Impact of corporate governance on capital structure

Corporate governance is a mechanism which maintains the trust of a company inside and outside
so that investors encouraged to invest in the company (Own words). Corporate governance is a
process which helps to create the shareholder value with the help of management in a way which
ensures the sheltering of interest of all types of stakeholders either it is individual interest or
collective interest (Hassan and Butt, 2009). Corporate governance is an arrangement which
directs and control the companies. Corporate governance’s main purpose is to assign the
shareholders, managers, board and other stakeholders to their rights, responsibilities, and duties
and also set down the procedure and rules to take the decisions related to business concerns. CG
also makes available an assembly which helps to set the objectives of business and ways to
achieve these objectives and monitoring management performance (OECD, 1999). Corporate
Governance is a system which protects the interest of stakeholders and more importantly the
interest of shareholders in present economic and corporate environment and they have a key role
in the economic growth of a country’s economy (source internet). In this era, good corporate
governance is very important for companies to compete in the market. The trust of investors and
lenders depends on the company’s governance. Good corporate governance helps the companies
to implement their policies, to set strategic goals and to make a strategic decision in an efficient
way.

It is not wrong to say corporate governance exist since the existence of companies however in
past the soul of corporate governance was weak due to unawareness of public but due to some
recent financial scandals such as (Adelphia communication, Enron, WorldCom, Waste
management, Rite Aid, ImClone Systems, Peregrine systems etc.) public become aware and
cautious about their financing decisions and as a result professionals and regulatory bodies pay
their attention towards the strong corporate governance mechanism.

Corporate governance mechanism mostly linked with the board of directors, management, and
auditors. Board of directors is elected by the shareholders and what they do to accomplish the
affairs of the company is called governance. The prime responsibility of the Board of directors is
the governance of the company except this, directors are also responsible to make strategic
decisions, setting overall objectives of the companies, recommendations of plans to achieve the
objectives, arranging resources, protecting the interest of all stakeholders and defining the rules
and regulations which must be obeyed by the management of the companies. Board of directors
hire the employees to run the affairs of company day to day is called management. Management
main responsibility is to conduct the day to day affairs of companies, also give a response and
coordinate to all operational activities, implement the plans of the board of directors and make
proposals & suggestions to the board of directors. Auditor has to verify there is an appropriate
governance mechanism is placed or not.

According to (Jensen & Meckling, 1976) corporate governance links with the agency theory.
When there is a separation of ownership and control then a conflict of interest arises, and it is
called agency problems and the cost which is incurred to remove problem is called agency cost.
Agency problem may be between management and shareholders, management and creditors,
senior management and junior management and major shareholders and minority shareholders.
Corporate governance is an entire extension of Agency theory, it is right to the extent that when
the relationship between shareholder (Principal) and management (agent) exists and arise a
conflict then agent will work his benefits rather than for shareholders but in case of directors of
corporate entities they are not agent, they work like watchdogs and protect the interest of all
stakeholders. The aim of corporate governance is to remove the agency problems and minimize
the agency cost so that the performance of the company can be improved.

Agency cost is one of the most important factors in determining the capital structure of a
company. If a company, choose a good capital structure it will lead the company to success
otherwise it will lead to bankruptcy. So, to make a good decision about capital structure a good
corporate governance structure plays an important role. Corporate governance uses the debt tool
to reduce the agency problems which results in company better performance. There are many
studies which showed that there is a significant association between corporate governance and
capital structure i.e. Hafez (2017). Similarly, some studies showed there is no significant
relationship between corporate governance and capital structure i.e. Detthamrong et al., (2017).
Corporate governance in Pakistan

