Equity or Debt Financing: Does Good Corporate Governance Matter?

• Published date: 01 March 2012
• Date: 01 March 2012
• Author: Vivek Mande,Young K. Park,Myungsoo Son
• DOI: http://doi.org/10.1111/j.1467-8683.2011.00897.x

Equity or Debt Financing: Does Good Corporate

Governance Matter?

Vivek Mande, Young K. Park, and Myungsoo Son*

ABSTRACT

Manuscript Type: Empirical

Research Question/Issue: We examine whether corporate governance plays a role in inf‌luencing a f‌irm’s choice of f‌inanc-

ing, i.e., equity versus debt. We hypothesize that the likelihood of equity f‌inancing increases with governance because of a

reduction in agency costs between investors and managers in these f‌irms. While the reduction in agency costs occurs for

both equity and debt f‌inancing, we argue that there is a more signif‌icant effect on equity f‌inancing.

Research Findings/Insights: Using a sample of over 2,000 US equity and debt issuances over the period 1998 to 2006, we

f‌ind that our measures of corporate governance effectiveness have a positive impact on the likelihood of choosing equity

compared to debt. This association is more pronounced in small f‌irms where information asymmetry is higher between

managers and investors.

Theoretical/Academic Implications: Our f‌indings ref‌ine and extend the pecking order hypothesis, which suggests that

f‌irms will issue equity as their last resort because of the high information asymmetry associated with equity f‌inancing. We

provide some of the f‌irst evidence that the pecking order hypothesis can be mitigated by corporate governance.Specif‌ically,

we f‌ind that the likelihood of issuing equity increases as governanceincreases. Further, we f‌ind that where agency costs due

to information asymmetry are greater, the positive impact of governanceon the likelihood of equity f‌inancing is also greater.

That is, in support of agency cost theory, we f‌ind that f‌irms facing high agency costs benef‌it the most from investing in

corporate governance mechanisms that lower the agency costs. We are not aware of any prior study, published or unpub-

lished, that has documented this result.

Practitioner/Policy Implications: From a practical perspective, our study suggests that f‌irms wishing to access equity

capital markets should pay attention to their corporate governance. Specif‌ically, by investing in corporate governance

systems, f‌irms facing high agency costs may be able to obtain easier access to not just debt but also equity markets. From

a practice standpoint, in the years prior to securing f‌inancing, f‌irms should consider making improvements to their

governance (e.g., changes to board structure and/or auditor), carefully weighing the costs of making these improvements

against the benef‌its of securing better and cheaper access to equity markets.

Keywords: Corporate Governance, Equity Finance, Debt Finance, Agency Theory

INTRODUCTION

This paper examines whether the quality of corporate

governance plays a role in a f‌irm’s choice of equity

versus debt f‌inancing. The extant literature f‌inds that corpo-

rate f‌inancing policy is strongly inf‌luenced by agency prob-

lems facing a f‌irm (Berger, Oferk, & Yermack, 1997; Jensen &

Meckling, 1976; Myers & Majluf, 1984). We argue that a

reduction in agency conf‌licts effected through high quality

corporate governance systems increases the tendency of

f‌irms to issue equity.

Agency problems arise due to the separation of ownership

and operational control of a f‌irm. Managers deriving utility

from control of their companies’ operations can, for

example, entrench themselves and pursue self-serving

actions that come at the expense of shareholders (Jensen &

Meckling, 1976). Managers entrench themselves in a variety

of ways, making sub-optimal investment decisions (e.g.,

“empire building”) and strategically increasing their voting

power (Shleifer & Vishny, 1989; Stulz, 1988). Studies show

that managersare able to entrench themselves because trans-

action costs in the market for corporate control are high

(Jensen, 1986; Jensen & Meckling, 1976). Related research

*Address for correspondence: 4350 Mihaylo Hall, California State University, Fuller-

ton, Fullerton, CA 92834, USA. Tel: 657-278-2732; Fax: 657-278-4518; E-mail: mson@

fullerton.edu

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© 2011 Blackwell Publishing Ltd

doi:10.1111/j.1467-8683.2011.00897.x

suggests that it is prohibitively costly for shareholders to

wrest control back from entrenched managers (Shleifer &

Vishny, 1989; Stulz, 1988).

Agency risks arising from managerial entrenchment can

make equity less attractive than debt f‌inancing (Myers &

Majluf, 1984). Thisis because entrenched managers are more

likely to select opportunistic and risky investments even

when these investments are not in the interests of sharehold-

ers (Dittmar & Mahrt-Smith, 2007; Masulis, Wang, & Xie,

2007). And, while management’s entrenchment can also

adversely affect debt holders’ interests, the effects are likely

to be greater on equity holders (see, e.g., Chava, Kumar, &

Warga, 2010).

