Introduction
Good governance and capital structure play a crucial role in the maximization of corporate profitability, either through an increase in profit margin or a reduction in capital cost or both (Uwuigbe, 2014), and in effect shareholders’ wealth. Companies who are aware of these factors in their objectives of profit maximization eagerly put their good governance principles into corporate codes, which act as valuable reference points in their governance decisions. As such, sound corporate governance engenders investor confidence in terms of capital preservation and acceptable returns of investments (Okiro, Aduda, & Omoro, 2015; Agyei & Owusu, 2014; Heng, Azrbaijani, & San, 2012). With investor confidence, the corporation possesses an important capital resource in a highly competitive market environment wherein massive opportunities are available for expanded operations, which add value to the company, as well as stiff competitions in certain markets, which can demand more resources, whether financial or otherwise, to support combative market initiatives to gain grounds in improving market shares.
Meanwhile, rigorous capital structure increases business value due to the avoidance of high financial risks, often experienced in highly leverage situations, has been directly related to business continuity, and that of the corporate’s ability to deal with competition (Priya & Nimalathasan, 2013; Heng, Azrbaijani, & San, 2012). Low financial risk structures may consist of equity financing (i.e., selling capitalization rights for cash flow problems) or a low interest rate on borrowed capital, which particularly available in low market situations.
Nevertheless, it is clear that Corsi and Prencipe (2015) are correct in observing that structures and choices in corporate governance principles, including its faithful implementation in practice, are influenced by the accepted capital structure or perhaps the other way around.
This paper attempts to explore the current development of corporate governance as a concept and as used corporate codes as indicated specific areas of contention: size of the board of directors; executive remuneration; and growth rate and market conditions.
Developments of the corporate governance codes
Developments in the corporate governance definitions and code scope
Saad (2010) defined governance as a stewardship responsibility of the Board of Directors to provide oversight on a company and to establish goals and strategies and ensure its execution for the benefit of the organization and its direct stakeholders. Thus, it is essentially a system of effective organizational direction, monitoring, regulation, and control (Carausu, 2015; Corsi & Prencipe, 2015; cf. Uwuigbe, 2014). It consists of the relationship between the corporate executives (the CEO and the senior managers), the Board of Directors, the shareholders, and other direct stakeholders. Carausu (2015) expanded this network of interaction between internal stakeholders (e.g. the Board of Directors, the CEO, the senior managers, and the rest of the employees) and external stakeholders (e.g. shareholders, creditors, the government, and even the local community). Thus, at the micro-economic level, corporate governance deals with the manner in which the corporation is structured and operated, which involves such issues as performance, efficiency, development, capital structure, and relationships (Carausu, 2015). Meanwhile, at the macro-economic level, it deals with the elements in its legal environment (e.g. regulatory laws) and external relationships with shareholders and other stakeholders.
As such, many factors have direct influences over corporate governance. Corporate governance, for instance, are influenced by internal and external factors (Okiro, Aduda, & Omoro, 2015; Carausu, 2015; Muazeib, Chairiri, & Ghozali, 2015; (Priya & Nimalathasan, 2013). Internal factors include the board characteristics (e.g. size, composition, diversity, culture, size of independent directors, etc.), ownership structure (e.g. executive ownership, non-managerial ownership, and institutional shareholding), CEO duality (i.e. in cases of the dual roles of the CEO as an executive and as the chairperson of the Board), and information asymmetries. Meanwhile, external factors include statutory audit (e.g. auditor size, independence, etc.), corporate influence on its market, and stock market valuation of corporate performance.
Carausu (2015), however, believed that the most important and widely observed mechanisms in corporate governance include the Board (size or composition or both), ownership structure, executive remunerations, institutional investors, market conditions, and capital structure. In line with this, and as previously indicated, this study focuses primarily on three corporate governance factors (size of the board of directors, executive remuneration, and growth rate/market conditions) and their respective relationships with the corporate capital structure.
Developments in the capital structure definition
A company’s capital structure essentially refers to the mix of capital sources (e.g. equity and/or leverage), which the organization utilizes in order to finance its operations. These capital sources are of different natures and thus have their specific advantages and disadvantages. Leverage, for instance, has no direct impact on the investors’ equity base. However, since it is a borrowed capital, it is subject to mandatory reimbursement plus an interest rate, characteristics that cannot be found in equity (Carausu, 2015). These differences make equity sources vulnerable to executive mismanagement (more risks are taken by the shareholders) while debt can be used to control management behaviour (higher risks threaten management job security).
