DOES CORPORATE GOVERNANCE QUALITY AFFECT CAPITAL STRUCTURE?

Does corporate governance quality affect Capital structure?

INTRODUCTION

The relevancy of capital structure and the role it plays in capital structure has been a topic for discussion for a period of over sixty decades.  While some authors like Modigliani and Miller (1959) argue that corporate governance quality does not affect capital structure, other authors like Bown and Taylor (2006) argue that a company with a better corporate governance quality affect the capital structure. With the debate as to whether corporate governance quality affect capital structure continuing, it has become important to discuss the effect of corporate governance quality on the capital structure of a firm as this topic seems confusing to most financial researchers. The main reason of the existence of corporate governance is to assist in providing better balances and cheques between the management and the shareholders of a firm (Huang and Song, 2006). This is important as the management acts in the best interest of the shareholders. The theory that mainly explains the importance of corporate governance is the agency theory. According to Driffield et al., (2007) the agency theory mainly seeks to solve the main problems that exists between the principal and the agent in which the agent must act in best interest of the agent.

If a firm ensures that it is governed correctly, then the capital structure is likely to perform well. One way in which the agency theory can be applied in ensuring that corporate governance in a firm is quality is by employing leverage. There are several ways in which the agency problems can be solved by employing leverage. The first way in which the agency conflicts can be reduced is through motivating managers of the firm to increase their ownership. This means that the company will employ debt finance which will displace equity capital. The equity base of the firm will be significantly reduced which will ensure that the management owned equity has increased significantly (La Rocca, 2007). In addition to that, debt usage by firms increases the chances of a firm going bankrupt, Therefore, if the management is aware of such risks, they will significantly increase their efficiency by reducing their perks consumption. Lastly, since the usage of debts usually attract interest payments, the issue of free cash flow problem will be solved. Therefore, this paper will contribute to the growing research of whether corporate governance quality affects capital structure.

LITERATURE REVIEW

Since the introduction of capital structure irrelevance by Modigliani and Miller (1958), several capital structure theories have emerged. The first theory that seeks to investigate the issue of corporate governance quality and if it affects capital structure is the agency theory. Several authors such as La Rocca, (2007) argue that managers always act to their best interest in which they will make investment decisions that will either increase their compensation or decrease the risks that they face with employment. Therefore, this means that the usage of debt financing is an important governing tool that can be employed in the reduction of conflict that exists between the shareholders and the management. Using debt financing will assist in reducing the availability of free cash flow to managers of a firm therefore assist in ensuring that the corporate governance structure affects the capital structure (Antoniou et al., 2008).

The other theory that investigates whether the corporate governance structure affects the capital structure is the pecking order theory. This theory states that a firm will prefer internal financing compared to external financing (Huang and Song, 2006).  However, the theory is based on two main assumptions in which information asymmetry assists between the shareholders and the management and two managers of a firm are likely to prefer internal financing compared to external financing. This implies that if the internal cash flow operations are not enough a firm is likely to source the money from external sources (Huang and Song, 2006). This means that debt will be employed by most managers as it is the safest way in which a firm can acquire capital investment without increasing risks. If debt is not sufficient for the firm, it is likely that the firm will seek the next less risky debt strategy implying that equity will only be employed if there is no reason to use debt as a strategy.

One author who investigated the relationship between corporate governance quality and capital structure is Huang and Song, (2006) who in his investigations found out that the board size of a firm affects the capital structure. The authors also found out that there was no relationship between the duality of the management and the firm’s capital structure. In addition to that, Sotu (2003) who investigated the same topic found out that there was a relationship between corporate governance quality and the capital structure. The author found out that a weak corporate governance system was caused by a firms’ diffused ownership together with a firm finance leverage that is higher. The author suggests that one way in which the conflict between the management and the shareholders can be reduced is through having a centralized ownership. A corporate governance system that is quality will assist in lowering the usage of internal finance and increasing the usage of external financing. This means that there is no relationship between the quality of a corporate governance system and the financial leverage of a firm.

Rehman et al (2010) who also investigated the same topic found out that there was a relationship between the size of the board which greatly influenced its quality and the capital structure. Another author who investigated if corporate governance quality affects the capital structure is Antoniou et al (2008) who found out that firms which operated in both bank oriented and market oriented economies had their capital structure influenced by not only the capital markets exposure but the corporate governance practices. Lastly, Driffield et al., (2007) who also investigated whether there was a relationship between the quality of the corporate governance and the capital structure found out that a positive relationship existed between these two factors. In fact, the size of the board together with its composition and the duality of the CEO greatly affected the capital structure.

