Interrelationships among capital structure, dividend s , and Ownership: Evidence from South Korea

Interrelationships among capital structure, dividends, and Ownership: Evidence from South Korea Yohanes Kristiawan H 16668

Topic • Relationship among financing decision, dividend policy and ownership

Theory used by the article • Convergence of interest theory: Debt and ownerships are subtitutes-twomeans of accomplishing the same task. Stock ownership is expected to have a negative effect on leverage if convergence of theory holds. • Entrenchment theory:Insider ownership have a positive impact on leverage if the entrenchment theory holds, because new debt policy must be used in conjunction with ownership to ensure that management acts appropriately. dividends are expected to have positive impact on debt if the entrenchment theory is valid, because both can be used to reduce cash flows and liquidity that would otherwise be misused by management.

Pecking order theory: According to the pecking order theory management prefers internal funds (available liquid assets) to leverage, in part because liquid assets can be spent in a more discretionary, and potentially sub-optimal, manner. This increases agency costs, and in turn increases the need for debt financing to reduce the use of internal funds. Consequently, both cash flow and liquidity are expected to have a negative impact on debt. Since more profitable firms have ample stored funds, profitability should exhibit a negative relationship with leverage. • Signalling theory, managers are willing to use leverage and or dividends as a means of providing a positive signal to capital markets.

Hypothesis • There are a relationship between debt policy, dividend policy, and ownership structure.

Variable used • Firms leverage (LEV): The ratio of total debt to book value of total assets. • Dividends (DIV): The ratio of cash dividends to operating income. • Firm’s ownership (OWN): Measured by the percentage of stock owned by insiders • Firm’s cash flow (CF): Calculated as the ratio of net income plus depreciation to total assets. • Firm liquidity (CR): Measured as the ratio of current assets to current liabilities. • Profitability (PRO): The ratio of net income to net sales. • Firm’s size (SIZE): Characterized by the natural log of market value of equity.

Method of analysis • Simultaneous equations model is estimated using 3 stage least squares (3SLS) methodology. The 3SLS method is preferred over the ordinary least squares (OLS) method as the latter leads to biased and inconsistent parameter estimates when a system has interdependent endogenous variables.

Result • The debt equation result Examining the 3SLS results in Table 3, we see that the coefficient estimate for OWN is significantly negative. Concomitantly, the DIV variable has a significantly positive coefficient estimate-a finding that supports entrenchment theory. The negative and statistically significant parameter estimates for CF and CR are also consistent with Myers and Majluf's (1984) pecking order theory. Finally, the coefficient for PRO is not statistically different from zero.

The dividend equation results Unlike the results of Table 3, the 3SLS coefficient estimates for the dividend equation provide consistent results in favor of entrenchment theory. The OWN and LEV coefficient estimates are both significantly positive, implying that not only are debt and dividend policies complementary, but also that higher ownership levels lead to higher dividends, possibly to prevent entrenched managers from acting in a manner inconsistent with stockholders.

The ownership equation results Table 5 also exhibit a negative relationship between these two variables; however, the causality is reversed. Again, the sign and significance of this coefficient estimate supports the convergence of interests theory. Table 5 provides an analogous result, although again the causality is reversed. Thus, we find additional evidence that entrenchment theory and the convergence of interests theory are not mutually exclusive alternatives to explain agency costs. Unexpectedly, the CF and CR variables have negative and significant coefficient estimates, implying that liquidity is not a significant determinant of managerial ownership-a finding that goes against the pecking order theory. Finally, the coefficient for SIZE is not significant, which is inconsisteznt with previous empirical results.

Conclusions: • The 3SLS regression results suggest that higher levels of ownership and dividends negatively affect leverage. Concomitantly, ownership and leverage both positively impact dividends. Lastly, we find that leverage is negatively associated with ownership, while dividends positively impact ownership. • This study also considers the convergence of interests theory and the entrenchment theory and their abilities to explain the role of managerial stock ownership in lowering agency costs.

Financial decisions, ownership structure and growth opportunities: An analysis of Brazilian firms

Topic • influence of financial decisions and ownership structure on firm value in function of whether companies have profitable growth opportunities

Theory used by the article • Underinvestment theory: The underinvestment view (Myers, 1977) stresses the negative effect of too much corporate debt on firm value, since it may incentivize managers to forego profitable investment projects. • Overinvestment Theory: The overinvestment view applies when the firm has no growth opportunities, and is closely related to the free cash flow (Jensen, 1986 and 1993; Lang et al., 1996; Smith and Watts, 1992; McConnell and Servaes, 1995; Singh and Faircloth, 2005). This theory emphasizes the negative consequences of too much cash flow under the discretionary control of managers. If the firm has no growth opportunities, managers are likely to be tempted to waste the cash flow on unproductive projects.

