the relationship between corporate governance and finance

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INTERDISCIPLINARY JOURNAL OF CONTEMPORARY RESEARCH IN BUSINESS

COPY RIGHT © 2012 Institute of Interdisciplinary Business Research 489

NOVEMBER 2012

VOL 4, NO 7

The Relationship between Corporate Governance and Finance Patterns of the

Listed Companies

Corresponding Author: Mahmoud Moeinaddin Ph.D.27

Mohsen Karimianrad28

Abstract

The present study intends to examine the relationship of corporate governance and selection of

the finance patterns. Financing the company and application of potential investment

opportunities is chiefly regarded by the managers. Appropriate and timely applications of the

company‟s capacity can have a considerable influence on the future profitability. There are

various methods for financing the firms with different consequences. Management structure and

ownership can impact the decisions made for this selection. Management ownership and non-

executive members of the board that impact the management structure are utilized as the

corporate governance mechanisms in addition to the institutional shareholders and ownership

concentration which play a monitoring role on the board of directors. Finance patterns include

financing through self-financing through retained earnings, incremental debt and issuing stocks.

The required data include the information of 53 listed companies in Iran in a five year period

including 2006-2010. The findings indicate that there is a significant relationship between

corporate governance mechanisms and finance patterns. Actually, considering specific corporate

governance regime can lead to the selection of a particular finance pattern.

Keywords: Corporate Governance, Institutional Shareholders, Non-executive Members of the

Board, Ownership Concentration, Finance

1. Introduction

Organization of Economic Cooperation and Development (OECD, 2004) defined corporate

governance as the relationship of managers, board of directors, shareholders and stakeholders.

Corporate governance is an indispensable factor of the organizations. It is not only the required

clause for the appropriate growth of the firm in the market, but also the most precious item for

the shareholders for the purpose of keeping up with the impartiality, accountability, disclosure

and transparency of the different elements and parameters (Base, 2009).

Corporate governance provides a structure by which the objectives of the firm are defined.

Additionally, this structure determines how to monitor the performance of the managers (Al-

Najjar ,2010).

There are some issues confronted by the managers to manage and control the company that

include institutional shareholders and penetration of them in making the decisions related to their

finance needs. Today, it seems that internal sources of the companies are not essential. It is

especially expected that those companies that use the instruments and finance patterns in a

desirable and timely manner in the inflation situation, experience a considerable growth. It is

therefore interpreted that the decisions made by corporate governance for the purpose of

selecting a finance method is one of the main factors in improving the economic efficiency. In

27

Assistant Professor, Islamic Azad University Yazd Branch, Islamic Republic of Iran, 09133546008 28

M.A. in accounting, Islamic Azad University Yazd Branch, Islamic Republic of Iran

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doing so, diverse ways such as receiving loans and issuing stocks are performed by the managers

and it might lead to the different behavior of them by considering the effect of the size and

institutional shareholders on the managers.

2. Theoretical Background

Agency theory is one of the well-known theories about corporate governance. Agency problem

was first introduced by Ross in 1973 followed by Jensen and Mcling. They considered the

managers as the agents and the shareholders as the owners of the firms. There is no monitoring

and control probability in the firms with the dispersion shareholders and that‟s why the managers

look forward their own interests.

If the large institutional shareholders play the role of the monitoring agencies and dividends are

paid to reduce the agency costs, then there should be an alternative relationship between

dividend policy and institutional ownership. This relationship requires the positive association

between the percentage of shares owned by the institutional ownerships and earnings

accumulation (Stouraitis and Wu, 2004).

Regular payments of dividends can reduce the agency conflicts among the interests of the

managers and shareholders. Therefore, the range of possible abuse from the resources is reduced

by the managers. According to this assumption and considering the retained earnings as an

internal finance resource, dividend payment requires companies to rely on the external markets

to finance themselves. There was a great deal of opposition to the management tendency toward

retaining more earnings by the institutional owners. They can also require managers to pay the

dividends according to their voting and penetration power (Bichara, 2008). On the other hand, it

is expected that the agency costs are declined by increasing the ownership concentration and

reducing retained earnings (Harada, and Nguyen, 2006).

