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Corporate Governance: An International Review, 2009, 17(6): 694–709

Governance Mechanisms and Firm Value:


The Impact of Ownership Concentration
and Dividends
Lukas Y. Setia-Atmaja*

ABSTRACT

Manuscript Type: Empirical


Research Question/Issue: This study examines whether ownership concentration affects board and audit committee
independence, and whether the impact of board and audit committee independence on firm value is moderated by
ownership concentration and dividend payouts.
Research Findings/Insights: Using panel data on a sample of Australian publicly listed firms over the period 2000–2005
(1,530 firm-year observations), the study finds that ownership concentration has a negative impact on board independence,
but no impact on audit committee independence. Results also suggest that board independence enhances firm value and that
performance impact of board independence is stronger in closely-held firms and/or firms having low dividend payouts. A
marginally positive impact of audit committee independence, especially among closely-held firms, is also found.
Theoretical/Academic Implications: This study suggests that the impact of governance mechanisms is moderated by
companies’ ownership structure and dividend policies. It extends research on the effectiveness of governance mechanisms
by distinguishing two types of agency problems and using a simultaneous equations model. The findings underline the
important governance role that independent boards and audit committee can play in a country that has high ownership
concentration and high levels of private benefits of control.
Practitioner/Policy Implications: The results of this study strengthen the idea that independent directors can also play a key
role in the governance of closely-held firms. As such, for investors, as far as agency costs are concerned, investments in
closely-held firms that have a higher proportion of independent directors on the board and audit committee are sensible.
Closely-held firms should be aware of the investor’s need for more independent directors, especially when dividends
are low.

Keywords: Corporate Governance, Ownership Concentration, Dividend, Agency Theory

INTRODUCTION committee may assist the board of directors by providing


oversight on financial reporting and accounting controls that

B oards of directors can play a significant role in control-


ling agency problems, which is the heart of corporate
governance, particularly in monitoring executive manage-
could alleviate information asymmetry between insiders
and outsiders (Klein, 1998).
The impact of many key governance mechanisms depends
ment (Fama & Jensen, 1983). The normative literature considerably on companies’ ownership structure (Bebchuk
suggests that a board can monitor its firm more closely and & Hamdani, 2009). It is widely believed that ownership con-
take appropriate governance actions if it has enough inde- centration may have a significant impact on corporate gov-
pendent directors to ensure effective monitoring (Jensen, ernance by mitigating or exacerbating agency problems. For
1993). The literature also underlines the critical role that example, agency problems can be reduced by the presence
audit committee can play in corporate governance. Audit of blockholders with greater incentive and more power to
monitor management (Shleifer & Vishny, 1986). Neverthe-
less, minority shareholders’ wealth expropriation can
*Address for correspondence: Prasetiya Mulya Business School, Finance, RA Kartini,
Cilandak Barat, Jakarta, Indonesia, 12430, Jakarta, 12430, Indonesia. E-mail: lukas@ also be prevalent in closely-held firms (Shleifer & Vishny,
pmbs.ac.id 1997). The literature (e.g., Anderson & Reeb, 2004; Raheja,

© 2009 Blackwell Publishing Ltd


doi:10.1111/j.1467-8683.2009.00768.x
GOVERNANCE MECHANISMS AND FIRM VALUE 695

2005; Westphal, 1998) suggests that independent directors This study finds that ownership concentration has a sig-
can play an important role in protecting the expropriation of nificant negative impact on board independence. There are
minority shareholders by controlling shareholders among two possible explanations for these results. Controlling
closely-held firms. shareholders may prefer less independent boards to facili-
The literature also suggests that dividends can alleviate tate acts at their discretion (the rent extraction argument).
agency problems. Dividends serve to reduce agency prob- Alternatively, the presence of blockholders with powerful
lems between owners (or large controlling shareholders) incentives to monitor managers substitutes the monitoring
and managers (or minority shareholders) by reducing the role played by independent directors on the board (the sub-
amount of free cash flow that might otherwise be expropri- stitution argument). Indeed, this study finds that closely-
ated (Jensen, 1986; La Porta, Lopez-de-Silanes, Shleifer, & held firms underperform widely-held firms, which provides
Vishny, 2000) and forcing insiders to raise funds in the support for the rent extraction argument. This study,
capital markets more frequently, thus subjecting themselves however, finds little evidence that ownership concentration
to outside scrutiny (Easterbrook, 1984; Rozeff, 1982). Raheja affects audit committee independence.
(2005) suggests board and audit committee independence This study also finds that board independence enhances
should increase as private benefits to insiders (agency prob- firm value, especially in closely-held firms that have lower
lems) increase. As such, dividends and ownership concen- dividend payouts. A marginally positive relationship
tration should moderate the performance effect of the board between firm value and audit committee independence is
of directors and audit committee. also found, especially among closely-held firms. Given that
This paper attempts to deliver incremental insights on the agency problems between controlling and minority
corporate governance by addressing five main research shareholders in closely-held firms can be more severe than
questions: (1) Does ownership concentration affect the deci- those between owners and managers in widely-held firms
sions on board independence and audit committee indepen- (Villalonga & Amit, 2006) and that blockholders may exac-
dence?; (2) Do closely-held firms with a less independent erbate the agency problems by not paying or only paying low
board or audit committee underperform those with a more dividends (La Porta et al., 2000), the results highlight the key
independent board or audit committee?; (3) Does the impact role that independent directors on the board and audit com-
of board or audit committee independence on firm perfor- mittee can play in protecting minority shareholders from
mance differ between closely-held and widely-held firms?; expropriation by controlling shareholders, and support for
(4) Does the impact of board or audit committee indepen- the notion that board or audit committee independence
dence on firm performance differ between low and high should increase as private benefits to insiders increase
dividend payout firms?; and (5) Does the impact of board or (Raheja, 2005). The results could serve to justify initiatives to
audit committee independence on firm performance differ encourage board independence and audit committee inde-
between closely-held firms having low dividend payouts pendence in a country where private benefits of control are
and other firms? relatively high.
This paper utilizes panel data on a sample of Australian This study contributes to the literature in two important
publicly listed firms over the period 2000–2005. There are ways. First, it examines the moderating effect of ownership
two key motivations for undertaking research on the structure (i.e., closely-held versus widely-held firms) and
relationships among internal governance mechanisms, dividends on the impact of corporate governance mecha-
ownership, dividends, and firm value in Australia. First, nisms (i.e., independent directors on the board of directors
although Australia has strong legal shareholder protection and audit committee). It therefore sheds light on the effec-
(La Porta, Lopez-de-Silanes, & Shleifer, 1999), the Austra- tiveness of internal governance mechanisms in controlling
lian market is characterized by larger private benefits of agency problems under the two different types of owner-
control (Lamba & Stapledon, 2001; Nenova, 2003)1 and a ship structures and dividend policies. Second, the study
higher concentration of ownership (La Porta et al., 1999) adds to the literature by examining the impact of corporate
compared to other strong law country markets. A cross- governance mechanisms using simultaneous equation ap-
country study by Dahya, Dimitrov, and McConnell (2008) proach. It therefore acknowledges that corporate governance
suggests that in countries with weak legal shareholder pro- decisions are endogenously determined in response to
tections a dominant shareholder could offset the value dis- agency problems inherent in organizations (Agrawal &
count associated with weak legal shareholder protection by Knoeber, 1996; Hermalin & Weisbach, 2003).
appointing an independent board. This research therefore The rest of the paper is structured as follows. The next
offers an opportunity to further examine the key role own- section discusses related literature and develops hypoth-
ership concentration can play in determining a firm’s eses. Data and methodology are discussed, after which the
internal governance mechanisms and their effectiveness results are analyzed and discussed, and conclusions drawn.
especially in the presence of strong legal protection and
high private benefits of control. Second, after the introduc-
tion of the dividend imputation tax system in 1987, the
incentives for Australian firms to pay dividends have
LITERATURE REVIEW AND
increased (Cannavan, Finn, & Gray, 2004).2 This makes it HYPOTHESIS DEVELOPMENT
possible to test the moderation effect of dividends on the
performance impact of governance mechanisms in environ-
Internal Governance Mechanisms and Firm Value
ments where tax is supposedly the main reason for paying Over the last three decades, the idea of independent direc-
dividends. tors has become important, particularly with stock market