Conversely, capital structure, one of the most perplexing matter in corporate finance (Uwuigbe, 2014), determines the mechanisms with which the corporation makes a trade-off between the effects of income taxes (corporate and personal), bankruptcy costs, and agency costs (Okiro, Aduda, & Omoro, 2015; cf. Priya & Nimalathasan, 2013). It demands a balancing of capital costs and expected returns associated with specific expenditures where capital financing must be established. Thus, the management must seriously consider the most profitable source of capital, either as a sole source of financing or a specific combination of both.
Consequently, capital structure establishes the specific mix of financial sources for the firm (e.g. equity and/or debt mix) in accordance with its specific needs (Agyei & Owusu, 2014). The choice of capital structure must be as specific to the corporate project as possible without discounting the use of a corporate-wide policy that determines a specific mix of financial sources within specific percentage limits.
Moreover, capital structure is one of three financial decisions that drive added value to the company; the other two decisions involve investment decisions and dividend decisions (Priya & Nimalathasan, 2013), which are outside the scope of this study.
Agency cost theory believes that a rigorous capital structure assists in mitigating the negative impacts of agency costs to the corporate bottom line. This is so because associated decisions directly impact on the corporate value and the shareholders’ wealth (Priya & Nimalathasan, 2013; Heng, Azrbaijani, & San, 2012), both of which are fundamental obligations that senior managers are expected to accomplish within a reasonable financial period and for which they are paid to accomplish. For instance, the risks taken in a high leverage or low equity/asset ratio policy reduce outside equity costs due to its reliance on leverage and increases firm value due to the value-increasing motivation derived from the high leverage risk, pushing executives to think better and act better in the shareholders’ interests.
In effect, capital structure can be a tool for financial management decisions as well as for coercing senior managers to perform better in response to the inherent potential risks in the financing mix adapted by the organization. Leverage possesses the risks inherent in mandatory reimbursement contracts while equity promises a type of compensation that is often accessible only to executives in relation to their job performance (Carausu, 2015). Either way, the executive has something to lose from the capital structure that the company adopted. For instance, with regards to leverage, each company has a specific and quantifiable point at which debt can be counterproductive to the bottom line and profitability. Going beyond this point can encourage executives to mindlessly expand the corporate empire into territories where it has no inherent capability to subdue or profit from and can result to massive depletion of hard-earned profits from other more dependable ventures and markets. And yet, it remains an accepted fact that an optimal capital structure cannot be achieved without enormous difficulty; that is, in ensuring corporate control and development simultaneously (Carausu, 2015).
Theoretical literature
Size of the Board of Directors
The Boards of Directors hold the primary responsibility for the governance of their companies (Tihanyi, Graffin, & George, 2014; Priya & Nimalathasan, 2013). Hence, it is long held that the Board size is one of the most important and widely influential mechanisms in the relationship between corporate governance and capital structure (Carausu, 2015).
Moreover, it is believed that board size, when effectively utilized, guarantees both the highest level of expertise and independence, which is directly related to agency costs (Agyei & Owusu, 2014). From this perspective, large boards mitigate managerial abuse, increase business performance, and monitor a wide range of corporate issues that are crucial in the overall business performance of the company
Executive remuneration
The scheme with which corporate executives receive their compensations for professionally managing the organization is another one of the most important and widely recognized factors in the corporate governance – capital structure relationship (Carausu, 2015). It constitutes a mechanism with which shareholders ensure that the size of executive benefits are closely linked with corporate performance, particularly long-term performance. Unwise use of this element, such as linking executive benefits to short-term earnings, can lead to a myopic management strategy that focuses on short-term profitability at the expense of its long-term growth and sustainable profitability.
Current observers, such as Carausu (2015), noted that equity compensation for corporate executives had been subject to many important influential factors, such as profitability, capital requirements for growth investments, tax management, and dividend policy, among others.
