University of Nottingham

Do Corporate Governance Factors Matter for Financial Distress Prediction of Firms? Evidence from Taiwan.

Jia-Ling Wu

MA Finance and Investment

Do Corporate Governance Factors Matter for Financial Distress Prediction of Firms? Evidence from Taiwan.

by

Jia-Ling Wu

2007

ABSTRACT A large number of researchers devote themselves to the study of financial distress predictive models over the past decades. The first analysis method, which is Univariate approach, towards predicting model was introduced by Beaver (1966) and Multiple Discriminant Analysis (MDA) was proposed by Altman (1986) thereafter. Due to the fact that these two approaches can not perform precisely to predict a financial distress, Martin (1977) introduces the Logit model applied in the predictive models and Ohlson (1980) even expands selected samples to improve the accuracy rate of prediction. Although prediction models of financial distress have been improved via various applied statistic models, more information should be included to improve the quality of predictive models. Hence, Daily and Dalton (1994a) conduct a study to explore the relationship between corporate governance mechanism and probabilities that companies might experience financial crisis by means of considering both financial and governance variables since corporate governance has been proved that it has a substantial impact on the performance of firms. To investigate whether corporate governance is related to the probability of financial distress, ten governance variables are adopted in this study and the Binary Logit model is employed to establish a financial distress predictive model. The results indicate that seven variables, which are the percentage of shares held by institutional shareholders, the extent of concentration, cash flow rights, the ratio of cash flow to control rights, the ratio of board seats held by outside directors and supervisors, management participation and stock pledge ratio, have a significant impact on the financial distress predictive probability. The classification accuracy rate is also raised by means of adopting governance variables besides financial variables in the predictive models and the predictive model perform differently in the electronic and non-electronic industry. It is also discovered that the qualities of corporate governance in Taiwan still need to be improved. In sum, this study concludes that weak corporate governance leads to higher probability of financial distress.

Acknowledgment When this study is finished, it means that I will finish my study in the UK as well. It is the first time that I study abroad and I really had a wonderful time in the UK this year. Although it is so frustrating to study sometimes, the warm friendship still supports me to keep on working during this year. I wish to express my gratitude to all the teachers in the department of finance and investment and my supervisor, Dr. Pei Sun. Without their strict attitude towards teaching, I would still know little in the field of finance. Although I am not proficient at some parts of my study and it leads to some confusion when I was doing my dissertation, Dr. Pei Sun is always willing to give me some suggestion and provide me with some useful journals to clarify my confusion. I would also like to show my special thanks to all the coursemates in my department and all the friends I met in the UK. Without their support, it is hard to overcome the hard time I met during this year. Thanks for my sisters assistance in collecting the data. Lastly, my special thanks are due to the support from my family. I would never have courage to study abroad without their support. This year will become the best time I have never experienced in my life.

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Contents Abstract Acknowledgement Contents List of Tables List of Figures Chapter 1 Introduction 1.1 Research Motivation 1.2 Research Purpose 1.3 Research Structure and Process Chapter 2 Literature Review 2.1 Introduction to Financial Distress Predictive Model 2.1.1 Definition of Financial Distress 2.1.2 Literature of Financial Distress Predictive Model 2.2 Introduction to Corporate Governance 2.2.1 Definition of Corporate Governance 2.2.2 Literature of Corporate Governance Chapter 3 Research Design and Methodology 3.1 Research Hypothesis 3.2 Data Source and Sampling 3.3 Definition of Variables 3.4 Empirical Methodology Chapter 4 Analysis and Discussion of Empirical Results 4.1 Normal distribution test 4.2 Descriptive Statistics 4.3 Empirical Results 4.3.1 Multicollinearity Test 4.3.2 Binary Logit Model 4.3.3 Classification accuracy rate 4.4 Analysis and Discussion Chapter 5 Conclusion and Limitation 5.1 Conclusion 5.2 Limitation References
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Page i ii iii iv vi 1 1 3 4 6 6 6 7 11 11 11 21 21 22 24 33 39 39 41 49 49 57 64 71 73 73 74 75

List of Tables Table 3-1 Number of sample firms Table 3-2 Samples with failed firms by industry Table 3-3 Financial variables Table 3-4 Governance variables Table 4-1 K-S test of financial variables Table 4-2 K-S test of governance variables Table 4-3 Mann-Whitney U test of financial variables (failed v.s. non-failed) Table 4-4 Mann-Whitney U test of governance variables (failed v.s. non-failed) Table 4-5 Mann-Whitney U test of financial variables (Electronic v.s. Non-electronic) Table 4-6 Mann-Whitney U test of governance variables (Electronic v.s. Non-electronic) Table 4-7 Pearson Correlation Coefficient (Financial ratio variables) Table 4-8 Pearson Correlation Coefficient (Governance variables) Table 4-9 KMO and Bartletts Test (Financial variables) Table 4-10 KMO and Bartletts Test (Governance variables) Table 4-11 Total Variance Explained from financial variables Table 4-12 Selected Financial Variables- by Rotated Component Matrix Table 4-13 Coefficients of Binary Logit Model (financial variables) Table 4-14 Coefficients of Binary Logit Model (governance variables) Table 4-15 Coefficients of Binary Logit Model (financial & governance variables) Table 4-16 Calculation of Classification Accuracy Rate Table 4-17 Classification accuracy rate (Electronic, Financial variables) Table 4-18 Classification accuracy rate (Non-electronic, Financial variables) Table 4-19 Classification accuracy rate (Electronic, Governance variables)
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Page 23 23 28 31 39 40 42 44 46 48

50 52 54 54 55 56 58 61 62 64 65 66 67

Table 4-20 Classification accuracy rate (Non-electronic, Governance variables) Table 4-21 Classification accuracy rate (Electronic, Financial & Governance variables) Table 4-22 Classification accuracy rate (Non-electronic, Financial & Governance variables)

68 70 70

List of Figures Figure 1-1 Research Process Figure 3-1 The process of research methodology Page 5 34

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Chapter 1 Introduction 1.1 Research Motivation Bankruptcy of firms, such as Enron and WorldCom, has been concerned recently since it has a considerate impact on the whole economy. Financial scandals not only arose in American enterprises but also in Taiwanese companies. Similarly, quite a few numbers of listed companies in Taiwan, such as Pacific Electric Wire & Cable (PEWC) and Procomp Information Ltd., also experienced financial distress. All these events of financial distress were commonly caused by poor corporate governance system. The controlling shareholders or managers might tend to expand their credit by means of pledging their shares. They also have incentive to benefit themselves at expense of firm value. A study conducted by Prowse (1998) even indicates that highly concentrated ownership and poor corporate governance system lead to the financial crisis in East Asian countries. Accordingly, poor governance system indeed has adverse impact on the performance of firms and it even causes firms fall into a big danger of financial crisis. A large amount of studies towards the financial distress predicting models have been conducted. The first analysis method toward predicting model was introduced by Beaver (1966), while it seems not an appropriate approach to predict financial distress firms and Multiple Discriminant Analysis (MDA) was proposed by Altman (1986) consequently. Although MDA provides better information about the probability that companies might fall into a danger of bankruptcy, its drawbacks are also recognised and Logit model, then, was applied in the prediction of financial crisis by Martin in 1977. Ohlson (1980) even expands selected samples to improve the accuracy rate of prediction. After Logit model was introduced, a great number of studies were conducted by comparing various approaches to predict financial crisis. It seems true that Logit model performed properly in predicting models. Although prediction models of financial distress have been improved via various applied statistic models, it seems true that the models which simply consider financial ratios could not provide adequate information predicting financial distress. Prowse (1998) discovers that highly concentrated ownership and poor corporate governance mainly induce to East Asian
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financial crisis and Mitton (2002) even explicitly states that corporate governance has a substantial impact on the performance of firms. Accordingly, a governance mechanism also plays a crucial role in the development of financial distress predicting models. Daily and Dalton (1994a) conduct a study to explore the relationship between corporate governance mechanism and probabilities that companies might experience financial crisis by means of considering both financial and governance variables. The study clearly indicates that the classification accuracy rate can be raised if governance variables are applied in the predicting models besides financial ratios. Hence, a predictive model including financial and governance factors will be presented in this research. In addition, Yeh et al. (2002) assert that companies in the electronic industry need to raise a large amount of funds and more investors are involved. That facilitates the dispread ownership structure. As a result, the ownership is not highly concentrated by comparison with that of companies in the non-electronic industry. The main purpose of this research is to provide a valid model of predicting financial distress of companies. Firstly, investors can realise their investment risks through this predicting model and avoid suffering from the losses of investing those companies with highly probability of filing for bankruptcy. Secondly, the variables that significantly influence the probability that firms might experience financial crisis also can be viewed as reference material for financial institutions to establish a credit-rating system or credit extension. Lastly, the result of this study also can offer more information about the quality of corporate governance to authorities concerned.

1.2 Research Purpose The construct of corporate governance has gradually played a vital role in the development of financial crisis predicting model since more researches have demonstrated that accuracy rate of predicting models will be raised provided that models are concerned with corporate governance variables in addition to financial variables. Therefore, this research will discover which variable can be regarded as warning signs that companies might experience financial distress and investigate if governance variables improve the accuracy rate of financial crisis predicting model. Furthermore, the concept of corporate governance in Taiwan was mainly introduced in 2002 and it is compulsory for all TSE & GTSM listed firms to disclose information of corporate governance. As a result, it seems true that the improvement of corporate governance should be obvious. While the system was launched for several years, a few studies examined if corporate governance has been improved or not. As a result, this study will investigate if the system of corporate governance has been improved by means of comparing the impact of corporate governance on predicting models from 1999 to 2002 and 2003 to 2006. In addition, due to the fact that characteristics of electronic and non-electronic industries are fairly different, the impacts of financial ratios and governance factors on financial distress predicting models might also vary in different industries. In the previous researches, the results only illustrate the impacts in general without considering the distinction between electronic and non-electronic industries. Consequently, this research will also examine the effects of financial and governance variables in electronic and non-electronic industries.

1.3 Research Structure and Process This research is mainly conducted following by five chapters. Chapter 1 Introduction Present the background and motivation of this research first and clarify the research purpose and structure. Chapter 2 Literature Review First of all, the definition of financial distress and empirical studies towards predicting financial distress of firms will be introduced. Then, the construct of corporate governance and issues on ownership structure and board position will be discussed. Finally, researches on financial crisis of firms concerned with corporate governance variables will be presented. Chapter 3 Research Design and Methodology Firstly, collect data from TSE & GTSM listed firms and define each variable adopted in this research. Next, propose research hypotheses from research questions and establish financial distress predicting model by means of empirical methodology. Chapter 4 Analysis and Discussion of Empirical Results Examine the research hypotheses and analyse empirical results. The discussion of research results is also presented. Chapter 5 Conclusion and Limitation Reveal the conclusion and limitation of this research and propose possible suggestions for following researchers.

Figure 1-1 Research Process Motivation and Purpose

Literature Review

Financial Distress Predicting Model

Introduction of Corporate Governance

Hypothesis and Methodology

Data Collecting

Definition of Variables

Descriptive Statistics

Logit Model

I.Financial II.Governance III.Financial & Variables Variables Governance Variables Analysis and Discussion

Conclusion and Limitation

Chapter 2 Literature Review Over the past decades, a considerable number of articles have been devoted to the study of predicting financial distress of firms. In the 1930s, scholars began to establish financial crisis warning models which adopted variables based on financial ratios. The figures on financial statements do play an essential role of forecasting financial crises for firms. However, it has been proven that financial information is not the only indicator to predict financial distress of companies due to the fact that figures can be window-dressed. Consequently, more studies have been conducted to improve the development of predictive models by means of adopting non-financial variables, such as corporate governance factors. Therefore, this chapter will be divided into two parts. The first part will introduce the studies of financial crisis predictive models simply based on financial ratios. Next, the concept of corporate governance and the researches of predictive models considering both financial elements and corporate governance factors will be presented in the second part. 2.1 Introduction to Financial Distress Predictive Model 2.1.1 Definition of Financial Distress While different scholoars have various definitions of financial distress, the term is generally defined as a situation in which companies have financial difficulties or suffer from a huge loss and that triggers the bankruptcy or liquidation of firms. Beaver (1966) is the first person who develops a financial distress predictive model and he defines a failed company as being in financial distress if the following events have occurred. Firstly, the company fails to pay obligations on matures and a preferred stock dividend. Secondly, the phenomenon of overdraft exists. All these factors which lead to bankruptcy can be viewed as a sign of financial distress. Altman (1968) also explains the situation that a firm might have a financial crisis in two aspects. He states that a company would probably have a financial distress if its asset value is below its debt and the cash flow is insufficient to pay off its obligations. Although scholars define financial distress differently, they all describe it as a situation in which firms are in danger of filing for financial distress.

