Proof Reading. Effects of Internal Governance Mechanisms on The Debt Ratio of Tunisian Companies

ISSN : 23486503 (Online) International Journal of Research in Management & Effects of Internal Governance Mechanisms on The Debt Ratio of Tunisian Companies I Nourchen Hamza Hakim, II Habib Affes I Contractual Assistant at the Faculty of Sciences: University of Sfax,Tunisia. PhD researcher at Faculty of Economics and Management of Sfax,Tunisia. LARTIGE Research laboratory university of SfaxTunisia II Associate Professor at the Faculty of Economics and management,university of Sfax,Tunisia. Associate Professor at the Faculty of Business Administration Jizan University Saud Arabia. LARTIGE Research laboratory university of SfaxTunisia Abstract In this study, we propose to study the impact of internal governance mechanisms on the debt ratio of Tunisian firms. Using a sample of 13 Tunisian public companies listed on the TSE between 2003 and 2009, we conducted regressions of the board and the companies ownership structure variables on their debt ratio. The results show that the board size has a negative and insignificant impact on the debt ratio of the Tunisian firms, whereas the percentage of outside directors and the duality of function have a positive effect. Regarding the impact of ownership structure on the debt ratio, the results show that the participation of institutional investors and leaders in the capital has a positive but insignificant effect on the corporate debt ratio in our sample. Keywords Ownership structure; Board of Directors; debt ratio I. Introduction Corporate governance is one of the main issues raised in the corporate world. It is also a structure that monitors and controls the leaders' behavior in various fields. Corporate governance has an impact on the various aspects of business management, such as performance management, results management and capital structure. The management of the capital structure reflecting the firms; financial leverage as well as the way in which firms" capital is used by the managers is one of the main issues since the inclusion of debt in the structure of capital impacts both the market value and corporate performance (AlYassen and Amarneh, 2013). Good corporate governance and optimal capital structure are necessary for each company to improve its market value. Corporate governance is defined as the system by which trading companies are managed and supervised (Kajola, 2008). Corporate governance is a philosophy and a mechanism that entails processes and structures which facilitate the creation of a shareholders value through the management of corporate affairs in such a way that it ensures the protection of the individual and collective interest of all the stakeholders (Hasan and Butt, 2009). An optimal capital structure reflects a better debtequity ratio for the firm that minimizes the funding cost and reduces the possibilities of bankruptcy (Gill et al, 2011). Berle and Means (1932) were the pioneers of the corporate governance theory, whereas, Modigliani and Miller (1958) were the pioneers of that of capital structure. Since then, several authors have attempted to follow Berle and Means (1932) by developing new theories. For instance, Jensen and Meckling (1976) developed the agency theory and defined an agency relationship as a contract under which one or more persons (principal) hires another person (agent) to run on his behalf any one activity which involves delegating some decisionmaking power to an agent. Some studies define financial leverage as the amount of debt obtained for funding which is necessary for the needed property acquisition (Hampton, 2001). According to the theory of asymmetric information, the managers are better informed than the investors about the companies' prospects. Since the leaders have more information about these prospects, they do not get involved in others regarding the future company's profits, therefore they resort to indebtedness. However, if the leaders do not behave so, they will be able to meet the company's financial needs through the share distribution (and Yassen AlAmarneh, 2013). Good corporate governance practices may have significant impact on the company's strategic decisions, e.g. external financing, which are made within the board. Therefore, corporate governance variables, like the board size, 3 the board composition and the CEO duality may have a direct impact on the capital structure decisions (Hasan et Butt, 2009). Unlike the studies dealing with the impact of ownership structure and the board of directors on the company's performance, the studies about the ownership structure and board of directors' impact on the capital structure are very few (Brailsford et al (2001). This study investigates the impact of the company's governance variables, namely, the impact of both ownership structure and the board of directors variables on the debt ratio of the Tunisian companies (financial leverage). This research is organized as follows: Section 2 presents the literature review. Section 3 is about the methodology and the presentation of the variables.section 4 discusses the results and section 5 is a conclusion. II. Literature Review A. Capital structure Theories 1. Tradeoff theory Modigliani and Miller, (1958), state that financial structure has no impact on the firm's value. When corporate tax is introduced, the company's value rises with the debt level (Modigliani and Miller (1963). By extending Modigliani and Miller's model (1958 to 1963) and including the personal income tax in his model, Miller (1977) suggests that the company's value is independent from its www.ijrmbs.com All Rights Reserved, IJRMBS 2014 1

