Leverage, Executive Incentives and Corporate Governance: Mahmoud Agha

Accounting and Finance 53 (2013) 130
Leverage, executive incentives and corporate governance

Mahmoud Agha
Business School, The University of Western Australia, Crawley, WA, Australia
Abstract This paper analyses the eect of executive incentives and internal governance on capital structure. Using a large sample of non-nancial US-listed rms over the period 19992005, it is found that managers have dierent attitudes towards leverage when oered dierent incentive schemes; leverage initially decreases in bonuses and stock incentives and then increases in these incentives after a certain incentive level, suggesting the existence of the entrenchmentalignment eects under these incentive schemes. In contrast, leverage initially increases in option incentives and then decreases after a certain option incentive level. When all of these incentive schemes are combined together into a single incentive package, the entrenchmentalignment eects prevail. It is also found that leverage increases in internal governance and managers behave dierently under dierent governance regimes such that the entrenchmentalignment eects prevail under weak governance rms, whereas the alignmententrenchment eects prevail under strong governance rms. The results also suggest that managers target leverage ratio is less than the one predicted by theory or preferred by rm shareholders. Key words: Leverage; Incentive schemes; Internal governance; Alignment eect; Entrenchment eect
The author would like to thank his colleagues Professor Robert Durand at Curtin University and Professor Richard Heaney at the University of Western Australia for their invaluable comments and feedback. The author would also like to thank his colleagues in Accounting and Finance Discipline Group at the University of Western Australia for their comments and feedback. The initial draft of this paper won the best paper award in the corporate governance stream at the 2010 AFAANZ Conference in Christchurch, New Zealand. I would like to thank my paper reviewer(s) who nominated this paper for the best paper award. I would also like to thank my paper discussant, Associate Professor Keith Duncan from Bond University, and all participants at the 2010 AFAANZ Conference for their comments and feedback. Thanks are also due to Professor Ender Demir and all participants at the 2010 EBES Conference for their feedback and suggestions. I am also thankful to all participants at the UWA Business School Forum for their comments and feedback. Many thanks also to Professor Terry Walter, Dr Dirk Baur and all participants at September 2010 seminars at the University of Technology-Sydney for their comments and suggestions. All errors are mine. Received 11 February 2011; accepted 3 October 2011 by Robert Fa (Editor). 2011 The Author Accounting and Finance 2011 AFAANZ
M. Agha/Accounting and Finance 53 (2013) 130
JEL classication: G3, G32 doi: 10.1111/j.1467-629X.2011.00450.x
1. Introduction Shareholders usually prefer more debt used in their rms capital structures to magnify the return on their equity investment and possibly to expropriate wealth from debtholders (Maxwell and Stephens, 2003). However, many researchers have noticed that rms, on average, use a leverage level far less than the one predicted by theory or preferred by rm shareholders (see e.g. Myers, 1984; Graham, 2000). The usual interpretation for this phenomenon is that rms reserve some borrowing capacity to take advantage of future growth opportunities. Alternatively, managers might be averse to using high leverage levels to protect their human capital and limited undiversied wealth from default risk and subsequent bankruptcy and/or to avoid further monitoring of their actions by creditors, suggesting that managers can aord a particular leverage level less than that preferred by shareholders. To mitigate this problem, shareholders usually oer managers incentives to align their interests and install a governance system to monitor their actions. This paper analyses the eect of the most common incentive schemes oered to managers in practice and internal governance on leverage. There are dierent views for each relation. Some researchers argue that oering managers incentives linked to rm value or its performance would align their interests with those of the shareholders, which in return would result in a positive relation between leverage and the incentives, hereafter the alignment eect. Jensen and Meckling (1976), Kim and Sorensen (1986), McConnell and Servaes (1990) and Berger et al. (1997) support this view. Others argue that the relation between leverage and executive incentives is negative because of managers aversion to default risk or because of their reluctance to bear further monitoring of their actions by creditors, hereafter the entrenchment eect. Fama (1980) and Friend and Lang (1988) support this view. Yet, there is another important view arguing that the relation between leverage and executive incentives is nonlinear. According to this view, the relation is initially positive because of the alignment eect, and then, it turns negative after a certain incentive level as managers become entrenched, hereafter the alignmententrenchment eects. Brailsford et al. (2002) and Florackis and Ozkan (2009) support this view. For the relation between leverage and corporate governance, there are also two dierent views. Some researchers argue that better governance signals the quality of rm to creditors, which lowers its cost of debt nancing, resulting in a positive relation between leverage and corporate governance. Furthermore, higher governance reduces managers entrenchment and discretion over rm
2011 The Author Accounting and Finance 2011 AFAANZ
aairs, resulting in an increase in leverage. Berger et al. (1997), Cremers et al. (2004), Klock et al. (2005) and Florackis and Ozkan (2009) support this view. The other view is that leverage itself can be used as an eective internal governance tool that disciplines managers and forces them to avoid wasting rm cash ows into negative net present value projects; therefore, higher leverage may reduce the need for higher governance, and vice versa. Jensen and Meckling (1976), Jensen (1986), Stulz (1990), Zwiebel (1996) and Jiraporn and Gleason (2007) support this view. In this paper, we revisit these relations between leverage on the one hand and executive incentives and internal governance on the other. Using a large sample of non-nancial US-listed rms over the period 19992005, managers are found to have dierent attitudes towards leverage when oered dierent incentive schemes; the relations between leverage and both bonuses and stock incentives are initially negative that turn positive after a certain incentive level, whereas the relation between leverage and option incentives is initially positive that turns negative after a certain option incentive level. The negative convex relations between leverage and both bonuses and stock incentives imply that managers are initially averse to debt when oered these incentives up to a certain incentive level when leverage starts increasing in these incentives, suggesting the existence of the entrenchmentalignment eects under these incentive schemes. In contrast, when managers are oered option incentives, they would initially become risktakers such that leverage initially increases in option incentives up to a certain option incentive level when leverage starts decreasing in option incentives oered beyond this level, which may give support to the proponents of the alignmententrenchment eects. These dierent eects for the incentives on leverage could be due to the relations between these incentives and rm risk. Because increasing rm leverage increases its risk as well as its expected return, the value of bonuses and stock incentives may or may not increase as the rm leverage is increased, and the costs to the managers of using more debt such as increased default risk and further monitoring of their actions may outweigh the benet of doing so when these incentives are little. Therefore, managers would be initially averse to debt when oered bonuses and stock incentives to preserve the value of these incentives and reduce the other costs associated with debt, but once these incentives become signicant, managers realize that the value they are missing as a result of their aversion to debt outweighs the costs of using more debt; at this point, managers start using more debt to capture some of the value missed. In contrast, increasing rm risk will always increase the value of any option written on its shares because there is always a positive relation between option value and the volatility of the underlying share, all else held constant. Indeed, Tian (2004) nds that executive stock options create an incentive to increase systematic risk and an incentive to reduce the unsystematic risk which managers are usually reluctant to bear. Duan and Wei (2005) nd that executive options increase in value as the systematic risk is increased and this eect is stronger when rm total risk is low. And, because
increasing rm leverage increases both types of risk, the results found in this study imply that managers initially increase rm leverage to increase its systematic risk to boost the value of their options, but further increases in rm leverage for this purpose would also increase its unsystematic risk and diminish the eect of the systematic risk on option value, causing the costs of increasing rm unsystematic risk to outweigh the benet of increasing its systematic risk. Therefore, managers use less leverage once their option incentives exceed a certain level to reduce the unsystematic risk and the costs associated with debt. The analysis then proceeds to check which eects prevail when all the incentive schemes are combined together into a single incentive package; it is found that leverage initially decreases in the incentive package and then increases after a certain incentive level, suggesting that the entrenchmentalignment eects prevail when managers are oered an incentive package composed of a mixture of incentives. On the other hand, a governance index composed of 25 internal governance factors is created using principal component analysis (PCA), and the relation is found to be positive, suggesting that higher governance counters managers initial aversion to debt, reduces their entrenchment and discretion over rm aairs and possibly signals the quality of rm. The support found in this study for the entrenchmentalignment eects is in contrast with the claims that support the existence of the alignment eect and the alignmententrenchment eects. A possible explanation for this dierence could be due to the role of governance and size bias. Many researchers in this literature use a small sample of large rms in their analyses (see e.g. Berger et al., 1997; Brailsford et al., 2002).1 And, because large rms usually have strong governance systems, it is not surprising to nd evidence in support of the alignment eect or the alignmententrenchment eects. This is because when managers are subject to strong monitoring levels, they have a little discretion over rm aairs. Therefore, these managers might initially behave in the interests of rm shareholders to avoid being replaced by the board of directors until their incentives become signicant; at this point, these managers become entrenched and start reducing rm leverage towards their aordable level. However, when a large sample of small and large rms is considered, such as the current sample that includes 1662 rms, the evidence found supports the entrenchmentalignment eects rather than the alignmententrenchment eects. To test these arguments, we split the sample into two subsamples as in Florackis and Ozkan (2009); rms in the lower 40 per cent in terms of the governance index are labelled weak governance rms, and those in the upper 40 per cent
1
Berger et al. (1997) use 434 large US rms in their analysis and nd evidence in support of the alignment eect using linear specication for stock and option incentives. Brailsford et al. (2002) use just 49 large Australian rms in their analysis because of data limitation and nd evidence supporting the alignmententrenchment eects using quadratic specication for stock incentives. However, both acknowledge that their results might be subject to potential size bias. 2011 The Author Accounting and Finance 2011 AFAANZ
are labelled strong governance rms. The results found support the existence of the entrenchmentalignment eects for weak governance rms where managers have a greater discretion over rm aairs such that leverage initially decreases in the incentive package and then increases after a certain incentive level. In contrast, for strong governance rms, the results are in favour of the alignmententrenchment eects, supporting our earlier argument and the ndings of those who used a small sample of large rms. However, in both cases, managers at high incentives seem to converge their leverage choice towards a specic level less than the one predicted by theory or preferred by rm shareholders, suggesting that managers have their own target leverage ratio less than that which is optimal. The ndings in this paper provide new insights into the existing literature. The results in this analysis suggest that managers have dierent attitudes towards leverage when oered dierent incentive schemes. Moreover, while the literature is divided between the entrenchment eect and the alignment eect or the alignmententrenchment eects, to the best of our knowledge, this is the rst study to nd evidence in support of the entrenchmentalignment eects that dominate the alignmententrenchment eects in a sample of small and large rms. Furthermore, few papers have analysed the attitude of managers towards leverage under dierent governance settings; in this paper, managers are also found to behave dierently under dierent governance regimes such that the entrenchment alignment eects prevail under weak governance regimes, while the alignment entrenchment eects prevail under strong governance regimes. The results also suggest that managers target leverage ratio is less than the one predicted by theory or preferred by shareholders, which could explain why rms in practice underlever their capital structures. These empirical ndings represent the major contributions of this paper to the literature. The remainder of this paper is structured as follows. In Section 2, the research hypotheses are developed. Section 3 describes the data used in the empirical analysis. In Section 4, we conduct the empirical analyses and discuss the results. Section 5 concludes. 2. Theoretical background and hypotheses 2.1. Leverage and executive incentives Risk-averse managers may evade making decisions that are in the best interests of rm shareholders. Increasing rm leverage towards the optimal level that maximizes its value is one of those decisions that managers may evade. Many researchers have observed that rms, on average, use a leverage level far less than that preferred by shareholders or predicted by theory. The usual interpretation for this phenomenon is that rms reserve some borrowing capacity to take advantage of future investment opportunities. Alternatively, risk-averse managers may avert using high leverage levels to protect their human capital and
limited undiversied wealth from default risk and/or to avoid attracting additional monitoring of their actions by creditors. This aversion to debt may result in a leverage ratio inconsistent with shareholder wealth maximization. To alleviate this conict, principals usually oer managers incentives to align their interests with those of the shareholders and install a governance system to monitor managers actions. The most popular incentive schemes that have been in use so far include bonuses, stocks and options. One of the objectives of oering these incentives is to encourage managers to use more debt to maximize rm value as debt is a cheaper source of nancing compared with equity. Some researchers claim that an alignment of interests occurs when managers are oered incentives linked to rm value or its performance (see e.g. Jensen and Meckling, 1976; Kim and Sorensen, 1986; McConnell and Servaes, 1990; Berger et al., 1997). According to this view, oering managers incentives linked to rm value or its performance would encourage them to avoid engaging in value-decreasing activities, which would ultimately result in a positive relation between leverage and the incentives. Managers may also prefer more leverage to increase their equity stake voting power and to make their rms less-attractive targets in takeover attempts (see e.g. Harris and Raviv, 1988; Stulz, 1988). In contrast, other researchers claim that the relation is negative because of the greater non-diversiable risk of debt to managers than to shareholders and/or the reluctance of managers to attract additional monitoring of their actions by creditors, suggesting the existence of the entrenchment eect (see e.g. Fama, 1980; Friend and Lang, 1988). Yet, there is another important view arguing that the relation between leverage and executive incentives is nonlinear. According to this view, leverage initially increases in the incentives because of the alignment eect, and then as the incentives are further increased, managers become entrenched after a certain incentive level, and leverage starts decreasing in the incentives oered beyond this level, suggesting the existence of the alignmententrenchment eects (see e.g. Brailsford et al., 2002; Florackis and Ozkan, 2009). When risk-averse managers are oered little incentives, these incentives might be insignicant to convince these managers to increase rm leverage because the costs to them of using more debt, such as increased default risk and further monitoring of their actions by creditors, may outweigh the benets of doing so. Moreover, using more debt may put the value of their incentives that are linked to rm value or its performance at risk because increasing rm leverage increases its risk as well as its expected return. Indeed, Zajac and Westphal (1994) argue that executive incentives are potentially a double-edged sword; while these incentives may create an alignment eect, they may also lead to risk-avoiding behaviours by managers if their incentives are closely linked to rm wealth because managers, unlike the owners, have already invested their non-diversiable and non-tradable human capital and most of their limited wealth in their rms. And, because bonuses and stock incentives are closely linked to rm wealth, the value of these incentives may or may not increase as the rm leverage is increased