With regards to the researches of predictive financial crisis models in Taiwan, most scholars define companies with financial crisis according to Operating Rule of the Taiwan Stock Exchange Corporation Article 49, 50 and 50-1. Under this Rule, a company would be classified as the one undergoing financial distress if its stock trading is required to be full-cash delivery, the stock trading has been suspended or its stock is delisted from Taiwan Stock Exchange (TSE). According to the Rule, a firm which fails to pay for loans or interest or whose net worth is below half of the capital stock should follow the rule of full-cash trading. The Corporation Law also clarifies the conditions where a company should be required to trade at 100% margin. Article 211 specifies when the loss of a firm is more than half of its paid-in capital or it is obvious that the total assets are below its debts, the stock trading should be forced to follow this rule. Article 282 also determines that the stock of a firm should be traded by full-cash when a firm has a bad cheque or the stakeholders file for restructuring. Due to the limitation of samples collecting, most scholars define a company with financial distress based on Operation Rule and Corporation Law, while it seems reasonable that some events which induce to a higher probability of causing financial distress of firms should also be considered. According to Taiwan Economic Journal (TEJ) database, the companies which have problems with bank runs, bounced checks, filing for restructuring or a payment extension are also regarded as failed companies. Accordingly, failed companies selected in this study will be classified not only according to the definition of Operating Rule of the Taiwan Stock Exchange Corporation and Corporation Law, but also the events which cause the danger of filing for bankruptcy. 2.1.2 Literature of Financial Distress Predictive Model Beaver (1966) is the pioneer who applies financial ratios, which measure profitability, liquidity and solvency of firms, to predict their probability of financial distress. Although he addresses that financial rations, are highly relevant in forecasting financial crisis, the study is conducted by Univariate analysis. It would seem that the Univariate approach is not appropriate for a financial crisis predictive model since the prediction abilities of different ratios would lead to great difference and they might interact with other variables, whereas the Univariate approach assumes that each ratio is completely independent. Hence, Altman (1968) introduces the Z-score model, which is conducted by Multiple Discriminant Analysis (MDA), which
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is also regarded as a linear regression approach, instead of Univariate analysis. In his study, 66 companies are selected as samples, where 33 bankrupt companies and 33 normal companies are chosen respectively during 1946 and 1965 by industry and size. He adopts 22 financial ratios to assess the probability of a firms financial crisis and 5 of them are concluded as having significant prediction abilities. By means of MDA, an overall index, Z-score, is formed as Z=0.012X1+0.014X2+0.33X3+0.006X4+0.999X5, where X1=working capital to total assets, X2=retained earnings to total assets, X3=EBIT to total assets, X4=equity market value to total liabilities at book value and X5=net sales to total assets. Z-score can be viewed as a cut-off and the company will be classified as the one which has a higher probability of going into bankruptcy if its Z-score is lower than 1.8.The result of this study also indicates that the MDA model is more adequate for short-term forecast because the classification accuracy rates of this model are 95%, 72% and 48% in the 1st, 2nd and 3rd year prior to the date that the company actually went bankruptcy. While it can not be denied that the Z-SCORE model contributes to the improvement of predictive models of firms financial crisis, the drawbacks are also recognized. Martin (1977) has argued that MDA is a linear regression approach, explanatory variables should be qualified to the hypothesis of normal distribution and the variance-covariance matrices of the independent variable should be equal for both failed and non-failed companies, while most researchers have found that financial data is not usually satisfied with these hypotheses. Therefore, it would seem that non-linear regression approaches are more adequate since normal distribution hypothesis of variables is not the premise of this approach. With regard to financial distress predictive models, the frequently applied non-linear regression approaches are the Logit and Profit models as no premises should be assumed when applying these models. Consequently, Martin (1977) applies Binary Logit model, where dependent variables are classified into failed and non-failed firms, to build a financial crisis predictive model towards financial institutions and the samples were selected during the period of 1969 to 1974. In his research, 25 financial ratios are applied to predict the probability that financial institutions might have a financial crisis two years prior to the time that they actually go bankruptcy. Concerning with previous researches, samples are usually selected and classified as bankrupt and non-bankrupt firms by the ratio of 1:1, whereas it seems that the classification accuracy rate of predicting the probability
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that companies might be in danger of financial distress still can be improved by means of expanding sample size. Consequently, Ohlson (1980) reveals that the probability of forecasting firms financial crisis is exaggerated in prior studies owing to the factor that samples of failed and non-failed companies were selected by the ratio of 1:1. It induced to overestimate the probability that companies might have financial distress as a result. Hence, he selects105 firms with financial distress and 2058 without financial distress randomly during the period of 1970 and 1976. By using of Binary Logit approach, 9 ratios are implemented to the predictive model and 4 ratios, which are the log form of total assets to GNP price-level index, total liabilities to total assets, Net income to total assets, and working capital to total assets indicating the size of the company, financial structure, operational performance and current liquidity respectively. The results of his study also demonstrates that the classification accuracy rate has been improved to 96.12%, 96.55% and 92.84% in the 1st, 2nd and 3rd year prior to the date that the company actually went into bankruptcy. After the Logit model was introduced, some scholars tended to examine the forecasting ability of this model by comparing with other models. Collins and Green (1982) examine the predicting ability of Binary Logit model, MDA and Linear Probability model and discovered that the classification accuracy rate of Binary Logit model is still superior to the other two. In addition to Binary Logit models, the other form of Logit models is the Multinomial Logit model. Unlike the Binary Logit model, where the dependent variables of financial crisis predictive models can only be classified as failed and non-failed firms, the dependent variables of the Multinomial Logit model can be divided more than two categories. It seems more reasonable that the situation of financial distress should be recognized as different stages instead of simply being a failed firm or non-failed firm. Hence, by means of the Multinomial Logit model, Lau (1987) first classifies dependent variables, which indicated a firms financial status, into five stages, where 0 represented stable financial status, 1 represented reducing dividend payment, 2 represented default due to not paying loans, 3 represented protected by bankruptcy laws, and 4 represented being bankrupt. The results of their study demonstrated that each stage of a firms financial status can only be discriminated precisely one year prior to the bankruptcy and it was not appropriately applied in other years. Although multiple stages of financial distress tend to present the financial status of firms more precisely, the classification error also raises when
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applying Multinomial Logit model instead of the Binary Logit model. Despite the fact that Logit models are widely applied in financial distress predictive models, the problem of selecting a cut-off point is also a controversial issue. By means of the Logit model, the determinations of cut-off will affect the classification accuracy rate since the cut-off is usually assumed equal to be equal to 0.5 in the Logit model, while it seems true that underestimating the cut-off might cause a huge loss. It would be possible that a failed firm will be determined as a non-failed company if the cut-off is misjudged. As a result, Artificial Neural Network (ANN) model is applied in financial crisis predictive models by Odom and Sharda (1990) first because the limitations of MDA and Logit model do not exist in an ANN model. They select 65 bankrupt firms as samples during the period 1975 to 1982 and divide all samples into two groups, which are training groups and test groups. The study indicates that the classification accuracy rate of ANN is significantly better than the MDA approach in a training group, where the accuracy rates of MDA and ANN are 86.84% and 100% respectively. Tam and Kiang (1992) also examine the predicting ability of ANN by comparing the accuracy rate derived from the Logit and ANN models. In their study, the ANN model is considerably better than Logit one year prior to the bankruptcy, whereas Logit model is more appropriately applied in the predictive model two or three years before the bankruptcy. Although most researches have proven that ANN can raise the classification accuracy rate when applied in financial crisis predictive models, the negative aspect is also argued. The model does not provide how each variable contributes to the result. It seems not possible to select the variables which significantly contribute to the model. It might induce the production of biases if the significant variables are omitted. Furthermore, due to the fact that ANN is founded on the theory of physical architecture of the network, it is often implemented by trial and error. Hence, the result of ANN seems weaker due to a lack of statistical basis. Lastly, it is often criticised that the coefficients derived from ANN models are hardly interpretable. (Trigueiros and Taffler, 1996)