Stakeholders‟ theory, interest convergence hypothesis and the stability assumption of the

management position are all derived from accepting the agency theory. This was introduced by

Demsetz in 1983 and was more nalyzed by the other researchers. According to this hypothesis,

the competitiveness in the labor market of the managers and the incentive of keeping the position

and achieving higher and better positions leads managers protect their interests. If the manager

owns a major part of the stocks, there might be no motivation for using their maximum efforts.

Hierarchy theory of finance is the most significant theory about financing the companies.

According to Myers & Majluf (1984), the firms prefer financing through the internal resources

than the external finance sensitive to the information. The theory is based on this assumption that

the internal individuals are more knowledgeable than the shareholders. Therefore, the investment

resources are initially financed from the retained earnings followed by the debts with low risk

and high risk and finally by issuing stocks. This arrangement intends to reduce information

asymmetry and other finance costs.

Some specific studies in industrialized and developing countries demonstrate the different

behavior of them in selecting finance patterns. Singh and Hamid (1992) and Singh (1995)

examined the finance patterns in fifty developed and developing countries. The main findings

revealed that the developing countries apply more external resources to finance and issuing new

stocks to increase their net assets. In a similar study, Corbett & Jenkinson (1994) found that the

most important finance pattern is the internal resources; while issuing securities holds a small

share in their finance.

According to the above statements, it can be concluded that considering the corporate

governance mechanisms can affect management efficiency. Four measures are selected in this

study to investigate the hypotheses. Institutional shareholders‟ ownership is one of the measures

used because of the adequate experience, expertise and facilities they possess. Ownership

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concentration is the other measure which is regarded because of the considerable influence on

the firm and the board of directors. On the other hand, board ownership and the ratio of non-

executive members of the board are applied because of the executive power in the firm and the

monitoring effect over the board member, respectively. The main hypothesis of the study is

described as follows:

There is a significant relationship between corporate governance mechanisms and

finance patterns.

Financing through retained earnings, borrowing and issuing stocks are selected among the

finance patterns and two measures are regarded for each one. Therefore, the main hypothesis of

this study is examined through three sub hypotheses.

3. Research Background

Jensen et al (1992), Farinha (2003) and Harada, and Nguyen (2006) found the negative

relationship between ownership concentration and dividend. In other words, these studies

confirm the direct relationship between ownership concentration and retained earnings.

Abdelsalam and colleagues (2008) found that board composition is not significantly related to

dividend policy, but increasing institutional ownership leads to reducing the retained earnings.

They conducted the study among the Egypt companies. Guo and Ni (2009) confirmed the

negative relationship between institutional ownership and retained earnings. However, Kumar

(2003) found the positive relationship between institutional ownerships and retained earnings in

Indian companies.

Anderson (2004) covered the information of 500 companies in a time period including 1993-

1998 and found that finance costs are inversely dependent upon the non-executive members and

board size. Kouki and Guizani(2009) analyzed the effect of ownership structure on dividend

policy of Tunisian companies. Their findings showed that there is a negative relationship

between ownership concentration and retained earnings.

Al-Najar (2010) conducted a study in Japan and documented that there is no significant

relationship between dividend policy and institutional investment. Chalevas & Tzovas (2010)

examined the effect of corporate governance rule before and after the implementation and found

that its accomplishment will reduce the capital cost and increase the financial leverage. Lin

(2010) asserted that finance costs through borrowing have a significant relationship in those

firms with a high divergence between owners controlling right and factors affecting it.

4. Methodology

This is an applied study with the post event orientation and is classified as a correlation

study. We have used the previous studies to provide the literature review. Additionally, the

required information was collected from what has been documented in the financial statements

of the listed companies on Tehran Stock Exchange. The correlation and multivariate regressions

were used to test the relationship between the variables; while the significance of the model was

confirmed by F-statistics. Other tests related to the data are presented in different tables. The

Pearson correlation coefficient is applied to investigate the correlation of independent variables

in a pair-wise form. The significant level of 95 and 99 percent were considered along with t-

statistics.

