Financial Paper: Relation Between Leverage and Insiders

Introduction and Background

Financial management has a lot to do with decision-making. Several decisions have to be made in different levels and phases of investment, corporate financing, asset management, and apportionment of dividends. Investment decisions are mainly centered on three areas, namely opening of new ventures, expansion of existing business ventures, and replacement of existing machinery or introduction of new technology. Investment decisions are succeeded by financing decisions. The underlying question that this paper seeks to answer is whether there is a link between the profitability and the leverage of firms, in particular investigating the extent to which leverage affects the performance of the firm. It has been established that the separation between firm ownership, control of the firm, and the ensuing agency costs has lately become a thorny issue in corporate governance. Quite often, managers find themselves making decisions and setting objectives of the firm, which do not resonate well with the owners of the firm. The control battles between managers and owners have led to a new order in corporate governance where the capital structure has been used to align the objectives of the managers and those of the shareholders.

Hypothesis

The hypothesis for this paper is that the value of the firm is proportional to the level of corporate ownership by the top managers and that firms are increasingly increasing the level of corporate ownership by their top executives to increase the value of the firm and to align the interests of the managers with those of the stockholders in order to optimize the value to the stockholders. The primary hypothesis in this regard, therefore, is that the value of the firm can be seen as a function of the distribution of equity ownership among the corporate insiders, the individual stockholders, the block stockholders, and the institutional investors.

Literature Review

Traditionally, there has been no distinction between the owners of stocks of firms. It was universally accepted that shareholders of a firm could be easily be described as being a widely diverse and homogenous group of owners who played a passive role in the management of the firm. The extent of the influence of the shareholders on the operations of the firm was only felt through voting that would be greatly influenced by the managers.

In fact, the presumption has been that managers will naturally be led to act in the best interests of shareholders based on the signals that arose from the capital markets coming from forces that operate in the managerial labor market and also influenced by risk. However, this assumption has been challenged lately where there has been concern that managers will pursue their own private interest at the expense of the shareholders unless deliberate efforts are made towards aligning the interest of the managers with those of the shareholders (Donaldson and Davis 49). This means that corporate ownership in the modern business world has a great relationship with the leverage of the firm. The rest of this paper gives evidence to this effect based on empirical work done by different researchers in finance.

McConnell and Servaes (2) have asserted that managers will respond to two major opposing forces and that the effectual relationship between corporate ownership and value will depend on which of these two forces will dominate. These opposing forces can be described as follows: the natural tendency of a manager is to allocate the resources of the firm in such a manner that suits their best interest, which will most often conflict with the interest of the stockholders.

As the management’s equity ownership increases, there is a corresponding increase in the convergence of the interests of the managers and the stockholders. The first force will tend to have a negative effect on the value of the firm, whereas the second force will have a positive effect. This means that the relationship between firm value and corporate ownership can be looked at from an empirical perspective.

Atchison has asserted that the managers of a firm will not under normal circumstances act in the best interests of the stockholders but will rather place their own individual interests ahead of those of the firm’s stockholders. In other words, the managers ‘objectives will not always match those of the stockholders to include their managers among the company owners to ensure that the managers ‘interests will be aligned with those of the stockholders.

To redress this situation, most corporations have attempted to include the managers among the company’s owners. Firms will try as much as possible to reduce the conflict of interest between the managers and the stockholders. This will ensure that the managers do not strive for their individual interests but rather safeguard the interest of the stockholders.

Atchison continues to observe that many companies have come to accept that executive compensation is one way of ensuring that the interests of the managers and the stockholders will converge, or at the least, it will be possible to control conflict of interest. Atchison, however, cautions that this measure should be taken with due care since it could also induce the managers to set short-term goals for the firm so as to generate short-term gains, which will lead to a higher compensation package.

This new measure by companies is anchored in the agency theory. Agency theory looks at the relationship between the owners and the managers of a company. It considers the manner in which conflicts between the owners and the managers are in a bid to align the interests of the two parties.

The alignment of interest hypothesis was formulated by Jensen and Meckling, who described the relationship between corporate performance and managerial ownership. This theory postulated that increased equity ownership by the managers could mitigate the firm’s cost of equity and enable firms to align the interest of the managers with those of the stockholders. This is because managers who hold a large portion of the firm’s shares will be motivated to improve the performance of the firm, which will increase their share of wealth. Additionally, the managers will also reduce any pay-outs to external shareholders, which would negatively affect the performance of the firm. This will therefore lead to improved value of the firm.

Cooper, Gulein, and Rau (6) observe that the salaries of managers are being increasingly aligned with the aggregate firm performance. This is to say that many firms are now designing compensation packages in such a manner that will induce the managers to pursue the best interests of the stockholders. To achieve this, a big portion of the compensation package for managers is being placed on restricted stock options.