Moreover, Joseph, Ocasio, and McDonnell (2014) observed that organizations where the CEO and other senior managers received stock option incentives, tend to prefer more equity stakes to increase capitalization than those not having stock option plans. These findings, however, are counterintuitive because increased capital infusion tends to dilute the share value because new capital involves the issuance of new shares of stocks, which also consequently dilutes the value of the shares optioned to executives. Moreover, increased equity infusion tends to mean nothing to the interests of the executives without stock option plans, thus, making them unaffected by shares dilution. The Pecking Order Theory holds that firms tend to use internal funds (i.e. retained earnings, usually undistributed earnings) over external funds (e.g. new equity and/or leverage) to finance expenditures (Muazeib, Chairiri, & Ghozali, 2015; Agyei & Owusu, 2014). However, when external financing becomes the only option, they tended to prefer debt over equity for the simple reason that equity financing will dilute shareholder value.
Growth rate and market conditions
Uncertainty tended to have an inverse relationship with capital structure. Some current literature (e.g. Priya & Nimalathasan, 2013) found no significant relationship between growth rate and capital structure while others (e.g. Liao, Mukherjee, & Wang, 2015; OECD, 2015) contended that growth rate has unstable and reliable (thus, highly risky) relationship with capital structure. Thus, lenders tend to demand an increased risk premium. Conversely, businesses in the mature stage tended to more stable and dependable growth rates, although in relatively lower rates.
This relationship between growth and capital structure may even deteriorate in the use of merger and acquisition as a means of pushing corporate growth. Even a successful merger or acquisition has its own risks, increased organizational complexity being only one of them. A CEO, for instance, must increase the demands of his time to include the newly acquired company with the expected decrease of his time with existing companies in a conglomerate. This expanded scope of top supervision can effectively diminish his capability to see the daily operations of each company, which may result to missing important strategic cues simply due to limited time available to see through the reports before him (Carausu, 2015).
Meanwhile, market conditions, including the economic environment, play a significant role in the relationship between corporate governance and capital structure (Carausu, 2015). Its complexity and, at times, gross unpredictability make it difficult for a single-factor influence in the relationship can occur. The Market Timing Theory of Capital Structure proposed that companies issue more equity when the markets are highly favourable and issue more debt and redeem shares in bearish environments (Iatridis & Zaghmour, 2013). So far evidence tend to support this theory though.
Empirical literatures
Size of the Board of Directors
In practice, it is one of the most important mechanism that shareholders ensure the alignment of their interests (i.e. company interests) with those of the executives (i.e. management interests). Company size has been found directly related with Board size (Agyei & Owusu, 2014). Carausu (2015) indicated a long-held belief that the larger the Board is the greater number of supervising managers to oversee corporate level issues and anticipate long-term business issues. However, it does not necessarily follow that smaller Boards are more cost-efficient that larger Boards. Essentially, the findings in this area were at best mixed.
Nevertheless, Board size was directly associated with capital structure (Uwuigbe, 2014; Rehman, Rehman, & Raoof, 2010; Abor, 2007). In addition, such factors as composition, expertise, independence, type, and attendance can effectively distort the impact of size on the quality of Board decisions (Carausu, 2015). Directors can also cooperate with the senior managers against the interest of the shareholders, not to mention the costs associated with a large Board that is passive and ineffectual.
Meanwhile, scholars, such as Tricker (2015), Vakilifard et al. (2011), and Abor and Biepke (2006), observed a direct relationship between Board size and equity financing and a reverse relationship between Board size and leverage (cf. Agyei & Owusu, 2014). In effect, larger Boards of Directors tended to use higher equity stake in the company to fund its capital structure requirements instead of using more debt, while smaller Boards tended to prefer more debt financing over increased equity, preferably external equity (Tricker, 2015; Abor & Biepke, 2006), stake in the capital structure. The same had been observed with the size of independent directors wherein the larger the number of independent directors, the lower the financial leverage resulting from their impact in influencing the Board towards low leverage decisions (Abor, 2007) as well as from entrenchment (Agyei & Owusu, 2014).
However, Corsi and Prencipe (2015) disagreed. They noted a significant positive relationship between Board size and leverage or the debt-to-equity ratio, indicating the effective power of the Board to regulate senior management tendency to increase leverage levels, thus, increasing shareholder value (Agyei & Owusu, 2014). Moreover, they observed that large Boards had resulted to increase or the pursuit of higher leverage due to the inherent highly positive perception of corporate value. Consequently, they tend to obtain lower cost of debt than smaller Boards (Corsi & Prencipe, 2015; Agyei & Owusu, 2014). First, there was apparently a general perception among creditors that corporations were in better hands with large Boards than with smaller ones. Second, since larger Boards are often found in larger companies, these companies usually have larger assets, making them attractive to creditors. In effect, the relationship between the Board size and capital structure are currently mixed (cf. Heng, Azrbaijani, & San, 2012).