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5.Statistical Population and Sampling

Tehran listed companies are selected as the sample for a five year period covering 2006 to 2010.

The statistical sample is chosen among the firms of the specified industries according to a

filtering criterion. The specified firms are selected among the others:

1. Those firms that are listed on Tehran Stock Exchange before 2006.

2. The firms that their end of the fiscal year is consistent with the calendar year.

3. Those firms that experience no variation in the fiscal year during the period.

4. Those firms with no transaction cease for more than six months.

5. The firms should not be classified as financial intermediaries or banks.

6. The required data about those firms should be available.

7. There should be no loss reported in their financial statements.

8. Those firms that have borrowed at least once in a time period covering 2006-2010.

6.Variables

Independent Variables

Managerial share ownership (MANOWN)

This variable is calculated by dividing the shares held by executive and non-executive members

to the total issued stocks.

Institutional Investor Ownership( INSOWN)

Bushee (1998) defined the institutional investors as the large investors such as banks, insurance

companies, investment firms and pension institutes. In the present study, this variable is

calculated by summing the shares held by the institutional investors and total issued stocks.

Non-Executive Directors of the board (NED)

Non-executive directors are the part time members who are not of executive responsibility. This

ratio is calculated by dividing the non-executive directors to the total directors.

Ownership Concentration

Herfindal-Hirschman index is the proxy used to calculate the ownership concentration. This

index is an economic proxy for measuring the exclusivity level of the market. Hence, the share

percentage of any shareholder is squared and summed together. The result is between 0 and 1

and the closer number of 1 is more concentrated:

OWNCON= ∑ (of ownership percentage)2

Dependent Variables

Financing through retained earnings is measured through the two following measures:

Self- Financing Ratio- Fixed Assets (SFRF): It is measured by dividing retained earnings

to the book value of the fixed assets.

Self-Financing Ratio- Total Assets (SFRT): It is calculated by dividing the retained

earnings to the total assets.

Financing through borrowing is measured through the two following measures:

Incremental Debt Financing Ratio (IDFR): This is the result of dividing total debts to the

total assets.

Debt on Equity (DOE): This variable is computed by dividing the total debts to the total

owner’s equity.

Financing through issuing stocks is measured through the two following measures:

New Equity Financing Ratio (NEFR): It is measured by dividing the owner’s equity

except for retained earnings to the total assets of the firm.

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Incremental Equity Financing Ratio (IEFR): It is calculated by dividing the total owner’s

equity to the total assets at the end of the period.

Control Variables

Firm Size: This variable is the natural logarithm of the total assets.

Book Value of property, plant and equipment to total Assets (PPE): This is the ratio

calculated by dividing the book value of the tangible fixed assets to the total assets. The

summary findings are presented in table 1. Table1. Summary of the Variables

Variable Title The Position in the

Model Ind. Source

The ownership percentage of the Board Independent MANOWN Valenti et al (2011) The ownership percentage of the Institutional

Shareholders Independent INSOWN Pushner (1993), Chalevas and Tzovas

(2010) Non-Executive Directors Independent NED Valenti et al (2011), Lin et al (2010) Ownership Concentration Independent OWNCON Lee (2008), Garcia (2011) Self-Financing Ratio- Total Assets Dependent SFRT Chung & Wang (2000), G. Saldana

(1999) and Abdul Samad (2002) Self- Financing Ratio- Fixed Assets Dependent SFRF G. Saldana (1999), Chung & Wang

(2000)and Abdul Samad (2002) Incremental Debt Financing Ratio Dependent IDFR G. Saldana (1999), Chung & Wang

(2000)and Abdul Samad (2002) Debt on Equity Dependent DOE Renneboog (2000), Duc Pham &

Carlin (2009) and Barbuţa (2010) New Equity Financing Ratio Dependent NEFR G. Saldana (1999), Chung & Wang

(2000)and Abdul Samad (2002) Incremental Equity Financing Ratio Dependent IEFR G. Saldana (1999), Chung & Wang

(2000)and Abdul Samad (2002) Firm Size Control Size Gonenc (2005), Alnajjar (2010) Book Value of the property, plant and

equipment total Assets Control PPE M. Bowen et al (2008), Chalevas and

Tzovas (2010)

7. Data Analysis

The descriptive and inferential statistics are used to analyze the collected data. The findings are

summarized in table 2.