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2.2 Introduction to Corporate Governance 2.2.1 Definition of Corporate Governance The issue of corporate governance was launched in 1970s, while it was not highlighted until the East Asian financial crisis from 1997 to 1998 since some studies have indicated that corporate governance is associated with the cause of financial crisis during the crisis. Shleifer and Vishny (1997) define corporate governance as a mechanism employed by a firm to make sure that investors can return their investments. They refer to corporate governance from three perspectives. Firstly, from the perspective of law, corporate governance is concerned with the issue of how to monitor the behaviours of firms through the foundation of laws and avoid firms from engaging in illegal behaviours. Secondly, from the perspective of economy, the objective of corporate governance is to maximize the economic value of firms. Lastly, from the perspective of finance, corporate governance emphasizes on the issue of how to ensure that managers would gain the profits for their companies in an efficient and effective method. The Organization for Economic Cooperation and Development also proposes that corporate governance is the system that manages and controls companies. It clearly defines the rights and responsibilities of each stakeholder and establishes the rules that everyone should follow when making decisions. Although, corporate governance can be defined diversely, the fundamental principle is that corporate governance is generally regarded as a mechanism that leads to the successful operation of firms. 2.2.2 Literature of Corporate Governance (1) Ownership Structure A. Shareholdings of inside shareholders The composition of ownership can be divided into two categories: inside shareholders, which represent managers or the board of directors or controlling shareholders, and outside shareholders, which indicate institutional investors. Accordingly, the relationship between ownership structure and firm value also can be analysed in these two perspectives. From the inside shareholders point of view, the impact of dispersion ownership on a firms value has drawn the attention of numerous scholars. Based on the theory of separated ownership and control rights, Jensen and Meckling (1976) introduce convergence of interest hypothesis to
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demonstrate claim that the shareholdings of managers or controlling shareholders are positively relevant to the firm value since their wealth is highly related to the performance of firm if the percentage of their shareholding is higher. As a result, it seems true that higher shareholdings of managers or board of directors would increase firm performance. On the contrary, Jensen and Ruback (1983) propose an entrenchment hypothesis to illustrate that the agency problem might induce to the conflicts between shareholders and managers or board of directors because of their different interests. They reveal that the shareholdings of the inside shareholders are negatively relevant to the firm value as they might have power to protect themselves from losses and undertake anti-takeover behaviours, such as rejection of merger projects which benefits shareholders but damages their wealth. B. Shareholdings of Institutional shareholders From the outside shareholders point of view, Pound (1988) proposes three hypotheses demonstrating the relationship between institutional investors and firm value. First of all, he proposes efficient monitoring hypothesis, which assumes that institutional investors are more equipped with expertise so that they can monitor the behaviours of managers efficiently without paying large amount of costs. As a result, higher percentage of shares held by institutional investors would facilitate the increase of firm value. While it seems true that institutional investors with high shareholdings would decrease the monitoring costs and boost the firm value, they also have incentives to approve the project that benefits them but damages the performance of the firm. Duggal and Millar (1999) also indicate that institutional investors often emphasize a short-term profit of the project at the expense of rejecting long-term investment. That would possibly diminish the firm value and the problem is viewed as conflict of interest hypothesis. Lastly, he proposes a strategic alignment hypothesis to demonstrate that managers or the board of directors might cooperate with institutional investors to gain profits at the expense of minority shareholders benefits. Despite the fact that institutional investors do not mainly occupy the structure of ownership in most Taiwanese listed companies, empirical studies still reveal the argument whether the existence of institutional investors benefits the firm value. A study conducted by Chang (1999) tends to support the efficient monitoring hypothesis since the result demonstrates that the shareholdings of institutional investors are positively related to the performance of firms.
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However, Wu (2004) argues that the existence of institutional investors has a negative effect both on hi-tech and traditional industries since institutional investors tend to make profits by means of holding their shares for a short-time and not seek to maximize the firms value. C. Extent of Concentration In the early studies of ownership structure, Berle and Means (1932, cited from Lemmon and Lins 2003) first propose that separation of ownership and control is prevalent in most enterprises. They state that agency problem is derived from this phenomenon since managers have lower shareholdings so that they do not suffer from failure of companies. However, some studies are not in accordance with the research of Berle and Means (1932) since most empirical studies have indicated that the separation of ownership and control rights does not actually exist in most listed companies cross countries. A study conducted by Shleifer and Vishny (1986) indicates that the phenomenon of combination between ownership and control right is more prevalent nowadays and it might lead to conflict between controlling shareholders and minority shareholders, which is regarded as a central agency problem. This problem is even worth noticing among the countries with highly-concentrated ownership. It seems possible that controlling shareholders would benefit themselves at the expense of minority shareholders. Due to the prevalence of highly concentrated ownership in most markets, Jensen and Meckling (1976) propose convergence of interest hypothesis to support the benefits of highly concentrated ownership. They state that managers or controlling shareholders would engage in the activities which maximize shareholders wealth because their wealth is positively related to the value of firms; similarly, if the ownership is concentrated on the board of directors, they also have incentives to monitor managers to boost the performance of firms. The study conducted by Shleifer and Vishny (1986) also discovered that agency problem will be diminished if ownership is concentrated on controlling shareholders. They would have incentives to monitor managers and seek for maximizing wealth of shareholders. Nevertheless, negative impacts of highly concentrated ownership are also discovered in previous researches. Jensen and Ruback (1983) propose entrenchment hypothesis to demonstrate that highly concentrate ownership do not certainly have positive impacts on the performance of firms. Demsetz (1983) also asserts that dispersed ownership is positively
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related to firm value, while concentrate ownership might harm the performance of firms since managers tend to engage in the activities which have adverse effects on their wealth but benefit shareholders. D. Control Rights and Cash Flow Rights According to the study conducted by La Porta et al. (1999), it also indicates that a tendency of concentrated ownership reveals in most listed companies, except US, UK and Japan. Among their investigated samples, 68.59% of them have an ultimate shareholder and it is often controlled by a family. Claessens et al. (1999) also examine the ownership structure by selecting samples in 9 countries of East Asia based on the research method proposed by La Porta et al. (1999) and the result indicates that 73.8% of the firms have an ultimate shareholder and 48.2% of these firms whose control rights belong to families. In accordance with previous studies, Yeh, Lee and Woidtke (2001) reexamine the ownership structure of Taiwan and they claim that the phenomenon of existing ultimate shareholders in Taiwan is even prevalent. Among the samples they selected from 1997 to 1998, almost 70% of these firms have an ultimate shareholder and more than half of them are controlled by a family. Therefore, it is obvious that the agency problem between majority and minority shareholders also exist in the listed companies in Taiwan. While it seems the family control is prevalent, it still can be argued if family-controlled ownership is beneficial to the firm value. Shleifer and Vishny (1997) assert that a family-controlled firm, in those countries where the mechanism of corporate governance is not well established, would suffer from the problem that controlling shareholders expropriate the benefits of minority shareholders. However, La Porta et al. (2000) argue that a family-controlled firm can be beneficial since a familys reputation facilitates the external capital at a lower cost and cohesive management boosts the performance. Concerned with highly concentrated ownership, it provides both advantages and disadvantages. La Porta et al. (2002), claim that the cash flow ownership of an ultimate shareholder is positively related to the firm valuation due to the fact that the cash flow ownership stands for the ultimate shareholders personal wealth. Therefore, it is evident that cash flow ownership facilitates the ultimate shareholders incentives to increase the firm value. However, the drawbacks of concentrated ownership are also recognized. The study conducted by Shleifer and Vishny (1997) also indicates that controlling shareholders would prefer to get involved in the
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activities that are produced so that the benefits can not be shared by minority shareholders. Furthermore, La Porta et al. (1999), Claessens et al. (2000) and Lemmon & Lins (2003) propose that the conflicts between controlling and minority shareholders induce to the increasing costs of concentrated ownership and the problem that cash flow rights and control rights diverge from one-share-one-vote has also arisen. When the deviation in control rights from cash flow rights of controlling shareholders is increasing, controlling shareholders would probably intend to expropriate the benefits of minority shareholders since more voting rights offer controlling shareholders more power to derive the interests from minority shareholders. The majority shareholders could benefit themselves by means of not paying dividends or transferring the profits to another company which they can control. That also damages the firm value. The problem also prevails in Taiwan since Claessens et al. (1999) discover that the phenomenon of divergent cash flow rights and control rights is also obvious, where 49% of them intend to increase their control by means of pyramid structures and 8.7% of them by using cross-holdings. Wu (2004) also discovers that the phenomenon of highly concentrated ownership does exist in Taiwanese listed companies but has a different effect on the firm value in electronic industry and non-electronic industries. The result indicates that directors and institutional investors occupy most of the shares in electronic industry and these controlling shareholders would have incentives to seek for the profits of firms when the ownership is getting highly concentrated. In contrast, most shares of firms are held by a family in other industries and the controlling shareholders tend to expropriate the profits of firms through their control rights. Hence, it induces to the decrease of firm value and raises the probabilities that a firm might file for bankruptcy. (2) Board Position A. Outside Directors Cadbary (1992) determines that the inside governance mechanism is mainly exercised by a board which is composed of directors and supervisors. The responsibility of the board is to protect the interests of shareholders by means of monitoring and stimulating the management of companies effectively. Consequently, the board of directors plays a vital role in the development of the inside governance mechanism. The board is commonly composed of inside directors, which represent the directors who are
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majority shareholders or serve as managers of the firm, and outside directors, who indicate the directors who do not serve as the members of management and can monitor the management independently. The necessity of outside directors can be specified in two aspects. Firstly, from the perspective of monitoring, due to the fact that inside directors usually perform both roles of decision-makers and monitors, it seems possible that they would make a decision considering their self-interests. However, outside directors are not the shareholders and usually have no interests with the firm. They are more qualified to supervise the management of the firm and make policy based on the interests of whole shareholders. Shleifer and Vishny (1997), Weisbach (1998), Luoma and Goodstein (1999) claim that inside directors are usually responsible for the operation of the firm so that they might have incentives to implement a project which tends to benefit themselves but damage the firm value. The existence of outside directors provides a method to alleviate the conflicts between managers and shareholders. Furthermore, outside directors usually stand for the interests of whole shareholders, while inside directors might gain benefit at the expense of minority shareholders interests in the countries where ownership is highly family-controlled. As a result, it seems true that the existence of outside directors can also alleviate central agency problem between majority and minority shareholders. Secondly, from the perspective of decisions, people who are more experienced or possess expertise are usually selected as members of outside directors. They are capable of assisting firms to make a substantial decision. Bhagat and Black (1999) believe that it is more important that outside directors are occupied by people who possess expertise than they are fairly independent of the firms management since their experience tends to influence the firm value significantly. Fama (1980) also states that outside directors can protect the interests of minority shareholders more effectively than inside directors and boost the performance of firms. Although it seems true that outside directors perform monitoring effectively, Zahra and Pearce (1989) argue that some reasons will diminish their abilities of monitoring. Firstly, outside directors have lower incentives to monitor managers owing to their low shareholdings. Secondly, the employ and remuneration of outside directors are determined by managers and that might induce to the decrease of outside directors control rights. Lastly, most outside directors do not have sufficient time for monitoring and they usually make decisions based on the information that inside directors
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offered. On the contrary, inside directors have more incentives devoting themselves to the operation of the firm since they usually serve as managers simultaneously. The results of studies investigating the relationship between setting outside directors and the performance of firms are not consistent. Shivdasani and Yermack (1998), discover that the performance of a firm can be boosted by means of increasing the number of board seats of outsider directors, while the studies conducted by Yermack (1996), Agrawal and Weisbach (1991) indicate that the board seats of outside directors are negatively related to the performance of a firm. Bhagat and Black (1999) even discover that the performance of a firm is diminished if a board is entirely occupied by external directors. The results of researches in Taiwan also show conflicts towards this issue since the system of independent directors was not introduced in Taiwan until the end of 2002. The establishment or disclosure of outside directors is not implemented completely before that time. As a result, Wang (2001) states that the establishment of independent directors has no significant impact on the performance of firms, whereas Chen (2004) claims that the percentage of outside directors has a positive impact on the firm value in spinning industry but has a negative effect in hi-tech industry. B. Management Participation It is also controversial whether the Chief Executive Officer (CEO) should also serves as the chairman of board, which is viewed as a problem of duality. It is often recommended that the CEO should not serve as the chairman of board simultaneously from perspective of agency problem. A CEO who acts as an executive and a monitor would induce to a problem that the CEO might exploit the rights to influence strategy-making. The effectiveness of a board of directors will be diminished due to a lack of independence (Baker and Patton, 1987). An empirical study conducted by Daily and Dalton (1994a) also demonstrates that companies with the CEO serving as the chairman of board have worse performance. Nevertheless, there are still little empirical studies supporting that CEO duality benefits the performance of firms. Weir and Liang (2002) state that if the CEO is involved in daily operation and is responsible for the performance of a firm, they would have incentives to maximize the interests of the firm under the duty since their wealth is relevant to the firm value. Simpson and Gleason (1999) also discover that companies have lower possibilities of filing for bankruptcy if their CEO also serves as the chairman of board. Although the empirical studies demonstrate the conflicts between these two hypotheses,
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the regulations of corporate governance in Taiwan seem to support the hypothesis that the CEO should not serve as the chairman of board simultaneously. The Corporate Governance Best-Practice Principles for TSE/GTSM Listed Companies have been implemented in Taiwan since 2002 and they specify that a firm should increase the board seats of outside directors to strengthen monitoring mechanism if the CEO also serves as the chairman of the board. C. Stock Pledge Ratio Stock pledge is regarded as a method whereby directors, supervisors, managers and majority shareholders would pledge their shares for loans or credits. Weng (2000) claims that stock pledge provides inside shareholders with opportunities to boost their control rights over the firms since they can gain more control rights without actually paying for shares by financial leverage. Accordingly, the shares they control are in excess of the capital they exactly invest in. When the degree of stock pledge ratio is higher, it means that ultimate shareholders can raise their control rights through highly financial leverage. The overinvestment by ultimate shareholders would create the risk of leading companies into bankruptcy since it is possible that their pledged shares could be closed out and that facilitates the reduction of firm value. The results of studies conducted by Weng (2000) and Yeh, Lee and Woidtke (2001) both illustrate that stock pledge ratio is negatively related to the value of firms value and positively related to the probability that firms will experience financial crises. (3) Governance with Predictive Models The relationship between corporate governance mechanism and prediction of financial distress is highlighted because of East Asian financial crisis. A study conducted by Prowse (1998) indicates that highly concentrated ownership and poor corporate governance system lead to the financial crisis in East Asian countries. Johnson et al. (2000a) even claim that country-specific corporate governance provides a more adequate explanation for the currency depreciation and collapse of stock market in these emerging markets. He states that the problem that managers or controlling stockholders could benefit from the expropriation of minority shareholders is even worse in a country with weak mechanism of corporate governance. In accordance with the study of Johnson et al. (2000a), Mitton (2002) also addresses that corporate governance can be performed at explaining not only cross-country but also cross-company performance.
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The result of his study clearly demonstrates that corporate governance has a significant impact on firm performance. Poor corporate governance would lead to reduction of firm value and raise the probability of driving firms fall into the danger of bankruptcy (Yeh & Lee, 2001). As a result, it seems true that the factors of corporate governance are also concerned with the financial crisis predictive model of firms. More studies have been conducted to investigate if the combination of financial ratios and corporate governance variables could raise the accuracy rate of financial crisis predictive models rather than adopting financial variables solely. Daily and Dalton (1994a) employ a Logit regression model to examine the relationship between corporate governance structure and the financial distress of firms considering both financial and governance variables. Three financial indicators are adopted as variables to demonstrate the profitability, liquidity and leverage, where net income is divided by total assets, current assets is divided by current liabilities and long-term debt respectively. The governance variables are included based on the perspectives of common stock shareholdings, the quality of board position, the CEO-board chairperson structure and the interaction between board position and the CEO-board chairperson structure. First of all, the common stock shareholdings can be measured by using the percentage of a firms shares held by shareholders who own above 5% of its shares, institutional investors, managers and directors. Second, the board quality can be evaluated by using four indicators, which are the total number of top managers who serve on a firms board, the total number of outside managers who serve on the board, the total number of CEOs who serve on a board and the academic prestige of the members on the board. The result of their study apparently demonstrates that there is a positive impact on firm value when the CEO does not serve as the chairman of board simultaneously. The classification accuracy rate of financial crisis prediction can be raised from 71.23% to 84.13% by adding variables of common stock shareholdings. Furthermore, the classification accuracy rate of financial crisis prediction increases from 84.13% to 87.17% by adding the indicators of board position. With adding the indicator of the CEO-board chairperson structure, the accuracy rate can be raised to 89.04%. It seems obvious that additional information generated from corporate governance raises the accuracy rate of predicting a firms bankruptcy. With regards to Daily and Daltons study (1994b), characteristics of a failed firm are also recognised. They assert that a failed firm has lower net profit margin, lower liquidity,
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lower percentage of shares held by financial institutions and higher percentage that the CEO also serves as the chairman of board. Yeh, Lee and Woidtke (2001) also examine the predicting ability of corporate governance by investigating the listed companies in Taiwan. The study demonstrates that three variables, which are the number of board seats held by the largest shareholders, stock pledge ratio and cash flow rights leverage, significantly influence the accuracy rate of financial distress prediction of firms one year prior to the filing of bankruptcy.

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Chapter 3 Research Design and Methodology 3.1 Research Hypothesis

Hypothesis 1: The corporate governance mechanism is related to the probability of financial distress. Hypothesis 2: Corporate governance variables help to predict financial distress more precisely. Hypothesis 3: The predictive model perform differently in the electronic and non-electronic industry. Hypothesis 4: The quality of corporate governance has been improved.

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3.2 Data Source and Sampling In this study, the samples collected from TSE & GTSM listed firms during the period from 1999 to 2002 are viewed as the first group, and those collected from 2003 to 2006 are viewed as the second group. Due to the fact that the East Asian financial crisis, which occurred between 1997 and 1998, might induce to abnormal financial information, the samples of the first group are collected after the crisis. Furthermore, as the Corporate Governance Best-Practice Principles for TSE/GTSM Listed Companies was issued in 2002, the disclosure of corporate governance tends to be complete thereafter; thus the samples of the second group, to be compared with the first group to investigate if there is a considerable improvement of corporate governance, are collected since 2003. Companies are classified as failed firms if they experience the situations which are defined as financial distress during this period. When the samples of failed firms are determined, the non-failed firms, which are regarded as matching samples, will be selected in accordance with the approach that Beaver (1966) proposes for selecting matched samples and the principles that Lee and Yeh (2004) introduce. Firstly, the matched samples must be in the same industry as failed firms. Secondly, the total assets of matched samples should be approximate to those failed firms. In terms of the sample selecting approach, Fmijewski (1984) asserts that the classification accuracy rate and predicting ability of models will not be affected if samples are not selected at random, while the estimation of parameters and probability that companies might be in danger of financial distress will still have biases. Hence, increasing the relative samples size between failed and non-failed firms is the best approach to alleviate the problem. The matching samples are selected on a two-to-one basis instead of one-to-one basis. Owing to the fact that the characteristics of banking, security and insurance industries differ from other industries, the ratios derived from financial statements could be distinct from others. Hence, the firms which are located in these industries will be eliminated from this study and those firms whose financial states are incomplete will be eliminated as well. In sum, there are 476 firms selected in this study, where 164 are failed companies and 312 represent non-failed ones. The data source is based on annual reports of TSE listed companies, TEJ database and Market Observation Post System (MOPS).
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Table 3-1 Number of sample firms Sample Period Group 1 1999 2000 2001 2002 Group 2 2003 2004 2005 2006 In total Data source: by this research 16 14 33 15 164 30 28 62 30 312 28 23 28 7 52 46 50 14 No. of Failed Firms No. of Non-failed Firms

Table 3-2 represented the proportion of samples with failed firms which are located in different industry. Electronic industry is the majority which occupies 46.95% of selected samples.
Table 3-2 Samples with failed firms by industry Industry Electronic Food Plastic Textile Transportation Machinery Appliance and Cable Construction Steel and Iron Department Stores Tourism Bioengineering Others Data source: by this research Samples 77 10 5 13 1 6 2 23 15 4 2 2 4 Percentage 46.95% 6.10% 3.05% 7.93% 0.61% 3.66% 1.22% 14.02% 9.15% 2.44% 1.22% 1.22% 2.43%

