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Corporate Ownership & Control / Volume 9, Issue 4, 2012, Continued - 2
197
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Corporate Ownership & Control / Volume 9, Issue 4, 2012, Continued - 2
198
CORPORATE OWNERSHIP & CONTROL Volume 9, Issue 4, 2012, Continued - 2
CONTENTS
THE RELATIONSHIP BETWEEN TRADING VOLUME AND STOCK RETURNS IN THE JSE SECURITIES EXCHANGE IN SOUTH AFRICA 199 Raphael T Mpofu CORPORATE GOVERNANCE, AGENCY COSTS AND INVESTMENT APPRAISAL: AN ASSESSMENT 208 Baliira Kalyebara, Abdullahi D. Ahmed THE INFLUENCE OF CULTURAL VALUES ON THE BOARD OF DIRECTORS: LESSONS FROM FIVE CORPORATIONS 221 Elsa Satkunasingam, Aaron Yong Sern Cherk DETERMINING WHICH MANAGEMENT LEVEL MAKES DECISIONS WHEN OUTSOURCING THE DISTRIBUTION FUNCTION 230 Johan Muller, Louise van Scheers CRIME, SECURITY AND FIRM PERFORMANCE IN SOUTH AFRICA 241 Busani Moyo OWNERSHIP STRUCTURE AND DEBT POLICY OF TUNISIAN FIRMS 253 Hentati Fakher, Bouri Abdelfettah THE INTRA-INDUSTRY EFFECTS OF CHAPTER 11 FILINGS: EVIDENCE FROM ANALYSTS’ EARNINGS FORECAST REVISIONS 262 Gary L. Caton, Jeffrey Donaldson, Jeremy Goh
Corporate Ownership & Control / Volume 9, Issue 4, 2012, Continued - 2
199
THE RELATIONSHIP BETWEEN TRADING VOLUME AND STOCK RETURNS IN THE JSE SECURITIES EXCHANGE IN
SOUTH AFRICA
Raphael T Mpofu*
Abstract
This study examines the relationship between trading volume and stock returns in the JSE Securities Exchange in South Africa. The study looked at the price and trading returns of the FTSE/JSE index from July 22, 1988 till June 11, 2012. The study revealed that stock returns are positively related to the contemporary change in trading volume. Further, it was found that past returns were not affected significantly by changes in trading volumes. The results present a significant relationship between trading volume and the absolute value of price changes. Autoregressive tests were used to explore whether return causes volume or volume causes return. The results suggest that volume is influenced by a lagged returns effect for the FTSE/JSE index. Therefore, return seems to contribute some information to investors when they make investment decisions. Keywords: South Africa, FTSE/JSE, Trading Volume, Stock Returns * Associate Professor, Department of Finance & Risk Management and Banking, University of South Africa, PO Box 392, Pretoria, 0003, South Africa Fax: (+27) 12 429-4553 Tel.: (+27) 12 429-4497 E-mail: [email protected]
1. Introduction
Since Eugene Fama (1970) proposed the efficient
markets hypotheses, a number of studies have been
done in various markets to determine the validity of
these hypotheses. The three types of efficiency
proposed by Fama were that of the strong-form; semi-
strong form and weak-form efficiency. In the weak
form efficiency, Fama proposed that it is not possible
for investors to profit from historical share price
information. With the semi-strong form, he stated that
investors could only profit from historical share prices
if they had access to all the information required for
asset selection reflected all publicly available
information. Finally, in the strong-form efficiency,
Fama stated that for investors to profit from historical
share price movements, all information, including
private information, should be incorporated in the
share price. The discussion on market efficiency
therefore looks at how information is factored in share
prices and the hypothesis of market efficiency can be
tested by looking at the relationship between share
prices and expected returns and for investors to make
profitable asset allocations based on that historical
information.
Since Fama points out that a market is weak-
form efficient if all the information contains in past
stock prices fully reflect in current prices (Fama,
1970, 1991), this implies that past share prices cannot
be used to predict the future price changes and
therefore invalidates the use of technical analysis in
asset selection and asset allocation decisions. This
however goes against the grain of current investment
decisions as a number of investors rely heavily on
technical analysts who base their decisions on the
movement of historical share prices.
Given the important role of technical analysts in
investment decisions as per findings of Karpoff
(1987); that volume drives prices; that there are
positive relations between the absolute value of daily
price changes and daily volume for both market
indices and individual stocks (Rutledge, 1984); the
role of trading activities in terms of the information it
contains about future prices (Gervars, Kaniel and
Mingelgrin, 2001), this study sought to determine the
existence of the weak-form market efficiency.
Literature reveals that most of the studies on volume-
price relationships have been based on developed
markets. Therefore this study is to empirically test the
trading volume-price relationships in the JSE
Securities Exchange.
Although there has been extensive research into
the empirical and theoretical aspects of the stock price
– volume relationship, this research has focused
mostly on developed countries financial markets.
Since there seems to be no consensus on the
relationship, this study sought to seek further insights
by investigating the relationship in an emerging
market.
Corporate Ownership & Control / Volume 9, Issue 4, 2012, Continued - 2
200
This study looked at the price and trading returns
of the FTSE/JSE index from July 22, 1988 till June
11, 2012. The subsequent sections look at a summary
of related literature, the data collection methods used
and a detailed analysis of monthly time-series data
covering a period of 24 years. The last section
presents the conclusions from the data analysis and
the limitations of the study as well as proposals for
future research on the volume-return trade-off.
2. Review of Related Literature
The literature on trading volume and share price
returns is very extensive. Maury Osborne was the first
researcher to publish the hypothesis that price follows
a geometric Brownian motion and was responsible for
the earliest literature identifying that price deviation is
proportional to the square root of time (Osborne
1959). Most of the early studies find positive
correlation between the daily price changes and daily
volume for both market indices and individual stocks.
Karpoff (1986, 1987) provides a theory that links
returns with trading volume and leads to an
asymmetric relationship between volume and price
change. This is supported by studies from Jain and
Joh (1988); Epps (1975) and Jennings, Starks and
Fellingham (1981).
Some early studies using daily and weekly stock
data conclude that prices and volume are virtually
unrelated and that price changes follow a random
walk (Granger and Morgenstern, 1963; Godfrey et al,
1964). In contrast, using daily and hourly price
changes for both market indices and individual stocks
Crouch (1970a, 1970b) finds a positive correlation
between volume and the magnitude of returns.
Examining the relation between volume and
returns, a positive contemporaneous correlation has
been found by Rogalski (1978) using monthly stock
and warrant data and by Epps (1975), (1977) using
transactions data. To explain such results, Epps
proposes a theoretical framework consistent with his
findings and supported by Smirlock and Starks (1985)
and by Assogbavi, Khoury, and Yourougou (1995).
Granger and Morgenstern conducted an early
empirical study based on the New York Stock
Exchange (NYSE) composite index from 1939-1961
(Granger and Morgenstern, 1963). While their
findings indicated that there is no relation between
absolute value of daily price changes and daily
volume, subsequent studies did find a relationship
between absolute price change and volume change
(Crouch, 1970; Epps and Epps, 1976; Haris, 1986).
Studies done in the last decade have also found a
relation between stock returns and trading volume
(Chen, Firth and Rui, 2001; Khan and Rizwan, 2001;
Lee and Rui, 2002; Pisedtasalasai and Gunasekarage,
2008). Other authors have included Admati and
Pfleiderer (1988), Barclay, Litzenberger and Warner
(1990), Barclay and Warner (1993), Brock and
Kleidon (1992), Easley and O'Hara (1987), Foster and
Viswanathan (1990) and Kyle (1985).
Miller (1977) also looked at the relationship
between stock price and volume. He hypotheses that
when investors differ in their opinions about the value
of a stock, the traders who hold the stock show
optimism about its value by driving demand up, hence
leading to an increase in the stock price. Miller’s
argument is that when investors have mixed beliefs
about a stock and face a shortage of that stock, the
stock’s price will reflect the opinion of the optimistic
investors forcing the price of the stock to rise
(Harrison and Kreps, 1978; Mayshar 1983; Morris,
1996). One can conclude from this hypothesis that if
there is a wide difference of opinion on the value of a
stock among investors, that stock is likely to trade at a
premium (Chen, Hong and Stein, 2002). Similarly,
Diether, Malloy, and Scherbina (2002) have also
shown that a stock that has a higher divergence of
opinion is normally followed by a lower future stock
return.
In examining the relationship between volume
and returns, a positive concomitant correlation has
been found by Epps (1975, 1977) using transactions
data. Epps proposes a theoretical framework that
implies that the ratio of volume to returns should be
greater for price increases than for price decreases.
This conclusion is also supported in studies by
Smirlock and Starks (1985) who employed individual
stock transactions data and found a strong positive
lagged relation between volume and absolute price
changes. Bhagat and Bhatia (1996) found evidence
that price changes lead to volume changes but did not
find evidence that volume changes lead to price
changes. Hiemstra and Jones (1995) found a
significant positive relation going in both directions
between returns and volume. Tse (1991) in his study
of the Tokyo Stock Exchange found significant
positive correlation in some series and not in others.
He concluded that the relationship between price
changes and volumes is weak. Chan and Tse (1993)
found that there was implicit positive correlation
between price and volume through their residuals.
Volume is a measure of the quantity of shares
that change amongst owners of a given stock. The
amount of daily volume on a security can fluctuate on
any given day depending on the amount of new
information available about the company. Of the
many different elements affecting trading volume, the
one which correlates the most to the fundamental
valuation of the security is the new information
provided. This information can be a press release or a
regular earnings announcement provided by the
company, or it can be a third party communication,
such as a court ruling or a release by a regulatory
agency pertaining to the company. So in considering
the price-volume relationship, Karpoff (1987)
suggests the following four possible reasons.
First, it adds insight to the structure of financial
markets. The correlations which are found can
Corporate Ownership & Control / Volume 9, Issue 4, 2012, Continued - 2
201
provide information regarding rate of information
flow in the marketplace, the extent that prices reflect
public information, the market size, and the existence
of short sales and other market constraints. Second,
studies that use a combination of price and volume
data to draw inferences need to properly understand
this relationship (also Beaver, 1968). The third is that
understanding the price-volume relationship is vital
for one to determine why the distributions of rates of
return appear kurtosic. The fourth is that price
variability affects trading volume in futures contracts.
(See also Karpoff, 1987; Gallant, Rossi, and Tauchen,
1992; and Blume, Easley, and O’Hara, 1994). This
interaction determines whether speculation is a
stabilizing or destabilizing factor on futures prices.
Given the diversity of viewpoints, this study
therefore sought to investigate the relationship
between stock price and trading volume in the JSE
Securities Exchange, an emerging market. The next
section looks at the data and the model used for data
analysis, which is then followed by a discussion and
interpretation of the results, leading to a conclusion
and recommendations.
3. Materials and Methods
3.1. The data
The dataset used in this study consists of daily time
series of the FTSE/JSE stock index of all listed firms
on the JSE Securities Exchange for the period July 22,
1988 to June 11, 2012. The variables used in the study
are all the daily closing prices and trading volume of
the FTSE/JSE index.
3.2. Methodology
The price-volume relationship was examined by
looking at the relation between changes in stock price
to trading volume. The contemporary correlation
between changes in volume-return is examined by
looking at correlation between the natural logarithms
of volume changes (V) and the natural logarithms of
absolute value of the stock returns| |. The variable
stock returns will be used throughout the rest of the
article. The second hypothesis looked at is the
relationship between past trading volume and future
stock returns.
The returns were calculated using the following
approximation:
(
)
(1)
where is the closing price of the index on
day t.
The following formula is used to compute the
daily trading volume changes.
( ) (2)
where is the trading volume of the index on
day t.
In order to avoid survivorship bias, (if stocks
with poor performance are dropped from calculation,
it often leads to an overestimation of past returns) all
stocks that were traded during the study period were
included. Tauchen and Pitts (1983) point out that a
price variability-volume study can be very misleading
if the volume is strongly trended over the sample
period. In line with their recommendations, volume
data was tested for stationarity using Said and
Dickeys' (1984) augmented Dickey-Fuller (ADF) test.
The results confirmed that the volume data are non-
stationary for the FTSE/JSE index over the study
period and this is consistent with the alternative
hypothesis that the volume data are non-stationary.
This test for stationarity ensures that the study on the
price change-volume relationship on the JSE does not
give misleading inferences.
A number of researchers and traders in financial
markets hold the view that volume has a strong
influence on prices movements. This has been found
to be true in studies by Crouch (1970), Clark (1973),
Tauchen and Pitts (1983), and Jain and Joh (1988)
who concluded that there was a positive correlation
between absolute price change and volume. In this
study, parametric tests for the price change-volume
relationship were done by regressing the price change
against the absolute price change against trading
volume. The regression equation is:
| | (3.1)
where
| | = absolute price change in day t
= trading volume for day t
=error term in the regression model,
(3.2)
where
= trading volume change in day t.
4. Results and Discussion
4.1. Descriptive analysis
Figure 1 shows the time plots of monthly log returns
and monthly log trading volumes of the FTSE/JSE.
As expected, the plots show that the basic patterns of
log returns are as expected.
Corporate Ownership & Control / Volume 9, Issue 4, 2012, Continued - 2
202
Figure 1. Price-Volume Trend 1988 to 2012
Table 1 provides the summary statistics for the
variables in this study. The FTSE/JSE stock market
price index shows very low volatile with a standard
deviation measure of 0.011 and the trading volume of
the stock index shows a very high standard deviation
of 2.41. There is also evidence of negative skewness
for both stock returns and trading volume at -0.411
and -1.533 respectively. The kurtosis value for stock
returns exceeds the normal value of three to four for
stock returns at a value of 6.272 but is in line with
findings from other research studies. The kurtosis
value for trading volume at 2.76 is within the
acceptable range for normality. In addition, the low
skewness value for trading volume supports a normal
distribution of the time series and also supports the
apriori condition of a random walk model in the weak
or strong form.
Table 1. Descriptive statistics for FTSE/JSE index stock returns and trading volume
Statistics
PRICE VOL
N Valid 5959 5959
Missing 0 0
Mean .000554 10.982349
Std. Error of Mean .0001534 .0311615
Std. Deviation .0118438 2.4054975
Variance .000 5.786
Skewness -.411 -1.533
Std. Error of Skewness .032 .032
Kurtosis 6.272 2.760
Std. Error of Kurtosis .063 .063
4.2. Testing for stationarity
The first test that was done was the stationarity test of
the time series using the Dickey– Fuller (1979) ADF
test. The results are reported in Table 2 and indicate
that all series are non-stationary and hence it was
concluded that price change and volume change series
are non-stationary. The implication of this finding is
that testing for causality between price and volume
should be based on unrestricted VARs in first
differences. The next step, therefore, was to determine
whether or not futures prices and volumes were
cointegrated. The results of the cointegration tests
indicate the absence of cointegration in both cases.
Thus, testing for causality will be based on
unrestricted VARs, hence the next test will test for
white noise or stationarity.
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Corporate Ownership & Control / Volume 9, Issue 4, 2012, Continued - 2
203
Table 2. Testing for stationarity of price changes and trading volume changes: Estimation Method – VARMAX Least
Squares Estimation
Equation Parameter Estimate Standard
Error
t Value Pr > |t| Variable
VOL CONST1 1.69588 0.09317 18.20 0.0001 1
AR1_1_1 0.49585 0.01214 40.84 0.0001 VOL(t-1)
AR1_1_2 -0.72744 1.59041 -0.46 0.6474 PRICE(t-1)
AR2_1_1 0.35003 0.01212 28.87 0.0001 VOL(t-2)
AR2_1_2 -0.77895 1.59031 -0.49 0.6243 PRICE(t-2)
PRICE CONST2 0.00040 0.00076 0.52 0.6008 1
AR1_2_1 0.00022 0.00010 2.19 0.0284 VOL(t-1)
AR1_2_2 0.08530 0.01295 6.58 0.0001 PRICE(t-1)
AR2_2_1 -0.00021 0.00010 -2.10 0.0355 VOL(t-2)
AR2_2_2 0.01939 0.01295 1.50 0.1345 PRICE(t-2)
A time series is called a white noise if it is a
sequence of independent and identically distributed
random variables with finite mean and variance. In
particular, if the series is normally distributed, all the
ACFs are zero. Based on Table 2, the daily returns of
the FTSE/JSE index are close to white noise with
ACFs close to zero in both single and second lags.
The p-values of these test statistics are all close to
zero. In finance, price series are commonly believed
to be non-stationary, but the log return time series
depicted as in equation 2 and used in the calculations
in this study shows that the series in stationary. In this
case, the log price series is unit-root non-stationary
and hence can be treated as an ARIMA process. A
Dickey-Fuller test produced the statistics shown in
Table 2 above. The t-test statistic for price was 0.52
with a p-value of 0.6, while the t-value for trading
volume was 18.20 with a p-value close to zero. Thus,
the unit-root hypothesis cannot be rejected at any
reasonable significance level. But the parameter
estimates were found not significantly different from
zero at the 5% level. In summary, for the time period
considered, the log series of the index contains a unit
root.
4.3. Testing for Autocorrelation
A necessary condition for testing for a
contemporaneous relationship between returns and
trading volume based on a Vector Autoregressive
(VAR) model, it was necessary to first necessary to
test for the presence of autocorrelation. The Durbin-
Watson test is a widely used method of testing for
autocorrelation. The first-order Durbin-Watson test in
Table 3 is highly significant with p < .0001. Once it
was determine that autocorrelation correction was
needed, stepwise autoregression was utilised to
determine the number of lags required. This resulted
in the second-order lags as implemented in the next
stages.
Table 3. Testing for Autocorrelation using the Durbin-Watson Test
The AUTOREG Procedure: Ordinary Least Squares Estimates
SSE 34474.4496 DFE 5957
MSE 5.78722 Root MSE 2.40566
SBC 27388.2215 AIC 27374.8362
MAE 1.81181152 AICC 27374.8382
MAPE 26.9036754 Regress R-Square 0.0000
Total R-Square 0.0000
Durbin-Watson Statistics
Order DW Pr < DW Pr > DW
1 0.4686 <.0001 1.0000
2 0.5370 <.0001 1.0000
3 0.5327 <.0001 1.0000
4 0.5293 <.0001 1.0000
Variable Approx DF Variable
Estimate
Standard
Error t Value Pr > |t| Label
Intercept 1 10.9817 0.0312 352 <.0001
PRICE 1 1.1102 2.6314 0.42 0.6731 PRICE
NOTE: Pr<DW is the p-value for testing positive autocorrelation, and Pr>DW is the p-value for testing negative
autocorrelation.
Corporate Ownership & Control / Volume 9, Issue 4, 2012, Continued - 2
204
4.4. Testing for contemporaneous relationship
The next analysis involved testing whether trading
volume does have a significant impact on stock
returns movements on the JSE Securities Exchange.
Table 4 presents the contemporaneous relationship
between returns and trading volume based on a
Vector Autoregressive (VAR) model. The F-statistics
and their corresponding level of significance are
indicated. The table shows the results for the test of
the null hypothesis that returns do not Granger-cause
volume and their F-statistics are significant at a 5 per
cent level for the FTSE/JSE index. The hypothesis is
accepted. This finding implies that past returns and
trading volume adds some significant predictive
power for future returns and trading volumes in the
JSE Securities Exchange. This suggests that trading
volumes are influenced by returns or price in the JSE
Securities Exchange. The tests revealed that there is a
significant correlation between monthly return and
trading volume.
Table 4. The AUTOREG Procedure: Dependent Variable – Trading Volume
Ordinary Least Squares Estimates
SSE 34474.4496 DFE 5957
MSE 5.78722 Root MSE 2.40566
SBC 27388.2215 AIC 27374.8362
MAE 1.81181152 AICC 27374.8382
MAPE 26.9036754 Regression R-Square 0.0000
Durbin-Watson 0.4686 Total R-Square 0.0000
Variable DF Estimate Standard-Error T Value Pr > |t| Label
Intercept 1 10.9817 0.0312 352.00 <.0001
PRICE 1 1.1102 2.6314 0.42 0.6731 PRICE
Estimates of Autocorrelations
Lag Covariance Correlation -1 9 8 7 6 5 4 3 2 1 0 1 2 3 4 5 6 7 8 9 1
0 5.7853 1.000000 |********************|
1 4.4209 0.764167 |*************** |
2 4.2167 0.728873 |*************** |
Preliminary MSE 2.1149
Estimates of Autoregressive Parameters
Lag Coefficient Standard Error t Value
1 -0.497987 0.012147 -41.00
2 -0.348328 0.012147 -28.68
Table 4 shows the results of Volume being
regressed on price with the errors assumed to follow a
second-order autoregressive process. The Yule-
Walker estimation method was used in conjunction
with the maximum likelihood method. The first part
of Table 4 shows the Ordinary Least Squares (OLS)
results followed by estimates of the autocorrelations
calculated from the OLS residuals. The
autocorrelations are also displayed graphically.
The Maximum Likelihood Estimates (MLE) are
then shown in Table 5, which shows the preliminary
Yule-Walker estimates used as starting values for the
calculation of the maximum likelihood estimates.
The diagnostic statistics and parameter estimates
in Table 5 have the same form as the OLS output
shown in Table 4, but the values shown are for the
autoregressive error model. The MSE for the
autoregressive model is 2.103 compared to an OLS
MSE value of 5.787 and hence a much improved
model which is closer to zero. The total R2 statistic
calculated from the autoregressive model residuals is
0.6367, reflecting the improved fit from the use of
past residuals to help predict the next value of trading
volume. The t-value of 88.17 is also significant.
The regression results in Table 5 indicate that
contemporaneous return explains a relatively large
portion of trading volume in the JSE Securities
Exchange FTSE/JSE index as evidenced by the high
R-square of 0.63. The Durbin-Watson statistic given
in Table 5 has a value of 2.1855, and, given that the
Durbin-Watson statistics has a range from 0 to 4 with
a midpoint of 2, the value obtained here confirms that
the model is good.
Corporate Ownership & Control / Volume 9, Issue 4, 2012, Continued - 2
205
Table 5. The AUTOREG Procedure: Dependent Variable – Trading Volume
Maximum Likelihood Estimates
SSE 12524.1337 DFE 5955
MSE 2.10313 Root MSE 1.45022
SBC 21372.9088 AIC 21346.1382
MAE 1.07760286 AICC 21346.1449
MAPE 13.2054636 Regression R-Square 0.0001
Durbin-Watson 2.1855 Total R-Square 0.6367
Variable DF Estimate Standard-Error T Value Pr > |t| Label
Intercept 1 10.9707 0.1244 88.17 <.0001
PRICE 1 0.7638 1.3938 0.55 0.5837 PRICE
AR1 1 -0.4981 0.0121 -41.06 <.0001
AR2 1 -0.3511 0.0121 -28.92 <.0001
Autoregressive parameters assumed given
Variable DF Estimate Standard-Error T Value Pr > |t| Label
Intercept 1 10.9707 0.1244 88.17 <.0001
PRICE 1 0.7638 1.3938 0.55 0.5837 PRICE
The parameter estimates in Table 4 show the
MLE estimates of the regression coefficients and
includes two additional rows for the estimates of the
autoregressive parameters, labelled AR1 and AR2.
The estimated model is:
(4)
where
( )
The signs of the autoregressive parameters
shown in the above equation for are the reverse of
the estimates shown in Table 5. The estimates of the
regression coefficients with the standard errors are
recalculated on the assumption that the autoregressive
parameter estimates are equal to the true values.
Trading volume on the other hand seems to explain a
relatively small portion of returns in the FTSE/JSE
index as evidenced by the low R-square of 0.008. This
indicates that the effect of stock returns on trading
volume is stronger than the effect of trading volumes
on stock returns.
5. Conclusion and recommendations
This article investigated the relationship between
stock returns and trading volume for the FTSE/JSE
stock index. Using daily data, price return was
regressed on trading volume and significant
relationship was found. The statistical evidence
indicated that there is a positive correlation between
trading volume and stock returns. In addition, it was
also found that stock returns tend to lead trading
volumes, but not vice-versa. This result indicates that
while South Africa is an emerging market, it exhibits
similar behavioural facets as other developed markets
like the United States as shown by the studies
highlighted earlier
The Autoregressive model was estimated for
testing the casual relationship between stock return
and trading volume variables. The result implies that
there is feedback prevailing in the JSE Securities
Exchange. Therefore, the evidence indicates a
stronger stock return causing volume than volume
causing returns. The findings suggest that there is a
positive association between return variance and
lagged trading volume for the JSE. The results of the
causality test show that the relationship between
trading volume and stock return is statistically
significant. While this result is consistent with
findings from earlier studies, it is recommended that
further studies are conducted on individual stock
behaviours so as to enhance a better understanding of
the JSE Securities Exchange.
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Corporate Ownership & Control / Volume 9, Issue 4, 2012, Continued - 2
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Corporate Governance, Agency Costs and Investment Appraisal: An Assessment
Baliira Kalyebara*, Abdullahi D. Ahmed**
Abstract
Undoubtedly, capital markets have an impact on investment appraisal decisions through interest rates (cost of capital) charged and debt covenants stipulated in debt contracts. However, the extent of influence of their interactions in shaping and determining a firm’s corporate governance policy, agency costs, investment decisions and firm value has been overlooked or not duly emphasised in the literature to date. This lack of interdisciplinary research in areas such as finance, accounting, capital markets and corporate governance may lead financial managers making wrong interpretation of the current empirical evidence. This may result into suboptimal decisions in capital budgeting decisions. There are various existing studies that have discussed the relation between corporate governance and one or two other business topics this paper is assessing. However, questions have persisted about the role capital markets’ interactions play in determining firm’s corporate governance, minimizing agency costs, long term investment decisions and firm value. The recent high profile global company collapses mainly due to poor corporate governance mechanisms have rekindled the interest in the role capital market interactions play in formulating firm’s corporate governance rules and policies and their impact on agency costs, investment appraisal decisions and firm value. This study intends to assess this issue and critically evaluates these related issues. The impact of multiple objectives on long-term investment decisions is also discussed. We find that capital market interactions have a significant impact in the way firms formulate their corporate governance, identify and control agency costs, optimize multiple objectives, make investment decisions and determine firm value. In a nutshell, there is a consensus among researchers that capital markets impact on capital investment decisions and firm value through interest rates, debt covenants that impact on managers’ self-interest behaviour, corporate governance policies and agency costs. Keywords: Corporate Governance; Capital Markets; Multiple Objectives, Investment Appraisal and Agency Costs JEL Classification: G29; G31; G32; M14 * School of Commerce and Law Central Queensland University, Rockhampton, Australia ** Corresponsing author, School of Commerce and Law, Central Queensland University, Rockhampton, Australia, Bruce Highway, Rockhampton QLD 4702 Australia Fax: +61749309700 Tel.: +61749232854 E-mail: [email protected].
