The Effects of Outside Board on Firm Value
in the Emerging Market from the
Perspective of Information Transaction
Costs*
S...
1. Introduction
While outside directors are there to monitor and supervise the management of the
firm to increase firm value...
emerging markets by using more refined independence and information asymmetry
measures.
In our empirical analyses, independ...
so grave at the firm. Taken together, board independence and information transac-
tion costs are important factors that dec...
credit ratings, which all proxy for information acquisition and processing costs, are
linked to the valuation effect. We e...
Table 1 Descriptive statistics for sample firms 1999–2006
The sample is drawn from FnDataguide. Data related to board of di...
performance issues by Morck et al. (1988). Tobin’s Q is the ratio of the sum of the
market value of common equity, the boo...
Table2Correlationanalysisamongthevariables
ThistablepresentstheSpearmancorrelationsamongthemainvariablesofsamplefirms.These...
financial corporate characteristics. Market microstructure variables are based on the
GH and HFV models. Using information ...
Thus, we use the information transaction costs with the permanent effect, k1
(GH) and k2 (HFV), as proxies for information...
sample period of 1999–2004. Panel B in Table 3 reports the empirical relationship
between information transaction costs de...
governance scores and the group with smaller firm sizes and lower governance
scores. However, when it comes to credit ratin...
Table4Effectsof(independent)outsidedirectorsonfirmvalue
Thistablepresentslinearordinaryleast-squaresregressionanalysesofeff...
In Table 5, we examine the relationship between the valuation effect of board
independence and information transaction cos...
coefficients of the interaction terms are not significant for the GH measure and
marginally significant for the HFV measure. ...
Table6Variousfirmcharacteristicsandvaluationeffectofboardindependence
Thistablereportsresultsfromregressingfirmvalueonboardi...
Table6(Continued)
Variable(1)(2)(3)(4)(5)(6)
Indepoutsidedirector·
Firmsizedummy
0.480***(0.109)
Indepoutside
director·Fir...
costs show a more positive impact of board independence, while firms with high
information asymmetry show a lower or negati...
Hasbrouck, J., 1991, Measuring the information content of stock trades, Journal of Finance
46, pp. 179–207.
Hermalin, B., ...
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Outside board effect on firm value

  1. 1. The Effects of Outside Board on Firm Value in the Emerging Market from the Perspective of Information Transaction Costs* Sung Wook Joh College of Business Administration, Seoul National University Jin-Young Jung** Johnson Graduate School of Management, Cornell University Received 31 August 2011; Accepted 11 January 2012 Abstract This paper examines whether the problem of high information asymmetry lowers the positive impact of board independence on firm value. Independent directors are outside directors who have never had business and professional ties with the firm. We adopt various proxies for information transaction costs from the market microstructure literature and traditional measures, such as firm size, firm age, number of analyst reports, governance scores, credit ratings, and institutional ownership, to see how they interact. Using data on publicly listed firms and their directors between 1999 and 2006 in Korea, we find that independent directors are correlated with higher corporate value when the firm has lower information transaction costs. The results suggest that the monitoring role of independent directors is limited when transferring firm-specific information is costly. Keywords Information asymmetry; Outside directors; Market microstructure; Firm value; Board independence JEL Classification: G14, G32, G34, G38, K22 *Acknowledgments: We are grateful to Editor Jun-Koo Kang and three anonymous referees. We are also grateful to the Institute of Banking and Finance, Hyuk Choe, and Cheol-Won Yang for providing us with the data. We appreciate research grants from the Management Research Center and Institute of Banking and Finance at Seoul National University. Any remaining errors are entirely those of the authors. **Corresponding author: Jin-Young Jung, Visiting Scholar of Finance, Research Associate of Emerging Markets Institute, Johnson Graduate School of Management, Cornell University, 248 Sage Hall, Ithaca, NY 14853-6201, USA. Tel: +1-607-527-0612, Fax: +1-607-254-4590, email: jj396@cornell.edu. Asia-Pacific Journal of Financial Studies (2012) 41, 175–193 doi:10.1111/j.2041-6156.2012.01069.x Ó 2012 Korean Securities Association 175
