Managerial Ownership and Firm Value: Evidence from China’s Civilian-run Firms

Wenjuan Ruan

School of Accounting and Finance

University of Wollongong, NSW, 2522

Tel: (61) - 2 4221 5528

Email: wenjuan@uow.edu.au

Gary Tian

School of Accounting and Finance

University of Wollongong, NSW, 2522

Tel: (61) - 2 4221 4301

Email: gtian@uow.edu.au

Shiguang Ma

School of Accounting and Finance

University of Wollongong, NSW, 2522

Tel: (61) - 2 4221 3312

Email: shiguang@uow.edu.au

This version: August 15, 2009

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Managerial Ownership and Firm Value: Evidence from China’s Civilian-run Firms

Abstract The conflict of interest between managers and shareholders reminds us of the necessity for an

appropriate level of managerial ownership that ensures management decisions align with the benefit

of shareholders. Prior evidence has demonstrated associations between managerial ownership,

financial decisions and firm value in developed markets. This paper extends prior research by

examining the influence of managerial ownership on firm performance through capital structure

choices using examples of China’s civilian-run listed firms from 2002 to 2007. The empirical results of OLS regressions on civilian-run listed firms replicate the nonlinear

relationship between managerial ownership and firm value. Managerial ownership also drives the

capital structure into a nonlinear shape, but with an opposite direction to the shape of managerial

ownership on firm value. The results of simultaneous regressions suggest that managerial ownership

impacts capital structure, which in turn, affects firm value. We also prove the endogeneity of capital

structure in China’s civilian-run listed companies.

Keywords: Managerial Ownership; Capital Structure; Firm Value; Civilian-run Firms

JEL Classification: G31; G32, G34

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1 Introduction

The effects of managerial ownership on firm value have been of particular research interest in

corporate finance (Denis and McConnell, 2003). It is generally known that managers’ and

shareholders’ interests are not fully aligned. The conflict of interest between management and

shareholders incurs agency problems that reduce firm value. Thus, increase of managerial ownership

from a low level not only helps to connect the interests of insiders and shareholders, but also leads to

better decision making leading to a higher firm value. However, when the equity owned by

management gets to a certain level, the increase of managerial ownership may provide managers

with greater freedom to pursue their own benefit without fear of decreasing firm value. Only, when

managerial ownership approaches a considerably high level, the agency problem can be largely

mitigated and the firm value is able to be maximized. The managerial ownership and firm value,

therefore, is hypothesized as a nonlinear relationship.

However, most cited literatures focused on the relationship between managerial share holding

and firm performance in the developed market. To some extent, because of the absence of strong

legal protections and other governance mechanisms, agency problems in many emerging markets are

relatively more severe than that in developed countries (La Porta et al., 1998; Wei et al., 2005).

Claessens and Djankov (1999) examined the relationship between management equity incentives

and firm performance for 706 Czech firms. They found and suggested that firm profitability changes

in human capital are quite important in bringing about improvement of corporate performance in

transition economies. Bunkanwanicha et al. (2008) investigated the relation between debt,

managerial behaviour and firm performance in Thailand and Indonesian markets. Their results

highlight the importance of the country-specific institutional settings in this issue.

In the drive to achieve transition aim from planned and command economy to market economy,

China established two stock markets of Shanghai Stock Exchange in 1990 and Shenzhen Stock

Exchange in 1991. In the initially several years after the market established, most listed companies

came from state-owned enterprises (SOEs); later on many non-state-owned companies have been

listed on the market as well. The recent widely recognized categories of equity ownership in China’s

listed firms are as state-owned ownership, legal-person ownership, civilian ownership, foreign

investor ownership, collective ownership, social groups ownership, employee ownership etc, which

are quite different from those in developed countries. With the development and maturity of listed

companies and capital markets, more and more China’s companies are prone to adopt western

corporate governance. Managerial ownership is one of these practices.

Another unique characteristic of the Chinese market is the rapidly growing number of civilian-

run firms. The civilian-run companies were built up by the natural persons, rather than the central or

local government or existing legal entity. Some of them have become listed firms through IPO

process or via takeover of a listed firm. Compared to state owned enterprises (SOEs, it implies the

companies with largest ownership belonging to the state), the civilian-run firms have much more

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autonomy and profit retention; and managers are being appointed on merit and ability rather than

political patronage. Most of these companies adopt managerial ownership governance, managers

even have more power to choose financial policies compared to those in many other developed

countries. This situation gives managers of civilian-run firms more discretion over funding, pricing,

and labor practices (Firth, Fung and Rui, 2006). Moreover, China has a relatively underdeveloped

legal environment in comparison with U.S.A, U.K and other developed countries, which would

make the implementation of managerial ownership more complicated. Our study of the Chinese

market may shed light on this relevant financial issue within a non-western environment, thereby

giving us some relevant information about how to improve the efficiency of an emerging and

transitional economy.

We chose China’s civilian-run companies as the research focus because: first, these companies

have a similar managerial ownership mechanism to the developed markets as the development and

implementation of modern corporate governance. Second, the civilian-run firms represent the trend

of the public firms in further economic reform of China. Finally, the managerial ownership is too

small in the state owned companies, and is not appropriate to be used as examining the conflict of

interests between insider and outsider shareholders. This gives rise to a large separation of cash flow

rights and control rights by insiders (Wei et al., 2005). When we investigated state ownership

dominated firms from Shanghai and Shenzhen security exchanges, the mean value of managerial

ownership over 2002 to 2007 is just 0.000929, and the median value is 0.00000798. While the

numbers of civilian-run companies are close to those in developed countries (mean value 0.0931;

median value 0.0009); it was possible for management in these firms to boast about their power to

choose financial policies similar to what happens in other developed countries, thus catering for their

self-interests in financial polices.

