The Impact of Ownership Structure on Capital Structure and Firm Value: Evidence from the KSE-100 Index Firms

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1 The Impact of Ownership Structure on Capital Structure and Firm Value: Evidence from the KSE-100 Index Firms Hamidullah and Attaullah Shah Abstract The crux of this paper is the joint determination of a firm s value through ownership structure and capital structure, using a random sample of 80 firms listed on the Karachi Stock Exchange, Pakistan from 2003 to In line with the previous literature, this paper first uses several variants of the panel data analysis such as pooled OLS, fixed effects, and random effects models to investigate the association between ownership variables and leverage. Then allowing for the possibility of endogenity among ownership variables, leverage, and firm value, the paper employs 3SLS regression models. Results of the panel data models signify the existence of negative association between the institutional ownership and leverage while managerial ownership does not show statistically significant association with leverage, possibly because of non-liner relationship between the two. These findings lend support to the monitoring role of leverage, implying that leverage can be used as a alternate of institutional ownership. Results of the 3SLS models show that leverage and Tobin s Q are negatively associated to managerial share ownership. Results of the second equation of the 3SLS model Tobin s Q is positively related to managerial ownership at lower level and negatively related to it at higher levels. These finding supports the managerial entrenchment hypothesis. The third equations suggest that leverage is positively related with Tobin s Q while negatively related with managerial share ownership. The simultaneous equations purport that ownership structure affect firm s value through capital structure. Keywords Ownership structure, Capital structure, Firm value, blockholding, 3SLS model, Pakistan. T I. INTRODUCTION HE association among managerial ownership, capital structure and a firm s value is of great interest to the researcher in the field of corporate finance. The managers take investment and financing decisions that directly affect the firm s value. Every decision of a manager either creates of destroys value for shareholders. There is a general concept that the shareholders and the managers interest are not aligned; an inherent conflict exists between the management and shareholders, which directly affects the firm s value. Jensen and Meckling (1976) pointed out agency problem, that managers have a natural inclination to take such decisions that could serve their interest rather than the interest of the Hamidullah is with National University of Modern Languages (NUML) Ims.hamid@gmail.com Attaullah Shah is with Institute of Management Sciences, Peshawar attaullah.shah@imsciences.edu.pk. shareholders. Harris and Revive (1990) suggested that managers prefer lower level of debts due to the fear of risk of bankruptcy, which will make managers jobless, others will doubt their managerial competencies, and unemployment risk will be more even elsewhere. In order to force managers to work in the best interest of the shareholders, J and M propose two options, firstly agency problem can be minimized by giving managerial ownership in the firm in the form of stock options, so far well presented in the literature of corporate finance by Jensen and Meckling (1976), Watts and Zimmerman (1978) and Miller and Rock (1985). Secondly, principal agent problem can be overcome by employing higher level of debts financing. Pineger and Wilbricht (1986) are of the view that, employment of higher debts act as an alternative of internal control system due to the reason that debts have periodic interest payments that makes manager more discipline. So far, many researchers worked on the relationship of the managerial ownership and capital structure. While others investigated the impact of the managerial ownership on firm s value and reported endogenity issue. However, no empirical work is there on the simultaneous relationship among the three. The crux of this research is that it has particularly focused on such issues relating to the ownership structure, capital structure and firm value in the context of Pakistani firms. The results suggested, Capital structure is endogenously determined by both firm value and managerial ownership while managerial ownership is also endogenously determined by the other two variables. II. LITERATURE REVIEW A. Ownership Structure and Firm Value The milestone of the agency relationship was laid down by none other than the Father of Economics Adam smith s (1776) who argued that the firm structure creates mismanagement and thus allows negligence of their own servant which firms fail to control. The directors of such [joint-stock] companies, however, being the managers rather of other people s money than of their own, it cannot well be expected, that they should watch over it with the same anxious vigilance with which the partners in a private copartner frequently watch over their own. Like the stewards of a rich man, they are apt 450