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3.3 Definition of Variables (1) Dependent Variables (Y) In this study, the Binary Logit model is applied in a financial crisis predictive model. Accordingly, the dependent variables are classified as two categories, where Y=1 represents the situation where companies are suffering from financial distress; otherwise, Y=0 implies that companies are financially healthy. (2) Independent Variables In this research, both financial and governance variables are adopted in the development of a financial distress predictive model. All the information derived from independent variables is based on one year prior to the time that companies experience the situation of financial distress. A. Financial Variables Financial ratios are selected as variables basically according to five financial ratios which significantly predict financial distress in Altmans study (1968) and nine ratios revealed in Ohlsons model. In addition, the financial ratios which are frequently selected to predict the financial situation of firms in previous literatures are also considered as variables in this research. They are classified into five aspects: Liquidity, Profitability, Operation Capability, Financial Structure and Cash Flow. Liquidity 1. Current ratio (X1) Current Ratio = Current Assets/Current Debts The figure of current ratio represents how many current assets can be a guarantee to payoff one unit of current debts. It implies the ability that company can cope with unexpected events. Since unexpected events might cause a firm to be in danger of suffering from financial crisis, higher the current ration indicates lower probability of filing for bankruptcy. 2. Quick ratio (X2) Quick Ratio = (Current Assets Inventory)/Current Debts

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Quick ratio represents similarly to current ratio, while the liquidity of inventory is fairly low so that it can not be the tool to pay for instant debts. Hence, inventory should be excluded from current assets. 3. Times interest earned (TIE) (X3) TIE = EBIT/Interest The ratio examines the ability that a companys earnings can meet interest payment on a pretax basis. If TIE is low, it implies that companies have difficulties to pay interest at mature time and that induces to higher possibility of filing for bankruptcy. Profitability 1. Gross margin (X4) Gross margin = Gross profit/Sales It is a basic indicator to investigate the capability that a firm can earn profit when focusing on their business. It implies that a firm earns more profits and has lower probability of filing for bankruptcy if the ratio is higher. 2. Return on asset (ROA) (X5) Return on asset = Net income to Asset This is applied to measure how companies gain profits by making use of total assets and investigate the efficiency that companies operate in their business. If the ratio is higher, the probability that firms will file for bankruptcy will decrease since the management of companies performs efficiently. 3. Return on equity (ROE) (X6) Return on equity = Net income dividing by Equity This ratio implies how much value a firm can create for shareholders and the ability that a firm can generate profits from investment. If ROE is high, it indicates that companies are more capable of generating cash and it is less likely to fall in danger of bankruptcy consequently.

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4. Net profit margin (X7) Net profit margin = Net income/Revenue Due to the fact that the profitability of a firm can also be affected by external operating activities, such as disposal of fixed assets, the ratio which is involved in net income should also be considered. The higher the net profit margin is, the lower the probability that a firm will suffer from financial crisis. Operation Capability 1. Asset turnover (X8) Asset turnover = Sales/Total assets This measure is applied to examine whether companies employ their total assets to create profits adequately. When the ratio is higher, it indicates that companies can create more profits by using the same level of total assets, whereas companies should reduce the investment if the ratio is too low and there is an excess of idle assts. 2. A/R turnover (X9) A/R turnover = Sales/Average account receivable This ratio is an indicator to measure if the credit policy of a firm is adequate. If the ratio is too low, it implies that company should adjust their credit policy since the policy is too loose. Companies can not receive the payment within a certain period of time. 3. Inventory turnover (X10) Inventory turnover = Sales Costs/Average inventory This ratio is employed to investigate the level of average inventory. If the ratio is higher, it means that companies do not hold too much inventory and it decreases the probability of expiring financial distress.

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Debt Leverage 1. Debt-Assets ratio (X11) Debt to Total assets = Debt/Total assets This ratio demonstrates the percentage of total asset which are financed through debt and applied to assess the financial health of companies. If the ratio is greater than one, it implies that companies are highly leveraged and most of the assets are financed by means of debt. That would induce to a higher probability that companies file for bankruptcy if they fail to pay the payment of debts. 2. Long-term Fund to Fixed Assets (X12) Long-term Fund to Fixed Assets = Long-term Fund /Fixed Assets The ratio examines if the long-term fund, which supports fixed assets, is stable. If the ratio is higher, it implies that companies have constant long-term fund to maintain fixed assets. Once the long-term fund maintains constant, it seems more likely that companies have lower probabilities of failing into bankruptcy. Cash Flow 1. Cash cover (X13) The ratio is calculated as Net cash flow from operating activity divided by current liabilities. It is viewed as an important indicator to measure the capability that firms can afford to the payment generated from current liabilities and dividends.

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Table 3-3 Financial variables Variable Liquidity X1 X2 X3 Profitability X4 X5 X6 X7 Operation Capability X8 X9 X10 Debt Leverage Cash Flow X11 X12 X13 Data source: by this research Ratio Current ratio Quick ratio Times interest earned (TIE) Gross Margin Return on Asset (ROA) Return on Equity (ROE) Net profit margin Asset turnover A/R turnover Inventory turnover Debt-Assets ratio Long-term Fund to Fixed Assets Cash cover

B. Governance Variables Corporate governance variables are basically classified as two categories, which are based on ownership structure and board position. There are ten governance variables included in this research. Ownership Structure 1. The percentage of shares held by the board (X14) The relationship between shareholdings of directors and supervisors in a firm has been examined in previous researches. Scholars demonstrate two opposite results concerning with the percentage of shares held by the board. Some of the results tend to support the view that more shares held by the board can contribute to the performance of firms, while others demonstrated that a higher percentage of shares held by the board induce to the decrease of firm value and raises the probability of experiencing financial distress. Therefore, the effect is also examined in the study. 2. The percentage of shares held by controlling shareholders (X15) Since the phenomenon that firms are highly concentrated is prevalent in Asian countries, agency problems are also arisen. Although cash flow ownership provides controlling shareholders with incentives to boost the firms value, the problems induce to the decrease of firms value and the higher probability of bankruptcy. Therefore, the relationship between the
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percentages of shares held by controlling shareholders and the probability of bankruptcy will also be discovered in this study. 3. The percentage of shares held by outside shareholders (X16) The results of empirical researches on the effect of outside shareholders towards Taiwanese listed companies vary significantly. Chang (1999) supports the existence of outside shareholders benefits the firm value and decrease the possibility that firms file for bankruptcy, whereas Wu (2004) argues that it harms the firm value. Hence, the impact of setting outside shareholders will be considered. 4. The Extent of Concentration (X17) Level of concentration is usually measured by means of Herfindahl Index in economic aspect and it equals to the sum of square of the percentage shares held by each type of shareholders. It can be expressed by following formula: (Taiwan Economic Journal database)
n

Level of concentration =
i=1

Xi2

Xi: The percentage of shares by each type of shareholders n: The sample size of each type 5. Control Rights (X18) Control rights are defined as direct and indirect control rights in accordance with the definition in the study of La Porta et al. (1999). Direct control rights represent the voting rights registered directly in the names of controlling shareholders, while indirect control rights indicate the voting rights which are held by controlling shareholders but derived from the shares registered in the names of other companies. In this study, the control rights are generated according to the approach that Claessens et al. (2000) introduces. 6. Cash Flow Rights (X19) Cash flow rights are defined as the percentage of capital that controlling shareholders actually invest and both direct and indirect cash flow rights are included.

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7. The ratio of cash flow to control rights (%) (X20) The ratio of cash flow to control rights can be derived from the equation that cash flow rights are divided by control rights. In general, the ratio of cash flow rights to control rights should be equal to 1, while the studies indicate that the figure deviates from 1 since controlling shareholders tend to increase their control rights by means of cross-holding or a pyramid structure. Higher ratio of cash flow to control rights would facilitate the lower probability of firms filing for bankruptcy. Thus, how the deviation of cash flow rights to control rights affects the probability of financial crisis will be examined in this study. Board Position 1. The ratio of board seats held by outside directors and supervisors (X21) The rules that each listed company should have outside directors and supervisors have been exercised since 2002 in Taiwan. It seems true that the ratio of board seats held by outside directors and supervisors is viewed as an indicator of measuring corporate governance. Although the empirical studies demonstrate different outcomes towards this issue, the setting of outside directors and supervisors still tends to improve corporate governance mechanism. With a sound system of corporate governance, the probability that a firm might file for bankruptcy can be reduced. Therefore, the factor is also adopted in this research. 2. Management Participation (X22) It has been argued that CEO also serves as the chairman of board. Although the advantages of this phenomenon are proposed, the results of empirical studies also indicate that it leads to worse performance of firms and raise the probability of filing for bankruptcy. Hence, this factor should also be an indicator of predicting financial crisis. The value of dummy variable represents 1 if the CEO also serves as the chairman of board and 0 otherwise. 3. Stock pledge ratio (X23) Directors and supervisors might tend to increase their control rights by means of pledging their shares for loans. It seems obvious that pledging shares is one of the factors which cause the situation of financial distress due to the overinvestment of directors and supervisors. Higher stock pledge ratio might lead to higher probability of having financial distress.
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Table 3-4 Governance variables Variable Ownership Structure X14 X15 X16 X17 X18 X19 X20 Board Position X21 X22 X23 Data source: by this research The percentage of shares held by the board The percentage of shares held by controlling shareholders The percentage of shares held by institutional shareholders The extent of concentration Control Rights Cash Flow Rights The ratio of cash flow to control rights The ratio of board seats held by outside directors and supervisors Management Participation Stock pledge ratio

C. Control Variables Although financial and governance variables are both considered in this model, the result will still be affected by the variables which are related to the feature of each firm. Hence, these variables, which are regarded as control variables, should be adopted in the development of the model. There are three control variables which are considered in this research. 1. Firm size (X24) As far as Ohlson (1980) is concerned, companies with large firm size would have better performance and a lower probability of experiencing financial crisis since firms with large firm size have higher economic benefits. However, managers in a firm with large scale might prefer to have fewer shareholdings because of their attitude towards risk aversion. Companies with large scale also increase investment risk because of their complexities. Accordingly, firm value could be diminished since managers have a lower incentive to maximize the interests of the firm. Hence, the factor of firm size is also considered in this study to assess its impact on the probability that firms might suffer from financial crisis. The impact of firm size is measured using the logarithmic form of firms total assets.

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2. Type of industry (X25) Due to the fact that features of the electronic industry and traditional industries differ significantly, the variables which can be applied to examine the probability that a firm might have financial distress also vary based on the industry. Previous researches have indicated that the ownership structure of the electronic industry and traditional industries are quite different. Firms in the electronic industry are widely held and not simply controlled by a family since they need to raise large amounts of external capital by means of issuing shares. On the contrary, traditional industries, such as plastic or construction industry, are generally controlled by families in Taiwan. Furthermore, the predicting capabilities of both financial and governance variables might also differ in these two types of industries. Hence, the comparison of how this model performs in an electronic industry and traditional industries will be revealed in this study. Dummy ID represents 1 only if the firm is located in the electronic industry and 0 otherwise.

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3.4 Empirical Methodology The empirical methodology of this study is mainly structured in three parts. The first part is regarding to the features of explanatory variables. Owing to the fact that the characteristics of the data set will influence the selection of implemented models, it is necessary to examine if the data follows a normal distribution and Kolmogorov-Smimov test is the approach to be applied. Secondly, it seems reasonable that the characteristics of financial and governance variables vary depending on the features of companies. The Mann-Whitney U test or t-test can be implemented to discover if there is a noticeable difference between two independent groups, which are failed and non-failed firms or between electronic and non-electronic industries in this study. If the data set is following a normal distribution, then t-test is more appropriate to be employed; otherwise Mann-Whitney U test will be applied. Secondly, the problem, which is recognised as multicollinearity, should be investigated by means of Pearson Coefficient before establishing a model since there might be a strong relationship between explanatory variables and it induces to the bias of results, If the correlation coefficient of variable is highly related to each other, it implies that there is a problem of multicollinearity. If the problem of multicollinearity exists, then Factor analysis can be implemented to reduce the variables and diminish the relationship among explanatory variables. Secondly, which model is appropriately employed to build a model should be determined after the explanatory variables are examined. Since the characteristic of data set will influence the selection of implemented models, it is necessary to examine whether the data is following the normal distribution. If the data follows a normal distribution, MDA approach is appropriate to form the model; otherwise, the predictive model is better performed by following a Binary Logit model. Furthermore, forward stepwise procedures is applied to determine the explanatory variables which have significant impact on dependent variables and those variables are selected to form a predictive model of financial distress. Before forming a model, descriptive statistics would be implemented to discover if there is a noticeable difference of variables between bankrupt and non-bankrupt firms. In this study, the Mann-Whitney U test is employed since Lastly, the Cox & Snell R2 and the Naglkerke R are employed to investigate
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the overall model fit, which explains how far the variation of dependent variables can be explained by this model, after the model is established. The classification accuracy rate of this model is also presented in the end. The investigating process of this study and the illustration of each methodology are clarified in this chapter. (Hair et al. 2006) Figure 3-1 The process of research methodology Kolmogorov-Smimov test I. Descriptive Statistics Normal Distribution T test II. Predictive Model Non-Normal Distribution Mann-Whitney U test

