Leverage dynamics, ownership type and firm growth

Transcription

1 Leverage dynamics, ownership type and firm growth The influence of leverage on growth opportunity and an inclusion of family firms T. Qin A thesis submitted in partial fulfillment Of the requirements for the degree Master of Science in Finance Name: Tian Qin ANR: Supervisor: N.R.D. Dwarkasing MSc Date: August 2014

2 Abstract This study mainly analyzes the effect of leverage on firm growth. In addition, I control for being a family owned firm. First, this paper studies the role of leverage on firm growth opportunity, which is measured similar to Long and Malitz (1985) where they use capital expenditure as the measurement for growth opportunity. Three following years capital expenditures are used to measure growth opportunity in my model. The results indicate a negative relationship between leverage and growth opportunity. Second, the characteristics of family firms are tested. The results show that family firms have lower leverage but higher growth opportunity. Third, the impact of leverage is further tested for different ownership types. The joint effect of leverage and ownership type is used to test whether leverage impact differs in family and non-family firms. The result indicates that for family firms, leverage has a positive effect on growth opportunity. The sample for this paper is public traded companies in S&P 500 excluding public utilities and banking industries from period 2003 to Family firms are manually collected from proxy statements and are defined based on shares ownership, board composition and founding family characteristics. This paper tests the robustness of the results using alternative measurements of growth opportunity and restricted samples. In order to address endogeneity issues where leverage and firm growth opportunity can be determined jointly, this paper uses an instrumental variable approach to test for the effect of leverage on firm investment. As an instrumental variable, tangibility will be used. The results from such an instrumental variable approach indicate leverage impact on growth opportunity is positive, which is against my previous findings. However, they need to be interpreted with caution since the instrumental variable is weak.

3 Table of contents 1. Introduction Literature review Leverage and growth opportunity firm ownership and its relation to leverage and growth opportunity Control ownership type for relationship between leverage and growth opportunity Hypothesis development and control variables Hypothesis control variables Sample and Data Leverage Firm-growth Family-owned firms Controls Regressions Growth opportunities and the role of leverage Leverage and firm ownership Firm ownership and growth opportunity Growth opportunity, ownership and the role of leverage Summary Endogeneity Robust test Conclusion Appendix Limitation Reference... 40

4 1. Introduction The impact of financial leverage on a firm s investment decision has always been a central issue in corporate finance. On one side of this issue is whether capital structure has an impact on investment opportunities. Moreover, is this impact different between family firms and nonfamily firms? For those on the other side is the endogeneity problem. High leverage reduces a firm s ability to finance growth through a liquidity effect (Bernanke 1993). Most of the previous studies have shown a negative effect of leverage on growth opportunity. But they all have their limitations. For example, Lang, Ofek et al. (1996) assume that the unobservable individual effect is zero and use a pooling regression with a sample period of , which is almost 20 years ago and might not suit the recent economy state. In addition, Aivazian, Ge et al. (2005) find a negative relationship between leverage and growth opportunity using comparisons of three empirical method: fixed-effects model, random-effects model and pooling regressions. However, their study is restricted to Canadian public traded companies. My study contributes to the existing literature using fixed-effects panel model, which has been confirmed the most suitable model to test the relationship 1, and a larger and representative sample of S&P 500 with 10-year-period from 2003 to 2012 consisting of both recessionary and non-recessionary years. The results indicate that there is negative relationship between leverage and growth opportunity. This relation holds irrespective of how leverage is measured and of which variables are used to forecast growth. Besides the above contributions, family ownership is used in this paper as a control variable. Family firms have better performances and more growth opportunity (Cantor 1990). A firm with good projects may grow no matter how their capital structure is, because it can always find funding (Lang, Ofek et al. 1996). In other word, family firms, with good firm performance and growth opportunity, grow no matter how their leverage looks like. Theories of optimal capital structure based on the agency costs of managerial discretion suggest that the impact of leverage on growth increases firm value by preventing managers from taking poor projects (Jensen 1986; 1 Aivazian, Ge et al. (2005) confirm that fixed-effect model is the most suitable model using LM test and Hausman test.

