CORPORATE GOVERNANCE AND CAPITAL STRUCTURE DYNAMICS: AN EMPIRICAL STUDY

• Author: Wei Wang,Tarun Mukherjee,Li‐Kai (Connie) Liao
• Date: 01 June 2015
• DOI: http://doi.org/10.1111/jfir.12057
• Published date: 01 June 2015

CORPORATE GOVERNANCE AND CAPITAL STRUCTURE DYNAMICS:

AN EMPIRICAL STUDY

Li-Kai (Connie) Liao

Tunghai University

Tarun Mukherjee

University of New Orleans

Wei Wang

Cleveland State University

Abstract

Consistent with theoretical predictions, we find that both a higher level of financial

leverage and a faster speed of adjustment of leverage toward the shareholders’desired

level are associated with better corporate governance quality as defined by a more

independent board featuring CEO–chairman separation and greater presence of outside

directors, coupled with larger institutional shareholding. In contrast, managerial

incentive compensation on average discourages use of debt or adjustments toward the

shareholders’desired level, consistent with its entrenchment effect. The effect of

corporate governance on leverage adjustments is most pronounced when initial leverage

is between the manager’s desired level and the shareholders’desired level where the

interests of managers and shareholders conflict.

JEL Classification: G30, G32, G34

I. Introduction

According to the static trade-off theory, a firm maximizes the wealth of its shareholders

when its capital structure reaches the optimal level via a trade-off of tax benefits against

financial distresscosts of debt. Consequently, any deviation from optimalleverage should

be removed quickly. However, empirical studies show incomplete leverage rebalancing

(e.g., Flanneryand Rangan 2006; Lemmon, Roberts, andZender 2008), often attributed by

researchers (e.g., Fischer, Heinkel, and Zechner 1989; Strebulaev 2007) to refinancing

costs.

1

In a recent paper calling attentionto the role of agency conflicts in capital structure

decisions, Morellec, Nikolov, and Sch€

urhoff (2012) offer another explanation for why

capital structure speedof adjustment (SOA) is slower than what the static trade-off theory

We are immensely grateful to Mark Flannery, the associate editor, and

€

Ozde

€

Oztekin, the referee, for giving

us countless helpful suggestions that have substantially improved the paper’s quality and contribution. We also

thank the editors for guiding us through the entire process. The usual caveat applies.

1

Other factors that could lead to partial adjustment of capital structure include equity mispricing (e.g., Warr

et al. 2012), cash-flow realization (Faulkender et al. 2012), institutional and macroeconomic factors (

€

Oztekin and

Flannery 2012;

€

Oztekin forthcoming), and so on.

The Journal of Financial Research Vol. XXXVIII, No. 2 Pages 169–191 Summer 2015

169

© 2015 The Authors. The Journal of Financial Research published by Wiley Periodicals, Inc. on behalf of The Southern Finance Association and

the Southwestern Finance Association

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would predict. Internalizing managers’private benefits in an augmented trade-off model

where firms face taxation,liquidation costs, and refinancing costs,Morellec, Nikolov, and

Sch€

urhoff demonstrate thatto produce the empirical SOA, one must introducereasonable

agency costs. When makingfinancing decisions, self-interested managers tradeoff the tax

benefits of debt againstthe total costs of debt, including not only costsof financial distress

but also those due to the disciplining effect of debt, that is, the loss of free cash flow at

managers’discretion for potential private benefits (Jensen 1986). As a result, managers

issue less debt and restructure less frequently than is optimal for shareholders. In other

words, managers on average would have a leverage target that is lower than the

shareholders’desired level and employ a slower SOA. Based on their model, Morellec,

Nikolov, and Sch€

urhoff further argue that an effective corporate governance system

advances shareholders’interest by persuading managers to use more debt as well as to

make more timely capital structure rebalancing. Overall, they show that agency conflicts

have a first-order effect on capital structure decisions.

In this article we empirically test the intriguing implications of the Morellec,

Nikolov, and Sch€

urhoff (2012) model: the greater the severity of agency conflicts, the

lower is the manager’s desired leverage level, and the slower is the SOA toward the

shareholders’desired level. We relate a firm’s capital structure decisions to its agency

costs that in turn depend on the governance system within which the firm operates. To

measure the strength of the firm’s corporate governance, we focus on the composition of

the board of directors it chooses, the executive compensation it pays, and the institutional

ownership it attracts. Directors and institutional investors monitor and discipline the

managers to contain agency conflicts, and we expect they would encourage the use of

debt and facilitate capital structure rebalancing. As board independence is viewed as

crucial for effective monitoring, we characterize a strong board of directors by the

separation between CEO and board chairman (e.g., Fama and Jensen 1983), and a high

proportion of outside directors (e.g., Weisbach 1988). The higher the institutional

holding, all else the same, the more effectively institutional owners monitor the managers

(e.g., Shleifer and Vishny 1986). Equity-based compensation packages aim at

incentivizing the managers but have the unintended consequence of causing managerial

entrenchment (Claessens et al. 2002) in the form of, among others, lower than optimal

leverage (Berger, Ofek, and Yermack 1997). Morellec, Nikolov, and Sch€

urhoff

document that on average a greater managerial delta, that is, sensitivity of managerial

compensation to stock price changes, is associated with greater agency costs as far as

capital structure decisions are concerned.

2

Therefore, we expect that, holding all else

equal, a high managerial delta discourages the manager from using debt and thereby

reduces his incentive to adjust the firm’s capital structure toward the shareholders’

desired level. We also create an aggregate governance quality factor by applying

principal component analysis (PCA) on the above four governance variables, and we

expect this proxy of strong governance to be positively associated with SOA.

2

Morrelec, Nikolov, and Sch€

urhoff (2012) document a U-shaped but on average positive relation between the

private benefit of control and managerial delta, consistent with the incentive versus entrenchment literature. They

suggest that, overall, the protection provided by managerial ownership outweighs the benefits for the manager from

the increased use of debt.

170 The Journal of Financial Research