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Ownership structure, corporate governance and capital structure decisions of rms

Empirical evidence from Ghana
Godfred A. Bokpin and Anastacia C. Arko
Department of Finance, University of Ghana Business School, University of Ghana, Legon, Ghana
Abstract
Purpose The purpose of this paper is to examine the effect of ownership structure and corporate governance on capital structure decisions of rms on the Ghana Stock Exchange (GSE). Design/methodology/approach To analyze the impact of ownership structure and corporate governance on rms nancing decisions, unbalanced panel data covering a period from 2002 to 2007 is employed using the seemingly unrelated regression approach to mitigate the effects of multicollinearity among the regressors. Findings The regression results reveal that managerial shareholding signicantly positively inuences the choice of long-term debt over equity. Among the corporate governance variables, board size is found to be positively and statistically signicantly related to capital structure choices. Firm level factors such as volatility in earnings, asset tangibility, dividend payout ratio and protability are signicant determinants of corporate capital structure decisions on the GSE. The ndings are largely consistent with theories of capital structure decisions observed in the literature. Originality/value The main value of this paper is to provide a comprehensive understanding of the impact of forms of ownership and other governance practices on capital structure decisions of rms from an emerging market perspective. Keywords Capital structure, Corporate governance, Financing, Ghana, Corporate ownership Paper type Research paper

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Studies in Economics and Finance Vol. 26 No. 4, 2009 pp. 246-256 q Emerald Group Publishing Limited 1086-7376 DOI 10.1108/10867370910995708

1. Introduction The relevance of capital structure to rm value remains fairly established following the seminal article by Modigliani and Miller, 1958 (Grabowski and Mueller, 1972; McCabe, 1979; Anderson and Reeb, 2003). Several theories including the pecking order theory, the free cash ow, the capital signaling, the trade-off, and market timing theories (windows of opportunities) and the fact that capital structure is voluntarily chosen by managers (Zwiebel, 1996) have been propounded to explain the choice of capital structure. Also, considerable research attention has been paid to the impact of agency costs on corporate nancing since Jensen and Meckling (1976) published their paper. Crutchley and Hansen (1989) maintain that managers choice of stock ownership in the rm, the rms mixture of outside debt and equity nancing, and dividends are meant to reduce the costs of agency conicts. Bajaj et al. (1998) suggest that ownership is positively correlated with various measures of the debt-equity ratio (leverage), implying that ownership structure has a correlation with nancial structure of rms (Kim and Sorensen, 1986; Mehran, 1992; Brailsford et al., 2002). Friend and Lang (1988) nd that debt ratio is negatively related to managerial