1. Introduction
The role capital markets’ interactions play in
influencing firm corporate governance mechanisms,
agency costs and investment appraisal decision
making is currently overlooked in the existing
literature. The current status quo may cause a
significant challenge to the financial managers in
interpreting the current literature. This study critically
examines the existing literature on the impact of
interdisciplinary interacts of capital markets,
corporate governance, agency costs and capital
budgeting decisions on firm value. (Shleifer & Vishny
1997) confirm that corporate governance policies
impact firm value. This assertion is supported in
(Ramly & Rashid 2010) that good corporate
governance mitigates managers’ self-interest
behaviours which in turn improves the firm’s quality
and flow of information, and firm value. Similarly,
(Ruiz-Porras & Lopez-Mateo 2011) and (Tian &
Twite 2011) conclude that capital market interactions
including interest rates (cost of debt) and debt
covenants impact corporate governance mechanisms,
agency costs, capital budgeting decisions and hence
firm value. The current literature recognizes that firms
have two main external sources of capital – equity and
debt (Whitehead 2009). The debt capital bears a
specified interest rate from day one that determines
the primary cost of debt. Thus the cost on debt is
Corporate Ownership & Control / Volume 9, Issue 4, 2012, Continued - 2
209
known and factored in the calculation before
investment decisions are made.
Nevertheless, the impact on long term
investment decisions as a result of minimization of
agency costs and the inclusion of debt covenants is
not considered. Debt capital is mainly supplied by
capital markets including commercial banks and other
financial institutions such as insurance companies,
superannuation funds, etc. The company (the
borrower) and the financial institution (the lender)
enter into a contractual relationship that explicitly
specifies the conditions of the debt capital that include
the interest rate to be charged and other restrictive
debt covenants that have to be complied with during
the life of the debt. Through the interest charges and
specified debt covenants the capital markets influence
the firm’s corporate governance, managers’
behaviour, debt equity ratio, agency costs, capital
budgeting decisions and firm value. The capital
markets’ monitoring of firm performance improves
corporate governance, mitigates the managers’ self-
interest behaviours and reduces negative earnings
management inclination.
However in practice, the impact of various
capital markets’ interactions are not all incorporated
in the investment appraisal decision making
techniques such as net present value (NPV) or internal
rate of return (IRR). Therefore, making capital
budgeting decisions using the traditional capital
budgeting techniques of NPV without considering the
impact of capital market interactions ignores one of
the significant factors that influence investment
appraisal decisions and firm value. This oversight
provides financial managers with wrong information
on which they base their interpretation of the current
empirical financial evidence and more often leads to
suboptimal decisions in long term investment decision
making. Figure 1 illustrates the impact of capital
markets interactions through debt capital, corporate
governance, agency costs, investment decision
making and the firm value.
Figure 1. Impact of debt capital on firm value and ownership structure
Capital markets
Debt Capital
Interest Rate
Cost of Debt
Debt Covenants
Positive and/or Negative
Firm’s Corporate Governance
Debt/equity Ratio
used as proxy for
(Agency costs)
Investment Appraisal Decisions
Firm value
Mitigate Financial Managers’
Self-interest Behaviours
EPS Optimal level
of ownership
Value-maximizing
governance structures
Corporate Ownership & Control / Volume 9, Issue 4, 2012, Continued - 2
210
2. Objectives and Motivation of the Study
The purpose of this study is to analyse the impact of
interdisciplinary interactions and in particular the
capital markets interactions on investment appraisal
decisions. The study addresses the role capital
markets play in determining capital budgeting
decisions through determining the level of interest
rates and devising debt covenants (positive and
negative). It also discusses the impact of debt
covenants on formulating the firm’s corporate
governance policy about capital budgeting decision
making. This study intends to add knowledge to the
existing theoretical and practical issues in the
literature about the impact of capital markets’
interactions on long-term investment decisions and
help financial managers make optimal investment
decisions that maximize firm value.
The conflict of interest that emanates from
separation of ownership and control and subsequent
agency problems, calls for efficient firm’s corporate
governance to enhance investors’ and shareholders’
confidence that management is making optimum
investment decisions that maximize firm value (Watts
& Zimmerman 1990). The capital markets’ covenants
and interest rates significantly shape and contribute
towards achieving efficient firm’s corporate
governance that impacts the firm’s level of debt
equity ratio (Debt equity ratio is calculated by
dividing firm’s net borrowings by shareholders’
funds) which in turn influences the firm’s cost of
capital and long-term investment decisions. The ratio
shows how much of debt capital is used to finance the
operations and long term investments of the firm
compared to equity capital. The higher the percentage
the higher the cost of capital and the more risky the
firm is able to meet its debt commitments. There are
other financial metrics that impact on the debt equity
ratio such as liquidity ratios and the level of net cash
flow. General business consensus believes that debt
equity ratio of 50% and below is regarded as
acceptable considering the nature of business. A firm
with debt equity ratio above 100% is regarded highly
geared and not financially healthy to the firm.
However, some companies in some industries have
astronomical high debt equity ratio as shown in Table
1. The magnitude of debt equity ratios of corporations
listed on the Australian Stock Exchange (ASX)
highlights how much capital markets are prepared to
lend to some companies and hence how much
influence they have on firm’s investment decisions
and firm value. For example, the debt equity ratios of
listed companies in Australian range between 0.001%
and 26,193.9% (http://asxiq.com/index.php. Accessed
14/07/2012). Table 1 below lists the top twenty
companies listed on ASX that have the highest debt
equity ratios.
Table 1. Debt Equity Ratios of Top Ten Companies Listed on ASX
Name Debt Equity Ratios
1 Becton Property Group 26193.9%
2 Redcape Property Group 10683.5%
3 Montec International Limited 7036.9%
4 Redbank Energy Limited 3603.4%
5 RGH Limited 28324.7%
6 World Reach Limited 2334.9%
7 Pearl Healthcare Limited 1630.9%
8 AACL Holdings Limited 1256.0%
9 TZ Limited 1216.9%
10 FirstFolio Limited 1152.0%
11 Central West Gold NL 1105.1%
12 Metroland Australia Limited 929.99%
13 Homeloans Limited 847.2%
14 Oldfields Holdings Limited 819.7%
15 Namoi Cotton Co-operative Ltd 692.7%
16 Prince Hill Wines Limited 690.1%
17 Energy and Minerals Australia Limited 506.8%
18 Farmworks Australia Limited 498.9%
19 Wide Bay Australia Ltd 464.4%
20 FSA Group Limited 441.0%
Source: http://asxiq.com/index.php. Accessed 14/07/2012.
It is clearly important to note from Table 1 that
if capital markets are willing to finance the operations
of some firms to the extent shown in the Table 1 then
they are entitled to safeguard their assets through
covenants and interest rates that impact on the firm’s
corporate governance and long-term investment
decisions. Likewise it is in the interests of the
borrowers (firms) if they require maintaining a good
Corporate Ownership & Control / Volume 9, Issue 4, 2012, Continued - 2
211
financial relationship with their lenders (capital
markets) then they is required to comply with the
terms and conditions included in the debt agreement
and meet their debt commitments promptly. Non-
compliance of the terms and conditions in the
agreement jeopardises their chances of securing debt
capital from capital markets in the future. The
compliance of the terms and conditions of the debt
agreements clearly impact on the firm’s operations,
corporate governance, the investment decisions and
hence firm value. Therefore, it is necessary to
consider the impact of capital markets interactions.
This study uses debt equity ratio as a proxy for good
corporate governance when making long-term
investment decisions. The impact of using debt equity
ratio on firm value has not been comprehensively
emphasised in the literature.
3. Capital markets
Companies have two main sources of capital, debt and
equity. Debt is obtained from capital markets and
equity is from shareholders. When companies apply
for debt from capital markets, elements in both the
capital market and the borrowing firm such as market
conditions, interest rates, firm’s corporate
governance, operation interactions and accounting
practices impact on capital market’s decisions and
hence affect the investment appraisal decisions of the
borrowing firm. Before a loan application is
approved, it is common practice for capital markets to
consider and assess the firm’s corporate governance
when estimating the firm’s potential level of default
risk. The higher the estimated default risk, the higher
the interest rate charged by the financial institution,
which translates into higher cost of capital to the firm
(Chen, Chen & Wei 2011), (Schauten & Blom 2006);
(Piot & Missonier-Piera 2007). The higher cost of
capital leads to reduction in the net cash inflows,
which leads to reduced NPV and hence a reduction in
the firm’s value. One of the ways of assessing the
firm’s corporate governance is determining whether
the firm’s accounting practices conform to the
national and international accounting standards, since
the capital markets’ operations are internationalised to
allow global competition (Wolk, Dodd & Rozycki
2008).
Capital markets are described as financial
institutions that lend the customers’ savings (savers)
that include corporations, households and
governments to the borrowers (corporations,
households and governments) for long-term
investments at a higher interest rates than those paid
to the savers. The long-term investments that are
financed by capital markets include investing in
equity, corporate debt and government debt (Viney
2011). They are supported by the foreign exchange
markets and derivatives markets. They also act as
conduits between savers and borrowers that comprise
of both domestic and international markets. The
participants in the capital markets encompass stock
exchanges, stock brokers, stock dealers, fund
managers, interest rates speculators, interest rates
hedgers, intermediary investors and service providers
(Viney 2011). They are significantly integrated with
banks, insurance companies, credit unions and other
financial institutions. In a nutshell, their main
contribution to the economy is to:
channel capital to the most efficient long-term
investments that yield the highest economic
returns;
provide access to depth and liquidity of the
market which allows investors to share and
manage risk efficiently; and
collect and disseminate significant financial
information that allows investors make informed
decisions in long-term investments.
Capital markets charge interest rates on the debts
lent out. The level of interest rates charged depends
on the level of default risk the firm borrowing is
estimated to have. Also the fact that debt capital is
invested in long-term risky projects, it is a normal
practice for the capital markets to insert debt
covenants in the terms and conditions section of the
debt contracts to safeguard their assets and mitigate
agency costs. Debt conditions serve the interests of
both the lender and the borrower. The nature of debt
covenants may be both positive and negative. For
example positive covenants may require the borrower
to maintain enough liquid assets to cover the debt
commitments whereas the negative one also referred
to as restrictive, may prevent certain activities such as
disposal of an asset unless agreed to by the lender.
According to (Alcock, Finn & Tan 2012) and
(Frankel & Litov 2007) capital debt is always
provided with restrictive covenants to mitigate debt
equity agency costs. From the definitions and
descriptions of corporate governance and capital
markets, it is evident that firms’ corporate governance
and capital markets through debt covenants aim at
maximizing firm value. There is evidence in the
literature that the integration of capital markets
principles and corporate governance principles is one
of the significant factors contributes to firm value
maximization. Debt covenants as determined by
capital markets lead to improved corporate
governance and better capital budgeting decision
making and firm value. However, the impact of the
integration of capital markets and corporate
governance on long-term investment decisions and
firm value has not been widely and emphatically
discussed in the literature
4. Corporate governance
Banks (2004, p. 3) defines corporate governance as
‘the structure and function of a corporation in relation
to its stakeholders generally, and its shareholders
specifically …’. In Australia, the (ASX 2007) defines
corporate governance as the system used by
Corporate Ownership & Control / Volume 9, Issue 4, 2012, Continued - 2
212
management to direct and manage companies to
maximise the firm value. The Economist Intelligence
Unit, (2002, p.5) defines it as:
Corporate governance is the system by which
business corporations are directed and
controlled. The corporate governance structure
specifies the distribution of rights and
responsibilities among different participants in
the corporation, such as the board, managers,
shareholders and other stakeholders, and spells
out the rules and procedures for making
decisions on corporate affairs. By so doing, it
also provides the structure through which the
company objectives are set, and the means of
attaining those objectives and monitoring
performance.
The three definitions are similar. The ultimate
aim is maximizing firm value. Two of the three
definitions above acknowledge that the interests of
non-financial stakeholders are as important as the
interests of financial shareholders. However, the
emphasis is on financial shareholders’ interests. In
April 2006, the UN launched the Principles for
Responsible Investment (PRI) at the New York Stock
Exchange. They were launched and endorsed by the
UN Secretary-General, Ban Ki-moon. These
Principles help in guiding financial managers to make
optimal strategic investment decisions to maximize
multiple objectives including shareholder wealth thus
in turn firm value. The Principles have become a
global benchmark for responsible investing. A large
number of international institutional investors have
become members of PRI by signing and complying
with them when making long term investment
decisions. The market value of the economy
controlled by the signatories of these Principles in the
first year of their establishment was said to have been
greater than US$8 trillion (UNEP, Finance &
Initiative 2006). As at 25/04/2012 there are a total of
1036 signatories to PRI worldwide including 249
asset owners, 611 investment managers and 176
professional service partners (PRI 2006)1. The signing
of the Principles by high profile international
organisations demonstrates support from the top-level
decision makers for sustainable investment. The
application of the Principles leads to better long-term
financial returns and a closer relationship between
investors, management and the community. These
Principles also have the potential of minimising
agency costs too. The extract of the message delivered
by the UN Secretary-General when launching the
Principles said among other things:
“By incorporating environmental, social and
governance criteria into their investment
decision-making and ownership practices, the
signatories to the Principles are directly
influencing companies to improve performance
1 See http://www.unpri.org/signatories., accessed 05/05/2012.
in these areas (see, UNEP Finance & Initiative
2006, p. 1). This, in turn, is contributing to our
efforts to promote good corporate citizenship
and to build a more stable, sustainable and
inclusive global economy”.2
The signatories commit to adopt and implement
the six Principles contained in the UN document.
Broadly, the members commit to:
(1) incorporate environmental, social and corporate
governance (ESG) issues into analysis and
decision-making processes;
(2) be active owners and incorporate ESG issues
into their ownership policies and practices;
(3) seek appropriate disclosure on ESG issues by the
entities in which they invest;
(4) promote acceptance and implementation of the
Principles within the investment industry;
(5) work together to enhance their effectiveness in
implementing the Principles; and
(6) each report on their activities and progress
towards implementing the Principles.
A decade before the UN Principles were
launched in 1996, the Australian Stock Exchange
(ASX) introduced a requirement that all listed
companies should include a statement of corporate
governance in their annual reports under the Listing
Rule 4.10.3. The ASX Corporate Governance Council
lists ten essential corporate governance principles,
which include among others that the board should add
value to the firm, recognise and manage risk, and
encourage enhanced performance (Shailer 2004).
These principles are broad allowing firms to pick and
choose sections of the Listing Rule that send positive
messages or good news to the stakeholders and reflect
the company in a good light to the public. However,
the intention of introducing the inclusion of corporate
government statement in the annual reports is good to
maximize firm value.
In the UK, investment management best
practices are contained in the Hermes Principles
Statement (Pitt-Watson 2002, pp. 6-11). The
statement contains ten principles. Principles 2 and 3
are directly related to this paper.
Principle 2 states that ‘Companies should have
appropriate measures and systems in place to
ensure that they know which activities and
competencies contribute most to maximizing
shareholder value’.
Principle 3 states that ‘Companies should ensure
all investment plans have been honestly and
critically tested in terms of their ability to deliver
long-term shareholder value’.3
The two principles above summarise the main
goal of most capital investment decisions in UK, be it
private or public investments. Also good corporate
2 See http://www.unpri.org/secretary-general-statement/index.php., accessed 05/05/2012. 3 See http://www.ecgi.org/codes/documents/ hermes_principles.pdf, accessed 05/05/2012.
Corporate Ownership & Control / Volume 9, Issue 4, 2012, Continued - 2
213
governance helps to mitigate tunnelling activities4
(Gao & Kling 2008) or negative earnings
management. Tunnelling activities include excessive
executive compensation, dilutive share prices, asset
sales, personal loan guarantees and empire building.
These activities are common with investors in
emerging markets similar to South Asia countries or
developing economies where government and
regulatory controls may not be in place or not
advanced enough to stop the practice from occurring.
A similar theory to tunnelling is the entrenchment
management theory.5 Management entrenchment is
part and parcel of corporate governance. However, it
is necessary to distinguish between illegal (negative)
and positive management entrenchments. The bad
entrenchments such as empire building destroy firm
value whereas positive entrenchment may include
protecting against a hostile turnover that does not
harm the firm value (Lu, Reising & Stohs 2007).
Corporate governance has became a buzz phrase
in the modern economic after the collapse of high
profile companies in the 1990s, including Arthur
Andersen, Global Crossing, Enron, WorldCom in the
US, and HIH in Australia, etc. In the same period,
WorldCom defaulted on US$23 billion of debt – the
largest default in history (Banks 2004, p. 8). In 2002,
234 companies with US$178 billion worth of assets
filed for bankruptcy (Banks 2004, p. 390). In 2001,
257 public companies with US$258 billion in assets
also filed for bankruptcy in the US. After witnessing
the kind of losses and bankruptcies that occurred in
the late 1990s and early 2000s, stakeholders including
shareholders lost confidence and trust in financial
reports, directors’ statements and external auditors’
reports (Keasey, Thompson & Wright 1997). A loss
of trust and confidence in the companies’ official
documents impacts negatively on the reliability of
financial accounting numbers used as inputs in the
investment appraisal decision making. The loss of
trust and confidence in the company’s ability to invest
shareholders’ money efficiently prevents new
investors from buying shares in the company, existing
shareholders may divest and new debts are charged at
higher interest rates because of the higher investment
risk expected. All these factors increase the total cost
of running the company including cost of capital, thus
reducing the net operating income, net cash flow
hence reducing firm value. Surprisingly, from the
reviewed literature in capital budgeting (Dean 1951);
(Weingartner 1967); (Seitz & Ellison 1999); (Bierman
& Smidt 2007), there is evidence that the boards of
4 Tunnelling may be described as illegal business practices in which a majority shareholder or high-level company management directs company assets to themselves, see http://investopedia.com/terms/t/tunneling.asp., accessed 05/05/2012. 5 Managerial entrenchment refers to anti-takeover efforts that are motivated by managers’ self-interests in keeping their jobs rather than in the best interests of shareholders.
directors do not significantly pay special attention to
long-term investments. Their focus is on short term
performance. (Banks 2004) listed and discussed a
sample of 339 significant companies that had
governance problems ranging from improperly
recognising advertising revenues of US$190 million
in 2002. All these 339 companies in the US were
forced to restate their revenues and earnings in 2002.
This confirms that corporate governance has direct
link to the figures reflected in the financial statements.
It strengthens the ‘moral fibre of the firm’ through
emphasising:
greater leadership by example
return to basic value systems
building corporate governance framework for
firms
redefining value creation
maximizing firm value.
Therefore, there is need for a study like this one
to analyse the impact of integrating capital markets
interactions, agency costs’ minimization and
corporate governance principles on capital budgeting
decision making decisions and firm value.
5. Investment appraisal
This paper uses the term capital budgeting
synonymously with investment decision making and
investment appraisal. Making capital budgeting
decisions is one of the most important strategic
policies a firm makes. There are different definitions
of capital budgeting but the main focus of all of them
is maximizing firm value. The following are some of
the definitions of capital budgeting or how it is
described. (Aggarwal 1993) asserts that capital
budgeting decisions are important, that individually
they are the most crucial decisions a firm makes
because of their long-term impacts on the firm’s
financial position. The effects of capital budgeting
decisions extend into the future to encompass the
whole organisation, and therefore the firm endures
them for a longer period of time, beyond the
consequences of operating expenditure. (Seitz &
Ellison 1999) briefly define capital budgeting as ‘the
process of selecting capital investments’. According
to (Agarwal & Taffler 2008) capital budgeting
decisions possess the distinguishing characteristics of
exchange of funds for future benefits, investment of
funds in long- term activities and the occurrence of
future benefits over a series of years. In a nutshell,
capital budgeting process is concerned with the
allocation of scarce financial resources to most
efficiently managed long-term activities in the hope
that the aggregate future benefits will exceed the
initial investment with the main goal of maximizing
firm value.
The main purpose of preparing a formal capital
budgeting process is to be able to identify those
investments that have the best chances of generating a
rate of return that exceeds the rate of cost of capital.
Corporate Ownership & Control / Volume 9, Issue 4, 2012, Continued - 2
214
Heavy operating costs that exceed cash in lows for a
long time may render an organisation unsustainable.
Again, the fact that the firm needs to raise and commit
‘large sums of money’ and invest it in long-term
capital projects, makes capital budgeting decisions
one of the most important strategic decisions,
requiring careful planning and implementation
(Brealey, Myers & Allen 2011). Therefore, capital
budgeting process is one of the crucial strategic
company policies in the life of the firm.
Unequivocally, it is correct to say that a company’s
future direction, survival and the pace of future
growth start with capital budgeting decisions. There
are not many companies that grow without making
long-term investments of any kind. Hence, capital
budgeting is the most critical decision of any
organisation that plans to grow, efficiently compete
and thrive for a long time. Sub-optimal capital
budgeting decisions don’t maximize firm value in the
long run. The value of listed companies is often
measured in term of share prices or market
capitalisation. The rate of return on capital
investments can also be measured using extra net cash
inflow that is discounted to present value using
appropriate determined discount rate. The cash flows
are the most important liquid resources for any
business because other resources can be bought if the
cash inflows exceed cash outflows. Share prices
quoted on stock exchanges are next to cash flows in
terms of liquidity because they can be converted into
cash flows quickly. It is acknowledged that viable
capital investments generate net cash flows in excess
of its initial cash flow to increase the overall value of
the organisation, in other words, a viable investment
should have a positive NPV or the NPV should be
greater than zero so as to add to firm value.
The following are some of the reasons that
support the assertion that capital budgeting is
one of the crucial policies a firm makes.
Long-term implications: Capital budgeting
decisions have an impact on the firm as a whole
for a long time span. They affect the firm’s
future capital structure, cash flows and growth.
A wrong decision may damage the firm’s long-
term growth and survival. However, if a firm
does not invest in log-term projects its
competitiveness may be weakened and its goal
of maximizing firm value may not be achieved.
Therefore, capital budgeting decisions determine
the future destiny of a firm.
Large amounts of money involved: Capital
budgeting decisions require significant amounts
of money as initial capital outlay. This factor
emphasizes the need for prudence, expertise in
capital budgeting process and well-thought
analysis and decisions because a wrong decision
may not only result in losses in that selected
project but also negatively impact on
opportunity costs that are available that could
not be undertaken at the time.
Irreversible decisions: Capital budgeting
decisions are often irreversible because they are
designed and tailored to suit a particular project
and involve investing huge amounts of money in
long-term projects that are directly related to that
particular firm. These projects are not easily
marketable or saleable because they are not
suitable for other available projects. The
purchase of unwanted long-term capital assets
results in wrong capital allocation and heavy
operating costs to the firm (Aggarwal 1993). The
only alternative available to redress wrong
capital purchases is to write-off the value of the
capital asset and to make a heavy capital loss.
Risk and uncertainty: Capital budgeting process
involves estimating future cash flows and future
rate of cost of capital (discount rate) for the
whole life of the project. The future is uncertain
and full of risks. The longer the period of the
project, the higher the risk and the higher the
uncertainty may be. All or some of the estimated
future cash flows and cost of capital may not
come to be correct. This factor suggests that
capital budgeting decisions may not be accurate
and reliable.
Difficult to make: Capital budgeting decision
making is a difficult and complicated
management exercise. It requires huge amounts
of money, expertise in the area and it requires a
lot of time to implement. Also there are not
many firms around that can afford the costs
involved in the exercise. The process may
require a cost benefit analysis before a capital
budgeting exercise is undertaken.
Optimal decisions in capital budgeting optimise
a firm’s main objective of maximizing the firm value
and also help the firm to stay competitive as it grows
and expands. These decisions are some of the integral
parts of overall corporate financial management and
corporate governance. A company grows only when it
invests in capital projects, such as plant and
machinery, to generate future revenues that are worth
more than the initial cost (Ross et al. 2011) and
(Shapiro 2005).
6. Capital markets and corporate governance
The two main sources of capital for companies are
debt and equity. Debt is acquired from capital markets
and equity is from shareholders. Sustainable
developed economies have developed and efficient
capital markets ((Viney 2011); (Ross et al. 2011) and
(Hunt & Terry 2011). Capital markets charge interest
rates (cost of capital) and insert debt covenants in the
debt contracts based on the estimated level of default
risk of the borrower in order to safeguard their assets.
Companies assessed to have high default risk attract
high interest rates and vice versa. High interest rates
translate into higher cost of capital to the borrower
Corporate Ownership & Control / Volume 9, Issue 4, 2012, Continued - 2
215
(Chen, Chen & Wei 2011); (Schauten & Blom 2006);
(Piot & Missonier-Piera 2007).
Capital market lending prerequisites include
channelling capital to the most efficient investments
that yield the highest economic returns. Therefore, the
level of cost of capital that is determined by the
capital markets and the type of covenants stipulated in
the debt agreements impact on the investment projects
the firm selects thus mitigating the managers’ self-
interest investment decisions. Collectively, these
conditions impact on the firm’s corporate governance,
agency costs, investment appraisal decisions and firm
value (Tian & Twite 2011).
