2-tailed) for unstandardized
variable is 0.205, which is higher than (0.05),
therefore, all data in this research have normal
distribution. Heteroscedasticity test shows that the
significant value for all variables are higher that α
(0.05). This means that there are no heteroscedasticity
in this test. Multicollinearity test also shows that the
results of VIF for all variables are smaller than 10
meaning that there are no multicollinearity between
independent variables in this model. Finally,
autocorrelation test shows the value of Durbin-
Watson is 2.172, dU = 1.77, dL = 1.53. It implies that
the value of DW is between dU and 4 - dU, i.e., there is
no autocorrelation in this model.
4.3 Findings on Hypotheses Testing and Discussion
The regression results from the Table 2 above shows
that earning management affects negative
significantly market return (ERC) as the proxy for
earning quality, which implies that the higher is
earnings management, the lower is the earnings
quality or market return and vice-versa.
Table 2. Summary of Multiple Linear Regression Test
No. Variable Regress.
Coeff t statistic t tabel Sig.
1 Earning Management (X1) -0.156 -2.291 < -1.984 0.023
2 Institutional Ownership (X2) -0.065 -0.955 > -1.984 0.341
3 Board of Director Size (X3) 0.296 3.472 > 1.984 0.001
4 Financial Leverage (X4) 0.221 3.115 > 1.984 0.002
5 Company Size (X5) -0.170 -2.061 < -1.984 0.041
Constant = -0.00000000004
Adjusted R Square = 0.078
Fhitung = 4.503
Therefore, as per expectation the first hypothesis
is accepted, meaning that the earning is the principal
factor that an investor mainly consider in decision
making process. The amount of reported earning
could be an indication for earning management that
may reduce the earning quality and harm the
investors’ interest. In this case, investors should take
care to the earning management practices by not
relying straight on to the reported earnings. This
finding of the study is in-line with Boediono (2005)
that earning management negative significantly
affects earning quality.
The result of second hypotheses test (a) shows
that the institutional ownership does not significantly
affect earning quality. It means this hypothesis is
rejected. This result implies that the existence of
institutional ownership can not guarantee earning
quality that is reported by the company. It is because
the existence of institutions is in place formally, but
they give up the monitoring process to the board of
director. This finding is in accordance with the study
of Rachmawati and Triatmoko (2007).
The finding of second hypothesis test (b) showed
that board of director size has positive significant
effect on earning quality as per expectation. It means
this hypothesis is accepted. This signifies that
investors’ believe that the existence of board of
director can effectively monitor the management
activities, thus constrain the extent of earning
management practices and improve earning quality.
This finding is consistent with Ismail et al (2008) that
board of directors has an important role in monitoring
the reported earning quality.
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213
The result of second hypothesis test (c) confirms
that the financial leverage can positively influence
earning quality. It means this hypothesis is accepted.
Investors believe that debts are used to support the
operating activities in the best way, so the reported
earning provides relevant information in investment
decision making process. This finding is in-line with
Moradi et al, (2010), Jang and Sugiarto (2007) as well
as the trade-off theory in the capital structure stating
that leverage as a proxy of capital structure has
positive impact on earning quality.
The result of second hypothesis test (d) shows
that the company size has negative impact on earning
quality. It means this hypothesis is accepted. This
indicates that the bigger the company size, the less
possibility of getting more qualified information
relating to it’s activities including reported earnings.
In case of profit announcement when investors
consider that earning has low predictive power and/or
less useful to predict future earning, that may
implicate to low earning response coefficient (ERC).
This finding in-line with Collins and Kothari (1989)
that company size has negative relationship with
ERC.
The third hypotheses testing used regression for
moderating variables, and the result is as follow:
Table 3. Summary of Regression for Moderating Variables on the Impact of Good Corporate Governance to the
Relationship between Earning Management and Earning Quality
No. Variable Regress.
coefficient t statistic t table Sig.
1 Earning Management (X1) -0.124 -1.734 < -1.660 0.084
2 Institutional Ownership (X2) -0.050 -0.691 > -1.660 0.491
3 Board of Director Size (X3) 0.178 2.427 > 1.660 0.016
4 Moderate_1 (X1-X2) 0.024 0.285 < 1.660 0.776
5 Moderate_2 (X1-X3) -0.073 -0.812 > -1.660 0.481
Constant = 0.060
Adjusted R Square = 0.029
Fstatstic = 2.246
The result of third hypotheis testing (a) shows
that the institutional ownership does not adequately
weaken the relationship between earning management
and earning quality. It is because the value of tstatistic
moderate_1 (X1-X2) is smaller than ttable and the
significance value 0.776 is higher than (0.05). Thus,
this hypothesis is rejected. Institutional ownership
faces dificulties in getting information from the
company management to play a role in controlling
and detecting earning management. Another reason is
that institutional ownership is more focused on
current income (Porter, 1992; Mas’ud, 2003),
therefore, this condition allows company management
an opportunity to conduct earning management in the
short term.
The result of third hypothesis (b) shows that the
board of director size cannot adequately weaken the
relationship between earning management and
earning quality. This is because the value of tstatistic
moderate_2 (X1-X3) is higher than -ttable and the
significance value 0.481 is higher than (0.05). Thus,
this hypothesis is also rejected. Because the
effectiveness of the board of director is affected by
many factors, such as board of director size and
composition, equalitable appointment system, profile
of board members, competenccy and independence of
members. These factors are not owned by all
companies, so company management tends to do
earning management for their personal interest.
(Anand, 2008).
Although both hypotheses are rejected
individually based on the statistical criteria, it is,
however, evident that both governance variables have
some moderating effects, though not significant, on
constraining earnings management to affect earnings
quality. Because, Table-3 above reveals that earnings
management can negatively affect earning quality at
10% level of confidence, which is weaker than the
effect reported in Table-2. Given that there is no
change in the findings of institutional ownership and
board of director size in Table-2 and Table-3 in
influencing earning management (i.e. insignificant
relation with earnings quality), still there is significant
change in earnings management influencing earnings
quality in Table-2 (i.e. it has strong significant
negative relation with earnings quality at 5% level of
confidence) and Table-3 (i.e. it has either no
significant relation with earnings quality or weak
significant negative relation with earnings quality at
10% level of confidence). Therefore, it can be argued
that both institutional ownership and board of director
can jointly deter earnings management to some extent
that leads to improving earnings quality as reflected in
Table-3 comparing with Table-2. Thus, we conclude
that institutional ownership and board size have
weaken the association between earnings management
and earnings quality, indicating that corporate
governance variables can deterring constrain earnings
management. However, the weakening effect is much
higher for board of director size than institutional
ownership.
The forth hypotheses testing used regression for
moderating variables, and the result is as follow:
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214
Table 4. Summary of Regression for Moderating Variables on the Impact of firm-specific Attributes to the
Relationship between Earning Management and Earning Quality
No. Variable Regress.
Coeff. t statistic t table Sig.
1 Earning Management (X1) -0.169 -2.359 < -1.660 0.019
2 Financial Leverage (X4) -0.138 -1.942 < -1.660 0.053
3 Company Size (X5) 0.001 0.011 > 1.660 0.992
4 Moderate_3 (X1-X4) 0.090 1.014 < 1.660 0.312
5 Moderate_4 (X1-X5) -0.032 -0.372 > -1.660 0.710
Constant = -0.052
Adjusted R Square = 0.028
Fstatistic = 2.175
The result of fourth hypothesis (a) shows that
financial leverage cannot strengthen the relationship
between earning management and earning quality.
This is because the value of tstatistic moderate_3 (X1-
X4) is smaller than ttable and the significance value
0.312 is higher than (0.05). Thus, this hypothesis is
rejected. Because the investors may have assumption
when the company has big amount of debt that
company management use that fund in supporting
company operational activities. This activity tends to
reduce the possibility of earning management
practices.
The result of forth hypothesis testing (b) also
shows that firm size cannot strengthen the relationship
between earning management and earning quality.
This is because the value of tstatsitic for moderate_4
(X1-X4) is higher than -ttable and significance value
0.710 is higher than (0.05). Therefore, this
hypotheis is also rejected. This implies that investors
are very careful in making investment decision
making as they rely on both financial and non
financial information. That is, company size cannot be
used to evaluate the existence of earning management
practices that can reduce earning quality. This finding
is consistent with Sulistiyono ( 2010).
Again, similar to Table-3, although both
hypotheses are rejected individually based on the
statistical criteria, it is, however, evident that both
firm-specific variables have some moderating effects,
though not significant, on strengthening earnings
management to affect earnings quality. Because,
Table-4 above reveals that earnings management can
negatively affect earning quality at a slightly lower
level than in Table-2 at 5% level of confidence. Also
importantly, in Table-4 the findings of both financial
leverage and firm size are different from that of in
Table-2. It appears that the significant influence of
financial leverage on earnings quality has shifted from
positive to negative sign, in one hand, the significant
negative influence of firm size on earnings quality has
shifted to insignificant relation with positive sign, on
the other. This indicates that high financial leverage
may decorate earnings quality as managers may
engage in more earnings management not to violate
debt covenants. Again, increased firm size may keep
the firm in a position to disseminate information to
keep investors updated and contain reputation in the
market, but still have resource limitation to do so
adequately. As a result, firm size lacks its influence to
positively affect earnings quality. Thus, we conclude
that leverage has strengthened the relation between
earnings management and market return, implying
that high leverage is more exposed to earnings
management. On the other hand, firm size remains
indifferent in strengthened the relation between
earnings management and earnings quality although it
shows a tendency to weakening earnings management
with positive but insignificant relationship with
earnings quality.
5. Conclusion This study investigates the impact of earnings
management on earnings quality along with a number
of moderating (both governance and financial)
variables in an emerging market context - Indonesia.
We use discretionary accruals following Modified
Jones Model and earnings response coefficient/CAR
as the proxies for, respectively, earnings management
and earnings quality (i.e. for market return). It
examines 4 different types of hypotheses (9
hypotheses in total) on a sample of 52 manufacturing
firms listed on the Indonesia stock exchange during
2007 to 2010 periods. Our regression results in Table-
2 reveal that earnings management has significant
negative influence of market return, confirming
hypothesis 1 as expected. Of the moderating
variables, good corporate governance variables
proxied by institutional ownership and board of
director size and firm-specific attributes proxied by
financial leverage and company size also have
significant effect on earning quality, except
institutional ownership variable. This confirms
hypothesis 2 partially for corporate governance
variables and completely for firm-specific variables.
Again, observing the use of moderator effects on
earnings management, Table-3 rejects hypothesis 3
statistically, but denotes that while both institutional
ownership and board size have some weakening effect
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215
of the association between earnings management and
market return, board size has more power to deterring
earnings management than institutional ownership.
Similarly, Table-4 also rejects hypothesis 3
statistically, but indicates that leverage has
strengthened the relation between earnings
management and market return showing more
exposure to earnings management by changing sign of
significant influence from positive to negative
between Table-2 and Table-4, whereas firm size
remains indifferent showing a tendency to weakening
earnings management by changing level of
significance and sign from negative significant to
positive insignificant between Table-2 and Table-4.
The results of this study have several
implications for Indonesian corporate sector and
policy makers in adopting appropriate governance
measures to constrain earnings management, for
instance ineffectiveness of external monitoring by
institutional owners, effective monitoring of board
with small size, negative signal of leverage in the
market, and positive indication of firm size in
disseminating reliable financial information in the
market etc. Given that this type of study is new
showing the relationship between earnings
management and market return along with governance
and firm-specific moderating variables, the study
does, however, assumes a number of limitations, such
as small sample size and period of years undertaken, a
few variable in this model, low value of Adjusted R2
etc. It is expected that future research can overcome
these limitations by taking larger sample size and time
periods as well as adding more variables such as
board of director members’ appointment equality
system, competency and independency that could be
measured with secondary and questionnaire based
primary data (Anand, 2008).
