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Introduction to Managerial Finance's Special Issue on Agency Theory and Capital Structure
Article Type: Guest editorial From: Managerial Finance, Volume 40, Issue 12
About 18 months ago, I set out as Guest Editor to put together a Special Issue on “Agency Theory and Capital Structure.” The official call for paper asked for theoretical, empirical, practical, and pedagogical papers covering a range of topics related to the general subjects of agency theory and capital structure. The goal was to generate papers that might be able to tie in these two subjects but any strong research papers falling within the general areas of agency theory or capital structure were welcomed.
To help generate submission for the Special Issue, I sent out correspondence to knowledgeable researchers who were identified as being familiar with the agency theory and capital structure topics. The call for papers produced over 20 submissions of which most were sent out for evaluation after passing the “eye test.” From those submissions, five papers were approved by anonymous referees. As might be expected, there was not always perfect agreement by the referees. When referees disagreed on a paper's acceptance for publication, I sought further opinions. Regardless, as a whole, the referees indicated five papers were worthy of publication and so my congratulations to these authors. From what I can tell, the authors successfully incorporated the essential referee feedback that was crucial for their papers. The five accepted papers represent research covering a variety of categories of research associated with this Special Issue.
The average paper for our Special Issue was examined by over two referees. This referee input helped to insure that the published work would be good quality with minimum errors. In some cases, it took over 15 requests to find available referees to evaluate a paper. Some referees were requested to give feedback up to three times on the same paper. Thus, the unsung heroes are the referees who took time away from their many other duties to selflessly aid the publication of this Special Issue. Since I am author of one of the five papers, I am required to report that my paper was handled separately outside of my authority under the same blind-review process as all Managerial Finance papers.
2. The five accepted papers
With the above preliminaries finished, I will now introduce the five accepted papers and, in the process, hopefully motivate readers to examine these papers. These five papers will be introduced in alphabetical order by the corresponding author's last name.
2.1 The financing behaviour of firms and financial crisis
The paper “The financing behaviour of firms and financial crisis” examines the extent to which firm-level factors influence capital structure decisions. The authors of this paper, Albert Danso and Samuel Adomako, had a twofold plan in mind. First, they wanted to provide evidence related to the determinants of capital structure for South African firms. Second, they desired to look at the role of 2007-2008 financial disaster on firm-level determinants.
Danso and Adomako state that two findings stand out. First, the pecking order and trade-off theories of capital structure applicable to developed economies are also applicable in South Africa. Second, the financial crisis significantly influenced the capital structure of South African firms. Noteworthy, the roles of profitability, volatility, tangibility, and no-debt tax shield were affected by the financial crisis. Danso and Adomako found that the tangible assets factor was the most influential determinant after the crisis. Due to the weak creditors’ right that exists in South Africa, the tangibility of a firm's assets becomes a substitute for this weak right.
Because South Africa partakes in common characteristics with other developing countries, the Danso and Adomako findings provide the basis for the generalizability of their South African findings to other emerging economies. Danso and Adomako state those institutional differences among emerging economies may show assorted contextual elements that warrant additional insight. Of importance, their results suggest that other developing countries, besides South Africa, were not isolated from the impact of the financial crisis of 2007-2008.
In term of future research, Danso and Adomako suggest researchers could compare data across a number of emerging economies to determine how the 2007-2008 financial calamities influenced the financing decisions of these firms. In addition, future research could explore and compare data from not only listed firms but also unlisted firms. Danso and Adomako also point out that an analysis of the effects of the financial crisis on small businesses could be productive. Finally, researchers should initiate future studies comparing direct and indirect effects of country-level factors on corporate leverage decisions. Such factors might include the level of banking sector development, quality of regulatory environment, stock market development and inflation.
2.2 The structure of equity ownership: a survey of the evidence
The examination of the role of equity ownership by blockholders and insiders has long been a major point of interest for corporate governance researchers. The paper “The structure of equity ownership: a survey of the evidence,” continues this interest by surveying the empirical literature on the structure of equity ownership and its impact on corporate governance and firm value. The author, Professor Nilanjan Basu, states studies on insider ownership face serious challenges due to the endogeneity of ownership, while studies on blockholder activism find that activism in the end does not make a difference for shareholder value. While studies of insider ownership and blockholder activism face challenges, Basu suggests that recent research has gradually overcome stumbling blocks and is making steady progress.