Efficient capital markets play a vital role in the
growth and health of the economy through pooling
domestic and international savings and channelling
them towards the most productive investments (Viney
2011). Furthermore, they collect and disseminate
significant financial information to investors that is
used by investors to make informed investment
decisions. They also provide access to financial depth
and liquidity of the capital market that allows
investors to share and manage the risk efficiently. In
the modern economy, all governments regulate and
monitor the financial activities and operations of
financial institutions because of the important role
they play in influencing the direction of country’s
economy (Fabozzi, Modigliani & Jones 2009). The
level of importance the capital markets have on the
economy is reflected in the kind of regulations the
government enact to supervise the industry because
any operational and strategic economic failure in the
capital markets significantly impact negatively on the
country’s economy. Recently there have been capital
markets’ failures such as Lehman Brothers that
exacerbated the global financial crisis (GFC). This
has impacted on the economies of many countries like
Portugal, Ireland, Greece and Spain (PIGS) and its
impact is still spreading especially in the European
Union member states and the world over. The
Telegraph of 19/05/2012 reported that the credit
rating agency, the Moody’s had downgraded the long-
term debt and deposit ratings of sixteen Spanish
banks. This will negatively impact on the borrowing
and lending ability of these banks both in domestic
and international capital markets. . In turn it will
impact on investments in Spain, the Spanish economy
and further make the GFC worse.
In summary, the government through physical
and monetary policies and the capital markets impact
on the whole economy through influencing the
interest rates (cost of capital) charged on borrowings
by corporations, governments and households to
finance capital projects and consumable goods. This
helps to manage and control the level of inflation in a
desirable range.
7. Corporate governance and investment appraisal
The main goal for firms to formulate company
policies that direct and control (corporate governance)
its operational and strategic decisions is to maximize
firm value (Banks 2004). In order to maximize firm
value firms need to invest in long-term capital
projects. Similarly, the main goal for capital
budgeting decisions is to maximize firm value (Banks
2004). Good corporate governance conforms to the
structure and function of a corporation in relation to
its stakeholders generally, and its shareholders
specifically by aligning conflicting interests such as
those which may arise during investing decisions. It
instils monitoring and bonding measures, a sense of
ethics, encouraging transparency and mitigates
managers’ self-interest behaviours such as negative
earnings management. The benefits of good
governance may include accessing reliable flow of
funds, improved access to lower interest rate sources
of funds, better credit ratings, better reputation and
more business opportunities that lead to lower debt
funding costs, higher share price, lower agency costs
and improved firm value. The lower debt funding
costs impact on future cash flows and NPV because
the future cash flows are discounted at a lower
discount rate (cost of debt). The following studies
confirm this assertion that good corporate governance
can reduce inter and intra-firm agency problems
((Shleifer & Wolfenzon 2002) and is also associated
with higher firm value ((Gompers, Ishii & Metrick
2003). Figure 2 below shows the relationship between
capital budgeting and corporate governance.
Figure 2. Relationship between corporate governance and capital budgeting
Since the collapse of high profile companies in
the US such as Enron, WorldCom, etc., management
decisions both operational and strategic have come
under scrutiny. The common factor in these
companies is the astronomical executive remuneration
and compensations – agency costs. The executives,
Capital Budgeting Maximize: NPV
Maximize
firm value Corporate Governance Minimize: Agency Costs
Optimize: Debt equity ratio
Corporate Ownership & Control / Volume 9, Issue 4, 2012, Continued - 2
216
whose compensation is based on the annual
performance (profits), will want to maximise annual
profits in the short term, so that they can receive large
amounts of bonuses quickly before their contracts
expire. Such executives will be reluctant to make
investment appraisal decisions which will bring in
profits after their contract period has expired. The
minimization of the short-term executive
compensation (agency costs) and introducing long-
term executive compensation such as share options
may persuade executives to invest in profitable long-
term capital projects. Therefore, there is a need to
integrate corporate governance principles, including
minimization of agency costs, to improve
management investment appraisal decisions. Table 2
shows selected and recent literature illustrating the
link between corporate governance and firm value.
Table 2. Summary of the literature on the link between corporate governance and firm value
Author(s) Sample, coverage & year Focus of the
study Key findings
Ammann, Oesch and
Schmid (2012)
Examine whether product market competition as a proxy of
corporate governance in 14 countries in European Union impact firm
value.
CG & firm value CG impacts firm
value
O’Connor (2012) Used 2784 firms of IFC Emerging Market Database (1980-2000) CG & firm value CG impacts firm
value
Gaeremynck and
Renders (2012)
The study examines the impact of principal-principal agency
problems on the quality and effectiveness of corporate governance
structures in listed companies from 14 European countries between
1999 and 2003.
CG & firm value CG impacts firm
value
Abbasi, Kalantari and
Abbasi (2012)
The research examined the effect of corporate governance on firm
value in food industry for companies listed on the Tehran Stock
Exchange (TSE) from 2002-2011.
CG & firm value CG impacts firm
value
Bayrakdaroglu, Ersoy
and Citak (2012)
The research examined the relationship between corporate
governance and value-based financial performance measures in
Turkey as an emerging market for 1998-2007.
CG & firm
performance
CG impacts firm
performance
Nini, Smith and Sufi
(2011)
Securities and Exchange Commission’s fillings of all US non-
financial firms (1996-2008) CG & firm value
CG impacts firm
value
Dharmapala and
Khanna (2011) Used a sequence of reforms in India (Clause 49) enacted in 2000. CG & firm value
CG impacts firm
value
Eberhart (2011)
Used Panel Data of 103 firms in Japan to examine the value
differences between Japanese firms selecting one of two legally
systems (1999-2007).
CG & firm value CG impacts firm
value
Chung and Zhang
(2011)
All stocks listed on the
NYSE, AMEX, and NASDAQ (2001-06).
CG &
institutional
ownership
CG influences share
prices and hence firm
value
Yang (2011) The research examined the impact of corporate governance on firm
value using panel data from 2004-2008.. CG & firm value
CG impacts firm
value
Al-Najjar (2010) All (86) non-financial Jordanian listed firms (1994 -03)
CG &
investment
decisions
CG impact
investment decisions
Chung, Elder & Kim
(2010)
Used 24 out of 51 corporate governance standards in Institutional
Shareholder Services (ISS) data from Best Practices User Guide and
Glossary (2003).
CG & stock
liquidity
CG impacts on stock
liquidity
Toledo, P (2010) Governance index constructed based on Spanish Code of Best
Practices
CG and firm
value
CG impacts on firm
value
Ammann, Oesch and
Schmid (2010)
6,663 firm-year observations from 22 developed economies over the
period from 2003 to 2007.
CG and firm
value
CG impacts on firm
value
Berthelot, Morris and
Morrill (2010)
The paper examined whether corporate governance rankings
published are reflected in the values investors accord to firms.
CG and firm
value
CG impacts on firm
value
Chong and Lopez-De-
Silanes (2006)
Used data available on external financing in Mexico to analyse the
link between CG and firm performance
CG & firm
performance
CG impacts on firm
performance
Black et al. (2006) 515 firms, Korea (2001) CG & firm value CG impacts on firm
value
Kumar (2005) 2,000 Indian firms (1994-00) CG & firm
financing
CG impact firm
financing
Drobetz, Schillhofer &
Zimmermann. (2004) 91 Germany firms (2002)
CG and share
performance
CG impacts on share
performance
Klapper and Love
(2004) 374 firms from 14 emerging economies (2000)
CG and firm
performance
CG impacts on
performance and firm
valuation
Gompers et al. (2003) 1,500 large firms (S&P) (1990) CG & equity
price
CG impacts on equity
prices and firm value
Lemmon and Lins
(2003) 800 non-financial firms, East Asian (1997) CG & firm value
CG impacts on firm
value
Corporate Ownership & Control / Volume 9, Issue 4, 2012, Continued - 2
217
8. Capital markets, corporate governance, investment appraisal and firm value
The main goal for firms formulating corporate
governance policies and making long-term
investments is maximizing the firm value (Banks
2004). Capital budgeting principles aim at sound
corporate financial management to maximize the
firm value (Seitz & Ellison 1999). Both sets of
principles of corporate governance and capital
budgeting aim at improving the firm’s
performance and overall responsibility of the
organisation that lead to maximizing firm value
(Allen, Carletti & Marquez 2009). Thus capital
budgeting and corporate governance are
interrelated and complement each other.
However, the existence of agency problems
hinders the achievement of firm value
maximization. The agency problems are caused
by the separation of ownership and control
inherent in many firms. Sometimes management
who make investment appraisal decisions, do not
pursue the firm’s objective of maximizing its
value, but seek to maximize their own interests
causing the firm agency costs. Agency costs
arise because of the conflict of interest that
exists between the firm’s management and its
shareholders. There are steps and decisions the
organisation can make to force or incites
management to act in its interests; colloquially
these decisions are sometimes referred to as the
‘stick and carrot’. They can be in the form
punishment or incentives or both. These
decisions cost money, and they are some of the
examples of agency costs.
As discussed earlier in the paper capital markets
charge interest rates (cost of debt capital) and
insert debt covenants in the debt contracts to
safeguard their assets (money lent to the firm)
and mitigate debt agency costs. Corporations
with good corporate governance are said to have
lower default risk and as a result they are
charged lower interest rates thus lowering the
cost of debt capital. The level of interest rates
charged and the type of debt covenants inserted
in the debt agreement influence the extent of
achieving the objective of maximizing firm
value in the same way as corporate governance
and investment appraisal decisions discussed
earlier.
Agency costs are divided into three main
categories, bonding costs, monitoring costs and
residual loss ((Deegan 2009); (Jensen &
Meckling 1976). Monitoring costs include those
costs incurred to control the managers’
behaviour through the firm’s board of directors
by watching the decisions management make to
ensure that management decisions maximize
firm value. Examples of this type of costs may
include directors’ fees, financial statements
issuance costs, ensuring the agents do their jobs,
external audit fees, communicating with the
referees, establishing incentives for good
performance and employee stock options costs.
(Jensen & Meckling 1976) show that bonding
costs are incurred by the agent in an effort to
ensure the principal that the agent will not take
actions that will reduce firm value and that if
such actions are taken, the principal should be
compensated. Hence bonding costs tend to
reduce agency costs. Examples of bonding costs
may include annual membership payment to
maintain professional registration, offering
written guarantee and buying and dressing in
acceptable attire. (Jensen & Meckling 1976)
define residual loss as the reduction in the firm
value due to agency cost. It is caused by the
inherent self-interest behaviours of managers of
maximizing their own wealth.
The aggregate impact of agency costs on
organisations’ survival is financially
significantly high because any stakeholders in
control of the organisation through making
financial decisions (most times management
does), try to maximize their own wealth. The
high level of agency costs coupled with failure
to maximise stakeholder interests, including
shareholder wealth, has driven many companies
to bankruptcy in recent memory. For example,
the results in a study conducted by
(Schlingemann 2004) that analysed the value of
agency costs of overvalued equity in three days
surrounding the announcement of acquisitions in
the period of 1998-2001 show that the acquiring
firms lost a total of $240 billions compared to a
total loss of $4.2 billion in the all of the 1980s
period.
In 2001 in Australia, the collapse of Ansett
Airlines was caused by a combination of airline
industry deregulation, poor management in Air
New Zealand, high agency costs, lack of
managerial flexibility and the dissatisfaction of
its employees (Easdown & Wilms 2003). When
the industry was deregulated Ansett Airlines
could not compete effectively with the new low
cost entrants such as Virgin Blue Airlines and
Compass Airlines. The financial situation
worsened when it built an unprofitable $300
billion tourist resort on Hayman Island. This is a
type of significantly costly residual loss agency
cost – investing in a project that has a negative
NPV. The last straw of Ansett’s collapse was the
prolonged pilots’ strike (Easdown & Wilms
2003) that reflected poor management in
ignoring the interests of one of the stakeholders.
This paper has already established that capital
markets through interest rates and debt
covenants improve corporate governance and
mitigate agency costs. As a result of agency
costs being reduced, net cash flows improve and
Corporate Ownership & Control / Volume 9, Issue 4, 2012, Continued - 2
218
hence firm value increases. Also the paper has
already discussed above that the main goal of
company policy formulation of corporate
governance is maximizing firm value. Since
capital markets impact on firm’s corporate
governance and in turn corporate governance
impacts on agency costs, capital budgeting
decisions and firm value then it is imperative
that a proxy of corporate governance in any form
such as debt equity ratio used in this study
should be incorporated investment appraisal
decisions. The objective of both corporate
governance and capital budgeting decisions is to
maximize firm value therefore both are
important to the performance and growth of a
company and form the basis of investors’
confidence and trust. Investors’ confidence and
trust in a company influence the investor
decisions – whether to invest or not to invest in
the company. Good corporate governance leads
to efficient financial management which boosts
investors’ expectation for better future
performance which in turn boosts new capital
investments (Ruiz-Porras & Lopez-Mateo 2011).
It ultimately results in investors investing more
in the organisation. New investments in projects
with positive NPV result into maximizing firm
value.
9. Conclusion and future research
According to most finance textbooks including
(Parrino et al. 2011; Gitman, Juchau & Flanagan
2011; and Ross et al. 2011) the discounted cash flow
(DCF) techniques are the most preferred methods
used in investment appraisal decision making in both
theory and practice. In theory NPV is the most
popular of the three DCF methods, but IRR is
preferred in practice. However, non-DCF techniques
are still used in some countries including Japan and
New Zealand. Some of the advantages of NPV
include the use of cash flow (being a measure of
wealth); considering time value of money (a dollar
today has more value than a dollar in the future) and
using a risk-adjusted discount rate. However, NPV as
a technique has limitations. They include:
difficulty in accurately forecasting the future
cash flows;
no universal or standard method of determining
the discount rate;
assuming the estimated discount rate will remain
the same for the life of the capital project;
ignoring the impact the different sizes of
amounts invested have on the NPV – a capital
project that has a high NPV may not necessarily
be the best if it requires larger sums of money
than other capital projects;
ignoring the impact of unequal lives of the
capital projects on the NPV – a capital project
that has a longer life may not necessarily be the
best if it requires longer life than other capital
projects;
inability to factor in financial, technological and
management flexibility and changes that are
common in a modern economy;
it is a one-off time investment metric –
economic conditions do not stay the same
throughout the life of capital projects;
it does not handle multi-criteria problems or
multiple objectives; and
it does not factor in agency costs’ impact.
Therefore, NPV has many restrictions. The focus
of this paper is about the last weakness above – the
failure to consider the impact (minimization) of
agency costs on capital budgeting decision making.
The paper has already discussed the significance of
the impact of the minimization of agency costs on
capital budgeting decision making. The investment
appraisal decisions can be improved by
complementing the use of NPV with the minimization
of agency costs which in turn should improve firm
value. Capital budgeting techniques, both naïve or
advanced, have the following common limitations,
they both:
consider each project as an individual
undertaking as opposed to considering the
project as part of the overall organisation
structure; and
fail to consider the relationship among the new
investments and the impact they may have on
the firm as a whole.
The assessment above has highlighted the
weakness that exists in theory and practice. The
review also found that the impact of capital markets’
interactions on investment appraisal decisions is
significant but is not considered in investment
appraisal decisions. Although the use of NPV has
been increasing, it is deficient in that it ignores the
impact of the capital markets, corporate governance,
financial and managerial flexibility, and agency costs
on investment appraisal decisions. It must be noted
that the studies reviewed in this paper were conducted
in different timeframes, in different countries, used
different samples, applied different valuation
techniques but all endeavoured to identify one capital
investment technique that maximizes firm value. The
NPV’s failure to consider the impact of agency costs,
financial and managerial flexibility, capital markets
interactions justifies a new study to develop a new
integrated approach in the form of multiple objective
linear programming (MOLP) model to value long-
term capital investments. This suggested new
approach is urgently needed for industries that have
inherently high information technology (IT) risk and
are dominantly IT-based such as the e-commerce
sector and the airline industry that use IT as major
source of company information. Significant amount of
research on capital markets, corporate governance,
agency costs, multiple objectives, investment
appraisal has been conducted but no one study has
Corporate Ownership & Control / Volume 9, Issue 4, 2012, Continued - 2
219
integrated the impact of these disciplines to find their
influence on the investment appraisal decisions.
This proposed new integrated approach or
framework for investment appraisal decision-making
in the area of capital market interactions research in
finance will be a significant improvement over the
existing models in capital budgeting decisions. To our
knowledge, this approach will be the first of its kind
to integrate different elements of capital markets such
as interest rates, debt covenants, corporate
governance, agency costs and multiple objectives in
investment appraisal decisions. It will also provide a
plausible solution to many existing capital budgeting
problems. It can be applied to various real life capital
investment projects in general and be able to factor in
different individual firm characteristics.
Another area for future research in investment
appraisal could look at, is developing an inclusive
“Social Welfare Maximisation model” rather than an
exclusive “Shareholder Wealth Maximisation Model”.
In this modern economy that is regarded as one global
village, another significant variable that should be
considered to improve investment appraisal decisions
of multinational companies in modifying and
improving existing investment appraisal techniques is
the inclusion of political risk of various countries in
which the organizations operate.
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Corporate Ownership & Control / Volume 9, Issue 4, 2012, Continued - 2
221
THE INFLUENCE OF CULTURAL VALUES ON THE BOARD OF DIRECTORS: LESSONS FROM FIVE CORPORATIONS
Elsa Satkunasingam*, Aaron Yong Sern Cherk**
Abstract
The Malaysian Code of Corporate Governance 2000 emphasises the monitoring role of the Board of Directors, especially that of independent directors. It has not however taken into account the cultural values in Malaysia which do not encourage differences of opinion or criticisms and has failed to provide sufficient safeguards for directors to exercise their role effectively. As a result, it is relatively easy for dominant Chairmen or CEOs especially in government-linked companies or CEO dominated companies to control the Board or senior management with very little opposition. This paper will discuss several incidences of financial mismanagement in companies caused by dominant directors with very little opposition from the rest of the board. It will highlight that the law has to take cultural values more seriously in order to equip the Board and especially independent directors with the ability to challenge dominant Board members. Keywords: Board of Directors, Cultural Values, Chairman/CEO Control * Senior Lecturer, School of Business, Monash University, (LL.B, LL.M, PhD) Tel.: 603- 55146391 E-mail: [email protected] ** Bachelor of Business and Commerce (Honours) Monash University E-mail: [email protected]
Introduction
The Malaysian Code of Corporate Governance 2000
(MCCG) subscribes to the agency theory by
emphasising the monitoring role of the Board,
especially independent directors (INEDs). The Code
was enacted by the High Level Finance Committee on
Corporate Governance (Finance Committee) formed
by the Malaysian Government to establish a new
framework for corporate governance when it became
clear that poor governance had contributed to the
Asian Financial crisis (Kim, 1998). The Finance
Committee referred to the literature in British and
American jurisdictions which justified the increased
role played by an independent Board based upon the
agency theory (Clarke, 2007; Cox 2003) and designed
the MCCG along similar lines. The MCCG applies a
‘comply or explain’ best practice rule intended to
assist corporations in designing their own approach to
corporate governance (Clarke, 2007). When
transplanting the provisions of the MCCG which were
based on the United Kingdom Hampel Report and
Combined Code, the Finance Committee referred to
specific problems faced by boards such as dominance
of the Board by Chairmen who were founders of the
corporation, politically connected or members of
royalty. The problem is acute in the Malaysian capital
market where many corporations are either family or
government owned. When this is viewed in light of
cultural values in Malaysia, the consequence is that
the rest of the board including INEDs are rarely able
to withstand directors who are dominant personalities
or those with political connections. There is a need to
ensure that laws take this into account.
The nomination committee’s role in selecting INEDs
The Board of Directors of a corporation is required to
participate in the decision making process and
monitoring tasks (Cox, 2003) but INEDs have a
special role to monitor the Board and management
effectively as executive directors (EDs) are involved
with daily operational details that may tend to
undermine their monitoring responsibilities and non-
executive directors (NEDs) may represent interests of
certain and not all shareholders. The appointment of
INEDs has been one of the main responses to CEO
dominance and agency problems (Clarke, 2007) as a
CEO dominated board affects its efficiency
(Shivdasani and Yermack, (1999). They are also
expected to carry out unbiased oversight of
management and the Board to detect and prevent
mismanagement (Sale, 2006). In addition, they must
warrant that the Board and management carry out
their duties in the most efficient and effective manner
without negligence thus enhancing corporate
performance because they can proactively examine
corporate affairs (Fairfax, 2010). The extent to which
INEDs perform their duties well depends upon their
Corporate Ownership & Control / Volume 9, Issue 4, 2012, Continued - 2
222
level of independence (Fama, 1980; Fama and Jensen,
1983), their degree of knowledge and skills (Hendry,
2005) and the authority given to them under capital
market regulations to carry out their role. In addition
to these important requirements cultural values in
society play a part in directors’ ability and willingness
to perform their role; a factor which is often ignored.
A plethora of codes recommend appointing more
INEDs on the board to safeguard corporate
responsibility, provide oversight of a corporation’s
financial reporting practices (Persons, 2006) and
protect shareholder interests (Hermalin and Weisbach,
2003). The expectation that transparency and
accountability will increase with independence of the
Board is so pervasive that INEDs have been placed in
important roles on Board Committees namely the
nomination, remuneration and audit committees. The
MCCG recommends that the role of INEDs is
increased through similar committees.
The key task of the nomination committee is to
ensure that the corporation recruits and retains the
best available executive and non-executive directors.
Powerful CEOs or Chairmen rather than shareholders,
often select directors (Van Ees and Postma, 2004)
which may result in a board that is more amenable
and compliant (Hermalin and Weisbach, 1988)
although this is not in line with the MCCG.
Shareholders may have the final vote in electing
directors to govern the corporation, but are often
cornered into either accepting the proposed candidates
or initiating a proxy challenge which is time
consuming and costly (Vafeas, 1999). It is therefore
important to have a nomination committee that is
independent from senior management and powerful
enough to make independent recommendations to
ensure that directors appointed to the board possess
the necessary skills and leadership to accomplish their
roles (Ruigrok, Peck, Tacheva, Greve and Hu, 2006)
and also to prevent board domination by individuals
or certain groups.
Although the role of INEDs on board
committees is emphasised in the MCCG, no other
code or legislation regulating the Malaysian capital
market emphasises their role. As the MCCG applies
on a ‘comply or explain’ basis, corporations often
have nominal committees without reporting whether
these committees are working in an effective manner.
There are no legal sanctions for failing to operate
effective board committees although audit committees
provide more comprehensive information in annual
reports due to Bursa Malaysia’s Listing
Requirements.
Threats to independence of INEDs
Conventional wisdom dictates that INEDs play a large
role in corporate governance but there is no common
definition of ‘independence’ in relation to directors in
Malaysia (Brudney, 1982). The most common term
that defines ‘independence’ is in Bursa Malaysia’s
Listing Requirements which defines independent
directors as persons without a business or family
relationship that will be deemed in conflict of interest
with the corporation (Borowski, 1982). From this
stance, INEDs must not be employees of the
corporation, outsiders who have a substantial
economic relationship with the corporation or family
ties with its management or other directors (Zattoni
and Cuomo, 2010). However it is difficult to find a
method of ensuring independence in substance over
form.
At times INEDs serving on the Board longer
than usual will form opinions about other directors on
the Board and may even develop friendships which
may affect their independent judgement even if they
fulfil the legal definition of an independent director
(Adams and Ferreira, 2007; Hwang and Kim, 2009).
This creates structural bias which makes it difficult
for them to arrive at fair and objective assessments
(Elson and Gyves, 2003). “Structural bias" refers to
bias resulting from board members’ familiarity and
ongoing interactions with each other after joining the
board (Velasco, 2004). When working together as a
group, board members tend to form collective
alliances. Hence, it is noted that structural bias can
have a big effect on decision-making within the
boardroom, spurring board members to protect each
other from legal sanctions (Cox and Munsinger,
1985). Similarly, structural bias could undermine
directors’ ability to be critical towards their fellow
directors. Enron’s Board was an example of a
homogenous and highly cohesive group that had a
strong affiliation to each other especially as most of
the board members had served for extended terms
(O’Connor, 2003).
Another threat to independence is ‘group think’
which is where Boards technically comply with
Listing Requirements and the definition of
‘independence’ but recruit members from a close
circle of friends or supporters resulting in directors’
reluctance to raise questions and scrutinize
performance of the Board (Hwang and Kim, 2009).
‘Group think’ poses a major problem in the Malaysian
capital market (Lin, 2011). Bursa Malaysia’s
Corporate Governance Guide (BM CG Guide) warns
against mixing collegiality with blind conformity
while the Corporate Governance Blueprint 2011 (CG
Blueprint) issued by the Malaysian Securities
Commission highlighted it as a major problem with
the definition of ‘independence’. The CG Blueprint
2011 stressed on board diversity such as different
ethnicity, gender and nationality to prevent ‘group
think’.
Although structural bias and group think is
common to all directors regardless of whether they
are independent or executive directors, it is
particularly acute where INEDs are concerned as the
whole purpose underlying their appointment is to
bring fresh views without bias or influence of other
directors.
Corporate Ownership & Control / Volume 9, Issue 4, 2012, Continued - 2
223
Cultural Values
The problems with structural bias and group think are
faced by corporations in all societies but are
compounded by cultural values in Malaysia. Power
distance collectivism and assertiveness are some of
the cultural values that may prevent directors from
carrying out their role effectively.
Power distance
Hofstede defines power distance as ‘… the extent to
which the less powerful members of institutions and
organisations within a country expect and accept that
power is distributed unequally.’ (Hofstede, 2005; p46)
This refers to the interpersonal power of influence
between two people as perceived by the less powerful
(Hofstede, 2001; p83). If the powerful person’s power
can be exercised at his or her whim and the powerless
person cannot really resist, then power distance is said
to be high.
The level of power distance in a particular
society can be used to measure the authoritarianism
prevalent in that society. When a person is invested
with power, there is a tendency to identify with this
power and to increase the distance between himself or
herself and the people without this power. The greater
the power distance between the two, the more the
powerful person will try to increase it and the less the
powerless person will resist it. If the power distance
between the two people or groups was never great to
begin with, the person with less power will struggle
more to reduce the distance (Mulder, 1977).
Many relationships are divided into the more
powerful and less powerful. Those who have power
are entitled to privileges and use their power to
accumulate more wealth and in turn more power
while the less powerful are not used to enforcing their
rights. The social aspect of power distance reveals
that power and inequality in society is accepted as the
norm in societies with high power distance and the
type of power exercised is coercive power and power
based upon the power-holder’s charisma. The
powerless are deferent towards the powerful and this
is inculcated into society (Hofstede, 2001; pp100 –
113). Power distance can also be described as the way
in which people within a particular culture deal with
inequalities.