International Journal of Research in Management & ISSN : 23486503 (Online) financial structure. The tradeoff theory is based on the concept of arbitration and takes into account various costs, such as bankruptcy costs (Myers, 1984) and agency costs (Jensen and Meckling (1976), Jensen (1986). Actually, an optimal debt ratio might arise from a compromise between the potential gains related, on the one hand, to indebtedness and, on the other hand, to the risks and costs that this very indebtedness can raise. It is a tradeoff between tax savings related to indebtedness and bankruptcy costs due to excessive debt. The target of arbitration theory is to achieve an optimal indebtedness ratio that can maximize the company's value. According to this theory, the optimal indebtedness level is reached when the marginal tax savings are nullified by the increase in the agency and bankruptcy costs. 2. The Pecking Order theory Models of "hierarchy" reject the hypothesis of an optimal debt ratio. Because of the asymmetric information between the insiders, (agents within the company), and the outsiders (those who are outside), the company follows a hierarchical funding. The hierarchical funding theory developed by Myers (1984) and Myers and Majluf (1984) does not rely on the optimization of the debt ratio. Myers and Majluf (1984), by reasoning in a context of asymmetric information, show that the information problems between the current and potential shareholders cause a priority at the funding level and develop a theory known as the pecking order theory. According to this theory, firms first prefer selffunding, then indebtedness, and finally issuance of shares. The study of Donaldson (196) is considered to be the primary reference regarding the hierarchical order of the funding sources. In fact, they suggest that firms are financed primarily through selffunding, then by debt and ultimately by raising the capital. According to the Pecking Order Theory, firms with few investment opportunities and free cash flow have very high low debt ratios. On the other hand, firms with significant investment opportunities and low cash flow will have high debt ratios. 3. The Market Timing theory The Market Timing theory suggests that firms should get financed either through equity or indebtedness. This theory is related to corporate finance and is often contrasted with the theory of pecking and the that of compromise. Baker and Wurgler (2002) suggest that the market timing is an important determinant of the use of the firms' capital structure. In other words, companies are not much interested in debt or equity financing, but just choose the type of financing which, at some point in time, seems to be more appreciated by the financial markets. Baker and Wurgler (2002) state that economic agents are irrational and that firms issue shares when the prices are high and buy them back when the prices fall. B. Indebtedness in the various governance theories 1 The agency theory Through the agency theory, Jensen and Meckling (1976) think that there are potential conflicts, interest divergence and information asymmetries between shareholders, managers and creditors. These authors consider debt a means to reduce the agency problem between shareholders and managers. However, debt can cause conflicts between the creditors and shareholders. In fact, the latter are better informed and tempted to increase their wealth at the expense of the creditors. These creditors can protect themselves by applying contractual clauses or asking for guarantees. 2. The theory of the leaders entrenchment Jensen (1986) argues that the relationship between entrenchment and the indebtedness ratio is negative. Actually, rooted leaders choose to lower their indebtedness level. More recently, Berger et al (1995) have suggest that there is a negative relationship between the managers' entrenchment and the firms' indebtedness ratio. In the same way, Friend and Lang (1988) and Mehran (1992) state that the agency costs arising from the conflicts between managers and shareholders as well as the opportunistic behavior of the former better explain the negative relationship between entrenchment and the indebtedness level. Nevertheless, Harris and Raviv (1988) and Stulz (1988) claim that entrenched managers tend to increase the companies' indebtedness level. 3. The Free Cash Flow theory Through the theory of free cash flow, Jensen (1986) shows that debt reduces the available funds that can be invested by the leaders, which causes the reduction of the agency cost. C. Ownership structure and indebtedness Jensen and Meckling, (1976), state that the managers' shareholding reduces their motivation to take benefits and expropriate the shareholders' wealth, which results in the alignment of shareholders and managers' interests. Fama and Jensen (1983) and Demsetz (1983) state that the managers' shareholding has a negative impact on the agency costs and can lead to the leaders' entrenchment, which drives them to behave in an opportunistic way. Jensen (1986) finds that the leaders are trying their best to maximize the company's size for their own interest. He confirms that these leaders' efforts help them have more power and status but with a negative effect on business efficiency. Stulz (1988), Harris and Raviv (1988) argue that indebtedness is positively related to the property capital of the managers who seek an exemption from the control market discipline. On the other hand, empirical studies confirm that managers' equity participation negatively affects the