Table 2. Descriptive Statistics of the Research Variables Kurtosis Skewness Std.

Deviation

Median Mean Number Variable

6/82 2/82 19/16 0 6/99 265 MANOWN

2/48 -1/7 2/11 80 74/63 265 INSOWN

57/02 7/59 1/05 60 61/52 265 NED

0/321 0/845 21/17 29/8 31/62 265 OWNCON

1/75 0/843 1/87 34/88 36/23 265 DOE

5/51 1/69 1/087 13/3 15/51 265 IEFR

10/97 2/83 1/54 1/56 1/9 265 IDFR

-0/343 0/361 0/14 39 40 265 NEFR

-0/34 -0/361 0/14 61 59 265 SFRT

0/611 0/567 0/09 21 21/9 265 SFRF

1/83 2/1 1/7 21/68 24/43 265 PPE

0/94 0/50 1/24 13/44 13/43 265 SIZE

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The descriptive proxies (central tendency and dispersion) are summarized in table 2. According

to the table above, all the variables are significantly different from the normal distribution except

for the IDFR, IEFR and SIZE.

The variables are normalized before the research. This is because it is assumed that the research

variables are normally distributed in estimating the parameters of the model.

Hypotheses Testing

Table 3 and 4 shows the findings of the regression model for the first hypothesis.

Table 3. The Summary Findings of Examining the Effect of Corporate Governance on SFRF

Estimation Period: 2006-2010

SFRFit = b0+ b1INSOWN it+ b2 MANOWN it+ b3 NED it+ b4OWNCON it+ b5Sizeit+ b6 PPEit+εit

Cross-section fixed (dummy variables)

R2

0.93 F 53.14

Adj. R2

0.91 (Prob) 0

Durbin-Watson 1.743

Explanatory Variable Coefficient t-statistics Prob. Sig.

Intercept 91/15 44/11 0 %99

OWNCON 817/0 003/2 046/0 %95

MANOWN 32/0- 484/0- 628/0 -

INSOWN 005/0- 328/2- 02/0 %95

NED 34/1- 235/5- 0 %99

SIZE 77/0- 92/7- 0 %99

PPE 79/3- 54/15- 0 %99

Table4. The Summary Findings of Examining the Effect of Corporate Governance on SFRT

It is asserted that the regression model is significant at 99 percent. The findings related to the

Durbin-Watson statistics demonstrate that the data are proportionately independent. R2 of the

model indicates the relevancy level of the model and SFRT and SFRF. This coefficient is equal

to 0.90 and 0.91 for the two above models. It means that 90 and 91 percent of the variations in

the SFRT and SFRF are predictable through the mentioned patterns. It is finally concluded that:

Institutional shareholders and retained earnings are inversely related. In other words,

Institutional shareholders results in less aggregation of earnings and more dividends.

SFRTit = b0+ b1INSOWN it+ b2 MANOWN it+ b3 NED it+ b4OWNCON it+ b5Sizeit+ b6 PPEit+εit


R2 Adj. R

2 Durbin-Watson

Statistics F Prob

0/92 0/90 6791/1 46/53 0


Intercept 566/0 048/6 0 %99

OWNCON 0562/0 058/1 291/0 -

MANOWN 040/0- 436/0- 662/0 -

INSOWN 001/0- 793/5- 0 %99

NED 005/0 3087/0 757/0 -

SIZE 017/0- 327/2- 020/0 %95

PPE

1/0- 651/4- 0 %99

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A direct relationship is found between ownership concentration and SFRT. That is, the

ownership concentration leads to fewer dividends and more application of retained

earnings in finance.

The non-executive members of the board and SFRF are inversely associated. It means

that increasing the number of non-executive members of the board to the total members

will decrease SFRF. This decline is the same as less application of the firm’s earnings in

obtaining the capital assets. Generally, those firms with a higher ratio of non-executive

members use another method but the earnings accumulation.