Cultures where power is exercised through
coercion and to pursue personal goals have high
power distance. McClelland referred to two ways in
which power can be exercised. The first is where
power is personalised to obtain dominance and pursue
personal goals. The second is where it is used to
further the goals of groups (McClelland, 1970). In
cultures where power distance is high there is little
resistance to power that is personalised. It is up to the
powerful in those cultures whether they wish to
exercise their power to further the goals of the group.
In societies with low power distance practices, the
powerful are expected not to exercise their power
arbitrarily to promote their own ends (Hofstede, 2005;
p46).
Hofstede’s Power Distance Index Values for 53
Countries and Three Regions (known as the PDI
index) has an average score of 57. Malaysia had a
score of 104 which shows a high level of power
distance. However the Global Leadership and
Organisational Behaviour and Effectiveness Research
Programme (GLOBE) which was conducted recently
shows that Malaysia‘s score for power distance was
5.17 which was also the average score. This shows
that power distance exists in Malaysian society albeit
not at very high levels.
The Finance Committee commented in the
prelude to the MCCG that there was a tendency for
Boards to be dominated by powerful Chairpersons
due to their social status, political links or because
they were the founders of the corporation. The MCCG
recommended separation of the role of Chairman and
CEO but did not prevent the Chairman or CEO from
becoming a member of important board committees,
for example the audit committee although it
recommended that INEDs should form the majority of
the audit committee. This is not ideal in a society
where there is deference to well-connected or
dominant personalities which could result in board
committees that are complicit with the CEO or
Chairman’s directives even if it transgresses good
governance. In other words the MCCG did not do
enough to prevent dominant Chairmen or directors
from being in a position to manipulate the Board.
Collectivism
In-group collectivism which refers to great
loyalty to family members and in-groups is
pronounced in Malaysia which obtained a score of
5.51 which was above the average score of 5.13 in
GLOBE’s study (Gelfand, Bhawuk, Nishi and
Bechtold, 2004). In societies with high in-group
collectivism, a sense of belonging to an ‘in-group’ is
important and therefore conflicts are ‘swept under the
carpet’ and in most cases face-to-face confrontations
are rare (Triandis, 1988). Criticism is not deemed to
be constructive unlike in less collectivist societies.
The concept of maintaining ‘face’ is important and
criticism is often seen as a weapon used by the critic
to cause ‘loss of face’ to the person being criticized
(Ho, 1976). Those who have opinions that differ from
their group are expected not to air their views but to
remain loyal to their own group and treat those within
their own group better than those outside the group
(Hofstede, 2001; p227).
Triandis states that the culture of a society
influences how people within that culture view their
‘self’. If a culture is collectivist then it influences
people to view the public and collective self more
than their private self which means that they are more
concerned with how others perceive them (Triandis,
Corporate Ownership & Control / Volume 9, Issue 4, 2012, Continued - 2
224
1990). In Asian cultures, where people are
interdependent there is a greater tendency among
people to perceive themselves in light of their public
and collective self (Triandis, 1989). People in
collectivist cultures behave according to norms and
interests of in-groups and value in-group goals
(Hofstede, 2005). They are interdependent because of
their definition of ‘self’ and will accept a high level of
demands from their in-groups. Social relations are
more enduring and occur in large groups. They also
value in-group goals and often place these goals over
their personal goals. For example, if family members
are seen as in-groups, the goals of these members will
take precedence over the individual’s goals. Their
sense of duty guides them towards observing social
norms and they are less concerned with personal
attitudes and values (Triandis, Leung, Villareal and
Clark, 1985). For these reasons directors in Malaysian
companies may face difficulties in presenting views
that differ from the majority especially when they
differ with the Chairman or CEO.
Assertiveness
The level of assertiveness in a society reflects
willingness of individuals to assert their views and to
speak up about issues that they are concerned about.
Cultures with low levels of assertiveness generally
view assertiveness as socially unacceptable and value
modesty. These cultures emphasise ‘face-saving’ and
indirect speech when dissenting with others and also
emphasise tradition, seniority and experience. In such
cultures, a person’s status is important and respect is
accorded to those with high status.
Trompenaars and Hampden-Turner studied
various societies’ adaptability to their surroundings
and found that societies have two orientations towards
nature which determines their level of assertiveness.
They either believe that they can control and
subjugate their surrounding environment or they have
to maintain harmony with it and sometimes subjugate
themselves to it (Trompenaars and Hampden Turner,
1997). Societies in the former category are ‘inner
directed’ or internal because they look within
themselves to take charge and actively control their
environment (Schein, 1992). Control is often exerted
through science. Societies in the latter category are
‘outer-directed’ or external as they believe in a
supernatural being that controls nature.
Trompenaars’ and Hampden-Turner’s studies
reveal that most Western societies fall into the former
group and Asian societies fall into the latter group. A
society’s cultural orientation towards nature affects
the manner in which that society conducts itself on a
day-to-day basis. Where a society believes that it has
to maintain harmony and subjugate itself to nature, it
will try to assert itself in a manner that is not
aggressive. Societies that believe that they can control
nature by obtaining knowledge about the laws of the
universe and using it to control their surroundings are
assertive to the point of being aggressive. Such
societies thrive on competition. The focus is on ‘self’
and conflict and resistance are seen as part of
controlling ones’ destiny. Their research reveals that
Western societies are more assertive while Asian
societies believe that maintaining peace and
compromising in order to maintain peace is a sensible
way to approach life, as there is no point in fighting
forces over which one has no control. However as
societies become developed, they do not subscribe to
the concept that they should subjugate themselves to
nature but seek to control it instead and in the process
become more assertive (Den Hartog, 2004).
GLOBE’s study indicated that Malaysia’s level of
assertiveness is 3.87 and is below the average global
level of 4.14 which reflects that submissiveness is
strong cultural trait.
The levels of power distance, collectivism and
assertiveness in Malaysia poses a challenge to the
board as a whole and the independence of INEDs as it
supports group think and structural bias although
independent directors are meant to be free of such
influence. Directors who are assertive and refuse to
acknowledge the status or power of the Chairman or
CEO may not be re-elected on the grounds that they
are not team-players. In a similar manner, low levels
of assertiveness in Malaysia means that individual
directors may be reluctant to assert their role as
monitors of the corporation especially in government-
linked or family owned corporations. These cultural
values could hamper the role of directors even in non
family or government owned Malaysian corporations
(Fontaine and Richardson, 2005).
Cultural Values and Compliant Boards: Lessons from Five Corporations
In recent years there have been instances of corporate
mismanagement due in part to poor board oversight.
The following discussion will emphasise the boards’
in particular INEDs’ failure to highlight financial
mismanagement although there was evidence pointing
to its existence. The mismanagement was due to a
variety of reasons which the board may not have been
able to prevent. The discussion will only highlight the
contribution of high power distance, in-group
collectivism and lack of assertiveness in government
linked and non-government linked companies which
resulted in compliant boards.
Government linked companies refers to
companies which have government investment
agencies as substantial shareholders. This occurred in
the 1980s when state enterprises were privatised as
part of an exercise undertaken by former Prime
Minister Mahathir Mohamed, to create Malay
capitalists. Malay individuals identified by the
government were given management and control over
privatised state enterprises as a wealth creation
exercise. The result was that GLCs approximated
almost 40% of market capitalization and a class of
Corporate Ownership & Control / Volume 9, Issue 4, 2012, Continued - 2
225
Malay capitalists who had close ties with politicians
was created (Tan 2008: 56-57, Gomez and Jomo
1999: 81-87). Family-owned companies also
comprised a considerable approximation of the capital
market in common with other Asian capital markets
(Lim, 1981; p113). In light of the ownership structure
of many corporations in Malaysia, there is a greater
likelihood of the existence of structural bias and
group think. A study of the top 20 corporations in
2010 in Malaysia according to market capitalization
excluding banks and financial institutions revealed
that many directors including independent directors
had served on the board of the same corporation for
an average of 19 years (Yong, 2011). The annual
reports of GLCs in 2010 also revealed that a large
section of the board in these corporations comprised
male Malay directors whereas ethnic Chinese family-
owned corporations had boards comprising mostly
male Chinese directors.
There are many instances of GLC boards that
were not assertive enough to withstand powerful
CEOs especially if they were aligned to politicians.
Proton, Malaysia’s national car-maker was the brain
child of former Prime Minister Mahathir Mohamed
who continued as Proton’s advisor even after his
tenure as prime minister ended in 2003. In 2005 the
CEO of Proton who was widely regarded as Dr
Mahathir’s appointee made a decision to acquire MV
Agusta a motorcycle manufacturer for RM 370
million in order to use Agusta’s technology (K
Hepworth, 2004). Proton spent approximately RM500
million to start the project before deciding a year later
to sell MV Agusta for RM 4.48 (1 Euro) to Italy’s
Gevi SpA on the grounds that Agusta was on the
verge of declaring bankruptcy which would expose
Proton to a debt of RM256 million (Moses, 2006).
The Board of Proton stated that they were unaware
that Agusta was in debt when they purchased it or that
a cash advance was made without controlling rights
although Proton owned more than 50% shares in
Agusta. They also claimed that they were misled into
believing that the cash advance was working capital
meant to be used to manufacture motorcycles
although it was used to settle Agusta’s debts. Dr
Mahathir argued that the main shareholder of Proton,
Khazanah Nasional, a government investment agency
had agreed to the purchase of Agusta and it had been
discussed by the Board. However one of the former
Board members stated that the decision was sent by
the CEO ‘straight to the top’ referring to the
government, bypassing the Board (Abdullah, 2006)
Sime Darby (Sime) is another example of a
government linked corporation where the dominant
shareholder, Permodalan Nasional Berhad, controlled
the selection of executive directors including the
CEO. In 2010 Sime disclosed losses incurred due to
cost overruns from the Bakun Hydroelectric Project
and both of its Qatar Petroleum (QP) and Maersk Oil
Qatar (MOQ) projects which amounted to almost RM
2 billion. Sime’s internal auditor issued a report in
2008 on the losses incurred by the oil and gas
segment which was brought to the attention of the
audit committee but the losses were deemed
immaterial after the committee requested an
explanation from the CEO. No further investigations
were conducted although its external auditor delayed
signing off on the accounts. Sime also denied reports
of cost overruns of RM800 million in 2009 even
though its internal auditor issued another report
voicing grave concerns over losses in the oil and gas
segment. In 2010 its external auditor recommended to
Sime’s Chairman, a former deputy Prime Minister of
Malaysia that it was necessary to form a working
group to investigate the extent of losses. It was
discovered that although the Board was aware of the
situation, they relied on Sime’s CEO’s explanation
regarding the delays in the project and the cost
overruns (Ng, 2010).
Malaysia Airlines (MAS) another government-
linked company suffered losses amounting to RM 8
billion when it was under the control of its executive
chairman Tajuddin Ramli who was appointed by the
government. He obtained controlling interest over the
airline in 1994 by obtaining a personal loan from a
syndicate of local banks amounting to RM 1.79
billion to purchase MAS shares from the Central
Bank. During this period he relocated MAS cargo
operations in Europe from Amsterdam and Frankfurt
to Hahn through Advanced Cargo Logistics Centre, a
company that was connected to his family. This
proved to be inefficient as cargo had to be transported
by land to Frankfurt for customs clearance. As Hahn
was not equipped to deal with large aircraft, outgoing
cargo was transported on smaller aircraft resulting in
losses amounting to RM10 to 16 million per month
(Jayasankaran, 2010). In 1998 Tajuddin sold MAS
aircraft to MAS Capital a new company under his
control. MAS Capital leased back the aircraft to
MAS. The book value of the aircraft was RM 9.5
billion but due to the depreciation of the ringgit, its
actual value amounted to RM14 billion. MAS Capital
refinanced the aircraft and used the surplus to pay
Tajuddin a combination of cash and shares amounting
to RM 739 million for stake in two of his companies.
The sum paid to Tajuddin was used to clear part of his
personal debt. When objections were raised by
investors former Prime Minister Dr Mahathir stated
publicly that this was a normal process (Pereira,
1998). In 2001, the government re-nationalised MAS
by purchasing Tajuddin’s stake at the same price at
which he had bought it from the Central Bank
although the market value was less than half that
amount. Tajuddin failed to service his personal loan to
the syndicate of banks and the non-performing loan
was purchased by Pengurusan Danaharta which was
established by the government to deal with non-
performing loans during the Asian financial crisis.
Danaharta was awarded RM589 million by the High
Court and in his defence, Tajuddin claimed that he
was asked by Mahathir and former Finance Minister
Corporate Ownership & Control / Volume 9, Issue 4, 2012, Continued - 2
226
Daim Zainuddin to purchase MAS in 1994 in order to
rescue the Central Bank which had suffered losses in
currency trading. In August 2011, the government
instructed Danaharta and all other government linked
companies to cease civil action against Tajuddin on
the grounds that they wanted to pursue an out of court
settlement (Ng, 2011). The major decisions in MAS
appear to have been made by the Chairman, Tajuddin
and the government with little reference to the Board.
The failure to question powerful CEOs or
Chairmen is not peculiar to government linked
companies. In the last 5 years, there have been multi-
million ringgit losses in several Malaysian
corporations namely Linear, Kenmark and Transmile
due to fraud or mismanagement. These corporations
had several things in common namely the founders
remained on the Board either as CEO or Chairmen
and were also members of the audit committee.
The Executive Director of Linear who was also
its founder issued a public statement in 2009 that it
had been awarded RM1.66 billion contract by a
Seychelles-based corporation, Global Investment
Group Inc (GIG) to build a district cooling system for
a project known as the “King Dome” project in
Malaysia. The value of the contract was said to be
worth US$5 billion. Linear did not have the capacity
to carry out a project of such magnitude but the Board
did not question the announcement by the executive
director. It was subsequently discovered by the
special auditor appointed to undertake an independent
probe into Linear’s affairs that its financial statements
from 1999 to 2008 were overstated as Linear’s
announcements of sales of solar energy panels and
cooling tower parts to foreign corporations could not
be proven and there was also no proof of the King
Dome project. The Executive Director who had been
instrumental in the purported projects had transferred
RM36 million to Linear’s Prime Savings & Trust
accounts in Sweden without prior approval from the
Board purportedly as a guarantee for performance to
facilitate the King Dome project (Tee 2011). Linear is
now placed in the Bursa Malaysia’s PN17 list which
is for corporations facing liquidity problems. The
directors of Linear, including INEDs did not inquire
into the details of the project and did not form a risk
committee to assess if Linear was over-exposed when
undertaking the project although there were warnings
from analysts that there was a lack of transparency in
the manner in which the project was announced.
The failure of the audit committee to introduce
strong internal controls resulted in losses to Transmile
Group Berhad (Transmile) where the founder Gan
Boon Aun, remained a dominant player on the Board
even after Transmile was listed in 1997. Transmile
was an investment-corporation which had subsidiaries
involved in the provision of air transportation
services. In 2005, Transmile’s auditors were unable to
obtain the supporting documents from the
management to satisfy itself as to the fairness of the
trade receivables and related sales to several
corporations. Investigations revealed that there were
no documents to support payments of RM341 million
made for the purported purchase of property, plant
and equipment from Transmile. Furthermore, the
investigation revealed that CEN Worldwide Sdn Bhd
(CEN) which was owned by Gan’s nephew continued
to be given credit although it owed Transmile RM103
million in unpaid debts (Rahman and Salim, 2010;
p99). Khiuddin Mohammed an executive director of
CEN was also an executive director of Transmile and
member of its audit committee. Gan and Khiuddin
played a large role in Transmile’s business
transactions until the financial losses were uncovered.
Transmile’s losses amounted to RM530 million due to
overstatements and it was subsequently delisted from
Bursa. Khiuddin was recently convicted for his role in
Transmile’s fraudulent transactions (Nazlina, 2011).
Furthermore the Board including the other audit
committee members did not question Khiuddin’s role
on the Board of CEN and the transactions between
CEN and Transmile.
Kenmrk Industrial Co Ltd (Kenmark) is another
recent example of a corporation where a dominant
director who was also its founder was able to control
the Board and management. Kenmark was established
by James Hwang, a Taiwanese who together with two
other Taiwanese directors owned almost 50% of
shares in the corporation. In May 2010 letters of
demand amounting to over RM60 million were issued
to Kenmark as guarantor for loans obtained by its
wholly owned subsidiaries. Hwang, Kenmark’s
managing director together with the other executive
directors who were his relatives and friends were not
contactable for a week. The INEDs who did not know
of these demands were alerted only when it was
highlighted by the Press. They were unable to answer
questions posed by the regulators or the Press on
Kenmark’s status (Goh, 2010). Hwang later
engineered active trading of the shares due to
misleading statements in the Press and disappeared
once he had divested himself of most of his shares.
The INEDs admitted that Hwang held information
‘close to his chest’ and did not keep them informed
about Kenmark’s financial transactions. The INEDs
attended Board meetings dominated by Hwang and
his family members and friends and were unaware of
the company’s risky financial position. Kenmark has
since been de-listed from Bursa Malaysia.
Boards should be prepared to demand more
accountability or transparency from senior
management and executive directors. Independent
directors who should not have strong connections to
the Board are ideally placed to make such demands.
However the levels of power distance, collectivism
and assertiveness in Malaysia make it difficult for
them to challenge the founder or dominant director in
these situations. In the cases mentioned above there is
a strong likelihood that some of the INEDs were not
independent in mind and had structural bias towards
their colleagues on the Board especially in the case of
Corporate Ownership & Control / Volume 9, Issue 4, 2012, Continued - 2
227
Sime where one director had served for 28 years. It is
also likely that ‘group think’ resulted in the selection
of directors who were less inclined to be suspicious of
people like them. The majority of the Board of Sime,
MAS and Proton comprised former civil servants or
government investment agency appointees. Many
members of the Board moved in similar social, work
and political circles and were possibly inclined to
accept the assurances of the CEO or Chairman who
came from the same background, that there was no
financial mismanagement in spite of red flags raised
by the auditors. It is difficult for them to demand
more accountability when the Chairman or CEO is a
person with strong political connections which raises
the issue of power distance. Many of the Board
members in government linked companies are Malays
and in Malay culture, criticisms and challenges
against those in authority or from a higher social
hierarchy are considered rude and causing loss of face
is often avoided. Criticisms if any, is only tendered in
mild language and often after showering the powerful
person with praises (Pye, 1985). Power distance may
also inhibit directors from criticising founders of the
Board to whom they may owe their position.
Furthermore in-group collectivism results in directors’
tendency to sweep matters under the carpet as
pursuing controversial issues may compromise their
loyalty to their in-groups. Pye notes that there is a
strong tendency to defend in-groups even in the face
of overwhelming evidence that someone in that in-
group has committed a wrong. This is because loyalty
is highly valued.
Malaysian Code of Corporate Governance 2012
The Securities Commission launched the Corporate
Governance Blueprint in 2011 and indirectly
addressed cultural values through proposed reforms in
Malaysian Code of Corporate Governance 2012
(MCCG 2012) making it easier for directors
especially INEDs to carry out their monitoring duties.
The reforms are addressed below.
Maintaining independence
An important step in maintaining independence of
directors has been to limit the tenure of all non-
executive directors including INEDs as there appears
to be a serious problem in this area in Malaysia. The
UK Code of Corporate Governance 2010 has taken
this step and stipulated that if NEDs serve more than
nine years they should be subjected to annual re-
election. The Singapore Code states that a period of
nine years is appropriate tenure but leaves it to the
Nomination Committee to justify if a director remains
independent beyond the nine years of his or her
service. Limitation of tenure will prevent structural
bias in INEDs who have served for many years and
while the flexibility of permitting the nomination
committee to justify employing a director beyond this
period may be maintained, the MCCG 2012 has
adopted the period of 9 years as the norm. There is no
guarantee that limiting the tenure of directors will
ensure that they are independent throughout their
tenure but it may reduce instances of structural bias
especially as the Code requires INEDs to be assessed
annually to determine their independence.
The MCCG 2012 maintains the requirement that
one third of the board should comprise INEDs but has
adopted similar provisions to the Singapore Code
which states that half the Board must comprise INEDs
when the Chairman of the Board and the CEO is the
same person or the Chairman is not an INED. This
change may address the problem of powerful
Chairmen or CEOs who dominate the Board and will
also take into account the high level of power distance
and low assertiveness in Malaysia. An increase in the
number of independent directors under such
conditions may result in greater assertiveness as they
would be able to put forward their views as a group.
This should also be implemented where the
corporation’s founder holds an influential position on
the Board even if he or she is not CEO or Chairman
as they appear to wield great influence over the Board
as in the case of Linear, Kenmark and Transmile.
Nevertheless this will not always ensure independent
and vocal boards as half the Board of Sime comprised
INEDs, but this did not prevent its financial losses.
The main reason for this is due to ‘group think’ as
almost all the members of the board moved in the
same work, social and political circles. This problem
should be addressed through greater board diversity.
The MCCG 2012 stipulates the need for diverse
boards and the CG Blueprint 2011 recommends that
more women should be appointed to the board. Spain
and Norway require corporations to increase the share
of female directors to 40% although there is much
debate on whether a quota will achieve its purposes as
corporations have been unable to meet the target or
have simply propelled women to the board to fulfil
the target without a comprehensive training plan to
ensure that they are properly equipped to take on the
role. Australian corporations have increased the
number of women on boards from 8% in 2008 to 14%
by April 2012 through a mentoring programme
initiated by the Australian Institute of Company
Directors (AICD) which identified capable women
and selected leading chairmen and directors of ASX
200 companies to mentor them until they were ready
to serve on the board. This is a sustainable method of
appointing women directors and will ensure that the
appointees provide value other than diversity to the
board.
There is sufficient diversity in Malaysia due to
the presence of different ethnic groups comprising
Malays, Chinese, Indians, Kadazan and Ibans as well
as other minority groups. The levels of power
distance, in-group collectivism and assertiveness
among the major ethnic groups comprising Malays
Corporate Ownership & Control / Volume 9, Issue 4, 2012, Continued - 2
228
and Chinese is not very different (Lim, 1998; Sendut,
Madsen and Thong, 1990) although there are lower
levels of power distance and higher assertiveness
among the Chinese (Abdullah, 1992). In-group
collectivism is high among both these groups which
creates a greater tendency for ‘group think’. While
Boards should comprise members of various ethnic
groups in Malaysia who bring different viewpoints,
the similarity of cultural values indicates that it may
be an added advantage to appoint foreign directors
where possible as they have different cultural values
and may not be as susceptible to ‘group think’. It
would also be an advantage to appoint women
directors who bring different perspectives to the
Board and are more meticulous about certain aspects
of internal controls (Adams and Ferreira, 2009) but
the number of women and board members from
diverse ethnic backgrounds should not be mandated.
Instead the Board should be evaluated every three
years to assess its effectiveness and diversity. Bursa
Malaysia’s Corporate Governance Disclosure Guide
2012 permits the Exchange to reject the nomination of
directors if it is of the opinion that it does not enhance
Board diversity. This may force corporations to
examine whether they have a diverse boards or risk
interference by the Exchange.
Conclusion
The significance of this research is that it highlights
that structural bias and group think which is a
problem faced by capital markets in general is
compounded by cultural values in Malaysia. It also
highlights that due to pervasive cultural values,
Malaysia directors including INEDs may not resist
dominant directors and as a result may not insist on
strong internal controls as this is perceived as a lack
of trust. Criticisms are often perceived as personal
attacks and directors who persist in criticising
members of the Board especially the Chairman and
CEO may find themselves isolated or even removed
from the Board on the grounds that they are not good
team players. There is also a natural inclination to
form in-groups which may affect the independence
and professionalism of some directors. INEDs are
placed in a difficult position of having to act as
monitors of the Board and senior management under
conditions where cultural values uphold in-group
collectivism and high power distance.
The MCCG 2012 has taken steps to address this
problem to a certain extent by emphasising the role of
INEDs, requiring the nomination committee to assess
their independence annually and limiting their tenure,
as well as emphasising board diversity. It attempts to
drive the message that INEDs have a clear role to play
which the board has to recognise even if it does not
resonate with cultural values in Malaysia. While there
is no guarantee that this will prevent structural bias
and group think, it sends a clear message that these
practices are discouraged. While it may take time to
change board practices, the provisions in the MCCG
2012 are a step in the right direction.
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Corporate Ownership & Control / Volume 9, Issue 4, 2012, Continued - 2
230
DETERMINING WHICH MANAGEMENT LEVEL MAKES DECISIONS WHEN OUTSOURCING THE DISTRIBUTION
FUNCTION
Johan Muller, Louise van Scheers*
Abstract
Outsourcing is one of the widest used methods of facilities management employed by organisations for doing business in today’s global economy. The main purpose of the research is to evaluate consensus amongst the different levels of management to outsource the distribution function at a South African steel retailer. The research survey was done in the form of a questionnaire utilising statements with a quantitative. The population selected was the first three levels of management across all six of the business units. Analysis of the data was done with the statistical package of social sciences SPSS and the applied pedometric techniques such as Chi-square and ANOVA. Findings and results from the analysis indicate that management are positive towards adopting outsourcing. Keywords: Outsourcing, Distribution Function, Retailer, Different Levels of Management, Top, Senior and Middle Management Levels Corresponding author, Marketing and Retail Department, School of Business Management, University of South Africa, PO Box 329
Unisa 0003 Tel.: 012 429 4938 E-mail: [email protected], [email protected]
1 Introduction
Driven by political and economic dynamic changes,
facilities management was borne to enable reacting to
change. Doing business in today’s global economy
requires exceptional skills from management in order
to be competitive and to have a specific competitive
advantage over competitors are even more
demanding. One of the widest used methods of
facilities management deployed by organisations is
that of outsourcing in various forms (i.e. I.T., H.R.,
Distribution, Warehousing, etc.) for various different
reasons (i.e. reduce costs, improve quality, focus on
core business, etc.). In order for outsourcing to be
successful, it needs to add benefits to profits,
efficiency or effectiveness ethic. Outsourcing assists
management to gain a competitive advantage over
competitors within their specific industries as part of
their organizational strategies and developing or
strengthening core competencies at the same time
(Taplin, 2008). Outsourcing the distribution function
involves hiring a third party to store and distribute
your products through its national or international
distribution network; this party provides the staff,
warehouses, and distribution centre and transportation
fleet. Distribution is not the core competency for this
steel retailer therefore management decided to
outsource this function to allow them to focus on your
mission-critical activities. However it seems that there
are differences in consensus amongst the different
levels of management to outsource this function.