firms' indebtedness level (Hasan and Butt (2009), Friend, Irwin and Lang (1988), Jensen, Solberg and Zorn (1992). Actually, when the leaders hold a significant proportion of the capital, then they will be subject to a significant nondiversifiable risk and therefore the will be encouraged to reduce the indebtedness level so as to limit the firm's default risk. These conflicting results direct the research towards the study of the rather nonlinear relationship between ownership structure and firms' debtedness (De La Bruslerie (2004), Brailsford et al (2002)). Brailsford (2002) put forward an empirical model showing a nonlinear relationship between the indebtedness level and the managers' shareholding. He points out that, in the case of low managers' holding, equity participation will be positively related to indebtedness for the purpose of aligning the managers' interests with those of the shareholders. However, when the management 2014, IJRMBS All Rights Reserved 2 www.ijrmbs.com

ISSN : 23486503 (Online) International Journal of Research in Management & participation is high, indebtedness will be low. In fact, the leaders will more entrenched and therefore try to reduce their risk. Jensen et al (1992) and Friend and Lang (1988) found a negative relationship between the managers' participation in the capital and the debt ratio. On the other hand, Kim and Sorensen (1986) and Mehran (1992), found a positive relationship between the managerial participation and the firms' debt ratio. Hypothesis 1: There is a negative relationship between managerial ownership and indebtedness 1. Institutional ownership and indebtedness Institutional investors have an important role in corporate governance. Most studies measured the overall capital structure using the debt ratio. For this reason, we will apply it to see the effect of the institutional participation on the debt ratio. The institutional participation impact on the debt ratio has been a subject of debate. Actually, some researchers find a positive relationship whereas others find a negative relationship. A study by Qianq (2007) conducted in the Chinese context on a sample of 568 companies between 2002 and 2004 shows that an increase of the institutional investors' shareholding causes an increase of the debt ratio. Similarly, Kunar found, in the Indian context between 1994 and 2000, that the relationship between institutional participation and indebtedness is positive. Institutional investors affect indebtedness through their impact on the agency costs (Stulz (1990), Zwiebel (1996) and Gomes (2000)). Asymmetric information affects the firms' indebtedness in several contexts, whether it is for signaling (Ross (1977), share issuing (Myers (1984) and Myers and Majluf (1984 )) or for reputation (Gomes (2000)). Institutional investors play an important role in supervising and collecting information. Moreover, they affect the agency costs, the information asymmetries, the decisions related to the capital structure and based on the determinants of the agency costs and the information asymmetries (Harris and Raviv (1991)). Ross (1977), Leland and Pyle (1977) suggest that firms with institutional investors holding a small part of the capital resort less to indebtedness. Crutchley et al. (1999) state that there is a positive and significant relationship between institutional investors and the firms' debt ratio of. Hypothesis 2: There is a positive relationship between institutional ownership and indebtedness D. The Board of Directors and indebtedness Corporate governance theories affect the capital structure of public listed companies (Berger et al, 1997; Friend and Lang, 1988; Wen et al, 2002; Abor, 2007). The literature review shows that there is a relationship between the characteristics of the board of directors (the size, composition, duality and remuneration) and capital structure. The obtained results are contradictory and uncertain. The Board of Directors is responsible for controlling the managers' actions. 1. The board size Pfeffer and Salancick(1978), Lipton and Lorsch(1992) (1978) and Lipton and Lorsch (1992) state that there is a significant relationship between the board size and capital structure. Berger et al (1997) show a negative relationship between the board size and the indebtedness ratio. However, Jensen (1986) claims that the board of directors of highly leveraged firms is rarely small. Wen et al (2002) and Abor (2007) found a positive relationship between the board size and the indebtedness ratio. Actually, firms with large boards of directors take more debt so as to raise their value. However, a largesized board causes difficulties in the decisionmaking process. These conflicts, which are caused by largesized boards, improve the firms' indebtedness ratio. Hypothesis 3: There is a positive relationship between the board size and indebtedness 2. The board of directors structure. The resource dependence theory developed by Pfeffer (1973) and Pfeffer and Salancick (1978) points out that the outside directors make it more possible for firms to get protected against external environment, reduce uncertainty, select the resources which enable the firm to raise funds or improve its status and identification. The authors also found a positive relationship between the rate of the outside directors and the indebtedness ratio. Wen et al (2002) found a negative relationship between the number of outside directors and the indebtedness ratio. They state that outside directors exercise more effective control over the leaders who consequently reduce their debt so as to ensure better performance. On the other hand, Wen et al (2002) found a negative relationship between the proportion of outside directors and the indebtedness ratio as well as a positive relationship between the proportion of outside directors and the market value of equity capital. However, Jensen (1986), Berger et al (1997) and Abor (2007) suggest that boards of directors of highly leveraged firms are dominated by outside directors whereas those of companies having low debt have few outside directors. 