Pearson Correlation Coefficient

Multicollinearity Factor Analysis

NonMulticollinearity

Normal MDA model

NonNormal Logit model

Normal MDA model

NonNormal Logit model

Cox & Snell R2 and Naglkerke R Classification accuracy rate

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(1) Normal Distribution Test In this study, the explanatory variables are classified as two independent groups which are selected from bankrupt and non-bankrupt firms respectively. Due to the unknown distribution of explanatory variables, an examination of testing whether the variables are following a normal distribution should be exercised. Moreover, the non-metric predictor variables are also included in this study so a parametric statistic test is not appropriate for the examination. Hence, Kolmogorov-Smimov (K-S) test, which is one of the non-parametric statistical tests, can be implemented to investigate whether the variables follow a normal distribution in this study. The hypothesis is the following: H0: The explanatory variables are normal-distributed H1: The explanatory variables are not normal-distributed Under significance level =0.05, H0 is rejected if p-value is under 0.05, which means the explanatory variables are not following normal distribution; if p-value is greater than =0.05, then the variables are normal-distributed. (2) Descriptive Statistics Before forming a predictive model, it is essential to examine the noticeable difference between firms with and without financial distress. Owing to the unknown distribution of explanatory variables selected from failed and non-failed groups, the T-test, which is a parametric approach, can not be exercised in this case. Hence, the Mann-Whitney U test is applied to investigate whether there is a significant difference between these two independent groups. Previous studies have demonstrated that the features of financial ratios and corporate governance factors in bankrupt and non-bankrupt companies are considerably different from each other. Therefore, the test is also included in this study. The hypothesis is as follows: H0: the mean values of explanatory variables in two groups are the same H1: the mean values of explanatory variables in two groups are not the same

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Under significance level =0.05, reject H0 if p-value is less than 0.05, which means the explanatory variables are statistically different in failed and non-failed firms; if p-value is greater than 0.05, the explanatory variables matter in these two groups. (3) Multicollinearity Test A. Pearson Correlation Coefficient This test is mainly applied to investigate whether there is a problem of multicollinearity. When a high inter-correlation relationship is present among the explanatory variables, it induces to the problem that each variable might be examined as a non-significant variable to model, while it is actually significant. Hence, Pearson Coefficient test can be applied to examine if there is multicollinearity. In general, the problem of multicollinarity tends to be severe if the value of Pearson Correlation Coefficient is great than 0.75. The Coefficient can be recognized from the correlation matrix. B. Factor analysis If explanatory variables are discovered and there is a strong relationship among these variables, then the problem of multicollinearity is recognized. Accordingly, Factor analysis (FA) is introduced by Spearman to solve the problem by means of reducing the number of variables. It seems evident that some financial ratios are highly interrelated and it would induce to the problem that each variable fails to measure its contribution to the model. The estimations of parameters might also be biased due to multicollinearity. Hence, FA helps to select variables which are the representative subset of variables. The most frequently used approach is principal components analysis. The procedures are as followed. At step 1, we assess if the variables are correlated with each other by means of Kaiser-Meyer-Olkin (KMO) test. If the value of KMO is located between 0.5 and 1, it implies that variables are dependent and FA is an appropriate approach to eliminate the problem. At step 2, the issue of a suitable number of factors should be determind. These factors are selected by the fact that their eigenvalues are greater than 1. At step 3, by means of factor rotation, the variables, which are strongly correlated, are classified into the same factors and the loading level of each variable is also determined. Due to the fact that each factor might be
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composed of several variables, the variable which has the highest value of loading will represent its factor group. (Pallant 2004) (4) Binary Logit model Qualitative Response Model (QRM) is basically implemented to deal with non-metric dependent variables. In this study, the dependent variables are classified as two categories, which are failed and non-failed firms and accordingly a QRM is properly employed in the study. Among QRMs, Linear Probability Model (LPM) is first employed to predict the financial distress of a firm, while it is criticized due to its limitation. Under LPM, data should follow normal distribution and the probability derived from it can be sometimes less than 0 and more than 1, which violates the characteristic of probability. As a result, it seems that LPM is not a proper model in this case. A Logit model can be implemented to avoid the limitations of LPM since the data need not necessarily to follow a normal distribution. The probability derived from the Logit model is always located between 0 and 1. For instance, Martin (1997) is the pioneer who implemented the Logit model as the predictive model of financial distress. Under his study, two groups of dependent variables are assumed, which is viewed as a dichotomy model and the Binary Logit model is applied as a result. When the company is suffering from financial distress, Y equals to 1; otherwise, Y equals to 0. The Logit model assumes that the bankruptcy probability follows a Logistic distribution. Assuming that Pi implies bankruptcy probability, then the Logistic specification of Pi can be expressed as (Maddala 2001) 1 eZ e-Z Pi =P(y=1| X) = F(Z)= = ; Pi =P(Y=0| X) = F(Z)= -Z Z 1+e 1+e 1+ e-Z where Z = +i Xi = +1 X1+ 2 X2++n Xn Due to the problem of heterscedasticity in a dichotomy model, the parameter in this model, Pi , should be estimated by means of Maximum Likelihood Estimation. When Pi is derived, then the firm can be determined as a failed or non-failed company according to the fact that its Pi is below or above the level of cut-off. In general, the cut-off level is determined as 0.5, while Martin (1977) suggests that it should be 0.22 from a conservative aspect. If Pi of the firm is above 0.22 or 0.5, then it is determined as a failed company; on the contrary, if its Pi is below 0.22 or 0.5, then it will be
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classified as a non-failed company. (5) Goodness-of-fit Test Cox & Snell R2 can be viewed as an indication of how much the variation of dependent variables can be explained by this model. It implies that the model is more appropriately implemented to analyse the data if the value of Cox & Snell R2 is higher. The equation is expressed as followed: (Maddala 2001) R2 = 1- L(0) / L(B)2/N L(0)= the likelihood function only considering intercept of the model L(B)=the likelihood function considering the whole model N= sample size However, the drawback of Cox & Snell R2 is that the maximum can not be 1 since L(0) / L(B) can not be 0. Accordingly, Naglkerke proposes an amended function based on Cox & Snell R2. The equation is expressed as followed: Amended R2 = R2/R2MAX, where R2MAX= 1-[L(0)]2/N R2 = 1-[L(0)/L(B)]2/N

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Chapter 4 Analysis and Discussion of Empirical Results 4.1 Normal distribution test K-S test is firstly employed to investigate if the data follows a normal distribution. As can been see from table 4-1 and 4-2, it is obvious that almost all the financial ratio variables, apart from X11 (D/A ratio), do not follow a normal distribution under significance level of 1%. The result is in accordance with previous studies that financial data does not usually follow a normal distribution. With regards to governance variables, only X16 (The percentage of shares held by institutional shareholders) is not significant at level 1% but still significant at 5%. It implies that governance variables also do not follow a normal distribution. Hence, T-test is not an appropriate approach to be implemented and Mann-Whitney U test is more proper to perform in terms of descriptive statistics.
Table 4-1 K-S test of financial variables Financial variables X1: Current ratio X2: Quick ratio X3: TIE X4: Gross Margin X5: ROA X6: ROE X7: Net profit margin X8: Asset turnover X9: A/R turnover X10: Inventory turnover X11: D/A ratio X12: Long-term fund/FA X13: Cash cover ***: significance level at 1% Data source: by this research Z-score 5.458 5.964 10.251 2.250 2.580 5.901 8.287 9.690 7.894 7.482 0.727 8.870 3.877 P-value 0.000 *** 0.000 *** 0.000 *** 0.000 *** 0.000 *** 0.000 *** 0.000 *** 0.000 *** 0.000 *** 0.000 *** 0.665 0.000 *** 0.000 ***

*: significance level at 10% ; **: significance level at 5%

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Table 4-2 K-S test of governance variables Governance Variables X14: board X15: X16: X17: X18: X19: X20: X21: X22: The percentage of shares held by The percentage of shares held by Level of concentration Control Rights Cash Flow Rights Deviation of cash flow rights to The ratio of board seats held by Management Participation 2.148 1.609 2.204 1.938 1.973 5.595 10.399 9.835 5.773 0.000 *** 0.011 ** 0.000 *** 0.001 *** 0.001 *** 0.000 *** 0.000 *** 0.000 *** 0.000 *** controlling shareholders institutional shareholders The percentage of shares held by Z-score 1.977 P-value 0.001 ***

control rights outside directors and supervisors X23: Stock pledge ratio ***: significance level at 1% Data source: by this research

*: significance level at 10% ; **: significance level at 5%

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4.2 Descriptive Statistics According to the result of K-S test, both financial and governance variables reject the hypothesis of normal distribution and a non-parametric approach should be adopted examine the significant variables of failed and non-failed firms. In this study, Mann-Whitney U test is employed consequently. Table 4-3 demonstrates the results of Mann-Whitney U test in terms of financial variables. As can be seen from table 4-3, the relationship of mean value between failed and non-failed firms fits the expected situations. The first three variables, X1(current ratio), X2 (quick ratio) and X3 (Times interest earned) are applied to investigate whether companies have abilities to deal with unexpected events that might induce to the bankruptcy and higher mean value of these variables indicate that firms have lower probability of filing for bankruptcy. It is obvious that the mean values of these three variables are at least two times higher than those of failed firms and the mean value of TIE in failed firms is even negative. It indicates that failed firms might fail to meet interest payment at mature time and it leads to higher probability of undergoing financial crisis. X4 (Gross Margin), X5 (ROA), X6 (ROE) and X7 (Net profit margin) are applied to measure the profitability of firms and these variable in non-failed companies also have better performance than those in failed companies. ROA and ROE in failed firms even have negative values. X8 (Asset turnover), X9 (A/R turnover) and X10 (Inventory turnover) are adopted to examine how efficiently companies operate their business. The mean value of X8 and X9 show the non-failed companies employ their assets to create profits more efficiently than failed firms, while the mean value of X10 in non-failed firms is slightly less than that in failed firms. X11 (D/A ratio) and x12 (Long-term fund/FA) are the variables employed to investigate the financial structure of firms. It is evident that failed firms are highly leveraged and have lower long-term fund than non-failed firms. Accordingly, companies might have higher probability of filing for the bankruptcy if their leverage level is too high. Non-failed firms also show their capabilities of affording to the payment generated from current liabilities from the variable of cash cover. The mean value of cash cover in failed firms even have negative figures and it reveals that a failed firm might not be able to meet the payment generated from current liabilities and dividends.

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All the financial variables of failed firms are significantly differ from those of non-failed firms under significance level of 1% apart from the inventory turnover, in which p-value is 0.136 greater than 1%.
Table 4-3 Mann-Whitney U test of financial variables (failed v.s. non-failed) Financial variables X1: Current ratio X2: Quick ratio X3: TIE X4: Gross Margin X5: ROA X6: ROE X7: Net profit margin X8: Asset turnover X9: A/R turnover X10: Inventory turnover X11: D/A ratio X12: Long-term fund/FA X13: Cash cover Failed firms Non-Failed Failed firms Non-Failed Failed firms Non-Failed Failed firms Non-Failed Failed firms Non-Failed Failed firms Non-Failed Failed firms Non-Failed Failed firms Non-Failed Failed firms Non-Failed Failed firms Non-Failed Failed firms Non-Failed Failed firms Non-failed Failed firms Non-Failed ***: significance level at 1%. Data source: by this research Mean 131.25 208.97 73.6 136.09 -29.93 2309.45 8.25 19.91 -9.49 6.54 -58.26 0.72 -81.26 11.19 0.86 1.43 5.95 11.77 9.7 8.19 63.96 43.71 557.4 856.32 -10.45 26.86 Standard Deviation 154.557 224.204 140.952 205.315 222.657 23615.127 18.220 17.759 17.210 10.916 140.314 56.8 368.433 165.189 0.714 9.96 7.14 29.934 29.810 15.767 19.190 17.347 2109.077 3867.902 74.550 52.454 0.000 *** 0.000 *** 0.000 *** 0.136 0.000 *** 0.001 *** 0.000 *** 0.000 *** 0.000 *** 0.000 *** 0.000 *** 0.000 *** 0.000 *** P-value

*: significance level at 10% ; **: significance level at 5%

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Table 4-4 illustrates the results of Mann-Whitney U test with regards to governance variables between failed and non-failed firms. In the perspective of ownership structure, as we can see from table 4-4, the average percentage of shares held by the board in non-failed firms is 26.73%, which is considerably higher than that in failed firms. The percentage of shares held by institutional shareholders in non-failed firms also considerably differs from that in failed firms, which are 36.11% and 28.27% respectively. It might reveal that institutional shareholders perform an efficient monitoring in non-failed firms and facilitate to the decrease of filing for bankruptcy. However, the average percentage of shares held by controlling shareholders between two groups is just fairly significant although the average percentage in non-failed firms is slightly higher than that in failed firms. The extent of concentration is even not significantly different between failed and non-failed firms. Hence, the phenomenon of highly concentrated ownership seems prevalent in both failed and non-failed firms. Furthermore, the difference of deviation between failed and non-failed firms is significant under significance level at 0.05, but the average deviation of cash flow rights and control rights in failed firms is just slightly higher than that in non-failed firms, which is 83.40% and 80.40% respectively. The result reveals that the problem of deviation of cash flow rights to control rights is prevalent both in non-failed and failed firms. Consequently, it is worth noticing whether higher deviation to control rights really has a negative impact on the performance of firms and constitutes to a higher probability of bankruptcy. As far as board position is concerned, the average percentage that the CEO also serves as the chairman of board in non-failed firms is 0.07, which is greatly lower than that in failed firms since it is 0.35 in failed firms. It seems true that the phenomenon of CEO duality is more prevalent in failed companies. The result tends to support that agency problem might lead to the increased probability of undergoing bankruptcy for firms if CEO also serve as the chairman of the board. Furthermore, the average stock pledge ratio of failed firms is twice as much as that of non-failed firms. The higher the stock pledge ratio is, the higher probability that companies might file for bankruptcy is. When the economics is undergoing recession, inside shareholders have higher incentives to exploit the wealth of firms since they pledge a higher percentage of their shares to expand credits.