Executive remuneration
Joseph, Ocasio, and McDonnell (2014) as mentioned in the previous section noted the tendency among top executives outside the Board of directors, particularly if they have stock option incentives, tend to prefer more equity stakes to increase capitalization than those not having stock option plans. The intuitive discordance of these findings has also been noted earlier. Conversely, Carausu (2015) apparently rightly observed that leverage tended to encourage executives to be more circumspect in their decisions due to the inherent risks in debt as a result of its mandatory reimbursement nature, thus making them more stringent in their capital management. These divergent empirical outcomes evidently failed to settle the clear relationship between executive remuneration and capital structure.
Growth rate and market conditions
Priya and Nimalathasan (2013) found only an insignificant but negative correlations between company growth and capital structure (as change in annual earnings). Conversely, Liao, Mukherjee, and Wang (2015) and Organization for Economic Cooperation and Development (2015) insisted that companies in the growth stage tend to show higher, but more unpredictable, growth rate due to its higher levels of risk and thus uncertainty (Iatridis & Zaghmour, 2013).
Nevertheless, corporations tend to issue larger amounts of equity in favourable market conditions Meanwhile, Muazeib, Chairiri, and Ghozali (2015) and Chang, Dasgupta, and Hilary, (2009) observed greater issuance of additional shares in favourable market conditions as investors tended to be bullish in their anticipations. Conversely, Huang, Ritter, and Jay (2009) observed more energy to buyback issued shares during market downturns and even to issue more debts apparently to somehow finance shares redemption. These findings apparently tend to support the Market Timing Theory of Capital Structure.
Conclusion
Current theoretical and empirical developments in the relationship between corporate governance and capital structures appeared to need further work in conceptual development with more definite and unambiguous empirical evidence. A review in the literature of three corporate governance factors – size of the board of directors; executive remunerations; and growth rate and market condition – showed good adequate theoretical explorations but limited or mixed empirical evidentiary outcomes.
The size of the board can be understood theoretically either direction. That is, large boards can be intuitively expected to perform better in making good governance decisions. However, it has an inherent weakness in the number, which can cause disagreements in viewpoints that can paralyze decision making or result to making bad choices of alternatives in relation to options in capital structure. Conversely, small boards have the advantage of more limited diversity in opinions and perspectives, which increase the chances of agreeing easily in relation to a capital decision. However, limited board size can also limit the potential availability of brilliant ideas that any small boards may not conceive on their own. Thus, at best, the relationship between corporate governance and capital structure in this specific factor is mixed and controversial, or perhaps more aptly dependent upon some other factors that can work in boards of different sizes.
The same mixed results turned up in the executive remuneration factor. Some literature insisted that stock option incentives for executives can be directly associated with their motivation to make good decisions in the use of safe and less costly capital structure; thus avoid high leverage decisions for its capital structure. However, other literatures made important points to conclude that leverage is directly associated with the executive motivation, as an adverse motivator, in ensuring that such a capital structure must be used to alarm the executives on the stake of losing their jobs if they cannot effectively manage a highly leveraged capital structure. Once again, both sides in the argument tended to make sense at least intuitively. Thus, this factor appeared to be more situational in value than general.
Surprisingly though the governance factor of growth rate and market conditions turned out to be more well-defined as far as options and implications are concerned in relation to capital structure. It makes a perfect sense that executives should prefer to sell more equity shares in bullish environments because the share prices tend to be unusually higher and therefore profitable. This profitability can be logically enjoyed in bullish environments when stock prices are in its lowest and the company can repurchase their sold shares at much cheaper prices; thus justifying a debt policy to finance this stock reacquisition tactic.
Overall, there is less optimism in the possibility of drawing a general rule that can govern the relationship between corporate governance factors board size and executive remuneration and capital structure decisions. The rules appeared to be better established within the contexts unique for each corporation and involved board constitution and executive temperament. However, the relationship between growth rate-and-market conditions and capital structure appeared to be so far clear and less subject to different results or interpretations.
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