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ISSN: 2047-2528 Vol. 2 No. 3 [16-34]

Corporate Ownership Firm Financing Choices and Firm Value

Evidenced from Emerging Markets, Pakistan
Hamid Ullah
Abdul Wali Khan University, Mardan
E-mail: Ims.hamid@gmail.com

Dr. Attaullah Shah

Institute of Management Sciences, Peshawar
E-mail: Attashah15@hotmail.com

Dr. Shafiq ur Rehman

University of Malakand, Peshawar
E-mail: shafiquol@hotmail.com

Mr. Amir Hussain

Institute of Management Studies,UOP
E-mail: amirhussain75@yahoo.com

1. ABSTRACT

This study has conducted to investigate relationship among corporate

ownership, corporate leverage and its impact on the firm value while using a
random sample of eighty non-financial listed firms on Karachi Stock Exchange,
Pakistan for a period of 2003 to 2010. The empirical results supported fixed
effect regression between leverage and ownership structure variables.
Institutional ownership is negatively related with the leverage while
managerial ownership has insignificant due to the fact that non-liner
relationship exists with leverage. Therefore, leverage can be substituted with
the institutional ownership. Second model shows relationship between the firm
value and blockholders. There exists a positive significant relationship
between the firm value and blockholders. Three regression models are
estimated for the relationship of ownership structure corporate leverage and
firm’s value. There empirical results suggested that leverage and Tobin’s Q
has negatively related with managerial share ownership (MSO) while the
second equation suggests that Tobin’s Q has negative relation with leverage,
managerial share ownership square (MSO2) while positively related with
managerial share ownership (MSO). The third equation suggests that leverage
is positively related with Tobin’s Q while negatively related with managerial
share ownership (MSO).thus it has verified that corporate ownership
determined corporate leverage and corporate leverage has direct impact on the
firm value.

Keywords: Ownership structure, Capital structure, Firm value, blockholding,

3SLS model, Pakistan.

2. Literature Review and Theoretical Frame work

This chapter provides an overview of the work done on the ownership structure, capital
structure and firm value. The literature first provides the underlying theories on the
concept and then reported different empirical research support for these theories and at the
end developed a theoretical frame work that has been tested in the empirical analysis
section.

2.1 Ownership structure and Firm Value

Managerial ownership and agency conflicts have been of a great interest to the academics,
and research students due to its strategic impact on the firm value. The conventional

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example of agency relationship is the conflicts of interest between a principal and has
agent. The managerial ownership is considered as a tool for the internal control mechanism
and thus acts as an alternative to monitoring in order to minimize the agency conflicts.

The milestone of this concept was laid down by none other than the Father of Economics
Adam smith’s (1776) who argued that the firm structure creates mismanagement and thus
allows “negligence of their own servant” which firms fail to control.
“ The directors of such [joint-stock] companies, however, being the
managers rather of other people’s money than of their own, it cannot well be
expected, that they should watch over it with the same anxious vigilance with
which the partners in a private copartner frequently watch over their own. Like
the stewards of a rich man, they are apt to consider attention to small matters
as not for their masteries honor, and very easily give themselves a
dispensation from having it. Negligence and profusion, therefore, must always
prevail, more or less, in the management of the affairs of such a company.”
Adam Smith (1776)

For almost one-half a century, no one worked on this concept until Berle and Means (1932)
originated again interest in the agency theory. They argued that an increase in the size of
an organization leads to the gap between the ownership and control due to decreases in
ownership equity. This provides an opportunity to managers to follow their own interest
rather than the interest of the real owners i.e. maximizing the shareholders wealth.

2.1.1 Agency Theory

Jensen and Meckling (1976) for the first time came up with the issue of conflicts of interest
between the shareholders and managers. They defined this agency relationship in the
following words.
“Agency relationship as a contract under which one or more persons (the
principal(s) engage another person (the agent) to perform some service on
their behalf which involves delegating some decision making authority to
the agent and will provide some incentives to the agents for the services
they perform in their behalf like remunerations bonus.”
Jensen and Meckling (1976, P.308)

Jensen and Meckling (1976) argued when managers make efforts to increase the firm
performance however can cannot be benefited 100 percent from the profit of the firm
because, they do not have 100 percent ownership in the firm. So whenever there is
financing demand, managers would not only consider the interest of the shareholders but
also their own interest. If both the principal and agents expect to maximize their own
interest then there can be a good reason to think that agent is not working in the best
interest of the principal leading to the agency issue. Conflicts of interest between principals
and agents and no direct observation of agents by principals leads to moral hazards
problems, which gives rise to agency cost. They also suggested that this conflict can be
minimized by giving manager ownership options in form of stock options, prerequisites and
incentives so far well presented in the literature of corporate finance by Jensen and
Meckling (1976), Watts and Zimmerman (1978) and Miller and Rock (1985).

a. Free Cash Flows

Jensen and Ruback (1983) argued that the manager will use the excess cash flows available
for their own interest by investing them in such projects, which might not have positive NPV
or productive projects for the maximization of profit and shareholder wealth. Instead, these
excess cash flows should be given to the shareholders as a dividend. The monitoring of
managers’ activities in order to make managers to work for the best interest of the
shareholders has its own cost called monitoring cost. The greater the monitoring by the
shareholders the higher would be the agency costs.

Lubatkin and chatterjee (1994) suggested that by increasing the debt to equity ratio, the
shareholder of the firm will be able to ensure that the managers are working at their best
interest and running business more efficiently and the excess cash flows so generated

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would be given as returns to the investors after the repayments of debts, and avoiding
negative NPV projects. This all is possible due to the fact that by introducing debts in to the
capital structure, the main two bodies of the corporate governance are lenders and
shareholders. If the managers failed to serves the shareholder interest and could not meet
the debts obligations so more managers that are efficient will replace them who could be
able to better serve the interest of the Shareholders.

b. Asymmetry of Information
Myers and Majluf (1984) are of the view that insiders are likely to be more informed than
the external investors about the firm operations, assets and value of the firm. When
information asymmetry is larger, then the firm issues debts. If they issue shares, the stock
prices would fall more due to this asymmetry. So current shareholders would prefer the
debts financing in order to avoid the under-pricing of the stock prices. Therefore, the high
managerial ownership firm manager would prefer high leverage in order to serves the
interest of present shareholders.