This research aims to determining the
management level which makes decisions when
outsourcing the distribution function at South African
steel retailer. The steel company is a privately owned
industrial management group. The group is
represented in the UK, Australia, USA and South
Africa where it manages a diverse portfolio of small-
to-medium sized enterprises focussed on addressing
niche segments.
2 Problem statement
Following the changes in the South African political
dispensation and the launch of the Broad Based Black
Economic Empowerment policy, organizations were
forced to revisit their structures and policies. A score
card was devised whereby organizations earn points
in different categories of the company, i.e.
shareholding, management structure, supply partners,
development & training programs, upliftment
programs, welfare participation contributions, etc.
This will categorise an organisation in terms of what
level of Black Economic Empowerment contributor
the company is for doing business. Fuelled further
with the economic recession globally, organizations
faced downscaling, retrenchments and restructuring
the way they used to do business in order to create
sustainability and compliance. These changes forced
the steel retailer to outsource some of the non-core
functions to stay competitive. One of the various
outsourcing options implemented by the steel retailer
Corporate Ownership & Control / Volume 9, Issue 4, 2012, Continued - 2
231
was to break down the head office structure by
relocating the finance related functions resources to
business units for better control and optimisation and
also outsourcing of the distribution function to an
external company. This was however left to the
demise of each business unit manger’s own decision
instead of a group strategy to which company they
will be outsourcing and on what basis this will be
structured.
3 Aim and Objectives
The main purpose of the research is to evaluate
differences in consensus amongst the different levels
of management to outsource the distribution function
at a South African steel retailer. The objectives are:
Determining the management level which makes
decisions when outsourcing the distribution
function
Gathering perceptions on views of the top,
senior and middle management on outsourcing
the distribution function
The following hypnoses were formulated:
H₁ = There is a positive correlation between the
general importance of outsourcing and the
opinion of the retailer toward outsourcing of
distribution.
H₂ = There is a positive correlation between the
retailer’s opinion toward outsourcing and the
potential improvement that outsourcing can
bring.
H₃ = There is a positive correlation between the
improvement of the retailer and the financial and
revenue implications to the retailer.
H₄ = There is positive correlation between the
financial and revenue reasons and the cost of
outsourcing distribution.
H₅ = There is a positive correlation between the
cost and the risks associated with outsourcing.
H₆ = There is a positive correlation between the
risks and the level of satisfaction with the
current situation.
H7 = There is a positive correlation between cost
driven reasons to outsource and level of
satisfaction with current situation
4 Research Methodology
A quantitative approach was used with a survey
questionnaire as the method for collecting the data
between 15 October and 15 November 2010. The
design for this research will be a quantitative
approach and the instrument available for data
collection will be a survey questionnaire. The
population for the research survey is the South
African steel retailer and the sample consists of the
three different levels of management classified as
Level 1, Level 2 and Level 3 as per the Organogram
of the organization. Table 1 represents a breakdown
of the management classification, the total
participants involved in the research and the number
of respondents within the three different levels.
Table 1. Research Participants and Classification
Management Classification Total Participants Number of
Respondents
Level 1 (Top Management) 7 7
Level 2 (Senior Management) 21 21
Level 3 (Middle Management) 33 33
Total 61 61
Source: The steel retailer S.A. Outsourcing Survey
Level 1 participants consists of top management
in the Group (all directors on the board) whose
responsibility mainly relates to strategic decision-
making within the Group and/or business unit.
Level 2 participants represent the top
management within the business units (directors and
senior managers at business unit level) and whose
responsibility mainly relates to strategic and/or
operational decision-making for the specific business
unit.
Level 3 participants represent the senior
management within the business units and whose
responsibilities mainly relates to operational decision-
making for those business units.
The questionnaire comprises 37 statements that
revolve around six important aspects of the
outsourcing phenomenon. The 37 statements of the
questionnaire measure the opinion of the three levels
of management based on a 5-point balanced Likert-
type scale.
5 Literature Review
Different organizations will outsource different
operations which could include mostly noncore
functional areas i.e. I.T., Distribution, Warehousing,
etc. relevant to their specific organizational needs.
There is different models available in order to assist
management in their decision making process for the
specific function to be outsourced. Outsourcing is the
process of purchasing goods or services on
specification from an external supplier that were
previously produced in-house (Mol, 2004:585).
Outsourcing can involve the transfer of an entire
Corporate Ownership & Control / Volume 9, Issue 4, 2012, Continued - 2
232
business function to a supplier or the transfer of some
activities associated with the function whilst some are
kept in-house. Wisner, Tan and Leon (2009:116) use
the term co-sourcing for the partially outsourcing of
functions or activities. We also find that vertical
integration or disintegration is associated with
outsourcing. Vertical disintegration is concerned with
the decision on whether to perform an activity
internally or source it from outside. Another term that
is often used in a manufacturing context is ‘make-or-
buy’ (McIvor, 2005:7).
Outsourcing
There is no certainty as to when outsourcing (the
concept of employing specialized skills from outside
the company to perform a specific function for the
organization for a period of time or indefinitely)
started, but this term was invented by the Information
Systems Trade Press during the late 1980’s. The term
was used to describe the trend that developed amongst
large organizations to transfer their information
systems to external service providers (Greaver, 1999).
According to Roman Seidl (2007) emerging research
was seen to have examined several aspects of
outsourcing and its impact on “why” and “how”. The
primary reason for outsourcing is found to have
changed from cost cutting to focussing on their core
business. A possible assumption is that today’s
companies analyse and categorise their processes
according to core and non-core processes,
consequently the sharpened company focus has
become the main reason for outsourcing.
One of Porter’s Generic Strategies (Porter, 1980)
is access to lower costs; which can be achieved
through optimal outsourcing and vertical integration if
executed smartly with the necessary research,
investigations and careful selection of sourcing
partners. Porter (Porter, 1998) also recognises the
value chain as useful in outsourcing decisions. By
understanding the linkages between activities it can
lead to more optical make-or-buy decisions that can
result in either a cost advantage or a differentiation
advantage. Readings from Bendor-Samuel (2000)
makes it clear that all over the world companies are
facing increasingly competitive markets and need to
improve organizational operations to stay ahead of
competitors and he maintains that outsourcing of non-
core activities is the main alternative management
tool available to achieve this goal.
Reasons to Outsource From the researcher’s various readings, Greaver
(1999), Badenhorst-Weis and Nel (2008), Rosenberg
& Macaulay (1993), IAOP (2009a), Dimension Data
(2009), Atos Origin (2004), Think180 (2008c) &
Seidl (2007), the following summary of reasons were
identified but are not limited to these:
Focusing in-house resources on more strategic
business issues and/or new technology and
systems;
Increased competition, need to improve
competitive advantage;
Globalization of markets;
Reorganization and streamlining;
Availability of necessary skilled workforce;
Different organizations will have different needs
and in-house skill sets for variation in reasons and
methods for outsourcing. Some organizations will
also make use of insourcing as appose to outsourcing
for a period of time depending on the requirements
and the level of in-house skills.
6 Research Findings
Overall summary of Management Mean Score
analysis:
Table 2. Overall Summary of Management Mean Score Analysis
Source: The steel retailer S.A. Outsourcing Survey
Corporate Ownership & Control / Volume 9, Issue 4, 2012, Continued - 2
233
Table 2 reflects the overall situation with the
seven grouped categories (Factors) pertaining to the
outsourcing concept at a South African steel retailer,
displaying the mean averages obtained by each
management group four each of the seven factors and
an overall measure for the factors. From the data in
Table 2 it becomes evident that Top Management is
the least positive with outsourcing but not at any
significance levels. Further investigation will explore
more in-depth analysis to interpret these summarised
results more intensely.
Table 3. Cronbach’s Alpha coefficient
Summary of Quantitative Data
Cronbach’s Alpha Coefficient
Source: The steel retailer S.A. Outsourcing Survey
Statistically spoken, a Cronbach value of
between 0.6 and 0.8 is of an acceptable level (the
internal consistency is adequate) and a value of
between 0.8 and 1.0 is considered good. From table 3
it is apparent that factor 2 of the data analysed is just
below the minimum requirement due to the low mean
scores of questions 5 to 7 which is a concern for this
research results.
Corporate Ownership & Control / Volume 9, Issue 4, 2012, Continued - 2
234
Table 4. Correlations between the 7 Factors
Correlations between the Seven Factors:
Source: The steel retailer S.A. Outsourcing Survey
Correlation is a measure of linear association
between 2 variables. A correlation coefficient of 1
indicates perfect correlation, and a correlation
coefficient of 0 indicates a total lack of any linear
association. In Table 4 the highlighted correlations
indicate where the correlation is significant between
two factors of the analysis i.e. the correlation between
Financial and Revenue Driven Reasons to outsource
and that of General Importance of Outsourcing is
0.019 which is below the level of 0.05 and is therefore
significantly different from “0”.
Hypotheses Testing
H₁ = There is a positive correlation between the
general importance of outsourcing and the opinion of
the organization toward outsourcing of distribution.
General Importance of outsourcing (F1)
Organizationally Driven reason to outsource (F2) =
0.067
The correlation between F1 and F2 is closer to
zero and indicates a lack of linear association.
This indicates that the organization as a whole
does not deem outsourcing to be of general
importance. The results show that the H₁ hypothesis
was rejected and the alternative is accepted. Ha₁ =
There is a Negative correlation between the general
importance of outsourcing and the opinion of the
organization toward outsourcing of distribution.
Middle and senior management agree more than top
management to the general importance of
outsourcing, because middle management especially
has to handle the distribution function.
H₂ = There is a positive correlation between the
organizations opinion toward outsourcing and the
potential improvement that outsourcing can bring.
Organizationally Driven reason to outsource
(F2) Improvement driven reasons to outsource
(F3) = 0.004
The correlation between F2 and F3 is closer to
zero and indicates a lack of linear association.
Generally the organization feels that outsourcing
won’t improve their business. The results show that
the H2 hypothesis is rejected, thus accepting the
alternative. Ha2 = There is a negative correlation
between the organizations opinion toward outsourcing
and the potential improvement that outsourcing can
bring.
Middle and senior management believes that
outsourcing is important but won’t improve the
organization.
Middle and top management are more involved
with the distribution and believes that outsourcing the
distribution function will definitely improve the
organization.
Corporate Ownership & Control / Volume 9, Issue 4, 2012, Continued - 2
235
H₃ = There is a positive correlation between the
improvement of the organization and the financial
and revenue implications to the organization.
Improvement driven reasons to outsource (F3)
Financial and revenue driven reasons to outsource
(F4) = 0.000
The correlation between F3 and F4 is at the
lowest point of the scale, indicating a total lack of
linear association, indicating that there is a complete
lack of association between the improvement of the
business and the financial and revenue implications.
This indicates that the H₃ hypothesis is rejected and
the alternative is accepted. Ha₃ = There is a negative
correlation between the improvement of the
organization and the financial and revenue
implications to the organization. Top management
obviously wants to improve the state of the
organization but they are not willing to spend money
on outsourcing distribution.
Top management’s opinion is very neutral
towards the statement that outsourcing will cause
general improvement, while middle management
believes that it will make a significant difference. Top
management is involved with the management of the
resources (financial and other) and they are not
involved with the operational functions.
H₄ = There is positive correlation between the
financial and revenue reasons and the cost of
outsourcing distribution.
Financial and revenue driven reasons to
outsource (F4) Cost driven reasons to outsource
(F5) = 0.176
The correlation between F4 and F5 is closer to
zero and indicates a lack of linear association. There
is little linear association between the cost and the
financial and revenue driven reasons. Therefore the
H4 hypothesis is rejected and the alternative is
accepted. Ha4 = There is negative correlation between
the financial and revenue reasons and the cost of
outsourcing distribution. Middle management is of the
opinion that there are positive financial consequences
to spending money on outsourcing distribution, while
top management is not willing to spend money on
outsourcing as they believe that it is better to spend
the money on something else.
H₅ = There is a positive correlation between the
cost and the risks associated with outsourcing.
Cost driven reasons to outsource (F5)
Reasons not to outsource and risks associated with
outsourcing (F6) = 0.755
The correlation between F5 and F6 is close to
one and therefore indicates a more perfect linear
association.
The belief is that it costs more not to outsource.
This indicates that it is more cost effective to
outsource distribution than to handle internally. The
results show that the H₅ hypothesis was accepted.
Middle, senior and top management’s opinions are
very close together and are above average toward the
cost involved not outsourcing distribution.
H₆ = There is a positive correlation between the
risks and the level of satisfaction with the current
situation.
Reasons not to outsource and risks associated
with outsourcing (F6) Level of satisfaction with
current situation (F7) = 0.534
The correlation between F6 and F7 is close to
the halfway mark, but indicates a closer to perfect
linear association. There is an above average opinion
toward the risks involved with outsourcing and the
level of satisfaction with the current situation. They
are a little hesitant to take on risks to improve their
current situation. This indicates that the H₆ hypothesis
can be accepted. Top management is not satisfied
with the current situation but is a little hesitant to take
on risks associated with outsourcing. The two factors
that have the most perfect linear association with each
other are F7 and F5.
H7 = There is a positive correlation between
cost driven reasons to outsource and level of
satisfaction with current situation
F5 = Cost driven reasons to outsource F7 =
Level of satisfaction with current situation = 0.906
The general feeling is that they want to improve
the current situation but keep the costs to a minimum.
The two factors with the most lack of linear
association with each other are F3 and F4.
Analysis pertaining to the three levels of Management
Ideally the mean scores should have a low standard
deviation; the Levene Test bigger than 0.05 and the
ANOVA bigger than 0.05.
Corporate Ownership & Control / Volume 9, Issue 4, 2012, Continued - 2
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Table 5. General Importance of Outsourcing Analysis by Management Level
Source: The steel retailer S.A. Outsourcing Survey
The data in Table 5 reflects an overall mean
score of 3.5458 with a standard deviation of 0.67568;
Levene’s test for homogeneity of variances with
P=0.859 versus 0.05 (no significant differences in
variances) and ANOVA significance value P=0.199
versus the alpha value of 0.05 (Management Level
has no significance upon the mean score of Factor 1).
The level of dispersion within the management levels
are however not good, standard deviation too high–
difficult to come to any conclusions.
Corporate Ownership & Control / Volume 9, Issue 4, 2012, Continued - 2
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Table 6. Data analysis of Factor 3 by Race classification within Management
Source: The steel retailer S.A. Outsourcing Survey
Table 6 shows that apart from three outliers, the
non-white box-plot analysis indicates a narrow spread
between the 100% and nil % margins, but with the
White management there is a too wide spread and
needs to be further analysed.
Table 7. Data analysis of Factor 3 for Whites by Management Level
Source: The steel retailer S.A. Outsourcing Survey
Table 7 indicates a fairly good spread with
Middle Management and Top Management apart
from the outlier, but with Senior Management we see
a too wide spread. There is thus significant statistical
difference with White Senior management. Taken into
account that there are 17 people in Senior
Management from a total of 43, they can have a
statistical influence on the results of White
Management in general.
Corporate Ownership & Control / Volume 9, Issue 4, 2012, Continued - 2
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6 Conclusion
Management consensus and perceptions on outsourcing the distribution function
General Importance of Outsourcing
An average mean score of 3.5458 (table 5) indicates
that management in general realizes the importance of
outsourcing and acknowledges that outsourcing
should and will form part of the organization’s
business strategy. The middle management reflects
the strongest opinion of 3.65 versus that of senior
management at 3.52 and top management less
convincing with a score of 3.14 (a ‘not sure’ per the
Likert scale).
Middle management who is closer to the action
on the floor realises the benefits of outsourcing and
top management should take note of this and
investigate why middle management is so much more
positive towards outsourcing. This is reflected in
statement 3 (table 5) with the highest mean score of
4.1 towards freeing up management time to focus on
core competencies whilst developing current or new
competencies.
Organizationally Driven Reasons to Outsource
The analysis indicates an even stronger sense of
importance of outsourcing and also a much higher
cohesiveness amongst all three levels of management
with senior management the most positive towards
organizationally driven reasons to outsource with a
mean score of 3.85 versus middle management of
3.83 and top management of 3.74 (see table 5).
The highest mean score of 4.0 attained for factor
2 reflective in statement 7 (see table 6) in that
management should consider outsourcing in order to
obtain specialized services to ensure flexibility within
the organization. This reinforces management’s
seriousness of the role that outsourcing can play in the
organization’s business strategies.
Statements 5 and 8 representing focussing on
customer needs attracted the lowest mean scores
(3.733 & 3.567 per table 5) but still indicating
management is convinced that outsourcing can
improve customer relations or service levels to
customers.
Indications are present that management agrees
that outsourcing will enhance organizational
effectiveness by focussing on core activities, obtain
specialised services through outsourcing to ensure
flexibility within the organization and should they not
be able to attract the correct skills to perform a
specific function.
Improvement Driven Reasons to Outsource
From the data in Table 4 it becomes evident that
factor 3 has the lowest mean score rating of all the
factors (excluding factor 7) of 3.475 and very low
level of Levene (0.056) and unacceptable level of
ANOVA (0.016) versus significance level of 0.05 as
minimum standard.
Indications from Table 5 is that statements 10,
13, 14 and 15 have very low mean scores (‘not sure’)
indicating management is less positive towards
outsourcing improving the organization’s image by
linking to credible providers in the market place,
improving the quality factor regarding services
provided to customers, broadening the existing skills
base within the organization and improving the risks
management function by transferring certain functions
to service providers.
Further analysis per Table 6 and Table 7
indicates that White Management and in particular
Top Management are less convinced towards
improvement driven reasons to outsource. From the
graph (see Table 18) top management’s 50th
percentile is below Likert scale of 3 (‘not sure’) and
although senior management’s 50th
percentile is just
below 3.5 of the Likert scale, the 100% and nil% is at
the 4.5 and 2.2 ratings respectively with an outlier at 2
indicating high levels of difference in opinion
amongst senior management. The research indicates
that the individuals in the age bracket 25 – 35 yrs are
mostly convinced towards outsourcing for
improvement with age bracket 36 – 45 yrs also more
than 3.5 per the Likert scale indicating a high positive
attitude towards outsourcing for improvement. The
research study revealed that the three levels of
management in general 16.77% of the statements per
the outsource questionnaire were answered negative
towards outsourcing, 15.58% “not sure” and
overwhelming 67.75% in agreement with utilising
outsourcing as a management tool. This indicates that
the management team of steel retailer recognizes the
importance of outsourcing and the implementation
therefore regarding non-core activities associated with
the organization and the impact thereof on operational
aspects of the business strategy.
The aim of the research was to establishing
whether there is consensus between top, senior and
middle management on outsourcing the distribution
function. The research concluded that there is no
consensus between top, senior and middle
management on outsourcing the distribution function.
The research reflects that middle management is
overall far more inclined to outsourcing than that of
top management in all of the 6 factors pertaining to
the questionnaires. Top Management is ‘not sure’
about four of the six factors leaving the impression
that they are not in favour of outsourcing. The
average mean score for all management is inclined to
outsourcing for five of the six factors and middle
management six out of the six factors. This leaves the
situation with a big gap between top and middle
management regarding outsourcing as a management
tool improving business processes and strategies.
Corporate Ownership & Control / Volume 9, Issue 4, 2012, Continued - 2
239
It would thus appear that Top Management is
too far removed from the operations and lost touch
with the rest of the management team and are not
acting responsibly towards the long-term future of the
Group.
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CRIME, SECURITY AND FIRM PERFORMANCE IN SOUTH AFRICA
Busani Moyo*
Abstract
We use cross sectional data from the World Bank enterprise surveys gathered in 2007 in South Africa’s four cities (Johannesburg, Cape Town, Durban and Port Elizabeth) to assess the impact of business related crimes on firm performance proxied using firm sales. Using Ordinary Least Squares (OLS) and Tobit model, we find that crime in the form of theft, robbery, arson and vandalism has a negative effect on sales and hence firm performance. However the impact of domestic shipment crime is mixed and varies from city to city depending on the magnitude of losses incurred by firms in each city. Results also show that crime is regressive in nature because crime related losses are relatively higher among small firms than large firms. The prevalence of crime amongst small firms and its negative effect on firm performance suggest the need for government and the business community to come together and develop security systems that are effective and affordable to small businesses. This is because, supporting small businesses is important for growth and employment creation. Keywords: Crime, Security, Firm Performance * Senior Lecturer in the Department of Economics at the University of South Africa, Preller Street, Muckleneuk Ridge, Pretoria: P.O. Box 392 UNISA 0003 South Africa Tel.: +27 12 429 6191, +27 84 526 9216: E-mail: [email protected], [email protected]
1 Introduction
According to the results of a global survey carried out
by PricewaterhouseCoopers in 40 countries between
April and July 2007 as well as November 2009, fraud
was found to be one of the most problematic issues
for business worldwide. The 2007 survey which
covered about 103 companies (of which 71% were
listed) found that South African companies have been
the subject of more crime than most other countries in
the world. According to the survey, 72% of these
companies uncovered fraud over the last two years,
compared to 43% of the businesses surveyed
worldwide6. The same pattern was also replicated in
2009 with about 52% of South African firms falling
victim to economic crime compared to 30% globally.
The most common crimes in South Africa,
according to the 2007 and 2009 surveys were asset
misappropriation (theft), product piracy and
counterfeiting, bribery and corruption as well as
financial misrepresentation. The surveys also found
that larger companies with more than 1000 employees
are most vulnerable to fraud, and that the financial
services companies reported more incidence of fraud
than any other industry.
6 The African continent also tops the list in terms of having the highest level of economic crime worldwide at 51%, followed by North America with 41%.
These findings were partly confirmed by the
World Bank enterprise survey data carried out on
1057 establishments in the manufacturing and
services sector of South Africa in 2007. Thus about
38% of firms identified crime, theft and disorder as a
major hindrance to doing business compared to a
regional average of 28% in the whole of Sub Saharan
Africa and 25% worldwide (see table 1 below). The
severity of crime in South Africa is also reflected by
the number of firms that have invested in systems and
controls to detect and deter economic crime. Thus
about 76% of firms have spent money on security
systems compared to the regional average of 60% in
whole of SSA.
Given the above findings the question then that
comes to mind is: Why is the level of crime so high in
South Africa? Schönteich and Louw (2001) argue that
there is no single satisfactory answer to this question
but a number of reasons have been given to explain
these high crime levels plaguing the country.
Corporate Ownership & Control / Volume 9, Issue 4, 2012, Continued - 2
242
Table 1. South Africa Crime related statistics, 2007
South
Africa
Region
(SSA)
World
% of firms paying for security 76.38 60.45 56.76
Losses due to theft, robbery, vandalism and arson against the firm (%
of sales)
1.01 1.68 1.03
If there were losses, losses due to theft, robbery, vandalism and arson
against the firm (% of sales)
2.39 6.14 4.71
Security costs (% of sales) 1.58 1.81 1.45
Security costs if the establishment pays for security (% of sales) 2.07 3.32 2.82
Products shipped to supply domestic market lost due to theft (%) 0.83 0.93 0.91
% of firms identifying crime theft and disorder as major constraint 38.04 27.68 25.53
% of firms identifying corruption as major constraint 16.87 34.65 36.59
Value lost due to power outages (% of sales) 1.60 5.84 4.90
Source: World Bank enterprise surveys
Table 2. South Africa Crime related statistics by major cities, 2007
Johannesburg Cape
Town
Port
Elizabeth
(P.E)
Durban
% of firms paying for security 73.57 90.34 53.03 63.78
Losses due to theft, robbery, vandalism and arson
against the firm (% of sales)
3.61 3.77 1.00 3.74
Security costs (% of sales) 3.41 1.55 1.00 1.13
Products shipped to supply domestic market lost due to
theft (%)
5.58 2.62 1.02 5.07
% of firms identifying robbery theft and disorder as
major constraint
33.66 56.69 28.28 30.30
% of firms identifying corruption as major constraint 25.31 37.80 22.07 34.85
% of firms identifying courts as major problem
Value lost due to power outages (% of sales)
Security costs in ZAR (if establishment pays for
security)
1.81
1.00
249 271
2.36
1.69
136 148
0.69
3.89
177 544
0.00
1.02
187 601
Source: World Bank enterprise surveys
Their explanations consider the impact of the
country’s ongoing political and socio-economic
transition, the impact of the proliferation of firearms,
the growth in organized crime, changes in the
demographic composition of the country, and the
consequences of a poorly performing criminal justice
system. They argued that South Africa is a heavily
armed society and according to the police Central
Firearms Registry, 3.5 million South Africans legally
possess about 4.2 million firearms of which slightly
more than half are handguns. It is also estimated that a
similar number of illegal firearms is circulating in the
country. Schönteich and Louw (2001) also went on to
argue that high levels of gang activity and availability
of firearms is evident in urban areas and is a factor
behind violent crimes or robberies committed in these
places. They also argued further that, South Africa is
the third most urbanized country in Sub Saharan
Africa and because of rural urban migration;
overcrowding, competition for limited resources,
greater stress and increased conflict have also
contributed to high crime levels both on business and
individuals in the country.
The PricewaterhouseCoopers survey findings
however, identified staff reductions because of the
recent global recession, poor or ineffective corporate
governance structures and weak internal audit and risk
management systems as some factors behind business
crime in the country. Thus the 2009 survey found that
89% of respondents believed that management’s
focus on survival strategies under the current harsh
economic environment has led firms to resort to staff
reductions7, resulting in fewer resources being
deployed on internal controls.
A corporate governance structure with vigorous
escalation procedures where employees can
7 Staff reductions result in reduced segregation which in turn impacts on the organisation’s ability to maintain a sound control environment creating gaps in the system.