© 2009 Blackwell Publishing Ltd Volume 17 Number 6 November 2009


696 CORPORATE GOVERNANCE

regulators and many corporate governance advocates around the appointment of “accounting” financial expert-
(Farrar, 2001). Indeed, financial economists generally sug- independent directors to the audit committee. More
gest that the representation of independent directors on recently, Hsu (2008) and Chan and Li (2008) report that
boards increases the effectiveness of boards in monitoring firm performance is positively associated with audit com-
managers and exercising control on behalf of shareholders mittee financial expertise.
(e.g., Fama & Jensen, 1983; Weisbach, 1988). The most widely Several studies have also provided evidence on the gov-
discussed question regarding board composition is there- ernance role of an audit committee in Australia. For
fore whether having more independent directors on the example, Koh, Laplante, and Tong (2007) examine the twin
board enhances firm performance. A number of studies have roles of accountability and value enhancement of corporate
been conducted in the US on this issue. For example, a study governance in the context of financial reporting. The authors
by Baysinger and Butler (1985) found that the proportion find that independent active audit committees and indepen-
of independent directors was positively correlated with dent boards are important governance mechanisms and
accounting measures of performance. In contrast, Bhagat value enhancing. Cotter and Silvester (2003), however, find
and Black (2001), Hermalin and Weisbach (1991), and Klein no support for a positive relationship between audit com-
(1998) have found that a higher percentage of independent mittee independence and firm value. Meanwhile, Psaros and
directors on the board does not have a significant impact Seamer (2004) report that the audit committee independence
on accounting measures of firm performance. A study by of Australia’s largest 250 companies appears to have dete-
Agrawal and Knoeber (1996) show that the proportion of riorated between 1998 and 2001.
independent directors has a negative relationship to market The positive impact of an audit committee on firm value
measures of performance. may come from the role of the audit committee in constrain-
Conflicting evidence on a direct relationship between ing earnings management. A number of studies provide
board composition and firm performance has also been support for this notion. For example, Davidson, Goodwin-
reported from Australia. Lawrence and Stapledon (1999) Stewart, and Kent (2005) show that a majority of non-
found that independent directors do not appear to have executive directors on the audit committee is associated with
added value to firms in the period 1985–1995. A similar a lower likelihood of earnings management. Hsu and Koh
result is reported by Cotter and Silvester (2003), who (2005) find that a long-term oriented institution can act as a
examine the largest 200 companies in 1997. In contrast, corporate governance mechanism to mitigate aggressive
Bonn, Yoshikawa, and Phan (2004) reported that a higher earnings management, while Chan, Faff, Mather, and
proportion of independent directors on the board leads to Ramsay (2007) documented a positive relationship between
stronger firm performance. the likelihood and frequency of firms issuing management
Why are the findings on the relationship between board earnings forecasts and audit committee independence.
composition and firm performance inconclusive? One pos- Stewart and Munro (2007) show that the existence of an
sible explanation is that most of the corporate governance audit committee is associated with a reduction in perceived
variables are endogenous. For example, firm performance is audit risk. Finally, Krishnamoorthy, Wright, and Cohen
both a result of the decisions made by previous directors (2002) and Chen, Carson, and Simnett (2007) suggest that
and, itself a factor that potentially affects the choice of audit committee plays an important role in enhancing finan-
subsequent directors. Studies of boards often neglect this cial reporting quality.
issue and therefore produce confusing results (Hermalin &
Weisbach, 2003). Independent Directors, Audit Committee and
An important role of boards is to establish sub-committees
to deal with specific matters. One such committee is the
Ownership Concentration
audit committee. The audit committee’s principal function is The relation between ownership concentration and boards
to review the firm’s financial statement, audit process, and of directors can be explained by agency theory. Jensen and
internal accounting controls. This helps mitigate the agency Meckling (1976) suggest that agency problems will be lower
problem by providing unbiased accounting information, when the interests of agents (i.e., managers) and principals
thus reducing the information asymmetry between insiders (i.e., shareholders) are more aligned through higher mana-
and outsiders. Principle 4 of the 2003 ASX Best Practices gerial share ownership. Agency problems between owners
Recommendations3 includes a recommendation that all and managers relate to managerial consumption of per-
members of the audit committee should be non-executive quisites, shirking, misallocation of company funds, and
directors and that the committee should comprise a majority entrenchment (Shleifer & Vishny, 1997). The presence of
of independent directors as well as is chaired by an inde- blockholders may also enhance corporate governance. Since
pendent director who is not chairperson of the board. Com- blockholders hold a significant percentage of firm equity,
panies within the S&P/ASX All Ordinaries Index must they have an incentive to collect information and monitor
comply with this recommendation. management (Shleifer & Vishny, 1986) as well as have
The empirical evidence on the relationship between enough voting power to force management to act in the
audit committee composition and firm value, however, is interest of shareholders (La Porta et al., 1999). Therefore, the
also inconclusive. A number of studies (e.g., Hsu, 2008; classic owner-manager conflict described by Berle and
Klein, 1998; Reddy, Locke, Scrimgeour, & Gunasekarage, Means (1932) should be lower in closely-held firms than in
2008) find that audit committee independence has insignifi- widely-held firms.
cant impact on firm value. In contrast, DeFond, Hann, The literature, however, suggests that combining owner-
and Hu (2005) find significant positive abnormal returns ship and control allows concentrated shareholders to

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GOVERNANCE MECHANISMS AND FIRM VALUE 697