If one goes back about ten years, Basu notes that literature surveys at that time pointed out the inconclusive evident on role of the equity ownership by blockholders and insiders. With this inconclusiveness as a backdrop, Basu goes on to the highlights the progress made in the last ten years in developing new avenues of research. Of importance to the reader, Basu summarizes the promising areas of research in a critical manner that will be useful not only for specialists but also for non-specialists.
For future research on insider ownership, Basu writes that the methodological challenges remain formidable. He adds that structural models and empirical studies focusing on exogenous changes (rather than potentially endogenous levels of insider ownership) are potential avenues for future research. Basu contends theoretical and empirical researchers are still early into the learning process so it will be exciting as we move into the future to find out what might be discovered. With this in mind, Basu poses questions for research on outsider blockholders based on issues that are becoming more prominent. Such questions include: “How does the identity of a blockholder affect his or her role in the firm?” and “How do multiple blockholders interact?”
2.3 Agency theory, capital structure and firm performance: some Indian evidence
The paper “Agency theory, capital structure and firm performance: some Indian evidence” empirically investigates the impact of capital structure choice on firm performance. This investigation takes place within the emerging economy of India. The author of this paper, Professor Varun Dawar, notes the underlying assumption behind the agency theory is that debt can discipline managerial discretionary behavior in a manner that lessens agency conflicts leading to optimal firm valuation. However, in India suppliers of debt capital being primarily state owned are subject to minimal disciplining influence by their owner-principal (e.g. by their government). Given this background, Dawar explores the relation between leverage and firm performance.
While controlling for factors such as size, age, tangibility, growth, liquidity, and advertising, Dawar uses recent data from 2003 through 2012 and finds leverage has a negative influence on the financial performance of Indian firms. His results contrast with the details of agency theory as commonly received and accepted in developed and emerging economies. Consequently, Dawar writes that postulates of agency theory have to be seen with a different viewpoint in India given the underdeveloped nature of their bond markets and the dominance of state owned banks in lending to the corporate sector. Dawar maintains that, compared to privately owned institutions in developed economies, the state-owned nature of lending in India has impacted the way in which presence of loan creditors induces managers toward striving for superior corporate performance. He argues that state-owned suppliers of debt capital (like state-owned banks) have been unable to exercise much of a disciplining influence on Indian corporate managers. These managers have continued to indulge in discretionary behavior with negative performance consequences.
There are practical ramifications for Dawar's findings. In particular, they will enable practitioners and analysts to understand as to why, in the bank-dominated debt financing system in India, leverage is negatively associated with firm performance.
In conclusion, the results of Dawar's study enrich the literature on capital structure and agency costs issues in several ways. First, this study finds a negative influence of capital structure on financial performance of Indian firms. Second, this paper shows that while firm size, tangibility, liquidity, and advertising are positively related to firm performance, they tend to be negatively related to firm age.
2.4 Capital structure and size: new evidence across the broad spectrum of SMEs
The paper “Capital structure and size: new evidence across the broad spectrum of SMEs” analyzes whether the factors determining capital structure are different for firms belonging to different size groups. The authors, Professors Nikolaos Daskalakis, Nikolaos Eriotis, Eleni Thanou and Dimitrios Vasiliou, adopt a model based on the well-known SMEs literature. The uniqueness of their paper lies in testing the differences in capital structure determination among different size groups of enterprises.
When investigating whether the factors determining capital structure are different for firms belonging to different size groups, the authors use a two-stage model. In their first stage, they separate their sample of SMEs into three groups based on size. They then analyze how the main factors tested in the literature (profitability, asset structure, size, growth) affect capital structure for each group. This analysis is designed to catch any differences regarding the direction of the relationship between the debt ratio and the regressors among groups. For their first stage, all size groups show that a firm's debt ratio is negatively related to profitability and asset structure and positively related to size and growth. These findings are consistent with those of other studies.
In their second stage, the authors examine whether the magnitude of the coefficients of the regressors from the first stage is different among groups. This examination will catch any differences on the relative contribution of each variable that would imply differences in financing behavior among groups. For this second stage, they find firm size does not affect the relation between the regressors and the debt ratio. Thus, even though size is an important regressor on capital structure determination, firms belonging to different size groups seem to behave similarly regarding the relation between the debt they use and their profitability, size, asset structure, and growth.