5 Stulz 1990). Family firms, with stronger monitoring power and less agency costs (Cantor 1990) are more likely to use leverage as a constraint for managers to not taking poor projects (Aivazian, Ge et al. 2005). Hence, leverage is expected to be positively related to growth opportunity for family firms since overinvestment for poor projects is restricted through leverage in family firms. The present paper provides new evidence on the relationship between financial leverage and investment and extends the prior literature by taking into account the ownership type. In addition, this paper also utilizes the instrumental variable approach to address the endogeneity problem pertaining to the relationship between leverage and investment. This approach is similar to the study of Aivazian, Ge et al. (2005), where tangibility is used as the instrumental variable. The first stage results show that tangibility is a weak instrument, which is in contrast to Aivazian, Ge et al. (2005). The difference is possibly caused by sample difference and the measurement of tangibility. 2 The result shall be interpreted with caution as tangibility is a weak instrumental variable. I do not test for the endogeneity of the firm ownership (family owned or not) and its impact on leverage or growth opportunity since I assume that firm ownership is rather an exogenous factor in line with what is reported by Smith and Watts (1992) and is unlikely to be reversely affected by leverage or growth opportunity. Further explanations of taking firm ownership as an exogenous factor are in Section 2.3. Various robustness tests are conducted throughout the paper using three different measures of growth opportunity. Moreover, I include a restricted sample of manufacturing industry to further test the robustness of this paper. The results remain stable. The paper is organized as follows. Section 2 presents possible theoretical links for the relationship between leverage, ownership type and growth opportunities. Section 3 shows the hypothesis development and control variables used in my models. Section 4 provides detailed information for data selection and definition of variables. Section 5 exhibits empirical results from a panel data specification for four different models. Section 6 represents results for a twostage regression approach while an additional robust test is presented in section 7. Section 8 2 Aivazian, Ge et al. (2005) use a sample of Canadian publicly traded firms and an instrumental variable of tangibility, which is measured as PPE/asset total. My tangibility is measured as tangible assets/ total assets.

6 summarizes and concludes the paper. Possible limitations of this paper are provided in the appendix. 2. Literature review This Section is structured as follows: Section 2.1 outlines the theoretical support for the negative relationship between leverage and growth opportunity. Section 2.2 analyzes the role of family firms and its relation to leverage and growth opportunity. Section 2.3 shows some literature support for possible reasons that leverage impact on growth opportunity differs between family firms and nonfamily firms. 2.1 Leverage and growth opportunity Modigliani and Miller (1958) suggest an irrelevance proposition and show that a firm s investment policy depends solely on future demand, technology, market interest rate, namely profitability, cash flow and net worth. However, the empirical literature 3 has challenged this position, arguing that financing consideration, in my case, leverage, also completes the investment relationship and influences growth opportunity. Empirical results show a negative relationship between leverage and growth opportunities. Lang, Ofek et al. (1996) analyze a large sample of US industrial firms and use several different measures of growth opportunities and find a strong negative relationship between leverage and growth opportunities. The negative relationship has also been found by Aivazian, Ge et al. (2005), where they use a sample of Canadian firms and three different models. Debt overhang (Myers, 1977) and underinvestment theory (Aivazian, 1980) are the major reasons causing the negative relationship between leverage and growth opportunity In Myers (1977) s paper, debt overhang reduces the incentives of the shareholder-management coalition in control of the firm to invest in positive net-present-value investment opportunities, since the benefits accrue, at least partially, to the bondholders rather than accrue fully to the shareholders. Consequently, firms with high leverage are less likely to exploit good growth opportunities. Thus, high leverage reduces a firm s ability to finance growth (Gertler and Gilchrist, 1993). 3 For example, Lang et al. (1996) & Aivazian, Ge et al. (2005).

7 Aivazian and Callen (1980) suggest a related underinvestment theory which centers on a liquidity effect in that firms with large debt commitments invest less irrespective of the nature of growth opportunity. Firms with high leverage normally have severe debt and less cash flow available for more investments. With less liquidity and inadequate source of funding, firms are unable to seize good investment projects and therefore have less growth opportunity. However, this underinvestment theory may suffer from endogeneity problem. The existing capital structure literature suggests that managers in firms with valuable growth opportunities should choose lower leverage because these firms might not be able to take advantage of their investment opportunities if they have to raise outside funds (Harris and Raviv 1991). If future growth opportunities are recognized by managers early, managers are likely to issue less debt in order to seize the investment opportunity. 2.2 firm ownership and its relation to leverage and growth opportunity Many researchers suggest a difference between family-owned firms and non-family owned firms with respect to leverage and firm performance. On the one hand, family firms are expected to have low leverage(villalonga and Amit, 2006). With more concern for firm survival (Chami, 2001) and the incentive to expropriate wealth from minority shareholders (Schack, 2001), family firms prefer to take risk reduction strategy and lower leverage. As Carly Fiorina (CEO of Hewlett-Packard) observes, founding families can have very different interests from minority shareholders because the family is concerned with issues such as stability and capital preservation. Specifically, Casson (1999) and Chami (2001) argue that founding families view their firms as an asset to pass to family members or their descendants rather than wealth to consume during their lifetimes. Firm survival is thus an important concern, which suggests that families will seek risk reduction strategies through cutting debt financing and lower leverage. Therefore, founding families normally held their stakes for a long time and controls a great percentage of their firm shares and are highly likely to have strong incentive to minimize firm risk and insure the stability of the business. Thus, family ownership is negatively related to leverage (Jensen 1986).