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Appendix 1. Clasical Assumption Test for Multiple Regression
Figure 1. Normality test
Figure 2. Multicolinearity test
One-Sample Kolmogorov-Smirnov Test
208
.6933
.3518
.074
.074
-.058
1.067
.205
N
Mean
Std. Dev iat ion
Normal Parameters a,b
Absolute
Positive
Negativ e
Most Extreme
Dif f erences
Kolmogorov-Smirnov Z
Asy mp. Sig. (2-tailed)
Unstandardiz
ed Residual
Test distribution is Normal.a.
Calculated f rom data.b.
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Figure 3. Heteroscedasticity test
Regression
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Figure 4. Auto-correlation test
Durbin Watson
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Figure 5. Distribution of t
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THE LIFECYCLE OF THE FIRM, CORPORATE GOVERNANCE AND INVESTMENT PERFORMANCE
Jimmy A. Saravia*
Abstract
According to firm lifecycle theory the agency costs of free cash flows are not transitory problems but are a persistent issue for mature firms. This paper extends the theory by suggesting that to neutralize the threat of takeover the controlling parties of maturing firms progressively deploy antitakeover provisions, and this allows them to overinvest safely and prevent retrenchment. Another contribution of this paper is to develop a new empirical index that permits the identification of mature corporations with governance problems due to agency costs of free cash flows. Empirical results show that as firms mature free cash flows increase, more antitakeover provisions are put into place and negative net present value projects are undertaken. JEL classification code: G31, G34 Keywords: Firm Life Cycle, Free Cash flows, Corporate Governance, Overinvestment Professor, Grupo de Investigación en Banca y Finanzas, School of Economics and Finance, Center for Research in Economics
and Finance (CIEF), Universidad EAFIT, Carrera 49 Número 7 Sur 50, Medellín, Colombia Tel: (574) 2619500 ext. 8771 Email: [email protected]
1. Introduction
According to Agency Theory (AT) when corporations
earn substantial free cash flows, growth maximizing
managements will tend to invest in projects that yield
returns which are lower than the firms’ cost of capital
(Jensen, 1986). Stated this way, the theory suggests
that any firm earning significant free cash flows will
likely overinvest in negative net present value
projects. However, from the perspective of the
lifecycle of the firm this formulation leaves out
important considerations such as the expectations,
held by insiders and outsiders alike, about the
company’s future funding needs and investment
opportunities.
In particular, according to the lifecycle theory of
the firm the agency costs of free cash flows are not
transitory problems, but a persistent issue once firms
reach a certain stage in their lifecycle (Mueller, 2003).
Specifically, as firms mature their cash flows increase
substantially while their investment opportunities
decline, and to prevent retrenchment, growth
maximizing managements find it necessary to invest
in negative net present value projects. However, too
much overinvestment leads to low firm valuation and
potentially a hostile takeover. It is this threat of
takeover that limits the amount of overinvestment
undertaken by the management of the firm. On the
other hand, firm lifecycle theory suggests that young
firms will not overinvest even if it earns free cash
flows at a particular point in time. This is because fast
growing young firms usually depend on outside
sources to finance their long term growth. If growth
maximizing managements of young firms expect that
the free cash flows will be a temporary phenomenon
they will not jeopardize future growth by
overinvesting in the present. Thus, firm lifecycle
theory implies that the free cash flows problem will
occur in mature firms but not in young corporations.
In this sense, one contribution of this paper is to
provide evidence on the investment performance of
corporations over the lifecycle of the firm that is
supportive of the lifecycle view.
Furthermore, this paper extends the lifecycle
theory of the firm by proposing that to neutralize the
threat of takeover, managements of maturing firms
and their boards of directors progressively deploy
more consequential antitakeover provisions which
allow them to overinvest safely and prevent a
pronounced decline in the size of their corporations.
That is, as firms mature and the free cash flow
problem becomes more pronounced, company
managements and their boards of directors put into
place progressively more antitakeover provisions to
accommodate the overinvestments while at the same
time maintaining a comfortable level of job security.
An additional contribution of this paper is to
develop a new empirical index that, based on the
financial characteristics of firms over their lifecycle,
permits the identification of mature corporations with
governance problems due to agency costs of free cash
flows. As discussed below, the derivation of the index
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225
gives a clearer perspective on the fact that the agency
costs of free cash flows are not a one-off problem, but
are a recurrent issue once firms reach a certain stage
in their lifecycle. Importantly, the latter is overlooked
in the empirical literature as researchers usually
employ measures of cash flows retained by
management in a given fiscal year normalized by
book assets (e.g. Chi and Lee, 2010; Lehn and
Poulsen, 1989) or cash levels at some point in time
normalized by book assets or sales (Harford et al.,
2008; Ditmar and Mahrt-Smith, 2007; Jovanovic and
Rousseau, 2002). Contrary to the empirical index
constructed in this paper, such measures imply that
the free cash flow problem can be present in a firm in
a given year and disappear in the next rather than
being a recurrent problem and a feature of the
lifecycle of the firm.
The rest of this paper is organized as follows:
section 2 discusses firm lifecycle theory and the
progressive deterioration of corporate governance
over the lifecycle of the firm as evidenced by an
increase in overinvestment and managerial
entrenchment. Section 3 discusses the theory behind
the empirical index proposed in this paper to separate
young from mature companies. Section 4 discusses
the econometric specifications to test the theory.
Section 5, describes the data and presents the
econometric results. Section 6 concludes.
2. The Lifecycle of the Firm and Corporate Governance Figure 1 illustrates some of the key aspects of the
lifecycle theory of the firm developed by Mueller
(2003). The situation faced by young firms is shown
on the left hand side of the figure. According to the
theory, young firms are characterized by rapid growth
and by the fact that the amounts needed to fund their
positive net present value investment opportunities
will generally exceed its internal cash flows (I* >
CF). Hence, for young firms the shareholder-wealth-
maximization policy is to procure outside capital and
invest until the firm’s marginal cost of capital equals
the firm’s marginal return on investment and pay no
dividends. In this situation, shareholders will clearly
be in favor of providing the means to the young firm
to increase the level of investments until all positive
net present value projects have been undertaken.
Conversely, growth maximizing managements of
young firms would not invest in negative net present
value projects since future profit would be reduced
and the effect would be to increase present growth at
the expense of the future growth of the firm. Thus, for
a young firm, managerial and stockholder interests
regarding investment policy and growth coincide.
This is also represented on the left hand side of Figure
1 where the growth of young firms is depicted by a
solid line. As can be seen, for young firms growth
takes place at a rate which is consistent with
shareholder wealth maximization.
Figure 1. Schematic representation of firm growth over its lifecycle.
Total
output of
the firm
(e.g. total
sales)
Growth-
maximizing
firm
Firm age (in years)
Shareholder-
wealth-
maximizing
firm
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226
On the other hand, the right hand side of Figure
1 illustrates the case of mature firms. According to
lifecycle theory, as firms become older their cash
flows increase enormously while their investment
opportunities decline as their industry matures. As a
consequence, for older firms the positive net present
value investment opportunities eventually become
smaller that its internal cash flows (I* < CF). Now, for
mature firms the shareholder-wealth-maximizing
policy would also be to continue investing until the
marginal rate of return of the firm is equal to its
marginal cost of capital. However, this would involve
the reduction in the size of the firm as shown by the
solid line in the figure. In order to prevent a reduction
in the size of the firm, firm lifecycle theory predicts
that growth-maximizing managements will tend to
reduce, but not totally suppress, dividend payouts as
these payments diminish the quantity of resources
available for growth. Instead, managements will
invest the funds in negative net present value projects.
Consequently, it is at this point in the lifecycle of the
firm that the key agency problem of free cash flows
takes place. This is depicted in Figure 1 by a dashed
line representing the fact that the growth of mature
firms will be higher than that of a hypothetical mature
shareholder-wealth-maximizing firm.
Nevertheless, the lifecycle theory of the firm
also points out that there exist mechanisms that
prevent managers from overinvesting too much in
negative net present value projects. The most
important of these mechanisms is the threat of a
takeover. If shareholder dissatisfaction with
management is too great the stock price may plunge,
and this may increase the likelihood of a takeover.
Now, it is clear that in the context of U.S. institutions
the managements of maturing firms and their boards
of directors can neutralize the takeover threat to a
certain extent by progressively deploying antitakeover
provisions. Thus, in this paper we extend the lifecycle
theory of the firm by suggesting that as firms mature
and the free cash flow problem becomes more
pronounced, company managements and their boards
of directors put into place progressively more
antitakeover provisions to accommodate the
overinvestments while at the same time maintaining a
comfortable level of job security. The implication is
that as firms mature corporate governance will tend to
deteriorate as reflected in managerial entrenchment
and overinvestment in negative net present value
projects.
In addition it is important to note that, as shown
in Figure 1, despite the fact that mature firms tend to
over-invest their rate of growth is much lower than
that of firms in their early years. This is a
consequence of reduced opportunities for internal
investment in mature industries as mentioned above.
Therefore, according to firm lifecycle theory it is not
the fastest-growing firms that tend to over-invest for
these are typically young firms with good investment
opportunities. Instead, over-investment problems are
likely to occur in mature firms, especially those with
entrenched managements. Faced with the prospect of
contracting hierarchies, reduced real salaries, lower
opportunities for promotion, and even unemployment
many managers will very likely look for ways to
make their companies grow. The upshot is that a
mature-growth-maximizing firm will undertake more
investment and pay a lower dividend than a
stockholder-wealth-maximizing firm with the
objective of preventing retrenchment.
Thus, it is readily apparent that the lifecycle
theory of the firm provides a wealth of predictions for
some of the key issues in the field of corporate
finance and corporate governance that range from
agency conflicts to funding and dividend policy. In
this paper we will concentrate on the following
testable propositions: (a) the agency costs of free cash
flows are a recurrent problem for mature firms but not
a characteristic problem of young firms, (b) as firms
mature progressively more antitakeover provisions are
put into place to accommodate overinvestment, hence
(c) corporate governance deteriorates as firms mature.
3. An Empirical Index to Separate Young from Mature Firms
We have seen that according to firm lifecycle theory
the cash flows of young firms are usually too small
when compared to the amounts required for
investment at the optimal level. Therefore, young
firms can be characterized as being dependent on their
outside sources of finance to fully exploit their
investment opportunities. In contrast, the cash flows
of mature firms are generally larger than the amounts
of cash required for investment at the optimal level.
Thus, mature firms can be considered to be financially
autonomous in the sense that they can fund all their
investments and at the same time return part of that
cash to investors in the form of dividends or stock
repurchases.
However, it is also important to take into
account that debt financing is not subject to the free
cash flow problem. Clearly, if the firm fails to pay
interest or capital it becomes bankrupt and can be
liquidated. It is only the equity-holders that suffer
losses from a policy of growth maximization through
overinvestment. Hence, the key issue regarding the
agency costs of free cash flows is to determine when a
firm is financially dependent on shareholders and
when is financially autonomous from its shareholders.
Accordingly, let us define firms that are
financially dependent on shareholders as those that on
most occasions have cash flows that are smaller than
their investments funded with equity and retained
cash flows, and consequently have to issue new shares
in order to undertake the investments. Conversely, let
us define firms that are financially autonomous from
shareholders as those that on most occasions have
internal cash flows which are greater than their levels
of investments funded with equity and retained cash
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227
flows. It is in these financially autonomous firms
where the agency costs of free cash flow can occur.
