Corporate governance is one of the hottest topics,especially in the aftermath of firm failures and/or a banking/financial crisis.Detthamrong, Chancharat & Vithessonthi (2017) investigated on two importantquestions have often been asked: First, can strong corporate governance reducethe firm’s risk (e.g., investment risk and financing risk)? Second, do firmswith strong corporate governance perform better those with weak corporategovernance?).
While empirical results appear to be mixed, many regulatorsaround the world have firm beliefs that strong corporate governance wouldreduce the probability of the firm taking on excessive risk (e.g.,over-leveraged) and enhance firm performance.Detthamrong, Chancharat & Vithessonthi (2017) alsofound that for an average firm, corporate governance (i.e., board size, boardindependence, audit committee size, female directorship, CEO duality, ownershipconcentration, and audit reputation) has no effect on leverage and performance.
However, leverage partially mediates the effect of audit committee size on firmperformance for large firms only. To the best of our knowledge, we are one ofthe first to show that corporate governance exerts the indirect effect on firmperformance via financial leverage for firms in an emerging market economy.Jiraporn, Kim, & Kitsabunnarat (2011) arguedcorporate governance is designed to alleviate agency problems. They relatedcapital structure to aggregate corporate governance quality. Agency theoryargues that capital structure decisions are influenced by agency costs. Moreover,on the basis of their empirical evidence Jiraporn, Kim, & Kitsabunnarat(2011) demonstrates a robust inverse relation, which is consistent with theprediction of the substitution hypothesis.
Furthermore, we also demonstratethat our results are unlikely influenced by endogeneity. Stronger governanceappears to bring about, not merely reflect, lower leverage. When we compare ourgovernance metrics with those previously employed, we find that our governancemetrics can explain variation in leverage choices much better. The results ofour study are important for they demonstrate that the overall quality ofcorporate governance has a palpable impact on crucial corporate decisions likecapital structure choices.
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Like corporate governance, leverage has been argued toalleviate agency costs as well. Agency problems can be mitigated by leverage inseveral ways. First, one way to reduce agency conflicts is to cause managers toincrease their ownership in the firm (Jensen & Meckling, 1976). Byincreasing the use of debt financing, effectively displacing equity capital,and firms shrink the equity base, thereby increasing the percentage of equityowned by management. Second, the use of debt increases the probability ofbankruptcy. This additional risk may further motivate managers to decreasetheir consumption of perks and increase their efficiency (Grossman & Hart,1982). Finally, the obligation of interest payments resulting from the use ofdebt helps resolve the free cash flow problem (Jensen, 1986).For instance, using the ISS governance data to gaugethe strength of corporate governance, Brown and Caylor (2006) found that firmswith better governance quality are more profitable and more valuable (higherTobin’s q).
Their results imply that firms with better governance qualityexperience lower agency costs and, hence, exhibit better performance and higherfirm value. Charoenwong et al. (2011) investigated the relationship between thequality of governance structure and adverse selection component with stockslisted on Singapore Exchange. They show that corporate governance has aninverse relationship with the adverse selection components of bid–ask spreads.On the behalf of their empirical evidence Jiraporn,Kim, & Kitsabunnarat (2011) showed a robust inverse relationship betweenleverage use and governance quality. In other words, firms where corporategovernance is weaker are found to be significantly more leveraged. We arguethat, due to the role of debt in mitigating agency costs, higher leveragesubstitutes for weaker governance mechanisms in alleviating agency conflicts. Asfirms improve their governance index from the 25th to 75th percentile, theirleverage would decrease by as much as 12.
88%.Recently, the importance of traditional firm-specificdeterminants of capital structure has been challenged. Matemilola, Ariffin,Saini & Nassir (2017) investigate the managerial experience of top managersas a determinant of capital structure, with regard trade-off theory. Theirresults revealed that top managers’ experience is positively related to bookvalue measures of capital structure. As top managers’ (CEOs) experienceincreases, both the book total debt and long-term debt ratios increase.
Their resultswere robust using both the market total debt and long-term debt ratios. Basedon the findings, the results suggest that top managers’ experience is apotential determinant of firms’ capital structure. The findings also suggestthat experienced top managers maximize the benefits of debt interesttax-shield; top managers can increase firm value.Experienced top managers (CEOs) aim at an optimalcapital structure mix that maximizes the benefit of an interest tax shieldemphasized in Myers (1984) trade-off theory.
According to Myers (1984), optimalcapital structure is reached when the tax-shield benefits of debt is balanced,at margin, by costs of financial distress. Moreover, debt is substituted forequity, or equity for debt, until the value of firm is maximized (Myers, 1984).Matemilola, Ariffin, Saini & Nassir (2017) argued that holding all otherthings constant (e.g. holding the firm’s assets and investment plans constant),experienced top managers’ use more debt to shield the firm’s profits fromtaxes; this encourages the usage of more debt capital.
Therefore, top managers'(CEOs) experience is positively related to debt (capital structure). They drawinsight from the upper-echelons theory and integrates it with the trade-offtheory of capital structure. The trade-off theory argues for the existence ofan optimal capital structure that balances the tax-shield benefits of debtagainst the financial distress costs of debt (Myers, 1984; Frank and Goyal,2008; Nhung and Okuda, 2015). The static version of the trade-off theoryassumes that firms will always be at their optimal capital structure (Myers,1984). There is evidence that chief executive officers (CEOs)have particular management styles and that they matter for corporateperformance (see Adams, Almeida, and Ferreira, 2005; Bennedsen, Perez-Gonzalez,and Wolfenzon, 2008). Most evidence on CEO-specific heterogeneity examineseducation, personal characteristics, or personality traits.
Malmendier and Tate(2005) study education, Kaplan, Klebanov, and Sorensen (2012) personalcharacteristics, and Malmendier and Tate (2005, 2008), Graham, Harvey, and Puri(2013), Hirshleifer, Low, and Teoh (2012), Malmendier, Tate, and Yan (2011),and Lin, Ma, Officer, and Zou (2011) analyze personal traits. Less is knownabout the work experience of CEOs. An exception is Custódio and Metzger (2013)who study CEOs’ industry expertise in the context of diversifying mergers andacquisitions (M) activity.