8 In addition to the argument of family concern, lower leverage is also a strategy used in family firms to exploit minority shareholders. In one perspective, Demsetz and Lehn (1985) observe that families have the incentives and the power to expropriate wealth from minority shareholders. Schack (2001). Faccio et al. 4 indicate that the incentive is strongest when family influence exceeds its ownership rights. In another perspective, debt can play a role in limiting minority shareholder expropriation by removing corporate wealth from family control. 5 Hence, lower leverage is a method used to exploit minority shareholders for family firms. The concentration of the ownership for family-owned firms makes firms take risk-avoidance strategy, specifically, family firms can mitigate firm risk by employing financing forms with low probabilities of default, which suggests a greater reliance on equity financing in their capital structure (Cantor 1990). Therefore, in order to take risk-avoidance strategy, family firms will choose to a lower leverage. Most empirical studies confirm this negative relationship between family firms and leverage. Villalonga and Amit (2006) find that family firms, with a significant lower proportion of independent directors than do nonfamily firms, have lower leverage. Shleifer and Vishny (1986) observe that large, undiversified shareholders can impose on the firm due to their high risk aversion level because families typically have over 69 percent of their wealth invested in the firm and that one of the most important costs that large, undiversified shareholders can impose on the firm is firm aversion or avoidance. 6 Several other studies such as Friend and Lang (1988) and Agrawal and Nagarajan (1990) also indicate this relationship. Thus, families will seek risk reduction strategies by issuing lower debt which can cause lower leverage for family business. However, from a debt usage perspective, Zwiebel (1996) shows that family-controlled firms may use debt as a credible signal to forgo poor investments. In other word, family firms may use high leverage stress to prevent managers to take poor investment projects. If so, family firms will 4 Faccio, Lang & Young also argue that the issue of ownership and control is more problematic in East Asian than in the United States because of less transparent capital markets and the affiliation of the firm with a group of firms also controlled by the family, which allows corporate wealth to be expropriated through intragroup sales. 5 Both Jensen, 1986 and Faccio et al suggest dividend and debt financing has an influence in exploiting minority shareholders rights. 6 Using the families that appear in both Forbes s 400 Wealthiest Americans Survey and in the S&P 500, we find that families have 69% of their wealth invested in the firm. Some of the families in our sample include the Waltons(Wal-Mart), Dorrances( Campbell Soup), Fords (Ford Motor). And Strattons (Brigs and Stratton).

9 employ more debt and higher leverage than nonfamily firms. Moreover, Cantor (1990) shows that although the leverage of family firms are lower than non-family firms, the difference is not significant using U.S. industrial firms by controlling size, firm age and firm performance. Therefore, the relationship between family firms and leverage is further studied in this paper. On the other hand, family firms are expected to have more growth opportunity (Cantor 1990). Family firms, with greater concern for the company (Donnelley 1964), longer investment horizon (James, 1999) and less possibility to be taken over (Cantor 1990), are more likely to have better performance and more growth opportunity. Unlike other managers, the family managers normally have many shares of the company and are unlikely to diversify their portfolio. As a result, they care more about the company and are likely to devote their effort into creating long-term benefits of the company. Besides, the family owners view the firm as their property and believe that reputation is all-important (Donnelley 1964). With the family name easily recognized, they can build their family reputation, which gives advantages as to branding corporation and dealing business with other people. Hence, with years of generation socialization, family firms have built a broad connection with the others and have more sources to access investment opportunity. Families have advantages in disciplining and monitoring managers, having extended investment horizon, specialized knowledge and less managerial myopia. James (1999) and Stein (1988) shows that families have longer investment horizon, greater investment efficiency and incentives for myopic investment decisions by managers, Kole (1997) observes that family controlled firms are less likely to have any explicit incentive compensation plan. Cantor (1990) suggest that family ownership is an effective organizational structure and thus find it easier to define and seize good growth opportunities than non-family firms. In addition, McConaughy, Walker et al. (1998) also find that family control is associated with higher firm performance, which would in turn to have higher chance to have better growth opportunities. Therefore, family firms with greater reputation and connections, longer horizon and powerful monitoring power should have greater performance and growth opportunity.