From the foregoing considerations, an autonomy
index or “A-index” can be constructed as follows:
over a number of past years immediately preceding
the year in question, add up the number of times a
given company has cash flows which are greater than
its investments funded using new equity plus retained
cash flows (CF > ΔE + CF - Dividends). Clearly,
financially dependent young firms will tend to issue a
substantial amount of new equity and pay no
dividends so that their CF will usually be smaller than
their level of investments using new equity and
retained cash flows. On the other hand, financially
autonomous mature firms will issue very little new
equity and will pay dividends, so that their CF will be
usually greater than their level of investments using
new equity and retained cash flows. Thus, firms that
are financially autonomous from their shareholders
will obtain a higher score in this index relative to
those that are financially dependent on their
shareholders.
Now, how long a period should we consider in
order to construct the A-index? Graham (2006, p. 319)
suggests that in analyzing firm financial statements
one should use a fairly long period in the past: 7 to 10
years “in order to iron out the frequent ups and downs
of the business cycle”… and to get “a better idea of
the company’s earning power.” Hence, the A-index
for a given company in a given year will be
constructed by adding one point for each year in
which a company has greater cash flows than
investments funded with equity plus retained cash
flows over the previous 7 years. Accordingly, the A-
index will range from 0 to 7.
Importantly, the A-index is designed to avoid a
problem present in empirical studies that measure
firm age in years. Specifically, the difficulty is that
some firms mature faster than average e.g. those
producing intermediate goods like transistors, while
others mature much more slowly e.g. those
manufacturing consumer products like Coca Cola
(Mueller and Yun, 1998). Hence, if one measures firm
age in years there is a danger that some young firms
will be classified as mature when their economic
characteristics indicate they are still young, or vice-
versa, mature firms could be classified as young when
in fact they present all the characteristics of a mature
company. This problem is illustrated in Figure 2
below.
As can be seen, the A-index represents a better
empirical index for the purpose of separating young
firms from mature companies than firm age. While
measuring firm age in years can lead to an erroneous
classification as some firms mature faster than others,
the A-index will classify young firms as financially
dependent as long as they retain their strong growth.
On the other hand, the A-index will classify mature
firms as financially autonomous due to their slow
growth (or even negative growth).
Figure 2. Schematic representation of two firms with lifecycles of different length
Source: author’s considerations
Total
output of
the firm
(e.g. total
sales)
Firm with
long
lifecycle
Firm age (in years)
Firm with
short
lifecycle
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228
4. Econometric Specification
4.1. The “marginal q” method To test the propositions stated above, in this paper we
will employ a procedure first proposed by Mueller
and Reardon (1993) (henceforth M&R) to measure
deviations from shareholder wealth maximization as a
consequence of overinvestment. In stating their
method, M&R start by defining It as the investment of
a firm in period t, CFt+j as the cash flow that the
investment generates in t+j, and it as the firm’s
discount rate in t. Thus, the present value of the
investment, PVt can be expressed as follows:
1 )1(jj
t
jt
ti
CFPV
(1)
Then, M&R take the PVt from Eq. (1) and the
investment It, and calculate the ratio of “the pseudo
permanent return rt to it,” a ratio usually labelled qmt
or “marginal q.”
tmt
t
ttt Iq
i
IrPV
(2)
That is, M&R argue that if the company had
invested It in a project that generated a permanent
return rt, this project would have produced the same
PVt as in Eq. (1). The ‘qmt’ ratio is the key statistic in
M&R’s analysis; it can measure overinvestment
problems of the type where free cash flows are
retained and invested in negative net present value
projects. Then, M&R define the market value of the
firm Mt as:
(3)
Where, δt is defined as the depreciation rate that
the capital market appraises for the firm’s total
capital, and μt is the error of the market in evaluating
the market value of the firm. M&R then subtract Mt-1
from both sides of Eq. (3), replace PVt with qmt It, and
finally divide both sides by Mt-1 and obtain:
111
1
t
t
t
tmtt
t
tt
MM
Iq
M
MM
(4)
M&R then argue that Eq. (4) can be used to
estimate δt and qmt. To estimate Eq. (4) M&R utilize
data on the market value of each firm and its
investments. They define Mt as the sum of the market
value outstanding shares of a company plus the
market value of its outstanding debt. And they define
investment as:
ADVDREDDividendsCFI &
(5)
Where CF are the cash flows of the firm defined as
the sum of income before extraordinary items and
depreciation, and ΔD and ΔE are defined as net
additions to investment funds from changes in
outstanding debt and equity respectively. Moreover,
M&R argue that although R&D and advertising
expenditures ADV are charged to expenses (as
opposed to be treated as investments in the company
accounts) they are also forms of investment that can
produce intangible capital which contributes to a
firm’s market value, and that for this reason they add
them to their measure of total investment.
Figure 3. The M&R model – an example of an overinvestment situation.
Source: adapted from Mueller and Reardon (1993)
tttttt MPVMM 11
0 It/Mt-1
(Mt-Mt-1)/Mt-1 Slope =1
111
1
t
t
t
tmtt
t
tt
MM
Iq
M
MM
1ˆ mtq
t̂
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Corporate Ownership & Control / Volume 11, Issue 2, 2014, Continued - 1
229
Figure 3 exemplifies the M&R equation (Eq.
(4)) and its usefulness for measuring overinvestment.
A marginal q which is smaller than one indicates that
managements are investing below the firm’s cost of
capital. In such a case shareholders would clearly
prefer to receive the cash in the form of dividends or
stock repurchases rather than seeing it reinvested. If
managements are able to repeatedly invest below the
firm’s cost of capital, this would evidence the
investor’s inability to force the managements to pay
out the free cash flows.
4.2. Specification of the investment performance equation
Since the objective of the present econometric
investigation is to determine whether overinvestment
occurs as the firm matures, the following specification
for marginal q will be estimated:
tititititimt firmagedelawarefirmsizeEindexAindexq ,5,41,3,2,10 (6)
Where, A-index is the index of firm financial
autonomy developed above and E-index is an index of
managerial entrenchment developed by Bebchuk et al.
(2009). In this paper we will employ Bebchuk et al.’s
index since it is constructed using a more reasoned
approach than other indices available in the literature.
Instead of including every single anti-takeover
provision in their index, Bebchuck et al. base the
inclusion of each provision on discussions with
lawyers, their own personal analysis and the
examination of provisions that attract opposition from
institutional investors. In this way, Bebchuk et al.
identify six key governance provisions: staggered
boards, limits to amend by-laws, poison pills, golden
parachutes, supermajority requirements for mergers,
and supermajority requirements for charter
amendments. The E-index is created for a given firm
in a given year by assigning a point for each of the six
key provisions that the firm has. Thus, the E-index
ranges from 0 to 6. These two indices will be our key
corporate governance determinants of marginal q. As
can be seen, the coefficients have been entered in Eq.
(6) with their expected a priori signs according to
theory and previous research. The equation states that
marginal q declines as firm financial autonomy and
managerial entrenchment increase. This is because
lifecycle theory predicts that as firms become more
financially autonomous and more antitakeover
provisions are put in place overinvestment will tend to
occur and this will be reflected in a low marginal q.
Moreover, to control for other potential
determinants of qmt, additional variables are included
in Eq. (6). The first of the control variables, firmsize,
will be measured as the natural logarithm of the book
value of total assets at the end of year t-1. This
variable is expected to have a negative sign. This is
because traditionally (i.e. before the mid-1980s in the
U.S.) large firm size used to be considered enough to
allow managements to substantially over-invest and
yet feel secure to a large extent. However, from the
point of view of managements, following the hostile
takeover wave of the 1980s large firm size probably
has not been considered sufficient to provide security,
and therefore it is likely that this variable may be
insignificant for samples taken from more recent
periods. Nevertheless, it is possible that this variable
may still retain some of its explanatory power and for
this reason it is included in Eq. (6) as a potential
determinant of marginal q.
Secondly, a control variable which takes the
value of 1 if a firm is incorporated in delaware and
zero otherwise is included in Eq. (6). It is expected on
a priori grounds that this variable will have a positive
sign. The reason is that prior work, such as that by
Daines (2001), suggests that the institutional
environment for firms incorporated in the state of
Delaware may be more effective in restraining agency
problems, in which case marginal q should be higher.
Finally, following prior work on rates of return on
investment over the lifecycle of the firm, firm age is
included as a control variable in Eq. (6). This variable
will be measured as the natural logarithm of the
number of years since the company’s incorporation. It
is expected a priori and on the grounds of previous
empirical research that the variable will have a
negative sign (see in particular Mueller and Yun,
1998). However, it is also possible that this variable
could be insignificant given that different firms have
lifecycles of different length, and that consequently,
the A-index may be a better empirical indicator when
it comes to the task of distinguishing young firms
from mature companies.
Substituting Eq. (6) into Eq. (4), including time
and industry dummy variables, and simplifying the
following investment performance regression
equation is obtained:
1,
,1
1
,
1
11,
,,5
1,
,,4
1,
,1,3
1,
,,2
1,
,,1
1,
,0
1,
1,,
)()(
)()()(
ti
tiJ
j
jij
T
t
tt
ti
titi
ti
titi
ti
titi
ti
titi
ti
titi
ti
ti
ti
titi
MIndustryTime
M
Ifirmage
M
Idelaware
M
Ifirmsize
M
IEindex
M
IAindex
M
I
M
MM
(7)
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Corporate Ownership & Control / Volume 11, Issue 2, 2014, Continued - 1
230
Where Timet, t = 1,…, T-1 are time dummy
variables, and industryi,j, j =1,…, J-1 are industry
dummy variables, while α is the intercept for the base
or benchmark category.
Petersen (2009) has recently examined the
empirical literature and provides guidance on the
appropriate methods to follow when using corporate
finance panel data sets. Following his work, Eq. (7)
includes time dummy variables to deal with time
effects. In addition standard errors clustered by firm
will be used in the next section to address firm effects.
Finally, since depreciation rates should vary across
companies depending on the type of investments in
capital assets they undertake, Eq. (7) includes industry
dummy variables by assigning each company to a two
digit SIC industry code (Mueller and Yurtoglu, 2000).
5. Data and Econometric Results 5.1 Sample selection The starting point our data collection is Bebchuk et
al.’s (2009) E-index database. Currently, the database
contains information for the years 1990, 1993, 1995,
1998, 2000, 2002, 2004 and 2006. To obtain a sample
of firms with reasonably long time series of data with
which to build the variables, the database was initially
inspected for companies with non-missing values for
the years 1990 and 20044. In this manner 586
companies were identified. Given that some of the
companies changed names and ticker symbols, the
information was matched using 8 digit CUSIPs in
order to make sure that the data referred to the same
company5. Then, a search for these 586 firms was
performed using Datastream and 556 firms were
found. Next, banks, financial companies and certain
service industries (SICs 6000 to 6999 and above
8100) were excluded because the nature of capital and
investment in these industries is fundamentally
different when compared to non-financial firms. This
reduced the sample by 81 companies from 556 to 475.
For this final group of 475 firms the usual practice of
researchers who utilize corporate governance
provision indices (e.g. Gompers et al., 2003; Bebchuk
et al., 2009) was followed and the observations for the
years in which IRRC does not publish governance
provisions data were filled in by assuming that the
provisions remain unchanged in the period between
IRRC publications. Given the information contained
in Bebchuk’s database at the time of the data
4 Bebchuk et al.’s database contains two sub-samples, a no
dual class stock sub-sample and a dual class stock sub-sample. Following prior research we exclude dual class stocks for the reason that in those companies “the superior voting rights may be sufficient to provide incumbents with a powerful entrenchment mechanism that renders the other entrenchment provisions relatively unimportant” (Bebchuk et al., 2009). 5 CUSIP is an acronym that refers to the 8 character
alphanumeric security identifier distributed by the Committee on Uniform Security Identification Procedures.
collection for this paper it was possible to assign
values for the 475 firm’s E-indices for a period of 19
years, comprising the years from 1990 to 2008.