exchange profits for private rents (e.g., Bebchuk, 1999; board and audit committee independence (Research Ques-
Bebchuk & Kahan, 1990:1090; Faccio, Lang, & Young, 2001; tion 1) is developed:
Fama & Jensen, 1983; Shleifer & Vishny, 1997) define
Hypothesis 1a. Board independence is significantly lower
private benefits as “any value captured by those controlling
among closely-held than widely-held firms in Australia.
the company after the control contest and not shared
among shareholders at large.” For example, the opportu- Hypothesis 1b. Audit committee independence is significantly
nity to engage in self-dealing and in taking corporate lower among closely-held than widely-held firms in Australia.
opportunities is regarded as private benefits of control.
Since ownership concentration can influence board and
Furthermore, Shleifer and Vishny (1997) and La Porta et al.
audit committee independence, it can be argued that own-
(2000) suggest that minority shareholder expropriation
ership concentration may moderate the role of board and
relates to insiders using the firm’s profits to their benefit
audit committee independence in corporate governance.
rather than returning them to other shareholders. For
Studies that examine the monitoring role of independent
example, insiders can simply steal or sell assets in the firms
directors in firms with different ownership provide incon-
they control to another firm they own at below market
clusive evidence. For instance, Anderson and Reeb (2004)
prices. They can also divert corporate opportunities from
find that among large US corporations, family firms outper-
the firm, appoint unqualified family members in manage-
formed non-family firms only when family firms have a rela-
rial positions, or overpay executives.
tively strong board (i.e., have more independent directors on
As such, ownership concentration can either mitigate or
the board). More recently, Dahya et al. (2008) study the rela-
exacerbate agency problems and consequently may affect
tionship between firm value and the proportion of indepen-
the composition and effectiveness of the internal gover-
dent directors in firms with a dominant shareholder across
nance mechanisms. For example, to facilitate their opportu-
22 countries. They found a positive relationship, especially
nistic behavior large controlling shareholders may prefer
in countries with weak legal shareholder protections, which
boards and audit committees that have fewer independent
suggests that a dominant shareholder could offset the value
directors.
discount associated with weak legal shareholder protection
Agency theorists also suggest independent directors can
by appointing an independent board.
serve to protect minority shareholders against expropria-
How can independent directors be an effective gover-
tion by large shareholders. Raheja (2005) hypothesizes that
nance device in the presence of a dominant shareholder
the optimal number of independent directors on the board
such as families? Dahya et al. (2008) argue that although the
increases as the private benefits to insiders increase.
dominant shareholders can remove independent directors
Indeed, Westphal (1998) suggests that since governance
just as easily they appoint them, they should consider the
mechanisms in closely-held firms are limited, minority
costs of replacement of independent directors. The authors
shareholders potentially rely on their boards and their
also suggest that independent directors have an incentive
committees to limit the controlling shareholder’s oppor-
to monitor a dominant shareholder as long as a market
tunism. Meanwhile, Anderson and Reeb (2004) argue that
for independent directors occurs (Fama & Jensen, 1983)
interests of minority shareholders are best protected when
and that independent directors can drive their power to
independent directors have greater power relative to
monitor a dominant shareholder legally, contractually, or
controlling blockholders. An agency theory perspective
implicitly.
thereby suggests that controlling blockholders seeking to
Erickson, Park, Reising, and Shin (2005), however,
extract rent for their private benefits are unlikely to
examine the relation between board composition and firm
assemble boards or audit committees that can limit their
value in the presence of significant ownership concentration
control of firms, implying that a negative relation exists
using publicly traded Canadian firms. They find that greater
between ownership concentration and board and audit
board independence does not have a positive influence on
committee independence.
firm value and that poorly performing firms increase the
Empirical studies show that ownership concentration
proportion of outside directors in subsequent periods.
has a significant impact on board and audit committee
Based on Anderson and Reeb (2004) and Dahya et al.
independence. For example, Anderson and Reeb (2004)
(2008), this study develops the following hypotheses to
report that family blockholders in large US firms prefer to
examine whether closely-held firms with a less independent
limit independent director presence on the board. Kim,
board or audit committee underperform closely held firms
Kitsabunnarat-Chatjuthamard, and Nofsinger (2007) find
with more independent board or audit committee (Research
that ownership concentration and board independence
Question 2):
are negatively related in 14 European countries. Cotter and
Silvester (2003) report that board independence of Austra- Hypothesis 2a. Among Australian closely-held firms, board
lian firms is associated with low management ownership independence is positively related to firm performance.
and an absence of blockholders. Setia-Atmaja, Tanewski,
Hypothesis 2b. Among Australian closely-held firms, audit
and Skully (2009) indicate that family controlled firms have
committee independence is positively related to firm
lower independent boards than non-family firms in Aus-
performance.
tralia. Méndez and Garcia (2007) show the existence of
lower audit committee activity when the ownership struc- In addition, to test whether the impact of board or audit
ture is concentrated in the hands of large shareholders. committee independence on firm performance differs
Based on this empirical evidence, the following hypoth- between closely-held and widely-held firms (Research
eses to answer whether ownership concentration affects Question 3), this study develops the following hypotheses:

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698 CORPORATE GOVERNANCE

Hypothesis 3a. The impact of board independence on firm per- From previous discussion, it can be argued that both own-
formance is stronger in closely-held than widely-held firms. ership concentration and dividends may determine the level
of agency problems and therefore moderate the governance
Hypothesis 3b. The impact of audit committee independence on
role of independent directors on the board or audit com-
firm performance is stronger in closely-held than widely-held
mittee. The following hypotheses are utilized to answer
firms.
whether the impact of board or audit committee indepen-
dence on firm performance differ between closely-held firm
having low dividend payouts and other firms (Research
The Role of Dividends in Corporate Governance Question 5).
The important role that dividend policy can play in corpo-
Hypothesis 5a. The impact of board independence on firm per-
rate governance is derived basically from the notion that
formance is significantly stronger in closely-held firms having
dividend policy can assist dispersed (or minority) share-
low dividend payouts than other firms.
holders in monitoring managers (or large controlling
shareholders). Dividends serve to reduce agency pro- Hypothesis 5b. The impact of audit committee independence on
blems between owners (or large controlling shareholders) firm performance is significantly stronger in closely-held firms
and managers (or minority shareholders) by reducing the having low dividend payouts than other firms.
amount of free cash flow that might otherwise be expropri-
ated (Jensen, 1986) and forcing insiders to raise funds in the
capital markets more frequently, thus subjecting themselves DATA AND METHODOLOGY
to outside scrutiny (Easterbrook, 1984; Rozeff, 1982).
Sample
Easterbrook (1984) suggests that as all agency problem
controls are costly, substitution among them should be The study examines annual panel data over a six-year period
expected. Alternatively, Agrawal and Knoeber (1996) suggest from 2000 to 2005, an important period in Australia during
that complementary monitoring mechanisms can also exist which it experienced vigorous debate of corporate gover-
to control monitoring and expropriation issues. Heraclous nance with the redevelopment of the Corporate Law Eco-
(2001) notes that firms will adopt a corporate governance nomic Reform Program (Audit Reform and Corporate
structure to cope with the environment, and choose among Disclosure) Bill in 2003 and the introduction of the ASX
alternative governance mechanisms such as boards and divi- Corporate Governance Council Implementation Review
dends. Consistent with these arguments, Setia-Atmaja et al. Groups’ principles on corporate governance in 2004. The
(2009) report that Australian family firms have a different sample comprises firms that were listed on the Australian
governance structure, compared to their non-family counter- Stock Exchange (ASX) as of June 30, 1998 (i.e., 1,214 firms,
parts. In particular, family controlled firms have higher divi- includes data from 1998 and 1999).4 Financial firms (218
dend payouts and have significantly lower levels of board firms) are excluded because their dividend policies are influ-
independence compared to non-family firms. More impor- enced by government regulations (e.g., La Porta et al., 2000).
tantly, the authors find that dividends are more effective The sample is further restricted to firms with annual reports
governance mechanisms in mitigating the expropriation of available for 2000–2005 (i.e., 140 firms were excluded) and
minority shareholders’ wealth by families, whereas inde- those firms that are eligible to pay dividends (i.e., 540 firms
pendent directors are a more effective device to control were excluded).5 This removes the possibility that zero divi-
owner-manager conflict in non-family firms. dends simply result from a firm’s inability to pay dividends.
In addition, La Porta et al. (2000) posit that dividends can The final sample comprises 316 firms or 1,530 firm-year
be used by controlling shareholder in closely-held firms to observations over a six-year period. Table 1 summarizes the
establish a reputation for moderation in expropriating sampling procedure.
minority shareholders’ wealth. Firms that pay higher divi-
dends therefore should have lower agency conflicts than
those paying lower or no dividends. Therefore, it can be
Primary Variable Measures
argued that dividends may moderate the role of board and This study defines board independence as the proportion of
audit committee independence in corporate governance. independent directors on the board (denoted as Board-Ind)
This study hypothesizes that independent directors on the (Anderson & Reeb, 2004), whereas the independence of the
board or audit committee should play a more important audit committee is measured using a dummy variable with
governance role in firms that encounters higher moral a value of one if the percentage of independent director is
hazard problems. The following hypotheses are used to test equal or more than 50 per cent and zero otherwise (denoted
whether the impact of board or audit committee indepen- as AC-Ind) (Chan & Li, 2008). This paper defines indepen-
dence on firm performance differs between higher and dent directors as “individuals whose only business relation-
lower dividend paying firms (Research Question 4): ship to the firm is their directorship” (Anderson & Reeb,
2004:219). The 2003 ASX Corporate Governance Council’s
Hypothesis 4a. The impact of board independence on firm per-
definition of independent directors is not used in this study
formance is stronger in firms having low dividend payouts than
as the sample starts from 2000. Independent directors are
other firms.
identified through the corporate governance and directors’
Hypothesis 4b. The impact of audit committee independence on statements as well as information on related party transac-
firm performance is stronger in firms having low dividend tions in annual reports obtained from Connect – 4 and
payouts than other firms. DatAnalysis databases, and then individually analyzed.