10 Besides, family members are more united due to their blood linkage and are therefore not easy to be taken over(cantor 1990). A takeover is an alternative mechanism to offset poor investment choices. While without family consent, takeovers are difficult to achieve in family firms. In that case, having high debt can restrict poor investment choices and blunt family opportunism (Cantor 1990). In other word, with less chance to be taken over, family firms have less poor investment choices and more growth opportunity. Although, theoretically, family firms have many advantages over non-family firms, their disadvantages are not erasable. Family firms frequently pride themselves on their loyalty to employees and their strong culture and traditions (Dyer 1988). Both practices can create resistance to change. In addition, Lansberg (1988) argue that most family firms prefer to nurse the business along rather than shift their focus to new growth possibilities because the business is their creation, their identity and their comfort. What s more, most empirical results have shown that family firms do not grow. Jones, Cohen et al. (1988) study the fastest growing companies in the United States by public accounting firm Coopers & Lybrand and find that only 1% are firms run by family successors to founders. In a Mass Mutual Life Insurance survey of more than 1000 family for, growth was ranked sixth among seven possible business goals, with much higher priority placed on increasing profitability, reducing debt and increasing family wealth outside of the business (Ward 1997). However, these studies have limitations of being outdated. In recent years, with the fast development of technology and globalization, family firms might have more knowledge of running businesses and better suitability of recent policy (Burkart, Panunzi et al. 2003). In my perspective, with the perfection of credit institutions and more usage of debt and leverage, family firms can have better growth opportunity. 2.3 Control ownership type for relationship between leverage and growth opportunity. As previous literature indicates, family firms have lower leverage (Villalonga and Amit, 2006) as well as more growth opportunity(cantor 1990). These relationships indirectly suggest that the leverage impact on growth opportunity might differ between family firms and non-family firms. In this study, the leverage impact on growth opportunity in family firms are hypothesized to be positive. Three reasons are used to explain this hypothesis: the form of financing of family firms (Jensen, 1986), the overinvestment theory (Stulz 1990) and firm performance (Lang, Ofek et al. 1996).

11 Jensen (1986) argues that concentrated ownership reduces the agency cost of free cash flow and can create greater cash levels in family firms, thus allowing the firm to rely less on debt as a form of financing. Therefore, family firms rely less on debt as a form of financing. As a result, the underinvestment theory (Aivazian, 1980) might not apply to family firms since family firms with sufficient cash flows and funding can invest in good investment projects and will attain growth opportunity regardless of their leverage. Besides, leverage, however, can have a positive effect on growth opportunities according to overinvestment theory. Overinvestment stands between the conflict of management and shareholders (Jensen 1986; Stulz 1990). Many issuances of debt pre-commit the firm to pay cash as interest and principal, forcing managers to serve such commitments. However, the repayment ability might be constrained by the availability of free cash flow, and this constraint can be further tightened via debt financing. Thus, leverage is one mechanism for overcoming the overinvestment problem suggesting a positive relationship between debt and investment for firms (Aivazian, Ge et al. 2005). Theories of optimal capital structure based on the agency costs of managerial discretion suggest that the impact of leverage on growth increases firm value by preventing managers from taking poor projects (Jensen 1986; Stulz 1990). With powerful monitoring power and less agency costs, the negative impact from leverage to growth opportunity should be constrained. The overinvestment theory only applies to family firms because of the agency costs. With managers in family firms more strictly monitored by family members, family firms will give up some poor investment according to leverage situation. However, the managers from non-family firms care less for the corporation s long-term safety or survival compared to family owners (Casson 1999) and could invest in poor investment projects regardless of their capital structure. This prevents firms from overinvesting poor investment projects. Moreover, a firm with good projects grows no matter how its balance sheet looks, because it can always find funding (Lang, Ofek et al. 1996). In my case, family firms perform better and have more opportunity than nonfamily firms. Therefore, family firms can grow no matter how their leverage looks like because they have better performance and growth opportunity. Hence, the negative relation between leverage and growth opportunity might not exist or even turn out to be positive due to overinvestment theory (Jensen 1986; Stulz 1990) and family firm s

12 form of financing(lang, Ofek et al. 1996). The negative relationship for nonfamily firms can be even severer due to lack of discretion as managers do not own the firm and will not view the firm as important as family members. Empirical results also support this hypothesis. McConnell and Servaes (1995) use Tobins Q as a measure of firm performance and show that corporate value is negatively correlated with leverage for firms with weak growth opportunity, and positively correlated with leverage for firms with strong growth opportunities. The results are consistent with my hypothesis that leverage induces underinvestment for nonfamily firms, which will reduces firm value, as well as the hypothesis that leverage attenuates overinvestment in family firms, which however increases firm value. In this paper, family firms are taken as an exogenous factor. First of all, the illiquidity of family owned shares. Shares held by families normally are not traded on an open market. Therefore, investors in close corporations have no easy way to adjust the ownership structure if condition changes. Secondly, high trading costs is also a reason for ownership type to be exogenous. Stiglitz (1996) argues that ownership type is an exogenous determinant of firm performance in emerging markets. Core (2002) also indicates that ownership type is exogenous as adjustment costs are high. Thirdly, without family consent, takeovers are difficult to achieve in family firms (Cantor 1990). When other investors want to takeover family firms for their growth opportunities, they normally need to negotiate with the shareholders or acquire enough shares to have control of the board. Family firms have more control over the board because of the powerful monitoring power as previously mentioned. Besides, family member are more united for their blood linkage, which will prevent their firms from acquisition. Finally, Families view the company as their own legacy and consider survival as the most important concern (Chami 2001) Thus, family firms are on average risk averse. They have lower leverage, sufficient cash and strong power to fight against takeover or retain family ownership. Therefore, I take ownership type as an exogenous factor. 3. Hypothesis development and control variables 3.1 Hypothesis Debt overhang theory (Myers, 1977) suggests that high leverage depresses shareholders and reduces their incentive to take value-generating projects to finance growth. Underinvestment