The authors state their findings can be used by consultants and financial institutions to develop financial products for the smaller firms. They add their study has limitations to be addressed by future research. First, there is a selection bias and survivorship bias that can be addressed. Second, larger national studies could examine differences or similarities by sectors and by geographic regions. Third, there is question as to whether their results have been altered under the scope of the economic crisis. Fourth, they suggest that a cross-country comparison could provide some interesting results.
2.5 Debt-equity decision-making with wealth transfers
The paper “Debt-equity decision-making with wealth transfers” is written by me (Professor Robert M. Hull). I offer an instructional class exercise of the debt-equity decision-making process when wealth transfers are present. In this exercise I use the Capital Structure Model (CSM) framework. By incorporating wealth transfers due to risk shifting between debt and equity, this paper extends previous capital structure teaching applications that use the CSM. The closest approximation to the CSM, for those who are unfamiliar with it, would be the Dividend Valuation Model (DVM). The DVM, like the CSM, uses perpetuity formulations with and without growth. However, the DVM does not allow growth rates to change with leverage like the CSM.
The pedagogical exercise is aimed at upper level finance students and graduate level students. The exercise applies: first, standard textbook G L equations like the simple tax shield model and Miller's personal tax model and second, more recent CSM G L equations including those covering wealth transfers. In regards to the CSM equations, this poses a demand for instructors who must learn the basics of the CSM in order to help students understand many of the variables and computations in the exercise. Given the estimates for tax rates, discount rates (costs of borrowing), and growth rates, the CSM equations offers potential to guide managers of growth firms on how to choose an optimal debt level.
Unlike prior exercises that focus on unlevered firms as their starting point for each G L equation, this paper's class exercise has a levered firm as its starting point. This starting point enables a wealth transfer effect to be studied thus making this paper's exercise unique in teaching students the interconnections of wealth transfers and debt-equity decision making. A wealth transfer begins with addition of new debt that causes a shift in risk from outstanding debt to equity. When more senior debt is issued, the outstanding debt is diluted taking on more risk and thus increasing its discount rate and causing its value to fall. G L from equity's viewpoint is enhanced at the expenses of the wealth loss experienced by outstanding debt as this loss becomes equity's additional gain. Of utmost importance, the exercise demonstrates the maximum G L and optimal leverage ratio can both be impacted when this shift in risk takes place.
In conclusion, I would like to thank those who submitted papers to this Special Issue. I would also like to once again express my gratitude to the referees whose names will not be given to preserve anonymity. Without your time and effort, knowledge cannot be properly advanced.
To those who submitted and did not make this Special Issue, I would like to thank you for your submission and note that your papers had qualities that can lead to eventual publication. Hopefully, the remarks by our referees will help guide these papers towards eventual publications. Papers received after the deadline of the Special Issue can be resubmitted to another Managerial Finance issue.
Finally, I would like to thank all of those on the staff of Managerial Finance who have supported my efforts as Guest Editor. In particular, special thanks to Don Johnson, Managerial Finance's Head Editor for his prompt help and expert guidance.
Professor Robert M. Hull, Washburn School of Business, Washburn University, Topeka, Kansas, USA
Danso, A. and Adomako, S. (2014), “The financing behaviour of firms and financial crisis”, Managerial Finance, Vol. 40 No. 12, pp. 1159-1174
Basu, N. (2014), “The structure of equity ownership: a survey of the evidence”, Managerial Finance, Vol. 40 No. 12, pp. 1175-1189
Dawar, V. (2014), “Agency theory, capital structure and firm performance: some Indian evidence”, Managerial Finance, Vol. 40 No. 12, pp. 1190-1206
Eriotis, N., Daskalakis, N., Thanou, E. and Vasiliou, D. (2014), “Capital structure and size: new evidence across the broad spectrum of SMEs”, Managerial Finance, Vol. 40 No. 12, pp. 1207-1222
Hull, R. (2014), “Debt-equity decision-making with wealth transfers”, Managerial Finance, Vol. 40 No. 12, pp. 1223-1250
About the Guest Editor
Professor Robert M. Hull has taught for the past 24 years at Washburn University and is the Clarence W. King Endowed Chair in Finance.