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GOVERNANCE MECHANISMS AND FIRM VALUE 699

TABLE 1 Model
Sample Distribution
The following model is used to test Hypotheses 1a and 1b.
Description Total Board -Ind or AC -Ind = f ( closely -held , dividend , debt ,
firm size , CEO , firm age , free cash flows, lag
Sampling frame 1,214 profitability , growth opportunity , industry , year ) (1)
Excluded
Financial firmsa 218 The dependent variable is Board-Ind or AC-Ind. Closely-held is
Firms with missing Annual Report 140 the key variable of interest in both equations. In addition,
Firms ineligible to pay dividends 540 several control variables are incorporated. Description of all
Total excluded 898 variables in the regression models is presented in Appendix.
Final sample 316 Dividend and debt – Independent directors, debt, and divi-
Delisted firms 14 dends can be used as substitute or complementary gover-
Active firms 302 nance tools (Agrawal & Knoeber, 1996; Easterbrook, 1984;
Jensen, 1986). Firm size – Boone, Fields, Karpoff, and Raheja
a
These include banks (GICS industry group 4010), diversified (2007) argue that board independence increases as firms
financial (GICS industry group 4010), and real estate investment grow in size over time. Lehn, Patro, and Zhao (2004) argue
trust (GICS sub industry group 40401010) firms. that larger firms demand more independent directors
because they encounter more significant agency problems.
CEO – Prior studies (e.g., Hermalin & Weisbach, 1998)
suggest that board independence diminishes as CEO’s influ-
Consistent with prior research (e.g., Faccio et al., 2001; La ence increases. Firm age – Hermalin and Weisbach (1998)
Porta et al., 2000), the dividend payout ratio is measured as indicate that younger firms tend to have a lower proportion
total ordinary dividends divided by net income before of independent directors on the board because the scope and
extraordinary items (denoted as dividend).6 This study uses complexity of these firms are lower than in older firms. Free
the natural logarithm of Tobin’s Q to measure firm value cash flow – Agency theory predicts a positive association
(denoted as Tobin’s Q). The actual definition of Tobin’s Q is between free cash flow and board independence or audit
market value of the firm divided by replacement cost of committee independence. This control variable has been
assets. However, as replacement cost of assets information used by Lehn et al. (2004) and Coles, Daniel, and Naveen
(the denominator) is not available in Australia, this study (2008). Lag (Profitability) – Hermalin and Weisbach (2003)
defines Tobin’s Q as the market value of equity plus the book suggest that prior year profitability may affect the decision
value of all liabilities and preference shares scaled by total on board composition. Growth opportunity – Coles et al.
assets.7 (2008) argue that board independence or audit committee
With regard to ownership concentration, this study cat- independence is negatively related to the firm’s growth,
egorizes firms as closely-held or widely-held based on because independent directors are less effective in monitor-
whether a single shareholder controls at least 20 per cent of ing firms with high growth potential. In addition, a two-way
the equity. Twenty per cent of the voting rights is considered fixed effects model is included. The first fixed effect (indus-
to be sufficient for effective control and is used in prior try dummy variables based on two digit GICS codes) con-
ownership studies (Faccio et al., 2001; La Porta et al., 1999). siders any variation in the dependent variable due to
Twenty per cent is also the control threshold adopted in industry differences, while the second fixed effect (i.e., year
Australia’s takeover regulations.8 Dummy variable Closely- dummy) removes any secular effects among the indepen-
held (equals 1 for closely-held firm and 0 for widely-held dent variables.
firm) is used in the regression and simultaneous analyses. Random effects regressions are used to estimate
Data to construct Closely-held is collected from “substantial Equation 1. A random effects technique is employed to
shareholding” disclosures in companies’ annual reports. address the possibility of a spurious relationship between
Under the Australian Corporations Act 2001, substantial the dependent and independent variables. This may arise
shareholders (i.e., investors who own 5 per cent or larger of due to the exclusion of unmeasured explanatory variables
equity) have to disclose their shareholdings in the company that nevertheless still affect firm behavior. The ownership
annual report. This includes any direct interests (i.e., shares concentration (dummy) variable used in this study tends
registered in her/his name) as well as other relevant interest. to be relatively stable over the study period. This is con-
If a firm has at least one such shareholder controlling 20 per sistent with the notion that controlling shareholders gener-
cent or more equity, it is categorized as a closely-held firm. ally maintain control over their firms for long periods.
For example, in the 2003 annual report of Oakton Limited, Thus, the random effects model is considered more appro-
Paul Holyoake reports a 38.86 per cent shareholding. Thus, priate than fixed effects model and hence is used in this
Oakton Ltd. is categorized as a closely-held company. In study.
contrast, the 2002 annual report of Coles Myer Ltd. reports Prior studies were concerned with endogeneity prob-
two substantial shareholders – Myer Family Investment Pty lems between governance mechanisms and firm value and,
Ltd. and Maple Brown Abbot Ltd. who own 5.03 per cent thus, used a simultaneous equations model in their analysis
and 5 per cent shares, respectively. Coles Myer Ltd is there- (e.g., Agrawal & Knoeber, 1996; Hermalin & Weisbach,
fore classified as a widely-held firm. 1991). In this study, a system of two equations that address