Corporate Ownership & Control / Volume 9, Issue 4, 2012, Continued - 2
243
assertively report their concerns confidentially and in
which perpetrators are dealt with seriously by
management is a powerful deterrent tool. However,
the fact that 71% of South African respondents
reported that increased pressure and incentives were
the most likely causes for the greater risk of fraud
should therefore raise alarm in most organisations8.
The survey also found that the majority of economic
crimes were perpetrated from within (62%) whilst
38% were external perpetrators. This should not be
shocking because employees have a greater
understanding of the company and the internal
controls in place designed to prevent fraud and so
weak internal audit and risk management controls
make it easy for employees to defraud the company.
The aim of this study therefore is to examine
how these high crime levels in South Africa have
affected the performance of firms in the
manufacturing and services sectors. Our argument
here is that crime result in firms redirecting resources
away from productive activities to financing security
systems thereby compromising firm performance9.
Thus, instead of simply producing their products,
companies feel driven to spend more on preventing
theft, fraud and robberies as well as securing their
premises and other assets. The other motivation is that
there are very few studies that have been done in this
area (using firm level data) particularly on Africa.10
Studies that tended to relate crime with economic
variables have been done largely at macro level and
these related crime to economic growth, employment,
income distribution and even foreign direct
investment (FDI) (see Detotto and Otranto, 2010;
Josten, 2000; Antoni et al, 2007; Daniele and Marani,
2008; etc). Our argument is that, when studying
crime, it is more appropriate to do the analysis at firm
and individual or household level because these are
the economic agents directly affected by criminal
behaviour. This is important for developing
theoretical models of crime.
Additionally, macro level studies also assume
that crime levels are the same across the country when
8 71% of South African respondents felt that increased pressure and incentives were the most likely causes for the greater risk of fraud compared to 68% globally. The most significant contributors to increased pressure and incentives were targets that are more difficult to achieve (54%) and the fear that people might lose their jobs (31%). 9 In addition to leading to greater uncertainty, a high incidence of crime may induce enterprises to exit from the market place or relocate to safer locations (World Bank, 2003 on Jamaica). Crime may also have a detrimental effect on potential entry of firms (local and foreign) and their expansion (Krkoska and Robeck (2006). 10 Some enterprise notes in this area have been written by Amin M from the World Bank but they are all on Latin America and Eastern Europe and Central Asia whilst Krkoska and Robeck (2006) also carried out a similar study using 34 European and Asian countries.
in actual fact they may be interesting variations
depending on the size and level of urbanisation of the
each area, effectiveness of the local policing units and
even income growth and unemployment levels in each
city.
Given that a number of firms in this study spend
funds on establishing and strengthening security
measures, we also want to find out whether these
security expenditures minimise the impact of crime on
firm performance. In carrying out our analysis, we
will control for other firm specific factors like firm
size, age and whether the firm export or not. City and
sectoral dummies will be used to capture variation in
the prevalence of crime according to where the firm is
located and in which sector it operates11
.
This paper is organised as follows: Section one
covers introduction whilst section two is on literature
review. The empirical methodology and descriptive
analysis of data are covered in sections three and four
respectively. Section five covers results and
conclusions.
2 Literature Review
According to Krkoska and Robeck (2006), the
literature on crime is grouped into three strands
namely institutions, economics of crime and the
unofficial economy12
. Research on institutions
includes enterprise experience with crime as one of
several indicators to measure the quality of an
institutional set up. Hay and Shleifer (1998) and Frye
and Zhuravskaya (2000) studied the impact of weak
institutions on the enterprise sector and showed crime
as one symptom of general institutional weakness.
They argued that crime thrives where the state is
unable to exert power over public administration,
protect property rights or provide institutions that
support the rule of law. Frye and Schleifer (1997)
found that enterprises in Russia rely on private
protection either through employment of legal
protection agencies or through payments to organized
crime to substitute weak law enforcement.
The main focus of the economics of crime
literature is on law enforcement aspects of the fight
against criminal activities as well as factors which
explain the decision to commit crime. This area is
divided into theoretical and empirical literature.
Eeconomists in this realm agree that a person
commits an offense if the expected utility to him
exceeds the utility he will get by using his time and
other resources at other activities. Thus people
11 Descriptive statistics showed that most firms in Cape Town and those in the textile and garment sector complained more about crime than firms in other cities and sectors. 12 The third strand of crime literature which relate to unofficial economy is defined to include irregular and illegal activities and mainly covers tax evasion.
Corporate Ownership & Control / Volume 9, Issue 4, 2012, Continued - 2
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become criminals not because their basic motivation
differs but because their benefits and costs differ.
A prime example of theoretical papers analyzing
the economic impact of crime is the seminal paper by
Becker (1968). Becker modeled general crime as a
type of economic activity that is immoral, but
nevertheless, can be analyzed by standard economic
tools. He used a model that related crime and
punishment to develop optimal public and private
policies including the optimal amount of resources
and level of punishment to minimize social loss from
crime. Assuming that crime is an economic activity
carried out by individuals who balance costs and
benefits, offenders will refrain from entering the
criminal business when the risk or cost of high
punishment is too high. He argued that many theories
agree that the increase in the probability of conviction
or punishment if convicted generally decreases the
number of offenses committed and that a change in
this probability has a greater effect on the number of
offenses than a change in punishment.
Studies that examine the economic impact of
crime from an empirical perspective include Glaeser
and Sacerdote (1999). They looked at the relationship
between crime and economic growth and argued that
factors of production tend to avoid places where the
risk of expropriation through crime is high and that
the location decisions of well educated households are
particularly sensitive to local crime rates. They also
argue that one potential channel through which
growth might affect crime is the labor market. If it is
relatively easy to find a job even for less educated
people, the relative attractiveness of crime as an
economic activity goes down and faster-growing
regions should therefore experience less crime. Using
a panel data for U.S. Metropolitan Statistical Areas
(MSAs) between 1987 and 2006 and using lagged
abortions to instrument for crime, they found strong
evidence for a growth depressing effect of crime.
Their estimates suggest that, reducing the annual
crime rate by five crimes per 1,000 people (for the
period from 1987 to 2006, this is equivalent to
lowering crime in the average MSA by 10 percent) is
associated with an increase in per-capita earnings
growth by about 0.5 percentage points. Taken
together, these results suggest that crime is costly to
growth because of its adverse effects on local
production.
Gaviria (2002) used survey data gathered by the
World Bank and the Inter American Development
Bank in 1999 on 29 countries from Latin America and
the Organisation of Economic Cooperation and
Development (OECD). He looked at effects of
corruption and crime on firm performance using
ordinary least squares method and found that crime
has a noticeable effect on the economic outcomes of
firms or reduces firm competitiveness. He also found
that the prevalence of corruption and crime differs
substantially from one country to another and that
both phenomena are closely associated. Another
World Bank (2003) study on economic development
in Jamaica paid particular attention to the issue of
crime. The study found crime to be one of the main
reasons for weak economic development in Jamaica
due to its substantial costs on business in the country.
Descriptive statistics analysed by Amin (2009a)
using World Bank survey data show that a third of the
firms in 14 Latin American countries experienced at
least one incident of crime during 2005. 72.8% of all
firms lost money either due to crime or expenses on
security, which together average 2.7% of annual sales
for a typical firm. He also found that firms in Latin
America are as likely to be victims of crime as much
as individuals and households (33% vs. 38% for
households are reported in a study by Gaviara and
Pages, 2002). Amin (2009a) also found that, large
firms are more likely to be victims of crime than
small firms (42.4% vs. 31.4%), but however losses
due to crime as a percentage of annual sales are much
higher for small firms than large firms (1.4% vs.
0.65%). This burden on smaller firms contradict
findings by Gavaria and Pages (2002) as well as
Glaeser and Sacerdote (1999), who found that
relatively better off (larger firms in this case) suffer
more from crime than the rest. Finally, Amin (2009a)
also found that the incidence of crime is higher in
bigger cities compared to smaller ones. He argued that
this could be because criminals prefer bigger cities
where it is easier for them to remain anonymous and
there is more wealth to steal. The enterprise survey
data showed that this result holds only across cities
within a country not across countries, hence what
matters is how big or small a city is relative to other
cities in the same country with absolute size of the
city being irrelevant. In this case, natural population
growth should not call for more resources but a
reallocation from the slower to faster growing cities.
Bourguignon et al (2002) looked at the
relationship between income distribution and crime
using a simple theoretical model and panel data in
seven Colombian cities over a period of 15 years.
They were trying to explain the factors that drive
individuals to engage in both social and business
related economic crimes. They found that would be
criminals are common among those people living in
households where income per capita was below 80%
of the mean. Distributional changes among those
people who are above this limit are not likely to have
no significant influence on the crime rate. These
findings by Bourguignon et al (2002) are similar to
what was found by Ehrlich (1973) in what probably
was the first empirical paper on the economics of
crime. Ehrlich (1973) found using cross sectional data
a significant relationship between the crime rate and
the share of the population below half the median
income across the US states. However Freeman
(1996) mentions that no significant effect was found
in a cross section of time series for various
metropolitan areas in the US after controlling for
fixed effects.
Corporate Ownership & Control / Volume 9, Issue 4, 2012, Continued - 2
245
Krkoska and Robeck (2006) also used the World
Bank enterprise survey data conducted in 34 countries
in Europe and Asia to explain business characteristics
that make firms vulnerable to crime. They found that
high rates of crime are particularly associated with the
weak development of micro enterprises in the services
sector, operating in large countries with high
unemployment. Their paper also highlighted the
deterrent effect of crime on FDI inflows and job
creation especially in less advanced transition
countries.
3 Empirical Methodology
The methodology that we are going to use to examine
the nature of the relationship between crime and firm
performance in South Africa borrows largely from the
work of Gaviria (2002). The estimated equation
which also takes into account other firm
characteristics is presented as follows:
ijijijij ZCrimeX 310 (1)
where ijX stands for sales of firm i in city/
region j
and ijZ is a vector of firm characteristics
like firm size, firm age, location and sector, whether
the firm exports or not. ij is a random error term.
The crime variable used in this study would be
measured using a dummy taking the value of one if
the firm has experienced losses as a result of theft,
robbery, vandalism and disorder and zero otherwise.
A negative value of 1 indicates that crime
negatively affects firm performance. Several
mechanisms can explain the adverse effect of crime
on firm sales. First, crime raises operational costs
(through extra security measures), lowering
competitiveness and ultimately lowering sales and in
extreme cases may result in firms shutting down
operations (Gaviria, 2002). Secondly, crime (through
misappropriated resources, vandalism etc) prevents
companies from enhancing productivity and this
affect sales growth. Finally crime may cause firms to
lose valuable human capital (through crime related
deaths or emigration to safer places) and this also
affects productivity and hence competitiveness. We
will also use an interaction variable (crime dummy
times security costs) to analyse the impact of crime on
sales given that the firm has invested on security. We
do this to ascertain whether investing on security
helps firms minimise or deter economic crime and
hence improve firm competitiveness.
3.1 Data
The World Bank’s Investment Climate Surveys (ICS)
on manufacturing and services sectors from South
Africa is the primary source of data used in this study.
The survey was done in 2007 and the total number of
establishments covered is 105713
. These firms were
also drawn from 14 International Standards Industrial
Classification (ISIC) industries in four cities namely
Johannesburg, Durban, Port Elizabeth and Cape
Town. The sectors covered in this study include
textile and garments, chemical and non metallic
products, construction and transport, machinery and
electronics, metals, rubber and plastics, as well as
food. The survey data on crime used in this study is
based on the following questions asked in the 2007
survey.
(i) In 2006 what percentage of the value of your
domestic shipments was lost while in transit due
to theft
(ii) In 2006, did the establishment pay for security?
If yes how much was spent as a percentage of
annual sales.
(iii) In 2006, did the establishment experience losses
as a result of theft, robbery, vandalism or arson.
If yes how much was lost as a percentage of
annual sales.
4 Descriptive Analysis Of Data
Using World Bank survey data and relating crime to
other firm characteristics like firm size, firm age and
ethnicity, we found that crime appear to be regressive
in nature in that losses due to theft and robbery are
relatively lower in large sized firms compared to
smaller ones (see table 5 appendix). It is about 1.3%
amongst large firms compared to 4.3% in small firms.
Firms complaining about crime are also relatively
more amongst smaller firms (34%) than larger firms
(32%). Probably this could be a result of the fact that
most large firms invest in security systems compared
to smaller firms. Thus statistics show that about 91%
of large firms pay for security compared to only 68%
of smaller firms. Whilst the highest losses from crime
expressed as a percentage of sales were about 10%
amongst large firms, they are about 30% amongst
smaller firms14
. The seriousness of business related
crime also extends to domestic shipments that are lost
due to theft. Thus about 2.7% is lost by large firms
compared to 4.3% in smaller firms. However, the
percentage of sales spent on security is higher
13 The data are collected through firm surveys that include a common set of questions for all countries surveyed. The sample is selected by a simple random or stratified random sampling method controlling for size sub sector, geographic distribution based on company registration records or manufacturing census information available from government. The sample size varies ranging from about 100 for small African economies like Lesotho to more than 1000 for big countries like India, China etc. 14 We use maximum and minimum values for this.
Corporate Ownership & Control / Volume 9, Issue 4, 2012, Continued - 2
246
amongst small firms than larger firms. But the fact
that large firms’ sales are higher in absolute terms
than smaller firms means that they still spend more on
security systems and hence are able to minimize
criminal incidences.
By relating crime to ethnicity, statistics show
that there is no big difference between losses
experienced by most ethnic groups in the country
even though the Indian owned firms appear to have
incurred relatively huge losses compared to European
owned firms. Thus statistics also show that the
maximum loss that was experienced by an Indian
owned firm is about 40% compared to 10% amongst
African and other Asian owned firms. The same
situation is replicated again even when looking at
domestic shipments lost due to theft. They are also
relatively higher among Indian owned firms
compared to other ethnic groups. Probably this could
be a result of weak or inadequate security systems put
in place by Indian firms. This is because even though
there are many Indian firms paying for security, the
amount spent by these firms as a percentage of sales
(2.66) is lower than what are other big ethnic groups
(Africans, Europeans and Other) spend (3.14). Indian
firms are also far much smaller than in size compared
to Europeans and Other ethnic groups and therefore
affected by the regressivity of crime (see table 5 for
more). If there is a positive relationship between the
size of firms, amount of money spent on security
systems and the effectiveness of these systems, this
could then explain why Indians have experienced
more crime losses than other groups.
We also examined whether being old translate
into being more experienced in dealing with criminal
activities or not. Statistics show that a larger
proportion of older firms (more than 18 years, to
differentiate between old and young firms, we used
the mean age which we calculated to be 18 years) pay
for security and that these older firms experience
lesser losses than younger firms (less than 18 years).
This pattern is similar to that shown by the firm size
variable probably implying that smaller firms are also
relatively younger in age. Statistics on table 5 support
that small firms are relatively far much younger than
large firms.
To ascertain whether crime has any effect on
firm performance in the form of sales, we related sales
to losses incurred as a result of theft, robbery and
vandalism. The nature of the relationship is shown by
Fig 1 below. Thus it appears that there is a prima facie
negative relationship between these two variables.
However, this relationship holds only when looking at
all the other sample cities except Cape Town.
However, using a correlation matrix (table 7
appendix), the sales variable appears negatively
related to crime even though the relationship is not
significant.
Figure 1. Sales and Crime Relationship
Sales and Crime relationship
15.2
15.3
15.4
15.5
15.6
15.7
15.8
15.9
0
1
2
3
4
Johannesburg Capetown Port Elizabeth Durban
Sale
s (
logs)
Crim
e losses (
% o
f sale
s)
sales crime level
Source: World Bank Investment Climate data
5 Results and Conclusions
After identifying a prima facie negative relationship
between firm sales and crime losses, the next step was
to see whether this can be confirmed by regression
results. We estimated using ordinary least squares,
country, city and sectoral level regressions.
Results at country level (see table 3 below) show
that variables like exporting, firm size and firm age
are consistent and robust determinants of firm
performance proxied using firm sales. These variables
are positive and significant with or without city and
sectoral dummies and even when using a Tobit
specification. Thus being large in size probably
Corporate Ownership & Control / Volume 9, Issue 4, 2012, Continued - 2
247
through economies of scale improves firm
performance and this is also true for older firms. The
positive correlation between firm size and age suggest
that most large firms are older and therefore many
years of experience in producing a particular good
enables a firm to grow in size, generate economies of
scale as well as productivity effects that promote
better firm performance. Exporting (represented by a
dummy =1 if a firm exports and 0 otherwise) also has
a robust positive effect on performance suggesting
that more external markets are good for firm sales
growth.
The variables that are central to this study like
crime dummy and domestic shipments dummy are
also consistent in terms of their impact on firm
performance. The crime dummy is also consistently
negative and significant and robust to changes in
model and variable specification. Thus crimes
committed against firms in the form of theft,
vandalism arson etc have a negative effect on sales or
firm performance. The variable that captures domestic
shipments crime (proxied by domestic shipments
dummy) is negative but insignificant suggesting a
weak effect on firm performance. This is supported by
statistics on table 1 in that at country level, these
losses are an insignificant percentage of sales (0.83)
compared to other crime losses (2.39).
Table 3. Country level regressions
variables (1) OLS (2) OLS (3) OLS Tobit
Dependent variable
City dummies
Sales
No
Sales
Yes
Sales
Yes
Sales
Yes
Sect oral dummies No Yes Yes Yes
Export dummy
0.6755
(0.1189)***
0.5461
(0.1001)***
0.6577
(0.1099)***
0.4989
(0.1054)***
Crime dummy
-0.0465
(0.0231)**
-0.0326
(0.0121)*
-0.1876
(0.0227)***
-0.2952
(0.0211)***
Domestic shipments crime dummy
-0.0116
(0.0121)
-0.0156
(0.0168)
-0.0611
(0.0899)
-0.0337
(0.0897)
Firms size
1.9365
(0.03541)***
1.3209
(0.046)***
1.8765
(0.0469)***
1.9851
(0.0443)***
Firm age
0.1324
(0.0320)***
0.1898
(0.0657)***
0.1983
(0.0597)***
0.1889
(0.0330)***
Crime dummy * security costs
0.1778
(0.0321)***
0.1769
(0.0226)***
Domestic shipment dummy* security costs
Constant
No of observations
11.1086
(0.1296)***
680
10.2007
(0.3718)***
680
-0.0434
(0.0896)
11.6003
(0.348)***
680
0.0415
(0.0876)
13.5342
(0.2132)
680
***significant at 1%; ** significant at 5%; * significant at 10%: Standard errors in parenthesis
The use of the Tobit model here was to check for
robustness taking into account that sales values are a
censored variable (censored from below in that sales
values cannot be less than zero) and that ignoring this
may bias our estimates (Elbadawi et al 2007). The
pattern of significance of our variables appears not to
have been affected by this change in model
specification. The crime dummies are still negative
and domestic shipments dummy is still insignificant.
We also decided to include interaction variables that
capture the impact of crime on sales conditional on
the firm investing in security. Our aim is to find out
whether investing in security has an ameliorating
effect on sales by limiting criminal incidences against
firms. Results show that the variable has a positive
and significant effect on firm sales. This supports the
belief that security measures are very important in
minimizing the negative effects of crime on firm
performance and firms should therefore implement
and strengthen them. The situation is however
different when looking at domestic shipment crime
interaction dummy. When using OLS the sign is
negative but positive under the Tobit approach. This
suggests that security measures used to combat
domestic shipment crime have a weak effect on firm
sales. Since these types of losses are very small, very
little security resources are probably channeled by
firms towards these crimes resulting in them having
insignificant effect (These results might also be
affected by endogeneity as a result of the simultaneity
problem. It is possible that firms that are performing
well (high sales) invest more in security in as much as
investing more in security positively effect firm sales
or performance. However, coming up with
instruments to minimize this problem is difficult in a
cross sectional model like ours).
We also decided to assess whether the location
of the firm in terms of the city and sector in which it
operates from has any influence on firm performance
(see table 4 below). This is partly in response to what
Corporate Ownership & Control / Volume 9, Issue 4, 2012, Continued - 2
248
we found under descriptive statistics that more firms
in Cape Town and Johannesburg and those in the
textile and garment sector identified crime as a major
problem in addition to having lost a relatively larger
amount to criminal activities (We also chose these
cities and sectors based on sample sizes. These are the
top two cities and sectors in terms of the number of
observations or with large sample size.). The pattern
of results is not significantly different from the one on
table 4 above except that crime related variables are
not significant in the metals sectors. Thus the impact
of crime on firm performance does not appear to
discriminate firms on the basis of location as found
under descriptive statistics above. The other
noticeable thing is that the domestic shipment
interaction variable is now consistently positive and
insignificant whilst the shipment dummy is only
negatively significant in Johannesburg. This could be
because losses made by firms in Johannesburg as a
result of domestic shipments crime are relatively
higher (see table 2 above). However sectoral level
results show that crime does not appear to have a
significant effect on firm performance. This is partly
corroborated by descriptive statistics in table 6,
appendix in that according to rankings, the metals
sectors is the 6th
sector that experienced high losses
due to theft, robbery and vandalism.
However, a negative relationship between crime
and firm performance exist in the metal sector even
though it appears weak.
Table 4. City and Sectoral level results using OLS
Variables
Johannesburg
Cape Town
Textile and
Garment
sector
Metal sector
Dependent variable
City dummies
sales
No
Sales
No
Sales
No
Sales
No
Sectoral dummies Yes Yes No No
Export dummy
0.4336
(0.1235)***
0.4447
(0.2003)*
0.3775
(0.2339)
0.4689
(0.2335)
Crime dummy
-0.2442
(0.0356)***
-0.3879
(0.0897)***
-0.3997
(0.0886)***
-0.0398
(0.0587)
Domestic shipments crime dummy
-0.8914
(0.0567)**
-0.1467
(0.1760)
0.1144
(0.1231)
-0.0247
(0.3127)
Firms size
1.7965
(0.0853)***
1.4675
(0.1769)***
1.6189
(0.1315)***
1.8867
(0.1455)***
Firm age
0.1359
(0.0567)*
0.4489
(0.1254)***
0.3874
(0.1452)**
0.3568
(0.1443)**
Crime dummy * security paid
0.2897
(0.0352)***
0.2987
(0.0861)***
0.2723
(0.0339)***
-0.0657
(0.0782)
Domestic shipment dummy * security
paid
Constant
No of observations
0.0987
(0.0756)
11.4003
(0.1165)***
428
2.8643
(4.8906)
13.6437
(0.5712)***
115
0.0789
(0.1123)
12.0779
(0.3349)***
110
0.1443
(0.1228)
11.8524
(0.3765)***
111
***significant at 1%; ** significant at 5%; * significant at 10%: Standard errors in parenthesis
5.1 Conclusions
The results in this study have shown that crime (theft,
robbery, vandalism, arson etc) has negative effects on
firm performance and this is a finding that does not
appear to discriminate in accordance to firms’
geographical location but however varies according to
sector. Results also suggest that investing in security
is important and can ameliorate the negative effect
that crime has on sales. Therefore firms should
strengthen their security measures and deterrent
punishment should be imposed on convicted criminals
by the courts or the affected firms so as to minimize
their negative effects on firm performance and general
economic growth in the country. However domestic
shipment crime though not significant at country level
appears to matter most to firms in Johannesburg.
Results suggest that the significance of this variable
depends on the size of shipment losses incurred by
firms in each region or city. Additionally, measures
should also be taken to help small sized firms in
containing crime since they appear to be the ones
mostly affected. Government or the business
community should encourage the development of
affordable and effective security systems to help the
growth of small businesses.
Corporate Ownership & Control / Volume 9, Issue 4, 2012, Continued - 2
249
APPENDIX
Table 5. Crime and other firm characteristics
FIRM SIZE
Small Medium Large
ETHNICITY FIRM AGE
African Indian Asian European Other < 18yrs >18yrs
% of firms paying for security 68.3 83.3 91.3 61.6 64.9 61.1 82.1 76.9 66.4 80.3
Losses due to theft, robbery etc against the firm (% of sales)
Minimum
Maximum
4.29
0.10
30.0
3.65
0.10
20.0
1.39
0.10
10.0
3.90
0.10
10.0
5.69
0.10
40.0
3.75
1.00
10.0
2.21
0.10
20.0
4.35 4.00 3.17
0.10 0.10 0.10
20.0 40.0 20.0
Security costs (% of sales)
Min
Max
2.89
0.10
15.0
3.19
0.10
15.0
2.49
0.10
20.0
3.25
0.10
25.0
2.66
0.10
10.0
1.58
0.40
5.00
2.70
0.10
20.0
3.46 3.63 2.36
0.10 0.10 0.10
15.0 25.0 20.0
Domestic shipments lost due to theft (%)
Min
Max
Age of firms
Firm size
Firms complaining about crime as major obstacle
Firms complaining about corruption as major problem
4.26
0.10
20.0
10.1
10.1
34.4
26.6
4.21
0.10
20.0
19.2
41.9
41.8
29.8
2.74
0.10
21.0
32.2
426.5
32.1
27.0
5.49
1.00
15.0
16.3
42.1
32.3
22.8
6.87
0.10
70.0
16.1
63.9
57.7
35.1
4.79
0.50
10.0
11.2
61.7
50.0
27.8
4.49
1.00
50.0
20.5
131.4
30.9
23.2
5.79 7.14 3.69
0.10 0.10 0.10
40.0 70.0 50.0
19.2 5.50 31.9
163.1 53.9 195.9
38.6 35.1 35.8
40.4 26.3 27.6
Source: Author’s own calculations based on World Bank Investment Climate data
Corporate Ownership & Control / Volume 9, Issue 4, 2012, Continued - 2
250
Table 6. Sectoral distribution of losses in the four cities
Textile
Garment
Chemical
Non metallic
Construction
Transport
Machinery
Electronics
Metals Rubber
Plastics
Other Food
% of firms paying for security 73.8 84.6 66.7 85.7 70.5 81.8 78.3 81.2
Losses due to theft, robbery etc against the firm (% of sales)
Minimum value
Maximum value
5.02
0.60
30.0
1.33
0.20
4.00
1.60
0.20
3.00
4.61
0.10
20.0
2.23
0.10
10.0
3.27
0.20
10.0
3.18
0.10
20.0
3.09
0.10
15.0
Security costs (% of sales) 2.15 2.66 0.30 3.35 3.61 3.38 3.63 3.91
Domestic shipments lost due to theft (%) 3.88 3.38 ---- 1.72 3.35 6.50 4.76 4.97
LOSSES DUE TO THEFT
Johannesburg
Cape Town
Port Elizabeth
Durban
% OF FIRMS PAYING FOR SECURITY
Johannesburg
Cape Town
Port Elizabeth
Durban
DOMESTIC SHIPMENT LOST DUE TO THEFT
5.36
5.00
1.00
-
69.4
95.2
60.0
75.0
0.80
-
-
4.00
88.7
90.5
66.7
62.5
1.60
---
---
---
70.0
100
-
25.0
2.41
20.0
-
-
90.0
71.4
100.