In light of the above discussion, we hypothesize:

H1: Firm value is positively correlated with the percentage managerial ownership.

2.2 Institutional Investors and Capital Structure

Institutional investors are large group of agents in financial markets for the corporate
equity and they account for large fraction of stock turnover in the stock exchange.
Therefore, institutional investors play a vital role in the well-functioning financial markets.

a. Active Monitoring Hypothesis

Shliefer and Vishny (1986) presented an active monitoring hypothesis states that
institutional investors can lessen the capability of manager to take such decisions that
could not maximize shareholders wealth. These institutions have a hug stake in these firms
so they supposed to monitor manager decisions in order to avoid exploitation of firm
resources. Institutional investors play vital role in the determination of capital structure of
the firm. They monitor the firm performance and ensure that the managers are acting in the
best interest of the shareholders and thus reduce agency costs. (Jensen 1986, Pound 1988).
Lev (1988) suggested that the institutional investors are more capable to monitor the firm
performance as compared to individual investors, due to their access to various sources of
firms’ information. Crutchley, Jensen, Jahera and Raymond (1999) found that institutional
ownership and firm capital structure positively related with each other. They are of the view
that institutional shareholding is simultaneously determined with leverage, due to the fact
that the level of debts employed by the firm is directly affected by the portion of the
institutional investment.

b. Passive Voters Hypothesis

Pound (1988) presented his argument against the active monitoring hypothesis and argued
that large external block holders may be passive voters. These external block holders may
conspire with the insiders and may expropriate dispersed external shareholders. By
supporting the above argument, McConnell and Servaes (1990) presented the passive voters
hypothesis by considering the large group of shareholders and value of the firm. This
hypothesis state that, external block holders may be passive voters i.e. they may not play a
role in monitoring the management of the firm, so external blockholders are negatively
correlated with employed debts.

Finally, institutions enforce the firms to form shareholder advisory committees that would
review the financial and operational activities of the firm. Therefore, this would provide
information flow to the major shareholders from management. Wall Street Journal (1993),
suggested Pennzoil and Champion International to make shareholder committee to check
their financial and operational performance. Otherwise, these institutional investors would
arrange informal meetings in order to discuss business operations on a periodic basis.

H2: Institutional shareholdings and debt employed are negatively correlated.

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2.3 Blockholding, Capital Structure and Firm Value

Friend and Lang (1988) argued that external block holders influence managers in order to
protect their significant investments. Blockholders are normally the financial institutions
that can force managers to take decisions that are aligned with the interest of the
shareholder. Therefore, the ability managers to act in their own interest diminish with the
increase in the institutional ownership. Thus, the manager may find it difficult to employee
less leverage in order to minimize their employments risk. According to “Active monitoring
hypothesis”, external block holders can lessen the capability of manager to take such
decisions that could not maximize shareholders wealth by quality of monitoring system.
Shliefer and Vishny (1986) hence, we can infer from the above arguments that external
block holding and leverage are positively related.

Pound (1988) suggested that the large group of external shareholders might be passive
voters. He put forth argument against the active monitoring hypothesis. He is of the view
that large group of external block holders can be treated as like a dispersed outsider
shareholders. Following the above argument McConnell and Servaes (1990) presented
“Passive Voters hypothesis” which argues that there exist a negative relationship between
the institutional shareholdings and firm leverage.

Shome and singh (1995) empirically examined the existence of active monitoring hypothesis
by event study methodology. They examined the market reaction to announcements of
block holders’ acquisitions of more shares. They reported that there was a significant
positive relationship between abnormal returns and the external block holder acquisitions
of shares. Moreover, they also showed that there is positive relationship between the
abnormal returns and reductions in the agency cost.

Therefore, it can be hypothesized from the cited literature

H3: The higher the external blockholders ownership percentage the higher should be the firm
value.

2.4 Managerial Ownership and Firm Value

Managerial ownership plays an important role in the capital structure decisions, which in
fact have strong impact on value of firm. Berle and Means (1932) argued that the
distribution of a firm’s ownership between the outsiders and insiders affects the value of
firm through their monitoring functions. This concept gained importance once again after
J&M presented the agency theory, which states that managers normally have a tendency of
making use of the firm’s resources in a way that serve their interest against the interest of
shareholders. As the manager’s ownership, increases in a firm the conflicts interest
between firm’s managers and shareholders decreases leading interest of both parties to
converge. This is consistent with the convergence of interest hypothesis i.e. the market
value of the firm increases with the increase in the management ownership because the
manager employed optimal level of debts that benefit the firm.

Morck, Shleifer, and Vishny (1988) used piecewise linear regression to estimates the
relationship between the firm value (proxy used was Tobin’s Q) and the board of director
shareholdings for 500 firms and for period of one year i.e. 1980. The results shows that a
positive relationship exist between the firm value and ownership structure at 0% to 5% of
board ownership range and thus showed a dominant convergence of interest effect of
management ownership. While after 5% to 25%, there is a negative relationship between the
two variables so entrenchment effects overcome the convergence of interest effects.
Morck et al. are of the view that
“Theoretical arguments alone cannot unambiguously predict the relationship
between management ownership and market valuation of the firm's assets.
While the convergence-of-interest hypothesis suggests a uniformly positive
relationship, the entrenchment hypothesis suggests that market valuation can be
adversely affected for some range of high ownership stakes."

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Hill and Snell (1988) argued that the ownership structure explained that ownership
concentration brings innovations through the change in performance and thus leads to
value maximization of the firm shareholders. They also verified the positive relationship
between the ownership concentration and firm performance, while taking the firm
productivity as a proxy for the firm value.