Market prices and accounting data for these
companies were obtained from the Datastream
database as described in the Appendix.
5.2 Sample description and test of hypotheses for differences between means
Table 1 provides summary statistics for the empirical
variables employed in this paper. As can be seen the
firms in the sample contain substantial variation in
their age, size, financial autonomy, entrenchment and
other variables important for testing our hypotheses in
the context of firm lifecycle theory.
This table provides summary statistics for the
variables employed in this paper. A-index is a firm-
level index of financial autonomy computed by
adding one point for every year, in the previous 7
years, in which a given firm’s cash flows are greater
than its investment financed using equity and retained
cash flows. E-index is the entrenchment index created
by Bebchuk et al. (2009). (Mt-Mt-1)/Mt-1 is the
percentage change in the market value of the firm
between the end of year t-1 and the end of year t.
It/Mt-1 is the investment undertaken by a given firm
during year t divided by the market value of the firm
at the end of year t-1. logtotalassets is the natural
logarithm of the book value of total assets measured
at the end of year t-1 in US$. delaware is a dummy
variable that takes the value of 1 if a firm is
incorporated in Delaware and zero otherwise.
logfirmage is the natural logarithm of firm age
measured in years since the company’s incorporation.
To further describe the sample used in this paper
Table 2 below presents the values of the A-index and
E-index variables sorted by firm age. Moreover, for
each variable the table presents tests hypotheses for
differences between the means of the youngest firms
(0 to 15 years of age and 16 to 30 years age) and the
means of older firms in the other time buckets. This is
interesting because it helps elucidate whether mature
firms earn more free cash flows than younger
companies and if the managements of older firms are
more entrenched. The information in the table
suggests that both propositions are correct. As can be
seen, older firms have higher A-indices on average
than younger companies and the tests of differences
between means indicate that the differences are
significant at the 1% level. Moreover, the table
indicates that the E-index tends to increase with firm
age and that the differences between the means of the
variable for young and mature firms are also
statistically significant at the 1% level.
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Table 1. Summary Statistics
Variable N Mean Median Std. Dev. Min Max
A-index 8687 5.0199 6 2.1651 0 7
E-index 8687 2.6594 3 1.3638 0 6
(Mt-Mt-1)/Mt-1 8620 0.0807 0.0309 0.3454 -0.8363 4.5065
It/Mt-1 8639 0.1262 0.0942 0.1607 -0.7120 2.2021
logtotalassetst-1 8686 21.6287 21.5468 1.4726 17.2768 27.2513
delaware 8687 0.4649 0 0.4988 0 1
logfirmage 8687 4.0373 4.2195 0.6085 0.0000 5.0752
Table 2. Financial autonomy and managerial entrenchment over the lifecycle of the firm
Firm age
A-index E-index
N Mean Std.
Dev.
Diff. 0-
15yrs
Diff. 16-
30yrs N Mean
Std.
Dev.
Diff. 0-
15yrs
Diff. 16-
30yrs
0 to 15
years 358 2.5419 2.3933
358 2.0196 1.4151
16 to 30
years 997 3.5757 2.3800 -1.0338*
997 2.3019 1.3942 -0.2823*
31 to 45
years 1235 4.4121 2.3583 -1.8702* -0.8364* 1235 2.5870 1.3933 -0.5674* -0.2851*
46 to 60
years 1114 4.7271 2.1890 -2.1852* -1.1514* 1114 2.7136 1.3682 -0.694* -0.4117*
61 to 75
years 1471 5.4317 1.9390 -2.8898* -1.856* 1471 2.6139 1.3574 -0.5943* -0.312*
76 to 90
years 1560 5.9314 1.4570 -3.3895* -2.3557* 1560 2.7423 1.3393 -0.7227* -0.4404*
91 to 105
years 1198 5.7362 1.5470 -3.1943* -2.1605* 1198 2.9332 1.2421 -0.9136* -0.6313*
106 to 120
years 445 5.7371 1.5218 -3.1952* -2.1614* 445 3.0090 1.3237 -0.9894* -0.7071*
121 to 135
years 154 5.4545 1.9607 -2.9126* -1.8788* 154 2.9935 1.1289 -0.9739* -0.6916*
136 to 150
years 122 5.9508 0.9435 -3.4089* -2.3751* 122 2.7377 1.2779 -0.7181* -0.4358*
151 to 165
years 33 5.5758 1.1997 -3.0339* -2.0001* 33 2.8788 1.139 -0.8592* -0.5769*
Table 2 presents the means and standard
deviations of the A-index and E-index variables sorted
by firm age. The A-index is a firm-level index of
financial autonomy computed by adding one point for
every year, in the previous 7 years, in which a given
firm’s cash flows are greater than its investment
financed using new equity and retained cash flows.
The E-index is the entrenchment index created by
Bebchuk et al. (2009). Firm age is the company’s age
measured in years since its incorporation. In addition,
for the A-index and E-index variables, the table tests
hypotheses for differences between the means of the
youngest firms (0 to 15 years as well as 16 to 30 years
of age) and the means of older firms in the other time
buckets. * and ** indicate that the difference is
significant at the 1% and 5% level respectively (one
tailed t-tests).
From these results we can conclude that while
younger firms depend on outside shareholders to
finance investments, older firms earn free cash flows
on a continuing basis which makes them largely
independent from shareholders. In addition, compared
to young firms older firms have more consequential
antitakeover provisions put in place as measured by
the E-index. Both results taken together suggest that
mature firms use the free cash flows that they earn on
a ongoing basis to overinvest while, on the other
hand, young companies will not overinvest even if
they earn free cash flows on a given year since their
managements know they will have to come back to
the shareholders for additional funding in the future.
Finally, correlations between the empirical
variables are presented in Table 3. It is interesting to
note that the E-index presents positive and significant
correlations with the A-index and logfirmage. This
implies that as firms mature, and on average become
more financially autonomous, their managements tend
to deploy a larger number of consequential anti-
takeover provisions. On the other hand, Table 3
shows that the A-index presents significantly negative
correlations with (Mt-Mt-1)/Mt-1 and It/Mt-1. This
suggests that, consistent with firm lifecycle
arguments, companies with a low A-index (young
firms) invest relatively more, and have a higher rate of
increase in their market values when compared to
firms with a higher A-index (older companies). The
latter is reinforced by the fact that that logfirmage also
has negative and significant correlations with (Mt-Mt-
1)/Mt-1 and It/Mt-1.
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232
Table 3. Correlation matrix
Variable A-index E-index (Mt-Mt-1)/Mt-1 It/Mt-1 logtotal-
assetst-1
delaware logfirmage
A-index 1.0000
E-index 0.0503* 1.0000
(Mt-Mt-1)/Mt-1 -0.1224* -0.0698* 1.0000
It/Mt-1 -0.1419* 0.0095 0.5219* 1.0000
logtotalassetst-1 0.1014* -0.0790* -0.0844* -0.0945* 1.0000
delaware -0.1363* -0.1307* 0.0419* 0.0774* 0.0340* 1.0000
logfirmage 0.4158* 0.1533* -0.1231* -0.1145* 0.2344* -0.2388* 1.0000
This table presents the correlation matrix for the
variables employed in this paper. A-index is a firm-
level index of financial autonomy computed by
adding one point for every year, in the previous 7
years, in which a given firm’s cash flows are greater
than its investment financed using equity and retained
earnings. E-index is the entrenchment index created
by Bebchuk et al. (2009). (Mt-Mt-1)/Mt-1 is the
percentage change in the market value of the firm
between the end of year t-1 and the end of year t.
It/Mt-1 is the investment undertaken by a given firm
during year t divided by the market value of the firm
at the end of year t-1. logtotalassets is the natural
logarithm of the book value of total assets measured
at the end of year t-1 in US$. delaware is a dummy
variable that takes the value of 1 if a firm is
incorporated in Delaware and zero otherwise.
logfirmage is the natural logarithm of firm age
measured in years since the company’s incorporation.
* and ** indicate that a correlation is significant at the
1% and 5% level respectively.
Moreover, table 3 shows that the A-index has a
positive and significant correlation with logtotalassets
and logfirmage. This implies that, consistent with firm
lifecycle theory, companies with a high A-index are
on average relatively larger and older. Finally, note
the negative and statistically significant correlation
between delaware and logfirmage. This suggests that
the positive relationship between incorporation in
Delaware and good firm performance reported by
Daines (2001) may reflect that firms incorporated in
Delaware are younger on average than firms
incorporated elsewhere and not any corporate
governance advantage of incorporating in that State.
Having elucidated that database contains firms
with sufficient variation in their age, sizes and other
variables for the purposes of testing the paper’s
hypotheses, the next subsection employs the
econometric methods discussed above to test for
overinvestment.
5.3 Econometric results Table 4 below presents the results from
estimating Eq. (7). Mueller and Yun’s (1998)
investigation regarding investment performance over
the lifecycle of the firm is replicated in Table 4
column 1. This column shows results obtained by (a)
specifying marginal q as equal to an intercept plus a
coefficient times the natural logarithm of firm age, (b)
substituting for marginal q in the basic M&R
investment performance regression equation (Eq. 4)
and finally (c) estimating the parameters by OLS.
Similar to Mueller and Yun’s findings, the results in
the table show a significantly positive intercept of
1.8002 and negative and significant coefficient for
logfirmage of -0.1810. These estimates for our
sample, pertaining to the time period 1990-2008,
imply that for the average firm marginal q falls below
1 (indicative of overinvestment) around 80 years after
its incorporation (qmt = 1.8 - 0.18 (ln(80)) = 1). Table 4 presents estimates of ‘marginal q’ for
firms in the paper’s database over the time period from 1990 to 2008. The technique employed was originally developed by Mueller and Reardon (1993). The estimation method is OLS. The dependent variable is (Mt-Mt-1)/Mt-1, which is the percentage change in the market value of the firm between the end of year t-1 and the end of year t. It/Mt-1 is the investment undertaken by a given firm during year t divided by the market value of the firm at the end of year t-1. A-index is a firm-level index of financial autonomy computed by adding one point for every year, in the previous 7 years, in which a given firm’s cash flows are greater than its investment financed using equity and retained cash flows. E-index is the entrenchment index created by Bebchuk et al. (2009). logtotalassetst-1 is the natural logarithm of the book value of total assets measured at the end of year t-1 in US$. delaware is a dummy variable that takes the value of 1 if a firm is incorporated in Delaware and zero otherwise. logfirmage is the natural logarithm of firm age measured in years since the company’s incorporation. The regressions include year dummy variables to pick up movements in stock market values which are common to all firms. Moreover, each company is assigned to a two digit SIC industry code and industry dummy variables are also included. * and ** indicate that the coefficient is significant at the 1% and 5% level respectively (one tailed t-test). Following Petersen (2009) standard errors clustered by firm are reported in parentheses.