because increasing rm leverage magnies its possible losses as well as its possible gains. Therefore, risk-averse managers oered bonuses and stock incentives are expected to initially use less debt when these incentives are increased to preserve the value of these incentives and reduce the other costs associated with debt, but once these incentives become signicant such that the value of the rm they are missing as a result of their aversion to debt outweighs the costs of using more debt, these managers are expected to increase rm leverage, possibly towards their aordable level to capture some of the value missed. In summary, we expect to nd evidence in support of the entrenchmentalignment eects when managers are oered bonuses and stock incentives such that leverage initially decreases in these incentives and then increases after a certain incentive level. Proposition 1: There is a negative convex relation between leverage and bonuses and stock incentives. However, unlike bonuses and stock incentives, increasing rm risk by increasing its leverage will always increase the value of any option written on its shares because there is always a positive relation between option value and the volatility of the underlying share, all else held constant (see Hamada (1972) for the link between leverage and stock beta). Hence, given this consideration and the fact that option payos are protected from downside risk, it is possible to nd a positive relation between leverage and option incentives as some researchers have found (see e.g. Berger et al., 1997; Coles et al., 2006). However, increasing rm leverage will also increase its unsystematic risk such as default risk which managers are usually averse to in order to protect their human capital and limited undiversied wealth. Indeed, Tian (2004) nds that executive stock options create an incentive to increase rm systematic risk as well as an incentive to reduce its unsystematic risk. Duan and Wei (2005) nd that executive options increase in value as the systematic risk is increased and this eect is stronger when rm total risk is low. And, because leverage has an eect on both types of risk, managers oered option incentives might initially use more leverage to increase rm systematic risk and boost the value of their option incentives, but further increases in rm leverage for this purpose would also increase its unsystematic risk and diminish the eect of the systematic risk on option value, causing the costs of increasing its unsystematic risk to outweigh the benet of increasing its systematic risk. Therefore, risk-averse managers are expected to use less leverage once their option incentives exceed a certain level to reduce the unsystematic risk and the related costs such as default risk and creditors monitoring of their actions. Proposition 2: There is a positive concave relation between leverage and option incentives. However, managers are usually oered a mixture of incentives, hereafter the incentive package, composed of some or all of these incentive schemes. In this
case, we expect the eect of bonuses and stock incentives to dominate the eect of option incentives in this package because options do not pay unless the stock price exceeds the strike price. Therefore, when risk-averse managers are oered an incentive package, it is less likely that these managers would use more debt that will increase rm default risk, attract additional monitoring of their actions and possibly put the value of their other incentives at risk just to make their option incentives pay. Risk-averse managers are expected to initially use less debt as their incentive package is increased to preserve the value of their incentives and reduce the costs associated with debt until the incentive package oered to them becomes signicant such that the value they are missing as a result of their aversion to debt outweighs the costs of using more debt; at this point, these managers are expected to increase rm leverage, possibly towards their aordable level to capture some of the value missed. In summary, we expect the entrenchment alignment eects to prevail when managers are oered an incentive package. Proposition 3: There is a negative convex relation between leverage and the incentive package. 2.2. Leverage and corporate governance The literature on the relation between leverage and corporate governance is also inconclusive; some researchers argue that better governance signals the quality of rm to creditors, which lowers its cost of debt nancing, resulting in a positive relation between leverage and corporate governance (see e.g. Cremers et al., 2004; Klock et al., 2005; Florackis and Ozkan, 2009). Higher governance also reduces managers entrenchment and discretion over rm aairs and increases rm leverage (e.g. Berger et al., 1997; Kayhan, 2008). Others argue that increasing rm leverage acts as a self-disciplining governance tool that puts managers on the edge and forces them to avoid engaging in value-decreasing activities, which may result in a negative relation between leverage and corporate governance (see e.g. Jensen and Meckling, 1976; Jensen, 1986). In line with this negative relation, John and Litov (2010) nd that entrenched managers use more debt by following a conservative investment policy that helps them get better nancing terms. Because managers are expected to initially use less debt, governance is expected to counter the initial aversion of managers to leverage, reduce their entrenchment and discretion over rm aairs and possibly signal its quality to creditors. Proposition 4: There is a positive relation between leverage and corporate governance. However, risk-averse managers are not expected to have the same attitude towards leverage under all governance regimes. When risk-averse managers work under weak governance regimes, they have a greater discretion over rm aairs given the low monitoring of their actions. Hence, these managers are entrenched
and are expected to initially use less debt as their incentive package is increased to preserve the value of their incentives and reduce the costs associated with debt until the incentive package oered to them becomes signicant such that the value they are missing as a result of their aversion to debt outweighs the costs of using more debt; at this point, these managers are expected to increase rm leverage, possibly towards their aordable level to capture some of the value missed. In other words, we expect the entrenchmentalignment eects to prevail for weak governance rms. Proposition 5: Under weak governance regimes, we expect to nd a negative convex relation between leverage and the incentive package. In contrast, risk-averse managers who work under strong governance regimes are not entrenched and have a little discretion over rm aairs given the strong monitoring of their actions. These managers face the risk of losing their job if they do not increase rm leverage to a satisfactory level. Indeed, Berger et al. (1997) nd a substantial increase in rm leverage after a forced replacement of rm CEO. Therefore, we expect these managers to initially behave in the interests of rm shareholders by increasing rm leverage to avoid being replaced by the board until the incentives oered to them become signicant; at this point, these managers become entrenched and start reducing rm leverage, possibly towards their aordable level that would not expose their incentives and the rm to high levels of risk and/or restrict their actions. In other words, we expect the alignmententrenchment eects to prevail for strong governance rms. Proposition 6: Under strong governance regimes, we expect to nd a positive concave relation between leverage and the incentive package. 3. Data and variable measurement The data used in this paper are drawn from two sources. Standard & Poors ExecuComp and Compustat databases are used to calculate executive incentives and rm nancials, and the RiskMetrics (formerly the IRRC) database is used to construct a governance index for each rm-year. Because the RiskMetrics database contains many missing data for the years 19961998 and has stopped collecting data on boards of directors since 2006, analysis is conned to using the data over the period 19992005. Financial rms are excluded from the analysis. Over the sample period, there are 1662 rms with complete executive incentives, nancials and governance data, representing 8400 rm-year observations (unbalanced panel data). All variables are measured contemporaneously with leverage except the incentive schemes that are measured at the start of each scal year. Processing of these data is fully described in the next subsections.
10
3.1. The dependent variable: leverage Total debt to book value of assets is the most widely used proxy for leverage. Some researchers recommend the use of another proxy calculated as total debt to market value of rm assets (Welch, 2004). The market value of rm assets is calculated as the market value of rm equity plus the book value of its liabilities. Most researchers and even practitioners prefer the use of the rst proxy as capital structure is mainly determined by the existing assets in place rather than the growth opportunities implied by the second measure (Myers, 1977; Graham and Harvey, 2001). Moreover, because prices of shares are volatile, using the second proxy for leverage may produce unreliable and inaccurate results. Furthermore, using the second proxy may also lead to spurious correlation with Tobins Q, a measure of growth opportunities that is generally used in the analysis of capital structures (Barclay et al., 2006). For these reasons, the rst proxy for leverage is used in this analysis. 3.2. The independent variables 3.2.1. The executive incentives Over time principals of rms have used dierent incentive schemes to align the interests of managers with those of the shareholders. In this paper, the analysis is conned to the most commonly used incentive schemes, which include bonuses, stocks and options. All incentive schemes oered to rm CEOs are measured at the start of each scal year (lagged incentives) for two purposes. First, this treatment reduces the possibility of reverse causality between leverage and the incentives. Second, it can help in predicting the eect of recent changes in the incentives oered to managers on their leverage choice. Bonuses are usually linked to rm prot; therefore, bonuses for any year are calculated as the cash bonus paid to the manager at the start of the scal year divided by income before extraordinary items. There were many occasions when some rms paid their managers cash bonuses despite negative earnings. Paying bonuses to managers during loss-making years is consistent with these rms expecting their fortunes to improve in the future. Therefore, given this consideration and to ensure consistent scaling, whenever a rm pays a bonus to its manager during a loss-making year, the bonus incentive is calculated as the ratio of cash bonus paid to the manager, divided by the product of the rm sales and the average net prot margin for all rms in the year in which the rm incurred losses. This measure of bonus incentives will be used when we analyse the eect of bonus incentives on leverage separately. When we combine bonus incentives with other incentive schemes, we divide the cash bonus by the market value of rm equity to ensure consistent scaling. This is because all other incentives are scaled by total outstanding shares; therefore, when we divide the bonus paid to the manager by rm market value of equity, the resulting ratio would be
11
equivalent to the percentage of rm shares managers can buy using their cash bonuses. Stock incentives for any year are calculated as total shares owned by the manager at the start of the scal year, divided by rm total outstanding shares at that time. Option incentives are calculated as the sum of delta-adjusted number of options held by the manager at the start of the scal year, divided by rm total outstanding shares at that time.2 For options granted in prior years, ExecuComp reports only the aggregate number and the aggregate intrinsic value of options that are in-the-money for both vested and unvested options. The intrinsic value of any option is the dierence between the stock price at the start of the scal year and the option strike price. Because managers are not expected to exercise their options once they vest, vested options can also be considered unvested options, but with a shorter time to maturity. Therefore, the numbers and the intrinsic values of both forms are added to create a single option incentive item. Then, the strike price is imputed by dividing the aggregate intrinsic value by the number of options, and then, we subtract this average intrinsic value per option from the reported stock price at the start of the scal year to calculate the strike price. Occasionally, the resulting strike price is negative; this is because the intrinsic value reported by ExecuComp pertains to those options that are in-themoney only. In this case, the strike price is set equal to the stock price. Next, this option is assumed to have 5 years to expiration, and then, we use the risk-free interest rate pertaining to each year obtained from the ocial US Treasury website, the volatilities and dividend yields reported by ExecuComp to calculate the delta for each option. After the delta-adjusted number of options is calculated, it is scaled by rm total outstanding shares. This treatment was rst proposed by Murphy (1999) and applied by Aggarwal and Samwick (2006) and Williams and Rao (2006). 3.2.2. The governance index Using the RiskMetrics database, an internal governance index is constructed for each rm-year over the sample period composed of 25 internal governance variables. Early researchers on governance used to assign an equal weight to each variable used in the construction of their governance indices. Recently, PCA has become widely used in the construction of governance indices. The PCA technique has the advantage of condensing a large set of variables into a
2
It is worth mentioning here that ExecuComp reports two classes of options: those that were granted to managers in the sample year, and those that had been granted in prior years. Options granted in prior years are also classied under two categories: vested (exercisable) and unvested (un-exercisable) options. Option incentives granted during the sample year usually have 10 years time to expiration and therefore are usually reported under unvested options. 2011 The Author Accounting and Finance 2011 AFAANZ
12
tractable one and reports the components (linear combinations) that capture as much of the variation in the original data set as possible. The weights (loadings) for the governance variables produced by the PCA technique are based on statistical measures instead of the equal weighting approach. To construct the index, we follow the methodology employed by Ammann et al. (2011).3 First, we retain all the components that have an eigenvalue >1. Then, because we have a panel data, we rotate these components using oblique rotation to allow for the components to be correlated. Finally, we use the rotated weights obtained from the rst principal component to construct the governance index. The rst principal component used to construct the governance index explains 20 per cent of the variation in our data set compared with 16.4 per cent captured by the one used by Ammann et al. (2011) in the construction of their index. Table 1 summarizes the variables used to construct the governance index along with the weights produced by PCA. The index is composed of internal rather than external measures of governance such as the G-index developed by Gompers et al. (2003). Therefore, our governance index can be considered a proxy for internal monitoring of managers actions by boards of directors and related committees, which serves the purposes of this study because it involves analysis of the role of the internal rather than external governance system. The selected variables reported in Table 1 are commonly used in the literature to proxy for internal governance (see e.g. Black et al., 2006; Brown and Caylor, 2006; Larcker et al., 2007; Florackis and Ozkan, 2009). As shown in Table 1, the variables have been classied into four groups. Group A includes variables that describe the structure of the board of directors. Group B describes members dedication to rm. Group C describes the existence of investors who have sucient resources to monitor the actions of managers. Group D describes the committees that are usually related to boards of directors. Some variables reported in Table 1 have the predicted sign and in line with the existing literature, while others fall under those where the literature is still inconclusive. For example, some researchers argue that larger board size is detrimental to rm performance given the coordination costs involved at large boards (Yermack, 1996). Others argue that larger boards might be benecial especially in rms with greater advising needs (Coles et al., 2008; Linck et al., 2008). The positive loadings for the size of the board and related committees (variables 1, 15, 17, 20, 23) support those who argue that larger board is benecial. Similarly, it is not clear whether frequent board meetings are benecial or not because while frequent board meetings might put the manager under close scrutiny, it might also involve a lot of coordination and communication costs and may tackle managers smooth running of rm aairs. The negative loading for this
3
Ammann et al. (2011) investigate the relation between rm value and corporate governance. Using 64 governance factors, representing 6663 rm-year observations from 22 countries over the period 20032007, they nd a signicant positive eect for the governance indices they created on rm value. 2011 The Author Accounting and Finance 2011 AFAANZ