In this study, by using OLS regression, we replicate the nonlinear relationship between

managerial ownership and firm value, which are stated in Morck et al. (1988) and Cho (1998)’s

research. However, we find that the turning points of managerial ownerships with respect to the firm

value have moved upward with Chinese civilian-run companies. For example, the turning points of

companies in developed countries are 5% and 25% in Morck et al. (1988) and 7& and 38% in Cho

(1998). By contrast in our regression results, they are 18% and 64% of managerial ownership when

the line of firm value gets turned. We argue that in Chinese corporate governance backgrounds,

managers need more ownership to control the firm for their own benefits, or to be motivated to align

their own benefit with shareholders’ interest.

Moreover, managerial ownership drives the capital structure as a nonlinear shape as well, due

to managerial entrenchment (Friend and Lang, 1988; Berger et at 1997). However, the directions of

the nonlinear shapes for managerial ownership and firm value and for managerial ownership and

capital structure are oppositely related. Finally, we find that the direct influence of managerial

ownership on firm value becomes insignificant when capital structure is taken into consideration.

The results from simultaneous regressions show that managerial shareholding significantly impacts

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capital structure, which in turn, affects firm value. The results of simultaneous equations also show

that capital structure is endogenously determined in equilibrium in China’s civilian-run listed

companies.

The remainder of this paper is organized as follows. Section 2 is the literature review and

theoretical predictions about the relationship among managerial ownership, debt policy and firm

value. Section 3 explains the sample selection and interprets the summary statistics. Section 4

contains the empirical specifications and results, where we also discuss the methodology and models

employed in this study. Section 5 concludes this research.

2 Literature review and theoretical predictions

There has been much research indicates that managerial ownership affects corporate value

because equity holding by management could motivate managers to make financial decisions for

their own benefit or base on shareholders’ interest, thereby leading to decrease or increase in firm

value (Morck et al., 1988; McConnell and Servaes, 1990; Short and Keasey, 1999; Miguel et al.,

2004). “The effectiveness of these incentives is potentially a function of the level of managerial

ownership in the firm”（Davies et al. , 2005, pp. 647). Some published papers have provided

evidence that support the nonlinear relationship hypothesis. Other research has shown that the

relationship between managers and shareholders has the potential to influence financial decision-

making, which in turn impacts upon firm value.

The pioneering work about the relationship between managerial ownership and firm value is

from Morck et al. (1988), they used piecewise linear regressions to estimate the relationship between

Tobin’s Q and the shareholdings of the board of directors for 371 Fortune 500 firms in 1980. They

found a positive relation between ownership and Q in the 0% to 5% board ownership range and

beyond 25%, which was dominated by the convergence of interest effect of management. While

there is a negative and less pronounced relation in the 5% to 25% range, in which the entrenchment

effect overpasses the convergence of interest effect. Whereafter, McConnell and Servaes (1990)

used regression of Tobin’s Q and the fraction of shares owned by corporate insiders for firms in

1976 and 1986 to find their curvilinear relationship. Short and Keasey (1999), Miguel et al. (2004)

studied the association of management ownership and corporate value using the data of UK and

Spanish and found the similar conclusion respectively. Davies et al. (2005) echoed above

conclusions but extended the specification of management holdings from cubic to quintic and found

the similar nonlinear relationship between managerial ownership and firm value. All of these above

research literatures constitute the significant basement for the research of entrenchment and

convergence of interest effect arose from managerial stock ownership and firm valuation.

Meanwhile, the issue about how managerial ownership affects corporate value is also important.

Brailsford et al. (2002) argued that corporate managers and external block owners are two key

groups of shareholders who have powerful influence on the decisions in a firm’s resource allocation.

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Cho (1998) found managerial ownership impacts upon firm value because shareholding motivates

management to make investment decisions on their own or for shareholders’ benefit, which

consequently affects firm performance. Leverage choice is another important financial decision in

addition to investment policy and has various effects on firm value, which has been proved by

classical corporate financial literature (Modigliani and Miller, 1963; Ross, 1977; Myers, 1977;

Jensen, 1986 etc). Ruan et al. (2009) employed a relatively recent data set that comprises of firms

identified as S&P 500. They observed that capital structure can also act as an intermediate variable,

which is affected by managerial ownership but eventually influences firm value.

Since the inaugurated literature by Jensen and Meckling (1976), the relationship between

capital structure and firm performance is always a prevalent issue in financial area. Corporate

governance theory predicts that financial leverage influences agency costs and thereby affects

corporate value. It is suggested the greater financial leverage could help mitigate agency costs by the

threat of acquisition and financial distress, which causes personal losses to managers of salaries,

reputation, perquisites, etc. (e.g., Grossman and Hart, 1982; Williams, 1987) McConnell and

Servaes (1995) investigated equity ownership and the effectiveness of leverage choice to find the

“two faces” relation between firm value and debt. As they conjectured, corporate value is positively

correlated with the level of debt financing for firms with few growth opportunities; while firm

valuation is negatively correlated with the debt level for those with high growth opportunities.

However, a large of literatures regarding determinants of capital structure considers firm value as an

important factor influencing corporate capital structure (Titman and Wessels, 1988; Ozkan, 2001;

Korajczyk and Levy, 2003 etc.) So the mixed results in the prior study impel academics to develop

whether there is a reverse causation from performance to capital structure, which reflects the

endogeneity of capital structure. Berger and Patti (2006) firstly employed simultaneous-equation

model to research the possibility of reverse causality from firm value to capital structure in banking

industry. They used profit efficiency as an indicator of firm value and acquired satisfactory effect

which is not only economically significant and statistically significant, but hold by a number of

robustness checks.