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Table 4-4 Mann-Whitney U test of governance variables (failed v.s. non-failed) Governance variables X14: The percentage of shares held by the board Non-Failed X15: The percentage of shares held by controlling shareholders Non-Failed X16: The percentage of shares held by institutional Non-Failed X17: Extent of concentration X18: Control Rights X19: Cash Flow Rights X20: The ratio of cash flow to control rights Non-Failed X21: The ratio of board seats held by outside directors and supervisors Non-Failed X22: Management Participation X23: Stock pledge ratio Failed firms Non-Failed Failed firms Non-Failed ***: significance level at 1% Data source: by this research 0.07 0.35 0.07 33.51 13.89 0.14 0.48 0.43 34.83 23.02 0.000 *** 0.008 *** Failed firms 80.40 0.05 28.16 0.11 0.111 Failed firms Non-Failed Failed firms Non-Failed Failed firms Non-Failed Failed firms 36.11 26.33 27.15 21.49 31.12 17.27 25.18 83.40 20.99 18.92 17.42 14.91 16.37 12.87 16.76 27.91 0.024** 0.000 *** 0.000*** 0.140 shareholders Failed firms 15.77 28.27 11.73 19.43 0.000 *** Failed firms 26.73 13.94 14.17 11.58 0.051* Failed firms Mean 19.33 Standard Deviation 13.73 0.000 *** P-value

*: significance level at 10% ; **: significance level at 5%

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Due to the fact that the characteristics differ in the electronic and the non-electronic industries, it seems reasonable that the impacts of financial and governance variables also might be different. As a result, the comparison between firms which are located in the electronic and the non-electronic industries will be conducted in this study. Table 4-5 demonstrates the results of Mann-Whitney U test towards financial variables in different industries. In terms of the liquidity, firms located in electronic seem have higher liquidity comparing with non-electronic firms since the current ratio and quick ratio in electronic firms are significantly higher than that in non-electronic firms. Although the gross margin and ROA of electronic companies are higher than those of non-electronic firms, the differences are not significant. The ROE and net profit margin indicate that electronic and non-electronic firms both suffer from negative profitability and the difference between these two groups is not substantial due to its p-value is greater than 0.05. However, the difference of profitability between firms within the non-electronic industry seems more obvious since the deviation of net profit margin of non-electronic firms is 283.35 Regarding to debt leverage, the D/A ration in electronic and non-electronic industries is significantly different and it seems obvious that D/A ratio in non-electronic industry are considerably higher than that in electronic industry. It might indicate that electronic firms tend to raise their funds by means of issuing shares since they need a great amount of funds to meet R&D expense and daily operation, while non-electronic companies usually raise funds through debts. Nevertheless, non-electronic firms have higher capability of maintaining fixed assets by a more stable long-term fund. Lastly, in terms of cash cover, while electronic firms have more net cash flow to meet the need of payment generated from current liabilities, the difference between electronic and non-electronic firms is not significant.

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Table 4-5 Mann-Whitney U test of financial variables (Electronic v.s. Non-electronic) Financial variables X1: Current ratio X2: Quick ratio X3: TIE X4: Gross Margin X5: ROA X6: ROE X7: Net profit margin X8: Asset turnover X9: A/R turnover X10: turnover Non-Electronic X11: D/A ratio X12: fund/FA Non-Electronic X13: Cash cover Electronic Non-Electronic ***: significance level at 1% Data source: by this research 820.2783 18.8289 10.6148 4200.1413 53.94401 69.0846 0.426 Long-term Electronic Non-Electronic Electronic 5.7997 48.1391 52.9131 650.6098 11.71464 20.42614 21.05533 1432.869 0.003*** 0.019** Inventory Electronic Non-Electronic Electronic Non-Electronic Electronic Non-Electronic Electronic Non-Electronic Electronic Non-Electronic Electronic Non-Electronic Electronic Non-Electronic Electronic Non-Electronic Electronic Non-Electronic Electronic Mean 205.5921 165.4984 144.298 93.5522 3219.86 344.5584 17.4084 14.9218 1.2631 0.8127 -22.8870 -17.5370 -30.2246 -38.5456 0.9904 1.7747 5.6023 12.5041 13.0162 Standard Deviation 205.0916 204.9269 157.02312 202.7082 29779.39 3915.2459 20.62386 17.28605 18.7782 12.71388 101.0645 96.62911 209.8648 283.34689 0.77032 13.64823 5.97875 30.65756 30.58961 0.000*** 0.000*** 0.000*** 0.945 0.962 0.379 0.088* 0.191 0.000*** 0.001*** P-value

*: significance level at 10%; **: significance level at 5%

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Table 4-6 illustrates the output of Mann-Whitney U test towards governance variables in different industries. Apart from variable X15 (the percentage of shares held by controlling shareholders) and X17 (the content of concentration), all the governance variables differ markedly. In view of ownership structure, although firms in electronic and non-electronic industries are recognized as concentrated firms, the extent of concentration of non-electronic firms is still higher than that of non-electronic firms due to the fact that non-electronic firms are often controlled by families and the control rights belong to families. Nevertheless, institutional shareholders mainly occupy the shares of electronic firms. It reveals that institutional shareholders prefer to invest in the electronic industry rather than in the non-electronic industry. Regarding to control rights, it is obvious that the control rights of non-electronic firms are considerably higher than that of electronic firms owing to its family-concentrated ownership structure. The problem that cash flow rights and control rights diverge from one-share-one-vote in the non-electronic industry is also severer than that in electronic industry. As far as board position is concerned, the ratio of board seats held by outside directors and supervisors in the electronic industry is significantly higher than that in the non-electronic industry since electronic companies often raise their funds by means of issuing shares. The establishment of outside directors would provide a mechanism to protect the interests of minority shareholders because inside shareholders might gain benefits at expense of minority shareholders. Outside directors are capable of monitoring efficiently to protect the interests of whole shareholders. On the contrary, the percentage of board seats held by outside directors is lower in non-electronic industry. It might induce to the severe problem of agency problem. Furthermore, the percentage that CEO also serves as the chairman of the board in non-electronic industry is markedly higher than that in electronic industry. It is also evident that the inside shareholders in the non-electronic industry tend to pledge their shares for funds substantially. The stock pledge ratio of non-electronic firms is considerably higher than that of electronic firms. It also leads to higher probability of bankruptcy.

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Table 4-6 Mann-Whitney U test of governance variables (Electronic v.s. Non-electronic) Governance variables X14: The percentage of shares held by board Non-Electronic X15: The percentage of shares held by controlling shareholders Non-Electronic X16: The percentage of shares held by institutional shareholders Non-Electronic X17: Level of Electronic Non-Electronic X18: Control Rights X19: Cash Flow Rights X20: The ratio of cash flow to control rights Non-Electronic X21: The ratio of board seats held by outside Non-Electronic X22: Participation Non-Electronic X23: Stock pledge ratio Electronic Non-Electronic ***: significance level at 1% Data source: by this research 0.34 8.43 29.13 0.47 18.22 32.20 0.000*** Management Electronic 0.018 0.25 0.75 0.43 0.031** directors and supervisors Electronic 86.78 0.13 22.81 0.16 0.000*** Electronic Non-Electronic Electronic Non-Electronic Electronic concentration 36.07 24.39 30.11 17.52 25.77 73.37 21.59 15.37 16.92 13.75 16.55 32.98 0.000*** 0.000*** 0.000*** 29.11 31.60 19.74 22.06 0.364 Electronic 15.89 35.43 12.46 21.33 0.006*** Electronic 23.48 13.85 15.09 10.31 0.115 Electronic Mean 25.16 Standard Deviation 13.45 0.037** P-value

*: significance level at 10%; **: significance level at 5%

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4.3 Empirical Results 4.3.1 Multicollinearity Test (1) Pearson Correlation Coefficient Before establish a predictive model, it is essential to investigate whether there is a strong relationship between explanatory variables. It is recognized as the problem of multicollinearity. If the problem of multicollinearity is severe, it seems possible that the outcome of the research might be biased and the estimated parameters are possibly underestimated or overestimated. Accordingly, Person Correlation Coefficient test can be applied to examine if the relationship between explanatory variables is very strong. When the correlation coefficient is greater than 0.75, then it indicates that the problem of multicollinearity is severe to influence the estimated ability of models. As can been seen from Table 4-7 regarding financial ratio variables, only the correlation coefficient between X1 and X2 is substantially higher, while the p-value, which is employed to investigate if the correlation coefficient is significantly different from zero, illustrates that there is an association between two variables since the p-value of most variables is less than 10%. Hence, another test, KMO test, should be conducted to determine that if the problem of multicollinearity exists in financial ratio variables. The condition is the same with regards to governance variables. As far as table 4-8 is concerned, only the correlation coefficient between X18 and X19 is strongly significant, whereas the p-value of most of other variables is less than 0.1. Hence, KMO test also should be conducted to examine if there is a multicollinearity problem towards governance variables.

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Table 4-7 Pearson Correlation Coefficient (Financial ratio variables) X1 X1 X2 X3 X4 X5 X6 X7 X8 X9 X10 X11 Pearson Sig. Pearson Sig. Person Sig. Person Sig. Person Sig. Person Sig. Pearson Sig. Pearson Sig. Person Sig. Person Sig. Person Sig. X12 X13 Person Sig. Person Sig. 0.966 0.000** 0.097 0.038* 0.370 0.000** 0.174 0.000** 0.124 0.007** -0.123 0.007** -0.010 0.826 0.004 0.932 -0.027 0.558 -0.499 0.000** 0.039 0.391 0.077 0.094 0.116 0.013* 0.362 0.000** 0.169 0.000** 0.095 0.038* 0.062 0.175 0.016 0.730 -0.029 0.532 0.027 0.564 -0.458 0.000** 0.000 0.997 0.082 0.076 0.072 0.124 0.130 0.005** 0.041 0.380 0.024 0.606 -0.004 0.931 0.047 0.312 0.009 0.846 0.116 0.013* 0.003 0.952 0.125 0.007** 0.380 0.000** 0.166 0.000** -0.203 0.000** -0.0140 0.754 0.097 0.034* -0.047 0.305 -0.329 0.000** 0.008 0.869 0.278 0.000** 0.479 0.000** 0.182 0.000** 0.026 0.572 0.088 0.057 -0.074 0.106 -0.407 0.000** 0.052 0.26 0.38 0.000** 0.061 0.183 0.012 0.801 0.041 0.371 -0.052 0.262 -0.486 0.000* * 0.050 0.275 0.144 0.002* * 1 1 1 1 1 1 X2 X3 X4 X5 X6

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X7 X1 X2 X3 X4 X5 X6 X7 X8 X9 X10 Pearson Sig. Pearson Sig. Pearson Sig. Pearson Sig. Pearson Sig. Pearson Sig. Pearson Sig. Pearson Sig. Person Sig. Person Sig. X11 X12 X13 Person Sig. Person Sig. Person Sig. 0.017 0.707 0.047 0.307 0.028 0.539 -0.042 0.357 0.000 0.991 0.125 0.007** 1

X8

X9

X10

X11

X12

X13

1 -0.012 0.790 -0.013 0.776 0.258 0.000** -0.013 0.775 -0.005 0.961 0.003 0.943 -0.031 0.502 0.010 0.822 0.168 0.000** 0.040 0.389 -0.031 0.501 -0.004 0.928 0.018 0.695 -0.245 0.000** -0.035 0.447 1 1 1 1 1

*: Correlation is significant at 0.05 level (2-tailed) **: Correlation is significant at 0.01 level (2-tailed) Data source: by this research

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Table 4-8 Pearson Correlation Coefficient (Governance variables) X14 X14 X15 X16 X17 X18 X19 X20 X21 X22 X23 Person Sig. Person Sig. Person Sig. Person Sig. Person Sig. Person Sig. Person Sig. Person Sig. Person Sig. Person Sig. -0.164 0.000** 0.343 0.000** 0.418 0.000** 0.632 0.000** 0.379 0.000** -0.243 0.000** 0.111 0.015* -0.005 0.910 -0.276 0.000** 0.242 0.000** 0.152 0.001** 0.278 0.000** 0.319 0.000** 0.094 0.039* 0.135 0.003** -0.066 0.151 -0.078 0.089 0.252 0.000** 0.413 0.000** 0.151 0.001** -0.288 0.000** 0.032 0.480 -0.165 0.000** -0.022 0.637 0.385 0.000** 0.303 0.000** -0.007 0.878 0.130 0.004* 0.002 0.969 -0.053 0.246 0.799 0.000** -0.039 0.394 0.021 0.653 -0.027 0.559 -0.096 0.036* 1 1 1 1 1 X15 X16 X17 X18

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X19 X14 X15 X16 X17 X18 X19 X20 X21 X22 X23 Person Sig. Person Sig. Person Sig. Person Sig. Person Sig. Person Sig. Person Sig. Person Sig. Person Sig. Person Sig. 0.480 0.000** -0.058 0.210 0.061 0.185 0.005 0.907 1

X20

X21

X22

X23

1 -0.123 0.007** 0.075 0.104 0.189 0.000** 0.114 0.013* -0.286 0.000** -0.041 0.378 1 1 1

*: Correlation is significant at 0.05 level (2-tailed) **: Correlation is significant at 0.01 level (2-tailed) Data source: by this research

