The Impact of Ownership Structure On Corporate Debt Policy: A Time-Series Cross-Sectional Analysis
The Impact of Ownership Structure On Corporate Debt Policy: A Time-Series Cross-Sectional Analysis
The Impact of Ownership Structure On Corporate Debt Policy: A Time-Series Cross-Sectional Analysis
Eastern
The
Financial
Finance Review
Association
The Financial Review 33 (1998) 85-98
Larry G. Perry
University of Arkansas
James N. Rimbey*
University of Arkansas
Abstract
This study examines the influence of agency costs and ownership concentration on the
capital structure of the firm. Of particular interest is the composition of equity ownership as
a determinant of overall capital structure and the dynamic adjustment of capital structure to
changes in the equity ownership. Results indicate that the distribution of equity ownership
is important in explaining overall capital structure and that managers do reduce the level of
debt as their own wealth is increasingly tied to the firm. It is also noted that the time-series
component is important in resolving the conflicting results reported in prior research.
1. Introduction
Agency theory has been advanced as a possible explanation for the observed
variation in capital structures across firms. Jensen and Meckling (1976) suggest that
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a manager's capital structure decision amounts to balancing the agency cost of debt
against the agency cost of equity to minimize their impact on the value of the firm.
This paper attempts to resolve some of the uncertainty surrounding the question
of ownership structure and corporate debt policy. An extensive time-series cross•
sectional analysis is employed to examine the dynamic response of capital structure
to agency variables through time within firms, as well as across firms. This adds
additional information and allows stronger conclusions than the conflicting results
derived from use of static cross-sectional models reported to date.
The agency theory articulated by Jensen and Meckling posits that there exists
a natural conflict in the interests of outside shareholders and the managers of a firm,
leading to the possibility that managers may make suboptimal decisions that improve
their own welfare at the expense of shareholders. Recognizing the impact of these
conflicts between owners and managers, the market makes unbiased estimates of
such costs and reduces the value of firm shares accordingly. This loss is the firm's
agency cost of equity.
Several methods have been suggested to mitigate the agency problem and
reduce the attendant costs. These methods fall into the two categories of either
external control devices or motivational mechanisms. In the latter group, one way
of bringing the interests of owners and managers into closer alignment is to cause
managers to increase their ownership in the firm (Jensen and Meckling, 1976). A
second way suggested by Jensen and Meckling is to increase the use of debt
financing, in effect displacing equity capital. This shrinks the equity base, thus
increasing the percentage of equity owned by management. The use of debt not
only serves to align the interests of managers and owners, but also increases the
probability of bankruptcy and job loss. This added risk may further motivate manag•
ers to decrease their consumption of perks and increase their efficiency (Grossman
and Hart, 1982). Another benefit of the use of debt is a solution to the problem of
the over-retention of earnings (Jensen, 1986).
While the outcome of each of these predictions may appear to be clear, the
empirical evidence is not. Kim and Sorensen (1986), Agrawal and Mandelker (1987)
and Mehran (1992) find a positive relationship between the percentage of shares
held by insiders and the firm's debt ratio. Using different data sources, sample
periods and sampling techniques, Friend and Hasbrouk (1988), Friend and Lang
(1988) and Jensen, Solberg, and Zorn (1992) report a negative relationship. In a
study requiring pre-set levels of share ownership, Chaganti and Damanpour (1991)
find that insider stock ownership has no impact on the capital structure of the firm.
Amid this uncertainty there is yet another aspect to be considered in the
ownership question. The nature of the distribution of shares among the outside
shareholders has been suggested as a device to mitigate agency costs, thus affecting
the firm's capital structure. Since ownership represents a source of power that can
be used either to support or oppose existing management, the concentration or
dispersion of that power becomes relevant. While prior research has viewed the
effect of agency variables on certain characteristics of the firm, this study examines
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the equity ownership structure as it affects corporate debt policy and improves upon
prior research in several ways.
In his study of agency costs and the dividend paying behavior of firms, Rozeff
(1982) argues that dividend payments are a part of the firm's monitoring/bonding
package, in that firms tend to pay out more in dividends when insiders own a lower
proportion of shares. As in Rozeff, the variable representing inside ownership in
this model is the percentage of shares owned by insiders as reported by Value Line
Investment Survey.
Two measures of outside shareholder concentration are also considered in the
ownership structure for the monitoring role they might play. The first is the natural
log of the number of outstanding shareholders as reported by Value Line. Rozeff
argues that the greater the number of shareholders, the more diffused the ownership,
hence a negative or insignificant relationship should be expected between the number
of shareholders and the level of debt. The second proxy represents the make-up of
outside ownership and is included to examine the Grier and Zychowicz (1994) tenet
that institutional investors may substitute for the disciplinary role of debt in the
capital structure. This variable is defined as the percentage of shares owned by
institutional investors, also as reported by Value Line.