The separation of ownership from management also

results in information asymmetry about a company’s perfor-

mance. Managers have information about their f‌irms which

is not available to shareholders until the managers opt to

release it. Thisinformation asymmetry also results in agency

problems, i.e., managers can use their private information to

act in their own self-interest at the expense of shareholders

(Jensen & Meckling, 1976).

The widely accepted pecking order hypothesis (POH)

(Myers & Majluf, 1984) considers the role of information

asymmetry in inf‌luencing a f‌irm’s f‌inancing policy. It argues

that in the face of information asymmetry, f‌irms will prefer

debt over equity, because investors will signif‌icantly dis-

count the price of equity taking into account agency costs,

and make an equity offering unattractive for the f‌irm.

Our paper explores whether equity f‌inancing might be an

option for f‌irms that f‌ind ways to reduce agency conf‌licts

due to management’s entrenchment and information asym-

metry. The literature suggests that investing in high quality

corporate governance provides a potential remedy to many

agency problems, reducing the cost of equity. First, good

quality corporate governance provides equity investors with

direct protection from self-serving managerial behavior.

When the monitoring provided by corporate governance is

not present, entrenched managers can make ineff‌icient

investment decisions and expend resources resulting in the

destruction of shareholder value (Dittmar & Mahrt-Smith,

2007; Masulis et al., 2007).

Second, effective corporate governance reduces the infor-

mation asymmetry by ensuring the release of credible f‌inan-

cial information (Ajinkya, Bhojraj, & Sengupta, 2005). High

quality corporategovernance ensures a high quality of f‌inan-

cial reporting, which in turn reduces monitoring costs for

providers of equity capital as they will not need to conduct

costly private search for this information (Cohen, Krish-

namoorthy, & Wright, 2004). Thus, as corporate governance

becomes stronger, it should reduce the cost of equity and

increase the willingness of investors to provide funds.

Good quality corporate governance can also be expected

to reduce the cost of debt f‌inancing. Effective corporate gov-

ernance results in managers using resources more eff‌iciently

which reduces default risk and, in turn, lowers the cost of

debt (Bhojraj & Sengupta, 2003). However, the impact of

corporate governance on debt f‌inancing is less direct com-

pared to its impact on equity f‌inancing. Debt holders have

direct protective mechanisms such as debt covenants for

ensuring repayments of f‌ixed amounts of interest and prin-

cipal (Chava et al., 2010) and, therefore, need to rely less on

corporate governance mechanisms which offer indirect pro-

tection. The POH also argues thatthe impact of agency prob-

lems from information asymmetry is relatively smaller for

debt f‌inancing and as a result the biggest impact of corporate

governance should be felt by equity holders.

Based on these arguments, we explore whether gover-

nance can reduce agency problems to a level where equity

becomes more desirable than debt for some f‌irms. Using a

comprehensive index of corporate governance variables that

includes proxies for board and audit committee effective-

ness, the role of the CEO, institutional ownership, auditor

type and shareholder rights, we study whether governance

quality is positively related with the probability of issuing

equity. Our univariate analysis and multivariate regression

results are generally consistent with our hypothesis, namely

that we f‌ind a positive association between our governance

proxies and the likelihood of equity f‌inancing. Our multi-

variate results are based on estimations of a two-stage least

squares model that takes into account the endogeneity

between corporate governance and choice of f‌inancing.

While prior studies have examined the relationship

between credit ratings and corporate governance

(Ashbaugh-Skaife, Collins, & LaFond, 2006) as also the cost

of debt/equity and corporate governance (Ashbaugh,

Collins, & LaFond, 2004; Bhojraj & Sengupta, 2003), we do

not know of any published work that has examined the

association between corporate governance and the choice of

f‌inancing. The study closest to our work is an unpublished

paper by John and Litov (2010) who document that debt

issuances are positivelyrelated to the G index. These authors

suggest that their results are consistent with entrenched

managers having better access to debt markets. By contrast,

our f‌inding is that the likelihood of issuing equity increases

due to a reduction of agency costs relating to information

asymmetry and management’s entrenchment stemming

from good governance. In particular, our study f‌inds that as

information asymmetry (proxied by f‌irm size/analysts’ fore-

cast dispersion) increases, the positive inf‌luence of gover-

nance on the likelihood of equity f‌inancing also increases.

Thatis, where agency costs are greater, the positive impact of

governance on the likelihood of equity f‌inancing is also

greater. We are not aware of any prior study, published or

unpublished, that has documented this result, thereby pro-

viding new evidence on how the POH can be mitigated by

governance.

The organization of this study is as follows. The next

section discusses the literature and presents the hypotheses,

followed by a discussion of our research design. We then

report the empirical results, and the last section concludes

the study.

LITERATURE REVIEW AND HYPOTHESES

DEVELOPMENT

Agency Costs as Determinants of Choice of

Financing: Equity or Debt

A number of theories in the literature demonstrate how

agency costs affect a f‌irm’s choice of f‌inancing. The pecking

order hypothesis (POH) argues that because managers have

196 CORPORATE GOVERNANCE

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