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233
Table 4. Investment performance over the lifecycle of the firm
Variable (1) (2) (3) (4) (5)
It/Mt-1 1.8002* 1.5942* 1.7184* 2.5330* 2.4793*
(0.2679) (0.1146) (0.2409) (0.4451) (0.4514)
(logfirmaget )It/Mt-1 -0.1810* -0.0392 -0.0352
(0.0640) (0.0566) (0.0608)
(A-indext )It/Mt-1 -0.0740* -0.0694* -0.0664* -0.0690*
(0.0146) (0.0144) (0.0144) (0.0149)
(E-indext )It/Mt-1 -0.0616* -0.0586* -0.0636* -0.0630*
(0.0202) (0.0198) (0.0206) (0.0211)
(logtotalassetst-1)It/Mt-1 -0.0374** -0.0424*
(0.0218) (0.0201)
(delawaret )It/Mt-1 -0.0559
(0.0583)
Industry dummy variables? yes yes yes yes yes
Time dummy variables? yes yes yes yes yes
Adjusted R2 0.3523 0.3616 0.3616 0.3628 0.3626
Number of observations 8618 8618 8618 8618 8618
However, as discussed above, a specification in
which firm age is measured in years since firm
incorporation has some important drawbacks. The
most important is that, logically, different firms will
have lifecycles of different lengths when measured in
years. This is the reason why the A-index was
constructed. Moreover, while the presence of free
cash flows is a necessary condition for
overinvestment, it is not sufficient. The reason is that
if management overinvests the market value of the
firm may plunge and a hostile takeover may ensue
(Mueller, 2003). This is why it is important to include
an index of antitakeover provisions such as the E-
index to determine how insulated firm management is
from the takeover threat. Thus, Table 4 column 2
specifies marginal q as equal to an intercept plus a
coefficient times the A-index plus another coefficient
times the E-index. This specification is then
substituted in M&R investment performance
regression equation (Eq. 4) and finally the parameters
are estimated by OLS. As shown in Table 4 column 2,
there are significantly negative coefficients for both
the A-index and the E-index at the 1 percent level.
Importantly, this result is consistent with the
predictions of firm lifecycle theory as it signifies that
marginal q will tend to decrease as both the A-index
and the E-index increase.
Next, Table 4 column 3 presents the results of
running a regression equation which includes the
preceding two kinds of measures (i.e. years since firm
incorporation and firm characteristics as captured by
the A-index and E-index) as a means to detect
overinvestment problems. As can be seen, while both
the A-index and the E-index coefficients remain
negative and significant at the 1% level, the
coefficient for the natural logarithm of firm age
becomes insignificant at any conventional level. The
reason for this result is that, as mentioned earlier,
although it is logically to expect that firms will go
through a lifecycle there is no reason to expect that
the lengths of company lifecycles measured in years
will be similar for the diversity of firms. Different
companies produce different types of products and
operate under different business conditions. For this
reason this paper argues that is more effective to
measure firm characteristics such as financial
autonomy and managerial entrenchment directly as a
means to assess firm age, than to try to determine if a
firm is young or mature by using firm age measured
in years.
Further, Table 4 column 4 presents the results of
running a regression equation with additional control
variables. Specifically, column 4 presents the results
of estimating Eq. (7) where specific predictions for its
coefficients are formulated. As can be seen, in this
specification both the A-index and the E-index
coefficients are negative as predicted and are
significant at the 1% level. However, the coefficient
for logfirmage although negative as expected on a
priori grounds is insignificant at any conventional
level. Interestingly, the coefficient for logtotalassetst-1
is negative as predicted, and it is significant at the 5%
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Corporate Ownership & Control / Volume 11, Issue 2, 2014, Continued - 1
234
level (one tailed t-test). This provides evidence in
favor of the proposition that large firm size gives
managements protection from the takeover threat, and
that consequently, the managements of larger firms
have more leeway to overinvest than those of smaller
companies. On the other hand, contrary to our
expectations the coefficient for delaware is negative
and insignificant at any conventional level. Thus, at
least for our sample we find no evidence that the
institutional environment for firms incorporated in the
State of Delaware may be more effective in
preventing agency problems as manifested by
overinvestment.
Finally, Table 4 column 5 presents the results of
running a more parsimonious regression equation in
which marginal q is specified as equal to an intercept
plus a coefficient times the A-index, plus another
coefficient times the E-index, and finally an additional
coefficient times logtotalassetst-1. As shown in the
table, for this specification the intercept is
significantly positive at the 1% level and the
coefficients for the A-index, E-index and
logtotalassetst-1 are significantly negative at the 1%
level.
The investment performance results are further
illustrated with the aid of Table 5. This table presents
values for marginal q implied by the estimates in
Table 4 column 5 for different combinations of the A-
index and the E-index (similar results are obtained if
the estimates in Table 4 column 4 are used instead).
Note that in the calculations logtotalassetst-1 is held at
its mean value of 21.6287. Hence, for example, the
estimates imply that the value of marginal q for the
average firm when the A-index = 1 and the E-index =
1 equals 1.4302 (qmt= 2.4793 -0.069(1) –0.063(1) –
0.0424 (21.6287) = 1.4302).
Table 5. Calculated qmts for different combinations of the A-index and the E-index
A-index
0 1 2 3 4 5 6 7
E-i
nd
ex
0 1.5622 1.4932 1.4242 1.3552 1.2862 1.2172 1.1482 1.0792
1 1.4992 1.4302 1.3612 1.2922 1.2232 1.1542 1.0852 1.0162
2 1.4362 1.3672 1.2982 1.2292 1.1602 1.0912 1.0222 0.9532
3 1.3732 1.3042 1.2352 1.1662 1.0972 1.0282 0.9592 0.8902
4 1.3102 1.2412 1.1722 1.1032 1.0342 0.9652 0.8962 0.8272
5 1.2472 1.1782 1.1092 1.0402 0.9712 0.9022 0.8332 0.7642
6 1.1842 1.1152 1.0462 0.9772 0.9082 0.8392 0.7702 0.7012
Table 5 presents values for marginal q implied
by the estimates in Table 4 column 5 for different
combinations of the A-index and the E-index. A-index
is a firm-level index of financial autonomy computed
by adding one point for every year, in the previous 7
years, in which a given firm’s cash flows are greater
than its investment financed using equity and retained
earnings. E-index is the entrenchment index created
by Bebchuk et al. (2009). Note that in the calculations
logtotalassetst-1, the natural logarithm of the book
value of total assets measured at the end of year t-1 in
US$, is held at its mean value of 21.6287.
The results in Table 5 show that the values of
marginal q for the average firm are substantially
higher than 1 when firm financial autonomy as
measured by the A-index is low and managerial
entrenchment as measured by the E-index is also low.
Specially, the table shows the highest value of
marginal q of 1.5622 when the A-index and the E-
index are both equal to zero. More generally, the table
shows that the values of marginal q decline
progressively as financial autonomy and
entrenchment become more important.
The results in Table 5 can be best interpreted
with the aid of Figure 4. Marginal q equals the area
under the marginal rate of return schedule (mrr)
between 0 and the level of investments divided by the
area under the cost of capital (i) between 0 and the
level of investments (Mueller and Yurtoglu, 2000).
Thus, an estimated marginal q that is greater than one
is consistent with the interpretation that firms are
maximizing shareholder value by equalizing their
marginal rates of returns to their marginal cost of
capital. For example, as shown in Figure 4, if a firm
invested I1 it would equalize its marginal rate of
return mrr to its marginal cost of capital i, and its
marginal q would equal the area under mrr from 0 to
I1, that is ‘a + b,’ divided by the area under the
marginal cost of capital curve, namely ‘b’, which is
clearly greater than one.
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Corporate Ownership & Control / Volume 11, Issue 2, 2014, Continued - 1
235
Figure 4. Interpretation of marginal q results
Therefore, since the data indicates that marginal
qs are substantially greater than one for low values of
the A-index and the E-index, we conclude that there is
significant evidence in favor of the hypothesis that the
managements of financially dependent firms as
measured by the A-index who are not entrenched
using anti-takeover provisions as measured by the E-
index (i.e. young firms) will tend to invest in a
manner which is consistent with shareholder wealth
maximization as measured by marginal q.
In addition, the results in Table 5 show that the
values of marginal q for the average firm are close to
1 when firm financial autonomy as measured by the
A-index is high and managerial entrenchment as
measured by the E-index is low. For instance, the
table shows a value of marginal q of 1.0162 when the
A-index is equal to 7 and the E-index is equal to 1. In
general, the table shows values for marginal q which
are close to 1 in the upper-right hand region of
Table 5.
Now, an estimated qmt which is close to 1 can be
interpreted as an indication of “moderate”
overinvestment taking place. To see this suppose that
a firm invests I2 as shown in Figure 4, and moreover
assume that the areas labelled ‘a’ and ‘d’ in the figure
are approximately equal. In this case, marginal q
would equal the area under mrr, that is ‘a + b + c’,
divided by the area under the cost of capital curve, i.e.
‘b + c + d’. Given that ‘a’ and ‘e’ have approximately
equal areas, marginal q approximately equals 1 and,
as the figure shows, there is overinvestment taking
place as the marginal investment project has a rate of
return that is below its cost of capital.
Therefore, the estimates of marginal q presented
in Table 5 are consistent with the hypothesis that the
managements of financially autonomous firms as
measured by the A-index who are not entrenched
using anti-takeover provisions as measured by the E-
index will tend to over-invest moderately as measured
by marginal q. Note that overinvestment is
“moderate” for the case of these mature firms because
of the threat of takeover.
Furthermore, the results shown in Table 5
indicate that there is strong evidence of
overinvestment as measured by marginal q when both
the A-index and the E-index have high values. From
the previous discussion it is clear that no firm that
maximizes shareholder wealth would undertake
investment for which qmt < 1, for this unequivocally
implies overinvestment. Now, when the A-index = 7
and the E-index = 6 the marginal q implied by the
estimates of Table 4 column 5 equals 0.7012. This
suggests that on average for every dollar that firms
with these high levels of financial autonomy and
entrenchment invested during the period 1990-2008,
the market value of these firms increased by only
about $0.70. Consequently, the estimates of marginal
q presented in Table 5 are consistent with the
hypothesis that the managements of mature
financially autonomous firms as measured by the A-
index who are also entrenched using anti-takeover
provisions as measured by the E-index will tend to
over-invest substantially as measured by marginal q.
Finally, the results in Table 5 show that the
values of marginal q for the average firm are
substantially greater than 1 when firm financial
autonomy as measured by the A-index is low and
managerial entrenchment as measured by the E-index
is high. For instance, the table shows a value of
marginal q of 1.2472 when the A-index is equal to 0
I2
mrr
Cost of
capital ‘i’
mrr, i
0 I1 I
a
b c
d
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Corporate Ownership & Control / Volume 11, Issue 2, 2014, Continued - 1
236
and the E-index is equal to 5. This suggests that on
average for every dollar that firms with these levels of
low financial autonomy and high entrenchment
invested during the period 1990-2008, the market
value of these firms increased by about $1.25. In
general, the table shows values for marginal q which
are greater than 1 in the lower-left hand side region of
Table 5. Hence, the estimates of marginal q presented
in Table 5 are consistent with the hypothesis that the
managements of financially dependent firms as
measured by the A-index who are also entrenched
using anti-takeover provisions as measured by the E-
index will tend to invest in a manner consistent with
shareholder wealth maximization as measured by
marginal q. In other words, if there are no free cash
flows there can be no overinvestment even though the
management of the firm is entrenched. However, this
does not rule out that there may be other agency
problems involved that cause the managements of
these firms to keep antitakeover provisions in place6.
6. Conclusions
The agency costs of free cash flows are a problem
which is characteristic of mature firms. As firms
mature their cash flows eventually become larger than
the amounts needed to fund all positive net present
value projects. If it is taken into consideration that
some mature firms need to retrench, it is not
surprising that their managements will employ some
of the free cash flows to mitigate the negative growth.