The theoretical evidence about how managerial behavior influences financing behaviors

directly and indirectly is just emerging in the middle of last decade. Zwieble (1996) developed a

model in which managers choose debt by their own interest for empire-building. Novaes (2003) set

up a managerial model to explore how self-interested managers expropriate firm value by the tool of

leverage. Wang (2008) developed a contingent claims model to explain the role that shareholder-

manager conflicts play in risk choice and financing decisions. An average managerial entrenchment

power of approximately 2.5% of asset value for the S&P 500 firms was predicted in his model. The

empirical support for entrenchment rising from managerial ownership affecting leverage decisions is

quite limited. Friend and Lang (1988) examined whether managerial entrenchment induced by

insiders’ equity holding “at least in part” motivates capital structure decisions on a serious-year basis.

Berger et al. (1997) used cross-sectional analysis to find evidence that firm leverage is affected by

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the degree of managerial entrenchment and entrenched managers seek to avoid debt. Brailsford et al.

(2002) used evidence of Australia to get a nonlinear relation between the level of equity steak owned

by insiders and capital structure measured by debt-equity ratio, and supported the effects of

convergence-of-interests and management entrenchment.

However, the literature previously cited largely focus on the relationship between managerial

share holding, financial policies and firm value in developed economies. Debate on whether such a

relationship has universal relevance in corporations within emerging markets is not yet resolved.

Several recent articles studied corporate governance in emerging (or transition economy) markets,

focusing on the relation between ownership structure and firm value (Lins, 2003; Wei, et al., 2005

etc.). All these studies found that there is a nonlinear relationship between managerial ownership

and firm value in a large number of emerging markets, revealing that management and insiders have

the ability to engage in expropriation of other shareholders’ benefits.

Corporate insiders in China’s listed companies often gain control over a firm not only by

swinging the votes their way, but also through non-pecuniary benefits, such as staff consumption,

building up “management empire” etc. So we argue that agency problems in China are more severe

due to the emerging market environment and weak legal protection for outside shareholders.

Resolving the agency problem between managers and shareholders in these companies can not help

to protect the interests of stockholders, but rather it would play a positive role in the reformation of

Chinese economic system. But as the state owned enterprises has too less of managerial ownership

as we investigated, we exclude these state-owned companies in our selected sample in this paper.

Since quick development of civilian-run companies, we focus on the issue of how managerial

behavior in accordance with shareholder ownership influences both firms’ financing behavior and

firms’ value in China’s civilian-run listed firms in this paper.

On the basis of theoretical analysis and empirical evidence from literature review, we develop

following hypotheses in this study:

H1: There is a nonlinear “N” shape between managerial ownership and firm value, which

represents the change of the alignment between managers’ interest and shareholder’s wealth in

terms of managerial ownership level.

H2: There is a nonlinear “inversed N” shape between managerial ownership and capital

structure, which represents the change of the managers’ incentive motivated by their ownership

in the firm.

H3: Managerial ownership affects capital structure which, in turn, affects firm value.

3 Data and statistics

In this study, we mainly use civilian-run enterprises listed in both Shanghai and Shenzhen

Stock Exchange. When a listed firm is finally controlled by an individual rather than the state or a

legal person or other ownership type, we define this firm as a civilian-run company. The sample

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consists of 723 observations of China’s civilian-run listed firms from 2002 to 2007. From 2001,

Chinese companies implemented the New Accounting Standards and Policies, so we start our

sample from 2002. As 2008 is the beginning year of the global financial crisis, and the Chinese stock

market fell sharply, we didn’t use data from 2008 in our study. From 2005, the China Securities

Regulatory Commission has launched the Reform of Non-tradable Shares, which is influencing the

ownership structure of listed firms. We investigate the mean percentage of tradable shares in listed

companies was increased from 41.53% in 2005 to 47.61%, 52.88% and 59.01% in 2006, 2007 and

2008 respectively. While the mean managerial ownership in civilian-run listed firms are almost the

same, as 9.88%, 10.21%, 10.07% and 10.09% in 2005, 2006, 2007 and 2008 respectively. Therefore

we consider the Reform of Non-tradable Shares from 2005 is not a matter that may alter our

evidence.

We exclude ST, PT1 firms and firms in financial and insurance industry from this subsample

first. Then we exclude firms with missing data or incomplete information for our modelling. The

final sample consists of 197 civilian-run listed firms from 2002 to 2007; which is an unbalanced

panel data set with 723 firm-year observations. All of the data are extracted from CCER database,

which is developed by the Beijing Sinofin Information Service Limited Company. But we make

some necessary supplement about the data from annual report from Shanghai and Shenzhen Stock

Exchange webpages.

Managerial ownership has been articulated in Holderness (2003) investigation of US equity

ownership by insiders and blockholders, where insiders are defined as the officers and directors of a

firm. Cho (1998) defined “insider ownership as the fraction of shares, not including options, held by

officers and directors of the board” (pp. 106). Davies et al. (2005) took managerial ownership as

having a stake in all board members’ shareholding. Following these definitions, we use ownership

stake of all board members as a proxy of managerial ownership.

Table 1 describes managerial ownership, Tobin's Q, and capital structure for the sample of 197

civilian-run enterprises from 2002 to 2007. The mean combined ownership of all board members is

9.31%, which is almost double that of 4.6% in S&P 500 firms in 2005 (Ruan et al., 2009), but still

much smaller than 12.14% of mean insider ownership in Fortune 500 firms in 1991 (Cho, 1998).

The Tobin’s Q in 2002 to 2007 ranges from 0.326 to 10.207 with a mean of 1.413. The leverage

ratio measuring capital structure ranges from zero to as large as 0.953. The mean leverage ratio is

0.481 that is almost the same as the median of 0.497. The skewness of three variables show that both

managerial ownership and Tobin’s Q are right-skewed, while leverage ratio is negative skewed. The

values of kurtosis present that the distribution of Tobin’s Q is much steeper than that of the other

two variables.

