finance

The finance essay below has been submitted to us by a student in order to help you with your studies.

The impact of good Corporate Governance

There are some empirical researches have analyzed the impact of corporate governance on firm performance for the developed markets. Several studies have proved that good corporate governance practices have led the significant impact on firm higher productivity, increase in the economic value of firms, and lower risk of systematic, unsystematic and financial failure for countries. Shleifer and Vishny

(1997), John and Senbet (1998) and Hermalin and Weisbach (2003) explained in their research studies an excellent literature review in the area of corporate governances. It has now become an important area of research in also emerging markets.

Mitton (2001) has analyzed in their research study the impact of

different corporate governance practices in the cross-section of countries with sample of 398 firms Korean, Malaysian, Indonesian, Philippines, data Thailand have found that the firm-level differences in variables are related to corporate governance has strong impact on firm performance during East Asian Crisis in 1997 and 1998. The results suggests that better price performance is associated with firms that have

indicators of higher disclosure quality, with firms that have higher outside

ownership concentration and with firms that are focused rather than diversified.

Brown and Caylor (2004) have measured of Corporate Governance

Using Gov-Score which is prepared with 51 factors, 8 sub categories for 2327 firms based on dataset of Institutional Shareholder Service (ISS). They further explained in their study that better governed firms are relatively more profitable, more valuable and pay more cash to their shareholders. Gompers, Ishii, and Metrick (2003) in their study use Investor Responsibility Research Centre (IRRC) data, and conclude in their study that firms with fewer shareholder rights have lower firm valuations and lower stock returns. They further classify 24 corporate governance factors into five groups: Tactics for delaying hostile takeover, Voting rights, director/officer protection, other takeover defenses, and state laws. These factors are anti-takeover measures so G-Index is effectively an index of anti-takeover protection rather than a broad index of corporate governance. Their findings show that firms with stronger shareholders rights have higher firm value, higher profits, higher sales growth, lowest capital expenditures, and made fewer corporate acquisitions.

[Lipton and Lorsch (1992); Jensen (1993)] have explained in their research study that limited board size increasing firm performance because the benefits by larger boards of increased monitoring are outweighed by poorer consensus, difference of understanding and decision-making of larger groups. But Yermack (1996) has explained in their study of inverse relation between board size and profitability, asset utilization. Anderson, (2004) has explained that cost of debt is lower for larger boards, because creditors view these firms as having more effective monitors of their financial accounting processes. Brown and Caylor (2004) has explained in their study that between 6 and 15 with board sizes of firms have higher returns on equity and higher net profit margins than do firms with other board sizes. The relation between board independence, proportion of outside directors, and firm performance is inconclusive. Fosberg (1989) has found no relationship between the proportion of outsider directors and firm performance. Whereas, Baysinger and Butler (1985) and Rosenstein and Wyatt (1990) have explained in their study that market rewards those firms who appoint outside directors; Brickley, Coles, and Terry (1994) find a positive relation between stock market reaction and the proportion of outsider directors.

The research evidence on the association between firm performance and audit committee related governance factors is mixed. Brown and Caylor (2004) have shown in their study that independent audit committees are positively related to dividend yield, but not to operating performance or firm valuation. They further explained that consultation fees paid to independent audit committees less than audit fees paid to auditors are negatively related to performance measures and company has a formal

policy on auditor rotation is positively related to return on equity but not to

their performance measures. Klein (2002) finds a negative relationship between audit committee independence and earnings management, and Frankel, et al. (2002) has shown in their study a negative relationship between auditor independence and earnings management. whereas, Ashbaugh, al.(2003) and Larcker and Richardson (2004) find a contradictory evidence. Agrawal and Chadha (2005) also find similar conclusion in this regard.

Brown and Caylor (2004) has shown in their study that firms are more valuable when the CEO and board chair positions are separate.

Implementation of code of corporate governance it is now become an important area of research in Pakistan. Cheema (2003) suggests in their research study

that corporate governance can play a vital role for Pakistan to attract direct foreign investment and mobilize greater saving through capital, unless the code of corporate governance system is compatible with the objective of raising external equity capital through capital markets. The structure of corporate in Pakistan is characterized as concentrated family control, cross-shareholdings, interlocking directorships, and pyramid structures. The main objective of code of corporate governance is to protect minority shareholder, increase corporate performance, profit maximizing for families without providing offsetting benefits in the form of equally efficient monitoring by minority shareholders. They argue that a crucial challenge for policy makers is to optimize the dual objectives of minority shareholder protection

and the maintenance of profit-maximizing incentives. Therefore it is necessary for corporate to implement corporate governance for their progress. Pakistan is interesting to analyze corporate governance for many reasons.