Table 1 The variables used to construct the governance index using the PCA technique Variable A. Board structure 1. Board size 2. Board members 3. Chairperson of the board Measurement
13
Weight
4. Board has designated director(s) 5. Board has foreign member(s) 6. Board has outside advisor(s) 7. Members election power B. Member dedication 8. Meetings per year 9. Directors attendance 10. Independent members dedication 11. Aliated members dedication C. Ownership 12. Block holder director
1. Number of board members 2. Percentage of independent members in the board 3. The variable equals one if the chairperson of the board is dierent from the CEO, and zero otherwise 4. Number of designated directors in the board 5. Number of foreign members in the board 6. Number of outside advisors in the board 7. Percentage of the board members with election power 8. Number of meetings per year 9. Percentage of board members who attend at least 75% of board meetings 10. Percentage of independent members who serve in more than 5 other rms board 11. Percentage of aliated members who serve in more than 2 other rms boards 12. Number of block holder directors other than the CEO who own at least 5% of rm shares 13. Percentage of rm shares owned by block holder directors 14. Percentage of institutional ownership in rm shares 15. Number of governance committee members 16. Percentage of independent members in the governance committee 17. Number of audit committee members 18. Percentage of independent members in the audit committee 19. The variable equals one if the chairperson of the audit committee is independent, and zero otherwise 20. Number of compensation committee members 21. Percentage of independent members in the compensation committee 22. The variable equals one if the chairperson of the compensation committee is independent, and zero otherwise 23. Number of the nomination committee members
0.017 0.114 )0.089
0.018 0.021 0.045 0.045
)0.136 0.092 0.062 0.082
0.048
13. Block holder director ownership 14. Institutional ownership D. Control committees 15. Governance committee size 16. Governance committee members 17. Audit committee size 18. Audit committee members 19. Chairperson of audit committee
0.041 0.086
0.548 0.555 0.016 0.033 )0.030
20. Compensation committee size 21. Compensation committee members 22. Chairperson of compensation committee 23. Nomination committee size
0.039 )0.006 )0.054
0.389
14
Table 1 (continued) Variable
Measurement 24. Percentage of independent members in the nomination committee 25. The variable equals one if the chairperson of the nomination committee is independent, and zero otherwise
Weight 0.420 )0.019
24. Nomination committee members 25. Chairperson of nomination committee
The table reports the variables used in the construction of the governance index using PCA. The variables above have been calculated from the following data items as they appear in RiskMetrics database. 1. Count the number of board members. 2. DIRTYPE. 3. CHAIRMAN and CEO. 4. DESIGD. 5. CNTRYEMP. 6. PRITITLE, SUBTITLE, OTHERTITLE, PROFTYPE, and DIRTYPE. 7. NOMINEE. 8. MTGDATE. 9. ATTENDANCE. 10 and 11. PROXYBSC. 12 and 13. STKHOLDING and CEO. 14. INSTHOLD. 15 and 16. CORPGOV. 17 and 18. AUDITMBR. 19. AUDITCHAIR. 20 and 21. COMPMBR. 22. COMPCHAIR. 23 and 24. NOMMBR. 25. NOMCHAIR. Source: RiskMetrics database. PCA, principal component analysis.
factor (variable 8) suggests that frequent board meetings could be counterproductive. Moreover, some researchers argue that member independence is preferable to evaluate the performance of management objectively and reduce management discretion (Byrd and Hickman, 1992). Others cast doubts on the eectiveness of independent members who might lack the relevant knowledge about rm aairs (e.g. Fernandes, 2005). The positive loadings reported for member independence at the board and related committees (variables 2, 16, 18, 24) support the view that member independence is more eective. An exception to this nding is the loading for member independence at the compensation committee (variable 21) that has a negative sign. The magnitude of this loading is negligible compared with other loadings, however. Furthermore, it has been argued that separating the role of the CEO from the role of the board chairman would be preferable, while others do not support this view because independent chairman might not be familiar with rm aairs. Pi and Timme (1993) nd that rms that separate the two functions outperform those that do not, while Donaldson and Davis (1991) nd exactly the opposite. Brickley et al. (1997) argue that combining the two functions is ecient and in line with shareholders interests, and that legislative reforms to separate the two functions are misguided. Faleye (2007) also argues that separating the two functions might be counterproductive. The negative loadings for chairman independence at the board and related committees (variables 3, 19, 22 and 25) are consistent with those who support the combined functions. 3.2.3. The control variables The ratio of net property, plant and equipment (NPPE) to total assets is used to control for asset tangibility, and the natural logarithm of total assets is used
15
to control for rm size. Tobins Q is used to control for growth opportunities calculated as the ratio of total liabilities plus market value of equity to the book value of total assets. Furthermore, the ratio of operating cash ow to total assets is used to control for rm protability. Finally, for each year, the coecient of variation in rm earnings before interest, taxes, depreciation and amortization (EBITDA) is used to control for operating risk using quarterly observations of (EBITDA) during the past ve years. Table 2 summarizes the descriptive statistics for all variables that will be used in the empirical analysis. As shown in the table, the average leverage ratio is just 23.5 per cent, consistent with the notion that rms in practice underlever their capital structures. The average incentive package was 0.039, representing the average stake of managers in their rm shares. The average governance index during the sample period was 8.93, representing a modest level of monitoring relative to the highest governance index of 21.05.
Table 2 Descriptive statistics for all variables over the sample period Standard 25th 75th Number Mean deviation Minimum Percentile Median Percentile Maximum 8400 8400 8400 8400 8400 8400 8400 8400 8400 8400 8400 8400 0.235 0.009 0.000 0.026 0.012 0.039 0.184 0.018 0.001 0.061 0.014 0.063 0.000 0.000 0.000 0.000 0.000 0.000 0.162 0.002 16.678 0.403 )0.188 )5.272 0.073 0.000 0.000 0.001 0.003 0.007 6.875 0.129 20.167 1.187 0.057 0.236 0.235 0.004 0.000 0.003 0.008 0.016 8.939 0.243 21.094 1.554 0.100 0.381 0.351 0.010 0.000 0.014 0.016 0.035 10.995 0.445 22.173 2.290 0.154 0.605 1.761 0.138 0.007 0.366 0.273 0.646 21.503 0.986 27.344 23.714 0.374 5.817
Variables Leverage Bonus/IBEX Bonus/MV Stocks Options The incentive package The governance index NPPE Ln (Assets) Tobins Q Protability Operating risk
8.933 2.834 0.307 21.250 2.089 0.106 0.480 0.227 1.505 2.089 0.089 0.848
Leverage is calculated as the sum of long-term debt plus debt in current liabilities (data items 9 plus data item 34), all scaled by the book value of total assets (data item 120). Bonus/IBEX is calculated as cash bonus divided by income before extraordinary items (data item 118). Bonus/MV is calculated as cash bonus divided by market value of equity (data item 199 times data item 25). Stocks and options are scaled by total number of outstanding shares. The incentive package is calculated as the sum of Bonus/MV, Stocks and Options. NPPE ratio is calculated as NPPE (data item 141), divided by total assets. Ln(assets) is the natural logarithm of total assets. Tobins Q is calculated as total liabilities plus market value of equity, scaled by the book value of total assets. Protability is calculated as operating cash ow (data item 308) divided by total assets. Operating risk is calculated using the coecient of variation in quarterly EBITDA (data item 13) during the past 5 years of any sample year. Incentives and nancials are calculated from ExecuComp and Compustat databases, respectively. The governance index is calculated using the RiskMetrics database. The statistics represent 1662 rms and 8400 rm-year observations over the period 19992005. NPPE, net property, plant and equipment.
16
Table 3 The correlation matrix between all variables that will be used in the analyses