Faced with the option between over-investing and
firing workers, they will likely choose the more
popular route. The lifecycle theory of the firm and the
derivation of the A-index give a clearer perspective on
this fact.
The A-index contrasts with current
measurements of free cash flows in that it makes it
clear that the agency costs of free cash flows are a
recurrent problem for mature firms and a feature of
the lifecycle of the firm. The A-index compares the
size of the cash flows with the actual investments
undertaken using equity and retained earnings rather
than solely measuring the size of the retained cash
flows or the level of cash held by a corporation at
some point in time. In this sense, the contribution of
this paper has been to develop a new empirical index
that allows us to separate young from mature firms
more effectively than using chronological firm age.
Finally, firm lifecycle theory and the results in
this paper leads us to conclude that, assuming that the
objective of a policy maker is to improve corporate
governance in the sense that managers remain
responsive to the wishes of the shareholders, there is
only one effective policy to be implemented: to
6 I discuss and examine this issue empirically elsewhere. I
conclude that these companies are mature firms that have lost their financial autonomy but that would not remove their antitakeover provisions due to their prior investments in unrelated businesses which makes them potential hostile takeover targets (Saravia, 2010).
outlaw the deployment of anti-takeover provisions. If
this policy were implemented over-investment on the
part of mature corporations would be mitigated to a
moderate level. The reason is that if shareholder
dissatisfaction with management were to become too
great the stock price would plunge, and this would
increase the likelihood of a takeover. Thus,
management would be under increasing pressure to
pay out the funds to shareholders in the form of
dividends or stock repurchases rather than over-
investing.
References
1. Bebchuk, L., Cohen, A., and Ferrel, A. (2009), “What
Matters in Corporate Governance?” The Review of
Financial Studies, Vol. 22, pp. 783-827.
2. Chi, J.D., and Lee, D.S. (2010), “The Conditional
Nature of the Value of Corporate Governance”, Journal
of Banking & Finance, Vol. 34, pp. 350-361.
3. Daines, R. (2001), “Does Delaware Law Improve Firm
Value?” Journal of Financial Economics, Vol. 62, pp.
525-558.
4. Dittmar, A., and Mahrt-Smith, J. (2007), “Corporate
Governance and the Value of Cash Holdings”, Journal
of Financial Economics, Vol. 83, pp. 599-634.
5. Gompers, P., Ishii, J. and Metrick, A. (2003),
“Corporate Governance and Equity Prices”, Quarterly
Journal of Economics, Vol. 118, pp. 107-155.
6. Graham, B. (2006), The Intellingent Investor, Collins
Business Essentials, New York, NY.
7. Harford, J., Mansi, S., and Maxwell. W.F. (2008),
“Corporate Governance and Firm Cash Holdings”,
Journal of Financial Economics, Vol. 87, pp. 535-555.
8. Jensen, M. (1986), “Agency Costs of Free Cash Flow,
Corporate Finance, and Takeovers”, American
Economic Review, Vol. 76, pp. 323-329.
9. Jovanovic, B., and Rousseau, P.L. (2002), “The Q-
Theory of Mergers”, American Economic Review, Vol.
92, pp. 198-204.
10. Lehn, K., and Poulsen, A. (1989), “Free Cash Flow and
Stockholder Gains in Going Private Transactions”
Journal of Finance, Vol. 44, pp. 771-787.
11. Mergent, Inc. (2004), Mergent Industrial Manual. Vol.
1 & 2. Mergent, New York, NY.
12. Mueller, D.C. (2003), The Corporation: Investments,
Mergers and Growth. Routledge, New York, NY.
13. Mueller, D.C., and Reardon, E.A. (1993), “Rates of
Return on Corporate Investment”, Southern Economic
Journal, Vol. 60, pp. 430-453.
14. Mueller, D.C., and Yun, S.L. (1998), “Rates of Return
over the Firm's Lifecycle”, Industrial and Corporate
Change, Vol. 7, pp. 347-368.
15. Mueller, D.C., and Yurtoglu, B. (2000), “Country Legal
Environments and Corporate Investment Performance”,
German Economic Review, Vol. 1, pp. 187-220.
16. Petersen, M. A. (2009), “Estimating Standard Errors in
Finance Panel Data Sets: Comparing Approaches”, The
Review of Financial Studies, Vol. 22, pp. 435-480.
17. Saravia, J. A. (2010), An Investigation of the
Relationship between Corporate Governance and Firm
Performance, Unpublished PhD Thesis, University of
Surrey, Guildford, Surrey, U.K.
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237
APPENDIX
Table A.1 lists the sources of data used in this paper. The
first column of the table displays the data items used, while
the second column presents the data sources. Panel A
presents the data needed to compute the market value of a
firm at the end of year t (Mt), which in turn is required to
implement the Mueller and Reardon (1993) marginal q
method. Specifically, the table shows that Mt is computed
by adding the market value of common stock (wc05301 x P)
plus the book value of total debt (wc03255) and preferred
stock (wc03451). Where the market value common stock
is calculated by multiplying the end of fiscal year number of
shares (wc05301) times the end of fiscal year price per
share (P).
This table lists the main sources of data used in this
paper. Panel A shows the data items needed to compute the
market value of a firm at the end of year t. Panel B lists the
data items needed to calculate the investment of a firm over
year t. Panel C lists the sources of data for important items
such as Bebchuk et al.’s (2009) E-index, as well as date of
incorporation which is used to compute firm age.
Table A1. The main sources of data used in this paper
Panel A. Firm market value (Mt)
Data item Datastream datatype
Market value of common stock (wc05301 x P)
End of fiscal year number of shares wc05301
End of fiscal year price per share P
Book value of total debt wc03255
Preferred stock wc03451
Panel B. Investment (It)
Data item Datastream datatype/ other
Cash flow wc04201
Dividends wc04551
Net new debt = change in total debt during year change in wc03255
Net new equity = change in number of common shares
outstanding x average share price over year t
change in wc05301 x average P
R&D expenditures wc01201
Advertising expenses
Approximated by multiplying company sales by
advertising to sales ratios from the IRS reports on corporation
returns for 1995.
IRS reports on corporation returns. Table 6:
Balance sheets, income statements, tax and selected
other items. See Mueller and Yurtoglu (2000).
Total sales wc01001
Panel C. Other
Data item Datastream datatype/ other
Total assets wc02999
Date of fiscal period end wc05350
Consumer price index (CPI) World bank - world development indicators
Entrenchment index (E-index)
Available from Bebchuk’s webpage at http://
www. law.harvard.edu /faculty/ bebchuk/data.shtml Date of Incorporation (to compute firm age) Mergent Industrial Manual (Mergent, 2004)
Industry SIC codes ‘Eqy Sic Code’
(Bloomberg table wizzard)
State of incorporation ‘State Of Incorporation’
(Bloomberg table wizzard)
On the other hand, Panel B lists the data needed to
calculate the investment of a firm over year t (It) which is
also necessary to implement the M&R marginal q method.
In particular, It is calculated by first subtracting dividends
(wc04551) from cash flows (wc04201) and then adding net
new equity (the change in the number of shares wc05301
times average share price P over year t), net new debt (the
change in total debt wc03255 over year t), R&D
expenditures (wc01201), and advertising expenses
(estimated by multiplying total sales (wc01001) and
advertising to sales ratios taken from IRS reports on
corporation returns, see Mueller and Yurtoglu, 2000).
Moreover, Panel C lists the sources of data for Bebchuk et
al.’s (2009) E-index, the companies’ dates of incorporation
which is used to compute firm age, as well as the book
value of total assets.
The financial data utilized to compute the autonomy
index are also taken from Table A.1. As discussed
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238
previously, the A-index is calculated by adding one point
for each year in which a company has greater cash flows
than investments financed using equity and retained cash
flows during the previous 7 years. Investments in financed
using equity and retained cash flows (Ie) are measured as
follows:
EDividendsCFI e (A.1)
Where CF is the cash flow of the firm (wc04201),
Dividends are taken from Datastream (wc04551) and ΔE
stands for net new equity. Therefore, when calculating the
A-index for a given firm in year t, 1 point is added for every
year (from t-7 to t-1) in which CF > Ie. Finally note that
prior to the calculation of the M&R variables all items were
deflated by using the CPI (2000 = 1). The CPI data for the
U.S. were obtained from the World Bank, World
Development Indicators, ESDS International, and
University of Manchester.
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239
EXECUTIVE COMPENSATION, ORGANIZATIONAL CULTURE AND THE GLASS CEILING
M. Dewally*, S. Flaherty**, D. Singer***
Abstract
This study examines the impact of organizational culture on executive compensation systems. Organizational culture is found to have a strong impact on the relationship between CEO equity compensation and organizational effectiveness. Compensation patterns found in traditional organizations are interpreted to reflect a Managerial Power Theory of executive compensation. In contrast, in positive organizations, the exercise of managerial power appears to be constrained by the internal values of that organization and the need for the leader to maintain his or her authenticity. Female executives who have penetrated the glass ceiling in both traditional and positive organizations are found to contribute to a culture in which executive compensation reflects an Optimal Contract approach to principle-agent relationships for CEOs and shareholders. Keywords: Organizational Culture, Executive Compensation, Managerial Power Theory Asst. Prof. of Finance, Towson University
Email: [email protected] ** Asst. Prof. of Finance, Towson University Email: [email protected] *** Prof., of Finance, Towson University Email: [email protected]
1. Introduction
This study examines the impact of organizational
culture on the effectiveness of executive
compensation systems. While Landsberg (2012)
suggested the importance of business culture in
determining executive compensation and a large body
of literature has focused on organizational culture and
organizational performance (Xiaomin and Junchen,
2012; Kotter, J. P. and J. L. Heslett, 2011), little
research has looked explicitly at the relationship
between culture and executive compensation in
organizations.
The purpose of executive compensation systems
is to increase organizational effectiveness.
Effectiveness may be interpreted as synonymous with
the goal of publicly held corporations to maximize
shareholder wealth subject to certain social
constraints (Freeman and Parmar, 2007). Executive
compensation systems are thus directed towards
aligning executive compensation systems with
shareholder wealth (Balachandran, Joos, and Weber,
2012; Lee and Widener, (2013). This frequently takes
the form of equity bonuses whose value depends on
the price of the firm’s stock (Chng, et. al., 2012).
2. Executive Compensation Theory
Research has found that higher equity compensation
levels for executives do not necessarily enhance
shareholder wealth. Martin, Gomez-Mejia, and
Wiseman, (2013) have shown that equity based pay
affects the risk behavior of executives. The risk
sensitivity of equity compensated executives may
manifest itself either in undue risk aversion or in
excessive and imprudent risk-taking, neither of which
outcomes necessarily maximize shareholder wealth.
The relationship between executive equity
compensation and firm strategy is seen as highly
nuanced and complex and dependent on a large of
array of institutional and contextual factors (Devers,
McNarama, Wiseman, and Arrfelt, 2008; Weisbach,
2007). While the current state of behavioral research
on executive equity compensation is inconclusive, this
study has focused on the outcome of executive
compensation on organizational effectiveness rather
than the behavioral factors which lead to that
outcome.
The popular and academic literatures on
executive compensation suggest that this
compensation is often both out of line with
organizational performance and outrageously high
(Lawler, 2012; Lin, et. al., 2013). A research study
by Bebchuk and Fried (2004) suggested that executive
compensation systems often fail to accomplish the
goal of aligning the corporate and personal interests
of executives. The thesis they hypothesized has come
to be known as The Managerial Power Theory of
executive compensation, which argues that current
corporate governance practices distort executive
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240
compensation goals because the executives
themselves exert direct and indirect influence over
their compensation practices (Schneider, 2013). A
large body of evidence suggests that executives do in
fact exert various types of influences on their
compensation packages (Balachandran, Joos, and
Weber, 2012; Chng, et.al. 2012; Bebchuk, Fried and
Walker, 2002).