There is a large number of stakeholders whose interest is associated with the company. Among
these stakeholders some are minor, and some are dominant. Dominant stakeholders have the
opportunity to protect their interest and take the benefits at the expense of minor shareholders
and in that’s way minor stakeholder’s rights are exploited. In Pakistan mostly, company’s
ownership held by the major shareholders which have more than the 50% is of share capital in
this way they are able to dominate their directors on the board and do everything according to
their interest. If these companies are not forced to obey law and regulations of good corporate
governance, then the interest of all stakeholders will be exploited and in the result, the economy
will suffer. For the protection of the interest of all stakeholder’s security and exchange
commission of Pakistan (SECP) publish the corporate governance code in March 2002. After the
corporate governance code promulgation, corporate governance becomes a famous topic of
research in Pakistan. In 2012 a revised code of corporate governance was published in which
many amendments related to the corporate governance structure done. Some key points of
Corporate governance code 2012; Number of independent directors shall be 1/3 of total board
members and must be one independent member on the board, the number of executive directors
must be not more than the 1/3 of total directors including the CEO, After the code of corporate
governance 2012 a timeframe of two years was given to the board to construct a mechanism to
evaluate the performance of the directors and internal audit system was also upgrade it can be
done by outsourced listed company or from a professional services provider or from the internal
staff of holding company. In case of an internal audit by holding company; the company has to
appoint an employee who will provide coordination between the internal audit staff and the
board.

Theories:

Agency Theory
Jensen and Meckling were given this theory in 1976. This theory explains the association
between the principal and agent. According to this theory, the principal is the owner while the
agent is a person who acts on the behalf of his principal to perform the task who known as an
agent. In a company, shareholders are the owners while management acts as an agent. In
business transactions, management does the best for shareholders when there is no self-interest
of them. If the interest of management is influenced due to shareholders interest, then a conflict
arises which is called agency problem (also known as conflict of interest). To remove the conflict
of interest a cost incurs which is called agency cost i.e. high monitoring, incentives, reasonable
remuneration. The main sources of Agency cost are two: the first one is cost linked with the
agents using and second one is the separation of ownership and management. Conflict of interest
arises among different parties in a firm; it can be between principal and agent, it can also be
between the shareholders and management. According to agency theory, optimum capital
structure is that mixture of debt and equity which will reduce the conflict cost incurred to resolve
the agency problem among principal and agent. If the conflict is between shareholders and debt
holders then it can be resolved by debt and interest payments. As the debt holders have legal
power and if the management fails to pay debt or interest payments then they can sue and in that
case management may have to lose their job. That’s why management runs the company in an
efficient way and this results in to increase shareholder’s wealth.

Trade-off theory

The prime objective of trade-off the theory of capital structure is to find the optimal combination
of debt and equity by which companies can be financed. Trade-off theory explains the benefits of
the use of debt finance such as agency benefits and tax reduction and also the costs which firm
have to bear i.e. agency costs, financial distress. Hence the company which is seeking to
maximize its value they have to reconcile the benefits and costs associated with debt and equity
finance. It was suggested by Ross et. al, (2008) that the value of the firm can be optimized by
balancing the marginal benefits and marginal costs of debt finance. The firms which follow the
trade-off theory have target debt which firms achieved continuously step by step (Myers, 1984).
According to the Cook and Tang, (2010) the target leverage can be achieved by the firms of
developed economy faster as compared to the firms belonging to developing the economy.
According to Myers by balancing the benefits and costs associated with debt and equity finance
target leverage can be achieved but it is not clear how much debt used, or equity used.
Target debt was categorized by (Frank & Goyal, 2009) in two categories. First is known as static
trade-off theory, according to which target debt might be static and can be recognized for a
single period trade-off among the benefit and cost of debt. Other is the dynamic which makes the
adjustment over time as any change incurred in the benefits and costs of debt magnitude.

Pecking order theory

Pecking order theory was given by the Myers in 1984. According to this theory, firm follow a
hierarchy of preference in the selection of sources of finance; where firms first prefer to use the
retained earnings then debt and lastly use the equity for firms financing needs. This theory
suggests no optimal capital structure or target capital. This theory is based on information
asymmetry. Bestowing to this theory managers are more informed about the firm’s decisions
which they are going to take and also about the firm value than the investors and due to this
information asymmetry investors demand a discount for risky securities. To avoid this problem
managers, prefer the retain earnings and if it is not enough then debt and lastly equity. This
sequence of preference may also be due to advantages associated with retaining earnings as there
is no floatation cost or transaction cost, no fixed payments like dividend or interest, no legal
process, easily available, no splitting of ownership, risk-free, no financial distress and
bankruptcy cost as compared to debt and equity.