Stocks Options The governance index NPPE Ln(Assets) Tobins Q Protability Operating risk 1.00 0.00 )0.29 )0.04 )0.18 0.03 0.02 0.02 1.00 )0.04 )0.16 )0.32 0.01 )0.05 0.02 1.00 0.00 0.28 )0.05 0.10 )0.05 1.00 0.20 )0.17 0.12 )0.04 1.00 )0.08 0.01 )0.07 1.00 0.31 )0.09 1.00 0.00 1.00
Variables
Leverage
Bonus
Leverage Bonus/IBEX Stocks Options The governance index NPPE Ln (Assets) Tobins Q Protability Operating risk
1.00 )0.03 )0.12 )0.09 0.03 0.31 0.30 )0.20 )0.24 )0.06
1.00 0.01 0.22 )0.05 )0.11 )0.22 0.00 )0.10 0.01
The table summarizes the correlations between all variables that will be used in the empirical analysis. All variables are measured as dened in Table 2. The statistics pertain to our sample of 1662 rms and 8400 rm-year observations over the period 19992005. NPPE, net property, plant and equipment.
17
4. Empirical results 4.1. Univariate analysis Table 3 reports the correlation matrix between all variables that will be used in the empirical analysis. As shown in the table, leverage is negatively correlated with all the incentive schemes, but positively correlated with the governance index. Furthermore, the correlations between leverage and the remaining control variables are in line with the existing theories. Finally, none of the reported correlations is >0.50, and so the multicollinearity problem is not expected to be a major concern. 4.2. Regression analysis Table 4 reports the results from estimating the leverage function using three specications: ordinary least square (OLS), random eects and xed eects. As shown in the table, leverage is a nonlinear function of all the incentive schemes; leverage is a negative convex function of bonuses and stock incentives, but it is a positive concave function of option incentives. These results imply that managers are initially averse to debt when oered bonuses and stock incentives up to a certain incentive level when leverage starts increasing in these incentives, suggesting the existence of the entrenchmentalignment eects under these incentive schemes. Risk-averse managers oered low bonuses and stock incentives may initially use a relatively high leverage level to magnify the return on these low incentives. Then, as these incentives are further increased, using more leverage for this purpose becomes less attractive, so these managers start using less debt to preserve the value of these incentives and reduce the other costs associated with debt such as the default risk and creditors monitoring of their actions. However, in all cases, the results reported in Table 4 imply that there is a certain level of bonuses and stock incentives at which managers realize that the value they are missing as a result of their aversion to debt outweighs the costs of using more debt; at this point, these managers start increasing rm leverage, possibly towards their aordable level to capture some of the value missed. The relations between leverage and both bonuses and stock incentives are more likely driven by risk-aversion considerations especially the desire to preserve the value of these incentives rather than the desire to reduce the default risk. This possibility is supported by the initial positive relation between leverage and option incentives as shown in Table 4, which suggests that option incentives do the intended job in encouraging managers to take on more risk given that option incentives are protected from downside risk and their values increase in the volatility of the underlying stock, unlike other incentives. Yet, the results reported in Table 4 indicate that leverage decreases in option incentives after a certain incentive level, which may give support to the alignmententrenchment claim. However, given the structure of their payos and the fact that their values increase in the volatility of the underlying share, option incentives have been
18
Table 4 Regressions of leverage on the incentive schemes and internal governance OLS Variable Constant Bonus/IBEX (Bonus/IBEX)2 Stocks (Stocks)2 Options (Options)2 The governance index NPPE Ln(Assets) Tobins Q Protability Operating risk Industry dummy Year dummy Adj. R2 p > F-statistic Coecient t-Stat. )0.251 )0.365 3.349 )0.271 0.564 0.766 )7.561 0.001 0.143 0.022 )0.004 )0.277 )0.001 )(3.94)*** )(2.56)** (2.84)*** )(3.24)*** (2.03)** (2.93)*** )(2.36)** (1.83)* (9.76)*** (11.19)*** )(5.35)*** )(17.72)*** )(0.60) Yes Yes 0.351 0.000 Random eects Coecient t-Stat. )0.327 )0.329 2.670 )0.293 0.671 0.575 )4.686 0.001 0.130 0.026 )0.003 )0.291 )0.002 )(2.75)*** )(2.44)** (2.29)** )(10.77)*** (4.30)*** (2.83)*** )(3.47)*** (2.07)** (8.02)*** (7.35)*** )(5.28)*** )(11.95)*** )(1.65)* Yes Yes 0.238 0.000 Fixed eects Coecient t-Stat. )0.363 )0.341 2.431 )0.260 0.572 0.358 )3.395 0.001 0.081 0.028 )0.003 )0.261 )0.002 )(2.08)** )(2.35)** (2.14)** )(6.00)*** (4.68)*** (1.73)* )(2.16)** (2.53)** (5.55)*** (3.38)*** )(4.49)*** )(9.07)*** )(1.47) No Yes 0.232 0.000
The dependent variable in all above specications is the leverage ratio calculated as total debt to the book value of total assets. All variables are measured as dened in Table 2. The regressions pertain to our sample of 1662 rms and 8400 rm-year observations. All standard errors are calculated using White heteroscedasticity robust standard error. ***, **, *, represent coecient is signicant at the 1, 5 and 10 per cent levels, respectively. NPPE, net property, plant and equipment.
recently criticized for encouraging managers to speculate in risky projects and use excessive debt beyond the level preferred by shareholders, which caused the collapse of rms such as Enron and Qwest communication. Therefore, the concave relation found between leverage and option incentives could also be due to an initial divergence of interests if managers oered option incentives overlever their rms beyond the optimal level to magnify the value of their options at the expense of rm value followed by a convergence of interests after a certain incentive level. Hence, the relation between leverage and option incentives should be interpreted with caution. The results reported in Table 4 also show that leverage increases in internal governance, suggesting that higher governance counters managers aversion to debt, reduces their discretion over rm aairs and possibly signals its quality to creditors. The remaining results in Table 4 are consistent with the existing theories. The positive relation between leverage and asset tangibility proxy (NPPE) suggests that rms with signicant tangible assets can use more debt as these assets can be used as collateral for debt. Moreover, the positive relation between leverage
19
and rm size is also in line with the theory that large rms usually use more debt in their capital structures because there is less information asymmetry in large rms that gives them easier access to debt markets. The negative relation between leverage and Tobins Q is also in line with the theory that high growth rms usually adopt lower leverage in their capital structures to avoid the possibility of underinvestment as shown in Myers (1977). Furthermore, the negative relation between leverage and protability could be in line with the pecking order theory that predicts that rms usually prefer to use internally generated funds to nance their projects before resorting to external sources of nancing such as debt. Albeit weak, the negative relation between leverage and operating risk suggests that rms with volatile cash ows avert using more debt to reduce the default risk and subsequent bankruptcy. In Table 5, we test which eects prevail in practice when all the incentive schemes are combined together into a single incentive package that represents managers stake in their rm shares. As shown in Table 5, leverage is a negative convex function of the incentive package, suggesting that the entrenchmentalignment eects prevail when managers are oered an incentive package composed of a mixture of incentives. These results also imply that the eects of bonuses and stock incentives dominate the eect of option incentives in the incentive packages oered to managers.
Table 5 Regressions of leverage on the incentive package and internal governance OLS Variable Constant The incentive package (The incentive package)2 The governance index NPPE Ln(Assets) Tobins Q Protability Operating risk Industry dummy Year dummy Adj. R2 p > F-statistic Coecient t-Stat. )0.235 )0.132 0.103 0.001 0.140 0.021 )0.004 )0.279 )0.001 )(3.18)*** )(2.95)*** (1.86)* (1.95)* (8.93)*** (9.53)*** )(5.71)*** )(18.30)*** )(0.64) Yes Yes 0.350 0.000 Random eects Coecient t-Stat. )0.319 )0.125 0.098 0.001 0.128 0.025 )0.003 )0.293 )0.002 )(2.83)*** )(3.39)*** (2.14)** (2.21)** (7.57)*** (7.39)*** )(5.28)*** )(12.32)*** )(1.66)* Yes Yes 0.247 0.000 Fixed eects Coecient t-Stat. )0.353 )0.124 0.097 0.001 0.082 0.028 )0.003 )0.263 )0.002 )(2.04)** )(3.37)*** (2.00)** (2.49)** (5.34)*** (3.33)*** )(4.49)*** )(9.13)*** )(1.48) No Yes 0.233 0.000
The dependent variable in all above specications is the leverage ratio calculated as total debt to the book value of total assets. All variables are measured as dened in Table 2. The regressions pertain to our sample of 1662 rms and 8400 rm-year observations. All standard errors are calculated using White heteroscedasticity robust standard error. ***, **, *, represent coecient is signicant at the 1, 5 and 10 per cent levels, respectively. NPPE, net property, plant and equipment.
20
4.3. The role of corporate governance The support found for the entrenchmentalignment eects is in contrast with the view which claims that an alignment eect occurs at low incentive levels followed by the entrenchment eect at high incentive levels, that is, the alignmententrenchment eects. The dierence in our results and other researchers results might be due to the tendency of many researchers in this literature to use a small sample of large rms in their studies. However, large rms usually have strong governance structures, and in these rms, it is not surprising to nd evidence in support of the alignment eect or the alignmententrenchment eects. This is because when managers are subject to strong monitoring levels, they have a little discretion over rm aairs. Therefore, these managers might initially behave in the interests of rm shareholders to avoid being replaced by the board of directors until the incentives oered to them become signicant; at this point, these managers become entrenched and start reducing rm leverage towards their aordable level. However, using a large sample that includes small as well as large rms, such as the current sample, it becomes evident that managers, in general, are initially averse to debt before the alignment eect takes place. This argument is supported by the positive relation between leverage and the governance index, which suggests that governance counters the initial aversion of managers to leverage. To formally test these arguments, we split the sample into two subsamples as in Florackis and Ozkan (2009); rms in the lower 40 per cent in terms of the governance index are labelled weak governance rms, and those in the upper 40 per cent in terms of the governance index are labelled strong governance rms. Table 6 reports the descriptive statistics for the two subsamples. As shown in the table, weak governance rms have a slightly lower average leverage ratio of 23.1 per cent compared with 23.8 per cent for strong governance rms. Furthermore, the results reported in Table 6 show that the average incentive package of 5.8 per cent for weak governance rms is much higher than the average incentive package of 2.2 per cent for strong governance rms. This dierence suggests that principals may consider the incentive package and governance as substitutes for each other such that high incentives may be enough to align the interests of managers with those of the shareholders under weak governance rms, and vice versa. Finally, in line with our former argument, strong governance rms are much larger in size than weak governance rms; the average size of weak governance rms is around $1.1 Billions, whereas the average size of strong governance rms is around $2.5 Billion. Table 7 reports the average leverage ratio under each incentive segment for the full sample and for weak and strong governance rms. For the full sample, the average leverage ratio in Panel A initially decreases in the incentive package and then increases again, supporting the negative convex relation between leverage and the incentive package reported in Table 5. And, for weak governance rms, the pattern reported in Panel A also suggests a negative convex function. However, for strong governance rms, it is hard to draw inferences from the pattern