There was no significant relationship found between Managerial share ownership and

retained earnings. Therefore it can be concluded that the ownership level of the board

has no influence on self financing. This is inconsistent with the hierarchy theory of

finance. This is because the theory expects self financing to be one of the initial priorities

of the managers.

Another finding provides evidence about the inverse relationship between self financing

and firm size index and PPE.

Testing the Second Hypothesis

The results of examining the second hypothesis are summarized in tables 5 and 6.

Table 5. The Summary Findings of Examining the Effect of Corporate Governance on IDFR

IDFRit = b0+ b1INSOWN it+ b2 MANOWN it+ b3 NED it+ b4OWNCON it+ b5Sizeit+ b6 PPEit+εit


R2 Adj. R

2

Durbin-Watson

Statistics F Prob

0/96 0/94 1/7320 86/87 0


Intercept -1/01 -13/61 0 %99

OWNCON 0/134 2/411 0/0168 %95

MANOWN 0/011 0/0831 0/933 -

INSOWN 0/0003 0/763 0/445 -

NED -0/019 -0/897 0/370 -

SIZE 0/114 17/4 0 %99

PPE 0/078 3/31 0/0011 %99

Table 6. The Summary Findings of Examining the Effect of Corporate Governance on DOE

According to the F-statistics and its probability, it can be concluded that the regression model is

significant at 99 percent for both models. R2 of the model explains that how the model and IDFR

DOEit = b0+ b1INSOWN it+ b2 MANOWN it+ b3 NED it+ b4OWNCON it+ b5Sizeit+ b6 PPEit+εit


R2

Adj. R

2

Durbin-Watson

Statistics F Prob

0/95 0/94 1/76422 75/25 0


Intercept -6/742 -21/77 0 %99

OWNCON 1/149 4/982 0 %99

MANOWN -0/215 -0/187 0/85 -

INSOWN 0/003 1/640 0/102 -

NED 0/07 0/532 0/59 -

SIZE 0/588 24/51 0 %99

PPE

0/336 2/092 0/037 %95

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in table 5 are related. This is 0.94 and it means that 94 percent of the variations in IDFR are

predictable from this pattern. Additionally, this finding holds the same for DOE.

The conclusions of the second hypotheses are summarized as follows:

There is a significant relationship between ownership concentration and incremental

debt financing. While, the other corporate governance mechanisms are not related to the

incremental debt financing. It means that more concentration on ownership will lead to

more borrowing in finance.

There was no significant association found between institutional shareholders,

managerial ownership and non-executive members with the incremental debt financing.

This issue is not appropriate until the essential ratios like liquidity and solvency ratios are

in a satisfactory level.

The findings also reveal that there is a direct association between financing through

borrowing and firm size and SFRT.

Testing the Third Hypothesis

The summary findings of the third regression model (significant relationship between corporate

governance mechanism and financing through issuing stocks) are provided according to the two

measures of NEFR and IEFR in tables 7 and 8.

Table 7. The Summary Findings of Examining the Effect of Corporate Governance on NEFR

NEFRit = b0+ b1INSOWN it+ b2 MANOWN it+ b3 NED it+ b4OWNCON it+ b5Sizeit+ b6 PPEit+εit


R2

Adj. R

2

Durbin-Watson

Statistics F Prob

0/9718 0/9639 1/72208 122.630 0


Intercept 1/539 23/125 0 99%

OWNCON -0/099 -1/946 0/053 -

MANOWN -0/050 -0/607 0/544 -

INSOWN 0/001 2/556 0/011 %95

NED -0/003 -0/524 0/60 -

SIZE -0/10 -22/73 0 %99

PPE

-0/001 -0/19 0/84 -

Table 8. The Summary Findings of Examining the Effect of Corporate Governance on IEFR

IEFRit = b0+ b1INSOWN it+ b2 MANOWN it+ b3 NED it+ b4OWNCON it+ b5Sizeit+ b6 PPEit+εit