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(2) Factor Analysis A. KMO and Bartletts Test The prerequisite of adopting Factor Analysis is to assess the suitability of the data. Factor Analysis is applied to reduce data set if there is a problem of multicollinearity. As a result, the strength of the relationship between variables should be investigated by means of KMO test first. In general, there are two statistical approaches can be employed to test the strength of relationship between variables. The first one is KMO test. It is often recommended to exercise Factor Analysis if the value of KMO index is between 0.6 and 1 (Hair et al. 2006). The second one is Bartletts Test. If the result of Bartletts test of Sphericity is significant, in which the p-value of it is less than 0.05, then it seems appropriate to perform Factor Analysis to reduce variables. As we can see from table 4-9 and 4-10, the values of KMO index in terms of financial and governance variables are 0.621 and 0.451 respectively. Although the p-value of Bartletts Test of Sphericity related to both financial and governance variables is significant, only the value of KMO towards financial variable is located between 0.6 and 1. Therefore, there might be a problem of multicollinearity existing in financial variables, whereas it seems the relationship between governance variables is not significant strong and there is no need to perform the Factor Analysis regarding to governance variables consequently.
Table 4-9 KMO and Bartletts Test (Financial variables) Kaiser-Meyer-Olkin Measure of Sampling Adequacy. Bartlett's Test of Sphericity Approx. Chi-Square df Sig. Data source: by this research Table 4-10 KMO and Bartletts Test (Governance variables) Kaiser-Meyer-Olkin Measure of Sampling Adequacy. Bartlett's Test of Sphericity Approx. Chi-Square df Sig. Data source: by this research .451 1927.672 45 .000 .621 1852.476 78 .000

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B. Factor Extraction After investigating whether the data set is suitable for Factor Analysis, a suitable number of components should be determined. Accordingly, factor extraction is applied to determine the smallest number of factors which can present the set of variables properly. In this study, principal components analysis, which is recognized as the most common approach, is employed to determine the number of components in accordance with the fact that initial eigenvalue is greater than 1. As can be seen explicitly from table 4-11, the first six components are selected since their initial eigenvalues are greater than 1. The percentage of variance also represents how far these components can explain the variance.
Table 4-11 Total Variance Explained from financial variables Component Total 1 2 3 4 5 6 7 8 9 10 11 12 13 3.119 1.443 1.144 1.135 1.089 1.002 .950 .941 .810 .632 .406 .278 .050 Initial Eigenvalues % of Variance 23.993 11.103 8.800 8.734 8.375 7.706 7.306 7.239 6.228 4.863 3.127 2.141 .386 Cumulative % 23.993 35.096 43.896 52.630 61.005 68.711 76.016 83.255 89.483 94.346 97.473 99.614 100.000

Extraction Method: Principal Component Analysis. Data source: by this research

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C. Factor rotation and interpretation Once the suitable number of components is determined, then it is important to interpret it properly. In generally, there might be several variables included in each components and the output from unrotated component matrix might fail to be interpreted properly since it does not illustrate to what extent these variables can represent the component, while a rotated output provides more information to assess the variables. After rotating these components, the output clarifies the loadings of each variable so that the components can be interpreted easily. Hence, it is vital to perform a rotated technique in Factor Analysis. As can be seen from table 4-12, X1, X2 and X11 are the main variables occupying the component 1 and their loadings are 0.955, 0.971 and 0.531 respectively. These three variables mainly stand for the component 1, but X2 has the highest loading by comparison with others. Therefore, X2 is selected to represent and label the component 1. The same rule is applied in other components. X6, X9, X7, X8 and X12 represent the component 2, component 3, component 4, component 5 and component 6 respectively.
Table 4-12 Selected Financial Variables- by Rotated Component Matrix Component Component 1 Variable X1 X2 X11 Component 2 X4 X5 X6 X10 X11 X13 Component 3 X3 X4 X9 X13 Component 4 Component 5 Component 6 X4 X7 X8 X11 X12 Data source: by this research 56 Variable Loading 0.955 0.971 0.531 0.337 0.778 0.810 0.302 0.603 0.370 0.469 0.346 0.705 0.589 0.579 0.843 0.960 0.379 0.940 X12 X8 X7 X9 X6 Sig. Variable X2

4.3.2 Binary Logit Model This study is mainly conducted by means of binary logit model since the data set does not follow a normal distribution. The empirical study in this research can be divided into three parts: a predictive model only considering financial variables, a predictive model only considering governance variables and a predictive model considering both financial and governance variables. (1) Financial Variables Table 4-13 is the coefficients derived from the Binary Logit Model only adopting financial variables. As can be seen in this table, during the period from 1999 to 2002, ROE has a significant effect on the predictive model at 1% level in the electronic industry. Net profit margin and A/R turnover are also significantly effective under the significance level at 5% and 10% respectively in the electronic industry. Similarly, these three variables have a significant impact on the model in the non-electronic industry at level 1% or 5%, but quick ratio is also significantly effective in non-electronic industry. In this study, the results indicate that quick ratio, ROE, net profit margin and A/R turnover all have a negative relationship with the probability that firms might undergo a financial crisis. The higher the values of these variables are, the lower the probabilities that firms might experience a financial distress. In terms of liquidity, higher quick ratio indicates that companies can cope with unexpected need of cash which is derived from current assets. With regards to profitability, higher ROE reveals that companies with higher capabilities to create profits for shareholders. Higher net profit margin also demonstrates that firms are profitable. The higher the A/R turnover is, the lower probability that companies might suffer from the problem of bankruptcy. From 2003 to 2006, quick ratio and ROE are significant under the significance level at 5% and 1% respectively in the electronic industry. A/R turnover and ROE are also significant at level of 5% and 1%. ROE is the only variable which has a significant impact on the financial distress predictive model during the period from 1999 to 2006 in both electronic and non-electronic industry. How far the variation of the probability that companies might experience a financial distress can be explained by this predictive model is measured by the value of Nagelkerke2 in this study. Under the fact that this model is
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developed only considering financial variables, the predictive model applied in the non-electronic industry has the highest capability to explain the probability that firms will experience a financial distress, in which the value of its Nagelkerke2 is 0.592.
Table 4-13 Coefficients of Binary Logit Model (financial variables) Variables Year X2 Quick ratio X6 ROE X7 Net profit margin X8 Asset turnover X9 A/R turnover X12 Long-term Fund to Fixed Assets X24 Firm size Cox & Snell R Square Nagelkerke R Square Electronic 99-02 yr -0.006 (0.110) -0.066 (0.009)*** -0.230 (0.021)** -0.796 ( 0.523) -0.684 (0.092)* -0.001 (0.788) 0.082 (0.830) 0.399 0.554 03-06 yr -0.009 (0.014)** -0.091 (0.000)*** -0.007 (0.293) -0.346 (0.390) -0.002 (0.964) 0.000 (0.383) 0.049 (0.794) 0.335 0.460 Coefficient (P-value) Non-Electronic 99-02 yr -0.026 (0.000)*** -0.004 (0.039)** -0.018 (0.002)*** -0.004 (0.936) -0.039 (0.034)** 0.000 (0.403) -0.078 (0.691) 0.289 0.399 03-06 yr -0.001 (0.727) -0.086 (0.000)*** -0.002 (0.880) -0.046 (0.877) -0.332 (0.023)** 0.000 (0.858) 0.296 (0.321) 0.425 0.592

*: significance level at 10%; **: significance level at 5% ***: significance level at 1% Data source: by this research

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(2) Governance Variables Table 4-14 clearly illustrates the coefficients derived from Binary Logit Model only considering governance variables. During the period from 1999 to 2002, only stock pledge ratio is significant in the electronic and non-electronic industry at level of 10% and 1% respectively. It is obvious that the stock pledge ratio is positively related to the probability that firms might have financial crises. Controlling shareholders might boost their control rights by means of pledging their shares for loans without actually paying for shares. It induces to higher probability of bankruptcy since the highly financial leverage will create risk for firms. Hence, the capability of explaining the predictive probability in the model developed in accordance with the data collected during the period from 1999 to 2002 is low since there is only one significant variable in this predictive model and value of its Nagelkerke2 is also lower than the model considering only financial variables at the same period. From 2003 to 2006, content of concentration is significant at level of 5% in the predictive model based on the electronic industry, and cash flow rights, the ratio of cash flow to control rights and the ratio of board seats held by outside directors and supervisors are significant at level of 1%. The relationship between the extent of concentration and the probability that companies might undergo financial crises is negative in this study. It might present that the performance of firms is better when the ownership is more concentrated since the wealth of managers or controlling shareholders is positively related to the value of firms. They have incentives to create profits for companies. In this study, the relationship between cash flow rights and the probability that companies might experience a financial distress is negative. If the cash flow rights are higher, the probability that companies might suffer from the problem of bankruptcy will decrease since the cash flow rights stand for the wealth of ultimate shareholders and they would engage in the activities that maximize the value of firms. Accordingly, the negative relationship between the ratio of cash flow to control rights and the predictive financial crisis probability is also discovered in this study. In addition, the ratio of board seats held by outside directors and supervisors is negatively associated with the probability that firms might experience bankruptcy in this study. The establishment of outside directors facilitates a better performance of firms since outside directors and
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supervisors have no interests with firms so that they are often more qualified to supervise the management of firms. They often possess expertise of the business and can provide more suggestion to firms. Hence, the setup of outside directors and supervisors usually benefit the value of firms and decreases the probability that companies might undergo the bankruptcy. Furthermore, according to the output of Binary Logit model base on non-electronic industry during the period from 2003 to 2006, like the predictive model based on the electronic industry, the variables that extent of concentration and stock pledge ratio also have a significant impact on the predictive model, while the percentage of shares held by institutional shareholders and management participation are significant at level of 10% and 5% respectively in the financial distress predictive model based on non-electronic industry during the same period from 2003 to 006. The relationship between the percentages of shares held by institutional shareholders and the probability that companies might suffer from the problem of bankruptcy is negative since institutional shareholders have incentives to monitor managers or controlling shareholder efficiently. Lastly, the positive relationship between management participation and the probability that firms might undergo bankruptcy is discovered in this study. It indicates that the performance of firms might be diminished if the CEO also serves the chairman of the board owing to the fact that the CEO might deprive the benefits of firms from shareholders. The value of Nagelkerke2, which is equal to 0.279 in the electronic industry and 0.327 in the non-electronic industry, is also lower than the model considering only financial variables at the same period from 2003 to 2006.

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Table 4-14 Coefficients of Binary Logit Model (governance variables) Variables Year X14 X15 shares X16 The The held The percentage percentage by of of 99-02 yr -0.049 (0.486) 0.090 (0.252) -0.020 (0.508) -0.044 (0.570) X18 Control Rights X19 Cash Flow Rights X20 The ratio of cash flow to control rights X21 The ratio of board seats held by outside directors and supervisors X22 Participation X23 Stock pledge ratio Cox & Snell R Square Nagelkerke R Square ***: significance level at 1% Data source: by this research Management 0.783 (0.417) 0.033 (0.063)* 0.292 0.407 0.648 (0.156) 0.006 (0.034)** 0.279 0.383 0.579 (0.207) 0.034 (0.000)*** 0.305 0.424 1.395 (0.039)** 0.047 (0.002)*** 0.327 0.450 0.036 (0.697) -0.005 (0.966) -0.004 (0.871) 9.448 (0.389) shares held by board controlling of Coefficient (P-value) Electronic 03-06 yr -0.022 (0.504) 0.025 (0.379) -0.022 (0.181) -0.120 (0.037)** 0.066 (0.053)* -0.184 (0.000)*** -0.043 (0.001)*** -5.013 (0.001)*** Non-Electronic 99-02 yr -0.002 (0.933) 0.011 (0.575) -0.013 (0.267) -0.040 (0.102) 0.001 (0.985) -0.068 (0.261) -0.010 (0.625) 8.008 (0.890) 03-06 yr -0.041 (0.224) 0.024 (0.519) -0.034 (0.084)* -0.126 (0.086)* 0.013 (0.889) 0.030 (0.767) -0.030 (0.408) -0.496 (0.842)

shareholders percentage shares held by institutional shareholders X17 content of concentration

*: significance level at 10%; **: significance level at 5%

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(3) Financial & Governance Variables Table 4-15 demonstrates the coefficients developed from Binary Logit Model considering both financial and governance variables. During the period from 1999 to 2002, it seems true that the predictive model based on electronic industry does not provide a good predictive ability since there is only one significant variable, which is ROE, in the development of model. In terms of non-electronic industry at the same period, quick ratio, ROE, stock pledge ratio and firm size are the variables that have a significant impact on the predictive ability. Furthermore, with considering both financial and governance variables simultaneously, the variation of the probability that companies might experience a financial distress can be explained by this predictive model has been improved considerably in this study, where the value of Nagelkerke2 is o.543 and 0.615 in the electronic and non-electronic industry respectively, which are much higher than that in the predictive models considering only financial variables or governance variables. During the period from 2003 to 2006, ROE, the extent of concentration, cash flow rights, the ratio of cash flow to control rights and the ratio of board seats held by outside directors and supervisors are the variables which significantly influence the predictive probability that companies might be in danger of filing for bankruptcy in the electronic industry. In terms of the non-electronic industry, the significant variables, which are ROE, the ratio of board seats held by outside directors and supervisors, management participation and stock pledge ratio, are also discovered in this study. The value of Nagelkerke2 also reveals the information about how the dependent variable can be explained by this model and it is 0.796 and 0.808 in the electronic and non-electronic industry respectively. The highest value of Nagelkerke2 concludes that the financial distress predictive model can be developed more precisely provided that adopting financial and governance variables in the model.
Table 4-15 Coefficients of Binary Logit Model (financial & governance variables) Variables Year X2 Quick ratio X6 ROE 99-02 yr -0.023 (0.197) -0.137 (0.050)** 62 Coefficient (P-value) Electronic 03-06 yr -0.007 (0.062) -0.017 (0.072)* Non-Electronic 99-02 yr -0.030 (0.001)*** -0.006 (0.015)** 03-06 yr -0.005 (0.198) -0.171 (0.009)***