Table 6 Descriptive statistics of the variables under dierent governance regimes
21
Mean Panel A: Weak governance rms Leverage 0.231 The incentive package 0.058 The governance index 6.137 NPPE 0.313 Ln (Assets) 20.807 Tobins Q 2.218 Protability 0.099 Operating risk 0.515 Panel B: Strong governance rms Leverage 0.238 The incentive package 0.022 The governance index 11.719 NPPE 0.300 Ln (Assets) 21.608 Tobins Q 2.013 Protability 0.113 Operating risk 0.434
Standard 25% 75% deviation Minimum percentile Median percentile Maximum
0.201 0.087 1.461 0.234 1.392 2.858 0.097 1.013 0.170 0.039 1.501 0.224 1.516 1.315 0.083 0.706
0.000 0.000 0.162 0.002 16.678 0.403 )0.188 )5.272 0.000 0.000 9.765 0.005 17.710 0.520 )0.177 )4.432
0.030 0.009 5.215 0.127 19.838 1.144 0.049 0.256 0.114 0.006 10.588 0.129 20.470 1.246 0.063 0.215
0.222 0.023 6.411 0.244 20.622 1.516 0.096 0.419 0.239 0.012 11.436 0.236 21.484 1.595 0.106 0.343
0.366 0.062 7.325 0.463 21.598 2.342 0.153 0.667 0.338 0.023 12.556 0.425 22.627 2.274 0.156 0.544
1.442 0.628 8.175 0.973 26.803 23.061 0.345 5.817 1.761 0.581 21.503 0.968 27.344 19.077 0.374 4.786
All variables are measured as dened in Table 2. Incentives and nancials are calculated from Standard & Poors ExecuComp and Compustat databases, respectively. The governance index is calculated using the RiskMetrics database. Each panel contains 3360 rm-year observations. The statistics represent the two subsamples over the period 19992005. NPPE, net property, plant and equipment.
reported in Panel A; the leverage ratio initially decreases, then increases, then decreases in the incentives. In Panel B, we exclude all leverage ratio outliers (leverage ratios <1 per cent) from each incentive segment >5 per cent. The eect of these outliers is profound especially at high incentive segments where there are few leverage observations such that a very low leverage ratio has a signicant eect on the average leverage ratio calculated under these segments. As shown in Panel B, the average leverage ratio for the full sample is still negative convex function of the incentives. The same negative convex function is also observed for weak governance rms. For strong governance rms, the pattern of the average leverage ratio is more like a positive concave function of the incentives. However, it is too early to draw inferences from this table without taking into account the remaining control variables. The next step is to estimate the leverage function under each subsample to analyse the attitude of managers towards leverage under the two governance regimes. However, the statistics reported in Table 6 show some dierences between the two subsamples in some aspects such as the incentive package and rm-specic characteristics such as size and growth. Therefore, it is possible that any dierence found in the behaviour of the two managers under the two governance regimes might be due to these dierences rather than the dierence in the
22
Table 7 Leverage by incentive segments and governance strength Weak governance rms Strong governance rms
Full sample Panel A: The actual observations Executive incentive < 5% 5% < Executive incentive < 10% 10% < Executive incentive < 15% 15% < Executive incentive < 20% 20% < Executive incentive < 25% Executive incentive > 25% Panel B: The winsorized observations Executive incentive < 5% 5% < Executive incentive < 10% 10% < Executive incentive < 15% 15% < Executive incentive < 20% 20% < Executive incentive < 25% Executive incentive >25%
0.247 0.200 0.180 0.154 0.168 0.177 0.247 0.239 0.232 0.229 0.235 0.241
0.243 0.208 0.191 0.150 0.172 0.173 0.243 0.230 0.204 0.196 0.225 0.238
0.253 0.192 0.184 0.231 0.233 0.207 0.253 0.260 0.253 0.267 0.303 0.246
All variables are measured as dened in Table 2. Incentives and nancials are calculated from Standard & Poors ExecuComp and Compustat databases, respectively. The governance index is calculated using the RiskMetrics database. In Panel B, we remove all leverage ratios <1 per cent from each incentive segment >5 per cent.
governance strength. To mitigate this problem, when the leverage function is estimated for the two governance regimes, all variables in Table 6 are standardized by subtracting the mean of each variable from its individual observations and dividing this dierence by the standard deviation of that variable. This treatment converts the dependent variable and the explanatory variables under the two subsamples into standardized variables with zero means and unit variances, putting all variables under both subsamples on equal basis and controlling for possible dierences between the two subsamples. Both managers are now oered similar incentive package that has a zero mean and unit variance. Furthermore, standardizing all variables in this way reduces the eect of outliers that may distort the distributions of the variables under each subsample. The only dierences remain between the two subsamples are the strength of the governance regime and any unobserved heterogeneity. Table 8 summarizes the results from regressing the standardized leverage ratio on the standardized incentive package and control variables under the two governance regimes. In Panel A, we observe that the entrenchmentalignment eects prevail for weak governance rms where leverage is a negative convex function of the incentive package. This result suggests that managers who are subject to low monitoring levels have a great discretion over rm aairs such that they initially use less debt as their incentive package is increased, possibly to preserve the value of their incentives and reduce the other costs associated with debt. But once the incentive package oered to these managers becomes signicant such
23
Table 8 Regressions of the standardized leverage ratio on the standardized incentive package and explanatory variables under dierent governance regimes OLS Variable Coecient t-Stat. Random eects Coecient t-Stat. Fixed eects Coecient t-Stat.
Panel A: Weak governance rms Constant )0.401 The incentive package )0.098 (The incentive package)2 0.011 NPPE 0.256 Ln(Assets) 0.222 Tobins Q )0.039 Protability )0.242 Operating risk )0.026 Industry dummy Year dummy Adj. R2 p > F-statistic Panel B: Strong governance rms Constant 0.681 The incentive package 0.085 (The incentive package)2 )0.010 NPPE 0.162 Ln(Assets) 0.174 Tobins Q )0.045 Protability )0.186 Operating risk )0.033 Industry dummy Year dummy Adj. R2 p > F-statistic
)(3.74)*** )(8.04)*** (3.74)*** (9.65)*** (39.46)*** )(5.31)*** )(19.01)*** )(1.82)* Yes Yes 0.491 0.000 (2.37)** (4.48)*** )(3.66)*** (11.03)*** (6.98)*** )(1.55) )(7.18)*** )(1.91)* Yes Yes 0.502 0.000
)0.197 )0.090 0.015 0.272 0.232 )0.022 )0.139 )0.018
)(1.22) )(8.51)*** (6.27)*** (6.95)*** (6.58)*** )(2.93)*** )(9.72)*** )(2.71)*** Yes Yes 0.130 0.000 (0.46) (3.16)*** )(3.11)*** (0.64) (6.89)*** )(3.40)*** )(7.82)*** )(1.02) Yes Yes 0.153 0.000
0.000 )0.082 0.014 0.265 0.344 )0.013 )0.113 )0.020
)(0.05) )(4.69)*** (4.22)*** (4.91)*** (5.34)*** )(1.74)* )(7.51)*** )(1.73)* No Yes 0.836 0.000 (3.56)*** (3.79)*** )(3.36)*** )(1.95)* (2.32)** )(3.55)*** )(8.07)*** (0.24) No Yes 0.825 0.000
0.477 0.127 )0.015 0.028 0.210 )0.086 )0.150 )0.009
0.055 0.196 )0.020 )0.062 0.271 )0.103 )0.141 0.002
The dependent variable in all above specications is the standardized leverage ratio. All variables are measured as dened in Table 2 and have been standardized. All standard errors are calculated using White heteroscedasticity robust standard error. ***, **, *, represent coecient is signicant at the 1, 5 and 10 per cent levels, respectively. Using the actual rather than the standardized observations yields qualitatively similar results. The results obtained from the actual observations are available from the author upon request. NPPE, net property, plant and equipment.
that the value they are missing as a result of their aversion to debt outweighs the costs of using more debt, these managers start increasing rm leverage, possibly towards their aordable level, to capture some of the value missed. In contrast, in Panel B, we observe that the alignmententrenchment eects prevail for strong governance rms where leverage exhibits a positive concave function of the incentive package. These results support our earlier argument that managers who are subject to strong monitoring levels have a low discretion over rm aairs. Subsequently, these managers would initially behave in the interests
24
of rm shareholders to avoid being replaced by the board of directors until the incentive package oered to them becomes signicant; at this point, these managers become entrenched and start reducing rm leverage towards their aordable level that would not expose their incentives and the rm to high levels of risk and/or restrict their actions. The results reported in Panel B are now in line with the ndings of those who used a small sample of large rms and found evidence in support of the alignmententrenchment eects. That the two managers are found to behave dierently under the two governance regimes implies that the two managers have a specic target leverage ratio they can aord at most less than the one preferred by rm shareholders. The implication of working under dierent governance regimes is that the two managers might have a wide dierence in their leverage choices especially within intermediate incentive levels, but this need not be the case at low or high incentive levels. This is because both managers are, by assumption, risk-averse and being so means that both managers should have similar target leverage ratio. Therefore, the two managers may initially set their leverage ratio close to their target when oered low incentives, possibly to magnify the return on these low incentives. Then, as their incentives are further increased, the managers who work under weak governance regimes start using less debt to preserve the value of their incentives and reduce the other costs associated with debt up to a certain incentive level when the value they are missing as a result of their aversion to debt outweighs the costs of using more debt; at this point, these managers start increasing rm leverage towards their aordable target to capture some of the value missed. And, for the managers who work under strong governance regimes, the initial increase in leverage could be a natural response to the strong monitoring level they are subject to, that is, to please the board of directors and avoid being replaced, but once their incentives become signicant, these managers become entrenched and start reducing rm leverage towards their aordable target. Because both managers are risk-averse by assumption and are likely to have the same target leverage ratio, both may end up having almost the same leverage ratio at high incentive levels. Indeed, upon looking at Panel B of Table 7, we nd evidence in support of this argument. There, we observe that both managers have almost similar leverage ratio for incentives <5 per cent (the average leverage ratio is around 25 per cent). Then, as their incentives are further increased, the two managers have a wide dierence in their leverage choice for incentives oered above 5 per cent. Then, once their incentives exceed 25 per cent, the leverage ratio chosen by the two managers converges to almost similar level (again around 25 per cent). Many researchers have observed that rms, on average, use a leverage ratio far less than the one predicted by theory or preferred by rm shareholders (the average leverage ratio for the current sample is just 23.5 per cent). The usual interpretation for this phenomenon is that rms reserve some borrowing capacity (nancial exibility) to nance future growth opportunities. While this justication might explain why rms in practice underlever their capital structures, our
25
ndings suggest that agency cost theory might also have a role in explaining this phenomenon. Our ndings suggest that managers have their own target leverage ratio they can aord and prefer not to exceed, which seems to be less than that which is optimal for rm shareholders. Figure 1 illustrates these points. The argument that managers have a target leverage ratio makes it necessary to check for the existence of such a target using more formal dynamic approach, which will be the subject of the next subsection. 4.4. Endogeneity and capital structure dynamics In the regression analysis, three estimation techniques were used: OLS, random eects and xed eects. While the use of the xed eects estimator alleviates the possibility of endogeneity and omitted variable bias, it is not robust to endogeneity caused by unobserved heterogeneities that may arise from possible correlations between unobserved rm characteristics and some regressors. Furthermore, there are two regressors that might be endogenous to our models: the incentive package and the governance index. Following Florackis and Ozkan (2009), we will use the GMM estimator proposed by Arellano and Bond (1991) to address the problem of endogeneity. This model has the advantage of controlling for endogeneity caused by unobserved heterogeneities and any endogenous variable while allowing us to examine the dynamic nature of capital structure in practice, that is, whether rms adjust their leverage towards a specic target over time or not. The GMM estimator involves the use of rst-dierence transformation to the dependent variable and the regressors in addition to the use of the lagged dependent variable as one of the regressors. The model also involves the use of
The leverage ratio
The optimal leverage ratio
The leverage function under strong governance regimes
Managers target leverage ratio The leverage function under weak governance regimes
The incentive package

