(Luận văn thạc sĩ) firms histories, managerial entrenchment and leverage ratio from vietnams listed firms

UNIVERSITY OF ECONOMICS

ERAMUS UNIVERSITY ROTTERDAM

HO CHI MINH CITY

INSTITUTE OF SOCIAL STUDIES

VIETNAM

THE NETHERLANDS

VIETNAM – NETHERLANDS
PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS

FIRMS’ HISTORIES, MANAGERIAL ENTRENCHMENT &
LEVERAGE RATIO FROM VIETNAM’S LISTED FIRMS

BY

PHAM LE PHUONG LAN

MASTER OF ARTS IN DEVELOPMENT ECONOMICS

HO CHI MINH CITY, NOVEMBER 2016

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UNIVERSITY OF ECONOMICS

INSTITUTE OF SOCIAL STUDIES

HO CHI MINH CITY

THE HAGUE

VIETNAM

THE NETHERLANDS

VIETNAM – THE NETHERLANDS
PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS

FIRMS’ HISTORIES, MANAGERIAL ENTRENCHMENT &
LEVERAGE RATIO FROM VIETNAM’S LISTED FIRMS
A thesis summited in partial fulfillment of the requirements for the degree of
MASTER OF ARTS IN DEVELOPMENT ECONOMICS

By

PHAM LE PHUONG LAN

Academic Supervisor:

Dr. VO HONG DUC

HO CHI MINH CITY, November 2016


DECLARATION

I hereby declare that the content of this dissertation is developed, written and
completed by myself. The thesis has not been accepted for any degree and institution in my
name. Additionally, I certify that this work will not, in the future, be submitted in my name
for any other diploma and university. To my best knowledge and belief, my research has
not been contained any previously published material, excepting for all carefully and
clearly cited references.

The thesis has not been finalized without the supervision and guidance of Dr. Vo
Hong Duc, Economic Regulation Authority, Western Australia and Open University, Ho
Chi Minh City. Any other support and encouragement has been profoundly acknowledged.

Ho Chi Minh City, November 2016

Pham Le Phuong Lan

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ACKNOWLEDGEMENT

I would first like to express my utmost gratitude for my supervisor, Dr. Vo Hong
Duc, for his brilliant guidance and his patience, tolerance, caring and understanding. In
addition, his burning motivation, inspiration, enthusiasm and his excellent insight and
expertise, from the first lecture on Day one, have been a profound influence on me in every
day. He provides me with a valuable opportunity and a great honor to follow his wisdom
supervision. Without his persistent guidance and assistance, I could not been able to
accomplish my thesis and also better myself.
I would like to send my appreciation to the Vietnam Netherlands Programme, to all
lecturers for their teaching method and to the staffs and my friends for their magnificent

support. Specially, I would like demonstrate my gratitude to Dr. Truong Dang Thuy for
sharing constructive comments and econometric technique that improve the manuscript.
From the bottom of my heart, I am indebted to my parents and my brother for the
unconditional love, endless support, and unlimited tolerance regardless of how imperfect I
am. For my whole life, my caring father and my understanding mother are the ones who
raise me up whenever I feel sorrow, teach me what is right from wrong and believe in what
I choose so that I can pursue my studying. Simply, home is home – the place where I
belong to.

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ABSTRACT

Corporate governance principles provide the framework for firms to achieve their
objectives. The framework is generally considered as the interactions between
management, board, and shareholders. Fundamental theories and findings from empirical
studies primarily indicate that strong corporate governance successfully promotes a
business success in relation to both management and finance by reducing agency conflict
and achieving an optimal level of capital structure. The effect of corporate governance on
capital structure has been raised and investigated in various empirical studies for an
extended period of time. Within the corporate governance framework, the relationship
between managerial entrenchment and leverage ratio has attracted great attention from
academia, practitioners, and policy makers from developed world. However, this important
link has not been sufficiently considered and investigated in the context of developing
nations, including Vietnam.
Using a sample of 289 non-financial firms listed on Ho Chi Minh Stock Exchange
during the period 2006-2015, this study is conducted to provide two major pieces of
empirical evidence to fill the following gaps in current research of corporate governance in
the Vietnamese context. First, for the first time in Vietnam, the effect of corporate

governance, managerial entrenchment, together with the market timing behavior on
leverage ratio is considered. In this study, managerial entrenchment is proxied by blockholder holdings, board size, director age, CEO-Chairman duality, board composition, and
CEO age. Also, market timing behavior is represented by firms’ histories on leverage ratio
which is measured by the ratio between book leverage and market leverage. Second, the
impact of managerial entrenchment on firm’s leverage ratio is then classified into two
distinct regimes, including a high entrenchment regime and a low entrenchment regime.
Furthermore, a two-stage approach is used in this study: (i) to determine the target leverage
level; and (ii) to quantify the effects of managerial entrenchment and firms’ histories on the
observed leverage level of listed firms in Vietnam. Variety econometric techniques, along
with the traditional Ordinary Least Squares (OLS) method, are incorporated such as the
Generalized Method of Moments (GMM) and endogenous switching regression method.
Key findings achieved from this study can be summarized as follows.