RESEARCH DESIGN

The research design assists in describing the methods and the direction in which the research will take in answering the main research question. According to Saunders et al., (2007), the design of a research assists in defining the type of research. This type of research is the exploratory research design. The exploratory research design seeks to generate a hypothesis which will be used in a dataset to assist in examining whether the variables used in this research are connected. In using the exploratory research design, this doesn’t mean that there is lack of knowledge in the area of study. However, the strength of the relationship that exists between the two variables is unknown (Franklin, 2012). The reason why the exploratory research design was considered in this research is because this research type requires less methodological restrictions. In addition to that, the exploratory research design is objective in finding out whether the variables of a research are related and assist in finding answers to the questions being investigated. In understanding whether the corporate governance quality affect the capital structure, this section will describe both the dependent and the independent variables of the study, the hypothesis of the study together with statistical analysis plan and the methods used in data collection.

 

RESEARCH APPROACH

There are various types of research approach that can be employed in a study. However, in order to find out if corporate governance quality is affected by the capital structure, the deductive reasoning was used in this case. The deductive reasoning research approach was employed because one it assisted in reviewing previous empirical studies which were carried out before in order to assist in hypotheses development of its own study (Franklin, 2012). In addition to that, the study employed both statistics and regression model in order to do a resting on the hypothesis which have been proposed in the study. All these steps that have been described are important steps in understanding deductive reasoning (Saunders et al., 2007). Moreover, since the research is quantitative, employing deductive reasoning was important as it enabled the research to be carried out using the given data set for both the corporate governance and capital structure which assisted in making meaningful conclusion for the research. This means that the research will use a given data set to investigate whether the corporate governance affects the quality of the capital structure.

RESEARCH METHOD

The research method that will be used in this study is the quantitative method. The quantitative method mainly deals with statistics and mathematical formula (Berg, 2009). In order to investigate whether corporate governance affects the quality of capital structure, various data sets will be used which will be examined statistically to investigate whether this statement is true or false. Therefore, since quantitative method mainly deals with statistics, various data sets from the FTSE 100 will be used then regressed in order to understand whether there is a relationship between corporate governance and the capital structure. The quantitative method is also important in econometrics as it assists the research to be more objective when dealing with data sets. In this case, since the research will be investigating the relationship between corporate governance and capital structure, various data sets will be collected in relation to the two variables which will assist the research in being more objective. In addition to that, there are several other studies that have been carried out that investigate whether corporate governance quality affects the capital structure. Therefore, by using the quantitative method of study, comparisons will be made with this research and similar study to investigate whether similar results were found out.

 

RESEARCH HYPOTHESIS

A research hypothesis is important in any quantitative study as it assists the research in being more objective and gives the research direction (Adèr et al., 2008). In investigating whether corporate governance quality affects capital structure, the hypothesis that will be investigated in this case is

Hypothesis 1: There is a relationship between corporate governance quality and capital structure

Null hypothesis: There is no relationship between corporate governance quality and capital structure.

The research hypothesis will assist in investigating the main topic of the study and coming to a conclusion as to whether or not there is a relationship between corporate governance quality and capital structure.

 

DATA SOURCE AND DESCRIPTION

In investigating the relationship between corporate governance quality and capital structure, it was important to collect meaningful data. In this study, the FTSE 100 index in which the utility and financial firms were excluded from the London stock exchange was employed. The FTSE 100 index is a collection of companies that perform well in the stock market and was therefore chosen as it will assist in giving out the true nature of whether there is a relationship between corporate governance quality and capital structure.

The data that was used in this study was retrieved from google finance. Although Yahoo Finance has been in the industry for a long time, Google finance was used as a source of data because in the recent past, Google has risen to become one of the most prominent reliable source of information. Therefore, in this case, Google finance will be reliable as a source of financial information for the FTSE 100 index.

The data that was collected in this case consisted of the following. Since the main variables that were being investigated in this study is the corporate governance and the capital structure, the data that was collected was to reflected both the corporate governance and the capital structure. The data that was collected on corporate governance was based on the characteristics of the company in which the companies were retrieved from the FTSE 100 index. The characteristics of the data that was collected to investigate capital structure was the leverage ratio and the stock liquidity. In this case, the leverage ratio that was used the annual reports from the FTSE 100 was collected. The total debt and total asset were collected to calculate the leverage ratio. In calculating the stock liquidity, the data was collected from Google finance in which the daily stock price and the daily trading volumes was used. The data that was collected ranged from 2013 to 2017.

In measuring the variable in order to understand whether corporate governance quality affects the capital structure, the leverage will be used as the dependent variable while the independent variable of interest are the corporate governance variables.