ownership. Brailsford et al. (2002) suggest that the relationship between managerial share ownership and leverage may in fact be inverted u-shaped. In addition, Berglof (1990) suggests that in countries in which rms are typically closely held, debt nance plays a more prominent role than in countries characterized by more dispersed ownership structures suggesting the impact of insider system of corporate governance on nancing structure of rms. Thomsen and Pedersen (2000) report empirical evidence supporting the hypothesis that the identity of large owners family, bank, and institutional investors has important implications for nancial structure. In particular, they show that a more risk averse or a more patient entrepreneur issues less debt and more equity. Given that insider system of corporate governance is practiced among listed companies in Ghana (Bokpin, 2008), this study seeks to document the impact of ownership structure on corporate nancing, a mark departure from Abor (2007). Claessens et al. (2002) maintain that better corporate governance frameworks benet rms through greater access to nancing, lower cost of capital, better performance and more favourable treatment of all stakeholders. Corporate governance affects the development and functioning of capital markets and exerts a strong inuence on resource allocation. Corporate governance correlates with the nancing decisions and the capital structure of rms (Graham and Harvey, 2001; Litov, 2005; Abor, 2007). However, management incentives that include stock options introduces issues for the alignment of managerial and shareholder interests. The question is which way does managerial ownership affect capital structure decisions of rms? How does the form of governance affect the choice of nancing? The empirical evidence observed in the literature is inconclusive with much focus on developed capital markets. Unlike Abor (2007), this present study considers a much broader corporate governance index of the impact of ownership structure, managerial share ownership and other corporate governance variables on capital structure decisions of rms on the Ghana Stock Exchange (GSE). Earlier studies on the GSE have failed to consider the impact of these factors on corporate nancing decisions of rms (Aboagye, 1996; Boateng, 2004; Abor and Biekpe, 2005; Abor, 2007) implying that, these studies invariably ignores a gamut of other relevant variables that are central to understanding the relationship among ownership structure, corporate governance, and rms nancing decisions from a developing country perspective Aside, the study uses more recent data from 2002 to 2007 whilst employing a panel data analysis. The rest of the paper is divided into four sections. Section 2 considers the literature review; Section 3 discusses data used in the study and also details the model specications used for the empirical analysis. Section 4 contains the discussion of the results and Section 5 summarizes and concludes the paper. 2. Literature review 2.1 Ownership structure and capital structure The relationship between ownership and capital structures has attracted a considerable research attention over the last couple of decades. Jensen and Meckling (1976) dened ownership structure in terms of capital contributions. Thus, the authors saw ownership structure to comprise of inside equity (managers), outside equity and debt, thus proposing an extension of the form of ownership structure beyond the debt-holder and equity-holder view. Zheka (2005) unlike the above authors constructs

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ownership structure using variables including proportion of foreign share ownership, managerial ownership percentage, largest institutional shareholder ownership, largest individual ownership, and government share ownership. Bajaj et al. (1998) suggest that ownership is positively correlated with various measures of the debt-equity ratio (leverage), implying that ownership structure has a correlation with nancial structure of rms. Friend and Lang (1988) nd that debt ratio is negatively related to managerial ownership. Brailsford et al. (2002) suggest that the relationship between managerial share ownership and leverage may in fact be inverted u-shaped. Thus, debt rst increases with an increase in managerial share ownership; but beyond a critical level of managerial share ownership debt may fall because there could be only a few agency related benets by increasing debt further as the interests of managers and owners get very strongly aligned. Pindado and de la Torre (2005) conclude that insider ownership does not affect debt when the interest of managers and owners are aligned. Jensen and Meckling (1976), in relating capital structure to the level of compensation for CEOs came out with the ndings that there is a positive correlation between the two and this was supported by Leland and Pyle (1977) and Berger et al. (1997) who assert the claim that the correlation between CEO compensation and capital structure is a positive one. However, Friend and Lang (1988), Friend and Hasbrouck (1988) and Wen et al. (2002) found a negative correlation between CEO compensation and the nancial leverage of rms. Morck et al. (1988) argue that family ownership may give rise to greater leverage than in the case of disperse ownership, because of the non-dilution of entrenchment effects. Mishra and McConaughy (1999) document empirical evidence that funding family-controlled rms use less debt than non-funding family controlled rms. Thomsen and Pedersen (2000) report empirical evidence supporting the hypothesis that the identity of large owners family, bank, and institutional investors has important implications for nancial structure. In particular, they show that a more risk averse or a more patient entrepreneur issues less debt and more equity. Anderson and Reeb (2003) further argue that family ownership reduces the cost of debt nancing. Berglof (1990) suggests that in countries in which rms are typically closely held, debt nance plays a more prominent role than in countries characterized by more dispersed ownership structures. Berger et al. (1997) found less leverage in rms with no major stakeholder. Lefort and Walker (2000) conclude that groups are effective in obtaining external nance and that there are no signicant differences in the capital structure of groups of different sizes. Brailsford et al. (2002) suggest that rms with external block holders have low-debt ratios consistent with Friend and Lang (1988), who earlier on had indicated that rms with large non-managerial investors have signicantly higher debt ratios than those without non-managerial investors. Cheng et al. (2005) also indicates that the leverage increases as ownership concentration increases following rights issuance. Drifeld et al. (2005) argue that, higher ownership concentration is associated with higher leverage irrespective of whether a rm is family owned or not. Pindado and de la Torre (2005) suggest that there is a positive relationship between ownership concentration and debt thus, all things being equal, ownership concentration encourages debt nancing. However, they nd the positive effect of ownership concentration on debt to be smaller in cases of high free cash ow. They also nd that ownership concentration does not moderate the relationship between insider ownership and debt; in contrast, the relationship between ownership