Signalling theory: The signalling explanation is based on the asymmetric information between managers and investors (Amihud and Murgia, 1997; Benartzi et al., 1997). Firms with the best investment projects need to signal their growth opportunities in such a way that cannot be imitated by firms without good investment projects. • Free cash flow theory: Consistent with free cash flow theory, shareholders welcome dividend payments since the funds under managers’ discretionary control decrease. Consequently, the value of the firm is also positively related to dividend payout in firms with the poorest growth opportunities.

Hypothesis: • H1a: For firms with growth opportunities a negative relation exists between corporate debt and firm value. • H1b: For firms without growth opportunities a positive relation exists between corporate debt and firm value. • H2a: For firms with growth opportunities either a positive or a negative relation exists between dividends and firm value. • H2b: For firms without growth opportunities a positive relation exists between dividends and firm value. • H3: Both for firms with and without growth opportunities a positive relation exists between ownership concentration and firm value. • H4: A non-linear relation exists between ownership concentration and firm value. This relation – initially positive and negative beyond a critical threshold – holds for firms with growth opportunities.

Variable used • They measure the growth opportunities with the equity market-to-book ratio (MBE). • Two additional measures of growth opportunities: the price-earnings ratio (PER) and investment intensity (INV). PER is the market value-to-net profit ratio. Investment intensity is measured as the ratio of investment, including plant, property and equipment (PPE) and R&D, to the existing capital stock. • The explanatory variables are different measures of financial leverage, dividend policy and ownership structure. With regard to debt, this work uses the financial leverage ratio (LEV), defined as the book value of debt divided by total assets. Dividend policy (DIV) is introduced through the ratio dividends over total assets. • Concerning ownership structure, the work uses the proportion of shares owned by the largest shareholder (C1) as a measure of ownership concentration. It also uses C1 squared (C12) to test a possible non-linear effect of ownership concentration. Firm size is a control variable, measured as the log of total assets (SIZE).

Method of Analysis • They defined a multivariate regression model in which the q ratio depends on the leverage, dividends and ownership structure as follows (sub-index i refers to the firm and t to time): Qit = β0 + β1·LEVit + β2·DIVit + β3·C1it + β4·C12it + β5·SIZEit + ηi + ηt + εit (1) • The panel data methodology makes it possible to control the so-called constant and unobservable heterogeneity (Arellano, 2003; Hsiao, 2004). Panel data estimations rely critically on the fixed-effects term (ηi), namely the identification of some specific features of each firm that remain fixed over time. The fixed-effects term is unobservable, and hence becomes part of the random component in the estimated model. We also controlled for the effect of macroeconomic variables through a time effect ηt. The random error term εit controls both for the error in the measurement of the variables and for the omission of some relevant explanatory variables.

Result

Table 4 shows the results of the basic estimation; they confirm most of the hypotheses about the influence of leverage, dividends and ownership on firm value depending on the availability of growth opportunities. First, financial leverage is significant in all the estimations (columns 1-3 in panel A. Thus, consistently with Hypothesis 1a, the coefficient of LEV is negative for firms with the most growth opportunities. • In contrast (panel B in Table 4), when firms lack profitable projects, leverage is positively and significantly related to firm value. This result corroborates Hypothesis 1b, which suggests the disciplinary role of debt and how the value of the firm increases through a reduction in the free cash flow, preventing managers from incurring wasteful expenses.

Table 4 also reports the results for the dividend policy. This result implies dividends have a dual but complementary function. Firms with high growth opportunities seem to use dividends to signal growth opportunities (Hypothesis 2a). For firms without growth opportunities, where the free cash flow problem is more severe, dividends seem to play a disciplinary role on managers (Hypothesis 2b).

Third, as far as the ownership concentration is concerned, column (2) shows a positive relation with the value of the firm irrespective of the growth opportunities. This result confirms Hypothesis 3 by showing how the stake owned by the largest shareholder creates incentives to improve the firm’s performance through a more detailed control of managers. Nevertheless, when a quadratic term for ownership concentration (C12) is introduced, there are significant differences between firms with and without growth opportunities, as reported in column (3). In this case, for companies with good investment projects, a non-linear relation exists between firm performance and ownership concentration: positive for low levels of ownership concentration and negative for high levels. These results are coherent with Hypothesis 4, and suggest a combination of alignment and entrenchment effects (Morck et al., 1988).

Conclusion • The results of this work show that leverage and dividends in Brazil play a dual role depending on the availability of growth opportunities. Also, ownership concentration may improve the control of managers, but at the same time may also exacerbate problems between large and small shareholders in firms with the most growth opportunities. • The results suggest that ownership concentration improves the value of all the firms, irrespective of the growth opportunities. But on the other, in firms with growth opportunities there is a risk that large shareholders will expropriate wealth at the expense of minority shareholders according to the non-linear relation uncovered.

Interrelationships among capital structure, dividend s , and Ownership: Evidence from South Korea