Board of directors’ composition and capital structure

Outline

• Abstract
• Graphical Abstract
• Keywords
• 1. Introduction
• 2. Literature Review and Hypotheses Development
• 2.1. Literature Review
• 2.1.1. Trade-Off Theory
• 2.1.2. Pecking Order Theory
• 2.1.3. Other Capital Structure Theories
• 2.1.4. Institutional Environment and Capital Structure
• 2.2. Hypotheses
• 3. Data and Methodology
• 3.1. Dependent Variables
• 3.2. Independent Variables
• 3.3. Control Variables
• 3.4. Methodology
• 4. Empirical Results
• 5. Robustness Checks
• 6. Conclusion
• References

Conclusions

This article investigates empirically how the board of directors’ composition affects the mix of financing sources used by firms. The investigation is conducted using a panel data of 2,427 firms from 33 countries over the period of 2006 to 2010. After controlling for a wide set of capital structure determinants the results show that firms with a board of directors composed with more independent directors are more likely to have higher fractions of riskier financing sources in their capital structures. Particularly, the results provide strong evidence that firms with a larger fraction of independent directors on the board: (1) have more external financing sources when compared with retained earnings; (2) have more short term debt in relation with retained earnings; (3) have more long term debt compared with short term debt; and (4) have more external equity than long term debt. These results are consistent with our hypothesis which conjectures that a more independent board should lead firms to reduce information asymmetries between managers and outside investors and by that means reduce the cost of issuing more risky sources of financing as predicted by the pecking order theory of Myers (1984) and Myers and Majluf (1984). The results also provide some evidence that a more gender diversified board of directors and where the chairman is non-executive (i.e. the CEO is a different person from that of the chairman) can improve the board of directors’ independence and efficiency and therefore lead the firm to rely more on long term sources of financing. The effect of board size on financing choices is mixed, since larger boards can be more or less effective depending on the complexity of the firm.

With respect to policy implications the present study provides new insights into the way firms can have more external sources of finance. The result that a firm with a more independent board of directors have more long term debt and external equity suggests that it can match more easily (i.e. less costly) the maturity of their assets with the maturity of their financing sources (Hall et al., 2000). The results also provide important implications to securities regulators, since the investigation suggests that firms with more independent directors are more likely to issue long term debt and external equity. If that is the case, then regulators could promote the inclusion of independent directors in the board of directors of listed firms in order to develop their financial markets. Lastly, the results also add to the discussion over the capital structure theories. If the trade-off theory is to hold stand alone and the pecking order theory is not then one should not see such strong effect between the board of directors’ structure and the use of different financing sources. In fact the present study results suggest that managers pick financing sources taking into account the level of information asymmetry. Further, the results suggest that board independence is not only important to align the manager interest with those of the owners but is also important to other financing suppliers, such as bondholders.

The results presented are consistent with a number of empirical findings previously documented in the literature. For example, our results are consistent with the findings of Cronqvist et al. (2012) where firms with strong governance devices are less likely to reveal corporate leverage practices that arise from the CEO personal preferences. The results are also consistent with the literature that argue that governance mechanisms can substitute the effect of debt in reducing the free cash flow agency problems (e.g. Berger et al. 1997 and Jiraporn et al. 2012), since we find that firms with a more independent board of directors relies more heavily on external equity when compared with total debt and long term debt. Finally, the results are also consistent with previous empirical work that finds a negative relation between corporate governance devices and the cost of debt (e.g. Fields et al. 2012).

This study has several limitations that should be stressed. First, the financing sources are measured using book values and quasi market values. Given that long term debt market values can be much lower than book values during the sample period here considered the results are not as robust as would be if market values were considered. Further, the study do not do not segregate public from private debt. Information asymmetries costs are potentially lower for private debt since creditors can monitor more closely executive management. Additionally, the sample data analysed has a small time span (5 years) and a large cross section. Therefore, the results presented are more likely to characterize different financing policies across firms than across time. Finally, the present study does not control for firm ownership heterogeneity. Firms with diverse ownership structures may have different information asymmetry levels. As such, this study’s findings would benefit from further research that considers these limitations.

Future research could exploit these limitations and further provide new evidence as to whether other corporate governance devices could change firm financing choices, for example ownership structure.