First, the Companies Ordinance 1984 and Securities and Exchange Ordinance 1997, for fair disclosure of the Financial Reporting made it mandatory for publicly listed companies to report corporate governance information in their annual reports. Many cases reported that poor financial performance has been related with poor corporate governance practices in many sectors of the Pakistan economy. The implementation of code of corporate Ordinance 1984 and it was amended into 2002 to make it possible to study and analyze whether Code of corporate governance indictors had any effect on the financial performance of listed companies in Pakistan. Is the code of corporate governance principles adopted in Pakistan are similar to those implemented in other overseas jurisdictions it is possible in further study to make international comparisons.

The aim of corporate governance is to increase shareholder confidence. The three key elements of the Pakistan Stock exchange principles and guidelines that are also found in the corporate governance rules and codes in the USA, the UK, Canada and Australia include: non-executive/independent director, independence of chair, and board committees. The reason is to adopt such international best practices will lead to an improvement in the corporate governance practices in Pakistan listed companies.

All listed companies in their annual reporting to disclose all the recommended principles on corporate governance practices and explained to the shareholders.

This research extends the current literature on the corporate governance practices,

analyzing the effectiveness of the corporate governance practices recommended by the PKSC on listed companies’ financial performance.

Smith (1776), Berle and Means (1932), Jensen and Meckling (1976),

Fama and Jensen (1983) and Shleifer and Vishny (1997) and among others scholars explained in their study that agency problem arising from the separation of owner ship and control. They further explained that spread ownership structure create opportunity for managers to take control of firm assets that adversely affect shareholders wealth.

(Barnhart and Rosenstein, 1998; Denis, 2001) have explained in their study of code of corporate governance identifies a variety of mechanisms that are available to the best interest of the shareholders. These mechanisms are classified as Internal, the board, size of the board and independence of the board, and the establishment of the board committees and external, such as level of debt financing, block ownership, the market for corporate control, and product market competition.

Many Scholars (Demsetz and Lehn, 1985; McConnell and Servaes, 1990; Mikkelson and Ruback, 1985); in their research studies on corporate governance focuses mainly on a specific aspect of governance, such as insider ownership, (Mehran, 1995), blockholding, (Bhagat and Black, 2002; Denis and Sarin, 1997; Hossain et al., 2001), board composition and leverage (Agrawal and Knoeber, 1996; Begley and Feltham, 1999). This research uses an extensive set of corporate governance variables which provide comprehensive understanding of the company and governance practices and the principles that have been recommended internationally to improve governance practices. Three additional control variables are included in this study i.e., remuneration committee, audit committee, and dividends.

2.1 OWNERSHIP STRUCTER

(Berle and Means, 1932; Jensen and Meckling, 1976) in their study explained that equity ownership by insiders (officers and directors) will better align managers’ goals with shareholders’ goals.If Proportion of equity ownership of managers increases, their interests will be increase with those of outside shareholders, improving firm financial performance and reducing the agency problems. Demsetz (1983) explained in their study that performance of the firm will only increase if the ownership structure is in disequilibrium. Some studies find a positive relationship between an out-of-equilibrium level of insider equity ownership and firm performance. A corporate governance perspective, managerial ownership is a new concept for Pakistan; similarly the trend to issuing bonus shares to senior staff is growing. Therefore, it is understood that any increase in managerial ownership is likely to have a positive effect on firm financial performance.

Therefore, the first hypothesis is:

(1) H1a: Insider ownership is positively associated with a company’s

Financial performance.

(Denis, 2001; NZSC, 2006) explained in their study that shareholding of 5 percent or more of a company’s stock is considered to be a significant constituting a blockholding. Such blockholders may be corporations, individuals, or institutional investors. Shleifer and Vishny (1986) also explained the support for the view that block holdings are significant elements for controlling agency cost. The average block ownership of 85.9 percent in Pakistan firms also shows of weak regulations regarding shareholder rights allows initial owners to continue to hold large blocks of shares in companies after going public. As blockowners will provide a similar level of

vigilance as if they owned the company themselves. Many Scholars (Agrawal and Mandelker, 1990; Hill and Snell, 1988, Hill and Snell, 1989; Shleifer and Vishny, 1986) argued in their studies that Blockholding making manager monitoring easier the firms problem. Therefore blockholding is an important characteristic of the firms ownership structure in Pakistan, So it is understood that the presence of blockholders will have a positive effect on firm financial performance.

Therefore, the second hypothesis is:

(2) H1b: Blockholders will be positively associated with a company’s

financial Performance.

