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Interrelationships among capital

structure, dividends, and Ownership:

Evidence from South Korea
Yohanes Kristiawan H

Relationship among financing decision,

dividend policy and ownership

Theory used by the article

Convergence of interest theory: Debt and ownerships

are subtitutes-twomeans of accomplishing the same

task. Stock ownership is expected to have a negative
effect on leverage if convergence of theory holds.
Entrenchment theory:Insider ownership have a
positive impact on leverage if the entrenchment
theory holds, because new debt policy must be used in
conjunction with ownership to ensure that
management acts appropriately. dividends are
expected to have positive impact on debt if the
entrenchment theory is valid, because both can be
used to reduce cash flows and liquidity that would
otherwise be misused by management.

Pecking order theory: According to the pecking

order theory management prefers internal funds

(available liquid assets) to leverage, in part
because liquid assets can be spent in a more
discretionary, and potentially sub-optimal, manner.
This increases agency costs, and in turn increases
the need for debt financing to reduce the use of
internal funds. Consequently, both cash flow and
liquidity are expected to have a negative impact
on debt. Since more profitable firms have ample
stored funds, profitability should exhibit a negative
relationship with leverage.
Signalling theory, managers are willing to use
leverage and or dividends as a means of providing
a positive signal to capital markets.

There are a relationship between debt policy,

dividend policy, and ownership structure.

Variable used
Firms leverage (LEV): The ratio of total debt to book value

of total assets.
Dividends (DIV): The ratio of cash dividends to operating
Firms ownership (OWN): Measured by the percentage of
stock owned by insiders
Firms cash flow (CF): Calculated as the ratio of net income
plus depreciation to total assets.
Firm liquidity (CR): Measured as the ratio of current assets
to current liabilities.
Profitability (PRO): The ratio of net income to net sales.
Firms size (SIZE): Characterized by the natural log of
market value of equity.

Method of analysis
Simultaneous equations model is estimated

using 3 stage least squares (3SLS)

methodology. The 3SLS method is preferred
over the ordinary least squares (OLS) method
as the latter leads to biased and inconsistent
parameter estimates when a system has
interdependent endogenous variables.

The debt equation result

Examining the 3SLS results in Table 3, we see

that the coefficient estimate for OWN is
significantly negative. Concomitantly, the DIV
variable has a significantly positive coefficient
estimate-a finding that supports entrenchment
theory. The negative and statistically significant
parameter estimates for CF and CR are also
consistent with Myers and Majluf's (1984)
pecking order theory. Finally, the coefficient for
PRO is not statistically different from zero.

The dividend equation results

Unlike the results of Table 3, the 3SLS coefficient

estimates for the dividend equation provide
consistent results in favor of entrenchment
theory. The OWN and LEV coefficient estimates
are both significantly positive, implying that not
only are debt and dividend policies
complementary, but also that higher ownership
levels lead to higher dividends, possibly to
prevent entrenched managers from acting in a
manner inconsistent with stockholders.

The ownership equation results

Table 5 also exhibit a negative relationship between

these two variables; however, the causality is reversed.
Again, the sign and significance of this coefficient
estimate supports the convergence of interests theory.
Table 5 provides an analogous result, although again
the causality is reversed. Thus, we find additional
evidence that entrenchment theory and the
convergence of interests theory are not mutually
exclusive alternatives to explain agency costs.
Unexpectedly, the CF and CR variables have negative
and significant coefficient estimates, implying that
liquidity is not a significant determinant of managerial
ownership-a finding that goes against the pecking order
theory. Finally, the coefficient for SIZE is not significant,
which is inconsisteznt with previous empirical results.

The 3SLS regression results suggest that higher

levels of ownership and dividends negatively

affect leverage. Concomitantly, ownership and
leverage both positively impact dividends. Lastly,
we find that leverage is negatively associated
with ownership, while dividends positively impact
This study also considers the convergence of
interests theory and the entrenchment theory and
their abilities to explain the role of managerial
stock ownership in lowering agency costs.

Financial decisions, ownership

structure and growth opportunities:
An analysis of Brazilian firms

influence of financial decisions and ownership

structure on firm value in function of whether

companies have profitable growth

Theory used by the article

Underinvestment theory: The underinvestment view

(Myers, 1977) stresses the negative effect of too much

corporate debt on firm value, since it may incentivize
managers to forego profitable investment projects.
Overinvestment Theory: The overinvestment view applies
when the firm has no growth opportunities, and is closely
related to the free cash flow (Jensen, 1986 and 1993; Lang
et al., 1996; Smith and Watts, 1992; McConnell and
Servaes, 1995; Singh and Faircloth, 2005). This theory
emphasizes the negative consequences of too much cash
flow under the discretionary control of managers. If the
firm has no growth opportunities, managers are likely to be
tempted to waste the cash flow on unproductive projects.