Figure 1 The leverage function under dierent governance regimes.
26
instruments dated (t ) 2) or earlier for the lagged dependent variable and any endogenous regressor. However, the consistency of the GMM estimator rests on the use of valid instruments for the endogenous variables and the absence of second-order or higher autocorrelations in the error terms. Testing the validity of the instruments is performed using the Sargan test under the null that the instruments used are exogenous. Rejecting the null hypothesis means that the instruments used are endogenous and valid. The Wald test will be used to check for the rst- and second-order autocorrelations in the rst-dierence equation under the null that no autocorrelations exist in the residuals of the rst-dierenced equation. Typically, the rst-order autocorrelation is signicant because the lagged dependent variable is used as an explanatory variable. However, the existence of second- and higher-order autocorrelations in the residuals suggests the existence of autocorrelations in levels, which should be controlled for. Table 9 summarizes the results from regressing the rst dierence of leverage on the rst-dierence explanatory variables using the GMM estimator. The models estimated in the table are dynamic and specied as follows: DLeverageit b1 DLeverageit1
n X k2
bk DXitk Duit
where (Xk) is a vector of the explanatory variables. In model (1), we report the dynamic model without the incentive package and the governance index; the coecient of the lagged dependent variable is signicant, suggesting that leverage does vary over time and that rms do have a specic target leverage ratio. In model (2), we introduce the incentive package and the governance index and treat both of them as endogenous; the entrenchmentalignment eects continue to prevail and leverage still increases in governance. Moreover, the results reported in the table also show that asset tangibility, rm size and protability have important inuence on rm capital structures; indeed, many researchers have found these variables among the most inuential variables describing leverage. The statistics reported for each model indicate that our specications are valid. The p-value that tests the joint signicance of all estimates is <5 per cent for both models. The rst-order autocorrelation as tested using the (m1) test is signicant, but the second-order autocorrelation as measured by the (m2) test is not. Finally, the p-value for the Sargan test for each model suggests that the instruments used in these models are valid. 5. Conclusion This paper analyses the eect of executive incentives and internal governance on capital structure. Using a large sample of non-nancial US-listed rms over the period 19992005, it is found that managers have dierent attitudes towards leverage under dierent incentive schemes; leverage initially decreases in bonuses