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First, empirical evidence indicates that there is a negative relationship between
managerial entrenchment and leverage ratio. Findings from this study confirm the view
that entrenched managers’ decision to reduce a leverage ratio by issuing equity is
consistent with market timing behavior.
Second, the results achieved from the study demonstrate that a negative effect of
firms’ histories including financial deficit and various timing measures together with stock
price histories on leverage ratio of Vietnam’s listed firms is found over the research period.
Third, the impact of high managerial entrenchment regime and low managerial
entrenchment regime and firms’ histories on book leverage ratio and market leverage ratio
is found in this study. The results confirm that high-entrenched managers pay attention on
the market timing and benefit from the equity market. As a result, they reduce a leverage
ratio utilized in their firms.
Fourth, the results present that the high managerial entrenchment regime is in
relation to larger number of block-holders, larger boards, older CEOs with CEO-Chairman

duality and more outside directors.
Fifth, findings from this study also reveal empirical evidence to support the view
that the change of leverage ratio is a negative response to financial deficit, profitability,
timing measures – yearly timing and long-term timing and an alternative timing measure –
insider sales, and stock price returns. Considerably, the downward adjustment of debt ratio
results from the high managerial entrenchment effect.
Sixth, high authority of entrenched managers to the board could be linked to weak
corporate governance in the Vietnamese context. This observation is based on the reports
of International Finance Corporation and the State Securities Commission Vietnam (2006)
and International Finance Corporation and the State Securities Commission Vietnam
(2012).
Key words:

Managerial entrenchment, Firms’ histories, Leverage ratio, GMM,
Endogenous switching regression model, HOSE.

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TABLE OF CONTENTS

DECLARATION ................................................................................................................. ii
ACKNOWLEDGEMENT.................................................................................................. iii
ABSTRACT ......................................................................................................................... iv
TABLE OF CONTENTS ................................................................................................... vi
LIST OF TABLES ............................................................................................................... x
LIST OF FIGURES ............................................................................................................ xi

CHAPTER 1

INTRODUCTION ................................................................................... 1

1.1.

Problem statement ................................................................................................... 1

1.2.

Research objectives .................................................................................................. 3

1.3.

Research questions ................................................................................................... 3

1.4.

Research scope ......................................................................................................... 4

1.5.

The thesis structure ................................................................................................. 4

CHAPTER 2
2.1.

LITERATURE REVIEW ....................................................................... 5

Literature review ..................................................................................................... 5

2.1.1.

Corporate governance framework .................................................................... 5

2.1.1.1.

Corporate governance principles .......................................................... 5

2.1.1.2.

Why does corporate governance matter for an organization?............... 5

2.1.2.

The theoretical framework of corporate governance ........................................ 6

2.1.2.1.

Agency theory ....................................................................................... 6

2.1.2.2.

Signaling theory .................................................................................... 7

2.1.3.

The capital structure theory .............................................................................. 8

2.1.4.

Managerial entrenchment and capital structure decisions theory ................... 11

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2.1.5.
2.2.

Market timing and capital structure theory ..................................................... 12

Empirical evidence ................................................................................................. 14

2.2.1.

The influence of managerial entrenchment and leverage ratio ....................... 14

2.2.2.

The impact of firms’ histories on leverage ratio ............................................. 15

2.3.

2.2.2.1.

Financial deficit and Leverage ratio.................................................... 15

2.2.2.2.

Market timing and Leverage ratio ....................................................... 15

2.2.2.3.

Stock price returns and Leverage ratio ............................................... 26

Hypotheses .............................................................................................................. 17

2.3.1.

2.3.1.1.

Block-holder holdings and Leverage ratio .......................................... 17

2.3.1.2.

Board size and Leverage ratio ............................................................. 18

2.3.1.3.

Director age and Leverage ratio .......................................................... 18

2.3.1.4.

CEO-Chairman duality and Leverage ratio ........................................ 18

2.3.1.5.

Board composition and Leverage ratio ............................................... 19

2.3.1.6.