McConnell and Servaes (1990) find out a curvilinear relationship between the Tobin’s Q and
corporate insiders share ownership for firms. Consistent results were also evidence in the
study conducted in Spain and UK by Short and Keasey (1999) and Miguel (2004)
respectively. Davies et al (2005) evidenced nonlinear relationship between managerial
ownership and firm value while extended the model specification of management ownership
holdings from cubic to quintic. Holderness et al. (1999) have confirmed similar non-liner
relationship between the ownership level shareholdings and value of the firm.

Cho (1998) argued managerial ownership have a strong impacts on the firm value because
the manager of the firm take investment decisions for the interest of their own or
shareholders so their decision can affect directly the performance of the firm. Leverage
choice is also one of the most important decisions which affects the firm value so far has
been given in classical Corporate finance literature. (Modigliani and Miller, 1963; Ross,
1977; Myers, 1977; Jensen, 1986 etc).

From the above literature, it can be hypothesized that

H4: There is a nonlinear relationship between managerial ownership and firm value,
which represents the change of the alignment between managers’ interest and
shareholder’s wealth in terms of managerial ownership level.

3. RESEARCH DESIGNED AND METHODOLOGY

3.1 Sample Framework and Data Sources

Sample of the study is randomly selected from the listed firms of Karachi Stock Exchange;
including eighty firms for the period of 2003 to 2010. This sample was primarily determined
by the availability of data for the same period from different industry like cement, textile
and spinning, engineering, chemicals transportation, telecommunication, foods, oil and gas,
and pharmaceutical. This study was conducted using only secondary data that were
collected from the different sources such as annual reports of all listed firms of KSE and
balance sheet analysis of joint stock companies’ of state bank of Pakistan.

3.2 Measurement of Variables

The control variables are divided in to three categories according to its nature.

3.2.1 Two variables used for Control of Risk.

Two variables are used as a proxy for the measurement of risk.

3.2.1.1 Firm Size (Size)

Log of total assets is used as a proxy for the firm size. Some of the research shows
significantly positively correlated relation of the firm size and level of debts employed.
(Crutchley & Hanson 1979). However, it is difficult to define clearly prior theoretical
relationship between these two variables. While the empirical results of different studies are
not uniform regarding the firm size and debts financing. Kester (1976) reported that there
exists insignificant negative relationship between the firm size and level of debts employed
by the firm. Remmers, Wright and Beekhuisen (1974) are of the view that there is no
relationship between the firm size and level of debts used by the firm. Fama and Jensen
(1973) suggested that larger firms are more diversified then smaller firms, which reduce the
chance of bank bankruptcy of the large firm. Large firm can employ higher level of debts
then the smaller firm due their transparency in information flow to the lenders. Scott and
Martin (1975), Ferri and Jones (1979) also reported the positive relationship.

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Warner (1977) and McConnell (1972) argued that there is negative relationship between the
firm size and the financial distress cost. Rajan and Zingales (1995) are of the view that,
“the effect of size on equilibrium leverage is more ambiguous. Larger firms tend to be more
diversified and fail less often, so size may be an inverse proxy for the probability of
bankruptcy.” (p.1451). Hence, the above arguments suggested a positive relationship of firm
size and level debts.

Therefore, from the above literature, “it can be concluded that there exists a positive
relationship between the firm size and level of debts employed.”

3.2.1.1 Volatility in Earning (EBIT)

Volatility in earning is measured by the standard deviation of five years percentage changes
in the operating income before depreciation, interest and tax i.e. Cash flows (Bradley et al
1974). Volatility in earnings is an indicator of the firm business risk due to the facts that
volatility in future expected income of the firm is the key indicator in determining interest-
paying ability of the firm (Ferri and Jones 1979). Therefore, when the firm having higher
volatility in earning should used less level of debts because the debts and the volatility both
increase the chance of bankruptcy. Jensen et al (1992) suggested that the firm with higher
business risk characteristic will be given lower level of debts at a specific interest rate in the
industry due to the fact that debts required a periodic interest payments from the firm
operating profit so if the income of the firm is volatile so the lenders will be reluctant to lend
more. Myers (1977) suggested different view from the above, that firm with higher volatility
in earning i.e. business risk will have lower agency cost and thus they may borrow more
than the firm with the lower level of risk.

“In this paper Business risk or volatility in earning is measured by the standard deviation of
annual percentage change in the operating income before depreciation, interest and tax i.e.
Cash flows.”

3.2.2 Three Variables Used for Control of Agency Cost.

Three variables are used as a proxy for the agency cost.

3.2.2.1 Firm Profitability (PROF)

Modigliani and Miller (1963) are of the view that firm preferred debts over equity due to the
tax shield benefit attached with the debts employed. As the higher profitable firms have
more cash flows to pay off their interest payments so they would preferred high level of
debts in order to avail the tax shield benefits. Miller (1977) denies the above argument by
introducing the concept of personal tax effects. DeAngelo and Masulis (1970) argued that
firm might not be so much dependents on the tax- shield of interest but they can also
consider the other sources that can also provide the tax- shield benefit to the firm like
depreciation.

Pecking order hypothesis, of Myers and Majluf (1974) creating a relationship between the
firm profitability and capital structure, by suggesting that firm with a higher profit will
demand less level of debts, as more internal funds are available in order to fulfill the
financing needs of the firm. Since high profitable firm enjoying more earnings available for
retention as a retained earnings, as result firm equity increase relative to debts. Titman
and Wessels (1977) suggested that high profitable firm will used their cash proceeds to pay
off their debts so this will reduced the level of debts employed by the firm relative to the
equity. So there is negative relationship between the firm profitability and leverage, similar
relationship is also reported in the following studies Toy, Stonehill, Remmers, Wright and
Beekhuisen (1974), Kester (1976), Titman and Wessles (1977), Shyamsunder and Myers
(1999) and Fama and French (2002). While Long and Malitz (1975) and Firth (1995)
reported that their exist no relationship between profitability and leverage.