1 Chinese listed firms have been classified by the China Securities Regulatory Commission (CSRC) as “special treatment” (ST) or “particular transfer” (PT) firms for the purpose of protecting investor’s benefits. If a listed firm has negative profits for two consecutive years, it will be designated as an ST firm. If it continues to get loss for one more year, it will be designated as a PT firm. A PT firm will be delisted if it can not turn profitable within another year (Bai et al., 2002).

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[Table 1 here]

Table 2 reports the distribution of the number of observations, Tobin’s Q and capital structure

classified by different ranges of managerial ownership. Here, MANA indicates the proportion of

managerial ownership, which is the stake owned by all board members. The distribution of firm

numbers in the sample is skewed towards low levels of managerial ownership. There are 197 firms

in six years from 2002 to 2007. 505 out of 723 firm-year observations, which comprises 70% of the

sample observations show that board members have less than 5% ownership of the firms. In the

second range of 5% and 15% of ownership, there are 54 firm-year observations, which is a small

proportion of about 7% sample. Then, the left observations are allocated evenly within the ranges of

15% and 25%, 25% to 35% and 35% to 45% of stock ownership; each range consists approximately

6% of total observations. 25 firm-year observations have managerial ownership between 45% and

55%. However, the managerial holdings do span a wide range in the remaining 20 observations,

which have managerial ownership over 55%. The observations distribution is consistent with the

findings of Demsetz and Lehn (1985) and Morck et al. (1988), “suggesting the prevalence of

significant management ownership” (Cho, 1998, pp. 108).

[Table 2 here]

Table 2 also suggests that there would be a nonlinear relation between levels of managerial

ownership and Tobin’s Q. The mean Tobin’s Q increases from 1.332 in the first range of managerial

ownership to 1.473 in the second range of managerial ownership until 1.818 when managerial

ownership is between 25% and 35%. Then the mean Tobin’s Q goes down to 1.308 in the range of

35% to 45% of managerial ownership, until 1.096 in the range when managerial ownership over

55%. This distribution is accurately a non-monotonic from the results of descriptive statistics. But

the shape of Tobin’s Q profile just has one turning point rather than two as we proposed in H1. The

insufficiency of observations in the last of range of managerial ownership (over 55%) might be the

main reason of this result.

The association between the levels of equity stake owned by board members and capital

structure measured by leverage ratio is also non-monotonic as shown in Table 2. At the low level of

managerial ownership below 5%, the mean leverage ratio is 0.514. The leverage ratios decrease to

0.413, 0.397 in the following two ranges of managerial ownership. Then the leverage ratio increased

to 0.472 in the range between 25% and 35% of managerial ownership. Thereafter, the leverage ratio

falls down again to 0.405 as the value of managerial ownership is between 35% and 45%. What

interesting is, the mean leverage ratio repeats another increase to 0.465 and decrease to 0.374 once

each. This might be due to a finer classification we used in our sample. In a word, there is at least a

cubic curve between managerial ownership and capital structure from the results of summary

statistics in Table 2.

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4 Model specifications and results

4.1 Managerial ownership and firm value

In order to model the relationship between Tobin’s Q and managerial ownership (MANA) and

find out two extrimium turning points of managerial ownership when Tobin’s Q changes directions,

we specify a cubic function2 as follows:

Q=a + 1β MANA + 2β MANA2 + 3β MANA3 +Control variables +ε (1)

MANA stands for the proportion of managers’ stockownership, Q stands for Tobin’s Q, namely

firm value. The regression results with and without control variables between managerial ownership

and Tobin’s Q are in Table 3. According to the result insignificance of Hausman test, we adopt the

period random effect model with unbalanced panel data from 2002 to 2007.

[Table 3 here]

Table 3 shows the results of OLS regressions of managerial ownership and other firm

characteristics on Tobin’s Q. The intercept coefficients, which are the estimation of Tobin’s Q in

firms without managerial holdings, are 1.23 and 2.97 in equations with and without control variables.

Each coefficient about managerial ownership is of the expected sign, but the significance is not as

satisfactory as other research (e.g., Morck et al., 1988; McConnell and Servaes, 1990; Cho, 1998;

Himmelberg et al., 1999; Davies et al., 2005). MANA is significant at 5% levels in equations with

and without control variables. The squared managerial ownership (MANA2 ) has significant negative

effect on Tobin’s Q at 10% level in equation without control variables, but the coefficient is not

significant in the equation with control variables. The R square is relative larger in the equation with

control variables than that in the equation without control variables. These R squares are close to

those in other relevant papers (e.g., McConnell and Servaes, 1990; Cho, 1998; Davies et al., 2005).

We then calculate turning points by differentiating Tobin’s Q with respect to managerial ownership.

The average of two turning points of equations without control variables are:

MANA=17.5%; and MANA=64.3%

As was expected, Tobin’s Q firstly increases when managerial ownership is less than 17.5%,

and then it declines until managerial shareholding reaches to 64.3%. Finally Tobin’s Q rises again

slightly as managerial ownership is over 64.3%. This result validates Hypothesis 1 that was

2 For the number of turning points of managerial ownership to firm value, Morck et al. (1988) found two points; McConnell and Servaes (1990) modelled as a quadratic function, which had only one turning point; Cho (1998), Miguel et al. (2004) found two points following Morck et al. (1988); while Davies et al. (2005) used quintic equation and got four turning points. We don’t think the point numbers matter; however, the most important thing is how to explain the significance of each turning point. According to the theoretical predictions and results of the descriptive statistics of this study, we decided to use a cubic model, which means two extremum points and three intervals of managerial share ownership as we predicted.

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discussed in the theoretical predictions. As an N shape, at low levels of managerial ownership, an

increase in management equity holding would closely align with the interests of managers and

shareholders thereby increasing corporate value. However, at relatively high levels of managerial

ownership, an increase in management equity shareholding makes management more entrenched

and less subject to market discipline thereby reducing corporate value (Cho, 1998). When

managerial ownership goes up to a considerably high level, the interest between managers and

shareholders are fully aligned. In this situation, management would pursue best firm performance

and firm value would be increased.