concentration and debt is affected by insider ownership. Thus, the debt increments promoted by outside owners are larger when managers are entrenched. 2.2 Corporate governance and capital structure Corporate governance correlates with the nancing decisions and the capital structure of rms (Graham and Harvey, 2001; Litov, 2005). Jensen (1986) postulates that large debt is associated with larger boards. Though Berger et al. (1997) concludes on a later date that larger board size is associated with low leverage; several other studies conducted in recent times have refuted this conclusion. Wen et al. (2002) posit that larger board size is associated with higher debt, either to improve the rms value or because the larger size prevents the board from reaching a consensus on decisions, indicating a weak corporate governance system. Anderson et al. (2004) further indicate that larger board size results in lower cost of debt, which serves as a motivation for using more debt, and this has been conrmed by Abor (2007) who concludes that capital structure positively correlates with board size, among Ghanaian listed rms. In relation to the presence of external directors on the board, Wen et al. (2002) conclude that the presence of external directors on the board leads to lower leverage, used by the rm, due to their superior control. However, Abor (2007) concludes that capital structure positively correlates with Board composition among Ghanaian listed rms. And this is consistent with Jensen (1986) and Berger et al. (1997) who had earlier on concluded that rms with higher percentage of external directors utilize more debt as compared to equity. Berger et al. (1997) found less leverage in rms run by CEOs with long tenure and this was conrmed by Wen et al. (2002), who conclude that the tenure of CEO is negatively related to leverage, to reduce the pressures associate with leverage. Kayhan (2003) nds that entrenched managers achieve lower leverage through retaining more prots and issuing equity more opportunistically. Further, Litov (2005) supports this claim that entrenched managers adopt lower levels of debt. Abor (2007) also asserts that entrenched CEOs employ lower debt in order to reduce the performance pressures associated with high-debt capital. However, Bertrand and Mullainathan (2003) refuted this fact by showing in their study that entrenched managers enjoy the quiet life by engaging in risk-reducing projects, indicating a positive relationship between managerial entrenchment and leverage. Fosberg (2004) relates that rms with a two-tier leadership structure have high-debt/equity ratios. This was supported by Abor (2007), who concludes that capital structure positively correlates with CEO duality, which shows that rms on the GSE use more debt as the CEO duality increases. 3. Research methodology In order to gain the maximum possible observations, pooled panel crossed-section regression data are used. Panel data analysis involves analysis with a spatial and temporal dimension and facilitates identication of effects that are simply not detectable in pure cross-section or pure time series studies. Thus, degrees of freedom are increased and collinearity among the explanatory variables is reduced and the efciency of economic estimates is improved. The study is therefore based on the ofcial data published by the cross-sectional rms for the various years covering a period from 2002 to 2007.