© 2009 Blackwell Publishing Ltd Volume 17 Number 6 November 2009


700 CORPORATE GOVERNANCE

board independence (or audit committee independence) RESULTS


and firm value is developed to test Hypotheses 2a and
2b. Descriptive Statistics and Univariate Test
Descriptive statistics for all variables used in the model are
Board -Ind or AC -Ind = f (Tobin’s Q , dividend , debt , presented in Table 2. On average, firms report a dividend-
firm size , CEO , firm age , free cash flows, to-earnings ratio of 47.3 per cent. The average number of
lag -profitability , growth opportunity , industry , year ) (2a) directors on the board is approximately 6 and around 43.2
per cent of the board members are independent directors
(i.e., 2.8 independent directors on the board). About 58.7 per
Tobin’s Q = f ( Board -Ind or AC -Ind , dividend , debt , cent of audit committeess have a majority of independent
firm size , investment , profitability , lag -profitability , directors. Around 54.9 per cent of firms are closely-held. The
firm age , industry , year ) (2b) average blockholding (i.e., shareholders with more than 5
per cent equity stake) is 44.6 per cent, which suggests that
The endogeneous variables are Board-Ind or AC-Ind and Australian firms have relatively concentrated ownership.
Tobin’s Q. In addition, several control variables are incor- Table 3 reports differences in governance mechanisms,
porated in the Tobin’s Q equation. Dividend and Debt – ownership, and financial characteristics between closely
Dividend and debt helps to alleviate agency problems and and widely-held firms. On average, closely-held firms are
reduces extraction of private benefits of control as manag- smaller, have less investment and lower dividend to earn-
ers are forced to commit operating cash flows towards ings ratio (42.9 per cent versus 52.5 per cent) compared to
fixed charges and are subject to monitoring by external widely-held firms. Closely-held firms also have a signifi-
parties (Easterbrook, 1984; Jensen, 1986). Firm size – Larger cantly lower proportion of independent directors (34.7 per
firms tend to have fewer growth opportunities (Morck, cent versus 53.3 per cent), lower percentage of independent
Shleifer, and Vishny, 1988). Investment – Firms with lower audit committee (49.8 per cent versus 69.6 per cent), higher
investment tend to have fewer growth opportunities percentage of CEO chairman (20.1 per cent versus 9.7 per
(Morck et al., 1988). Profitability and Lag-Profitability – On cent), and smaller boards (5.8 versus 6.3 directors) compared
the basis of simple valuation model, it is reasonable to to widely-held firms.
expect that accounting profitability (measured by return on Table 4 reports various Pearson product moment correla-
assets) is positively related to Tobin’s Q (Beiner, Drobetz, tion coefficients among variables used in this study. It
Schmid, & Zimmermann, 2004). Firm age – Mikkelson, indicates that correlations among independent or firm char-
Partch, & Shah (1997) suggest that the number of years of acteristic variables are generally low. The maximum magni-
operating history is a significant determinant of post-listing tude of the correlation coefficient among the independent
performance. variables is around .46 (i.e., the correlation between firm size
Equations 2a and 2b are then estimated by using three- and board independence). This study also calculates vari-
stage least squares (3SLS) regressions for a sample of closely- ance inflation factors (VIFs) and finds that all independent
held firms. variables in Equations 1, 2a, and 2b have VIFs less than 2 (i.e.,
To test Hypotheses 3a and 3b, this study utilizes the fol- between 1.03 and 1.45). The overall results suggest that mul-
lowing equations: ticollinearity is not a potential threat when conducting mul-
tiple regression analyses.
Board -Ind or AC -Ind = f (Tobin’s Q , closely -held , dividend ,
debt , firm size , CEO , firm age , free cash flows,
The Association between Ownership Concentration
lag -profitability , growth opportunity , industry , year ) (3a)
and Governance Mechanisms
Column 1 of Table 5 reports the random effects estimation of
Tobin’s Q = f ( Board -Ind or AC -Ind , closely -held ,
ownership concentration and board independence (Equa-
closely -held ∗ Board -Ind or closely -held ∗ AC -Ind ,
tion 1). There appears a significant negative impact of own-
dividend , debt , firm size , investment ,
ership concentration on board independence, suggesting
profitability , lag -profitability , firm age , that closely-held firms prefer less independent boards.
industry , year ) (3b) Column 2 of Table 5 presents the random effects logit esti-
mation of ownership concentration and audit committee
To test Hypotheses 4a and 4b, a dummy variable Div-Dum is independence. It shows that the coefficient on AC-Ind is
included in Equation 3b. Div-Dum equals one if firms have negative, but not significant at the conventional level.
low dividend payouts (i.e., dividend payout ratio is below The results therefore provide support for H1a, but not
sample average) and zero otherwise. The interaction variable for H1b. The possible explanation for the board indepen-
between Div-Dum and Board-Ind or AC-Ind is also incorpo- dence result is that controlling shareholders in closely-held
rated. Closely-held and its interaction variables are removed firms tend to avoid independent directors who can limit
from Equation 3b. their opportunistic behavior (Anderson & Reeb, 2004).
Finally, to test Hypotheses 5a and 5b, a three way Alternatively, blockholders and independent directors may
interaction variable: closely-held * Div-Dum * Board-Ind or be substitute mechanisms in controlling agency problems
closely-held * Div-Dum * AC-Ind is included in Equation 3b, (Easterbrook, 1984; Jensen & Meckling, 1976). Therefore
replacing closely-held * Board-Ind or closely-held * AC-Ind. this research further examines the relationship between

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GOVERNANCE MECHANISMS AND FIRM VALUE 701

TABLE 2
Descriptive Statistics

Variable Mean Median Std. Dev. Min. Max.

Board Structure
% of independent directors .43 .42 .24 0 1
% of independent audit .58 – – – –
committeea
Number of directors 6.08 6.00 2.10 3 15
Ownership Structure
% closely-held firmsa .54 – – – –
% of substantial holdings .44 .44 .23 0 1
Dividend Policy
Dividend-to-Earnings .47 .48 .46 0 5.41
Firm Characteristics
Total debt/Assets .22 .22 .17 0 1.448
Total assets 1.15 (A$ billion) 1.12 (A$ billion) 3.59 (A$ billion) .90 (A$ billion) 5.52 (A$ billion)
% of CEO chairmana .15 – – – –
Firm age 34.02 21.00 28.24 3 168
Free cash flow/Assets .03 .02 .15 -1.00 1.10
Capital expenditure/Assets .06 .03 .07 0 .58
Lag (Profitability) .03 .03 .13 -2.11 .75
Growth opportunity .44 .41 1.10 -.86 8.60
Number of observations 1,530 1,530 1,530 1,530 1,530
a
This indicates proportion of firms, rather than the mean proportion for associated variable.

TABLE 3
Univariate Tests

Variable Closely-held firms Widely-held firms t-statistic

Dividends/earnings .42 .52 2.89***


% of independent directors .34 .53 15.03***
% of independent audit committeea .49 .69 7.95***
Number of directors 5.86 6.34 4.39***
% of substantial holdings .58 .27 33.95***
Total debt/Assets .22 .23 1.25
Total assets (A$ billion) .62 1.78 6.35***
% of CEO chairman* .20 .09 5.69***
Firm age 3.19 3.23 .97
Free cash flow/Assets .03 .02 .38
Capital expenditure/Assets .05 .07 5.81***
Lag (Profitability) .03 .04 1.75*
Growth opportunity .40 .49 1.73*
Sample size 840 690
a
This indicates proportion of firms, rather than the mean proportion for associated variable.
***p < .001, **p < .01, *p < .05.

ownership concentration and firm value (Tobin’s Q). Spe- found that closely-held firms significantly underperform
cifically, Equation 2b, which incorporates the closely-held widely-held firms, and hence providing support for the
variable, is estimated using random effects regression. expropriation argument. In addition, board independence
While the result is not presented to preserve space, it is is found to be positively associated with firm size and

© 2009 Blackwell Publishing Ltd Volume 17 Number 6 November 2009


702

Volume 17
Number 6
TABLE 4
Correlations

Tobin’s Board- AC-Ind Closely- Div- Dividend Debt Firm CEO Firm Free Profit- Lag Growth
Q Ind held Dum size Age cash ability (Profit- Opp.
flow ability)