CEO age and Leverage ratio ............................................................... 19

2.3.2.

2.4.

Managerial entrenchment and Leverage ratio ................................................ 17

The relationship between firms’ histories and leverage ratio ......................... 20

2.3.2.1.

Financial deficit and Leverage ratio.................................................... 20

2.3.2.2.

Market timing measures and Leverage ratio ....................................... 20

2.3.2.3.

Stock price returns and Leverage ratio ............................................... 21

2.3.2.4.

Profitability and Leverage ratio .......................................................... 21

2.3.2.5.

Leverage deficit and Change in target leverage .................................. 22

Analytical framework ............................................................................................ 23

CHAPTER 3
3.1.

RESEARCH METHODOLOGY AND DATA ................................... 24

Vietnam’s corporate governance and securities market framework ................ 24

3.1.1.

Vietnam’s corporate governance and institutional background ..................... 24
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3.1.1.1.

Vietnam’s adoption of corporate governance standards ..................... 24

3.1.1.2.

Vietnam’s corporate governance framework ...................................... 24

3.1.2.

The background of Vietnam’s securities market ............................................ 26

3.2.

Data sources............................................................................................................ 28

3.3.

Research methodology ........................................................................................... 28

3.3.1.

The two-stage approach in determining leverage ratios ................................. 28

3.3.1.1.

The target leverage ratio estimation .................................................... 28

3.3.1.2.

Model specification ............................................................................. 30

3.3.1.3.

Measurement of variables ................................................................... 31

3.3.2.

The Generalized Method of Moments (GMM) .............................................. 36

3.3.3.

Endogenous switching regression method ...................................................... 39

3.3.3.1.

The selection equation ........................................................................ 39

3.3.3.2.

The structural equations ...................................................................... 39

CHAPTER 4
4.1.

THE EMPIRICAL RESULTS ............................................................. 42

Data descriptions.................................................................................................... 42

4.1.1.

Descriptive statistics ....................................................................................... 42

4.1.2.

Correlation ...................................................................................................... 46

4.2.

The target leverage estimation.............................................................................. 50

4.3.

The influence of managerial entrenchment effect and firms’ histories on
Vietnam firms’ leverage ratio ............................................................................... 51

4.3.1.

The choosing of time period (t-n) – lag order selection for the model
specification .................................................................................................... 51

4.3.2.

Multicollinearity, autocorrelation and heteroskedasticity test ........................ 52

4.3.3.

Endogeneity test.............................................................................................. 53

4.3.4.

Managerial entrenchment effect, firms’ histories and leverage ratio ............. 54

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4.4.

The relationship of managerial entrenchment in both high and low
entrenchment regime and firms’ histories on Vietnam firms’ leverage ratio .. 60

CHAPTER 5

CONCLUSION AND POLICY IMPLICATIONS ............................ 66

5.1.

Concluding remarks .............................................................................................. 66

5.2.

Policy implications ................................................................................................. 69

5.2.1.

Implications for Vietnam’s listed firms .......................................................... 69

5.2.2.

Implications for Vietnam’s investors.............................................................. 71

5.2.3.

Recommendations for the Government of Vietnam and relevant authorities 71

5.3.

The limitation and further improvement ............................................................ 73

REFERENCES................................................................................................................... 74

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LIST OF TABLES

Table 3.1.

Measurement of variables........................................................................ 35

Table 4.1.

Descriptive statistics ................................................................................ 44

Table 4.2.

Correlation among managerial entrenchment proxies ............................. 46

Table 4.3.

Correlation among managerial entrenchment, firms’ histories and firms’
leverage ratio ........................................................................................... 47

Table 4.4.

The target leverage ratio estimation ........................................................ 50

Table 4.5.

Levin-Lin-Chu (2002) test ....................................................................... 51

Table 4.6.

The selection criteria ............................................................................... 52

Table 4.7.

Multicollinearity ...................................................................................... 52

Table 4.8.

Autocorrelation ........................................................................................ 53

Table 4.9.

Heteroskedasticity ................................................................................... 53

Table 4.10.

Endogeneity test ...................................................................................... 53

Table 4.11.

The Generalized Method of Moments regression of leverage ratio with
timing measures – yearly timing and long-term timing .......................... 58

Table 4.12.

The Generalized Method of Moments regression of leverage ratio with
timing measure – insider sales ................................................................. 59

Table 4.13.

The endogenous switching regression of leverage ratio with timing
measures – yearly timing and long-term timing ...................................... 64

Table 4.14.

The endogenous switching regression of leverage ratio with timing
measure – insider sales ............................................................................ 65

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LIST OF FIGURES

Figure 2.1.