Theories and hypotheses development

Since landmark work by Modigiliani and Miller (1958) Capital structure in corporate finance
become an important topic of research for the researchers. So, in this study, little attention has
been given to explore the impact of corporate governance on the capital structure of non-
financial firms of Pakistan. A Literature review of studies and hypothesis development is as
follows.

Board size:
The supreme body of the company is the board of directors which are liable for the firm’s
operation and managing the firm. Board performs an important role in regard to strategic
decisions making of financing. It is also responsible to take such decisions which results in the
growth of the firm. In case of failure of the company; it plays a vital role to alleviate that
situation (Chancharat et. al, 2012). The main objective of the board of directors is to work for the
value maximization of shareholders.
Board size is one of the most important attributes of corporate governance. The pioneer work on
the relationship between board size and leverage was done by Pfeffer and Salancick (1978), who
found a significant relationship between board size and leverage. There are a lot of studies done
regarding the relationship between board size and leverage but the findings are the mix. Jensen
(1986) done a study and found a positive relationship between leverage and board size. He
attributed this positive relationship to the fact that as there are more members then they are able
to take more debt and similarly if there is small size board then they are not able to take more
debt due to the small network so debt acts as a monitoring device and due to monitoring agency
cost reduced. In later these findings were verified by studies of following researchers (Ali Al
Model (2010), Nadeem Ahmed Sheikh and Zongjun Wang, (2012), Hossein Nabiki Boroujeni
(2013), Nasir Ali (2014), Li-Kai (Connie) Liao (2015), Monther Soliman Jaradat (2015)). Many
studies refuted the positive relationship between board size and leverage and they found negative
influence on capital structure, authors imply that due to larger board there is strong monitoring
due to which leverage tool is less used to force the managers for firm performance (Hamid Reza
Vakilifard (2011), A.Ajanthan (2013), Panagiotis Dimitropoulos (2014), Precious Angelo Brenni
(2014) Precious Angelo Brenni (2014), Uwalomwa UWUIGBE (2014)). However, some studies
found an insignificant relationship between the board size and capital structure (Hussainey
(2012), Christian Corsi (2015), Hassan M. Hafeez (2017), Siromi, Chandrapala (2017)).
We can develop a hypothesis that;

Ha1: There is a positive relationship between board size and leverage.

H0: There is a negative relationship between board size and leverage.

CEO duality:
CEO duality is another major attribute of corporate governance. CEO duality means a state
where the functions of chairman as well as of CEO are performed by one person. That condition
has a direct effect on financing decisions making of companies. When management decision
function and decision control function is carried by CEO then firm performance decrease and
agency cost increased the reason is that board’s ability to look after the CEO decreased (Dey et
al., 2011). According to Fama and Jensen (1983), management decision function and decision
control function must be separate. Fosberg (2004) found in his study that firms without CEO
duality employ optimum debt in the capital structure. When chairmanship and CEO post are
separate then there is good corporate governance and so less debt is used to eliminate agency
problems. Abor and Biekpe (2007) finding showed that CEO duality positively influences the
leverage. Most studies in the literature found the negative relationship between CEO duality and
leverage (See Nadeem Ahmed Sheikh and Zongjun Wang, (2012), Albert AGYEI (2014),
Monther Soliman Jaradat (2015), Li-Kai (Connie) Liao (2015), Agyenim Boateng (2015),
George Kiriakopoulos (2017), Siromi, Chandrapala (2017)). Also, some studies found the
positive relationship between CEO duality and leverage (Godfred . Bokpin, C. Arko (2009),
Hamid Reza Vakilifard (2011), Uwalomwa UWUIGBE (2014)).
Consider there are two firms; the first firm has CEO duality and second has no CEO duality. The
CEO’s of both firms are risk taker then the first firm with CEO duality will take more debt as
compared to the firm without CEO duality. On another hand, if the CEO’s of both firms are risk
averse then the first firm with CEO duality will take less debt as compared to the second firm
which is without CEO duality. So we Hypothesis that;

Ha2: There is a negative linkage between CEO duality and Leverage.

H0: There is a positive linkage between CEO duality and Leverage.