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Analytical framework The general form of the panel regression model is stated as: yit a X 0it b mit i 1; . . . ; N ; t 1; . . . ; T 1

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where subscript i and t represent the rm and time, respectively. In this case, i represents the cross-section dimension and t represents the time-series component. Y is the dependable variable which is a measure of capital structure. a is a scalar, b is K 1 and Xit is the itth observation on K explanatory variables. We assume that the mit follow a one-way error component model:

mit mi nit

where mi is time-invariant and accounts for any unobservable individual-specic effect that is not included in the regression model. The term nit represents the remaining disturbance, and varies with the individual rms and time. We therefore estimate the model (3) to investigate the empirical relationship among ownership structure, corporate governance, and capital structure choices: CAPSit x 0 OWNS it l0 GOV it d 0 CONTRL it 1it 3

where subscript i and t represent the rm and time, respectively. In this case, t represents the cross-section dimension and t represents the time-series component. CAPS is a measure of capital structure namely nancial leverage (long debt to equity), choice of short-term debt over equity and nally debt ratio. The choice of these variables follows standard nance literature. For nancial leverage which measures the choice of long-term debt over equity (Schmuckler and Vesperoni, 2000), the choice of short-term debt over equity (Demiguc-Kunt and Maksimovic, 1996) and nally debt ratio which is the ratio of total debt to total assets (Abor and Biekpe, 2005). GOV is a vector of governance variables namely board size (a measure of the numerical strength of the board at the reporting date), board independence (a measure of the blend of executive and non-executive directors to serve on the board), and CEO duality. The choice of these governance variables is largely informed by existing literature. OWNS is a vector of ownership variables including inside ownership also managerial ownership (is the proportion of shares held by managers and employees), and foreign share ownership consistent with Zheka (2005). CONTRL is a vector of control variables including volatility of income (a measure of risk), sales growth (a measure of transactional demands), asset tangibility and rm size. Several estimation techniques are often used in the estimation of panel data models involving equations such as these. These include the pooled regression model (the simple linear regression method), the xed effect estimation technique also known as the within effect estimator and the random effect estimator. The choice of technique depends on the relationship between the unobserved effects. In the xed effects model, the mi are assumed to be xed parameters to be estimated and the remainder disturbances stochastic with nit independent and identically distributed, i.e. nit , iid0; s 2 . The explanatory variables n X it are assumed independent of the nit for all i and t. The xed effects model is an appropriate specication if we are focusing on a specic set of N countries. There are too

many parameters in the xed effects model and the loss of degrees of freedom can be avoided if the mi can be assumed random. In a random effect model, mi and nit are random with known disturbances. In this case mi , iid0; s2 , nit , iid0; s2 and the mi are m n independent of the nit . The random effects model is appropriate for specication if we are drawing N individuals randomly from a large population. Unlike the xed effects model, the random effects model relegates the unobservable effects into the error term and assumes that they are uncorrelated with the explanatory variables. The variance-covariance matrix of the resulting non-spherical errors is then transformed to obtain consistent estimates of the standard errors and this is the most appropriate. But, this study employs three variables to measure capital structure and therefore to avoid problems of multicollinearity due to the collinearity in the explanatory variables we employ the seemingly unrelated regression (SUR) approach of Zellner (1962) to jointly estimate a regression of leverage, debt ratio and short-term debt to equity. 4. Empirical results 4.1 Descriptive statistics Table I provides the descriptive statistics embodying the overall mean, standard deviation, minimum and maximum values of both the dependable and the explanatory variables. Financial leverage records overall mean of 1.6063 whilst debt ratio registers overall mean value of 0.5884 implying that majority of the rms on the GSE nance their operation with external borrowing. Short-term debt records 2.3339 with risk registering 0.1359 as the overall mean, but there are variations in this variable over the period. Average managerial holding on the GSE is 0.1242 whilst foreign share ownership records overall mean of 0.2797. For tax, the overall mean is 0.2971. Average board size is 8.7391 whilst the maximum board size is 17, with the majority of the boards being independent. CEO duality records 0.0942 indicating that some boards have the CEO and the board chair as the same person. Asset tangibility records overall mean of 0.3476, average age of rms on the GSE is 40.0217. Dividend yield records 0.0483, protability registers overall mean of 0.0591 whilst average size records 4.0924.
Variable Leverage Debt ratio Short-to-equity Risk Inside ownership Foreign ownership Tax Board size Board independent CEO duality Assed tangibility Age Dividend yield Protability Size Obs. 138 138 137 136 136 138 138 138 137 138 138 138 138 136 136 Mean 1.6063 0.5884 2.3339 0.1359 0.1242 0.2797 0.2971 8.7391 0.1816 0.0942 0.3476 40.0217 0.0483 0.0591 4.0924 SD 5.3867 0.2186 2.5625 0.1625 0.1682 0.3293 0.2735 2.5639 0.1131 0.2932 0.2379 22.2273 0.0966 0.0793 1.3778 Min. 0 0 0 0 0 0 2 0.693 0 0 0 0 5 0 2 0.1676 0.0566 Max. 40 0.9222 9.7829 0.9468 0.9095 0.8891 1.6404 17 0.60 1 0.8551 111 0.88 0.2965 6.361