This nonlinear tendency is consistent with the results of Morck et al. (1988) and Cho (1998).

However, the turning points are different. Morck et al. (1988) used a piecewise regression on a

sample of Fortune 500 firms and found two extrimum values of managerial ownership being 5% and

25%. Cho (1998) used a gird searching technology with a sample of Fortune 500 firms as well and

found the turning points of managerial ownership to be 7% and 38%. Miguel et al. (2004) used

unbalanced panel data of 135 Spanish companies and found the two turning points to be 35% and

70%.

The sample differences in firms and study period may be possible reasons for the variation in

pairs of turning points. However, we suspect that the sample differences in market background are

the main explanation for the differing turning points. Under the developed market institution, the

study by Morck et al. (1988), Cho (1998), Davies et al. (2005) gave us evidence from the American

market. In the Chinese market, because of the weak protection, management have to take a

considerable large ownership, so that they would have the interest convergence with other

shareholders. Meanwhile, the sample time in this study is more approaching to present than the

studies about American companies. We argue that, due to the evolution of corporate governances

and regulations, both in developed and emerging market, the thresholds of managerial ownership for

either self-interested decision making or interest alignment between managers and shareholders have

moved up. In other words, managers need more ownership to obtain sufficient voting power to make

decisions that are in their own interest (Ruan et al., 2009). Therefore, more managerial ownership is

required for a full interest alignment between managers and shareholders in China’s civilian-run

listed firms.

4.2 Managerial ownership and capital structure

Based on the analysis of the theoretical predictions, we here examine the relationship between

managerial ownership and capital structure. For the convenience of a further comparison, and

according to the description in Table 2, we present model (2) below by modifying model (1).

According to the insignificant result of Hausman test, we adopt the random effect model, which is

the same as we did in model (1). The regression results are in Table 4.

CS (Capital structure) =a + 1β MANA + 2β MANA2 + 3β MANA3 +Control variables +ε (2)

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[Table 4 here]

In Table 4, MANA stands for the proportion of managerial ownership, CS stands for capital

structure, which is defined as total debt divided by total assets. All the coefficients are of the

expected signs and statistically significant at the 1% level. Then we calculate points of extremum

and intersection via derivation. The two turning points of equations without control variables are:

MANA = 17.8%; and MANA = 46.4%

The results of model (2) show negative relationships between managerial ownership and

leverage ratios when managerial ownership is in the range from 0% to 17.8% or beyond 46.4%;

while a positive relationship between managerial ownership and leverage ratios exists when

managerial ownership is in the range from 17.8% to 46.4%. This result validates our prediction and

Hypothesis 2. First, when the level of managerial ownership is low, an increase in managerial

ownership has the effect of aligning management and shareholders’ interests (Brailsford et al., 2002).

The main objective of managers is to maximize shareholders’ wealth and to achieve higher firm

performance by using less debt to avert financial distress. Thus a negative relationship exists

between managerial ownership and capital structure (Berger et al., 1997). Second, as the increase of

managerial ownership, external block holders may not have the ability to prevent self-interested

managers from indulging in non-maximizing behaviour. Board members become entrenched with

significant voting power and influence and begin to manipulate the debt ratio to achieve self-

interests. For example, they may increase debt to obtain more cash, therefore make suboptimum

investment decisions or build a “management empire”. However, when corporate managers hold a

considerable proportion of a firm’s shares (over 46.4%); managers have their own interests aligned

with those of shareholders. The entrenchment effect decreases, resulting in reduced debt ratio as

managers seek to reduce bankruptcy risks, or alternatively, the agency-related benefits from the use

of debt are substituted through managerial ownership. Brailsford et al. (2002) examined the

relationship between ownership structure and capital structure with a sample of top 500 companies

listed on the Australian Stock Exchange over the period 1989 to 1995. Their results indicate a

nonlinear inverted U-shaped relationship between the level of managerial ownership and leverage

ratios. The results of this study could supplement the evidence from Brailsford et al. (2002).

The regression results of models (1) and (2) and the estimated turning points can be shown

graphically in Figure 1. The track generated by model (1) displays a nonlinear relationship between

managerial ownership and Tobin’s Q, indicating that firm value increases as managerial ownership

rises from zero to 18% of P1 at point A. Firm value then fall down as board ownership increases,

until another value of 64% of P3 at point D is reached. Finally, firm value increases slightly again for

managerial ownership levels above 64%. The relationship between capital structure and managerial

ownership is also non-monotonic, as described by the track generated by model (2). The value of

capital structure decreases to point B in managerial ownership less than 18%, and then the value of

debt ratio increases to point C until managerial shareholding reaches to point P2, which is with 46%

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of managerial ownership; while the value of leverage goes down again when the stake of managerial

ownership is over 46%. The coincidence of 64% and 46% of managerial ownership may be due to

the limited sample of observations in the ranges over 45% compared to the multitude of sample

observations in the ranges with less managerial ownership. But to the other hand this may reflect

that in China’s present institutional environment and corporate governance background, the

relationship among managerial ownership, capital structure and firm value is more complicated than

that in developed market.

[Figure 1 here]

Figure 1 clearly shows the three levels of managerial ownership. At a low level of managerial

ownership (less than 18%), external discipline and internal controls or incentives dominate

managers’ behaviour (Fama, 1980; Davies et al., 2005). Managerial labour markets operate on the

principal that poorly performing managers can be removed and appropriately disciplined (Davies et

al., 2005). Managers have sufficient incentive to adopt financial policies such as debt decisions that

avert financial distress and achieve better firm performance. As the level of managerial equity

ownership rises beyond a certain level (approximately 18%), managerial objectives begin to be

entrenched. Internal mentoring and external discipline become weak. This lack of disciplinary

control over management may strengthen managers’ ability to pursue their own benefits at the cost

of decreasing firm value by using suboptimal corporate policies. As the level of managerial

ownership reaches a considerably high value (in this study, 46% and 64%), managers align their

interests with those of other owners, which leads to value maximization management behaviour, as

predicted by Jensen and Meckling (1976). For example, managers use less debt to avert being

purchased or increase financial risk.