According to Bebchuk and Fried, the 1990s was witnessed the extended bull market, where the compensation packages of managers of listed firms skyrocketed to unimaginable levels. For instance, the salaries of CEOs of S&P 500 firms had salary hikes that saw their salaries rise from just about $3.5 million to over $14.5 million, a rise of over 400%. Most of this increase was placed in option-based compensation. In the same period, the value of stocks that was awarded to managers rose over nine times.

The works of Jensen and Meckling (1976), Fama and Jensen (1983), and Shleifer and Vishny (1986) suggest that the structure of equity ownership plays a very critical role in fostering managerial incentives and the value of the firm. A wide array of literature has suggested that most investors will be inclined to invest in a well-diversified portfolio in order to minimize portfolio risk. By virtue that the liabilities of the stockholders are limited to the extent of their share ownership, it is, therefore, possible to diversify risks with other investments.
According to McConnell and Servaes (3), there are potential conflicts of interest between corporate managers and dispersed stockholders when managers do not have an ownership interest in the firm, a hypothesis that was formulated by Berle and Means (1932). Several dimensions of this problem have been affirmed by successive authors. Jensen and Meckling (1976) formulate the relationship between corporate value and managerial equity ownership, where stockholders are categorized into two groups.

The first group is the inside stockholders who manage the firm ad who have exclusive voting rights. The second group is the external stockholders who have no voting rights. Although both groups of stockholders are entitled to equal dividends per share of stock held, the inside shareholders are able to control the stream of cash flows through the consumption of additional nonmarketable perquisites. In such a scenario, there will be a natural inclination by the managers to institute and implement investment and corporate financing policies that benefit them, thereby reducing the benefits that accrue to external stockholders. This means that the value of the firm will depend largely on the proportion of shares held by the insiders. The larger the proportion of shares held by the insiders, the greater the value of the firm.

According to Burki and Guillermo (79), although so much effort has been made towards the diversification of shareholding in listed firms, empirical evidence around the world has shown that dispersed ownership is still a myth. Evidence has demonstrated that in an average median firm, over 45% of the common shares are held by the three top stockholders. The other result has shown that those countries with weaker or less developed investor protection policies tend to have a larger share ownership concentration.

According to Agrawal and Knoeber (4), managers are agents of the stockholders. This type of relationship presents a challenge for stockholders who are always seeking ways to ensure that the managers pursue and enforce their best interests. This assertion was made by Jensen and Meckling (1976), who suggested that the agency problem will always arise whenever a manager owns less than 100% of the firm’s shares.

Since the manager bears just a fraction of the cost whenever his behavior and decisions reduce the value of the firm, such a manager is unlikely to act in the best interest of the external shareholders. In this regard, Agrawal and Knoeber (5) are in agreement that one sure mechanism of alleviating the agency problem is through increased insider/manager shareholding. However, even where managerial wealth allows, this will be costly since it always preludes efficient risk-taking. There are also other mechanisms that can be employed to deal with the agency problem.

Four broad mechanisms have been used by firms to offer incentives to manage and, by so doing, alleviate the agency challenges between managers and stockholders. Three of these mechanisms rely on external parties to the firm, which are aimed at monitoring managers, while one is dependent on nonforces within the firm. The first three mechanisms are the use of debt, which relies on the capital markets in the evaluation of a manager’s performance.

The greater the debt, the greater the level of monitoring by lenders, which leads to improved management of the firm (Donaldson and Davis 51). The second measure is the market for managers, which are used to assess the performance of a manager and to determine the manager’s opportunity wage. The third measure is the market for corporate control, which makes use of takeover specialists in identifying and disciplining managers whose corporate performance is below average.

The fourth mechanism is the monitoring of the managers by the firm’s stockholders and board members. The fourth measure has always proved tricky and has the potential to aggravate the agency problem since it is not easy to monitor the monitors. There are several solutions available to this problem. For instance, more concentrated shareholding by the company insiders, who are the senior officers and directors, provides a greater incentive to effectively monitor the chief executive officer (CEO).

In a similar manner, more concentrated shareholdings by outsiders, who are the block stockholders and institutional stockholders, also act as a mechanism for diligent monitoring of the managers. Another key measure to this end is the market for directors, which is a measure that is used to motivate outside directors, thereby enabling greater use of external directors, which leads to more effective monitoring.

Empirical investigation

To investigate the extent to which firms are shifting towards aligning the goals of the managers with those of the stockholders, this study gathers data from major firms in the United States listed among the S&P 500 firms. A sample of 20 companies has been taken, which is a representative sample of large and medium-sized firms. The data collected for investigation include the composition of the board members to determine the number of insiders for each company, the percentage of shares held by the insiders, the name of the Chief Executive Officer, and the compensation package for each CEO splitting. Between cash-based compensation and stock options…

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