“An operating profit before interest and taxes scaled by total assets is used as a proxy for the
firm profitability”.

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3.2.2.1 Firm Growth (F.G)

Jensen and Meckling (1976) argued that, ‘with the financial structure (firms financed
almost entirely with debt type claims) the owner-manager will have a strong incentive to
engage in activities (investments) which promise very high payoffs if successful even if they
have a low probability of success. If they turn out well, he captures most of the gains, if
they turn out badly; the creditors bear most of the costs.’ (p. 334). The agency cost of
debts will be increases with the risk shifting behavior of the manager. So such risk shifting
behavior of the firm managers depends on the available investment opportunities of the
firm. So firm operating in low growth opportunities industry would engaged in less risk
shifting and have lower agency cost. Firm will take higher level of debts, if it is operating in
low growth opportunities environment.

Myers (1977) argued that growth opportunities would add value and continue till the firm
exists and operating. In case of insolvency the firm will lose its value more if it is operating
in high growth opportunities. Bradley et al. (1974) are of the view that debts should be
negatively related to the financial distress cost i.e. agency and bankruptcy cost of firm.
Hence, Firms will employ lower level of debts, if it operates in high growth opportunities
industry.

The relationship of firm growth and level of debts employed by firm is best explained by
Pecking order theory, signaling theory and tax based theory. According to pecking order
theory positive relationship exists between the firm growth and level of debts employed. If
the firm is operating in high growth industry so its need for funds exceeds the then the
funds can be provided internally through retained earnings. So the firm would employ
higher level of debts.

Signaling theory suggested a positive relationship between the firm growth and level of
debts employed by the firm. This theory suggest that high growth firms face greater
Information asymmetry, so would used high level of debts to make the firm performance
signal.

“The average annual percentage change in the value of total assets over the period is used
as a measure of firm growth.”
OR
“The market to book ratio is defined as the sum of market value of equity to total assets
minus net worth divided by total assets.”

3.2.2.3 Free Cash Flows (FCF)

Jensen’s (1976) presented free cash flow hypothesis, which states that managers with
excessive cash flows will invest in projects with negative NPV rather than paying it to the
shareholders of the firm. He predicted that firm having higher free cash flow would probably
be having higher leverage.

The debts employing capacity of the firm depends upon the availability of firm free cash
flows. As the debts, require fixed amount of periodical payments, so with higher cash flows
would have higher debts capacity and may used more debts. However, according to pecking
order theory, firm would prefer internal funds to debts, if free cash flows are available with
the firm. So as a result, firms with higher cash flows employ lower level of debts.

Brailsford, Oliver and Pua (2002) reported that no relationship exists between the firm free
cash flows and level of debt employed.

In this study, free cash flow is defined according to Lehn and Poulsen (1979) and Brailsford
et al. (2002). “It is operating income before tax, depreciation and amortization after deducting
the taxes and dividends paid divided by total assets.”

FCF = OYBT + DEP + AMO - TAXPAID - DIVPAID

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Where:
OYBT = operating income before income tax
DEP = depreciation expense
AMO = amortization separately reported, such as goodwill
TAXPAID = total tax paid
DIVPAID = total dividends paid

3.3.3 Three Variables Used for Control of Assets Specificity

Three variables are used as a proxy for the assets specificity.

3.3.3.1 Non- Debts Tax-shield (NDTS)

Theories of capital structure suggested that firm used more level of debts in order to avail
the tax-shield benefits attached with the debts due to interest payments. DeAngelo and
Masulis (1970) argue that if the firm uses high level of non-debt tax shields, then the
additional benefits of debts would be lower. Thus, firms that have higher level of non-debt
tax shields would get less tax benefits by issuing more debt thus will employ lower level of
debts. The above statements suggested negative relationship between non-debt tax shields
and D/E ratio.

“Depreciation to total assets is used as a proxy for non-debt tax shields is the same as used
by Brailsford et al. (2002) in his study.”

NDTS = Annual Depreciation Expense/ Total Assets

3.3.3.2 Tangibility of Assets (TA)

Long and Malitz (1975), Friend and Lang (1977), Jensen, Solberg and Zone (1992) and Grier
and Zychowicz (1994) argued that firm usually used riskier debts, when they have fixed
assets to be kept as a mortgage. If the firm have more collaterals to offer then the cost of
borrowing would be lower, otherwise cost will be higher. So if the firm has more fixed assets
then higher would be the firm leverage.

The relationship between the capital structure and assets structure explain with the
theories of agency cost and asymmetry information. As cited earlier that managers normally
employed less level of debts in order to serves their interest rather than the interest of
shareholders. So agency cost for the monitoring of capital expenditure is difficult for the
firm that has low level of collateral assets. (Grossman 1972, Jensen 1976).

“The ratio of net fixed assets to total assets is used as a measure of tangibility”

Tangibility = Net fixed assets/ Total Assets

3.3.3.3 Dividends (Div)

Ratio of dividends divided by operating income plus one is used as proxy for dividend.
Casual relationship of managerial ownerships and dividends payout is put forward by
Jensen (1976) through free cash flow hypothesis, according to which dividend payouts
would reduce agency cost linked with free cash flow available with the firm. Therefore,
dividend and managerial ownership can be substituted for controlling free cash lows agency
problems. Same hypothesis is supported by Anup Agrawal and Narayanan Jayaraman in
1994. So it can be concluded that there is negative causal relationships between
managerial ownership and dividends. Similar relationship is supported by Rozeff (1972) and
Chen and Steiner (1999). Crutchley and Hansen (1979) suggested that by keeping cost and
benefit analysis, firm should choose such policy that will increase dividends and reduce
leverage due to more volatility of firm income. So the above statement suggested negative
relationship between firm leverage and dividends.

3.3.4 Capital Structure Variable

Leverage is used as proxy for capital structure.

