Chapter 2 Theoretical Framework
This chapter starts off by presenting the most relevant studies and their corresponding findings. Second, based on the existing body of literature, the hypotheses that are used to answer the problem statement will be developed and presented.
2.1 Empirical Link: Managerial Ownership – Firm Financial Performance
The relationship between managerial ownership and firm performance has been studied extensively since Berle and Means (1932) argued that widely held corporations, where equity is diffused amongst numerous shareholders and control is concentrated in the hands of insiders, tend to underperform. According to Jensen and Meckling (1976) the relationship between shareholders and managers of corporations is a classic example of the agency relationship and the problems associated with the “seperation of ownership and control” are caused by the general problem of agency. An agency relationship is a contract under which a person (the agent) engages in activities on behalf of one or more other persons (the principal(s)). According to the agency theory there is reason to believe that the agent will not always act in the best interests of the principal. In order to make sure that the agent acts in the principals’ best interest, incurring agency costs for the principal are inevitable. Agency costs are defined as the sum of the monitoring expenditures by the principal, bonding expenditures by the agent and the residual loss resulting from the agency relationship (Jensen & Meckling, 1976). According to Jensen and Mecklings’ (1976) ‘convergence of interest’ hypothesis, a firm’s financial performance increases uniformly as managerial ownership in a firm increases. They advocate that managerial ownership helps to align the interests of managers and shareholder and lower agency costs, because managers will be less likely to engage in sub-optimal activities that may lower the share price. In contrast Morck et al. (1988) find that firm financial performance increases rapidly when board ownership increases from 0% to 5%, decreases when ownership increases further to 25%, and then again increases slowly as board ownership moves past 25%. According to these researchers the increase in firm financial performance with increase in ownership reflects the convergence of interests between managers and shareholders, while the decrease is caused by entrenchment of the management team (Morck et al., 1988). McConnell & Servaes (1990) use a larger data set than Morck et al. and find an inverted U-shaped relationship between managerial ownership and firm financial performance. In their research the relationship is positive until it reaches an inflection point between 40% and 50%. Some researchers have also reported that firm financial performance rises with ownership up to a stake of 1%, declines in the ownership range of 1% to 5%, rises again between 5% and 20% and ultimately declines when the ownership levels exceeds 20% (Hermalin & Weisbach, 1991). In short, these studies interpret the positive relationship at low levels of managerial ownership as convergence of interests or incentive allignment, whilst the negative relationship at higher level of managerial ownership is explained by the managers becoming entrenched.
2.2 Empirical Link: Leverage – Firm Financial Performance
In the aftermath of the Great Depression and throughout the 1930s and 1940s, people had a negative opinion towards the use of debt for financing investments and only turned to debt when it was absolutely necessary (McConnell & Servaes, 1995). Corporation’s attitudes towards the use of debt began to soften with the publication of Modigliani and Miller’s (1958) now famous paper, which stated that the firm’s financing choice does not matter in perfect capital markets. When Modigliani and Miller’s (1963) published their “tax correction” paper, corporations began embracing debt as a financing instrument. Recent literature has accepted the logic of Modigliani and Miller, but realize that capital markets are far from perfect and that financing indeed does matter. This has led to a growing body of literature where the role of debt in influencing corporate investment decisions is studied. According to the free cash flow theory, the interests of the corporation’s managers and shareholders can be better aligned by issuing debt to finance investments (Jensen & Meckling, 1976). In this case debt is used as disciplinary device to reduce managerial cash flow waste through the threat of default or pressure to generate cash flows to service debt, suggesting a positive effect of debt on firm performance (Grossman & Hart, 1982; Jensen, 1986). However, according to Myers (1977) debt will have a opposite effect on firm financial performance, as the risk of default may cause an “underinvestment” or “debt overhang” problem. Debt overhang or underinvestment distorts te firm’s incentives to invest, which causes the firm to pass up otherwise profitable investment opportunities. In more recent literature the findings on how leverage affects firm performance have also been mixed. Several studies have shown a positive relationship between leverage and firm financial performance (Dessi, 2003; Abor, 2005; Arbabiyan, 2009; Umar, 2012). These findings are in line with trade-off theory, which predicts a positive association between a firms’ leverage ratios and financial performance (Myers, 1984; Myers & Majluf, 1984; Karadeniz, 2009; Chakraborty, 2010). In contrast to the trade-off theory, the pecking order theory states that firms will prefer internal generated cash flows above debt or equity for the financing of new investment opportunities. Only when the firm’s internal financing are depleted they will issue debt, as the cost of debt is lower than equity. When issuing more debt were to threaten the survival of the firm, the firm will use equity as a source of financing (Myers, 1984). This theory suggests that firm’s that perform well prefer internal financing over debt, thus expecting a negative relationship between a firm’s capital structure and performance. A number of studies have emperically tested the pecking order theory and indeed find a negative relationship between a firm’s capital structure and firm performance (Shyam-Sunder, 1999; Zeitun, 2007; Onaolapo, 2010). These conflicting findings makes this topic and interesting research topic.
2.3 Empirical Link: Managerial Ownership – Capital Structure
The empirical link between managerial ownership and the corporation’s capital structure has also been the topic of many researchers, with contradicting results. Berger, Ofek ,and Yermack (1997) find that leverage is lower in firms where managerial ownership is low, which suggests a positive relationship between managerial ownership and a firm’s leverage ratio. Additionally, a study of US manufacturing firms from 1973 to 1983 also find a positive relationship between a firm’s leverage ratio and managerial ownership (Mehran, 1992). In a more recent study Short, Keasey, and Duxbury (2002) find similar results when other large shareholders are absent. These studies show that a increase in mangerial ownership increases the managers’ incentive to issue debt. Whereas, other studies using a sample of US firms find a negative relationship between managerial ownership and firm leverage, arguing that managers often have less diversified portfolios than other shareholders and therefore want to mitigate the risk of bankruptcy (Jensen, Solberg, & Zorn, 1992; Michael, 1995). Additionally, Chen & Steiner (1999) document a negative relationship between managerial ownership and debt policy, which they argue is caused by the substitution-monitoring effect. The substitution-monitoring effect is based on the substitution effect of agency devices, which states that one monitoring device can be replaced by another. Therefore, corporations will choose the agency device that is most cost-efficient (Kerstin, 2007).
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