According to the results of OLS regressions, we got proof of Hypothesis 1 and 2. In the

theoretical prediction of Hypothesis 3, we conjecture that managerial ownership affects capital

structure, which in turn affects firm value in China’s civilian-run listed firms. However, we could

not confirm this transmitting association without a stricter test. Next, we estimate a simultaneous

equations model to test this relationship.

4.3 Managerial ownership, capital structure and firm value

To capture the potential multiple relationship between managerial ownership, capital structure

and firm performance, we applied a set of simultaneous equations using the two-stage least square

(2SLS) method.

Managerial ownership=f (firm value, capital structure, ROA) (3)

Firm value=g (managerial ownership, capital structure, size) (4)

Capital structure=h (managerial ownership, firm value, ROA, CR5) (5)

13

We estimate the simultaneous equations with control variables 3 . ROA in equation (3) and

equation (5) is defined as net income is divided by the total asset in the year end. CR5 is the

ownership sum of the first five largest shareholders, which is a proxy of ownership concentration.

Table 5 reports the regression results of the simultaneous equations. First, for the multiple

relationship between managerial ownership, capital structure and firm value, as Cho (1998) and

Himmelberg et al. (1999) documented, once endogeneity is controlled, the perceived impact of

managerial ownership on corporate value disappears. The results of the firm performance equation

of model (4) in Table 5 suggests that the levels of managerial shareholding do not influence firm

value significantly, which contrasts with the OLS results of model (1). This evidence reflects the

complicated causality between firm value and managerial ownership, and other variables may act as

intermediates to assist managerial ownership, in turn imposing effects on firm performance. Capital

structure has a negative influence on firm value as described by the results of equation (4); this is the

evidence of its intermediate function. Managerial ownership also has significant effects on capital

structure, as shown in the result of capital structure equation (5) 4 in the last column of Table 5.

Therefore, these results address the influence of managerial shareholding on capital structure, which

in turn affects firm value.

[Table 5 here]

The results of equation (3) in Table 5 also suggest that the ownership of board directors is

insignificantly affected by Tobin’s Q, which is consistent with the result found by Demsetz and

Villalonga (2001), but is different from that in Cho (1998), Kole (1995), and Davies et al. (2005) , in

which that managerial ownership is endogenously determined. In equation (3), ROA has an

insignificant coefficient, which suggests that earnings have insufficient influence on managerial

ownership. Cho (1998) and Davies et al. (2005) use volatility in their managerial ownership

equations and obtained similar results. Furthermore, the negative and significant coefficient of

capital structure in model (3) suggests that board directors in firms with lower debt hold a larger

fraction of their firm’s shares.

The second column of Table 5 represents the coefficients of model (4). Relevantly, asset size is

quite a significant determination of firm performance. Therefore, we also use company size as a

control variable in equation (4). We measure firm size as the logarithm of total assets. As shown in

Table 5, there is a negative function of company size to firm value, which echo the findings of

McConnell and Servaes (1990), Miguel et al. (2004), and Berger and Patti (2006). But the

coefficient is insignificant, which is different from McConnell and Servaes (1995). 3 This study also advances dummy variables representing industry effect, based on three-digit Standard Industrial Classification (SIC) codes. Because the coefficients of industry variables are not significant, we eliminate them in the final results. 4 For the coefficients in the capital structure equation, each slope coefficient is of the expected sign and is statistically significant at the 1% level. The extremum turning points of model (5) through a derivation are MANA = 17.2%, 46.3%, which is almost the same as the results of model (2).

14

The significant negative coefficient of capital structure in equation (4) requires more discussion.

Morck et al. (1988) found that leverage has a negative but insignificant impact on corporate value,

and attributed this to the possibility that managers in highly leveraged firms might hold a higher than

average level of ownership (Davies et al. (2005). Demsetz and Villalonga (2001) interpreted the

negative association between leverage and firm value as being due to the relative inflation between

the current time period and the earlier time period when companies had issued much of their debt.

However, contradicting these results, McConnell and Servaes (1990) report a positive significant

coefficient for leverage ratio on firm performance. Leverage is one way of imposing external

discipline on management and, if effective, leads to increased corporate value. In China, many

civilian-run firms have more constrains in getting loans from banks and bond markets comparing

with state owned enterprises. As Huang and Song (2006) explained, China’ listed firms with higher

Tobin’s Q means they have good growth opportunity in the future. These firms with brighter growth

opportunities tend to have lower leverage aiming to avert the wealth transfer from shareholders to

creditors. In this study, the negative association between capital structure and firm value also meets

the requirement of being an intermediate variable of managerial ownership on firm performance.

Thus, we can take this negative relationship as evidence of both Hypothesis 2 and Hypothesis 3, as

discussed in theoretical predictions.

ROA measures a firm’s efficiency at generating profits from every dollar of assets. It shows

how well a company uses investment dollars to generate earnings growth. ROA was found to be

negative and significant related to the level of capital structure for the results of model (5).

Noticeably, some of the literature uses the accounting profit rate to measure firm performance, such

as ROE in Demsetz and Lehn (1985), and profitability in Chaessens and Djankov (1999). However,

some critics might say that accounting profit rate is backward-looking and Tobin’s Q is forward-

looking (Demsetz and Villalonga, 2001). In this study Tobin’s Q influences capital structure as

significant as ROA (-0.02 of Tobin’s Q and -0.06 of ROA on capital structure). Therefore, the

argument between Tobin’s Q and ROA do not exist in China’s civilian-run firms. We viewed

another important result from the simultaneous equations as being the endogenous character of

capital structure. The significant influence from firm performance variables on capital structure are

consistent with the results of Titman and Wessels (1988), Ozkan (2001) etc. Taken together, the

capital structure is not only an intermediate variable of influence between managerial ownership and

firm value, but also an endogenous variable which should not be neglected in China’s civilian-run

companies.