November 2009
Tobin’s Q
Board-Ind .21***
AC-Ind .20*** .76***
Closely-held -.19*** -.36*** -.27***
Div-Dum .22*** -.33*** .34*** -.09***
Dividend .14*** .29*** .27*** -.10*** .62**
Debt -.01 .08** .02 -.03 -.01 -.00
Firm size .19*** .46*** .40*** -.27*** .39*** -.29*** .25***
CEO -.10*** -.20*** -.23*** .14*** -.04 -.05* -.02 -.15***
Firm age -.04** .15*** .16*** .02 .17*** .11*** -.04 .22*** -.07**
Free cash flow .04 .04* .03 -.00 .09*** .06* -.08** .07*** -.18 .06*
Profitability .34*** .04* .04 -.03 .17*** .04* -.20** .02 .03 .01 .19***
Lag(Profitability) .19*** .08*** .07** -.04 .27*** .17*** -.07* .10*** -.00*** .05*** .09*** .26
Growth Opp. .03 -.06** -.05* -.04 -.11*** -.10*** -.06* -.08** -.07*** -.15*** -.00 -.06** -.06**
Investment .19*** .03 .03 -.14*** -.07*** -.10*** -.07* .02 -.02 -.05* .07 .10*** .10*** .03

Notes: This table reports Pearson correlation coefficients for all variables in the regression models.
***p < .001, **p < .01, *p < .05.
CORPORATE GOVERNANCE

© 2009 Blackwell Publishing Ltd


GOVERNANCE MECHANISMS AND FIRM VALUE 703

TABLE 5
Random Effects Estimations of Board Independence, Audit Committee Independence, and Ownership Concentration

Variable Dependent variable: Board-Ind t-statistic Dependent variable: AC-Ind t-statistic

Closely-held -.05*** -4.26 -.57 -1.26


Dividend .03*** 4.02 1.48** 2.45
Debt -.01 -.35 .05 .01
Firm size .04*** 8.32 6.92*** 8.33
CEO -.06*** -3.45 -.39 -.69
Firm age .01 .78 .15 .48
Free cash flow .00 .31 .34 .26
Lag (Profitability) .03 1.36 -.55 -.41
Growth opportunity -.00 -.67 -.45* -1.92
Constant -.34*** -3.54 -127.63*** -8.44
Industry dummy Included Included
Year dummy Included Included
Adjusted R2 .30
Wald Chi-Square 80.54

Notes: This table reports results of (1) random effects regressions of the relationship between board independence and ownership
concentration, and (2) random effects tobit regressions of the relationship between audit committee independence and ownership
concentration for the entire sample of 1,530 firm-year observations. The dependents variable is Board-Ind or AC-Ind. t-statistics are reported
in parentheses.
***p < .001, **p < .01, *p < .05.

dividends and negatively related to the presence of a CEO impact of board independence on performance for widely-
chairman. held firms) is statistically not significant at the conventional
level (i.e., t = -1.16, p > .05). The results suggest that the posi-
Governance Mechanisms and Value of tive relationship between board independence and Tobin’s
Q (Column 1 of Table 7) is derived from closely-held firms.
Closely-held Firms
The results, thereby, underline the important role that inde-
Table 6 reports the 3SLS estimations of board independence pendent directors can play in corporate governance of
or audit committee independence and firm value relation- closely-held firms and provide support for H3a.
ship among closely-held firms. In Column 1, the coefficient Table 8 presents the 3SLS estimations of audit committee
on Board-Ind is positive and significant, suggesting that independence and firm value relationship for the entire
among Australian closely-held firms, more independent sample. In Column 1, the coefficient on AC-Ind is positive
boards lead to higher firm value. The result provides support and marginally significant (i.e., t = 1.78, p < .10), suggesting
for H2a. In Column 2, however, the result fails to provide that independent directors on the audit committee enhance
support for H2b (i.e., the coefficient on AC-Ind is positive, firm value.
but not significant at the conventional level). When ownership concentration is considered, result in
Column 2 of Table 8 suggests that the impact of audit com-
Moderation Effect of Ownership Concentration mittee independence on Tobin’s Q differs between closely-
held and widely-held firms. That is, the coefficient on the
Table 7 presents the 3SLS estimations of board indepen- interaction term between closely-held and AC-Ind (which mea-
dence and firm value relationship for the entire sample. In sures the differential impact of audit committee indepen-
Column 1, the coefficient on Board-Ind is positive and sig- dence on Tobin’s Q for closely-held and widely-held firms) is
nificant at the conventional level, suggesting that indepen- positive and marginally significant (i.e., t = 1.77, p < .10).
dent directors on the board and audit committee enhance Hence, the result provides marginal support for H3b.
firm value.
Are these positive relationships moderated by ownership
concentration? The result presented in Column 2 of Table 7 Moderation Effect of Dividends and
suggest that the impact of board independence on perfor-
mance is stronger for closely-held than widely-held firms.
Ownership Concentration
That is, the coefficient on the interaction term between In Column 1 of Table 9, the 3SLS estimations suggest that the
closely-held and Board-Ind (which measures the differential positive relationship between board independence and
impact of board independence on Tobin’s Q for closely-held Tobin’s Q is moderated by dividends.
and widely-held firms) is positive (i.e., t = 2.10, p < .05). In In particular, the coefficient on the interaction term
contrast, the coefficient on Board-Ind (which measures the between Div-Dum and Board-Ind (which measures the dif-

© 2009 Blackwell Publishing Ltd Volume 17 Number 6 November 2009


704 CORPORATE GOVERNANCE

TABLE 6
3SLS Estimations of Board Independence, Audit Committee Independence, and Tobin’s Q of Closely-held Firms

Variable Dependent variable: Tobin’s Q t-statistic Dependent variable: Tobin’s Q t-statistic

Board-Ind 1.90** 3.56 – –


AC-Ind – – 2.03 1.50
Dividend -.04 -.58 -.03 -.05
Debt .24* 2.12 .22 1.38
Firm size .00 .17 -.34 -1.33
Investment 1.61*** 5.54 1.81** 2.83
Profitability 1.23*** 6.00 1.35*** 4.00
Lag-Profitability .08 .51 -.08 -.34
Firm age -.05† -1.78 -.07† -1.73
Constant -.77*** -3.10 5.56 1.26
Industry dummy Included Included
Year dummy Included Included

Notes: This table reports results of three-stage least squares (3SLS) regressions of the relationship between (1) firm value measured by
Tobin’s Q and board independence, and (2) Tobin’s Q and audit committee independence using a sub-sample of closely-held firms (815
firm year observations). The endogenous variables are Tobin’s Q and Board-Ind or AC-Ind. Only estimation on Tobin’s Q equation is
reported. Estimation on board independence or audit committee independence equation is not reported. t-values are shown in paren-
theses.
***p < .001, **p < .01, *p < .05, †p < .10.

TABLE 7
3SLS Estimations of Board Independence and Tobin’s Q: The Moderation Effect of Ownership Concentration

Variable Dependent variable: Tobin’s Q t-statistic Dependent variable: Tobin’s Q t-statistic

Board-Ind 1.07*** 5.10 -2.23 -1.16


Closely-held - - -1.80† -2.00
Closely-held*Board-Ind - - 3.65* 2.10
Dividend .01 .48 .07 1.09
Debt .13 1.52 .04 .53
Firm size -.00 -.19 .08 1.52
Investment 1.07*** 6.15 1.04*** 5.03
Profitability 1.76*** 12.00 1.31*** 9.10
Lag-Profitability .22* 2.12 .17* 2.05
Firm age -.08*** -4.88 -.01 -.43
Constant -.31 -1.58 -.47 -1.63
Industry dummy Included Included
Year dummy Included Included

Notes: This table reports results of three-stage least squares (3SLS) regressions of the relationship between firm value measured by
Tobin’s Q and board independence (Board-Ind). Moderation effect of ownership concentration is considered. The endogeneous variables
are Tobin’s Q and Board-Ind. Only estimation on Tobin’s Q equation is reported. Estimation on board independence or audit committee
independence equation is not reported. t-values are shown in parentheses.
***p < .001, **p < .01, *p < .05, †p < .10.