Table 9 Dynamic regressions of leverage on the incentive package and internal governance Model (1) Variable D Leverage(t ) 1) D The incentive package D (The incentive package)2 D The governance index D NPPE D Ln(Assets) D Tobins Q D Protability D Operating risk Year dummies Joint p-value m1 test m2 test Sargan test Sargan p-value Coecient 0.680 0.140 0.062 )0.004 )0.284 0.003 Z-statistic (10.81)*** (2.11)** (3.55)*** )(1.30) )(9.85)*** (1.09) Yes 0.000 0.000 0.142 16.92 0.090 Model (2) Coecient 0.632 )0.145 0.138 0.006 0.111 0.056 )0.003 )0.276 0.003
27
Z-statistic (10.29)*** )(2.50)** (2.54)** (2.09)** (2.03)** (3.55)*** )(1.19) )(9.86)*** (1.22) Yes 0.000 0.000 0.192 36.84 0.116
The dependent variable in all above specication is the change in leverage estimated using the GMM estimator in rst dierences. All variables are calculated as dened in Table 2. The regression pertains to our sample of 1662 rms representing 8400 rm-year observations. For the estimation, lagged levels dated (t ) 2) and earlier were used as instruments to the lagged dependent variable, the incentive package and the governance index. m1 and m2 are tests for the rst- and second-order autocorrelations in the rst-dierence residuals under the null of no autocorrelation in the rst- and second-order residuals, respectively. The Sargan test is a test of the validity of the instruments used under the null that the instruments used are exogenous. Rejecting the null hypothesis suggests that the instruments used are endogenous and valid. All standard errors are calculated using heteroscedasticity robust standard error. ***, **, *, represent coecient is signicant at the 1, 5 and 10 per cent levels, respectively. NPPE, net property, plant and equipment.
and stock incentives and then increases in these incentives after a certain incentive level (convex functions), while leverage initially increases in option incentives and then decreases after a certain option incentive level (concave function). These ndings imply that managers are initially averse to debt when oered bonuses and stock incentives up to a certain incentive level when leverage starts increasing in these incentives, suggesting the existence of the entrenchmentalignment eects under these incentive schemes. The relation between leverage and option incentives suggests that managers are initially risk-takers when oered option incentives up to a certain option incentive level when leverage starts decreasing, which may give support for the alignmententrenchment claim. When all of these incentive schemes are combined together into a single incentive package, the entrenchmentalignment eects prevail. It is also found that leverage increases in governance and managers behave dierently under dierent governance regimes such that the entrenchment
28
alignment eects prevail for weak governance rms, while the alignment entrenchment eects prevail for strong governance rms. However, at high incentives, both managers seem to converge their leverage choice towards a specic level, implying that managers have their own target leverage ratio less than the one predicted by theory or preferred by shareholders, which could explain why rms in practice underlever their capital structures. References
Aggarwal, R. K., and A. A. Samwick, 2006, Empire-builders and shirkers: investment, rm performance, and managerial incentives, Journal of Corporate Finance 12, 489515. Ammann, M., D. Oesch, and M. M. Schmid, 2011, Corporate governance and rm value: international evidence, Journal of Empirical Finance 18, 3655. Arellano, M., and S. Bond, 1991, Some tests of specication for panel data: Monte Carlo evidence and an application to employment equations, Review of Economic Studies 58, 277297. Barclay, M. J., C. W. Smith, and E. Morellec, 2006, On the debt capacity of growth options, Journal of Business 79, 3759. Berger, P., E. Ofek, and D. Yermack, 1997, Managerial entrenchment and capital structure decisions, Journal of Finance 52, 14111437. Black, B. S., J. Hasung, and K. Woochan, 2006, Does corporate governance predict rms market values? Evidence from Korea, Journal of Law, Economics, and Organization 22, 366413. Brailsford, T., O. Barry, and S. Pua, 2002, On the relationship between ownership structure and capital structure, Accounting and Finance 42, 126. Brickley, J. A., J. L. Coles, and G. Jarrell, 1997, Leadership structure: separating the CEO and chairman of the board, Journal of Corporate Finance 3, 189220. Brown, L. D., and M. L. Caylor, 2006, Corporate governance and rm valuation, Journal of Accounting and Public Policy 25, 409434. Byrd, J., and K. Hickman, 1992, Do outside directors monitor managers? Evidence from tender oer bids, Journal of Financial Economic 32, 195221. Coles, J. L., N. D. Daniel, and L. Naveen, 2006, Managerial incentives and risk-taking, Journal of Financial Economics 79, 431468. Coles, J. L., N. D. Daniel, and L. Naveen, 2008, Boards: does one size t all?, Journal of Financial Economics 87, 329356. Cremers, M., V. Nair, and C. Wei, 2004, The congruence of shareholder and bondholder governance, NYU Law and Economics Research Paper, Vol. 04-007 (New York University, New York). Donaldson, L., and J. H. Davis, 1991, Stewardship theory or agency theory: CEO governance and shareholder returns, Australian Journal of Management 16, 4964. Duan, J.-C., and J. Wei, 2005, Executive stock options and incentive eects due to systematic risk, Journal of Banking and Finance 29, 11851211. Faleye, O., 2007, Does one hat t all? The case of corporate leadership structure, Journal of Management and Governance 11, 239259. Fama, E. F., 1980, Agency problems and the theory of the rm, Journal of Political Economy 88, 288307. Fernandes, N. G., 2005, Board compensation and rm performance: the role of Independent board members, ECGI Finance Working Paper No. 104/2005. Florackis, C., and A. Ozkan, 2009, Managerial incentives and corporate leverage: evidence from the United Kingdom, Accounting and Finance 49, 531553. 2011 The Author Accounting and Finance 2011 AFAANZ
29
Friend, K., and K. Lang, 1988, An empirical test of the impact of managerial self interest on corporate capital structure, Journal of Finance 43, 271281. Gompers, P., J. Ishii, and A. Metrick, 2003, Corporate governance and equity prices, Quarterly Journal of Economics 118, 107155. Graham, J., 2000, How big are the tax benets of debt?, Journal of Finance 55, 19011941. Graham, J., and C. Harvey, 2001, The theory and practice of corporate nance: evidence from the eld, Journal of Financial Economics 60, 187243. Hamada, R. S., 1972, The eect of the rms capital structure on the systematic risk of common stocks, The Journal of Finance 27, 435452. Harris, M., and A. Raviv, 1988, Corporate control contests and capital structure, Journal of Financial Economics 20, 5586. Jensen, M., 1986, Agency costs of free cash ow, corporate nance and takeovers, American Economic Review 76, 323339. Jensen, M., and W. Meckling, 1976, Theory of rm: managerial behaviour, agency costs and capital structure, Journal of Financial Economics 3, 305360. Jiraporn, P., and K. Gleason, 2007, Capital structure, shareholder rights, and corporate governance, Journal of Financial Research 30, 2133. John, K., and L. P. Litov, 2010, Corporate governance and nancing policy: new evidence, AFA 2006 Boston Meetings and CELS 2009; 4th Annual Conference on Empirical Legal Studies Paper. Available at: http://ssrn.com/abstract=637341. Kayhan, A., 2008, Managerial discretion and the capital structure dynamics, Working paper (Louisiana State University, Baton Rouge, LA). Kim, W., and E. Sorensen, 1986, Evidence on the impact of agency costs on corporate debt policy, Journal of Financial and Quantitative Analysis 21, 131144. Klock, M. S., S. A. Mansi, and W. F. Maxwell, 2005, Does corporate governance matter to bondholders?, Journal of Financial and Quantitative Analysis 40, 693719. Larcker, D. F., S. A. Richardson, and G. Tuna, 2007, Corporate governance, accounting outcomes and organizational performance, The Accounting Review 82, 9631008. Linck, J. S., J. M. Netter, and T. Yang, 2008, A large sample study on board changes and determinants of board structure, Journal of Financial Economics 87, 308 328. Maxwell, W. F., and C. P. Stephens, 2003, The wealth eects of repurchases on bondholders, Journal of Finance 58, 895919. McConnell, J. J., and H. Servaes, 1990, Additional evidence on equity ownership and corporate value, Journal of Financial Economics 27, 595612. Murphy, K. J., 1999, Executive compensation. In: Ashenfelter, O., Card, D. (Eds.), Handbook of Labor Economic 3, 24852563. Myers, S., 1977, Determinants of corporate borrowing, Journal of Financial Economics 5, 147175. Myers, S., 1984, The capital structure puzzle, Journal of Finance 39, 799819. Pi, L., and S. G. Timme, 1993, Corporate control and bank eciency, Journal of Banking and Finance 17, 515530. Stulz, R., 1988, Managerial control of voting rights: nancing policies and the market for corporate control, Journal of Financial Economics 20, 2554. Stulz, R., 1990, Managerial discretion and optimal nancing policies, Journal of Financial Economics 26, 328. Tian, Y. S., 2004, Too much of a good incentive? The case of executive stock options, Journal of Banking and Finance 28, 12251245. Welch, I., 2004, Capital structure and stock returns, Journal of Political Economy 112, 106131.
30
Williams, M. A., and R. P. Rao, 2006, CEO stock options and equity risk incentives, Journal of Business Finance and Accounting 33, 2644. Yermack, D., 1996, Higher market valuation of companies with a small board of directors, Journal of Financial Economics 40, 185212. Zajac, E. J., and J. D. Westphal, 1994, The costs and benets of managerial incentives and monitoring in large U.S. corporations: when is more not better?, Strategic Management Journal 15, 121142. Zwiebel, J., 1996, Dynamic capital structure under managerial entrenchment, American Economic Review 86, 11971215.

