Conclusions

Consistent with theoretical predictions, we find that both a higher level of financial leverage and a faster
speed of adjustment of leverage toward the shareholders’ desired level are associated with better
corporate governance quality as defined by a more independent board featuring CEO–chairman
separation and greater presence of outside directors, coupled with larger institutional shareholding.
Empirical tests are rooted in the identification of two different leverage targets: optimal leverage level
where shareholders’ wealth is maximized, and the manager’s desired level where the manager’s own
wealth is maximized. The strong corporate governance system of a firm leads to higher SOA toward its
shareholders’ desired leverage level. Moreover, the effect of governance on SOA is the strongest when
the initial leverage ratio is located between the two desired levels where the interests of the manager and
shareholders clash. This article is the first to empirically investigate whether and how corporate
governance affects capital structure dynamics. This study also provides two additional messages for
research in related topics. First, our results comparing capital structure adjustments between firms moving
toward the shareholders’ desired leverage level and those moving toward the manager’s desired level
highlight the potential benefit of using an estimated target that takes into account the corporate
governance factors. Second, when it comes to capital structure decisions, the entrenchment effect of
equity-based compensation outweighs its incentive effect.

Limitation/suggestions
The study has been done only for sample consisting of 10,054 annual observations 1996–2008 though there
are other many more listed companies and so a different sample could have yielded very different results. In the
future, the study ought to analyze all listed companies for clear picture. Only two distinct leverage targets were
used for the study. Corporate governance facilitates capital structure rebalancing toward the shareholders’
but not the manager’s target. To induce value-maximizing capital structure decisions, a firm should use
more outside directors, attract more institutional investors, and lower the equity portion of executive
compensation. It would be advisable for the study to be of 10 or even 20 years as the broadened horizon will
negate the effects of any temporary phenomena that may cloud its analysis.

Critical appreciations

The study proves to be helpful in understanding both a higher level of financial leverage and a faster speed of
adjustment of leverage toward the shareholders’ desired level are associated with better corporate
governance quality.