Determination of the optimal ratio of outside equity to debt .................... 9

Figure 2.2.

Analytical framework .............................................................................. 23

Figure 4.1.

Managerial entrenchment effect .............................................................. 49

Figure 4.2.

Firm characteristics ................................................................................. 49

Figure 4.3.

Market timing effect ................................................................................ 49

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CHAPTER 1
INTRODUCTION
1.1.

Problem statement
Corporate governance principles provide the structure for firms to achieve their

objectives, and help those companies to shape instruments to maintain their objectives and
to control the firms’ performance. The framework is generally considered as the
interactions between management, board, and shareholders. Theoretical framework and
empirical evidence primarily indicate that strong corporate governance successfully
promotes a success of firms in association with both management and finance by reducing
agency conflict and achieving an optimal level of capital structure (Jensen 1986; Klock et
al. 2005; G20/OECD principles of corporate governance 2015).
The effect of corporate governance on capital structure has been raised and
investigated in various empirical studies for an extended period of time. Within the
corporate governance framework, the relationship between managerial entrenchment and
leverage ratio has attracted great attention from academia, practitioners, and policy makers.
According to Berger, Ofek and Yermack (1997), managerial entrenchment occurs when
managers, fail to experience the corporate governance disciplines, are able to manipulate
financing decisions to support their own interests rather than those of shareholders. On one
hand, it is believed that managerial entrenchment is related to an increase in leverage. In
their seminal paper, Jensen and Meckling (1976) considered that entrenched managers do
not always use the value-maximizing level of debt to implement capital structure. Those
managers may increase debt ratios beyond the optimal level to prevent them from takeover
risks, to strengthen their longevity with their firms, and to pass anti-takeover laws (Harris
and Raviv 1988; Stulz 1988; Wald and Long 2007). Similarly, Qi and Wald (2008) present
that the stronger anti-takeover efforts are linked to the more increase in leverage ratio. On

the other hand, it is expected that managerial entrenchment is in associated with less
leverage level. Welch (2004) shows that after obtaining benefits from large stock returns,
entrenched managers are willing to issue equity rather than debt, contributing to a decrease
in debt ratio. Moreover, John et al. (2008) find that for fear of a severe financial distress,
managers tend to avoid debt by pursuing conservative investment choices.

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Nevertheless, the relationship between managerial entrenchment and market timing
behavior on leverage ratio has not much been investigated. The market timing activity is
considerably explained by managers’ financing decisions through which companies choose
to raise debt or equity to finance their investment opportunities. Thus, the managerial
entrenchment and the market timing behavior should be simultaneously examined in this
study.
As mentioned, entrenched managers are seemingly to narrow down debt level and
are willing to carry out responsible investment decisions due to bankruptcy. Since
bankruptcy resulting from an increase in debt ratio helps those managers get rid of
takeover threats effectively (Zwiebel 1996). Unfortunately, avoiding debt probably limits
firms from accessing one of the low cost funds stemming from tax-shield benefits. Instead,
when it comes to meeting external financing demands, entrenched managers are likely to
issue substantial amounts of equity when the equity market is perceived to be more
favorable (Graham and Harvey 2001). This is consistent to the market timing theory that
capital structure is the cumulative outcome of past attempts to time the equity market
(Baker and Wurgler 2002). Specifically, Kayhan and Titman (2007) find that the past
attempts – firms’ histories such as financial deficits, timing measures and stock price
returns significantly reflect the market timing behavior, contributing to crucial roles in
determining a firm’s leverage ratio.
In Vietnam, few studies have examined the influence of managerial entrenchment
and the market timing effect via firms’ histories on choosing a firm’s leverage ratio. Also,

there are in lack of empirical evidences analyzing the market timing effect on leverage
ratio although many studies applied the trade-off theory and the pecking order theory, for
example, Vo and Tran (2015). Since the Vietnam’s securities market has just been
reaching an early stage of development, information asymmetry and agency problem may
lead to a drawback for firms on estimating stock prices and deciding an optimal leverage
level. Nguyen (2015) found that the market timing has the short-term and long-term effects
on a determination of the leverage level for the Vietnamese IPO firms. Although the paper
indicated that a sector’s value deviation along with past stock prices is an important factor
explaining for issuing equity and timing the market, managerial entrenchment and firms’
histories have been ignored in this study. Hence, this paper is conducted to provide
empirical evidence on the above issues which are still missing from previous studies in the
Vietnamese context.
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1.2.