66.7
2.71
1.00
1.00
1.05
78.1
92.3
40.0
38.1
2.38
-
-
5.50
92.9
100.
0.00
66.7
2.72
8.50
-
3.70
79.3
91.4
53.9
66.7
3.55
0.80
1.00
0.10
79.1
93.8
63.6
100.
Johannesburg
Cape Town
Port Elizabeth
Durban
4.39
4.53
1.00
2.20
3.93
1.10
--
2.00
-
-
-
-
1.83
1.50
-
1.00
3.19
1.77
1.05
15.0
8.33
-
-
1.00
4.97
4.00
-
3.00
5.24
1.94
1.00
9.50
Source: Author’s own calculations based on World Bank Investment Climate data
Corporate Ownership & Control / Volume 9, Issue 4, 2012, Continued - 2
251
Table 7. Correlation matrix
| Sales Crime Security Crime2 Ethnicity Age Size Location
-------------+---------------------------------------------------------------------------
Sales | 1.0000
|
Crime | -0.0095 1.0000
| (0.7575)
|
Security | 0.1545* 0.2366* 1.0000
| (0.0000) (0.0000)
|
Crime2 | -0.0176 0.0892* 0.0477 1.0000
| (0.5676) (0.0037) (0.1210)
|
Ethnicity| 0.4448* -0.0194 0.0312 -0.0294 1.0000
| (0.0000) (0.5288) (0.3115) (0.3388)
|
Age | 0.0977* -0.0157 -0.0179 -0.0297 0.0397 1.0000
| (0.0015) (0.6096) (0.5605) (0.3345) (0.1976)
|
Size | 0.7734* -0.0128 0.0313 -0.0003 0.2702* 0.4447* 1.0000
| (0.0000) (0.6950) (0.3386) (0.9934) (0.0000) (0.0000)
|
Location | 0.0581 -0.0756* -0.2011* 0.1209* 0.0686* 0.0040 0.0153 1.0000
| (0.0592) (0.0140) (0.0000) (0.0001) (0.0258) (0.8966) (0.6400)
*significant at 5%; p- values in parenthesis.
Crime represents the proportion of sales lost due to theft, arson and vandalism;
Crime2 is a dummy representing those firms identifying crime to be a major problem.
Security is percentage of sales paid for firm security.
Corporate Ownership & Control / Volume 9, Issue 4, 2012, Continued - 2
252
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Foreign Direct Investment: The Italian Case. CESifo
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A theoretical and empirical investigation. Journal of
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Market access, supplier access and Africa’s
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11. Freeman R (1996): Why do so many young American
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12. Frye T and Shleifer (1997): The invisible and the
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87
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and the rule of law. Journal of Law, Economics and
Organisation Vol 16
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and crime on firm performance: Evidence from Latin
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Victimisation in Latin American cities. Mimeo Inter
American Development Bank, Washington DC.
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Crime in cities: Journal of Political Economyy Vol 107
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Corporate Ownership & Control / Volume 9, Issue 4, 2012, Continued - 2
253
OWNERSHIP STRUCTURE AND DEBT POLICY OF TUNISIAN FIRMS
Hentati Fakher*, Bouri Abdelfettah**
Abstract
The relation between corporate governance and the financial decisions presents a rich subject but less pronounced in corporate finance. The purpose of this article is to study the impact of the ownership structure on the debt policy of the Tunisian companies. From the econometric tests applied to Tunisian data of panel, the results obtained corroborate the assumptions of the entrenchment theory. The ownership structure is unable to orient the management of the leaders towards the maximization of the shareholders' richness. The companies with concentrated property don't use the debt like mean to encourage the leader to act according to their interests. The remuneration system does not encourage the leaders to privilege the financing of the investments by debt. The presence of the financial institutions in the capital of the Tunisian companies does not influence the policy of financing of the company. They don't exert a particular role of control on the management of the leaders in place by the debt. Keywords: Ownership Concentration, Shareholding of the Leader, Financial Institutions, Debt Policy * Doctor and Teacher in finance at Economic Sciences and Management University of Sfax and member of laboratory of Corporate Finance and Financial Theory (COFFIT) E-mal: [email protected] ** Professor of Finance at Economic Sciences and Management University in Sfax, Tunisia and director of laboratory COFFIT E-mail: [email protected]
1 Introduction
In the capitalist countries, various companies knew a
development in their strategies characterized, in
particular, by the diffusion of their shareholding and
the separation of their functions of property and
decision15
. Such a development led to examine about
the rationality of the strategic decisions made by the
leaders. The latter are in the centre of the decision-
making process and it is probable that their personal
strategies come to influence the performances of the
companies (Paquerot, 1997). The separation of the
functions of property and decision can create a
relation of agency who generates agency costs who
can influence the performance of the company
(Jensen and Meckling, 1976).
The study of the relation between the ownership
structure and the performance of the company is the
several theoretical debate object following problems
generated by such a separation. Indeed, the agency
theory provides that when the share of the rights of
ownership of the leader increases, it is encouraged to
allocate a significant effort with creative activities
such as the search for new profitable projects.
However, the entrenchment theory conceives that the
ownership structure constitutes a means to extend the
15 The function of decision corresponds to the function reserved for the leaders.
capacities of the leaders. The latter can express for
example by the abandonment of certain types of
profitable investments because of rigid controls to
which they are subjected. In addition, the neutrality
theory supports the idea that the ownership structure
does not have an influence on the performance of the
company. The presence of the heterogeneous factors
in the external environment of the company forces the
leaders to maximize the value of the shareholders.
The relation between the ownership structure
and the performance of the company was the subject
of an abundant literature since the thesis of Berle and
Means (1932). Nevertheless, the study of the relation
between the ownership structure and the debt policy
of the company were less pronounced (Florou and
Galarniotis, 2007). The principal objective of this
article is to study the impact of the ownership
structure on the debt policy of the Tunisian
companies.
The principal questions relating to this article are
as follows: Does the companies with concentrated
property count less, in their policy of financing, on the
debt? Is the debt policy of the company influenced by
the nature of the shareholder?
This paper is arranged as follows. After this
introduction, the second part provides the theoretical
framework for the study. The third part describes the
data and variables used in the empirical analyses. The
results of regression model are presented in the fourth
Corporate Ownership & Control / Volume 9, Issue 4, 2012, Continued - 2
254
part. Finally, the paper discusses the conclusions
reached by the study and indicates directions for
future research.
2 Literature Review 2.1 The Ownership Structure as a Control Mode of the Leaders
Authors of the agency theory and those of the
government of company (Bethel and liebeskind, 1993;
Charreaux, 1997; Franks and Mayer, 1997; Ang, Stick
and Flax, 2001; Hiraki, Inoue, Ito, Kuroki, Masuda,
2003; Karathanassis and Drakos, 2004; Davies,
Hillier and McColgan, 2005) suppose that the
ownership structure constitutes part of the system of
corporate governance16
. It presents an effective
method of management control of the leaders. The
ownership concentration and the nature of
shareholders can answer the problem of incentive of
the controllers and contribute to the increase of the
performances of firm (Paquerot and Mtanios, 1999;
Lee, 2004).
The entrenchment theory, supported by Morck,
Shleifer and Vishny (1990), Paquerot and Mtanios ,
Alexandre and Paquerot, Fulghieri and Hodrick
(2005), stipulates that the leaders who have a solid
majority of the capital escape any control and can thus
manage the firm from a contrary of the maximization
of the value of the company. In this direction, the
leaders invest in credits specific to their know-how to
benefit from privileged information which makes it
possible to increase the job security, the remuneration
and the liberty of action to the detriment of the
shareholders (Coombes and Watson, 2000; Gompers,
Ishii and Metrick, 2003; Yermack, 2004). They do not
evaluate the investments compared to the created
richness, but compared to the advantages which they
will be able to withdraw for their entrenchment
strategy (Morck, Shleifer and Vishny, 1990; Dow and
Gorton, 1997; Subrahmanyam and Titman, 1999). In
addition, the neutrality theory thinks that the
ownership structure does not have an influence on the
performance of the company (Demsetz, 1983;
Demsetz and Lehn, 1985; Jensen and Warner,
1988; Agrawal and Knoeber, 1996; Himmelberg,
Habbond and Mitigated, 1999; Demsetz and
Villalonga, 2001). The pressures exerted by the
external environment of the company encourage the
16 Shleifer and Vishny (1997) define the corporate governance of the company like the whole of the mechanisms by which the contributors of capital guarantee the profitability of the action. Rajan and Zingales (2000) define the corporate governance as the whole of the mechanisms of allowance and exercise of the power. In the same direction, Rebrioux (2003) defines the corporate governance as the structuring and the exercise of the power in the organizations.
leaders to maximize the value of the company
(Raheja, 2005).
2.2 The Debt Policy of the Company:
Since Modigliani and Miller (1963), the debt was
emphasized in the policy of financing of the company.
These authors conclude that the tax advantage coming
from the character deductible from the interests leads
the companies to be involved in debt. The financial
literature attributes to the debt various functions.
Indeed, Ross (1977), who is at the origin of the signal
theory, regards the debt as a means of solving the
problems of the asymmetric information between the
better informed supposed leaders and the investors.
The level of debt constitutes a signal making it
possible to inform the investors of the real quality of
the investment opportunity (Ross, 1977). The debt can
be regarded as a means of pressure on the leaders
(Jensen, 1986). It can be also used to reduce the
asymmetric information ex- post between the
shareholders of a firm and its managers (Jensen and
Meckling, 1976). However, the financial literature
attributes to the debt harmful effects. In this prospect,
Altman (1984); Collongues (1977); Casta and Zerbib,
(1979); Malecot (1984); Gilson (1989, 1990) or
Wruck (1990) estimate that the excess of debt
constitutes a generator of bankruptcy costs, direct and
indirect costs17
. The In his article of 1984, Altman
conceives that the direct costs are related to the
process of rectification legal. He explains why the
bankruptcy generates indirect costs which are latter
involve a loss of confidence which results a loss of
customers before even the legal period of rectification
(Beaver, 1966; Altman, 1968).
The Pecking Order theory of capital structure
supposes, while being based on the assumption of
asymmetric information, that there is a classification
between the various modes of financing. Indeed,
Myers and Majluf (1984) think that the asymmetric
information generates phenomena of unfavourable
selection which affects the external request for
financing. To avoid undergoing this unfavourable
selection, the companies firstly finance their
investments by the self-financing. In the absence of
costs of failure, the leaders prefer the financial debt in
the long run at the expense of the emission of capital
to avoid revealing the information privileged at the
market. In the presence of costs of failure, the
company can be brought to emit capital to finance its
investments or to be freed of debts. The modeling of
Myers and Majluf (1984), was regarded as a play
intervening between the leaders who seek to
maximize the richness of the shareholders in place
17 In his article of 1984, Altman conceives that the direct costs are related to the process of rectification legal. He explains why the bankruptcy generates indirect costs which are costs of loss of credibility or loss of investment appropriateness.
Corporate Ownership & Control / Volume 9, Issue 4, 2012, Continued - 2
255
and the contributors of capital, new shareholders or
creditors (Charreaux, 1992). The leaders act in favour
of the existing shareholders to the detriment of the
future shareholders (Narayanan, 1988). Consequently,
the financing of the company is ensured in priority, by
self-financing then by debt and finally by new issue of
capital. This hierarchy makes it possible to limit the
risks to be in situations of under investment, to limit
the distribution of dividends and to reduce the costs of
the capital by limiting the recourse to the loans
(Myers, 1984). Frank and Goyal (2003) tested the
relevance of the Pecking Order theory. Their
conclusions suggest that this theory "functions better"
within the firms characterized by a higher level of
entrenchment of their leaders. The order of financing
of these firms decides as follows: self-financing, debt
and finally stockholders' equity.
The classification of the Pecking Order theory is
the same one as that retained by the theory of the
cycle of life. The latter conceives that the dynamic
companies will have need for financing external to
finance their growth. For the introduction period, the
only source of financing available is the own capital
stocks. However, these firms are characterized by a
fast passage to the phase of growth. This phase is
generally financed by the commercial debts or of the
banking debts in the short term. These short- term
financings can generate risks of illiquidity also since
the very high growth rates.
In the model of Cornell and Shapiro (1987), the
objective of the leader is to maximize the value of the
firm. For the other partners (lenders, customers....),
the objective is to minimize the risks related to the
purchase or the financing of the specific investments.
The achievement of these two objectives supposes the
minimization of the costs of implied contracts. To
minimize the costs of these contracts, the firm may
find it beneficial not to exhaust its capacities of self-
financing and debt before the date at which it must
honour its implied contracts. Indeed, on this date, the
issue of shares can be very expensive. Thus, the
support hierarchy is: self-financing, increase in the
capital and finally debt.
In the framework of the agency theory, Fama
(1980) examined the structure of the whole of the
contracts which intervene in the operation of the firm.
He noted that the structures of financing are always
mixed whatever the organisational form, with a pre-
eminence of the debts. He insisted on the role of the
control of the banking in order to carry out the
objectives of the contracting agents. According to the
theory of Free Cash-flows, the recourse to the
financing by debt obliges the leader to manage the
firm in an effective way to avoid the bankruptcy in
order to face its engagements (Jensen, 1986 and Stulz,
1990). In revenge, Black and Schloes (1973), Galai
and Masulis (1976) think that the presence of the
debts limits the motivations of the shareholders and
the leaders. The debt constitutes a source of conflict
between these two partners giving rise to costs of
agency of debt.
While referring to the theory of the transaction
costs, Williamson (1981) analyzes the decision of
financing as a particular transaction where the degree
of specificity of the financed credit plays a central
part. The debt or the own capital stocks is not
regarded any more instruments financial but as
'governorship structure' of the particular transaction
(Ghertman and Quelin, 1995) which constitutes the
financing of an investment.
According to the theory of Conventions, the
objective consists in establishing conventions and
agreements making it possible to face uncertainty
inherent in the relation of financing in a way
considered to be acceptable and effective by the parts
concerned (Rivaud-Danset, 1995). Thus, by reference
to conventions of financing, the managers of company
prefer the self-financing rather than the loan. The
theory of the target ratio conceives that the companies
adjust their capitalization towards an optimal lever of
debt by emitting debts when their debt ratio is lower
than the target ratio and while being freed of debts
when it is higher to him (Hovakinian, Opler and
Titman, 2001). The deviations of the target ratio
following accumulations of benefit or losses are
compensated by the dual emissions of actions and
debts (Hovakinian, Hovakinian and Tehranian, 2004).
3 Data and methodology
3.1. Procedure
The sample for the present study consisted of
Tunisian firms listed on the Stock Exchange market.
These firms operate in various branches (industry,
business, tourism and transportation). The firms
belonging to the financial sector like the banks, the
insurances and the leasing companies were not
included in this sample. The statistics come from the
data stock exchange published by the financial market
over a period of seven years from 1999 until 2005.
3.2. Measures
The debt policy. According to the study of Zhang, He
and Chen (2008), the debt policy refers to the ratio of
total debt to total assets (TDAS).
• The ownership structure: According to the
agency theory, the ownership structure is
presented by the ownership concentration, the
shareholding of the leader and of the financial
institutions.
• The ownership concentration. The ownership
concentration constitutes a control means of the
leaders by the shareholders and contributes to
the increase in the performances of the firm
(Paquerot and Mtanios, 1999). According to
Godard (2001) and Shabou (2003), the level of
ownership concentration refers to the percentage
Corporate Ownership & Control / Volume 9, Issue 4, 2012, Continued - 2
256
of the capital held by the first shareholder
(PCFS).
• The shareholding of the leaders: According to
the agency theory, the shareholding of the
leaders was regarded as a mean to reduce the
cost of control supported by the shareholders and
to encourage the leaders to contribute to the
creation of shareholders value (Jensen and
Meckling, 1976). According to Charreaux
(1987), the shareholding of the leaders refers to
the percentage of capital detained by the leaders.
This percentage is calculated by dividing the
number of shares detained by the leaders by total
number of shares of firm (NSDL).
• The shareholding of the financial institutions:
The financial institutions represent the best
shareholders having the resources necessary to
acquire important blocks of actions in the large
companies. They make it possible to solve
internal conflicts of interests in the firms
(Nekhili, 1994), to decrease the problems of
agency (Schwiete and Weigand, 1997) and to
influence the decisions taken by the leaders in
order to maximize the value of the company
(Lapointe, 2000; Yafeh and Yosha, 2003).
According to Patry and Poitevin (1995), the
shareholding financial institutions refer to the
percentage of the capital held by the financial
institutions. It measured by dividing the number
of shares held by the financial institutions to the
total number of the shares of firms (NSFI).
3.3 Regression model
The relationship between the ownership structure and
the debt policy was thus estimated using the following
regression model:
TDAS it = e + β1 × PCFSit + β2 × NSDLit + β3 ×
NSFIit + ɛit
in which:
TDAS it: The ratio of total debt to total assets for
firm i at time t; PCFSit: The percentage of the capital
held by the first shareholder for firm i at time t;
NSDL it: The number of shares detained by the
leaders dividing by total number of shares of firm i at
time t;
NSFI it: The number of shares held by the
financial institutions dividing by the total number of
the shares of firm i at time t;
e, β1, β2 and β3 constitute unknown parameter of
model; ɛ: the error term.
4 Results
4.1 Descriptive statistics
Descriptive statistics for the sample of firms are
reported in Table 1, Table 2, Table 3 and Table 4. In
fact, The Table 1 shows that the Tunisian companies
have an average level of concentration of about
37,74%. This average degree of concentration appears
weak compared to that of the French companies
which is 50% (This result comes from the study from
Broye and Schatt (2003) applied out of 402 French
companies with dimensions between 1986 and 2000.).
In Canada, Short and Keasey (1997) found that 60%
of the 500 larger companies have ownership
concentrated by only one shareholder. Moreover, the
principal known shareholders have the degree of
concentration between 0,66% and 83,75% of the
capital. In this context, the first five shareholders hold
on average more than 74% of the shares. However,
Demsetz and Lehn (1985) show, on a sample made up
of 511 American companies, that the five principal
shareholders hold on average 24,8%. Charreaux and
Pitol-belin (1985) found that the principal known
shareholders hold on average 52%. Fendjo (2006)
showed that the ownership in the Cameroonian
compagnies is strongly concentrated. The first five
shareholders are held with more than 50% of the
shares of 67% of the companies.
Table 1. Share of the capital of the first five shareholders
Variable Average Cumulated average Standard
deviation
Min Max
Share of the first shareholder 37,74 % 37,74 % 18,50 % 14 % 83,75 %
Share of the second shareholder 15,11 % 52,85 % 6,63 % 3 % 30,70 %
Share of the third shareholder 10,00 % 62,85 % 4,71 % 1,7 % 20,50 %
Share of the fourth shareholder 6,78 % 69,63 % 4,15 % 1 % 19,99 %
Share of the fifth shareholder 4,76 % 74,39 % 2,49 % 0,66 % 8,92 %
The Table 2 shows that the majority of the
Tunisian companies of the sample have a level of
ownership concentration lower than 50%. In this
framework, 70,4% of the sample companies have a
percentage of the capital held by the first shareholder
lower than 50%. On the other hand, 29,6% of
companies have a level of concentration exceeding
50%.
Corporate Ownership & Control / Volume 9, Issue 4, 2012, Continued - 2
257
Table 2. Distribution of the companies' frequency
Concentration level Percentage of the companies 0 to 50% 70,4 %
More than 50% 29,6%
The Table 3 shows that the Tunisian leaders hold
less than 5% of the shares of 58% of the companies of
the sample. They hold a share ranging between 5%
and 25% of the capital of 25% of the companies. They
hold, also, more than 25 % of capital of 17% of the
companies of the sample. The average percentage of
capital represented by the leaders in these companies
is of 33,82%. This percentage is higher than that in
the French and American companies. According to
Charreaux and Pitol-belin (1985), it is to the
maximum of 20%. For the United States, the share of
the property which is held by the leaders and the
administrators is about 30% (Morck, Shleifer and
Vishny, 1988).
Table 3. Distribution of the sample according to the shareholding of the leaders
The proportion of shares held by the leaders Percentage of the companies
0 to 5% 58 % 5% to 25% 25 %
More than 25% 17 %
Moreover, the Table 4 shows that the companies
in which the participation of the financial institutions
is higher than 50% (HPFI) present 10,71% of the
sample companies. The financial institutions have
strong participation in the capital of these companies
exceeding 69%. The companies in which the
participation of the financial institutions is lower than
50% (LPFI) are about 89,29% of the companies.
These companies have a weak participation of the
financial institutions in their capital which is about
16,21%. In France, the search for Morin and
Rigamonti (2002) revealed that the financial
institutions hold the greatest proportion of capital in
many companies. In Great Britain, Berenheim (1994)
noted that 75% of the shares were held by such
institutions. In the United States, Demsetz and lehn
(1985), on a sample of 511 firms, find that the
percentage of shares held by the first five financial
institutions is 18,4%. Patry and Poitevin (1995) found
that the financial institutions held 53% of the shares
of firms in 1992.
Table 4. Distribution of the sample according to the participation of the financial institutions
Group Percentage of companies Average of participation Standard deviation of participation
HPFI 10,71% 69,7 % 13,14 % LPFI 89,29% 16,21 % 11,33 %
4.2 Regression results
The realization of the statistics of Fisher associated
with the test of constant homogeneity shows that the
regression model in Table 5 includes individual
effects. The probability of the test of Hausman is
higher than the conventional threshold, which implies
that this model represents a model of panel with
random individual effects, which is more appropriate
than the model of fixed effects. The coefficients of the
regression model can be estimated by the method of
generalized least squares (MCG). According to the
test of Breusch-Pagan, the homoscedasticity
assumption is not justified. The variance of residual
error of this model should not be constant. Moreover,
there is no autocorrelation of the individuals errors
because the value of Durbin- Watson (Dw =
1,6912409) is lower than (Dl=1,73).
Table 5. Regression model results
Variable Coefficients Test Z Constant 0.2087422 (3.70)*** PCFS -0.3778822 (-3.12)*** NSDL 0.0273701 (0.28)
NSFI 0.0617449 (0.46)
Wald chi2 Hausman Test Test of Breusch-Pagan Test of Durbin Watson (9.87)** (3.35) (42.43)*** 1.6912409
**represents being significant at the level of 5%.
***represents being significant at the level of 1%.
Corporate Ownership & Control / Volume 9, Issue 4, 2012, Continued - 2
258
From the econometric tests applied to Tunisian
data of panel, the results obtained show that the
explanatory capacity of the regression model is, in
general, satisfactory (Prob > chi2 = 0.0197). The
ownership concentration has an incidence negative (-
0,377882) and statistically significant to the threshold
of 1% on the debt ratio. In this context, an increase in
1% of the capital held by the first shareholder will
involve a reduction in the debt ratio of 0.377882. This
result confirms the study of Bhojraj and Sengupta
(2003), Anderson, Mansi and Reeb (2003). Thus, the
Tunisian companies with ownership concentrated
count less on the debt policy to finance their
investments. They don't use the debt as mode of
financing to encourage the leader to act according to
their interests. The percentage of the capital held by
the leaders has an impact positive (0,0273701) but not
statistically significant on the debt ratio. This result
rejects the assumptions of Kim and Sorensen (1986),
Agrawal and Mandelker (1990), Smith and Watts
(1992), Mehran (1992) and Gaver (1993). The
shareholding of the leaders doesn't constitute an
incentive to carry out investments financed firstly by
debt. Such remuneration system doesn't represent an
efficient tool used by the
5 Conclusion
The objective of this study was to test the impact of
the ownership structure on the debt policy of the
Tunisian companies over the period 1999 - 2005. The
realization of statistics results shows that the Tunisian
companies have an average level of concentration.
The majority of these companies have a low level of
ownership concentration. The shareholding of the
leaders in the majority of the companies is weak.
However, the minority of these companies having a
strong participation of the financial institutions.
From the econometric tests applied to Tunisian
data of panel, the results obtained corroborate the
assumptions of the entrenchment theory. The
ownership structure is unable to orient the
management of the leaders towards the maximization
of the shareholders' richness. Firstly, the companies
with concentrated property don't use the debt like
mean to encourage the leader to act according to their
interests. Secondly, the companies which apply a
remuneration system by the formula of the
shareholding of the leaders in their capital don't
encourage the leaders to privilege the financing of the
investments by debt. They don't exert a particular role
of control on the management of the leaders in place
by the debt. Finally, the presence of the financial
institutions in the capital of the Tunisian companies
doesn't influence the decisions of financing of the
management of the firm in order to maximize the
shareholders' richness. Their presence doesn't improve
the efficient of control exerted on the management of
leaders. This inefficiency control can lead the leader
to realize the personal goals to the prejudice of
shareholders' richness.shareholders in order to
intensify their control on the management of the
leaders by debt. In addition, the percentage of the
capital held by the financial institutions has an effect
positive (0,0617449) but not statistically significant
on the debt ratio what rejects the empirical work of
Aoki (1991) and Nivoix (2004). The presence of the
financial institutions in the capital can't lead to
influence the management of the firm and to finance
its investments by a mode privileging the loans rater
than the own capital stocks. These shareholders don't
exert a particular role of control on the management
of the leaders in place by the debt.