Audit reputation:

When different market participants (i.e. investors, lenders) make a decision whether we have to
invest or lend to a firm, Yes or Not then they see the financial statements of the companies. Now
the question is that the accuracy and quality of information provided in the financial statements
are how much reliable. So the investors or lender have information risk; to remove this risk
audit’s firm reputation plays a significant role and it also helps in reducing the cost of capital of
companies (Azizkhani et al., 2010). So the firms which audited by international firms have more
access to debt finance due to information reliability than the firms which are audited by local
firms. There are different findings of studies regarding audit reputation and leverage. M. Hafeez
(2017) found external auditor had a significant positive relationship with leverage. The author
demonstrated that the certification provided by Big 4 auditors helps firms to finance their
operations with more debt. This is because Big 4 auditing companies provide higher audit quality
than their non-Big 4 counterparts (De Franco et al. 2011). The auditing service provided by Big
4s does not seem to offer the appropriate certification to use more debt George Kiriakopoulos
(2017). Ahmed Ibrahim muazeib (2015) found an inverse relationship between the external
auditor and leverage which implies that the problems which arise from the principal-agent
relationship could be lowered by corporate governance efforts in term of the external auditor’s
involvement. Because of the important role of the external auditor in financial services will
prevent further corporate scandals. Hussainey (2012) found an insignificant relationship with
capital structure.
So, we develop the Hypothesis;

Ha3: There is a negative association among the Audit reputation and leverage.
H0: There is a positive association between Audit reputation and leverage.

Institutional investors:

Institutional ownership is also one of the main attributes of corporate governance and the
determinants of capital structure. Agency theory recommends that an optimum ownership
structure and capital structure can reduce agency costs ( Jensen and Meckling, 1976). Hossein
Nabiei Boroujeni (2013) found a positive relationship with capital structure. The author implies
that institutional investor belongs to different financial institutions so finance is available at ease.
There are some other which also found a positive relationship between institutional ownership
and leverage (Panagiotis Dimitropoulos (2014), Albert AGYEI (2014), Li-Kai (Connie) Liao
(2015)). Hussainey (2012) and Ahmed Ibrahim muazeib (2015) found a negative association
with capital structure by suggesting that institutional investors not like to use debt financing. M.
Hafeez (2017) found that there was an insignificant association with capital structure. So, we
hypothesis;

Ha4: There is a positive linkage between institutional investors and leverage.

H0: There is a negative linkage between institutional investors and leverage.

Management ownership:
Managerial ownership is also an important determinant of capital structure. Managerial
ownership means the stock held by directors, CEO and their family members. When the
management has the shares of the company then they will not waste the company resources in
perks and do not invest in the projects which are below the cost of capital. In this way, the
agency problems come to end because of the alignment of interest between management and
shareholders (Jensen & Meckling, 1976).
Godfred . Bokpin, C. Arko (2009) found the positive relationship between managerial ownership
and capital structure. Some other researcher also found the same association among the
managerial ownership and leverage (Hossein Nabiei Boroujeni (2013), Panagiotis Dimitropoulos
(2014), Albert AGYEI (2014)). A negative relationship was found between managerial
ownership and capital structure by (Uwalomwa UWUIGBE (2014), Nasir Ali (2014), Christian
Corsi (2015), Li-Kai (Connie) Liao (2015)). The author demonstrates that managerial
shareholder uses less debt due to fear of bankruptcy risk. Nadeem Ahmed Sheikh and Zongjun
Wang, (2012), Siromi, Chandrapala (2017) found no significant relationship with capital
structure. So, we can hypothesis;

Ha5: There is a negative linkage between managerial ownership and leverage.

H0: There is a positive linkage between managerial ownership and leverage.

Board Independence:

According to agency theory due to independent directors monitoring of management can be

increased. Independent directors are beneficial for companies because of their independence and
experience. Now the corporate governance code 2012 made mandatory for companies to have
independent directors one-third of the total directors on the board. More independent directors
can perform their functions independently and keep an eye to look at the actions of others
(management) and take appropriate governance decisions. Nadeem Ahmed Sheikh and Zongjun
Wang, (2012) found a positive relationship with capital structure. The author demonstrates that
outsider directors had more capabilities and experience due to which firm performance improved
and also demonstrate the fact that outside directors are representative of financing institutions
and nominated directors by the controlling shareholders. Many other studies whose same
findings (Albert AGYEI (2014), Monther Soliman Jaradat (2015), Agyenim Boateng (2015),
George Kiriakopoulos (2017), Siromi, Chandrapala (2017)). Hossein Nabiei Boroujeni (2013)
found the negative relationship between independent directors and capital structure. The author
proposed that more independent directors then there will be high look after of actions of
management that’s why debt tool is less used to control free cash flow which used by
management. Some studies which also have the same findings (Nasir Ali (2014), Panagiotis
Dimitropoulos (2014), Precious Angelo Brenni (2014), Uwalomwa UWUIGBE (2014),). Hamid
Reza Vakilifard (2011), A.Ajanthan (2013) and Christian Corsi (2015) found the insignificant
relationship with capital structure. Then we can develop the hypothesis that;

Ha6: There is a negative linkage between non-executive board and leverage.

H0: There is a positive linkage between non-executive board and leverage.

Framework of Study
This is the framework of the study in which board size, CEO duality, board composition,
Institutional ownership, and managerial ownership are corporate governance attributes and taken
as explanatory variables while leverage has been taken as dependent variable.

Methodology

Data Collection

In this study quantitative approach has been applied and used panel data to reveal the
interrelationship between corporate governance and capital structure of public listed companies
in Pakistan. If we define the Panel data it consists of time series for each cross-section member
over the time in the data set. Where Cross section data is data on one or more variables collected
at a single point in time (source internet). The data has been taken from different sources
including annual reports, internet, newspapers, and journals. Further, the data of the study has
been collected from Bursa Malaysia database of listed companies at Karachi stock exchange for
a span of 2001 to 2016. This study excluded the data of financial sector for the capital structure;
the reason is that capital structures of financial service companies are different from the non-
financial companies and also the tangible product does not offer by financial institutions. A final
sample of 120 manufacturing firms quoted at Karachi stock exchange of Pakistan selected. The
listed firms are selected on the base of required data availability.

Data analysis

In this study econometric views (Eviews) software is used to illustrate the relationship between
the independent variable (IV) and the dependent variable (DV) to test the hypothesis and to
certify the findings. Eviews is a statistical and econometric analysis tool which has the capability
to estimate and forecast the data of different types such as cross-section, time series, and panel
data analysis.

Models

To study the affiliation among the corporate governance and capital structure; the following
model is developed.

¿ V it =β 0 + β 1 B S it + β 2 CEO D it + β 3 BIN Dit + β 4 IOW N it + β5 MOW N it +ε it …. (1)

Where

BSit= Board size, the number of directors at the board at the reporting date (Hafeez 2017)

CEODit= CEO duality indicates the corporate management where the CEO also serves as
chairman of the board (Augyei and Owusu2014).

BINDit=Board independence measured as a total percentage of the company’s shares owned by

the institutional of owners (Muazeib, 2015).

IOWNit= Institutional ownership defined as directors who are neither managers nor shareholders
of the firm and who don't have any contractual relationships with it, as well as any family
relationships with their leaders (Corsi, 2015).

MOWNit= Managerial Ownership is measured as the ratio of shares held by CEOs, directors, and
their immediate family members to total outstanding shares (Jaradat, 2015)
Variables Measurements
Corporate Governance Variables Proxy

Board size The number of directors at the board Hafez 2017

at the reporting date

Board independence Total percentage of the company’s Muazeib (2015)

shares owned by the institutional of
owners.

CEO duality CEO/Chair Duality (dummy variable, Agyei (2014)

It is taken as 1 if the CEO is chairman;
otherwise it is taken 0

Management ownership The ratio of shares held by CEOs, Jaradat (2015)

directors, and their immediate family
members to total outstanding shares

Institutional ownership directors who are neither managers Corsi (2015)

nor shareholders of the firm and who
don't have any contractual
relationships with it, as well as any
family relationships with their leaders

Capital Structure

Leverage Total debt divided by total equity Muazeib (2015)

Firm-Specific Attributes

Firm size The natural logarithm of total assets. Detthamrong et. al (2017)

Profitability Return on assets Muazeib (2015)

Asset tangibility Tangible fixed assets/total assets Dasilas (2015)