Management Power Theory may be contrasted
with Optimal Contracting Theory which assumes an
arms-length relationship between top executives and
the Board of Directors (Dorff, 2005). Compensation
thus reflects an exogenous market judgment rather
than the endogenous use of personal influence.
Optimal Contracting Theory may be viewed from the
perspective of “Principle-Agent Theory” in which the
principles (shareholders) attempt to get the agents (top
executives) to act according to the principles best
interests (Allen and Winton, 1995). The basic
problem with Optimal Contracting Theory is that the
ability to align executive and shareholder interests
requires solving significant information and
coordination problems which are in fact, so complex
that current corporate governance protocols assume
away such coordination problems (Hermalin and
Weisbach, 2012). Thus, any contract resulting from
negotiations between the CEO and the board is, de
facto, an optimal contract (Cao and Wang, 2013;
Weisbach, 2007).
3. Organizational Effectiveness
This study uses Tobin’s q as a measure of
organizational effectiveness. While organizational
performance has many different facets, an exogenous
market-based value for measuring overall
organizational effectiveness is provided by Tobin’s q,
the ratio of enterprise value (shareholder wealth and
the market value of debt) divided by book value.
Bolton, Chen, and Wang, N. (2011) have shown that
the relationship between Tobin’s q at the margin
determines investment preferences subject to the
constraints of capital structure. From an investor’s
perspective a preference is shown for using Tobin’s q
consistently used as a good measure of firm
performance (Semmler and Mateane, 2012).
McFarland contrasted Tobin’s q with other measures
of corporate performance in a simulation and found
that Tobin’s q was better correlated with true
performance than the accounting rate of return
(Stevens, 1990; McFarland, 1988).
4. Organizational Culture While this study posits two polar organization
cultures, traditional and positive, it is recognized that
real world organizations frequently have
heterogeneous cultures, embracing elements of both
sets of shared values. Nevertheless, organizations
may be said to have distinct personalities reflecting a
greater or lesser degree of traditional and positive
cultures (Reigle, 2013; Bradley-Geist, and Landis,
2012; De Vries, Kets, and Miller, 1986). Differing
management styles between traditional and positive
organizations and have been found to reflect differing
assumptions about the behaviors and values of
organization members (Seligman, 2004; Hoffman, et.
al., 2011).
An organization may be said to have a
distinctive personality reflecting the shared values,
norms and ethics of its members. Cameron and
Quinn (2011) identify organization personalities
within a Competing Values Model that differentiates
among organization on the values attached to
collaboration, competition, controlling and creativity.
Within this context flexibility and control are seen as
two differentiated sets of values. Flexibility values
encourage individuals to be open to change, and
spontaneously adapt and respond to that change to
accomplish organizational objectives. Control values
presume a stable and predictable environment where a
formal adherence to rules and conformance to
precedent are the keys to organizational success.
French and Holden (2012) found the type of
organizational culture impacts both how organizations
communicate and how they respond to crisis.
Particularly relevant to executive compensation
patterns was the finding of a strong relationship
between risk preferences and organization culture
(Cooper, Faseruk, Khan, 2013). Kimbrough and
Componation, (2009) also found that traditional
(mechanistic) and positive (organic) cultures
influence enterprise risk management practices.
4.1 Traditional Organizations Culture in traditional organizations is task oriented
with decisions made using a technically rational
framework characterized by tight worker controls
accomplished through a rigid hierarchy, direct
supervision and a set of policies and rules designed to
limit worker discretion. The culture in traditional
organizations focuses directly on the tasks to be
completed to achieve productivity—indeed, Frederick
Taylor often advocated replacing the “Principles of
Scientific Management” with the “Principles of Task
Management” (Wrege and Hodgetts, 2000).
The concept of management control is
surprisingly amorphous, but as the concept has
evolved it may be described as systematically
approaching organizational objectives by constraining
the actions of individual organization members
(Bredma, 2011). The spirit of what control is all
about my be found in Frederick Taylor’s emphasis on
a systematic and detailed solutions to problems of
cost reduction (Taylor, 1911; Wrege and Hodgetts,
2000)
Walton (2005) found bureaucratic rule-making
relevant to the goals of modern corporations. In
bureaucratic organizations rules are more frequently
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241
violated when the context of the organization changes
and performance suffers (Lehman and Ramanujam,
2009). West and Raso (2013) found rule-making
activities intensified among government agencies
when outcomes were defined in economic terms. It is
axiomatic among organization theorists that a great
danger in traditional organizations is that of excessive
control or a mismatch of control mechanisms to the
organization’s environment can damage
organizational effectiveness (Liu, Liao, and Loi,
2012); Harris, Harvey, Harris, and Cast, 2013).
In traditional organizations behavioral controls
emphasize negative sanctions against undesirable
behaviors. Traditional organizations assume people
are inherently irresponsible, prefer to be directed, and
dislike responsibility (Kopelman, Prottas, and Falk,
2012). This perception of workers creates an
approach to management focusing on punishment and
limiting worker discretion. (Jacobs, 2004; Lehman
and Ramanujam, 2011). These assumptions may be
expressed in an autocratic management style which
seeks to control worker behavior through the use of
tangible rewards such as pay and bonuses as well as
through the avoidance of threats and discipline
(Bolino and Turnley, 2003). Autocratic leaders in
traditional organizations are feared (Liu, Liao, and
Loi, 2012; Harris, et. al., 2013).
4.2 Positive Organizations
The culture in positive organizations focuses on the
emotional state of the workers to accomplish the tasks
necessary to accomplish productivity. In positive
organizations the goal is to have engaged workers
flourish in an atmosphere of proactivity, creativity,
curiosity, compassion, hope, and self reliance
(Cameron and Spreitzer, 2012; Avey, Luthans, and
Jensen, 2009; Bono, Davies, and Rasch, 2012;
Seligman, 2011).
Positive organizations focus on developing
members who thrive in an environment that calls for
personal freedom vitality, self-reliance and creativity.
Glynn and Watkiss (2012) have noted the importance
of cultural symbols in affirming the behaviors of
individuals in a positive organization. Such symbols
may be said to have generative potency for
individuals that results in enriched collective
strengths, virtuous behavior and increased capability.
Schein (1988) has found compensation to be an
important tacit cultural symbol for determining
behavior. This implies that compensation systems in
positive organizations have a moral dimension which
is not necessarily present in traditional organizations.
Thus culture may be expected to influence
compensation systems in positive organizations.
A requirement for the creation of positive
organizations is “authentic leadership” (Luthans and
Avolio, 2003; Dhiman, 2011). Authentic leadership
has many facets but the essence of this type of
leadership appears to be a leader who is “true” to
himself or herself (Avolio and Mhatre, 2012). Such a
leader has genuine concern for the well-being of all
organization members and is never Machiavellian or
false. Authentic leaders are trusted (Mishra and
Mishra, 2012). If it may be assumed that individuals
are in fact, self-actualizing, then it may be inferred
that positive organizations will be perceived by such
individuals as good places to work.
4.3 The Impact of Organizational Culture
Recent research has found that the state of the
organization, as opposed to the traits of individuals in
the organization, can play a significant role in
promoting desirable outcomes (Kluemper, DeGroot,
and Choi, 2013). Barney (1986) suggests that
organization culture can be a source of sustained
competitive advantage. While it cannot be
unequivocally stated that positive organizations will
perform better than traditional organizations, the bulk
of behavioral research suggests this is so (Wright and
Quick, 2009). The most recent research finds that a
positive orientation in an organization increases
productivity and organizational success (Cheung,
Wong, and Lam, 2012). Mussel (2013) found that
curiosity, a trait outcome in positive organizations,
was positively related to job performance. Further
research suggests that when new organization entrants
perceive their relationship with the organization as
supportive, caring, and entailing positive social
exchanges they become increasingly committed to the
organization (Allen and Shanock, 2013). Rich,
Lepine, and Crawford, 2010) found the job
engagement of organization members to be an
important factor in job performance.
5. Methodology
Positive organizations in this study were identified
from a data base created to find the “100 Best
Companies to Work For” (Moskowitz, Levering,
Akhtar, Leahey, and Vandermey, 2013), which was
constructed by Fortune Magazine in partnership with
the Great Place to Work Institute (GPWI).
Inclusion in this database was based on a score
that derived from a company’s “Trust Index” and
“Cultural Audit” created by GPWI. Employees in
259 firms were randomly surveyed to create a “Trust
Index.” The survey asked questions related to their
attitudes about management's credibility, job
satisfaction, and camaraderie in the organization.
Two-thirds of a company's total score were based on
the results of the institute's “Trust Index” survey. The
other third was based on responses to the institute's
“Culture Audit”, which includes detailed questions
about pay and benefit programs and a series of open-
ended questions about hiring practices, methods of
internal communication, training, recognition
programs, and diversity efforts. For the purposes of
this study, the top 100 scoring firms by the Great
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242
Place to Work Institute were classified as positive
organizations. This universe was then paired down to
37 firms by excluding companies domiciled overseas
and companies that are not publicly traded
corporations.
A comparable group of organizations were then
surveyed to determine if they could be classified as
traditional organizations. This determination was
made through an examination of their current Annual
Report for statements that reflected a commitment to
a command and control hierarchical management
style. Thirty seven such comparable organizations
were then identified as traditional. (See Table 1
below.)
This study then further disaggregated traditional
and positive organizations by those organizations
identifying named female executives. Organizations
with female other named executives were selected for
further study because an organization having women
who have penetrated the glass ceiling may be
characterized by a differentiated set of cultural values.
SEC rules on compensation disclosure require
organizations to name specific executives as
organizational leaders in their 10-k reports.
6. Characteristics of Organizations Studied
As can be seen from Table 1, little difference in the
average performance characteristics of traditional and
positive organizations surveyed in this study can be
found. However the variance within both
distributions is large. For example, the range for
Tobin’s q in traditional organizations was -3.52 to
2.71 while the range for positive organizations was -
.45 to 1.51. It may be that systematic differences in
organizational effectiveness between the two types of
organizations exist apart from central tendencies.
Table 1. Study Organizational Characteristics
Similarly Table 2 shows little difference in the
average compensation levels between the two types of
organizations. As above, however, the variance
within the average is large. The standard deviation for
total compensation for CEOs in traditional
organizations was $14.939 million and $7.49 million
in traditional organizations. The larger variance for
CEO compensation in traditional organizations
compared to positive organizations may be interpreted
to suggest that compensation practices differ between
the two types of organization.
Table 2. CEO Compensation Patterns
Traditional and Possitive Organizations
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7. Analysis
In examining the relationship between executive
compensation and organizational effectiveness, we
hypothesize a negative relationship between CEO
compensation and organizational effectiveness,
consistent with most research on this topic (Bebchuk
and Fried, 2004:Weisbach, 2007; Dorff, 2005). We
will further hypothesize that this relationship does not
hold for positive organizations because the power of
the CEO in positive organizations is mitigated by an
internal value system that would consider excessive
compensation a violation of that culture (an internal
“outrage” effect).
The model utilized also contains a dummy
variable to control for the presence of founding CEOs
(1 if present, 0 if not). The reason for this is that
founding CEOs often own so much equity in the
company, that further compensation is
inconsequential. As a result, they take a nominal
salary or bonus.
Executive compensation can have a number of
different dimensions (Ozkan, Singer, and You, 2012).