3. The duality of the board of directors This duality could affect the firm's funding decision. It is a management structure at two levels in which the duties of both the board chairman and the CEO are carried out by the same person. Since the Board is the highest decisionmaking structure in controlling the company, it must not be under the CEO's control. If this is not the case, the management and control of decisions will not be a separated..." (Fama and Jensen, 1983). As the president is the most influential on the board's decisions, the separation between the management and the controlling decisions is understood when the chairman of the board is at the same time the CEO. Therefore, the fact that the positions of chairman and the CEO should be held by different people (a twolevel management structure) would help monitor more effectively the agency problems related to ownership separation and to typical monitoring in modern societies. Fosberg, (2004), states that firms with separated executive and control functions raise their indebtedness more than the ones in which the CEO is also the Chairman of the Board (duality). Hypothesis 5: There is a negative relationship between the board of directors' duality and indebtedness www.ijrmbs.com All Rights Reserved, IJRMBS 2014 3

International Journal of Research in Management & ISSN : 23486503 (Online) E. Control Variables and indebtedness 1. The firm s size and indebtedness Size is an important explanatory factor of the firms' behavior in dealing with indebtedness. The relationship between the firm's size and indebtedness is sometimes positive and sometimes negative. Several arguments can explain the positive relationship between the firm's size and indebtedness. In fact, large firms are unlikely to go bankrupt because business diversification reduces the volatility of cash flow and thus the probability of bankruptcy (Titmann and Wessels, 1988, Rajan and Zingales, 1995). Furthermore, large companies are more likely to better access to capital markets and therefore can borrow under favourable conditions (Ferri and Jones, 1979). However, the negative relationship between the firm's size and indebtedness is explained by the information asymmetries. This negative relationship is specific to Germany. Stoss and Kremp, (2001), state that small firms in Germany are too dependent on funding from banks. 2. Performance and indebtedness Although performance and indebtedness relationship have been discussed by more than one researcher, the results are contradictory. The Pecking Order Theory (POT) writers state that the most successful companies are those that have more cash flow and therefore will be indebtedness aversion. However, proponents of the signal theory expect that banks using a previous profitability in assessing the firms' risk will raise their borrowing from the most successful companies (Ross, 1977). Table 1: Summary of the hypotheses Hypotheses H1: The relationship between the managers participation in the capital and indebtedness is negative. H2: The relationship between the institutional investors participation in the capital and indebtedness is positive. H3: The relationship between the board s size and indebtedness is positive H4: The relationship between the proportion of the outside and indebtedness is negative H5: The relationship between duality and indebtedness is negative H6: The relationship between performance (ROA) and indebtedness is negative H7: The relationship between the firm's size and indebtedness is negative E x p e c t e d signs + + III. Methodology A. Sample presentation The purpose of this research is to analyze the impact of internal governance mechanisms on corporate debt ratio. For this reason, we used a sample of 13 Tunisian companies listed on the Tunis Stock Exchange (TSE) over a period of seven years going from 2003 to 2009, which brings the number of the observations to 91. Both financial and governancesystem related data mainly those related to the Board of Directors are collected from the annual reports of the companies' activities, from the TSE guides and from documents of the Financial Market Council (FMC). On conducting the Fisher test (Ftest), we realize that our model is either a fixed or random individual effect model. The specific nature of these effects according to the Hausman test, (1968), shows that models which are consistent with the data structure of the sample have fixed effects. B. Models, variables and measures 1. Model This model is a panel data model with fixed effect. In fact, governance variables, such as ownership structure and the board of directors are going to be regressed on the debt ratio. Our regression model is defined as: LEV it = β0+ β1 (Log TCA) it + β2 ( % NED) it + β3 (propinstit) + β4 (propmanag)+ β5 (ROA) + β6 (LnTA ) + β7 (Duality) + εi 2. The study variables Table 2: Variables and Measures Variables significance measures Board of directors' variables LogTCA Board of directots' size The natural logarithm of the total number of directors %NED The proportion of the outside directors The ratio between the number of outside directors and the Board's size Dualité Chairman of the board senior management Binary variable = 2 if the CEO is the chairman of the board, and 1 otherwise Variables of ownership structure Propinstit The stake held by the institutional investors Number of shares held by the institutional investors / total number of shares Propmanag The stake held by the managers Number of shares held by the managers / total number of shares Control variables 2014, IJRMBS All Rights Reserved 4 www.ijrmbs.com