Signalling theory: The signalling explanation is based

on the asymmetric information between managers and

investors (Amihud and Murgia, 1997; Benartzi et al.,
1997). Firms with the best investment projects need to
signal their growth opportunities in such a way that
cannot be imitated by firms without good investment
Free cash flow theory: Consistent with free cash flow
theory, shareholders welcome dividend payments
since the funds under managers discretionary control
decrease. Consequently, the value of the firm is also
positively related to dividend payout in firms with the
poorest growth opportunities.

H1a: For firms with growth opportunities a negative relation exists

between corporate debt and firm value.

H1b: For firms without growth opportunities a positive relation
exists between corporate debt and firm value.
H2a: For firms with growth opportunities either a positive or a
negative relation exists between dividends and firm value.
H2b: For firms without growth opportunities a positive relation
exists between dividends and firm value.
H3: Both for firms with and without growth opportunities a positive
relation exists between ownership concentration and firm value.
H4: A non-linear relation exists between ownership concentration
and firm value. This relation initially positive and negative
beyond a critical threshold holds for firms with growth

Variable used
They measure the growth opportunities with the equity market-to-book

ratio (MBE).
Two additional measures of growth opportunities: the price-earnings ratio
(PER) and investment intensity (INV). PER is the market value-to-net
profit ratio. Investment intensity is measured as the ratio of investment,
including plant, property and equipment (PPE) and R&D, to the existing
capital stock.
The explanatory variables are different measures of financial leverage,
dividend policy and ownership structure. With regard to debt, this work
uses the financial leverage ratio (LEV), defined as the book value of debt
divided by total assets. Dividend policy (DIV) is introduced through the
ratio dividends over total assets.
Concerning ownership structure, the work uses the proportion of shares
owned by the largest shareholder (C1) as a measure of ownership
concentration. It also uses C1 squared (C1 2) to test a possible non-linear
effect of ownership concentration. Firm size is a control variable,
measured as the log of total assets (SIZE).

Method of Analysis
They defined a multivariate regression model in which the q ratio

depends on the leverage, dividends and ownership structure as follows

(sub-index i refers to the firm and t to time):
Qit = 0 + 1LEVit + 2DIVit + 3C1it + 4C12it + 5SIZEit + i + t + it (1)
The panel data methodology makes it possible to control the so-called

constant and unobservable heterogeneity (Arellano, 2003; Hsiao,

2004). Panel data estimations rely critically on the fixed-effects term
(i), namely the identification of some specific features of each firm
that remain fixed over time. The fixed-effects term is unobservable,
and hence becomes part of the random component in the estimated
model. We also controlled for the effect of macroeconomic variables
through a time effect t. The random error term it controls both for the
error in the measurement of the variables and for the omission of
some relevant explanatory variables.


Table 4 shows the results of the basic estimation; they

confirm most of the hypotheses about the influence of

leverage, dividends and ownership on firm value
depending on the availability of growth opportunities.
First, financial leverage is significant in all the
estimations (columns 1-3 in panel A. Thus, consistently
with Hypothesis 1a, the coefficient of LEV is negative
for firms with the most growth opportunities.
In contrast (panel B in Table 4), when firms lack
profitable projects, leverage is positively and
significantly related to firm value. This result
corroborates Hypothesis 1b, which suggests the
disciplinary role of debt and how the value of the firm
increases through a reduction in the free cash flow,
preventing managers from incurring wasteful expenses.

Table 4 also reports the results for the

dividend policy. This result implies dividends

have a dual but complementary function.
Firms with high growth opportunities seem to
use dividends to signal growth opportunities
(Hypothesis 2a). For firms without growth
opportunities, where the free cash flow
problem is more severe, dividends seem to
play a disciplinary role on managers
(Hypothesis 2b).

Third, as far as the ownership concentration is concerned, column

(2) shows a positive relation with the value of the firm

irrespective of the growth opportunities. This result confirms
Hypothesis 3 by showing how the stake owned by the largest
shareholder creates incentives to improve the firms performance
through a more detailed control of managers. Nevertheless, when
a quadratic term for ownership concentration (C1 2) is introduced,
there are significant differences between firms with and without
growth opportunities, as reported in column (3). In this case, for
companies with good investment projects, a non-linear relation
exists between firm performance and ownership concentration:
positive for low levels of ownership concentration and negative
for high levels. These results are coherent with Hypothesis 4, and
suggest a combination of alignment and entrenchment effects
(Morck et al., 1988).

The results of this work show that leverage and dividends

in Brazil play a dual role depending on the availability of

growth opportunities. Also, ownership concentration may
improve the control of managers, but at the same time
may also exacerbate problems between large and small
shareholders in firms with the most growth opportunities.
The results suggest that ownership concentration
improves the value of all the firms, irrespective of the
growth opportunities. But on the other, in firms with
growth opportunities there is a risk that large
shareholders will expropriate wealth at the expense of
minority shareholders according to the non-linear relation