X7 Net profit margin X8 Asset turnover X9 A/R turnover X12 Long-term Fund to Fixed Assets X14 X15 shares X16 The The held The percentage percentage by of of shares held by board controlling of

-0.012 (0.468) -8.193 (0.225) -1.975 (0.153) -0.014 (0.302) -0.212 (0.289) 0.109 (0.668) -0.110 (0.310) 0.150 (0.579) 0.140 (0.505) -0.008 (0.975) -0.034 (0.346) 4.089 (0.216) 7.32 (0.111) 0.123 (0.192) -2.056 (0.141) 0.395 0.543

-0.001 (0.867) -0.080 (0.842) -0.030 (0.584) 0.000 (0.591) -0.027 (0.453) 0.001 (0.973) -0.004 (0.823) 0.131 (0.066) 0.033 (0.390) -0.134 (0.015)** -0.032 (0.021)** -4.252 (0.019)** 0.497 (0.365) 0.003 (0.877) -0.061 (0.855) 0.571 0.796

-0.006 (0.399) -0.001 (0.987) -0.013 (0.473) 0.000 (0.635) -0.021 (0.501) 0.029 (0.214) -0.005 (0.700) 0.032 (0.292) 0.019 (0.811) -0.087 (0.285) -0.014 (0.557) 7.389 (0.198) 0.357 (0.508) 0.033 (0.000)*** -0.686 (0.029)** 0.446 0.615

-0.003 (0.208) -2.538 (0.271) -0.710 (0.303) -0.001 (0.483) -0.021 (0.755) 0.015 (0.811) -0.006 (0.886) 0.235 (0.397) 0.101 (0.703) -0.141 (0.613) -0.118 (0.178) -9.999 (0.046)** 4.003 (0.034)** 0.111 (0.029)** -0.239 (0.790) 0.582 0.808

shareholders percentage shares held by institutional shareholders X17 content of concentration X18 Control Rights X19 Cash Flow Rights X20 The ratio of cash flow to control rights X21 The ratio of board seats held by outside directors and supervisors X22 Participation X23 Stock pledge ratio X24 Firm size Cox & Snell R Square Nagelkerke R Square ***: significance level at 1% Data source: by this research Management

*: significance level at 10%; **: significance level at 5%

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4.3.3 Classification accuracy rate After the Binary Logit Model is developed, it is essential to measure how far this model can predict a firm which is actually undergoing the bankruptcy correctly. In this study, the cutoff level of 0.5 is applied to determine if the firm is a failed or non-failed firm. If the estimate probability that companies might suffer from the problem of bankruptcy, which is derived from Binary Logit Model, is greater than 0.5, then this firm will be classified as a distressed firm; similarly, the firm will be classified as a non-failed firm is the estimate probability is less than 0.5. Table 4-16 demonstrates how classification accuracy rate of non-failed and failed companies is determined. A represents the number that a non-failed company is also estimated as a financially-health firm; D indicates the number that a failed company is also estimated as a failed firm; B, which is viewed as type II error, states the number that a non-failed company is estimated as a failed company and C, which is regarded as type I error, illustrates that a failed firm is recognized as a non-failed firm. When A, B, C and D are determined, then the classification accuracy rate can be derived. E, which equals to A/A+B, is the classification accuracy rate of non-failed companies; F, which equals to D/C+D, is the classification accuracy rate of failed companies and G is the overall classification accuracy rate. The predicting abilities of the established models can be recognized through the accuracy rate.
Table 4-16 Calculation of Classification Accuracy Rate Estimated Y=0 Non-failed companies (Y=0) Failed companies (Y=1) Overall accuracy rate Data source: by this research A C Y=1 B D Accuracy rate E F G

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(1) Financial Variables As can be seen from table 4-17 and 4-18, they explicitly demonstrate that classification accuracy rate of the predictive model in the electronic and non-electronic industry only considering financial variables. It seems true that the classification accuracy rate in the electronic industry is decreased from 85.7% to 77.6% over the period 1999-2002 and 2003-2006. Although the classification accuracy rate in the non-electronic industry is only 75.6%, which is less than that in the electronic industry during the same period, the classification accuracy rate has been improved to 86.2% during the period of 2003 and 2006. This phenomenon might be caused by poor disclosure of financial information. It might indicate that the quality of disclosing financial information in the annual reports still needs to be improved.
Table 4-17 Classification accuracy rate (Electronic, Financial variables) Predicted Observed 0 99-02 yr prob.fail 0 1 Overall Percentage Predicted Observed 0 03-06 yr prob.fail 0 1 Overall Percentage 78 18 prob.fail 1 14 33 84.8 64.7 77.6 Percentage Correct 32 6 prob.fail 1 1 10 97.0 62.5 85.7 Percentage Correct

Data source: by this research

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Table 4-18 Classification accuracy rate (Non-electronic, Financial variables) Predicted Observed 0 99-02 yr prob.fail 0 1 Overall Percentage Predicted Observed 0 03-06 yr prob.fail 0 1 Overall Percentage 56 10 prob.fail 1 2 19 96.6 65.5 86.2 Percentage Correct 113 32 prob.fail 1 16 36 87.6 52.9 75.6 Percentage Correct

Data source: by this research

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(2) Governance Variables Table 4-19 and 4-20 demonstrate the classification accuracy rate of predictive model in the electronic and non-electronic industry only adopting governance variables. It is evident that the predictive model, which is only considering governance variables, can not provide a better estimate ability to predict a firm which might be in danger of filing for bankruptcy. The classification accuracy rate in the electronic is only increased slightly from 75.5% to 78.3%. Furthermore, although the accuracy rate in the non-electronic industry has been improved from 78.6% to 81.6%, the classification accuracy rate is still lower than that of the predictive model only considering financial variables. With regards to the quality of corporate governance variables, it seems true that the quality of corporate governance has not been improved considerably over the past years.
Table 4-19 Classification accuracy rate (Electronic, Governance variables) Predicted Observed 0 99-02 yr prob.fail 0 1 Overall Percentage Predicted Observed 0 03-06 yr prob.fail 0 1 Overall Percentage 81 20 prob.fail 1 11 31 88.0 60.8 78.3 Percentage Correct 29 8 prob.fail 1 4 8 87.9 50.0 75.5 Percentage Correct

Data source: by this research

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Table 4-20 Classification accuracy rate (Non-electronic, Governance variables) Predicted Observed 0 99-02 yr prob.fail 0 1 Overall Percentage Predicted Observed 0 03-06 yr prob.fail 0 1 Overall Percentage 55 13 prob.fail 1 3 16 94.8 55.2 81.6 Percentage Correct 113 27 prob.fail 1 15 41 88.3 60.3 78.6 Percentage Correct

Data source: by this research

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(3) Financial & Governance Variables Table 4-21 and 4-22 illustrate the classification accuracy rate of the predictive model considering both financial and governance variables. It is worth noticing that the classification accuracy rates in both electronic and non-electronic industry have been improved from the period 1999-2002 to the period 2003-2006. In terms of electronic firms, the classification accuracy rate has been improved from 81.6% to 83.9% from the period 1999-2002 to 2003-2006. The accuracy rate has also been improved from 84.7% to 92.0% during the same period of the non-electronic firms. By comparison the predictive models simply considering financial variables or governance variables, it seems obvious that the predictive model adopting both financial and corporate variables can estimate the probability that firms might be in danger of filing for bankruptcy more precisely since the classification accurate rate is significant higher than that in other predictive models based on single type of variables. This is in accordance with the hypothesis 2 that corporate governance variables help to predict financial distress more precisely. It is also apparent that the same variables adopted in the development of financial distress predictive models vary in different industry. In this study, the predictive models adopted the same variables during the same period also produce different significant variables in the electronic and non-electronic industry. The classification accuracy rates in these two industries are also considerably different. This phenomenon fits the hypothesis 3 that the predictive models perform differently in the electronic and non-electronic industry. The predictive models perform better towards non-electronic firms.

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Table 4-21 Classification accuracy rate (Electronic, Financial & Governance variables) Predicted Observed 0 99-02 yr prob.fail 0 1 Overall Percentage Predicted Observed 0 03-06 yr prob.fail 0 1 Overall Percentage 82 13 prob.fail 1 10 38 89.1 74.5 83.9 Percentage Correct 30 6 prob.fail 1 2 10 90.9 68.8 81.6 Percentage Correct

Data source: by this research

Table 4-22 Classification accuracy rate (Non-electronic, Financial & Governance variables) Predicted Observed 0 99-02 yr prob.fail 0 1 Overall Percentage Predicted Observed 0 03-06 yr prob.fail 0 1 Overall Percentage 56 5 prob.fail 1 2 24 96.6 82.8 92.0 Percentage Correct 114 16 prob.fail 1 14 52 89.1 76.5 84.7 Percentage Correct

Data source: by this research

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4.4 Analysis and Discussion The Binary Logit model is employed to investigate whether corporate governance mechanism is related to the probability of financial distress in this study. As can be seen from the results derived from Binary Logit model, there are seven variables that have a significant impact on the predictive probability of financial distress. In terms of ownership structure, four significant governance variables related to the perspective of ownership structure are discovered in this study. Firstly, the relationship between the extent of concentration and the probability that companies might undergo financial crises is negative in this study. The result tends to support the convergence of interest hypothesis that is proposed by Jensen and Meckling (1976). They state that inside shareholders have incentives to maximise the wealth of shareholders since their wealth is considerably related to the value of firms if the ownership is concentrated on the inside shareholders. In addition, the relationship between cash flow rights and the probability that companies might experience a financial distress is negative in this study. La Porta et al. (2002) suggest that cash flow ownership of an ultimate shareholder is positively related to the value of firms owing to the fact that ultimate shareholders personal wealth is highly related to the value of firms. Hence, higher cash flow ownership facilitates to a lower probability of financial distress. The results of this study tend to support the view of La Port et al. (2000). Besides the three variables mentioned above, the other two governance variables also play a vital role in the predictive models. The first one is the percentages of shares held by institutional shareholders. The negative relationship between this variable and the probability that companies might suffer from the problem of bankruptcy is also discovered in this study. Although the impacts of institutional shareholders on the value of firms are argued, the result of this study tends to support the efficient monitoring hypothesis which is introduced by Pound (1988). He assumes that institutional investors have expertise so that they can monitor the managers without paying too much cost. As a result, the existence of institutional investors contributes to a higher performance of firms and lower probability of firms that might undergo a financial crisis. The other variable is the ratio of cash flow to control rights. The phenomenon of divergent cash flow rights and control rights is obvious in Taiwan since
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controlling shareholders would tend to increase their control rights at the expense of minority shareholders interests. If they have higher control rights with low cash flows, the problem of central agency problem is even severe. However, the problem will be alleviated if their cash flow rights are high. The finding of this study is consistent with the statement proposed by Claessens et al. (2002). A higher ratio of cash flow to control rights decreases the probability that companies might experience a financial distress. In view of board position, three significant governance variables are discovered in this study. First of all, the relationship between stock pledge ratio and the probability that firms might have financial crises is positive. This is in accordance with the empirical studies conducted by Weng (2000) and Yeh & Lee (2001). They assert that the higher risk of firms will be created if inside shareholders pledge their shares for loans or credit since they would raise their control rights by using high leverage. Additionally, the ratio of board seats held by outside directors and supervisors is negatively associated with the probability that firms might experience bankruptcy in this study. Although Agrawal and Weisbach (1991) argue that the ratio of board seats held by outside directors is negatively related to the performance of a firm, the result in this study tends to support the hypothesis proposed by Fama (1980) presenting that outside directors can protect the interests of minority shareholders more effectively and increase the performance of firms. Lower probability for financial crisis will be also produced consequently. Lastly, the positive relationship between management participation and the probability that firms might undergo bankruptcy is discovered in this study. The finding in this study supports empirical study conducted by Daily and Dalton (1994a). They discover that companies with CEO serving as the chairman of board have worse performance. That induces to a higher probability for financial crisis of firms.

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Chapter 5 Conclusion and Limitation 5.1 Conclusion This research is conducted mainly focus on companies which experienced a financial distress from 1999 to 2006. The financial crisis predictive models are developed collecting data one year prior to the time that company actually suffered from the problem of financial distress. The predictive models are mainly developed in three parts: only considering financial variables, only considering governance variables and considering both financial and governance variables. The conclusion can be drawn as followed: 1. In terms of financial variables, quick ratio, ROE, net profit margin and A/R turnover have a significant impact on the estimate probability of financial crisis. With regards to governance variables, the percentage of shares held by institutional shareholders, the extent of concentration, cash flow rights, the ratio of cash flow to control rights, the ratio of board seats held by outside directors and supervisors, management participation and stock pledge ratio significantly influence the predictive probability for financial distress. 2. The Goodness-of-fit and classification accuracy rate of predictive models are improved by adopting governance variables besides financial variables. 3. The predictive models perform better towards non-electronic firms. 4. The quality of corporate governance mechanism is only improved slightly.

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5.2 Limitation The result of this research might be biased due to several limitations: 1. The validity of data source: The data is mainly collected from the annual reports of each public company and Taiwan Economic Journal (TEJ) database. If the information is not disclosed completely or there are mistakes in the database, those will lead to the accuracy rate of this study. 2. Deleted samples: Some samples are eliminated due to uncompleted data source. The samples which belong to the same group might be eliminated simultaneously. Hence, the information from that group will be ignored and that will influence the results of study. 3. Selected variables: In this study, only financial and governance variables are applied to produce a predictive model, while macroeconomic factors might also have impacts on the probability for financial distress. Hence, future studies can also be conducted by adopting other variables. 4. Type of directors: Due to the fact that it is not compulsory to disclose the type of director in the annual reports, the determination of type of director, such as inside director or outside director might be misjudged.

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