2.2 BOARD STRUCTER

The SECP amended regulations of corporate governance (2002) recommends that the boards of Pakistan publicly-listed companies should have an independent chair, the majority of members should be non-executive / Independent directors and a minimum of one third of the members should be independent directors. Therefore, the discussion in the corporate governance literature continues as to whether an increased participation of outside directors on the board leads to an improvement in the firm’s financial performance.

Therefore the third hypothesis is:

(3) H2a: The proportion of non-executive/independent directors is

Positively associated with the company’s financial performance.

(Hackman, 1990) explained in their study that there is no criteria of optimal “Board size”. But organizational behavior research study suggests that as group sizes grow larger, total productivity exhibits diminishing returns. Similar with, Jensen (1983) explained in their study that a board should have a maximum of seven or eight members to function effectively. (Psaros, 2009) explained that in Australia, the board size of the 250 largest companies have on average 6.89 members. (Firstenberg and Malkiel, 1994) explained in their study that from harmony perspective, smaller boards are more likely to reach consensus and also allow members to engage in genuine discussion and interaction. (Goostein et al., 1994; Psaros, 2009) explained that larger boards tend to provide greater management oversight, an increased of expertise, an access to wider range of contracts and resources. Forbes and Milliken (1999), Yawson (2006), Pye (2000), and Mak and Kusnadi (2005) explained in their studies that

larger boards suffer from higher agency problems because it is difficult to coordinate, decrease in reaching consensus and have difficulty making value maximizing strategic decisions.

Therefore, it is assumed that board size will have a positive effect on firm financial performances.

In the light of previous literature the fourth hypothesis is:

(4) H2b: Board size is positively associated with a company’s financial

performance.

2.3 USE OF DEBT AND DIVIDEND POLICY

Previous research studies have explained both theoretical and empirical evidence that use of both debt and dividend helps to discourage over investment of free cash flow by managers. (Agrawal and Knoeber, 1996) explained that debt acts as a corporate governance mechanism that can voluntarily be used to transfer the functions of monitoring and evaluating managerial performance and the capital market (debtholders); Begley and Feltham, 1999; Jensen, 1986), Agrawal and Knoeber (1996) and Beiner et al. (2003) argued that there is no relationship between debt and firm performance. Fama (1980) explained that managers may increase leverage beyond the “optimal capital structure” to increase the voting power of their equity stakes and reduce the likelihood of a takeover. In Pakistan publicly listed companies have relied on debt as a source of capital and debt holders have a tendency to protect their investment, monitor firm performance on a regular basis. It is understood that the use of debt will have a positive effect on firm financial performance.

Therefore, the fifth and sixth hypotheses are:

(5) H3a: Debt will be positively associated with a company’s financial

performances.

Similarly, companies may set a policy of dividend to earnings as a control

mechanism similar to debt financing. The higher the dividend payout ratio, the smaller the amount of free cash flows for investment. Crutchley and Hansen (1989) have explained in their study that dividend policy acting as a corporate monitoring performance. Farinha (2003) also explained practical evidence of dividend policy reducing agency problems either by increasing the rate of external capital rising and associated monitoring by investment bankers and investors (Easterbrook, 1984) or it is reasonable to believe that dividend payouts will have a positive effect on company performance.

Basing on the literature study it is understood that the use of both debt and dividend will lead to improved firm performance.

(6) H3b: Dividend payouts will be positively associated with a company

Financial performance.

2.4 BOARD COMMITTEES

(McMullen, 1996) explained in their study that the presence of an audit committee is related with fewer financial reporting problems. Klein (2002) argued that independent audit committees reduce the chances of earnings management thus improving transparency.

Main and Johnston (1998) and Weir and Laing (2000) explained in their studies that the presence of a remuneration committee has positive effect on performance. Klein

(1998) argued finds evidence of a positive relationship between the presences of a remuneration committee and performance and also explain that this relationship is not highly significant.

Although the PKSE recommendations and guiding principle to incorporate board

committees, a small number of studies, focus on board committees relationship with firm financial performance. Dalton et al. (1998) explained in their study that comparatively little research has been undertaken in the relationship between board sub committees and firm performance. On the other hand, the international evidence suggests that it is likely that experimental research in Pakistan will find a positive link between board sub-committees and company performances.

The seventh and eighth hypotheses are:

(7) H4a: The presence of an Audit Committee will be positively associated with

a company’s financial performance.

(8) H4b: The presence of a Remuneration Committee will be positively

associated with a company’s financial performance.


Request Removal

If you are the original writer of this essay and no longer wish to have the essay published on the UK Essays website then please click on the link below to request removal:

Request the removal of this essay


More from UK Essays