ISSN : 23486503 (Online) International Journal of Research in Management & ROA Net profit/total assets lnta The firm's size Natural logarithm of the book value of the company's total assets IV. Results and interpretations A. Descriptive statistics Table 2 presents descriptive statistics related to the variables selected in this first analysis. The explanatory variable concerns the debt. The explained variables are: board size, the number of outside directors, the stake held by the manager, the institutional investors and the control variables related to the firm's size and its accounting performance (roa). The descriptive statistics given in Table 9 show that the average debt level is below 50%, that is 46.08% with a standard deviation of 18.7%. Regarding the first explanatory variable measuring the percentage of shares held by the manager, it is assumed that, on average, the manager holds 9.8% whereas the institutional investors hold an average of 8.23%. This rate is lower than that of the leaders. The size of the surveyed companies (measured by the natural log of the total assets) is, on average, 10.94. Regarding the board of directors' characteristics, descriptive statistics show that the board's size measured by the logarithm is 9.36, that is 9 members, and that the average number of outside directors is 7.021 or 7 members. The performance indicator (ROA) is very low, that is 4.5%. Table 3 : Descriptive Statistics Variable Average Standard Min Max deviation lev.460847.187042.00701.795511 logtca.936212.101161.69897 1.079181 admext 7.021978 1.920521 4 11 dualité 1.89011.3144855 1 2 proppdg.098241.160657 0.745 propinstit.082329.117956 0.88 roa.045124.048105.098459.191036 lnta 10.94883.633318 9.623178 12.54701 B. Impact of the board of directors on the debt ratio The regression results show a positive and significant relationship between duality and indebtedness. The board's size measured by using (logtca) is negatively associated with indebtedness. This seems to be inconsistent with the study of Wen et al,(2002) and Abor (2007), who state that large sizedboard companies take more debts for the purpose of raising their value. The results show that the impact of the number of outside directors on indebtedness is positive but insignificant. This seems to be inconsistent with the study of Wen et al (2002) who state that outside directors have more effective control over the leaders, which consequently reduces their indebtedness, in order to ensure better performance. C. Impact of ownership structure on the debt ratio The regression results show that the participation of institutional investors and leaders in the capital has positive and insignificant effects on the firms' debt ratio The participation of institutional investors is negatively related to indebtedness. This seems to comply with the idea of Ross (1977) and Leland and Pyle (1977) who suggest that firms in which institutional investors hold a small share of capital resort to less indebtedness. Brailsford, (2002), Jensen and Meckling, (1976), Harris and Raviv, (1988), claim that there is a positive relationship between the managers' participation in the capital and the debt ratio. This is the hypothesis of the alignment of the managers' interests with the shareholders'. As for the control variables, there is a negative and significant relationship between the firm's size and indebtedness. Moreover, the results show that there is a significant negative relationship between performance measured by the ROA and indebtedness. Table 4: Results of the linear regressions of governance variables on the debt ratio Table 4 enables us to study the impact of ownership structure features, of the board of directors and of the control variables on the firms' debt (Lev) Variables Coefficient Logtca.2837299 Admext.0069966 Duality.1046588* Propinst.0344801 proppdg.1626166 roa.4547548** lnta.1032794*** constant 1.612983 *** V. Conclusion In this study, we examined the impact of internal governance mechanisms on the debt of listed Tunisian firms. The results show that the Board of Directors has a negative and insignificant impact on the firms' debt ratio. In addition, the results show that the impact of the proportion of the outside directors is positive whereas that of duality on the debt ratio is positive and significant. The results also show that the participation of the leaders and institutional investors in the capital is positively connected to the Tunisian companies' indebtedness. Regarding the control variables, the results show that there are significant negative relationships between performance measured by the ROA, the firm's size and the debt ratio Reference [1]. Abor, J. (2007). Corporate Governance and Financing Decisions of Ghanaian Listed Firms, Corporate Governance: International Journal of Business in Society, 7. [2]. Baker, M. and J. Wurgler 2002. Market timing and capital structure, Journal of Finance 57, 132 [3]. Donaldson, C., 1961, Corporate debt capacity. Harvard University. [4]. Berger P.G, Ofek E et Yermack D, (1997), «Managerial www.ijrmbs.com All Rights Reserved, IJRMBS 2014 5

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