While the literature distinguishes between fixed
compensation in the form of salary and equity
compensation resulting from the grant of stock or
stock options, this study has found the two measures
of compensation highly correlated in both traditional
and positive firms. As most of the controversy about
executive compensation centers over the equity
element of compensation, this study will focus on that
variable (Balachandran, Joos, and Weber, 2012; Cao
and Wang, 2013; Jensen, 1986).
Assuming the validity of the Management Power
Theory for traditional organizations, we hypothesize
that CEO equity compensation is negatively related to
organizational effectiveness. That is, CEOs in
traditional organizations are able to enhance their
compensation in spite of the lack of their positive
impact on organizational effectiveness. As founding
CEOs already have large equity holdings it may be
assumed that they are particularly committed to a goal
of organizational effectiveness. Consistent with the
literature we will also hypothesize that the size of the
firm (as measured by sales) will be positively related
to organizational effectiveness as a result of increased
market power and cost efficiencies consistent with
increased economies of scale ((Jensen, 1986;
Weisbach, 2007; Lin, Hsien-Chang, and Lie-Huey,
2013). The Return on Equity (ROE) will be used as a
variable to control for short-term performance issues.
Thus for traditional organizations:
H(1) Tobin q = a - b1(Founder CEO) –
-b1(CEO Equity Compensation) + b2(Size) +
+ b3(ROE)
H(1) is tested for traditional organizations in
Table 3 below. For traditional firms, the presence of
a founding CEO and the equity compensation of
CEOs exhibit a strong and significant negative
relationship to organizational effectiveness. Size was
also found to be significantly related to organizational
effectiveness, consistent with established research on
this topic. ROE was not found to be significantly
related to organizational effectiveness, suggesting that
this inherently short-term measure of performance is
not associated with the long-run performance of the
organization as judged by the market. Alternatively
an explanation of the absence of a significant
relationship between ROE and organizational
effectiveness may reflect a market judgment that the
earnings on which the ROE calculation have been
‘managed” and are not creditable (Louis and Sun,
2011).
These findings suggest that executive equity
compensation in traditional organizations is
frequently determined by the exercise of managerial
power rather than an arms-length principle-agent
transaction for all traditional firms.
Table 3. Determinants of Organizational Effectiveness in Traditional and Positive Cultures
Founder/ CEO Equity
Intercept CEO ROE Size Compensation R2 F Test
All Traditional .990 -.587* -.005 .359** -.310**
Firms (-4.336) (-.038) (2.603 (-2.144) .434 6.144
All Positive .617 .159 .403** -.047 .002
Firms (.959) (2.376) (-.268) (.011) .178 1.730 Linear regression with Tobin’s Q as the dependent variable. T values in parentheses.
* significant an p = .01, ** significant at p = .05, *** significant at p = .10, one-tailed test.
In contrast, it is hypothesized that the negative
relationship between CEO equity compensation and
organizational effectiveness will not hold for Positive
Organizations because concern with the emotional
state of organization members acts as a constraint on
CEO excesses and CEO compensation is an important
symbol of the authenticity of that CEO. It is further
hypothesized that ROE will be positively associated
with organizational effectiveness because the
relationship between short-run performance and long-
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244
run performance has more credibility in an
organization whose members are fully engaged and
personally committed to organizational goals. Size is
also expected to be a significant determinant of
organizational effectiveness as above.
Thus, for Positive Organizations
H(2) Tobin q = a + b1(Founder CEO) + b1(CEO
Equity Compensation) + b2(Size) + b3(ROE)
Table 3 shows that neither the presence of a
founding CEO or CEO Equity compensation in
positive organizations is significantly related to
organizational effectiveness. While this is not the
same thing as the expected significant positive
relationship between CEO equity compensation and
organizational effectiveness, the absence of the
significant negative relationship found in traditional
firms does suggest that positive organization culture
does exert a mitigating influence on executive power.
Table 3 also shows ROE to be significantly and
positively related to organizational effectiveness in
Positive Organizations. This is interpreted to reflect a
market belief in the validity of reported earnings in
organizations where individual members are not
passive automatons doing as directed, but actively
engaged individuals committed to organizational
goals. The absence of a significant relationship
between size and organizational effectiveness,
suggests that the gestalt found in a positive
organization is more important to organizational
effectiveness than the power conveyed by market
share or cost efficiencies contingent on size.
It may be concluded from the results of Table 3 that
the Managerial Power Theory of executive
compensation in traditional organizations provides a
more likely explanation of executive compensation
patterns than Optimal Contract Theory. It may also
be inferred from Table 3 that organizational culture in
positive organizations can act as a constraint on the
power of the CEOs to determine their compensation.
8. The Impact of Named Female Executives A further line of inquiry in this study is the impact of
named female executives in an organization on the
effectiveness of that organization. It is not
hypothesized that the mere presence of female
executives increase organizational effectiveness, but
that the presence of those named female executives
says something about the nature the organization’s
culture and how that culture affects organizational
effectiveness. If the presence of female named
executives reflects cultural characteristics of an
organization that enhance organizational effectiveness
it may also be expected that their presence impacts the
relationship between executive compensation and
organizational effectiveness because an organization’s
culture itself affects executive compensation patterns.
Therefore we hypothesize for traditional organizations
without named female executives:
H(3) Tobin q = a - b1(Founder CEO) – b2(CEO
Equity Compensation) + b3(Size) +
b4(ROE)
And for traditional organizations with named female
executives
H(4) Tobin q = a + b1(Founder CEO) + b2(CEO
Equity Compensation) + b3(Size) +
b4(ROE) + b5(Female Executive
Compensation)
These hypotheses are tested in Table 4 following.
Table 4. Determinants of Organizational Effectiveness
In Traditional Firms with and without Named Female Executives
Named female
Founder/ CEO Equity Equity
Intercept CEO ROE Size Compensation Compensation R2 F Test
Trad. Firms 1.292 -.767* -.421** .644** -.542** .610 8.598
W/O Named (-5.313) (-2.267) (3.612) (-3.348)
Female Exec.
Trad. Firms .820 1.267 .205 -.662 .789 .396 .820
With Named (1.633) (.118) (-.790) (.466)
Female Exec. Linear regression with Tobin’s Q as the dependent variable. T values in parentheses.
* significant an p = .01, ** significant at p = .05, *** significant at p = .10, one-tailed test
It can be seen from the results presented in Table
4, that even in traditional organizations the presence
of named women executives changes the relationship
between executive compensation patterns and
organizational effectiveness. In traditional
organizations without named female executives the
negative relationship between the presence of a
founder CEO and CEO equity compensation that was
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245
found in Table 3 continues, but the association or
ROE with organizational effectiveness is found to be
both strong and negative. This negative relationship
may reflect a market suspicion that earnings have
been managed. Size continues its positive association
with organizational effectiveness and ROE continues
to be negatively related to organizational
effectiveness. As above, this may be interpreted as a
strong confirmation of the Managerial Power Theory
because CEO compensation is able to rise above the
consideration of short term performance indications.
In testing H(5) when named female executives
are present in traditional organizations, the negative
relationship between CEO compensation and
organizational effectiveness disappears, as does the
relationship between organizational effectiveness with
size and ROE. Certainly, there is something about a
culture which sanctions the presence of named female
executives which constrain the exercise of CEO
power to influence their own compensation. One
interpretation of this state of affairs is that such a
culture is more rational than a culture without named
female executives. This would be because the market
is gender neutral with respect to executive ability and
the presence of females above the glass ceiling
testifies to that rationality. The absence of a
significant relationship between ROE and Size and
organizational effectiveness may provide further
evidence of that rationality. This may mean that
executive compensation is more reflective of Optimal
Contracting Theory in organizations with named
female executives present.
In testing H(5), for positive organizations
without named female executives the impact of
named female executives on the relationship between
organizational effectiveness and executive
compensation would be expected to be even greater
than found in the testing of H(4). Therefore we
hypothesize for Positive Organizations without named
female executives
H(5) Tobin q = a + b1(Founder CEO) + b2(CEO
Equity Compensation) + b3(Size) + b4(ROE)
This hypothesis is tested in Table 5. Table 5
confirms the results of Table 3 for positive
organizations without the presence of female named
executives. No systematic impact may be found
between organizational effectiveness and the presence
of a CEO founder, ROE, Size, or CEO Equity
Compensation. All of which may be interpreted if not
as support for the presence of an Optimal Contract
paradigm in the organization, the absence of a system
where executive compensation is self-determined.
Based on the above findings it would appear that
the strongest case for an Optimal Contracting Theory
of executive compensation would be made in positive
organizations with named female executives.
This hypothesis is tested in:
H(6) Tobin q = a + b1(Founder CEO) + b2(CEO
Equity Compensation) + b3(Size) + b4(ROE)
+ b5(Female Executive Compensation)
Table 5. Determinants of Organizational Effectiveness
In Positive Firms with and without Named Female Executives
Named Fmale
Founder/ CEO Equity Equity
Intercept CEO ROE Size Compensation Compensation R2 F Test
Positive .810 .119 .290 -.106 -.146 .150 .925
Firms (.563) (1.355) (-.508) ( -.705)
W/O Named
Female Exec.
Positive Firms -.185 .857* .912* -1.114** .526*** 1.096** .880 7.339
With Named (4.238) (4.468) (-2.964) (2.339) (3.052)
Female Exec.
Linear regression with Tobin’s Q as the dependent variable. T values in parentheses.
* significant an p = .01, ** significant at p = .05, *** significant at p = .10, one-tailed test
As can be seen in Table 5 above, the testing of
H(6) provides strong evidence for an Optimal
Contract Theory of executive compensation. Both the
presence of a founding CEO and CEO Equity
Compensation are significantly and positively related
to organizational effectiveness. The essence of
Optimal Contract Theory is that CEO compensation is
tied to organizational performance. In H(6) that
relationship is clearly seen. The fact that ROE is also
positively related to organizational effectiveness can
be taken as further evidence of the rationality which
pervades the positive organization. The negative
relationship between size and organizational
performance can be interpreted to mean that the
power of engaged, flourishing individuals who are
committed to the success of the organization are more
important to performance than any legacy attributes of
the organization.
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246
Conclusion
Executive compensation in an era of economic turmoil remains a socially contentious issue. The argument can
be made that executive pay merely reflects the market valuation of a scarce resource. What appears to be
excessive compensation for such executives is said to reflect the value of a very scarce resource. That executive
compensation represents an optimal contract between a CEO and the shareholders.
Alternatively, it can be argued corporate executives have effectively contravened the underlying
framework of corporate governance and unjustly enrich themselves through the exercise of their power at the
expense of shareholders and society. Under vthese circumstances, executive compensation can be explained by
the exercise of raw Managerial Power.
This study finds that organization culture can have a strong impact on executive compensation and the
conventions surrounding it. Executive compensation in traditional organizations is generally found to reflect the
exercise of managerial power. The culture of a positive organization is found to constrain the exercise of that
power and to create a more rational and market driven setting for compensation negotiations between a CEO and
the Board of
Directors which increases the possibility of creating an optimal contract between the CEO and the shareholders.
A further finding of this study is that the presence of named female executives reflects cultural attributes in both
types of organization that create a setting for an optimal contract between executives and shareholders.
Insofar as executive compensation is seen as a social problem that needs to be addressed, these finding
suggest that a top-down approach to executive compensation is unlikely to work as long as the values in the
organization are conducive to the exercise of unjust management power. In contrast, a bottom up approach,
beginning with the creation of a positive organization in which engaged and committed workers characterized by
tacit assumptions of fairness and ethical propriety will naturally limit the abusive exercise of management
power.
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