R2

Adj. R

2

Durbin-Watson

Statistics F Prob

0/9607 0/9496 1/7320 86/877 0


Intercept 2/019 15/56 0 99%

OWNCON -0/13 -1/85 0/064 -

MANOWN -0/011 -1/088 0/92 -

INSOWN -0/000 -0/710 0/47 -

NED 0/019 1/068 0/28 -

SIZE -0/11 -11/61 0 %99

PPE -0/07 -2/69 0/007 %99

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These regression models are both significant at 99 percent. As shown in table 7, R2 of the model

shows the relevancy of the model and NEFR which is 0.94. Additionally, this holds for the next

model (table8) as 0.96. This means that 94 and 96 percent of the variations in NEFR and IEFR

are predicted through the specified patterns, respectively.

The conclusions show that there is a direct relationship between institutional shareholders and

NEFR. However, none of the corporate governance mechanism don‟t significantly relate to

IEFR. It is interpreted that the institutional shareholders tend to finance through issuing stocks.

The results also indicate an inverse relationship between issuing stocks financing and firm size

and SFRT.

Conclusion and Discussion

Corporate governance is today highly debated in scientific journals and most of the studies

concentrate on the monitoring role of the board of directors for the purpose of protection

interests of the shareholders in making organizational decisions (Weisbach, 1988). This study

seeks to find the relationship of corporate governance mechanisms with some financing patterns

of the firms performing in emerging and evolutional markets and economies like Iran.

The findings provide evidence that the presence of the institutional shareholders will encourage

the financing through issuing stocks and will reduce the self financing through retained earnings.

It can be therefore concluded that institutional shareholders have more tendency to dividends and

pay less attention to retained earnings. This is inconsistent with the hierarchy theory of financing.

This result is supported by Abdelsalam et al (2008), Guo and Ni (2009) and Zhang and Keasay

(2002). This is however completely different from the findings of Kumar (2003). Al-najar (2010)

confirmed that there is no relationship between institutional shareholders and retained earnings.

The positive relationship between ownership concentration and financing through retained

earnings and borrowing is also another conclusion of the study. This is consistent with the results

of Jensen et al (1992), Farinha (2003) and Harada and Nguyen (2006). However, there is no

consistency with the findings of Kouki and Guizani (2009). This means that more ownership

concentration will lead to more borrowing in finance. When a more percentage of the stocks are

held by fewer owners, then they tend to finance through incremental debt in order to maintain

their position, control over the firm and earn more profit. This subject might lead to some

relationships with the managers which are not in line with the interests of the minority

shareholders.

The inverse relationship between non-executive managers and financing through retained

earnings is another conclusion of this study. This was also found by Anderson (2004). However,

the findings of Chalevas and Tzovas (2010) were completely inconsistent with the conclusions.

Finally, corporate governance mechanisms influence on the finance patterns of the companies.

Investors, shareholders and creditors can pay more attention to the corporate governance

mechanisms which are aimed to follow the objectives. Lower tax and keeping the sensitive

information of the market, consistency in dividing the expected profit, penetration probability of

some investors in the firm and the need to equipments, experiences and expertise should be

essentially considered in finance. Therefore, applying a specific finance pattern with a special

corporate governance mechanism can‟t be prescribed for all companies. Generally, it is

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suggested to increase the institutional shareholders because of their experience and expertise and

also to increase the non-executive managers because of the fact that they have no executive role.

Applicable Suggestions

Financing through retained earnings is a very important finance pattern for the shareholders and

they are suggested to pay more attention to increasing the non-executive managers of the board,

lowering ownership concentration and increasing the ownership of the institutional shareholders

in order to use less self-financing. This will finally lead to declining the expected risk and

enhancing the firm‟s value.

The investors are offered to consider the ratio of non-executive managers as a positive factor

when making investment decisions. The further subjects can be defined as follows:

Corporate governance has very extensive subjects and they provide a lot of research

opportunities. There are also some other methods to determine the finance patterns of the firms.

Additionally, there are some other patterns like property lease which can be investigated.

Eventually, we offer to separately study and examine the roles of the corporate governance

mechanisms.

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