13 theory (Aivazian and Callen, 1980) shows that with heavy leverage, firms are unable to invest in profitable projects and are less likely to seize growth opportunity. Thus, I hypothesize that there is a negative relationship between leverage and growth opportunity. There is a negative relationship between leverage and growth opportunity (H1) Families, with more concern for firm survival(chami, 2001) and greater incentive to exploit minority shareholders(schack, 2001), prefer risk-reduction strategy and lower leverage to limit minority shareholders exploitation. Thus I hypothesize a negative relationship between leverage and ownership type. There is a negative relationship between leverage and ownership type (H2) Family firms care more about their stability and are more devoted to the company since they are unlikely to diversify their portfolio(donnelley 1964). Besides, family firms, with longer investment horizon(james, 1999) and less possibility to be taken over (Cantor 1990), shall have greater growth opportunities than nonfamily firms. As a result, I hypothesize that family firms have better growth opportunity. There is a positive relationship between family firms and growth opportunity (H3) Family firms have expectations of high cash flows, net income (Jensen, 1986) and have reduced agency problem as well as better monitoring(jensen 1986; Stulz 1990). For such firms, leverage is less of a constraint on growth opportunity. Therefore, underinvestment theory (Aivazian and Callen, 1980) does not apply to family firms while overinvestment theory(jensen 1986; Stulz 1990) is more applicable, As a result, I hypothesize that for family firms, the negative impact leverage have on growth opportunity is not as significant as non-family firms. For family firms, leverage has a positive effect on growth opportunity. For non-family firms leverage has a negative effect on growth opportunity 3.2 control variables When studying the impact of leverage on growth opportunity, Tobin s Q, cash flow, net worth, firm size, firm age and firm risk are used as control variables. Firm-specific and time-specific effects are taken into account. (H4)

14 Many empirical studies also found differences between high Tobins Q and low Tobins Q firms. The reason for high Q firms to have better growth opportunities is because they have expectations of higher cash flow, or net worth, and this may reduce moral hazard and adverse selection problems inherent in the supply of credit to the firm in the capital market. (Aivazian, Ge et al. 2005). For those firms, leverage is less of a constraint to the growth opportunity. Therefore, I expect a positive effect from Tobin s Q to growth opportunity. What s more, cash flow is a constraint for this relationship. Whited (1992) show that cash flow in firms with high leverage contributes to more growth opportunity sensitivity than firms with low leverage. Cantor (1990) also confirms that investment is more sensitive to earnings for highly levered firms. Therefore, I expect a positive relation between cash flow and growth opportunity. Cooley and Quadrini (2001) build models to explain the conditional size and age correlations with growth. The model extends Hopenhayn (1992) by making financial considerations relevant for firm dynamics. In Hopenhayn (1992), size captures productivity differences across firms, which makes growth independent of age. While theoretical work by Jovanovic (1982) proposes a passive -learning model of industry dynamics. Firms enter an industry with incomplete information regarding their own productivity but gain information through production. Thus, the learning effect generates negative firm growth opportunity-age dependence under certain general condition. In addition, I expect a positive relationship between size and growth opportunity. Growth opportunity also differs for firm with different risk. With more firm risk over time, managers are eager to search and seize growth opportunity. And when a firm faces many investment opportunities, it is a relatively simple matter for owners to increase firm risk over time (Long and Malitz 1985). As a result, a positive relation between stock firm risk and growth opportunity is expected. Another regression studying the relationship between family firms and leverage is also conducted according to hypothesis 2. When researching this relationship, industry-and firmspecific differences are highly likely to be constraints. Empirical studies, for example, Cantor (1990) and Demsetz and Villalonga (2001), generally agree that firm size, firm age, firm risk

