Board Size, Firm Risk, and Equity Discount

• Published date: 01 September 2015
• DOI: http://doi.org/10.1111/jori.12033
• Author: Arun Upadhyay
• Date: 01 September 2015

BOARD SIZE,FIRM RISK,AND EQUITY DISCOUNT

Arun Upadhyay

ABSTRACT

Prior literature documents that larger boards pursue conservative invest-

ment policies and that their decision outcomes are moderate, which promote

an environment of risk aversion. I argue that this risk aversion hurts equity

holders when firms hold a larger amount of long-term debt. Addressing

potential endogeneity problems associated with board size, I find an equity

discount associated with larger boards in firms that have greater amounts of

long-term debt. On the other hand, larger boards are associated with an

equity premium when firms have a greater short-term debt-to-assets ratio.

The equity discount associated with larger boards disappears in firms with

no long-term debt. Further analysis also indicates that firms with larger

boards enjoy a better credit rating and a lower realized cost of debt. Overall,

analysis in this study suggests that the association between board size and

equity value is a function of a firm’s debt structure.

INTRODUCTION

Providers of capital choose different corporate governance mechanisms to assure

themselves of getting a return on their investment. Corporate boards are one of the

most important governance mechanisms that protect shareholders’ interests by

monitoring managerial activities. For example, boards often design managerial

compensation schemes that encourage managers to undertake risky projects that

benefit stockholders but hurt existing debt holders when managers add more debt.

An important attribute that affects a board’s effectiveness is board size (Jensen, 1993).

There is some evidence that smaller boards are more effective monitors of managerial

activities (Yermack, 1996). Cheng (2008) documents evidence that larger boards

pursue conservative investment policies and that their decision outcomes are

moderate. I add to this literature by examining how conservative policies pursued by

larger boards impact equity holders in firms that have a greater amount of debt.

Jensen and Meckling (1976) suggest that when governance structures align

managerial interests with stockholders’ interests, debt holders’ concern of asset

Arun Upadhyay is an Assistant Professor, Finance, College of Business, University of Nevada,

Reno. The author can be contacted via e-mail: aupadhyay@unr.edu. I would like to thank Steve

Balsam, Steve Casper, Rashmi Prasad, David Reeb, and Wanli Zhao for very helpful comments

and suggestions.

© 2014 The Journal of Risk and Insurance. 82, No. 3, 571–599 (2015).

DOI: 10.1111/jori.12033

571

substitution is increased. Since smaller boards monitor managers more effectively

and thus protect shareholders’ interest, arguably debt holders are more likely to

worry about potential asset substitution problems in firms with smaller boards. It is

possible that those firms that rely on debt capital more than equity capital might not

want to have a small board because their debt holders would ask for a larger premium

due to increased assets substitution risk. I argue that firms with a greater amount of

long-term debt in their capital structure would benefit by having a larger board, as a

larger board would help them reduce their cost of debt. Thus, similar to Coles, Daniel,

and Naveen (2008), this analysis offers a justification why some firms have a larger

board when prior evidence indicates smaller boards are more effective. However,

unlike Coles, Daniel, and Naveen, who focus on the advising needs and operational

complexity of a firm, this study uses the opposite impacts of risk on debt and equity

holders to explain why some firms could benefit from having a larger board.

Since risk taking is a central issue in the analysis of how board structures affect equity

value and since risk could affect equity holders and debt holders differently, this

study reexamines the association between board size and equity value by also

considering the impact of debt. The conflicting preference for risk by equity and debt

holders is magnified in the presence of long-term debt (Myers, 1977). This study

examines the association between board size and equity value in the presence of long-

term debt. In studying this relation, I focus on how board size impacts firm risk. This is

consistent with the idea that firms choose their monitoring mechanisms based on

their underlying characteristics and other market forces that frequently interact with

top decision makers. Brickley and Zimmerman (2010) argue that the behavior of top

managers is influenced not only by the governance mechanisms such as board of

directors but also by a host of other factors including capital structure policies. They

argue that corporate debt introduces an additional set of monitors such as banks and

rating agencies, and optimal board structures and compensation policies are unlikely

to be independent of these factors. Prior literature mostly focuses on the association

between board size and equity value without much regard to firm risk and without

simultaneously examining how debt structure could interact with this association. To

the best of my knowledge, this is the first study that examines how debt structure

impacts the association between board size and equity value.

Cheng (2008) finds that firms with larger boards are managed conservatively and

have lower firm risk. In a contingent claims framework, lowering firm risk would

lower the equity holder value and increase debt holder value (Black and

Scholes, 1973). This shift in value should be a function of the amount of leverage

in a firm’s capital (Parrino, Poteshman, and Weisbach, 2005). I, therefore, argue that

by following conservative policies larger boards hurt equity holders but benefit debt

holders in a leveraged firm. Thus, the extension of Cheng (2008) suggests a negative

impact of larger boards on equity value in leveraged firms.

1

This is similar to the

1

This extension appears to be in conflict with Coles, Daniel, and Naveen (2008) who find that the

firms with larger amounts of debt are valued more by the equity holders when they have larger

boards. Later, I find that the positive association between board size and Tobin’s qis driven by

short-term debt.

572 THE JOURNAL OF RISK AND INSURANCE