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2. 6. Asset risk
Long and Malitz (1985) argue that the firm's systematic risk (beta) captures
the firm's business risk in addition to its financial risk, and they follow the procedure
suggested by Hamada (1972) to unlever beta. However, Mandelker and Rhee (1984)
and Rhee (1986) argue that beta is composed of three levels of risk: intrinsic business
risk, financial leverage risk, and operating leverage risk. While this distinction may
seem subtle, due to the fact that these risks can offset one another it is important
that they be considered in any examination of the agency costs of debt.
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In this study beta is decomposed to isolate intrinsic business risk and operating
leverage risk as outlined in Rhee's model. 1 The firm's beta is calculated using the
standard form of the market model and Center for Research in Security Prices
(CRSP) daily returns over each full year. Book value of debt proxies for market value
of debt (Bowman, 1980), and the balance sheet items specified in Rhee's model are
derived from Compustat.
2. 7. Profitability
Profitability reflects earnings to finance investment. Myers (1984) suggests
managers have a pecking order in which retained earnings represents the first choice,
followed by debt financing, then equity. If this were true it would imply a negative
relationship between profitability and the debt ratio. A number of prior studies define
profitability as the ratio of operating income to total assets, which is the proxy
employed in this model.
I
Following Rhee (1986):
operating leverage risk = (1 - t)j3° CIS;
=
financial leverage risk (1 - t) 13° DIS;
intrinsic business risk = j3°;
where:
t = corporate income tax rate;
13 = systematic risk;
=
C risk-adjusted present value of total fixed costs;
D = market value of risky debt;
S = market value of common equity; and
13° = W[l - t)(CIS + DIS) + 1].
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2.10. Uniqueness
Titman and Wessels (1988) also argue that the capital structure decision takes
into account the risk of bankruptcy. The more unique the firm, the higher the risk,
thus the higher the cost of bankruptcy. Hence, a negative relationship is expected
between the firm's degree of uniqueness and its debt ratio. The Titman and Wessels
measure for uniqueness, defined as the ratio of advertising plus research and develop•
ment expense to annual sales, is the variable included in this model.
A basic premise of this study is that the variability in the debt ratio is a function
of the firm's dynamic behavior through time. Therefore, a time-series cross-sectional
approach (TSCS) is employed to analyze the data and examine the impact of agency
costs on the debt policy of firms. TSCS contains the necessary mechanism to deal
with both the intertemporal dynamics and the individuality of the firms being
investigated. The methodological improvements gained from pooling TSCS data
are well documented (e.g., Judge, Griffiths, Hill, and Lee, 1980; Dielman, 1983;
and Hsiao, 1986).
Also reported are the results of the individual cross-sectional and time-series
components of the full model. By definition, the cross-sectional regression uses the
average value for each variable, thus ignoring changes through time. It is a measure
of the agency effects on debt policy across firms. The time-series portion is a ''fixed
effects" construct which examines the agency effects on debt policy on the basis
of within-industry variation through time, ignoring cross-sectional changes between
firms. The use of the industry level grouping based on two-digit SIC codes is
employed to reduce measurement error in the variables as explained in Smith and
Watts (1992). Including industry dummy variables in the model relaxes the assump•
tion of a common intercept, allowing the intercept to vary as a means of representing
individual industry effects (Hsiao, 1986). Because many of the agency proxy vari•
ables have been subject to mixed results in previous research, two-tailed t-tests are
used to test the significance of the regression coefficients for each variable.
The model is expressed as follows: Debt ratio = f (percent insider ownership,
percent institutional ownership, shareholder dispersion, cash dividends, firm growth,
firm size, asset structure, intrinsic business risk, operating leverage risk, firm profit•
ability, tax rate, non-debt tax shield, uniqueness of the firm).
To measure dynamic behavior through time, it is assumed that firms evaluate
their financial position periodically and adjust their debt ratios based on anticipated
internal and external forces. This can be tested in two ways. The first is a TSCS
test with an appropriate lag between the explanatory variables and the debt ratio;
i.e., entering the prior period's debt ratio as an independent variable in accordance
with the dynamic model construction (Hsiao, 1986). This is accomplished in a series
of tests which include the difference in the year-to-year firm debt ratios on the left
side of the equation, with lagged debt on the right. As explained later, this allows
measurement of the annual rate of adjustment. The second way of testing the
adjustment of firm debt to change in the agency variables is to model the difference
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3. Results
Descriptive statistics for the variables included in the model are presented in
Table 1. The mean debt ratio across firms through time is 23.4%.2 Insider holdings
range from 0% to 72%, with a mean of 14.8%. Likewise, institutional holdings and
shareholder dispersion vary widely, offering a large continuum along which to
measure the hypothesized agency effects. Diagnostics show no severe multicollinear•
ity between variables. First-order autocorrelation and heteroskedasticity are present,
however application of the Parks (1967) GLS transformation alters neither the sign
nor significance of the model parameters. Hence, the OLS results representing
the interpretable impact of the explanatory variables without transformation are
reported here.
The first column of Table 2 presents the results of the primary TSCS analysis,
with debt as the dependent variable. The coefficients of all explanatory variables
are significant at the 0.0001 level. The adjusted R2 of the model is 0.464.