2 to consider attention to small matters as not for their masteries honor, and very easily give themselves a dispensation from having it. Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company. Adam Smith (1776) For almost one-half a century, no one worked on this concept until Berle and Means (1932) originated again interest in the agency theory. They suggested that an increase in the size of an organization leads to the gap between the ownership and control due to decreases in ownership equity. This provides an opportunity to managers to follow their own interest rather than the interest of the real owners i.e. maximizing the shareholders wealth. 1. Agency Theory Jensen and Meckling (1976) for the first time came up with the issue of conflicts of interest between the shareholders and managers. They defined this agency relationship in the following words. Agency relationship as a contract under which one or more persons (the principal(s) engage another person (the agent) to perform some service on their behalf which involves delegating some decision making authority to the agent and will provide some incentives to the agents for the services they perform in their behalf like remunerations bonus. Jensen and Meckling (1976, P.308) They also suggested that this conflict can be minimized by giving manager ownership options in form of stock options, prerequisites and incentives so far well presented in the literature of corporate finance by Jensen and Meckling (1976), Watts and Zimmerman (1978) and Miller and Rock (1985). a) Free Cash Flows Jensen and Ruback (1983) argued that the manager would use the excess cash flows available for their own interest by investing them in such projects, which might not have positive NPV or productive projects for the maximization of profit and shareholder wealth. Instead, these excess cash flows given to the shareholders as a dividend. The monitoring of managers activities in order to make managers to work for the best interest of the shareholders has its own cost called monitoring cost. The greater the monitoring by the shareholders the higher would be the agency costs(lubatkin and chatterjee 1994). b) Asymmetry of Information Myers and Majluf (1984) are of the view that insiders are likely to be more informed than the external investors about the firm operations, assets and value of the firm. When information asymmetry is larger, then the firm issues debts. If they issue shares, the stock prices would fall more due to this asymmetry. So current shareholders would prefer the debts financing in order to avoid the under pricing of the stock prices. So the high managerial ownership firm manager would prefer high leverage in order to serves the interest of present shareholders. In light of the above discussion, we hypothesize: III. METHODOLOGY A. Sample Framework and Data Sources Sample of the study is randomly selected from the listed firms of Karachi Stock Exchange; including eighty firms for the period of 2003 to This sample was primarily determined by the availability of data for the same period from different industry like cement, textile and spinning, engineering, chemicals transportation, telecommunication, foods, oil and gas, and pharmaceutical. This study was conducted using only secondary data, which were collected from the different sources such as annual reports of all listed firms of KSE and balance sheet analysis of joint stock companies of, state bank of Pakistan. IV. EMPIRICAL ANALYSIS: A. Pearson Correlation Matrix of Ownership Structure and Financial Variables: Pearson correlation matrix shows that managerial share ownership is negatively correlated with firm size, firm profitability, firm growth, dividend ratio and Tobin s Q while positively correlated with volatility, FCF, non-debts tax shield tangibility and leverage. Whereas Tobin s Q is negatively correlated with managerial share ownership, volatility, nondebt tax-shield and tangibility of assets. While positively correlated with firm size, profitability, growth, free cash flows and dividend ratio. B. Explanation and Discussion of the Regression Analysis of 3SLS: Pineger and Wilbricht (1986) argued that principal agent problem can be overcome by employing a unique capital structure where higher level debts financing are used. In other words, employing higher debts acts as an alternative to internal control system.the Husman test preferred 3SLS than OLS. The regression results of 3SLS model show that the coefficient of LEV ( ) is significantly negatively related with the MSO while the coefficient of Tobin s Q ( ) is significantly negative related with MSO. Moreover, all the control variables are also statistically significant. The equation one coefficients of the OLS and 3SLS regression shows that OLS underestimates the coefficients and 3SLS outperform the OLS. The coefficient sign of the OLS estimates are not supportive to the literature. This model proved the existence of negative relationship between the firm managerial ownership and leverage while negative with firm value. These results are consistent with the hypothesis that there exist a relationship between the managerial ownership leverage and firm value. The empirical results are consistence with Chung and Pruitt(1996),Cho(1998) Weber and Dudney(2003),David et al.(2004). McConnell and Servaes (1990) suggested a curvilinear relationship between the Tobin s Q and corporate managerial ownership but OLS regression model fail to support the existence of such relationship. On the other hand the 3SLS 451