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3.3.4.1 Leverage (Debt to Equity Ratio)

Total assets to total debts or Debts to equity are used as proxy for the capital structure of
firm. It is dependent variable in our different models, but in firm value models, it is consider
as independent variable. Debts to equity ratio are one of the key factors in the Capital
structure composition of the firm as stated by earlier theories (Titman and Wessels 1977,
Graham 1996). In most of the studies in fiancé long-term debts is consider as debts.
(Miguel and Pindado 2001). Leverage= Debts to equity

3.3.5 Firm Value Variable

Tobin’s Q is used as a proxy for the firm value.

3.3.5.1 Tobin’s Q

Tobin’s Q is considered as a proxy for the Firm Value in this research. Tobin’s Q is popular
concepts used in finance researches for the value of the firm. {Attiya Y. Javid (2009), Mara
Faccio and M. Ameziane LasferIts (1999) Bernard S. Black (2005), Zuobao Wei et al(2004)}

Tobin’s Q compares the markets value of the firm with the value of firm assets. If the firm Q
value is higher means that the firm is valued higher in the market and thus there would be
more chance of financing on equity market i.e. shares would be traded at higher prices.
Therefore firm with a higher Q might leads to lower level of debts employ by the firm.

In our research, Tobin’s Q is measured as Sum of market value of the firm, divided by book
value of assets.

3.3.6 Ownership Variables.

The following variables are used for the ownership structure.

3.3.6.1 Managerial Ownership:

In this study managerial ownership is proxy with the sum of percentage of directors,
executives, their spouse and Children out of total shares capital ownership of the firm.
Form the previous studies that we cited in literature shows the non liner relationship of the
managerial share ownership and capital structure as well as with the firm value. So we also
using simple percentage of managerial ownership, square managerial ownership form for
the support of “U” shape relationship hypothesis 4 and 6 and cube form of the managerial
ownership for the “N” shape.
MSO = (Directors + Executives + spouse + Children / Total share capital) * 100

3.3.6.2 Institutional Ownership:

Institution has a major role in the capital structure decision and on the overall value of firm
so far has been well highlighted in the above literature portion. So in this study
institutional ownership is proxy with the sum of percentages of Banks, Development
Finance Institutions, Non-Banking Finance Institutions, Insurance Companies, Moradabad,
Mutual Funds, National Investments Trust, National Investments Corporations and
Government investments out of total share capital of the firm.

INST = (Banks + DFI+ Non-BFI + IC+ Moradabad + M F+ NIT +NIC+ Gov / Total share
capital) * 100

3.3.6.3 Insider Blockholders or Ownership Concentration

The block holders affect the performance of the firm due to their huge stake in the
business. In this study we use two level of block holding i.e. top three major share holders
and top five major share holdings is based on the above cited literature.

O.C = (Top three major share holders capital/ Total share capital) * 100
0. C = (Top three major share holders capital/ Total share capital) * 100

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4. EMPIRICAL ANALYSIS

This chapter presents descriptive statistic of the ownership variables and financial
variables. Pearson correlation test is used to check the correlation among the ownership
and financial variables. Regression results of OLS and 3SLS models are in the end of the
chapter with the discussion on the results.

4.1 Descriptive Statistics

Managerial share ownership has minimum 0.00, maximum 0.920, mean is 0.197 and
standard deviation is 0.245. Blockholders have minimum 0.250, maximum 0.912, mean is
0.259 and standard deviation is 0.177. Institutional shareholders have minimum 0.00,
maximum 0.872, mean is 0.232 and standard deviation is 0.168. Tobin’s Q has minimum
0.143, maximum 4.898, mean is 2.340 and standard deviation is 1.759. While leverage has
minimum 0.082, maximum 0.985, mean is 0.580 and standard deviation is 0.193.
Moreover, descriptive statics of control variables are as under. Volatility has minimum
0.022, maximum 4.037, mean is 0.876 and standard deviation is 0.840. Size has minimum
1.736, maximum 5.273, mean is 3.528 and standard deviation is 0.738.

Table 4.1 Descriptive Statistics of the Ownership Structure of the Sample Firms.

Min Max Mean Standard. Deviation Skewness Kurtosis

MSO 0.000 0.920 0.197 0.245 1.247 0.492

BLOCK 0.250 0.912 0.259 0.177 -0.276 1.947

INST 0.000 0.872 0.232 0.1680 1.364 5.363

VOLT 0.022 4.037 0.876 0.840 1.598 2.229

SIZE 1.736 5.273 3.528 0.738 0.219 -0.559

PROF -0.256 2.128 0.136 0.209 5.410 40.373

GROWTH -0.742 1.703 0.195 0.280 2.047 6.263

FCF -0.986 2.082 0.119 0.201 5.676 48.980

NDTS 0.012 0.305 0.037 0.027 4.258 38.548

TANG 0.034 0.927 0.476 0.234 -0.213 -0.933

DIVD 0.667 2.784 1.161 0.216 2.041 7.808

Tobins.Q 0.143 4.898 2..340 1.759 3.326 15.856

LEV 0.082 0.985 0.580 0.193 -0.404 -0.324

Descriptive statistics of the variables used in this study are given in Table 4.1. MSO
represent the percentage of managerial ownership to the total share capital of the firm.
VOLT is Volatility in earning, SIZE is a proxy for the firm size, PROF represents firm
profit after taxes, Growth represents the firm growth, FCF stands for free cash flows,
NDTS stand for the non debts tax shield, TANG represents the tangibility of assets,
DIV stands for the dividends payout ratio, Tobin’s Q is used as a proxy for the market
value of firm and LEV represents the log of total debts to equity ratio and is used as
proxy for the leverage of firm.