Research objectives
The study is conducted to investigate the impact of managerial entrenchment and

the market timing effect through the firm’s histories on leverage ratio. The four main
objectives are presented as follows:
Analyzing the determinants of managerial entrenchment together with firms’

(i)

characteristics that influence leverage ratio of Vietnam firms.
(ii)

Evaluating the target leverage ratio of Vietnam firms.

(iii) Estimating the effect of managerial entrenchment and the market timing
presented through firms’ characteristics on leverage ratio.
(iv) Examining the relationship of managerial entrenchment in both high and low
entrenchment regime and firm’s histories on leverage ratio in Vietnam firms.
This study is different from other previous studies on the following grounds:


First, for the first time in Vietnam, managerial entrenchment together with
the market timing effect represented by firms’ histories on leverage ratio for
all listed firms in Ho Chi Minh Stock Exchange is considered.



Second, the effect of managerial entrenchment on firm’s leverage ratio is
classified as high entrenchment regime and low entrenchment regime.



Third, various measurements of firms’ characteristics is incorporated
including (i) financial deficits, (ii) leverage deficits, (iv) timing measure,
and (v) stock price returns and so on. Especially, insider sales can be used
as an alternative proxy for timing measure.



Fourth, various econometric techniques including the Ordinary Least
Squares (OLS), the Generalized Method of Moments (GMM) and
endogenous switching regression method are employed in this study.

1.3.

Research questions
In attempts to achieve the above objectives, the following four research questions

have been raised:
(i)

What are the determinants of managerial entrenchment and which are firms’
factors that significantly influence leverage ratio in Vietnam firms?

(ii)

Do Vietnam firms use target leverage and apply the market timing theory to
determine leverage ratio?
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(iii) How do managerial entrenchment and the market timing effect presented
through firms’ histories affect leverage ratio in Vietnam firms?
(iv) How do managerial entrenchment in both high and low entrenchment regime
and firm’s histories affect leverage ratio in Vietnam firms?

1.4.

Research scope
This study uses a dataset of 289 non-financial firms collected from Ho Chi Minh

Stock Exchange (HOSE) during the period of 2006 to 2015. The secondary dataset is
extracted from several sources such as annual reports, financial statements, and available

firms’ information on websites – cafef.vn, cp68.vn, and vietstock.vn. All financial firms
are eliminated from the sample for a reason that banks, insurances and investment funds
possess a different capital structures compared to those of firms in non-financial sector.

1.5.

The thesis structure
This thesis comprises five chapters. The main content of each chapter is organized

as follows:


Chapter 1 introduces an overview of the thesis containing the problem
statement, the research objectives, questions, and the research scope.



Chapter 2 begins with the existing theories and the empirical evidence
focusing on agency conflicts, managerial entrenchment, market timing and
firms’ characteristics. Later, the chapter identifies the research hypotheses
and the conceptual framework of the influences to firms’ leverage ratio.



Chapter 3 describes the methodology including the data measurements and
quantitative models employed in the thesis. Additionally, econometric
technique used to achieve the research objectives will be elaborated.



Chapter 4 expresses the empirical results. In particular, main findings are
revealed and compared to other empirical evidences.



Chapter 5 provides the key findings and the discussions. The implications
are delivered to shed light on the policy purposes. Finally, the chapter
indicates the limitations for future improvements.

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CHAPTER 2
LITERATURE REVIEW
In this section, Chapter 2 begins with corporate governance framework, the background of
Vietnam securities market, the existing theoretical framework of corporate governance and
capital structure, and the empirical evidence of managerial entrenchment behavior and
market timing effect through firms’ characteristics on leverage ratio. Later, the chapter
identifies the research hypotheses and the conceptual framework of these influences to
firms’ leverage ratio.

2.1.

Literature review

2.1.1. Corporate governance framework
2.1.1.1.

Corporate governance principles

Corporate governance principles provide the framework for companies to achieve
their objectives, and help those enterprises to shape instruments to maintain their
objectives and to control the firms’ performance. The framework is generally associated
with interactions between management, board, and shareholders. Strong corporate
governance is primarily believed to successfully promote a success of firms in relation to
both management and finance by reducing agency conflict and achieving an optimal level
of capital structure. Consequently, the principles support policy makers with effective
instruments to sustain economic growth efficiency and financial stability (Jensen 1986;
Klock et al. 2005; G20/OECD principles of corporate governance 2015).
The corporate governance principles do not provide the “perfect” role model for all
countries to follow. Rather, the principles synthesize some common elements that are
existed from different corporate structures. Furthermore, a variety of objectives and means
to achieve a suitable corporate governance structure is provided. In this way, based on an
appropriate and flexible orientation, the managements are freely to set up their own
corporate governance frameworks in response to their shareholders and debtholders’
expectations (G20/OECD principles of corporate governance 2015).