4.4 Robustness test

In this robustness test section, we would like to use piecewise regression with simultaneous

equations to explore whether considering different ranges of managerial ownership provides results

that significant difference from those estimated via model (3), (4) and (5). The sample consists of

197 China’s civilian-run listed firms from 2002 to 2007. The models are as follow and the

15

estimations are reported in Table 6.

Managerial ownership=f (firm value, capital structure, ROA) (6)

Firm value= g (piecedwised managerial ownership, capital structure, size) (7)

Capital structure=h (piecedwised managerial ownership, firm value, ROA, CR5) (8)

The piecewised managerial ownership (MANA) in firm value model (7) and capital structure

model (8) are defined by the results of turning points (18%, 64%) from equation (1) and turning

points (18%, 46%) from equation (2):

MANA up to 18% = managerial ownership if managerial ownership < 0.18,

= 0.18 if managerial ownership of firm >=0.18.

MANA 18% to 64%= 0 if managerial ownership < 0.18,

= managerial ownership - 0. 18 if 0.18 =< managerial ownership < 0.64,

= 0.64 if managerial ownership>= 0.64.

MANA over 64% = 0 if managerial ownership of firm < 0.64,

= managerial ownership - 0.64 if managerial ownership >= 0.64.

MANA 18% to 46%= 0 if managerial ownership < 0.18,

= managerial ownership - 0. 18 if 0.18 =< managerial ownership < 0.46,

= 0.46 if managerial ownership>= 0.46.

MANA over 46% = 0 if managerial ownership of firm < 0.46,

= managerial ownership - 0.46 if managerial ownership >= 0.46.

[Table 6 here]

In Table 6, three piecewise variables of managerial ownership in Equation (7) remain the

insignificant influence on firm performance, which are consistent with the nonexistence of direct

effect from managerial ownership on firm performance shown in Table 5. Concerning the results in

model (8), the coefficient of managerial ownership up to 18% significantly influences capital

structure at 1% level. While piecewised managerial ownership is in the range between 18% and 46%,

and over 46%, it has significant effects on capital structure at 5% level. Most control variables have

the similar coefficients signs and significance as results of model (3), (4) and (5) except firm size in

model (7). The results of model (7) show a significant negative relation between size and firm value,

which is consistent with that in McConnell and Servaes (1995). The results of robustness test prove

our three hypotheses again.

5 Conclusions

This paper extends the previous research (Morck et al., 1988; Cho, 1998; Short and Keasey,

1999; Davies et al., 2005) by at least two aspects. First, we introduce capital structure as an

intermediate variable between managerial ownership and corporate value. We apply two cubic

16

equations to explore the relationship between managerial ownership and firm performance, and

relationship between managerial ownership and capital structure. Then we apply simultaneous

equations in order to detect the interrelationship between managerial ownership, firm value, and

capital structure and find the intermediate role of capital structure. Second, we extend the research of

developed markets into emerging market as an example of China, which is a good supplement to the

previous study.

Through a sample of 197 civilian-run listed firms over 2002 to 2007, we find a nonlinear

relationship between Tobin’s Q and the fraction of shares owned by board of directors, which is

consistent with the results of Morck et al. (1988), Cho (1998), Short and Keasey (1999), and Miguel

et al. (2004). Tobin’s Q, which is a proxy of firm performance, increases as managerial ownership

grows until it reaches 18%. Thereafter, Tobin’s Q declines with the increase in managerial

ownership until it reaches 64%. Tobin’s Q rises again slightly as managerial ownership increases

from 64%. These two turning points were higher than those detected by Morck et al. (1988) and Cho

(1998), using earlier period data from the Fortune 500. We argue that, due to the evolution of

corporate governance and changes of regulation in China’s market environment, the managerial

control for pursuing self-interest and alignment of interests between managers and other

shareholders can only be approached by management holding more ownership than that in other

developed countries.

The association between managerial ownership and capital structure is non-monotonic as well. A

negative relationship exists between managerial ownership and leverage ratios when managerial

ownership is below 18% or higher than 46%. Within the managerial ownership range 18% to 46%,

the leverage ratio increases as the managerial ownership increases. By using a simultaneous

equation regression, we find that managerial ownership, the squared and cubic managerial

ownership do not influence firm value significantly when capital structure is added into the equation.

Managerial ownership significantly affects capital structure, and capital structure affects corporate

performance directly. These results address the influence of managerial shareholding on capital

structure, which in turn affects firm value. Furthermore, capital structure is endogenously

determined by both firm value and managerial ownership in China’s civilian-run listed companies

from 2002 to 2007.

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19

Table 1. Summary of main statistics

Mean Median Maximum Minimum Std.Dev Skewness Kurtosis observations

Managerial ownership 0.0931 0.0009 0.7481 0.0000 0.1657 1.8290 5.4023 723

Tobin’s Q 1.4125 1.0347 10.2065 0.3263 1.0056 3.4387 21.5381 723 Capital

structure 0.4807 0.4972 0.9528 0.0000 0.1688 -0.3159 2.6444 723

Note: Managerial ownership is the ratio of shares owned by all board members to total shares outstanding. Tobin's Q is market value of assets divided by book value of total assets; which is extracted from the CCER database. Capital structure is the ratio of total debt to total assets. The sample is 197 civilian-run Chinese listed firms in 2002 to 2007 from the Shenzhen and Shanghai Stock Exchange. There are 723 firm-year observations in total.