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4.2 Pearson Correlation Matrix of Ownership Structure and Financial Variables:

MSO VOLT SIZE PROF GROWTH FCF NDTS TANG DIVD Tobin’s Q LEV

MSO 1

VOLT 0.05 1

SIZE -0.30 -0.04 1

PROF -0.05 -0.14 -0.01 1

GROWTH -0.03 0.06 0.07 -0.04 1

FCF 0.04 -0.07 -0.91 0.91 -0.02 1

NDTS 0.13 0.07 -0.05 0.04 -0.17 0.18 1

TANG 0.25 0.02 0.08 -0.15 0.01 0.01 0.37 1

DIVD -0.18 -0.09 0.09 -0.09 -0.01 -0.07 -0.01 -0.21 1

Tobins.Q -0.16 -0.13 0.21 0.18 0.05 0.02 -0.16 -0.36 0.251 1

LEV 0.08 0.18 -0.02 -0.17 -0.01 -0.08 0.03 0.17 -0.32 -0.27 1

Table 4.2 shows the correlation among the different variables. Where MSO represents the percentage of
managerial ownership to the total share capital of the firm. VOLT is Volatility in earning, SIZE is a proxy
for the firm size, PROF represents firm profit after taxes, Growth represents the firm growth, FCF stands
for free cash flows, NDTS stand for the non debts tax shield, TANG represents the tangibility of assets, DIV
stands for the dividends payout ratio, Tobin’s Q is used as a proxy for the market value of firm and LEV
represents the log of total debts to equity ratio and is used as proxy for the leverage of firm.

4.2 Pearson Correlation Matrix of Ownership Structure and Financial Variables:

Pearson correlation test is used to check the correlation among ownership structure
variable and financial variables. The correlation matrix shows that managerial share
ownership is negatively correlated with firm size, firm profitability, firm growth, dividend
ratio and Tobin’s Q while positively correlated with volatility, free cash flows, non debts tax
shield tangibility and leverage. Whereas Tobin’s Q is negatively correlated with managerial
share ownership, volatility, non-debt tax-shield and tangibility of assets. While positively
correlated with firm size, profitability, growth, free cash flows and Dividend ratio. Moreover,
firm leverage is negatively correlated with firm size, profitability, growth, free cash flow,
dividend ratio and Tobin’s Q. while positively correlated with percentage managerial
ownership, volatility, and nondebt tax-shield and assets tangibility.

4.3 Regression Analysis of leverage and Ownership Types.

Agency theory of Jensen and Meckling (1976), presented the concept of inherent conflicts of
interest among the shareholders and the managers of the firm. Whenever there is financing
demand, managers would not only consider the interest of the shareholders but also their
own interest. So conflicts of interest between principals and agents and no direct
observation of agents by principals lead to moral hazards problems, which develops

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inherent conflicts between the two parties and thus gives rise to agency cost. This conflict
can be minimized by giving manager ownership options in form of stock options. This paper
is trying to find out an alternative method of controlling for the agency cost by minimizing
the shareholders and managers conflicts. Debts is one of the alternative used for this
purpose but employment of more debts can caused the firm bankruptcy or sometime
availability of debts and cost of debts is more so other alternative methods has been tested
in this paper, by studying the relationship of the leverage with the managerial share
ownership and institutional ownership in order to check for the substitute effects of these
alternative for debts. Ordinary least square (OLS) multiple regression, fixed effects and
random effect model are estimated. The empirical results shows that most of the coefficients
of the OLS regression model are insignificant i.e. MSO, Growth and tangibility shows that
there is no relationship between the firm leverage and MSO, while size has negative sign
which is unexpected. Therefore random and fixed effects models are estimated the
Hausman test results of the random effect model suggested that there is no random effect
in the data while F-value of the fixed effect model suggested that fixed effect is exists there
in the data. The statistically significant coefficients of the MSO and INST suggested that
there exist a relationship between the firm leverage and MSO and INST. The negative sign of
the coefficients suggested that MSO and INST can have a substitute effect with the leverage.
So managerial ownership and institutional ownership can be used as a monitoring tool for
the discipline the firm managers. This negative relationship of MSO with leverage is
consistent with the studies of Friend (1988), Agrawal, and Nagarajan (1990). While the
negative sign of the INST is supported by Shliefer and Vishny (1986) Active monitoring
hypothesis which suggesting that institutional investors can lessen the capability of
manager to take such decisions that not could maximize shareholders wealth. These
institutions have a hug stake in these firms so they are more capable of monitoring
manager decisions in order to avoid exploitation of firm resources. So our significant results
accept the active monitoring hypothesis while rejecting the passive voter’s hypothesis.

Table 4.3 Shows OLS, Fixed Effect and Random Effects Regression Models
ofLeverage Over Ownership Structure and Control Variables.

OLS Fixed Effect Random Effects

Variables Coefficient S.E Coefficient S.E Coefficient S.E
Const 0.977806 (0.1225)*** 0.7325 (0.4569) 0.8756 (0.0922)***

MSO -0.0196291 (0.0620) -0.1709 (0.01503)** -0.0433 (0.0682)

- (0.011)** -0.0021 (0.0008)** -0.0018 (0.0027)
INST 0.00233836
VOLT 0.0647239 (0.0195)*** 0.2914 (0.0175)** 0.0717 (0.0156)

Size -0.050697 (0.0159)*** 0.0901 (0.01059)* -0.0557 (0.0166)*

Growth -0.0638221 (0.1078) 0.1448 (0.0375)** 0.1011 (0.0703)

FCF -0.17513 (0.0977)* -0.1017 (0.0697) -0.1090 (0.0410)***

TANG 0.0874412 (0.0802) 0.0597 (0.2120) 0.0620 (0.063)

Div.Ratio -0.235562 (0.0588)*** -0.1595 (0.0521)** -0.1664 (0.0364)***

Hausman test F -value
R-squared R-squared 12.8087
0.280817 0.703165 P-value = 0.118603
F-value 26.84 P-value F-value 12.82 P-value
000 000
Table 4.3.shows the regression results of the OLS, Fixed effect and Random Effects models of
Leverage as an independent variable while managerial ownership and institutional ownership as
explanatory variable with some controlling variables. The first columns show coefficients with the
standard error and level of significance of OLS while the second and third column is shows the fixed
and random effect results of the regression, where the LEV is used as a dependent variable. Robust
standard errors are given in parentheses. The *, **, and *** show statistical significance at 1% level,