2.1.1.2.

Why does corporate governance matter for an organization?

Hart (1995) believes that corporate governance problems result from two
circumstances. The first one is known as the agency relationship which is the conflict
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interest between the owners and the managements of the organization. The second factor
comes from agency cost which is the result of agency conflict and is not narrowed by
signing an agreement.
The corporate governance principles are constructed to moderate these above

issues. Thanks to the globalization, the conflict interests of the owners and the
managements will be mitigated by welcoming and gaining substantial benefits from global
capital markets. When companies build up a robust relation to international capital flows
such those from high-developed countries, corporate governance agreements will be
widely accepted and will fit in with international principles. With the aid of implementing
effective supervision and mechanisms, the confidence of shareholders and debtholders will
be earned and the cost of capital will be declined, significantly improving wealth of the
owners and the managements. Definitely, this leads to a win-win relationship for the both
parties (G20/OECD principles of corporate governance 2015).

2.1.2. The theoretical framework of corporate governance
2.1.2.1.

Agency Theory

In their seminal paper, Jensen and Meckling (1976) develop the agency theory that
indicates the agency relationship between the owners and the top management of the firm
mainly results from the separation of ownership and control. The shareholders and
debtholders are represented for the principals while top managers are viewed as the agent.
The agency relationship is defined as an agreement of the principals and the agent. The
agent is the representative of the principals to execute some decision making authority
which maximizes the owners’ wealth. As a matter of fact, the best interests of the
principals should not always be achieved by the agent owing to the utility maximizing
relationship.
In attempts to protect their interests from divergences, the principals restrain the
abnormal behaviors of the agent by promoting incentives. First, the encouragement is
designed to increase the managerial ownership. Due to the rise of managerial ownership,
managers are forced to take full responsibilities for trading off shareholders’ wealth to
pursue their own interests. Nonetheless, once holding such the considerable power,
managers are likely rescued from being replaced and punished by the principals, causing

managerial entrenchment. Entrenched managers have a tendency to utilize their privileges

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to manipulate firms’ investment opportunities to preserve their well-beings (Morck,
Shleifer and Vishny 1988).
Additionally, the stimulation is existed in the form of an escalation in leverage or
debt creation (Grossman and Hart 1982; Jensen 1986). Debt financing seems to be a
powerful “penalty” in mitigating managers’ building empire desires (Hart 1995). For fear
of posing bankruptcy threats from debt financing, managers are motivated not only to
operate firms’ cash flows efficiently but also to supervise investment projects carefully,
generating cash flows in order to pay out future interest and principle disbursements.

2.1.2.2.

Signaling Theory

According to signaling theory, not merely the agency relationship comes from
interest conflicts among the owners and the managements, but also results from the
asymmetric information between the insiders and the outsiders. The insiders represent the
top managers whereas the outsiders signify the shareholders and debtholders. Managers are
supposed to obtain more information about firms’ investment opportunities than outsiders
(Ross 1977). To collect symmetric information, outsiders try their best to get the
information they need from a variety of sources. In truth, the permission to access to the
real value of firm’s present and future investment is limited and the reliability of
information is in need of verification. In this way, shareholders and debtholders are likely
subject to any financing change made by insiders. A modification of capital structure is in
relation to an alteration of the firm’s performance. When debt level is determined to be
boosted up, outsiders receive a signal from the firm that the promise of high future cash

flow is expected (Ross 1977). On the contrary, since firm’s investment is financed with
new equity issuing, outsiders will perceive the firm’s performance to be declined and share
the losses with newcomers. Hence, outsiders attribute the complete confidence of
managers in the future firm’s performance to the surge in leverage.

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2.1.3. The capital structure theory
In their well-known study of corporate governance, Jensen and Meckling (1976)
highlight that the capital structure theory is rather known as the theory of ownership
structure. As a matter of fact, the vital capital structure proxies are not simply the
accumulations of debt and equity but also the amounts of the equity of the manager.
Therefore, three determinants of the capital structure is incorporated to illustrate the theory
for a given size firm.
The total market value of the equity is calculated as:
𝑆 = 𝑆𝑖 + 𝑆0
The total market value of the firm is measured by:
𝑉 =𝑆+𝐵
where:


Si:

inside equity (held by the manager),



S0:

outside equity (held by outside investors of the firm),



B:

debt (held by outside investors of the firm).