3 regression model of Tobin s Q with the LEV, MSO, MSO 2 suggested that LEV and MSO, MSO 2 are significantly related with coefficients of ( ) ( ) and ( ) respectively. Empirical results are supportive to the hypothesis that there is non-linear relationship between the firm value and different level managerial ownership. This non-liner behavior can be interpreted as supportive to the alignment effect (a positive relationship) for a low level of managerial ownership and while supportive to the entrenchment effect (a negative relationship) for a higher level of managerial ownership. The studies of Morck Shleifer (1988), Chen (2006), and Davies et al (2004) support this non-linear relationship. So again the 3SLS regression outperforms the OLS and OLS having underestimated values of coefficient as well the sign of the coefficients are not supportive to literature. The results third model of the 3SLS regression shows that leverage is positively related with the Tobin s Q (0.0948) and also negatively related with the managerial ownership ( ). The negative sign of the managerial ownership is due to the reason that managerial ownership can be substituted for debts in order to make the manager more discipline. The results of the equation (3) are consistent with the studies of Friend et al (1988), Perry and Rimbey (1998) Jensen et al (1992). Hasunm test results also support the 3SLS regression model rather than OLS. V. CONCLUSION Adim smith (1776) Berle and Means (1932) Jensen and Meckling (1976) Harris and Revive (1990) laid down the concept of agency theory. This study is conducted to test that there exists relationship between the ownership structure, capital structure and firm value in Pakistani firms while taken a random sample of 80 firms from the Karachi listed firm. Two types of statistical techniques are used to jointly determine the relationship of ownership structure, capital structure with firm value i.e. OLS single step regression model and 3SLS regression model. Husman test results supported 3SLS model. The first equation shows the existence of negative relationship between the firm managerial ownership and leverage while negative with firm value. While the second model empirical results are supportive to the hypothesis of non-linear relationship between the firm value and different level managerial ownership. This non-liner behavior can be interpreted as supportive to the alignment effect (a positive relationship) for a low level of managerial ownership and while supportive to the entrenchment effect (a negative relationship) for a higher level of managerial ownership. (Morck Shleifer, 1988). The third equation results suggested that leverage is positively related with the Tobin s Q and negatively related with the managerial ownership. The negative sign of the managerial ownership because managerial ownership can be used as a substitute of debts in order to make the manager more discipline. These results are consistent with the studies of Friend et al (1988), Perry and Rimbey (1998) Jensen et al (1992). REFERENCES [1] Agrawal, Anup and Nandu J. Nagarajan, 1990, Corporate capital structure, agency costs, and ownership control: The case of all-equity firms, Journal of Finance 45, [2] Andrei Shleifer, Robert W. Vishny Journal of Finance, Volume 52, Issue 2 (Jun., 1997), [3] Bathala, C.T., K.P. Moon and R.P. Rao, 1994, Managerial Ownership, Debt policy, and the Impact of Institutional Holdings: An Agency Perspective, Financial Management, 23, [4] Berle A. A., Means G. C., (1932), The Modern Corporation and Private Property, The Macmillan Company, New York. [5] Bradley, M., G. Jarrell, and E. H. Kim, 1984, On the Existence of an Optimal Capital Structure: Theory and Evidence, Journal of Finance 39, [6] Bradley, M., G.A. Jarrell and E.H. Kim, 1984, On the Existence of an Optimal Capital Structure: Theory and Evidence, Journal of Finance, 37, [7] Brailsford, T. J., Oliver, B. R. and Pua, S. L. H. (2002), On the Relation between Ownership Structure and Capital Structure, Accounting and Finance, Vol. 42, pp [8] Chatterjee S, Lubatkin MH, Schulze WS Toward a strategic theory of risk premium: Moving beyond CAPM, Academy Of Management Review 24: (3) Jul. [9] Crutchley, C., M. Jensen, J. Jahera and J. Raymond (1999). Agency Problem and the simultaneity of Financial Decision Making: The Role of Institutional Ownership. International Review of Financial Analysis, 8 (2), [10] DeAngelo, H., Masulis, R.W., Optimal capital structure under corporate and personal taxation. Journal of Financial Economics 8, [11] DEMSETZ, H. (1983), The Structure of Ownership and the Theory of the Firm, Journal of Law and Economics, 26: ; [12] Eckbo, B. E., and Verma, S., (1994), Managerial Share