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5% level, and 10% level respectively. Lower part of the table presents R 2, F-statistics for fixed-effects
model and Hausman test for random effects model. LEV is the ratio of total debt to total assets
whereas MSO is percentage of managerial share ownership to total no of shareholdings, INST
represent percentage ownership of institutions to the total shareholdings. SIZE is the natural
logarithm of total assets. PROF is the ratio of net income to total assets.FCF is free cash flows and is
equal to firm operating income plus depreciation, tax paid and dividend paid. TANG is the value of
net fixed assets over total assets. VOLT is standard deviation shows the earning variation. NDTS
represents non-debt tax shields and is measured as a ratio of depreciation for the year over total
assets.DIV is the ratio of dividends divided by net income plus 1.

4.4 Regression Analysis of leverage and Blockholders.

The alignment of interest hypothesis suggested that the ownership of blockholders
increases their economic stake in the firm will also be increased and blockholders will make
more efforts to protect their investment and thus will closely monitor the performance of
corporate managers. Thus, the monitoring will be increase with the increase in the
ownership level of blockholders. Bethel et al (1998) argued the performance of the firms
improves after the activist block holders becomes the shareholder of the firm. Therefore,
increasing the blockholder will minimize the agency conflicts there by maximizing firm
value. Ordinary least square (OLS) multiple regression, fixed effects and random effect
model are estimated to test for the two competing hypothesis i.e. Active monitoring
hypothesis and Passive voter’s hypothesis. The empirical results show that the coefficients
blockholders estimated through OLS regression model is slightly significant at 5% but
insignificant at 1% and 2% confidence level. Therefore random and fixed effects models are
estimated the Hausman test results of the random effect model suggested that there is no
random effect in the data while F-value of the fixed effect model suggested that fixed effect
is exists there in the data. The empirical results of the fixed effect model suggested a
positive relationship between the Tobin’s Q and 5% blockholders ownership. The statistical
significance of the coefficient supported the active monitoring hypothesis, which states that
blockholders can lessen the capability of manager to take such decisions that could not
maximize shareholders wealth by quality of monitoring system and leads to increase in the
firm value. While rejecting the Passive voter’s hypothesis that large group of blockholders
can be treated as like dispersed shareholders and thus are negatively related with the firm
value.

Table 4.4 Shows OLS, Fixed Effect and Random Effects Regression Models of
Tobin’s Over Blockholding and Control Variables.

OLS Fixed Effect Random Effects

Variables Coefficient S.E Coefficient S.E Coefficient S.E
Const 0.899117 (0.0775)*** 0.7052 (0.2292)*** 0.8223 (0.1052)***

BLOK 0.102322 (0.0492)* 0.288 (0.01252)*** 0.0895 (0.0796)

VOLT 0.0682942 (0.0078)*** 0.2886 (0.1385)** 0.0740 (0.0155)***

Size -0.0505043 (0.0089)*** -0.0803 (0.0322)** -0.0567 (0.0162)***

Growth -0.036076 (0.0704) 0.1568 (0.0744)** 0.1082 (0.0687)

FCF -0.18018 (0.0464)*** -0.0974 (0.0431)** -0.1113 (0.0411)***

TANG 0.0890265 (0.0405)** 0.0618 (0.09022)** 0.0726 (0.0621)

Div.Ratio -0.237409 (0.0410)*** -0.1564 (0.0382)*** -0.1689 (0.0363)***

Hausman test F -value
10.0257
R-squared 0.285560 R-squared 0.701383 P-value = 0.187121
F-value 31.46 F-value 12.89 P-value
P-value 00 000
Table 4.4 shows the regression results of OLS, fixed effects and random effects model of
leverage over blockholding and some control variables. The first columns show coefficients

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with the standard error and level of significance of OLS while the second and third column is
shows the fixed and random effect results of the regression, where the LEV is used as a
dependent variable. Robust standard errors are given in parentheses. The *, **, and *** show
statistical significance at 1% level, 5% level, and 10% level respectively. Lower part of the
table presents R2, F-statistics for fixed-effects model and Hausman test for random effects
model, and results of the. BLOCK shows the five percent blockholding of ownership and the
control variables remain the same.

4.5 Regression Analysis of Corporate ownership, Managerial ownership and Firm

Value

Chiyachantana et al (2004) are of the view that high ownership concentrated firm would
have easier access to debts due to high quality monitoring and thus would be having higher
debts ratio. The same positive relationship between the insider ownership and debts holder
has shown in the studies of Harris and Reviv (1990), Kim and Sorensen (1986), Agrawal
(1987), Agrawal, and Knoeber (1996) however, a significant negative relationship has been
reported in the studies of Friend (1988), Agrawal, and Nagarajan (1990). So our fist model
in table 4.5 is testing the existence of relationship between the MSO and LEV, Tobin’s Q
and control variables i.e. GROWTH, TANG, VOLT and SIZE. The results show that the
coefficient of LEV (0.1651) is significantly positively related with the MSO while the
coefficient of Tobin’s Q (-0.0067) is significantly negatively related with MSO. Moreover all
the control variables are also statistically significant. The empirical results suggested that
higher is the concentration of managerial ownership will offered high quality monitoring
and thus will have easier access to debts which will leads to higher debts ratio. So our
results are consistent with the Kim and Sorensen (1986), Agrawal (1987), Agrawal, and
Knoeber (1996).