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Table I. Descriptive summary statistics of both the dependent and the explanatory variables

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Table II reports the empirical regression results. Inside ownership portrays a positive and statistically signicant relationship with choice of long-term debt over equity and debt ratio. But the relationship is negative and statistically insignicant with the choice of short-term debt over equity. Managers with shareholding in the rm will prefer to nance company operations with long-term debt rather than issuing equity probably because of the tax shield arising as a result of leverage which eventually adds to shareholders wealth. Foreign share ownership exhibits a positive and statistically insignicant relationship with all the measures of capital structure. For the corporate governance variables, there is a positive and statistically insignicant relationship between CEO duality and nancial leverage and choice of short-term debt over equity but a negative relationship with debt ratio. Entrenched CEOs will prefer nancing company operations with debt rather than issuing equity on the GSE. There is also a positive and statistically signicant relationship between board size and the choice of long-term debt over equity whilst the relationship is also positive in the choice of short-term debt over equity but negative in the case of debt ratio. But in the case of short-term debt and debt ratio, the relationship is statistically insignicant. Thus, directors in general will substitute equity for long-term debt in their nancing decisions. Board independence exhibits negative but statistically insignicant relationship with choice of long-term debt over equity and the choice of short-term debt over equity whilst it portrays a positive and statistically insignicant relationship with debt ratio. There is a statistically insignicant positive relationship between tax and all the capital structure decisions. For asset tangibility, there is a positive but statistically insignicant relationship with choice of long-term debt over equity. There is however a
Dependent variable Debt ratio 0.2633 0.0583 20.0696 20.0015 0.0566 0.0175 20.5793 20.0004 0.2877 20.6760 0.0331 20.3405 0.7055 12 0.1419 0.5285 144.61 0.0000 (2.89) * * (1.35) (1.52) (0.24) (0.42) (0.35) (9.93) * * * (0.60) (1.95) * (3.74) * * * (3.21) * * * (3.83) * * * (10.09) * * *

Variables Inside ownership Foreign ownership CEO duality Board size Board independence Tax Asset tangibility Age Dividend yield Protability Size Risk Constant Parms RMSE R2 x2 P-values

Leverage 8.4035 1.7222 0.3377 1.0431 22.9851 1.9688 2.7360 20.0102 28.5046 1.4179 20.1564 1.0976 28.9956 12 4.1845 0.4291 96.95 0.0000 (3.13) * * * (1.36) (0.25) (5.46) * * * (2 0.76) (1.33) (1.59) (0.52) (1.95) * (0.27) (0.51) (0.42) (4.37) * * *

Short to equity 2 0.2220 0.3888 0.1282 0.0058 2 1.6357 0.1684 2 7.0185 0.0108 4.7478 2 7.1927 0.4032 2 2.3939 3.3047 12 1.5813 0.5756 174.94 0.0000 (0.22) (0.81) (0.25) (0.08) (1.10) (0.30) (10.80) * * * (1.46) (2.89) * * (3.57) * * (3.50) * * * (2.41) * * (4.24) * * *