ferential impact of board independence on Tobin’s Q for Furthermore, results presented in Column 2 of Table 9
closely-held and widely-held firms) is positive (i.e., t = 3.40, suggests that the positive relationship between board
p < .05). It implies that performance impact of board inde- independence and Tobin’s Q is moderated by both
pendence is stronger among firms having low dividend dividends and ownership concentration. That is, the
payouts than the other firms (i.e., supporting H4a). coefficient on the three way interaction term between

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GOVERNANCE MECHANISMS AND FIRM VALUE 705

TABLE 8
3SLS Estimations of Audit Committee Independence and Tobin’s Q: The Moderation Effect of
Ownership Concentration

Variable Dependent variable: Tobin’s Q t-statistic Dependent variable: Tobin’s Q t-statistic

AC-Ind 4.39† 1.78 .49 .65


Closely-held – – -.07 -.21
Closely-held*AC-Ind – – .09† 1.77
Dividend -.35 -1.09 .06 1.04
Debt -.35 -1.09 .07 .73
Firm size -.74 -1.36 -.03 -.45
Investment 1.49* 2.17 1.16*** 5.58
Profitability 2.31*** 5.77 1.84*** 10.12
Lag-Profitability .13* 2.00 .19* 2.34
Firm age -.07 -.20 -.06*** -3.56
Constant 11.93 1.35 .52 .46
Industry dummy Included Included
Year dummy Included Included

Notes: This table reports results of three-stage least squares (3SLS) regressions of the relationship between firm value measured by
Tobin’s Q and audit committee independence (AC-Ind). Moderation effect of ownership concentration is considered. The endogeneous
variables are Tobin’s Q and AC-Ind. Only estimation on Tobin’s Q equation is reported. Estimation on board independence or audit
committee independence equation is not reported. t-values are shown in parentheses.
***p < .001, **p < .01, *p < .05, †p < .10.

TABLE 9
3SLS Estimations of Board Independence and Tobin’s Q: The Moderation Effect of Dividends and
Ownership Concentration

Variable Dependent variable: Tobin’s Q t-statistic Dependent variable: Tobin’s Q t-statistic

Board-Ind .41 1.03 -.12 -.15


Div-Dum -.65*** -3.53 -.40* -2.49
Div-Dum*Board-Ind 1.24*** 3.40 – –
Closely-held – – -.30† -1.69
Closely-held*Div-Dum*Board-Ind – – 1.16* 2.16
Debt .04 .52 .07 .82
Firm size -.01 -.93 .03 1.07
Investment .86*** 5.44 1.37*** 5.94
Profitability 1.19*** 8.27 1.63*** 10.67
Lag-Profitability .27* 2.51 .22* 2.01
Firm age -.08*** -4.23 -.06* -2.22
Constant .29† 1.81 -.27 1.20
Industry dummy Included Included
Year dummy Included Included

Notes: This table reports results of three-stage least squares (3SLS) regressions of the relationship between firm value measured by
Tobin’s Q and board independence (Board-Ind). Moderation effect of dividends and ownership concentration is considered. The endog-
enous variables are Tobin’s Q and Board-Ind. Only estimation on Tobin’s Q equation is reported. Estimation on board independence
equation is not reported. t-values are shown in parentheses.
***p < .001, **p < .01, *p < .05, †p < .10.

closely-held, Div-Dum, and Board-Ind (which measures the suggests that the performance impact of board indepen-
differential impact of board independence on Tobin’s Q dence is stronger among closely-held firms that pay lower
for closely-held firms having low dividend payouts and dividends than among the other firms (i.e., supporting
the other firms) is positive (i.e., t = 2.16, p < .05). It H5a).

© 2009 Blackwell Publishing Ltd Volume 17 Number 6 November 2009


706 CORPORATE GOVERNANCE

TABLE 10
3SLS Estimations of Board Independence and Tobin’s Q: The Moderation Effect of Dividends and Ownership
Concentration

Variable Dependent variable: Tobin’s Q t-statistic Dependent variable: Tobin’s Q t-statistic

AC-Ind .86 .94 -.12 -.15


Div-Dum -.25 -.57 -.40* -2.49
Div-Dum*AC-Ind .24 .38 – –
Closely-held – – -.10 -1.39
Closely-held*Div-Dum*AC-Ind – – .08 .28
Debt .06 .52 .09 1.03
Firm size -.13 -1.36 -.03 -.49
Investment 1.23*** 4.23 1.23*** 6.25
Profitability 1.86*** 9.24 1.88*** 11.92
Lag-Profitability .14 .95 .22* 2.12
Firm age -.06*** -2.69 -.06*** -3.69
Constant 2.30† 1.71 .64 .57
Industry dummy Included Included
Year dummy Included Included

Notes: This table reports results of three-stage least squares (3SLS) regressions of the relationship between firm value measured by
Tobin’s Q and audit committee independence (AC-Ind). Moderation effect of dividends and ownership concentration is considered. The
endogenous variables are Tobin’s Q and AC-Ind. Only estimation on Tobin’s Q equation is reported. Estimation on audit committee
independence equation is not reported. t-values are shown in parentheses.
***p < .001, **p < .01, *p < .05, †p < .10.

With regard to audit committee independence, results in not different from those reported in Tables 5–8. Third, to
Table 10 suggest that the marginally positive relationship remove the possibility that firms with positive retained earn-
between audit committee independence and Tobin’s Q ings, but negative net earnings, were unable to pay divi-
previously found (see Column 1 of Table 8) is not moderated dends due to cash shortages, the analysis was repeated using
by dividends or dividends and ownership concentration a subset of firms with only non-negative net earnings (con-
altogether. sequently, the sample size was reduced to 1,355 observa-
In Column 1 of Table 10, the coefficient on the interaction tions). The results are consistent with earlier analyses.
term between Div-Dum and AC-Ind is positive but not sig- Finally, the sensitivity of the findings in the presence of
nificant (i.e., t = .38, p > .05), while in Column 2 of Table 10, outliers and influential observations is tested by truncating
the coefficient on the interaction term between closely-held, the largest one to 5 per cent probability levels for each tail of
Div-Dum, and AC-Ind is positive but not significant (i.e., the distribution of the model variables. In general, the results
t = .28, p > .05). This study, thereby, fails to provide support are not substantially different from earlier analyses.
for H4b and H5b.

Robustness Tests DISCUSSION AND CONCLUSIONS


Several additional analyses were conducted to test the While conventional wisdom is asking for increased indepen-
robustness of the results. First, to examine whether the dence on boards and audit committees, little empirical evi-
results in Tables 5–8 are sensitive to the cut-off used for dence has been presented with regard to the impact of
closely-held firms, this study takes a 10 per cent and 15 per ownership concentration and dividend policy on the effec-
cent cut-off, instead of 20 per cent. The results are not tiveness of independent directors. This study therefore pro-
significantly different from those reported in Tables vides incremental insights by examining the relationships
5–8. Second, to examine whether the results in Table 5 between ownership concentration and governance mecha-
are sensitive to alternate measurements, Equation (1) was nisms as well as the effectiveness of governance mechanisms
re-estimated using alternate proxy for ownership concentra- in the presence of blockholders and high or low dividend
tion. Specifically, the aggregate ownership of shareholders payouts. Using a sample of publicly traded firms in Australia
holding at least 5 per cent of equity and the ownership of the over the period 2000–2005, this study provides several inter-
largest 20 shareholders was used. The results are not differ- esting results.
ent from those reported in Table 5. An alternate proxy for This paper finds that ownership concentration does have a
audit committee independencewas also used. Instead of significant negative impact on board independence. That is,
using a dummy variable, the proportion of independent compared to widely-held firms, closely-held firms have
directors in the audit committee was used. The results are lower proportion of independent directors on the boards.