The theory is developed to determine the optimal ratio of outside equity to debt
(Jensen and Meckling 1976).
The determination of the optimal ratio of outside equity to debt is
S0 ⁄B. The size of the firm is assumed to be constant. V presents for the actual value of the
firm and depends on the agency costs. Therefore, V ∗ refers to the value of the firm at a
given scale when agency costs are zero. The amount of outside financing
(B + S0 ) is held constant. The optimal fraction of outside financing obtained from equity
E ∗ is determined by E ∗ ≡ S ∗ ⁄(B + S0 ).

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AGENCY COSTS (MEASURED IN UNITS OF CURRENT WEALTH)

Figure 2.1.

𝐀𝐓 (𝐄) = 𝐀 𝐒𝟎 (𝐄) + 𝐀𝐁 (𝐄)

𝐀𝐓 (𝐄 ∗ )

0

𝐒𝟎
𝐄∗ = ൬
൰
𝐁 + 𝐒𝟎

10

E

FRACTION OF OUTSIDE FINANCING OBTAINED FROM EQUITY

Determination of the optimal ratio of outside equity to debt. Total agency costs, AT (E), is
a function of the amount of outside equity. Total outside financing is E ≡ S0 ⁄(B + S0 ), for a
given firm size V ∗ and given total amounts of outside financing(B + S0 ). The agency costs
linked to outside equity is AS0 (E). The agency costs related to debt is AB (E). The minimum
total agency costs is AT (E ∗ ) which is at optimal fraction of outside financing E ∗ .

Source:

Jensen and Meckling (1976)

Figure 2.1 describes two separate factors of the agency costs including: (i) the total
agency costs (a function of E) related to the amounts of equity held by the owner-manager
is AS0 (E); (ii) the total agency costs linked to the amounts of debt is AB (E). The total
agency cost is
AT (E) = AS0 (E) + AB (E)
The agency costs related to the amounts of equity held by the owner-manager is
AS0 (E). Since E ∗ ≡ S ∗⁄(B + S0 ) is equal to zero, it means that there is an absence of
outside equity. When the differences in the total equity equal to an increase in the equity
held by the outside equity investors, the manager is attracted to exploit the outside equity at

a minimum (zero), leading to a rising of the agency costs AS0 (E).
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The agency costs related to the amounts of debt is AB (E). The agency costs is
comprised of the decreases in value of the firm and monitoring costs associated with the
reallocation of wealth from bondholders to the manager by stimulating the manager’s
equity value. When all outside funds are financed by debt rather than equity S0 = E = 0,
the agency costs is maximized. On the contrary, as all outside funds are gained from equity
E = 1, this agency costs is at a minimum due to an incline to zero of debt. The manager’s
motivations of reallocating wealth from bondholders are declined owing to some following
reasons: (i) because the level of debt goes to zero, there is no amount of debt to reallocate
wealth from the debtholders to the manager; (ii) when the amount of equity S0 increases,
the manager’s total equity substantially decreases since E ≡ Si ⁄(S0 + Si ).
The sum of the agency costs by adding outside equity and debt financing is
displayed by the curve AT (E). Given that the total agency costs at a minimum value for
given size firm are AS0 (E) and AB (E), outside financing obtained by equity AT (E ∗ ) is at
certain point which is a combination of debt and equity level.

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2.1.4. Managerial entrenchment and capital structure decisions theory
Motivated by Jensen and Meckling (1976), many researchers have adopted agency
theory to answer the question of whether managers frequently maximize the level of debt
in making capital structure decisions to reduce agency costs. Based on the well-known
study of Grossman and Hart (1982), Berger, Ofek and Yermack (1997) come up with the
managerial entrenchment and capital structure decisions theory to predict efficiency
forecasts about a firm’s financing decisions contending with an agency problem.
Furthermore, the theory sticks on shedding light on whether and how entrenchment factors