Ownership, Voting Power, and Cash Dividend Policy, Journal of Corporate Finance, 1: [13] Ferri, M.G. and W.H. Jones, 1979, Determinants of Financial Structure: A New Methodological Approach, Journal of Finance 34, [14] Friend I., Lang L., (1988), An empirical test of the impact of managerial self-interest on corporate capital structure, Journal of finance, n. 2. [15] Friend, I. & Lang, H.P An empirical test of the impact of managerial self-interest on corporate capital structure. Journal of Finance, 43(2): [16] Friend, I. and L.H.P. Lang, 1988, An Empirical Test of the Impact of Managerial Self-Interest on. [17] Grier P and Zychowicz E J (1994), Institutional investors, corporate discipline and the role of debt, Journal of Economics and Business, 46, [18] Harris M., Raviv A., (1991), Capital structure and the informational role of debt, Journal of finance, n. 45. 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4 4.2 Pearson Correlation Matrix of Ownership Structure and Financial Variables: MSO VOLT SIZE PROF GROWTH FCF NDTS TANG DIVD Tobin s Q LEV MSO VOLT SIZE PROF GROT FCF NDTS TANG DIVD Tobin LEV Table 4.2 shows the correlation among the different variables. Where MSO represents the percentage of managerial ownership to the total share capital of the firm. VOLT is Volatility in earning, SIZE is a proxy for the firm size, PROF represents firm profit after taxes, Growth represents the firm growth, FCF stands for free cash flows, NDTS stand for the non debts tax shield, TANG represents the tangibility of assets, DIV stands for the dividends payout ratio, Tobin s Q is used as a proxy for the market value of firm and LEV represents the log of total debts to equity ratio and is used as proxy for the leverage of firm Table 4.3 Shows OLS Single Equation Models MSO= α+βlev+βtobins Q+βGrowth+βTANG+βVOLT+βSIZE Tobin s Q= α + βlev+ β MSO+ β MSO 2 + β PROF LEV=α + Tobin s Q + βgrowth + βvolt + βsize + βmso + βfcf + β NDTS + βdiv.ratio Variables Coefficient S.E Coefficient S.E coefficient S.E LEV (0.0293)** (2.120)** * Tobin s (0.0015)** (0.0056)*** Q * GROWT (0.0781)* (0.0991) H TANG ) *** VOLT (0.0071** (0.3931) (0.0136)*** SIZE (0.0051)** ( )*** MSO (2.2176)* (0.0362)*** MSO (4.4451) PROF (2.0461) FCF (0.0742) NDTS (0.397) Div.Rati (0.0375)*** o R-square F-value Table 4.5 shows the regression results of the single equation OLS model. The first column shows coefficients with the standard error and level of significance of OLS for each of the three equations. Where MSO in the above model represents the percentage of managerial ownership to the total share capital of the firm. VOLT is Volatility in earning, SIZE is a proxy for the firm size, PROF represents firm profit after taxes, Growth represents the firm growth, FCF stands for free cash flows, NDTS stand for the non debts tax shield, TANG represents the tangibility of assets, DIV stands for the dividends payout ratio, Tobin s Q is used as a proxy for the market value of firm and LEV represents the log of total debts to equity ratio and is used as proxy for the leverage of firm. Robust standard errors are given in parentheses. The *, **, and *** show statistical significance at 1% level, 5% level, and 10% level respectively. Lower part of the table presents R 2, shows the explanatory F-statistics shows the stability of the overall model. Table 4.4 Shows 3SLS Regression Models. MSO= α+βlev+βtobins Q+βGrowth+βTANG+βVOLT+βSIZE Tobin s Q= α + βlev+ β MSO+ β MSO 2 + β PROF LEV=α + Tobin s Q + βgrowth + βvolt + βsize + βmso + βfcf + β NDTS + βdiv.ratio 453

5 Variables Coefficient S.E Coefficient S.E Coefficient S.E LEV (0.0883)*** (0.0435)*** Tobin s Q (0.0085)*** (0.0104)*** GROWTH (0.0733)** (0.0786)* TANG (0.0419) VOLT (0.0135)*** (-2.62) (0.0083)*** SIZE (0.0070)*** (0.0083)*** MSO (1.2668)** (0.0439)*** MSO (8.2501)** PROF (0.8840) FCF (0.0500)** NDTS (0.2873)** Div.Ratio (0.0282)*** Hausman Test F= Prob > F = F = Table 4.6 shows the regression results of the 3SLS model. The first column shows coefficients with the standard error and level of significance for each of the three equations. Where MSO in the above model represents the percentage of managerial ownership to the total share capital of the firm. VOLT is Volatility in earning, SIZE is a proxy for the firm size, PROF represents firm profit after taxes, Growth represents the firm growth, FCF stands for free cash flows, NDTS stand for the non debts tax shield, TANG represents the tangibility of assets, DIV stands for the dividends payout ratio, Tobin s Q is used as a proxy for the market value of firm and LEV represents the log of total debts to equity ratio and is used as proxy for the leverage of firm. Robust standard errors are given in parentheses. The *, **, and *** show statistical significance at 1% level, 5% level, and 10% level respectively. Lower part of the table presents R 2, shows the explanatory power of the model while F-statistics of the Hausman test shows the stability of the overall model in case of 3sls model. 4.5 Table OLS and 3SLS coefficients Signe Variables OLS 3SLS OLS 3SLS OLS 3SLS LEV Tobin s Q GROWTH + - TANG + + VOLT SIZE MSO MSO PROF FCF - - NDTS + + Div.Ratio