Volume 17 Number 6 November 2009 © 2009 Blackwell Publishing Ltd


GOVERNANCE MECHANISMS AND FIRM VALUE 707

There are two possible interpretations for the results. First, These findings have several important implications. For
controlling shareholders prefer less independent boards to investors, the findings reveal that, as far as agency costs are
facilitate actions at their discretion (the rent extraction argu- concerned, investments in closely-held firms that have more
ment). Second, the presence of blockholders with more independent boards are sensible. For corporate decision
incentive and power to monitor managers substitutes the makers, the results imply that controlling shareholders
monitoring role of independent directors (the substitution should be aware of the need for more independent directors
argument). Indeed, this paper finds that closely-held firms on the board, as investors consider them as an effective
underperform widely-held firms, and hence provides governance mechanism to control agency problems between
support for the rent extraction argument (Shleifer & Vishny, controlling and minority shareholders. For policy makers,
1997). This study, however, fails to find evidence that own- the finding that firm performance is significantly influenced
ership concentration has any impact on audit committee by board independence in closely-held firms could serve to
independence. justify initiatives to encourage more independent directors
The study also finds that board independence and audit on boards.
committee independence are positively associated with firm
value which suggests that Australian publicly listed firms
could enhance their performance by increasing the propor- ACKNOWLEDGEMENTS
tion of independent directors on their boards or by having The author is a Research Fellow, Monash University, Austra-
more independent audit committees. Compared with prior lia, and Senior Lecturer, Prasetiya Mulya Business School,
studies in Australia, results on board independence are con- Indonesia. The author would like to acknowledge George
sistent with Bonn et al. (2004), who studied firms in 1999, but Tanewski, Michael Skully, Christine Brown, Jorge Farinha,
inconsistent with Lawrence and Stapledon (1999), who Barry Oliver, Gary Twite, Elisabete Vieira, and seminar par-
found that independent directors are not related to firm ticipants at the European Financial Management Association
value in the period 1985–1995. Results on audit committee 2007 and the Asian Finance Association 2007 annual meet-
independence are consistent with Chan and Li (2008), but ings for their useful comments and suggestions. He would
inconsistent with Klein (1998). Both are US studies. also like to express his gratitude to the anonymous review-
More importantly, this paper finds that the impact of board ers for their insightful comments. The financial support from
independence on firm value is moderated by ownership the Australian Government (AusAid) and Prasetiya Mulya
concentration and dividend policy. In particular, the 3SLS Business School, Indonesia, is gratefully acknowledged.
results indicate that closely-held firms with a less indepen-
dent board underperform those with a more independent
board. The results also suggest that the performance effect of NOTES
board independence is stronger among firms having low
dividend payouts or closely-held firms having low dividend 1. In a study on the determinants of corporate ownership struc-
payouts than among other firms. This study also finds that the ture, Lamba and Stapledon (2001) report a significant positive
performance effect of audit committee independence is mar- relationship between ownership structure and the level of
related party transactions. They also reveal private benefits of
ginally stronger among closely-held than widely-held firms. control are available in a large proportion of Australian publicly
This study, however, fails to find evidence that performance listed firms (p. 26). In a cross-country study on the value of
effect of audit committee independence is moderated by corporate voting rights and control, Nenova (2003) reports sig-
dividends. Given that the controlling-minority shareholder nificantly higher mean and median values of control-block votes
agency problems in closely-held firms may be more severe for Australia compared to other common law countries such as
than the owner-manager agency problems in widely-held Canada, Hong Kong, South Africa, the UK, and the US, suggest-
firms (Villalonga & Amit, 2006) and that blockholders may ing that controlling shareholders of Australian firms are able to
exacerbate the agency problems by paying lower dividends extract private benefits of control from minority shareholders.
(La Porta et al., 2000), the overall findings highlight the key 2. The Australian imputation tax system allows companies to pay
role that independent directors on the board and audit com- dividends that carry imputation credits for income tax paid by
the company (known as franked dividends). Imputation credits
mittee can play in protecting minority shareholders from can be used to reduce income tax paid by resident shareholders.
expropriation by controlling shareholders in closely-held 3. A revised version of the ASX Corporate Governance Council’s
firms. The results provide support for the notion that board or Principles and Best Practice Recommendations were issued in
audit committee independence should increase as private 2007. The Australian Stock Exchange (ASX) became the Austra-
benefits to insiders increase (Raheja, 2005). lian Securities Exchange in 2006.
The study has some limitations. The research considers 4. Additional lag data from 1998 and 1999 were required to cor-
only boards of directors or audit committees in the analysis. It roborate both independent director status of firms between 2000
does not consider other internal mechanisms such as mana- and 2005, and to augment some of the financial data analyses.
gerial compensation and external mechanisms, such as the 5. When a firm makes losses and has negative retained profits in a
labor market for managers, or takeover activities. While not given year, it is legally unable to pay dividends (Section 254T,
Australian Corporations Act 2001).
all blockholders are the same, this research treats them as a 6. This study excludes observations with negative earnings to
homogeneous grouping (i.e., firms are delineated into avoid negative dividend payout ratios. If net earnings are nega-
closely-held versus widely-held). In addition, it should be tive, the dividend payout ratio can be negative, which implies
noted that board composition may or may not signal actual incorrectly that these firms’ payout ratio is low. This treatment
independent behavior. Only a field study would verify this does not bias the results as it only effects less than 1 per cent of
further. the total number of observations.

© 2009 Blackwell Publishing Ltd Volume 17 Number 6 November 2009


708 CORPORATE GOVERNANCE

7. This proxy is highly correlated with the actual definition of 8. Chapter Six of the Australian Corporations Act contains a
Tobin’s Q and has been widely used in US studies (e.g., Demsetz general prohibition on acquiring more than 20 per cent of the
& Villalonga, 2001). In Australia, Craswell, Taylor, and Saywell voting rights in a publicly listed company (see Lamba & Staple-
(1997) also use the market-to-book (equity) ratio as a proxy for don, 2001).
Tobin’s Q.

APPENDIX
Variable Description

Endogenous variables
Board-Ind The proportion of independent directors on the board.
AC-Ind A binary variable that equals one if the percentage of independent director on an audit
committee is equal to or greater than 50 per cent, zero otherwise.
Tobin’s Q The natural log of market to book value of assets ratio.
Ownership structure
Closely-held A binary variable that equals one if a firm has a blockholder holding at least 20 per cent of
the firm’s shares, zero otherwise.
Dividend variables
Dividend Ordinary dividend divided by net earnings before extraordinary items.
Div-Dum A binary variable that equals one if firms have low dividend payouts (i.e., dividend payout
ratio is below sample average), zero otherwise.
Control variables
Debt The book value of debt divided by assets.
Firm Size The natural logarithm of total assets.
CEO A binary variable that equals one if the CEO is also the chairman of board, zero otherwise.
Firm Age The natural logarithm of the number of years since the firm’s incorporation.
Free Cash Flow The difference between net earnings before extraordinary items and capital expenditure
scaled by assets.
Profitability Earnings after tax scaled by assets (ROA).
Lag (Profitability) Previous year’s ROA.
Growth Opportunity The arithmetic average of growth in revenue in the previous five years.
Investment Capital expenditure scaled by assets.
Industry A dummy variable, based on two digit GICS codes, which equals one for “opaque industries”
and zero for “transparent industries.”

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