15 and firm performance shall be taken as the key control variables when studying the relationship between growth opportunity and leverage. If firms have high profits or free cash flow, the chance to repay debt and in turn lower leverage is higher. In addition, if having larger firm size, firm will have broader sources of income and greater chance to repay debt. What s more, Harris and Raviv (1991), Long and Malitz (1985) and Marsh (1982) generally agree that leverage increases with total assets, growth opportunities, and decreases with volatility. Therefore, I expect leverage to be positively related to firm size and firm age, but negatively related to firm performance and firm risk. The control variables I use for studying the leverage impact on growth opportunity and the relationship between family firms and leverage are the same according to previous statements. 4. Sample and Data Large public firms are often characterized as having dispersed ownership, independent board members, and a separation of ownership and management. However, many researchers found a significantly large percentage of concentrated ownership and family businesses in the existing public firms. Shleifer and Vishny (1986) note that concentrated shareholders are common and document over 77 percent of the Fortune 500 firms have at least one shareholder owning 5% or more of the firms. Villalonga and Amit (2006) also define 37 percent family firms of Fortune 500 firms in all industry based on individual shareholder level and board composition in sample period Therefore, family firms are presented in public traded firms and exhibit an important part. Characteristics variables over of Standard and Poor s 500 companies are selected from Wharton Research Database Services (WRDS). It is observed that there are both familyowned and non-family owned firms in Stand and Poor s 500 (Cantor, 1990). Cantor (1990) find family ownership and its influence are quite prevalent and significant in U.S. firms, even among the largest publicly traded companies. Families are present in one-third of the S&P 500 and account for 18 percent of outstanding equity based on their equity ownership structure, board composition and CEO characteristics. Besides, proxy statements of S&P 500 firms are easily accessible on the internet.

16 Banks and public utilities industries due to the difficulty in calculating Tobin s Q(Cantor, 1990). What s more, Companies which went through mergers or acquisition during the sample years are also excluded as their ownership structure is ambiguous. For example, ABBVIE INC is excluded from the sample due to the fact that it was separated into two publicly traded companies during my research period. I also exclude News Corp, as it went spun off to form a new, publicly traded company. 4.1 Leverage Leverage is any ratio that used to calculate the financial leverage of a company to get an idea of the company s methods of financing or to measure its ability to meet financial obligations. There are several different ways to calculate the ratio. In this study, the total liabilities to total assets ratio will be used. = I use book value measure of leverage as it does not reflect recent changes in the market s valuation of the firm. According to Lang, Ofek et al. (1996), a market value measure of leverage would give too much importance to recent changes in equity values and if a regression is based on market leverage, the market s expectation of growth as reflected in the firm s stock price, producing a negative relation between leverage and growth. Hence, to rule out this factor, I use book value to measure leverage. 4.2 Firm-growth Capital expenditure is a proper measure of firm-growth opportunity. With more capital investment, more chance is induced to gain profits and to build a larger firm. Long and Malitz (1985) use capital expenditure as a measure of tangible investment opportunity. In order to reduce endogeneity for the model, I use capital expenditures in the following years as a measure of growth opportunity. If growth opportunity is recognized earlier, managers will change leverage strategy (Harris and Raviv 1991). Capital expenditures in the following years are not as easily recognizable as those in the base year. Lang, Ofek et al. (1996) also use capital expenditures of next year and next three year as a measure of firm growth opportunity. In order to take into account both short-term and long-term opportunity, capital expenditures in the following three years are used as a measure of growth opportunity. (Capital expenditure in year t + 1, capital expenditure in year t +2 and capital expenditure in year t +3).

17 4.3 Family-owned firms A family business is a business in which one or more members of families have a significant ownership interest and significant commitments toward the business overall well-being. Cantor (1990) define family firms as those in which the founder or a member of his or her family by either blood or marriage is an officer, director, or block holder, either individually or as a group. However, no commonly accepted measure or criterion is provided as to identify a family firm. In this paper, family firms are defined as either those with founders or other family members sitting on board or those that one individual or family has the significant ownership (5%). The first classification for family firms is whether there are more than one family members sitting on board. The second classification for family-owned firms is with respect to founders, which is defined as the person either founded my sample firm or its relatives or descendants are sitting on board. I classify firms with either the founder or one or more of its relatives sitting on board as one definition for family firms. These two classification mainly focus on whether family members have a strong voice on board. The last definition used for family firms are the shares owned by the largest individual or family holders. With a significant portion of shares ownership, families are able to control the firm. In this paper, individuals or families have more than 5% of the total shares outstanding is one classification of family firms. I define family firms as those that meet the requirement of either two out of the three classifications in order to constrain the influence of diversification. Diversification measures whether family owners also sit on board and take control. Villalonga and Amit (2006) find that family ownership creates value only when the founder serves as CEO of the family firm or as Chairman with a hired CEO. Hence, the board diversification influences firm decisions like choice of leverage or even firm performance. I look through the proxy statement of each companies and choose the family-owned firms through their equity ownership structure, board composition and founders characteristics. There are 10 year period according to my sample. However, Proxy statement in 2012 is chosen to define family businesses. This is because that the ownership is unlikely to change frequently without occurrence of great events.