These results provide support for the proposition that the level of debt in the
capital structure is inversely related to insiders' shareholdings, which is consistent
with the various theoretical considerations (e.g., Easterbrook, 1984). The institutional
shareholdings variable is significantly negative, supporting the argument that institu•
tional investors may substitute for the disciplinary role of debt in the capital structure.
The significantly negative impact associated with the number of outside stock•
holders supports the argument that diffused shareholders have little effect or influence
on management's conservative position on debt issuance (e.g., Easterbrook, 1984).
In summary, the evidence on the ownership structure of equity is consistent
with the argument that higher insider ownership accompanied by diffuse outside
shareholdings permits managers to control financial policies of the firm and pursue
their own interests, as posited by agency theory. Interpretation of the results of the
effects of the other related variables included in the model also have meaning and
help in understanding the theoretical considerations.
2
While macroeconomic conditions did cause fluctuations in the capital structure of firms over time,
there is no evidence of any structural shift in overall debt ratios during the period under study.
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Table 1
Summary statistics
Firm characteristics relating to ownership structure and corporate debt policy for 311 firms over the
years 1972-1989.
Std.
Variable Mean Dev. Minimum Maximum
DEBT = book value long term debt to book value long term debt plus market value
equity
INSDR = percentage of common stock held by insiders
INSTINV = percentage of common stock held by institutional investors
STKHLDR = natural log of number of shareholders
DIVIDEND = dividend payout ratio
GROWTH= a forecast of future five-year sales growth
SIZE = natural log of firm sales
ASSET = ratio of inventory plus gross plant and equipment to total assets
BUSRISK = intrinsic business risk
OLRISK = operating leverage risk
PROFIT = ratio of operating income to total assets
TAXRATE = ratio of taxes paid to pre-tax income
NDTXSHD = ratio of depreciation, investment tax credit, and tax loss carryforward to
total assets
UNIQUE = ratio of advertising and R&D expenses to sales
Cross-
Sectional
Pooled TSCS Regression Time-Series Regression
Independent Variables OLS Regression Alone Alone
Table 3
whereby firms adjust their levels of debt in response to internal and external forces
as previously discussed. Results show lagged debt to be highly significant, with the
coefficient attaching to the lagged debt ratio being -0.2052. This indicates an implied
annual rate of adjustment in the debt ratio to shifts in the other variables of about
21 %, which appears reasonable.
One other effect observed with lagged debt is that the variables associated with
non-debt tax shield and number of shareholders become insignificant, and the growth
and dividend variables switch sign. The now positive impact of growth during the
adjustment process may indicate that the adjustment in debt level is partially driven
by the need for external financing for new projects, with debt financing receiving
priority over equity (Myers, 1984). Another possible explanation is that growth adds
value to the firm, which increases borrowing capacity (Titman and Wessels, 1988).
The sign change on the dividend variable may relate to the Easterbrook (1984)
argument that dividend increases reduce the equity base, thus increasing the debt
ratio.
As a second test of the influence of changes in the agency variables on adjust•
ment of debt ratios, the year-to-year change in debt ratios was regressed on year•
to-year changes in the explanatory variables. The results in Table 4 show which
variables have greatest impact on the debt ratio adjustment process. While the first
differences in the growth variable, collateral value of assets, and non-debt tax shield
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Table 4
Regression results of first differences in both dependent and independent variables
Time-series cross-sectional regression of the year-to-year change (first difference) in corporate debt
structure on the year-to-year changes (first differences) in variables impacting the equity ownership
structure to measure the dynamic response through time for 311 firms during the years 1972-1989. The
variables are as defined in Table 1.
lose significance in this model, the remaining proxy variables are quite robust. The
one surprise is the reversal of sign on the proxy representing number of shareholders.
One possible explanation is that increases in debt attract investor attention by
signaling a third-party review as suggested by Easterbrook (1984).
The results of each of these tests support the dynamic nature of adjustment of the
firm's capital structure in response to shifts in the ownership structure through time.
4. Conclusion
In this paper, the dynamic adjustment of capital structure of firms is examined
in an agency theory context. Of particular interest is the ownership structure of the
firm's equity as a determinant of overall capital structure, and especially how the
capital structure is adjusted in response to shifts in agency cost trade-offs. Studies
to date have attempted to test such dynamic relationships using only static models,
and have reported mixed results.
The results reported here show that the tenets of agency theory appear to hold
not only across firms, but also within firms across time. Managers act to adjust the
capital structure of firms in response to variations in the agency cost structure in a
dynamic manner. Further, it appears the structure of equity ownership is important
in explaining the overall capital structure of the firm. As managerial ownership
increases, thus raising the amount of personal wealth and human capital invested
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in the firm, managers tend to lower debt to reduce their overall risk and/or agency
costs. Institutional shareholdings also appear to influence the financial policies of
firms, with institutional holders substituting for the disciplinary role of debt in the
capital structure. When outside ownership is diffuse, those outside shareholders
have little influence on managers' conservative debt postures.
These are stronger conclusions than the conflicting results derived from use
of static cross-sectional models in prior research. The results also suggest that capital
structure models that do not include the impact of agency costs or their effect
through time may be incomplete.
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