Table II. Regression results of nancial leverage, debt ratio, and choice of short term debt over equity

Notes: Signicant at *10, * *5 and * * *1 percent levels, respectively; all regressions include a constant; t-statistics are in parentheses

negative and statistically signicant relationship between asset tangibility and the choice of short-term debt over equity and debt ratio on the GSE. Age exhibits a negative but statistically insignicant relationship with leverage and debt ratio whilst the relationship is positive with the choice of short-term debt over equity though the relationship is not statistically signicant. We also report a negative and statistically signicant relationship between dividend payment and the choice of long-term debt over equity. Firms that pay more dividends will signicantly cut down on the use of long-term debt. But, there is a statistically signicant positive relationship between dividend payment and debt ratio and the use of short-term debt. Thus, rms will opt for more short-term borrowings either to make up for the short fall in their nancing or to support dividend payment. There is a statistically signicant negative relationship between protability and all the capital structure measure variables except for leverage (choice of long-term debt over equity). It stands to reason that more protable rms will signicantly nance their operations with retained earnings rather than external borrowing. Thus, the more protable rms are the less reliance they will place on nancial institutions to nance their operations. The regression results also indicate statistically signicant positive relationship between rm size which represents transactional demand on the company and all the capital structure measurement variables except for nancial leverage. Firms will borrow more short-term funds as their operational size increases than issuing equity. But the relationship observed between rm size and nancial leverage is negative but statistically insignicant. Finally, we observe a negative and statistically signicant relationship between volatility in earnings (risk) and most of the capital structure decisions (debt ratio and choice of short-term debt over equity). But the relationship is positive in the case of leverage and statistically insignicant. 5. Conclusions and implications Several theories have been advanced to explain the capital structure decisions of rms. Consequently, empirical evidence is being sought on the relevance or otherwise of those theories. The relevance of these theories have hinged on rm level features with varying conclusions. Whilst empirical evidence on the determinants of capital structure have focused on developed economies with mixed results, the impact of ownership structure and corporate governance on rms capital structure choices in Ghana remain largely under studied (Kyereboah-Coleman and Biekpe, 2006; Abor, 2007). Using the SUR approach, this study seeks to ll the research gap by providing empirical evidence on the relationship between ownership structure, corporate governance and rms capital structure decisions on the GSE. Largely, the direction and magnitude of the impact of ownership structure and corporate governance depend on the capital structure measurement indices especially whether it is measured in terms of choice of long-term debt over equity or short-term debt over equity. Managerial share ownership signicantly positively inuences the choice of long-term debt over equity whilst foreign share ownership is insignicant in predicting corporate nancing decisions. Board size is also signicantly positively related to leverage implying that directors in general will substitute equity for long-term debt in their capital structure choices whilst we report insignicant relationships with the other measures of capital structure (debt ratio and choice of

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short-term debt over equity). Board independence and CEO duality are however not important factors in the choice of nancing mix of rms on the GSE. We also observe other rm level factors that are signicant in predicting corporate nancing decisions on the GSE. Asset tangibility which could serve as a collateral security is a signicant predictive variable in the choice of especially short-term debt over equity. Volatility in earnings (risk) is also a signicant determinant of capital structure decisions among rms on the GSE. In addition, protable rms will signicantly curtail external nancing and resort to internally generated funds such as retained earnings. We also report that, rms capital structure decisions are taken alongside rms dividend policy as we observe a signicant relationship between dividend payment and capital structure decisions. Since large body of literature exist on the important of capital structure to rm value, managers especially on the GSE give due consideration to their corporate governance arrangements as these factors are extremely crucial to both policy makers and nanciers. Capital structure decisions must be taken jointly with dividend policy and other rm level characteristics such as protability, volatility in earnings and acquisition of xed assets (asset tangibility) to ensure a comprehensive corporate response to the mix of security and nancing sources of rms that maximize shareholders wealth.
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