18 In this paper, 94 out of 402 firms are defined as family-owned business. Using the Standard & Poor s 500 firms from , I observe that family firms are an important class with the percentage of in S&P 500 companies excluding public utilities and banking industries. Unlike previous studies, 7 my family firm composition is in a rather small percentage. This is probably due to a more strict definition of family firms. 8 Table1. Summary industry of family-owned business The sample consists of all firms excluding public utility and banking from the proxy statement of 2012 for S&P 500 annual file. Family (non-family) refers to those firms with (without) family ownership or family presence on the board of directors. Percent family owned in industry is computed as the number of family firms divided by the total number of firms. With the total firm number of 402, 94 are family-owned firms. Industry name family-owned Non-family owned All % family owned in industry Agriculture % Mining % Construction % Manufacturing % Wholesale trade % Retail trade % Finance, insurance and real estate % Service industries % Non-classifiable establishments % From table 1, the analysis shows that family firms are presented in percent of all samples in S&P 500, indicating that families operate as an important part of sample. It can be noted that family firms present mostly in construction industry and none of which in agriculture. Both have small number of firms and might not be representative for all industries. Mediate presence of family business can be found in manufacturing, wholesale trade, retail trade finance, insurance and real estate and service industries. Therefore, family presences differ from industry to industry. All those information suggests the importance of controlling for industry affiliation in our empirical analysis. As a result, I take industry-fixed effects into account and include SIC code as identification for industry influence. 7 Anderson and Reeb (2003) found one-third of the S&P 500 firms are family owned. Belen and Raphael found 37 percent of Fortune 500 is family owned. 8 I choose family firms only if they meet two out of the three measurement of ownership type. The other papers such as Anderson and Reeb (2003) normally define family firms if they meet one requirement or they have a looser constraint for share holdings.

19 4.4 Controls One potential concern using family ownership data is that the level of stock minimal fractional ownership is different for different family owners to seize control of the firm because of differences in firm size, firm age and business practices. As a result, firm size, firm age and firm performance are the major control variables for leverage and firm-type. In addition, as mentioned above, empirical studies generally agree that firm size, firm age and firm performance are the major control variables for leverage and growth opportunity. Thus, the control variables in this paper are generally the same for either the relationship between firm-type and leverage or the relationship between leverage and growth opportunities. Moreover, time-varying characteristics are also very important. During recessions, the financial status of the whole world is not good; as a result, it is hard for firms or individuals to borrow money from the others or to have good growth opportunities during those years. What s more, as found by Halling, Yu et al. (2011), during expansion, leverage management are much more active than that in recession. As a result, to conduct a more accurate result of the relationship, Firm-specific and time-specific variables shall be taken into account in studying the relationship of the three variables. When determining a firm s age, I manually collect the founding year of those companies through their proxy statement. Some firms have specifically defined founding year, but some do not. If there is no specific founding date, I choose the earliest year of their earliest formation as their founding date. Firm size is the natural log of total assets (Cantor 1990). Firm risk is measured using the standard deviation of stock return, which is calculated as stock price next year minus stock price at base year divided by base year s stock price. Firm performance is measured using three variables: Tobins Q, Net income and cash flow. Tobins Q is calculated as total market value divided by total assets value. NI is the natural log of net income or loss. I use Earnings before Interest, depreciation and taxes as a measure of cash flow according to Long and Malitz (1985). It is better to use a cash flow measure gross of interest, since such a measure is less dependent on a firm s capital structure (Lang, Ofek et al. 1996)

20 I include year-fixed effects and choose years from 2003 to 2012 as my year observations. In this case, both non-recessionary ( ) and recessionary ( ) periods are taken into account equally. This provides a sample of 402 firms, or 3930 firm-year observations, from From the Compustat files in WRDS, I collect accounting information, yearly stock data and industry segment data. Table2. Summary statistics for growth, leverage, firm-type and control variables The sample period is All data are obtained from Compustat and proxy statement of each firm. Growth opportunity is the capital expenditure in each of the next three years, leverage is total liabilities divided by total assets. Size, cash flow and NI is the natural log of total assets, EBITDA and net income or loss. Tobins Q is measured as total market value divided by book assets value. Volatility is a measure of firm risk and is calculated as the standard deviation of stock return. variables mean P25 P50 P75 N min max leverage Size age Cash flow NI Tobins Q volatility Table 2 provides descriptive information for growth opportunity and leverage measure as well as other control variables. There is a negative sign for the growth opportunity in the minimum catalog, this is because I take the natural log of capital expenditures to measure growth opportunity to better suit the other variables. Typically the 25 th percentile of leverage is about 30% lower than the median and the 75 th percentile is also about 30% higher. What s more the mean is around 39% higher than the median, suggesting a larger group of low leverage but a smaller group of more extreme high leverage. In addition, the table reveals a high variation of those control variables. Firm age varies from 3 to 254, size effect also differs a lot with the minimum of and maximum of and firm performance averagely have 13 units of differences

