Can debt capital create value in firms suspected of having extreme agency problems? And does it? A good laboratory for research is emerging markets, where managers and families routinely employ pyramid ownership structures to give themselves control rights that far exceed their proportional cash flow ownership. Shareholders in these countries generally suffer from ineffective legal protection (La Porta, Lopez-de-Silanes, Shleifer, and Vishny (hereafter LLSV) (1998)) and underdeveloped markets for corporate control. The combination of misaligned managerial incentives and weak external governance in emerging markets makes overinvestment or the outright diversion of corporate funds more likely [Johnson, La Porta, Lopez-de-Silanes, and Shleifer (2000)]. Thus, emerging markets provide a unique setting in which to test whether debt functions as an alternative governance mechanism.
The international investment community is aware of these shortcomings of emerging markets. Mark Mobius, manager since 1991 of the $1.2 billion Templeton Developing Markets Trust, comments that “corporate governance is not improving so why fight it? ... It’s too Herculean a task and it’s too embedded in the culture.” Minority shareholders in emerging market firms should welcome any alternative firm-level governance that debt can provide.
Several authors have documented that the separation of control rights from cash flow rights is negatively related to firm value. We investigate whether debt mitigates the loss in value from these misaligned incentives, controlling for assets in place and future growth opportunities, among other factors. From a governance perspective, debt should create value for firms with high expected agency costs if the use of debt directly reduces overinvestment or allows firms to signal that they do not or will not overinvest.
Our investigation of the role of debt as a governance mechanism is unique because our data have wide variation in both expected agency costs and the types of debt contracts. In some firms, the separation between managerial control rights and cash flow rights is extreme – in others, there is no separation. We analyze traditional financial statement data as well as new data on a firm’s debt issues in domestic, international, and foreign bond markets and the internationally syndicated bank market. Differences in financial disclosure standards, creditor rights, creditor base, and contract terms across these debt markets result in different incentives to monitor borrowers, which should affect the valuation impact of debt. Our analysis also takes into account differences in the debt capacity of a firm’s assets in place and future growth opportunities. We control for the potentially endogenous relations among a firm’s value, debt, and ownership structure by estimating both simultaneously determined cross-sectional regression models using financial accounting data and time-series models that incorporate specific debt issues. Our sample of firms with wide variation in expected agency problems, investment opportunities, and types of debt allows us to conduct powerful tests of the agency hypothesis.
The cross-sectional tests show that book leverage helps mitigate the loss in firm value attributable to the separation of management control and ownership. Further, we find that this beneficial effect of debt is concentrated in firms that have either a relatively high percentage of assets in place or limited future growth opportunities.
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The Effect of Capital Structure When Expected Agency Costs are Extreme