Tunisia is a country that has companies which
their ownership is concentrated. These familial
companies have a small debt ratio; this can be
explained by the fear of the bankruptcy or the loss of
control of the company. The boards of directors apply
remuneration system for their leaders by the formula
of shareholding in order to act according to the
interest of shareholders. Such remuneration system
doesn't incite the leaders to create the value of
shareholders. The leaders seek to increase their own
wellbeing by other sources of remunerations like the
wages and others advantages to the detriment of the
richness of minority shareholders. The financial
institutions are not incited to realize the goals of the
companies and to reinforce their control on the leaders
by the debt policy. The asymmetric information
constructed by the leaders encourages them not to
exert their work correctly.
In general, this study leads us to wonder about the
solutions that permit to reinforce the efficiency of the
control of the Tunisian companies on the management
of their leaders. It is preferable to institute a board of
directors composed mainly of external administrators
and to implicate properly the financial institutions in
the corporate governance also since these investors
are regarded as the shareholders the more active and
the more apt than others to exert the control on the
managerial decisions and the pressure on the leaders
in order to oblige them to adopt the strategy of firm.
Several future research directions would add to
our understanding of the efficiency control of
Tunisian companies on the management of their
leaders. First, it is necessary to replicate this study in
other samples of firms not listed on the Stock
Exchange market. Second, it can examine the
influence of the other partners of the firm on the debt
policy. Finally, it is preferable to introduce others
variables of governance in order to know their
influence on the financial decisions like the board of
directors and the markets of external discipline.
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262
THE INTRA-INDUSTRY EFFECTS OF CHAPTER 11 FILINGS: EVIDENCE FROM ANALYSTS' EARNINGS FORECAST
REVISIONS
Gary L. Caton*, Jeffrey Donaldson**, Jeremy Goh***
Abstract
Shareholders suffer huge losses when firms they own file Chapter 11. Interestingly, even shareholders of rival companies experience statistically significant losses. We examine how the bad news associated with a bankruptcy filing is transferred to the filing firm's rivals. Using revisions in analysts' earnings forecasts as a proxy for changes in expected future cash flows, we find that after a bankruptcy filing the market revises downward its cash flow expectations for rivals. Regression analysis confirms a positive relation between changes in expected cash flow and stock market reactions. These findings are consistent with our hypothesis that bad news associated with bankruptcy filings are transferred to rivals through reductions in expected future cash flows. Keywords: Chapter 11, Sharegolders, Bankruptcy Filings, Rivals * Corresponding author, Montana State University, College of Business Bozeman, MT 59717-3040 Tel.: (406) 994-4421 E-mail: [email protected] ** College of Business University of Tampa 401 Kennedy Blvd. Tampa, FL 33606 Tel.: (813) 253-6221 x 3282 E-mail: [email protected] *** Singapore Management University, 50 Stamford Road Lee Kong Chian School of Business Singapore 178899 Tel.: + (65) 6828-0739 E-mail: [email protected]
Introduction
Previous studies reveal that the market discounts the
wealth of shareholders upon the announcement of a
bankruptcy filing. For instance, Bradley and
Rosenzweig (1992) report significant abnormal
returns of -24.34% for a five-day period surrounding
Chapter 11 filings. Lang and Stulz (1992) examine the
effect of bankruptcy filings on the rivals of filing
companies. They hypothesize that information
contained in announcements of bankruptcy filings
may have positive or negative implications for rivals
and coin the term competitive effect to describe the
former and contagion effect to describe the latter.
Specifically, the competitive effect occurs if the
bankruptcy indicates a weakness in the filing
company alone that can be exploited for the
competitive benefit of its rivals. Equity values of
rivals gaining this competitive benefit are expected to
react positively. On the other hand, the contagion
effect occurs if the bankruptcy filing indicates an
industry wide weakness that may spread like a
contagion to rivals because of their similar cash flow
characteristics. Equity values of rivals catching a
financial virus are expected to react negatively to
bankruptcy filings. Lang and Stulz's primary finding
is that bankruptcy announcements decrease the value
of a portfolio comprised of the equity of rival
companies by 1 percent on average, and conclude that
contagion effects dominate competitive effects for
rival companies.
Our primary focus is to examine the underlying
reason this negative valuation effect for announcing
companies is transferred to industry competitors. A
paper similar to ours in spirit is Ferris, Jayaraman, and
Makhija (1997) who separate rival companies into
two groups: those that file for bankruptcy themselves
over the subsequent three years, and those that do not.
Their premise is that at the original announcement,
the market makes a prediction of the likelihood of
future bankruptcy for the rival companies. The
authors then use the actual reported bankruptcies over
the subsequent three years as an indicator variable for
the market's prediction at the original Chapter 11
filing date. Those companies the market predicts will
fail (i.e., those that actually fail over the next three
years) are expected to suffer declines in value due to
the contagion effect, while those predicted to continue
operations (i.e., those that do not fail over the next
three years) are expected to gain in value due to the
competitive effect. Similar to Lang and Stulz, Ferris,
Jayaraman, and Makhija report a significant average
announcement effect of -0.56 percent for their full
sample over the three days surrounding the filing.
Corporate Ownership & Control / Volume 9, Issue 4, 2012, Continued - 2
263
However, when they split the sample based on their
prediction criterion, the equity of companies that
subsequently file drop an average of -4.68 percent in
value, while the equity of those that do not
subsequently file drop - 0.49 percent. Since both
numbers are statistically significant, they conclude
that the contagion effect dominates the competitive
effect even for those companies predicted to remain
viable over the next three years.
Although the equity of both groups in the Ferris,
Jayaraman, and Makhija sample show statistically
significant declines in value, the magnitude of the
difference in average revaluations is consistent with
the idea that market expectations for future
bankruptcy affect current announcement period
returns. However, their proxy for market expectations,
i.e., whether the firm actually declares bankruptcy
over the subsequent three years or not, is not available
a priori. We hypothesize that rather than making
yes/no predictions of future bankruptcy for each rival,
market participants simply revise their estimates of
future cash flows. Unexpected decreases in expected
future cash flows due to the new information should
produce negative changes in firm values. Thus our
primary question is the following: Does a bankruptcy
filing by a firm affect the expected future cash flows
of industry rivals? We use changes in analysts'
earnings forecasts to indicate changes in the market's
expected future cash flows for these companies. If
earnings forecasts for rival companies are revised
after a bankruptcy filing then the equity values of
those companies would be expected to change as well.
Our results support our hypothesis. But first,
similar to Bradley and Rosenzweig (1992), we find
stock market reactions for our sample of 183
companies filing a bankruptcy petition that average -
28.83% for the three days surrounding the
announcement. In addition, we find results that
support both Lang and Stulz (1992) and Ferris,
Jayaraman, and Makhija (1997). For our portfolio
comprised of 3,250 rival companies representing 121
different industries we find significantly negative
stock price reactions that average -0.51 percent. Our
contribution, however, is an analysis of abnormal
earnings forecast revisions. We find these revisions to
be both negative and significant for rivals of failed
companies. This finding is consistent with our
hypothesis that the transfer of negative information
from filing companies to their rivals is due to a
decrease in expected future cash flows, a change in
expectation created by new information regarding the
entire industry provided by the bankruptcy
announcement of a single member therein. Finally, we
use regression analysis to formally test for a
significant relation between the market reactions and
earnings forecast revisions of individual rival
companies. The negative forecast revisions for rivals,
their respective market reactions, and our cross-
sectional regression results showing a positive and
significant relation between the two, are consistent
with our hypothesis that the contagion effect is
transmitted from filing companies to rivals through
revisions in rivals' future cash flows, revisions that
were made as a result of the original Chapter 11
filing.
Sample selection
We compiled our sample of companies filing for
bankruptcy primarily through a search of the
Lexis/Nexus files. Secondary sources include the
Wall Street Journal Index, and information obtained
from both Indepth Data Corporation and New
Generation Research Company. Our sample
companies filed for bankruptcy between October 1,
1979 (the date the Bankruptcy Reform Act was
implemented) and December 31, 1994. To be
included in the final sample, we require sufficient data
in the Center for Research in Security Prices (CRSP)
data files. The resulting sample of Chapter 11 filing
companies includes 183 companies operating in 121
different four-digit Standard Industrial Classification
(SIC) codes. Table 1 presents a time series of the
sample of filing companies and shows that the mid-
1980s was a time of few failures, while the rate of
firm failure steadily increased during the early 1990s.
The top half of table 2 presents descriptive statistics
for the filing companies. The mean and median
market values of equity of the 183 filing companies
are $65.8 million and $12.5 million, respectively, with
a standard deviation of $452.4 million. Apparently,
the market value of filing companies is relatively
small as might be expected of companies filing
bankruptcy.
An analysis of intra-industry effects of Chapter
11 filings requires, by definition, data from the filing
company's industry rivals. Following Lang and Stulz
(1992), we define a filing company's industry rivals as
all companies with the same four-digit SIC code. In
order to qualify for our sample of rivals a company
must have sufficient stock return data, but in addition,
it must have sufficient earnings forecast data in the
Institutional Brokers Estimation System (IBES)
earnings forecast database for the 25 months
surrounding the Chapter 11 filing. Previous studies
have shown that the IBES database can contain errors.
Following Ederington and Goh (1998), we eliminate a
firm from our sample if its earnings forecast revision
(defined below) is more than five standard deviations
from the overall mean over all firms in the IBES
database for any given month. After the initial round
of data eliminations, the standard deviation is
recalculated and again firms with observations outside
five standard deviations are eliminated. After
applying these various requirements our final sample
of rivals includes 3,250 rivals in those same 121
industries. The bottom half of table 2 reports
summary statistics for the rival companies indicating
that they are very similar in size to the filing
companies. Their mean and median market value of
Corporate Ownership & Control / Volume 9, Issue 4, 2012, Continued - 2
264
equity is $60.45 million and $11.31 million,
respectively, with a standard deviation of $265.16,
about half that of the filing companies. In addition,
the mean and median number of rivals competing
with each filing company is 17.75 rivals and 6 rivals,
respectively, with a range from one rival in one of the
four-digit industries to 210 rivals in another industry.
Table 1. Distribution of bankruptcy filings by year
Year Number of filings
1980 6 1981 6 1982 16
1983 12
1984 3 1985 2
1986 0 1987 3
1988 3 1989 10
1990 12
1991 37 1992 26
1993 23 1994 24
Total 183 Filing firms are a sample of 183 companies that filed for Chapter 11 bankruptcy protection between October 1, 1979, and
December 31, 1994.
Stock Market Reaction
We compute standardized abnormal returns following
Patel (1976) as modified by Mikkelson and Partch
(1988). Day 0 is defined as the date the bankruptcy
petition is filed with the courts. The abnormal returns
are the difference between the actual return and an
expected return generated by the market model. We
estimate the parameters for the market model using
daily returns data from day t-251 to day t-505 (We
use this estimation period to prevent biased test
results since we look at the cumulative abnormal
returns in the pre-filing period from 250 days to 31
days prior to the filing.). Abnormal returns are
generated for both the filing companies and an
equally weighted portfolio of rival companies.
Finally, we compute a Z- statistic and use it to test for
statistical significance of standardized abnormal
returns and cumulative standard abnormal returns
(CAR).
Table 2. Summary statistics of firms filing Chapter 11 and their industry rivals
Filing Firms:
Mean market value of filing firms
Median market value of filing firms
Standard Deviation of market value of filing firms
$65.80 million
$12.46 million
$452.38 million
Rival Firms:
Mean market value of rival firms
Median market value of rival firms
Standard deviation of market value of rival firms
$60.45 million
$11.31 million
$265.16 million
Mean number of rivals per event
Median number of rivals per event
Minimum number of rivals per event
Maximum number of rivals per event
17.75 rivals
6 rivals
1 rivals
210 rivals
Filing firms are a sample of 183 companies that filed for Chapter 11 bankruptcy protection between October 1, 1979, and
December 31, 1994. Rival firms are the 3,250 companies whose four-digit primary Standard Industrial Classification code is
the same as that of the filing firms.
Corporate Ownership & Control / Volume 9, Issue 4, 2012, Continued - 2
265
Table 3 reports the stock market reaction to a
Chapter 11 bankruptcy filing for both the filing
companies and their rivals. Consistent with earlier
studies, we observe a large and significant negative
stock market reaction to announcements of a
bankruptcy filing for the filing companies. The three-
day CAR (-1 to +1) for the full sample of 183 filing
companies is -28.83 percent with z = - 43.79.
Moreover, 78 percent of the abnormal returns over
this three-day period are negative, which is
significantly different from the null hypothesis of 50
percent. Clearly, as shown in previous studies, the
market views bankruptcy announcements as important
informational events for the filing companies.
Table 3. Effects of Chapter 11 filings on both the filing and rival firms' stock prices
Day AAR
%
z-statistic Percent
Positive
z-statistic AAR
%
z-statistic Percent
Positive
z-statistic
-10 -2.60 -8.04*** 39% -1.95* -0.03 -0.76 45% -0.57
-9 -1.80 -6.33*** 37% -2.38** -0.02 -0.86 43% -2.34**
-8 -1.20 -0.75 41% -1.29 -0.30 -3.25*** 42% -2 70***
-7 0.60 0.61 45% -0.43 -0.09 -1.11 46% 0.26
-6 -0.69 -2.45** 46% 0.03 -0.04 -1.08 43% -2.20**
-5 -1.23 -3.82*** 42% -1.12 0.09 1.43 48% 1.28
-4 -3.06 -7.84*** 34% -3.39*** -0.20 -0.54 46% 0.15
-3 -1.81 -5.68*** 41% -1.44 -0.10 -1.05 46% -0.07
-2 -2.71 -8.84*** 34% -3 14*** -0.31 -1.72* 44% -1.42
-1 -0.68 -0.55 40% -1.53 -0.11 -1.70* 46% 0.1
0 -13.38 -40.50*** 28% -4.65*** -0.05 -0.86 45% -0.46
1 -14.77 -35.24*** 33% -3.43*** -0.36 -3.41*** 45% -0.73
2 3.89 13.29*** 46% -0.13 0.10 0.05 45% -1.01
3 4.51 13.35*** 47% 0.2 -0.15 -0.87 44% -1.48
4 1.73 4.52*** 46% -0.12 0.03 -0.13 47% 0.54
5 0.88 0.5 48% 0.35 -0.02 -1.35 46% -0.15
6 3.34 7.88*** 53% 1.55 -0.29 -2.22** 47% 0.7
7 0.98 6.64*** 48% 0.5 0.05 1.59 44% -1.48
8 1.45 3.85*** 47% 0.27 -0.26 -2.00** 45% -0.46
9 0.64 2.50** 54% 1.79* -0.22 -1.72* 45% -0.74
10 -3.10 -7.73*** 41% -1.22 0.39 2.48** 48% 1.30
Cumulative
Returns
-31,-250 -15.30 -6.56*** 36% -2 75*** -4.83 -5.01*** 48% 1.36
-1,1 -28.83 -43.79*** 22% -6 11*** -0.51 -3.44*** 42% -3 21***
31,250 107.31 13.20*** 67% 4.78*** -7.32 -5.31*** 45% -0.54
*** Indicates significance at the 0.01 level.
** Indicates significance at the 0.05 level.
* Indicates significance at the 0.10 level.
We estimate average abnormal returns based on the market model around the announcement day (Day 0) of chapter 11
filings. The market model is estimated over the (-251,-505) period. The sample includes 183 firms filing for Chapter 11
protection from creditors between October 1, 1980, and December 31, 1994, and 3,250 rival firms.
The equally weighted portfolio of rival
companies has an average three-day CAR that equals
-0.51 percent with z = -3.34. In addition, 58 percent of
the abnormal returns over this period are negative,
which is significantly different from 50 percent.
These finding for the rival companies is similar to
both Lang and Stulz, who report a - 1.07 percent
reaction over the eleven days surrounding the filing,
and Ferris, Jayaraman, and Makhija, who report a -
0.56 percent reaction over the same three-day event
window as ours, both of which have different sample
periods. Due to their magnitude, these average
cumulative abnormal stock returns for rival
companies do not appear to be economically
Corporate Ownership & Control / Volume 9, Issue 4, 2012, Continued - 2
266
significant in percentage terms, but as pointed out by
Ferris, Jayaraman, and Makhija, they are significant
in dollar terms. This is because the sum of the equity
value of the competitors is much larger than that of
the companies filing for bankruptcy. In fact, Ferris, et
al, report that for their sample the competitor portfolio
loses $3.32 of equity value on average for every
dollar of equity value lost by the bankrupt companies.
These event study findings indicate that
bankruptcy filings are bad news, on average, for both
the companies making the filing and their industry
rivals. We now turn our focus to determining how this
bad news is transmitted to the rivals hypothesizing
that the transfer of bad news is made through a
revision of the cash flow estimations of the rivals
upon the bankruptcy filing. The next section presents
our methodology for testing this hypothesis, and the
results of that test.
Abnormal Earnings Forecast Revisions
To judge whether or not the market reaction for rival
companies is due to changes in expected cash flow we
need a proxy for those expectations. Earnings analysts
help set the market's initial level of expected cash
flows with their initial forecasts of future earnings.
Similarly, revisions in analyst's forecasts help to reset
cash flow expectations to some new level. We use
reported earnings forecast revisions subsequent to a
bankruptcy filing as a proxy for changes in the
market's expectations of future cash flow from the
rival companies. Significant earnings revisions after a
filing are consistent with the hypothesis that bad news
for bankrupt companies is transferred to their rivals
through a change in the market's cash flow
expectations for those companies.
Following Brous (1992), we measure earnings
forecast revisions (FR) using the following equation:
FR i,t = [(F i,t – F i,t-1 )/ Pi] × 100 (1)
where Fi,t is the median analyst earnings
forecast in month t for the annual earnings per share
of firm i for the current fiscal year, and Pi is the stock
price for firm i six months prior to the bankruptcy
filing
Mean values of FR are reported in column two
of table 4 from six months before, through six months
after the filings, as well as cumulated forecast
revisions in the bottom two rows, while their t-
statistics are in column three. As shown there, large
and significant negative revisions in analysts' earnings
forecasts are observed in every month both prior to
and after Chapter 11 filings for rivals of filing
companies.
Table 4. Abnormal earnings forecast revisions for rival firms
Month FR T AFR t
-6 -0.245 -6.70*** -0.025 -0.79 -5 -0.318 -7 00*** -0.127 -2.72***
-4 -0.345 -7 27*** -0.149 -3.13***
-3 -0.398 -7.68*** -0.214 -4.09*** -2 -0.296 -5.80*** -0.025 -0.56
-1 -0.282 -7 27*** -0.035 -0.90 0 -0.286 -6.82*** -0.087 -2.19**
1 -0.232 -6.21*** 0.002 0.06
2 -0.197 -5.17*** 0.012 0.32 3 -0.285 -6.88*** -0.094 -2.22**
4 -0.241 -5.67*** -0.051 -1.27 5 -0.240 -4.93*** -0.040 -0.87
6 -0.176 -4.56*** 0.051 1.36
Cumulative Forecast Revisions
-6,-1 -1.884 -12.18*** -0.575 -4.89*** 0,5 -1.436 -11.03*** -0.218 -2.17**
*** Indicates significance at the 0.01 level.
** Indicates significance at the 0.05 level.
* Indicates significance at the 0.10 level.
For our sample of 3,250 rival companies, we define the forecast revision, FR for Month t as the mean of analysts' forecasts
reported in the IBES database in month t less the mean of analysts' forecast in month t-1, scaled by stock price at the end of
the month preceding the chapter 11 filing announcement. We define the adjusted forecast revision, AFR for month t as the
scaled forecast revision for month t less the expected forecast revision for month t. The t statistics test the hypothesis that the
mean analysts' earnings forecast revision is different from 0.
Corporate Ownership & Control / Volume 9, Issue 4, 2012, Continued - 2
267
Unadjusted forecast revisions such as these,
however, are biased. O'Brien (1988) shows that
earnings forecasts systematically decrease month after
month until the actual earnings are announced by the
firm. This implies that forecasters are systematically
over optimistic when making their first earnings
forecast for a company, and that they never fully
correct for that over optimism. A different type of
bias in unadjusted forecast revisions is reported by
Brous (1992) who shows that the median monthly
earnings forecast revisions for a specific company
across all analysts covering that company tend to be
serially correlated. That is, if favorable new
information arrives that leads to an upward revision in
a company's average earnings forecast, for example,
that average will tend to continue to rise in future
months. Brous argues that this serial correlation is due
to the fact that analysts typically update their forecasts
for any specific company only every four to five
months. That is, in any given month only about 20
percent of forecasts are updated. To test our
hypothesis for intra-industry information transfer
effects of bankruptcy filings, we need a measure of
forecast revisions after correcting for these two
effects. This measure we call the abnormal earnings
forecast revision (AFR).
We follow the methodology of Caton and Goh
(2003), which is a modified version of that employed
by Ederington and Goh and Brous, to isolate surprise
forecast revisions. We start by randomly choosing
500 companies from the IBES database. Then, for
each company we randomly select a 25-month period
between January 1984 and December 1990. Finally,
we pool the resulting data and estimate the following
equation:
Fr i,t = -.093 + .085 FR i,t-1 + .085 FR i,t-2 + .081
FR i,t-3 + .072 FR i,t-4 + .058 FR i, t-5 +
.040 FR i, t-6 + u i,t
(2)
The negative intercept in this equation, -.093, is
consistent with the finding by O'Brien that absent new
information, analysts tend to reduce their forecasts
over time. For instance, for a firm with a P/E ratio of
20, the negative intercept implies an average revision
of -1.86 percent (20 x .093% ) every month. The
positive coefficients on the lagged forecast revisions
are consistent with Brouse's finding that revisions in
the median forecast tend to be followed by further
revisions of the same sign as more analysts update
their forecasts. For instance, the coefficients for the
FRi;t-i , for all i = 1-6, indicate that a doubling of the
median forecast one month tends to be followed by an
increase of about 8.5 percent the following month, 8.5
percent two months hence, 8.1 percent three months
later, and so on.
Using the parameters from equation 2 and each
firm's past values of FR, we calculate the expected
forecast revision, E(FRi,t), for each month t. We then
define the abnormal earnings forecast revision for
month t, AFRi,t, as the difference between the actual
revision in the consensus forecast in month t and its
expected forecast revision calculated as outlined
above. Specifically:
AFR i,t = FR i,t - E(FR i,t) (3)
Columns four and five of table 4 presents the
abnormal earnings forecast revisions for the rivals of
companies filing for bankruptcy. First note the
significant negative abnormal forecast revision of -
0.087 in month zero, the Chapter 11 filing month.
This is consistent with our hypothesis that Chapter 11
filing produces changes in the market's cash flow
expectaions for rivals which then lead to abnormal
equity returns. As mentioned above, Brouse reports
that because analysts cover more companies than they
can updated in any given month, that it may take up to
six months for news to be fully reflected in the
forecasts of all analysts' following a particular
compmany. For this reason we cumulate the abnormal
forecast revisions for the six months from the filing
month to month +5. The mean cumulative abnormal
forecast revision over this period is -0.218, which is
statistically significant below the 5 percent level. This
result is consistent with the result for the filing month
itself. That is, if earnings expectations do indeed
proxy for expected future cash flow, the sudden
decrease in expected cash flow resulting from a
Chapter 11 filing may lead to the negative abnormal
equity returns found by us, Lang and Stulz (1992),
and Ferris, Jayaraman, and Makhija (1997).
Cross-sectional regression
We formally test for a relation between abnormal
earnings forecast revisions and changes in market
values of equity using regression analysis.
Specifically, we regress the abnormal stock returns
cumulated over the three-day period surrounding the
bankruptcy filing on the abnormal forecast revisions
cumulated over the six-month period from month 0
through month 5. The six- month cumulation should
capture all the change in earnings expectations caused
by the filing. In addition, we control for other firm-
specific information that could affect earnings
forecast revisions. Hertzel and Jain (1991) and Hertzel
and Rees (1998) both indicate that because of the
serial correlation inherent in the IBES data, there is
potential for a great deal of contaminating information
since forecast revisions could reflect information
released either months prior to or after the bankruptcy
filing. In order to control for such firm-specific
information, we include two variables in the cross-
sectional regression models, the pre-announcement
cumulative abnormal return over the interval from
Day -250 to Day -31, and the post-announcement
cumulative abnormal return over the interval from
Day +31 to Day +250. These two variables should
Corporate Ownership & Control / Volume 9, Issue 4, 2012, Continued - 2
268
capture any other firm-specific information that might
cause analysts to revise their earnings forecasts.
Results for the cross-sectional regression
analysis are presented in table 5 and suggest that the
stock market reaction is strongly related to abnormal
earnings forecast revisions. The regression coefficient
is positive and with a t-statistic of 3.34 is significant
below the 1 percent level. This is consistent with our
hypothesis that the negative stock market reaction
found by Lang and Stulz (1992), Ferris, Jayaraman,
and Makija (1997) , and shown in table 3 herein, may
be due to negative revisions in cash flow expectations.
That is, the average contagion effect is the result of an
industry-wide average reduction in cash flow
expectations that are a result of the Chapter 11 filing.
Table 5. Cross-sectional analysis of rival firms' cumulative abnormal forecast revisions on their cumulative
abnormal returns
Independent variables Coefficient t-statistic
Cumulative abnormal forecast revision 0.241 3.34***
Pre-announcement abnormal return 0.008 2.45**
Pre-announcement abnormal return 0.002 0.51
*** Indicates significance at the 0.01 level.
** Indicates significance at the 0.05 level.
* Indicates significance at the 0.10 level.
Conclusion
This paper provides evidence that the filing of a
bankruptcy petition reflects the release of new
information that affects the market values of rival
companies. As documented elsewhere, the
information contained in the filing comes as a surprise
to the market as evidenced by the negative stock price
reaction for rivals. We extend the analysis by looking
more deeply at how this negative information is
transferred from the filing company to its rivals. We
find significant negative abnormal earnings forecast
revisions for filing companies' industry rivals.
Furthermore, the results of a cross-sectional
regression analysis show a significant positive
relation between abnormal stock price reactions and
abnormal cumulative forecast revisions for rival
companies, thus formally confirming a positive
relation between the two. These findings are
consistent with our hypothesis that a Chapter 1 filing
produces a negative effect on the market's expected
future cash flows for rival companies that leads to
negative stock returns.
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