Leverage, Executive Incentives and Corporate Governance: Mahmoud Agha

Transféré par

Informations du document

Titre original

Copyright

Formats disponibles

Partager ce document

Partager ou intégrer le document

Options de partage

Avez-vous trouvé ce document utile ?

Ce contenu est-il inapproprié ?

Droits d'auteur :

Formats disponibles

Leverage, Executive Incentives and Corporate Governance: Mahmoud Agha

Transféré par

Droits d'auteur :

Formats disponibles

Accounting and Finance 53 (2013) 130

Leverage, executive incentives and corporate governance

M. Agha/Accounting and Finance 53 (2013) 130

JEL classication: G3, G32 doi: 10.1111/j.1467-629X.2011.00450.x

M. Agha/Accounting and Finance 53 (2013) 130

M. Agha/Accounting and Finance 53 (2013) 130

M. Agha/Accounting and Finance 53 (2013) 130

M. Agha/Accounting and Finance 53 (2013) 130

M. Agha/Accounting and Finance 53 (2013) 130

M. Agha/Accounting and Finance 53 (2013) 130

M. Agha/Accounting and Finance 53 (2013) 130

M. Agha/Accounting and Finance 53 (2013) 130

M. Agha/Accounting and Finance 53 (2013) 130

M. Agha/Accounting and Finance 53 (2013) 130

M. Agha/Accounting and Finance 53 (2013) 130

0.017 0.114 )0.089

0.018 0.021 0.045 0.045

)0.136 0.092 0.062 0.082

0.548 0.555 0.016 0.033 )0.030

0.039 )0.006 )0.054

2011 The Author Accounting and Finance 2011 AFAANZ

M. Agha/Accounting and Finance 53 (2013) 130

Weight 0.420 )0.019

24. Nomination committee members 25. Chairperson of nomination committee

M. Agha/Accounting and Finance 53 (2013) 130

2011 The Author Accounting and Finance 2011 AFAANZ

2011 The Author Accounting and Finance 2011 AFAANZ

1.00 0.01 0.22 )0.05 )0.11 )0.22 0.00 )0.10 0.01

M. Agha/Accounting and Finance 53 (2013) 130

M. Agha/Accounting and Finance 53 (2013) 130

M. Agha/Accounting and Finance 53 (2013) 130

M. Agha/Accounting and Finance 53 (2013) 130

2011 The Author Accounting and Finance 2011 AFAANZ

M. Agha/Accounting and Finance 53 (2013) 130

M. Agha/Accounting and Finance 53 (2013) 130

Standard 25% 75% deviation Minimum percentile Median percentile Maximum

M. Agha/Accounting and Finance 53 (2013) 130

M. Agha/Accounting and Finance 53 (2013) 130

)0.197 )0.090 0.015 0.272 0.232 )0.022 )0.139 )0.018

0.000 )0.082 0.014 0.265 0.344 )0.013 )0.113 )0.020

0.477 0.127 )0.015 0.028 0.210 )0.086 )0.150 )0.009

0.055 0.196 )0.020 )0.062 0.271 )0.103 )0.141 0.002

M. Agha/Accounting and Finance 53 (2013) 130

M. Agha/Accounting and Finance 53 (2013) 130

The leverage ratio

The optimal leverage ratio

The leverage function under strong governance regimes

The incentive package

2011 The Author Accounting and Finance 2011 AFAANZ

M. Agha/Accounting and Finance 53 (2013) 130

M. Agha/Accounting and Finance 53 (2013) 130

M. Agha/Accounting and Finance 53 (2013) 130

M. Agha/Accounting and Finance 53 (2013) 130

2011 The Author Accounting and Finance 2011 AFAANZ

M. Agha/Accounting and Finance 53 (2013) 130

2011 The Author Accounting and Finance 2011 AFAANZ

Vous aimerez peut-être aussi