Table 2. Mean values of Tobin’s Q and capital structure by managerial ownership levels

Managerial ownership Number of firms

Mean Tobin’s Q

Std.Dev of Tobin’s Q

Mean Capital structure

Std.Dev of capital structure

0<=MANA <5% 505 1.3323 0.8711 0.5140 0.1665

5%<=MANA <15% 54 1.4733 1.1183 0.4126 0.1311

15%<=MANA <25% 40 1.7733 1.5906 0.3973 0.1296 25%<=MANA <35% 40 1.8180 1.3831 0.4718 0.1607 35%<=MANA <45% 39 1.3076 0.7108 0.4048 0.1433 45%<=MANA <55% 25 1.2996 0.5526 0.4650 0.2468

55%<=MANA 20 1.0961 0.5145 0.3739 0.2155 Note: MANA is the proportion of managerial ownership, which is the ratio of shares owned by all board members to total shares outstanding. Tobin's Q is from CCER database. Capital structure is the ratio of total debt to total assets. The sample is 723 firm-year civilian-run listed observations from 2002 to 2007.

Table 3. Results of OLS on Tobin’s Q with managerial ownership from 2002 to 2007

constant MANA MANA2 MANA3 Capital structure Size Industry

dummy R2 F-statistic

panel observations

1.2346 (5.27)***

2.3664 (2.07)**

-8.6090 (-1.77)*

7.0211 (1.38) 0.008 1.9819 723

2.9666 (3.84)***

2.7402 (2.35)**

-7.3924 (-1.50)

3.0382 (0.59)

-0.4586 (-2.64)**

-0.1497 (-1.72)* Yes 0.032 4.6583 723

Note: ***, ** and * represent significance at 1% and 5% levels respectively. Panel observations are unbalanced from 2002 to 2007. Tobin’s Q is the dependant variable. MANA stands for managerial ownership. MANA2 and MANA3 are the quadratic and cubic terms of MANA.

Table 4 results of OLS on Capital structure with managerial ownership from 2002 to 2007

constant MANA MANA2 MANA3 CR5 ROA Industry dummy R2 F-

statistic panel

observations 0.5117 (69.40)***

-1.5120 (-6.22)***

5.8719 (5.65)***

-6.0928 (-5.61)***)

0.086

22.511 723

0.5799 (25.75)***

-1.3733 (-5.67)***

5.4140 (5.24)***)

-5.6118 (-5.19)***)

-0.1376 (-3.07)***

-0.0608 (-3.18)*** Yes

0.112

18.153 723

Note: ***, ** and * represent significance at 1% and 5% levels respectively. Panel observations are unbalanced from 2002 to 2007. Capital structure is the dependant variable. MANA stands for managerial ownership. MANA2 and MANA3 are the quadratic and cubic terms of MANA.

20

Table 5. Simultaneous regression analysis using two-stage least squares method.

Variable Managerial ownership (3)

Firm value (4)

Capital structure (5)

Constant term 0.1920(9.11)*** 2.9666(2.87)*** 0.6126(24.46)***

Tobin’s Q -0.0021(-0.35) -0.0172(-2.87)***

ROA 0.0257(1.32) -0.0553(-2.90)***

Capital structure -0.2031(-5.62)*** -0.4586(-1.84)*

MANA 2.7402(1.26) -1.2963(-5.37)***

MANA2 -7.3924(-1.12) 5.1720(5.04)***

MANA3 3.0382(0.44) -5.4323(-5.06)***

SIZE -0.1497(-1.29)

CR5 -0.1579(-3.51)***

Number of observations 723 723 723

Note: Tobin's Q is market value of assets divided by book value of total assets. ROA is the net income divided by the total asset in the year end. CR5 is the ownership sum of the first five largest shareholders. Capital structure is the ratio of total debt to total assets. MANA is the proportion of managerial ownership, which is the ratio of shares owned by all board members to total shares outstanding. The quadratic and cubic terms of MANA are MANA2 and MANA3. Size is the logarithm of total assets. Managerial ownership is the ratio of shares owned by all board members to total shares outstanding. Capital structure is the ratio of total debt to total assets. The sample is 197 Chinese civilian-run listed firms from 2002 to 2007; the unbalanced panel data construct 723 observations. *** and ** represent significance at 1% and 5% levels respectively.

21

Table 6. Robustness test using simultaneous regression with two-stage least squares method

Variable Managerial ownership (6)

Firm value (7)

Capital structure (8)

Constant term 0.0786(3.56)*** 5.1034(8.91)*** 0.2017(5.07)***

Tobin’s Q -0.0036(-0.79) -0.0828(-4.67)***

ROA 0.0177(0.98) -0.0269(3.03)***

Capital structure -0.0156(-2.52)** -0.0347(-3.08)***

MANA up to 18% 0.7643(0.66)

MANA 18% to 64% -1.8521(-1.02)

MANA over 64% 1.2537(0.22)

CR5 4.5693 (1.75)

SIZE -1.0756(-4.67)***

MANA up to 18% -0.3822(-4.42)***

MANA 18% to 46% 0.1956(1.95)**

MANA over 46% -0.7937(-1.98)**

Number of Observations 723 723 723

Notes: Tobin's Q is market value of assets divided by book value of total assets. ROA is the net income divided by the total asset in the year end. CR5 is the ownership sum of the first five largest shareholders. Capital structure is the ratio of total debt to total assets. Size is the logarithm of total assets. Managerial ownership is the ratio of shares owned by all board members to total shares outstanding. The sample is 197 China’s civilian-run listed firms from 2002 to 2007; the unbalanced panel data construct 723 observations. *** and ** represent significance at 1% and 5% levels respectively.

Tobin’s Q/Capital structure

C

P1 P2

Capital structure

Tobin’s Q A

B

P1 = 0.18 P2 = 0.46 P3 = 0.64

P3 Managerial ownership

D

Figure 1. Relationship among firm value, capital structure and managerial ownership

22