Managerial ownership plays important role in the formation of capital structure decisions,
which infect have strong impact on the value of the firm. Berle and Means (1932) argued
that the distribution of firm’s ownership between the outsider and insider owners affects
the value of firm. McConnell and Servaes (1990) suggested a curvilinear relationship
between the Tobin’s Q and corporate managerial ownership. Our second model is testing for
the relationship of the of Tobin’s Q with the LEV, MSO, MSO2 and control variables like
VOLT and PROF. The OLS regression result suggested that LEV and MSO are negatively
related with coefficient of (-5.207) and -6.0194 respectively. While MSO2 is not significantly
related with Tobin’s Q and the negative sign of the MSO is also not consistent with the
literature. Moreover the control variables are also insignificant. Third model is representing
the relationship of LEV with the Tobin’s Q, MSO and control variables i.e. GROWTH, VOLT,
SIZE, FCF, NDTS and DIV. Ratio.

Managers take decision about the corporate structure (equity and debts) of the firm, which
directly affects the firm value. If the managers take decision at the best interest of the firm
shareholders, use optimal capital structure for the finance need, which will reduce the
overall cost of capitalization and thus will maximize the return to the shareholders of the
firm and market value of the firm. Miller and Modigealine theory (1958), McConnell and
Servaes (1995) Berger and Patti (2006). Third model is tested for the relationship of the LEV
with the Tobin’s and MSO. The empirical results shows that the coefficients of Tobin’s Q is
positive while that of MSO is negatively related with leverage with coefficients of (-0.0173)
and (0.2125) respectively. The negative sign of the coefficient are not consistent with the
past literature so that is why we test for the 3SLS regression models.

Table 4.5 Shows OLS Single Equation Models

MSO= α+βLEV+βTobins Q+βGrowth+βTANG+βVOLT+βSIZE

Tobin’s Q= α + βLEV+ β MSO+ β MSO2 + β PROF

LEV=α + Tobin’s Q + βGrowth + βVOLT + βSIZE + βMSO + βFCF + β NDTS + βDiv.Ratio

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Equation 1 Equation 2 Equation 3

Variables Coefficien S.E coefficient S.E coefficien S.E
t t
MSO Tobin’s Q LEV
LEV 0.1651 (0.0293)*** 5.027 (2.1202)*
*
Tobin’s -0.0067 (0.0015)*** 0.0173 (0.0056)***
Q
GROWTH 0.1344 (0.0781)* 0.1513 (0.0991)
TANG 0.2876 0.0408) ***
VOLT -0.0160 (0.0071** -0.5165 (0.3931) 0.1127 (0.0136)***
SIZE -0.0131 (0.00512)* 0.0349 (0.00928)***
*
MSO -6.0194 (2.2176)* -0.2125
(0.0362)***
MSO2 5.3657 (4.4451)
PROF 0.5979 (2.0461)
FCF -0.0800 (0.0742)
NDTS 0.4060 (0.397)
Div.Rati 0.2293 (0.0375)***
o
R-square 0.4354 0.2745 0.2854
F-value 69.54 62.46 63.12
Table 4.5 shows the regression results of the single equation OLS model. The first column
shows coefficients with the standard error and level of significance of OLS for each of the
three equations. Where MSO in the above model represents the percentage of managerial
ownership to the total share capital of the firm. VOLT is Volatility in earning, SIZE is a proxy
for the firm size, PROF represents firm profit after taxes, Growth represents the firm growth,
FCF stands for free cash flows, NDTS stand for the non debts tax shield, TANG represents the
tangibility of assets, DIV stands for the dividends payout ratio, Tobin’s Q is used as a proxy
for the market value of firm and LEV represents the log of total debts to equity ratio and is
used as proxy for the leverage of firm. Robust standard errors are given in parentheses. The
*, **, and *** show statistical significance at 1% level, 5% level, and 10% level respectively.
Lower part of the table presents R2, shows the explanatory F-statistics shows the stability of
the overall model.

5. CONCLUSION

The relationship among managerial ownership, capital structure and a firm’s value is of
great interest to the researcher in the field of corporate finance. Jensen and Meckling (1976)
point out agency problem, that manager has a tendency to takes such a decisions that
could serves their interest rather than the interest of the shareholders. While Harris and
Revive (1990) suggested that managers prefer lower level of debts due to the fear of risk of
bankruptcy, which will make managers jobless, their managerial competencies will be
doubted by others, and unemployment risk would be more even elsewhere.

This study has investigated simultaneous relationship between the ownership structure,
capital structure and firm value in Pakistani firms while taken in to consideration a random
sample of 80 firms from the Karachi listed firm. Ordinary least square (OLS) multiple
regression, fixed effects and random effect model are estimated in order to test for the
relationship of ownership structure, leverage and firm’s value. The empirical results of first
model suggested that there is negatively significant relationship between the firm leverage
and institutional ownership while no significant relationship with managerial share
ownership due to the non-linear nature of MSO. To test for the Active and Passive

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Monitoring Hypothesis, multiple regression model is estimated with the Tobin’s Q and firm
blockholders. The empirical results of fixed effect model suggested a positive relationship
between the Tobin’s Q and 5% blockholders ownership. The statistical significance of the
coefficient supported the active monitoring hypothesis while rejecting the Passive voter’s
hypothesis, which argued that blockholders can lessen the capability of manager to take
such decisions that could not maximize shareholders wealth by quality of monitoring
system and leads to increase in the firm’s value. In order to test for simultaneous
relationship between the corporate leverage, managerial ownership and firm value three
regression has estimated. The first model is supportive to the hypothesis that there is non-
linear relationship between the firm value and different level managerial ownership. This
non- liner behavior can be interpreted as supportive to the alignment effect (a positive
relationship) for a low level of managerial ownership and while supportive to the
entrenchment effect (a negative relationship) for a higher level of managerial ownership.
(Morck Shleifer, 1988). The third equation results suggested that leverage is positively
related with the Tobin’s Q and negatively related with the managerial ownership. The
negative sign of the managerial ownership because managerial ownership can be used as a
substitute of debts in order to make the manager more discipline. These results are
consistent with the studies of Friend et al (1988), Perry and Rimbey (1998) Jensen et al
(1992).

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