21 from minimum to maximum. All of this information suggests that my sample includes a variety of firms with many differences and is representative. Volatility varies from to ; this is probably because of an inclusion of recessionary period of 2008 to 2012 and non-recessionary period from 2003 to Year 2008 suffers from great financial crisis and back then, stock prices become unstable and change rapidly. The volatility mean is nearly close or slightly larger than 75 th percentile suggesting a larger group of firms with small volatility while a smaller group with more extreme higher risk. Table3. Correlation among independent variables The table exhibits relationship between independent variables for all the three models. The sample period is Firm-type is a dummy variable to define family-owned business. Firm-type is 1 indicating a familyowned business and 0 for non-family owned firms. Significance levels are provided below the coefficient estimates. * is significance at 10% level. ** is significance at 5% level. *** is significance at 1% level. Leverage Leverage 1 Ownership type Size Firm age Cash flow NI Tobins Q Volatility Ownership type Size Firm age Cash flow *** 1 (0.002) *** 0.106*** 1 (0.000) (0.000) ** *** 0.254*** (0.020) (0.000) (0.000) *** *** 0.870*** 0.231*** (0.000) (0.00) (0.000) (0.000) *** *** 0.808*** 0.205*** 0.928*** (0.000) (0.000) *** 0.103*** *** *** *** NI Tobins Q Volatility *** *** *** *** 0.048*** *** 1 (0.000) (0.603) (0.000) (0.959) (0.001) (0.005) (0.001) Table 3 provides correlations among the independent variables used in this study. There is a strong negative correlation (-0.051) between book leverage and ownership type, which is expected since family firm is hypothesized to have lower leverage (Agrawal and Nagarajan 1990). At the same time, however, leverage is negatively correlated with Tobins Q while is positively correlated with net income and cash flow, which suggests a controversial relationship

22 between leverage and firm performance. Moreover, ownership type is also controversially related to firm performance with the correlation of , and for cash flow, net income and Tobin s Q. In addition, the correlation between cash flow and net income is the strongest both economically and statistically, suggesting that a firm s free cash flow is strongly linked to its net income. Not surprisingly, ownership type is mostly negatively correlated with firm age, firm size and firm performance, which is almost the opposite to the relationship of leverage. Though these correlations lead to the conclusion that there is negative relation between leverage and family firms, this relation could also result from the relation between firm age and firm performance. Therefore, I must also test the multivariate regressions in order to estimate the relation between leverage and family firms while controlling for those variables. In addition, there is no strong relationship between family-owned firms and firm risk since the correlation variable is not significant. 5. Regressions 5.1 Growth opportunities and the role of leverage The impact of leverage on investment is estimated using the following equation, the specification is similar Lang, Ofek et al. (1996) and Aivazian, Ge et al. (2005), but includes more control variables and is extended to a panel setting. h, = +, +, +, +, +, +, )+, +, Where growth opportunity is measured using capital expenditure in the following three years. Size is the log of total assets at time t, CF is cash flow measured as Ln (EBITDA) and NI is the natural log of net income. Aivazian, Ge et al. (2005)control for individual firm heterogeneity and employ both random and fixed effect model and find that fixed effect model is the most suitable model for estimating investment behavior. Thus, fixed effect panel model is used in my analysis.

23 Table 4. Regression analysis of leverage impact on growth opportunity This table provides the regression results of leverage on growth opportunity on S&P 500 publicly traded firms using three definitions of growth opportunity. In model 1, growth opportunity is measured as ( ), in model 2; growth opportunity is measured as ( ). In model 3, ( ) stands for growth opportunity. The sample period is Significance levels are provided in below the coefficient estimates. * is significance at 10% level. ** is significance at 5% level. *** is significance at 1% level. Dependent variables Model 1 Model 2 Model 3 intercept Leverage size Firm age Cash flow NI Tobins Q volatility *** *** *** *** *** * (0.008) (0.005) (0.091) 0.439*** 0.437** 0.468*** (0.107) (0.297) (0.465) 0.473*** 0.502*** 0.503*** *** *** (0.021) (0.000) (0.000) 0.071* 0.078*** 0.081*** 0.051*** 0.063*** 0.060*** N Adjusted R square Table 4 reports the regression results for the investment equation using two alternative measures of growth opportunity with fixed effect model. In model 1, growth opportunity is measured as ( ), in model 2; growth opportunity is measured as ( ). In model 3, ( ) stands for growth opportunity. The result shows that leverage has a negative impact on firm s growth opportunity at the 1% significance level for two measures of growth opportunity. The influence on growth opportunity measured as third-year capital expenditure is at 10 % significance level. The negative leveragegrowth opportunity relationship is robust for all measurement of growth opportunity. The point estimates range from to , which suggest that Ln (capital expenditure) decreases by to if leverage increase by 1. Hence, with one unit increase of leverage, the firm are likely to suffer from less growth opportunity with next-year investment decreasing by units and next third year investment decreasing by This is consistent with my previous