related to the leverage choice of managers. Previous literature review on the influence of
agency conflicts on management’s financing decisions puts emphasis on the superior role
of debt in mitigating the agency relationship between managers and shareholders.
However, the determination of leverage in association with agency problems is left aside.
The agency problems are known as the interest conflicts over the power of making
financing decisions between managers and owners. As a matter of fact, the conflicts of
interests result from such elements that managers prefer firm risk to be diminished owing
to their under-diversification in investment choices (Fama 1980; Amihud and Lev 1981);
for the pressure of maintaining firm performance and paying out large fixed interest
payments, managers suffer from being replaced (Jensen 1986); managers keep on holding
their position as long as possible for fear of being removed by better qualified applicants
(Harris and Raviv 1988; Stulz 1988).
To claim the prediction of firm value efficiency on firms’ financing decisions under
agency conflicts, models are constructed to point out the explanation. The implementing of
these models is first motivated with the managers’ desire for maximizing the value of firm.
In this way, managers are forced to decide the level of debt that maximizes the firm value
by means of some disciplinary instrument. As opposed, Novaes and Zingales (1995)
indicate that the proficient debt choice has nothing in common with the entrenchment
choice. Shareholders are the agent who is beneficial to the efficient debt choice while
managers manipulate the debt choice to maximize their entrenchment or to retain their
terms in office. Also, the disciplinary mechanism is influenced by the managerial
entrenchment. When the punishment mechanism is tightened, managers arrive at a
reduction in debt level to deal with great takeover pressure. In contrast, if managers are not
affected by the disciplinary instrument, they quickly increase debt financing to a high level
to “deactivate” takeover pressure. Furthermore, Harris and Raviv (1988), Stulz (1988), and
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Jung, Kim, and Stulz (1996) point out a number of evidence for the influence of
managerial entrenchment on firms’ leverage decisions. Harris and Raviv (1988), and Stulz

(1988) argue that entrenched managers move debt level beyond the target level so as to
control their voting rights and hinder them from takeover threats. On the contrary to the
study of Harris and Raviv (1988), Jung, Kim, and Stulz (1996) find that debt financing is
not put a high priority on raising funds for firms’ investment. Instead, the poorer
investment opportunities these firms have, the more portion of equity is issued. Their study
also shows that the investment capacity of firms issuing equity is larger than that of firms
financing debt. As a result, Jung, Kim, and Stulz (1996) conclude that due to severe agency
costs, entrenched managers considerably issue equity regardless of how better outcomes
for firm value would be when issuing debt.
Theoretical arguments and some empirical evidence suggest that managers are
seemingly to be entrenched to protect themselves from intrinsic and extrinsic corporate
governance control instrument such as supervising by the board, being subject to takeover
threat, or receiving stock-based performance motivation. Therefore, the leverage choice
may be taken into account as a key for these entrenched managers to pursue their own
interests and maximize their tenure.

2.1.5. Market timing and capital structure theory
Financing decision, the determining factor of capital structure is substantially
considered as one of the most debated dispute in corporate finance for several decades. The
decision is in association with whether companies decide to raise debt or equity to finance
their investment opportunities. Many researchers have established numerous theoretical
analyses concentrated on the vital contribution of debt mixed with equity such as the tradeoff theory (Modigliani and Miller 1963; Fama and Miller 1972; Jensen and Meckling
1976; Myers 1977; Miller and Scholes 1978; DeAngelo and Masulis 1980; Easterbrook
1984; Jensen 1986) and the pecking order theory (Myers 1984; Myers and Majluf 1984).
However, these traditional theories have not practically elaborated the capital structure
choice. As a result, the theory of capital structure is naturally explained with the help of
market timing theory (Baker and Wurgler 2002). This is because the market timing theory
emphasizes on the raising of funds with equity as stock price increases and with debt when
stock price falls. In this way, Baker and Wurgler (2002) believe that capital structure is
defined as the cumulative outcome of past attempts to time the equity market.

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It is important to know that two different versions of equity market timing both
result in capital structure dynamics. In the first market timing version, Myers and Majluf
(1984) develop a dynamic type based on rational managers and investors and adverse
selection costs fluctuating among different firms or time. On one hand, Lucas and
McDonald (1990) and Korajczyk, Lucas, and McDonald (1992) analyze adverse selection
altering between firms. On the other hand, Choe, Masulis, and Nanda (1993) research
adverse selection changing across time. In association with these studies, firms are likely to
simultaneously publicize equity issues and information in attempt to release information
asymmetry (Korajczyk, Lucas and McDonald 1991). Similarly, firms have a tendency to
announce equity issues in some favorable periods which hinder firms from the effect of
adverse selection as much as possible (Bayless and Chaplinsky 1996). Measuring
deviations in adverse selection with temporary changes in the market-to-book ratio is
compulsory to observe the impact of alterations in the market-to-book ratio on dynamic
capital structure.
In the second market timing version, it appears that equity market timing is utilized
by irrational investors on the belief that they could time the market. In this way, the market
does not need to be inefficient and managers do not necessarily follow a trend in stock
returns. Rather, equity is issued since managers think that they would irrationally decrease
cost and equity is repurchased due to an illogically increase in cost. As a result, market-tobook values do not result from future equity returns but relate to high expectations of
investors (La Porta 1996; La Porta et al. 1997; Frankel and Lee 1998).

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