  2. 2. 1. Introduction While outside directors are there to monitor and supervise the management of the firm to increase firm value and protect shareholder interests, there is no consistent empirical relationship between outside directors and corporate performance. For example, in the US, a higher share of outside directors improves monitoring of cor- porate affairs (Hermalin and Weisbach, 2003), but it might lower firm performance depending on the roles of the directors (Klein, 1998). With a few exceptions, most analyses using data outside the US show a positive correlation between outside directors and firm performance. There are positive effects of outside directors on firm value in New Zealand (Hossain et al., 2001) and Korea (Choi et al., 2007; Kim, 2007), while Vafeas and Theodorou (1998) do not find a significantly positive relationship between the two for UK firms. In this study, we argue that differences in the effects of outside directors on firm value come from two sources: independence of outside directors and infor- mation asymmetry within firms. While outside directors, unlike inside directors, are understood as non-executive directors, some of them might engage in busi- ness or professional activities associated with the firm. Outside directors with a business or professional relationship with the firm might find it difficult to maintain their independence. Classifying outside directors as independent or gray directors, we examine whether the higher share of independent directors increases firm value as the directors would engage in monitoring and supervising a firm’s management. We also argue that firm characteristics, such as the degree of information asym- metry, matters to the effectiveness of outside directors. As Duchin et al. (2010) argue, when information acquisition cost is high, outside directors are less effective at monitoring than when it is low. To explore this foundational hypothesis in an emerging market, we construct firm-specific proxies for information costs and esti- mate how information costs affect the relationship between performance and board independence. Using market microstructure-based information measures, our paper mitigates the problems associated with various proxies that are correlated with firm size, which is an important contribution to the stream of research on information asymmetry and firm value. As noted by Denis and McConnell (2003), board independence depends on sys- tems and regulations specific to a given country, as well as firm characteristics and financial conditions (Kaplan and Minton, 1994). We argue that firms with high information asymmetry would bring in fewer independent directors and solicit less monitoring from them because transferring firm-specific information to outsiders is costly (Maug, 1997). Therefore, board independence increases when information asymmetry costs are low because the costs and benefits of the board’s monitoring roles are correlated with information asymmetry (Linck et al., 2008). The purpose of this paper is to examine whether the effects of board indepen- dence on firm value are different across various information environments in the S. W. Joh and J.-Y. Jung 176 Ó 2012 Korean Securities Association
  3. 3. emerging markets by using more refined independence and information asymmetry measures. In our empirical analyses, independent outside directors are those who appear to have no current or past ties with the firm at either a professional or business level. In other words, independent outside directors are defined as those who have not accepted any consulting fees from the firm as a lawyer or accountant, for exam- ple, and have not been employed by the firm or by any subsidiary thereof. We test how firms with high information transaction costs affect the impact of board independence on firm value. We construct information transaction cost mea- sures from several sources. One source is the market microstructure literature based on the Glosten and Harris (1988) model, and the other is based on the Hasbrouck (1991), Foster and Viswanathan (1993) (HFV) model. Conceptually, these measures share the spirit of the Glosten and Milgrom (1985), under which information trans- action costs widens bid-ask spread. In addition, we also examine how other tradi- tional proxies for information transaction costs, such as firm size, firm age, the number of analyst reports, governance scores, credit ratings, and institutional own- ership, interact with board independence and affect the valuation effect of board independence. Our work has hand-collected information on outside directors appointed by all listed non-financial firms in Korea between 1999 and 2006. We choose Korean firms and their board directors for our test for a couple of reasons. First, Korean financial markets are a good example to test for the effect of information transaction costs on firm value as a representative emerging market vis-a`-vis other developed mar- kets. Hubbard and Palia (1999) choose the 1960s in the US to test for the motive of internal capital market, arguing that the capital markets during the 1960s were under-developed and the costs and benefits of information asymmetry risk were more important. Second, Korean society places great emphasis on the effect of con- nections in terms of firm activities (Jeon and Ahn, 2001; Kim, 2005; Siegel, 2007; Johnson et al., 2009), making it possible to better examine the role of board inde- pendence. Third, The Korean market has had a regulatory requirement regarding the ratio of outside directors on boards as a key part of governance reform in 1997, and information transaction costs have become even more important in the after- math of the Asian financial crisis. Some of the findings in the study are as follows. First, outside directors affect firm value positively and significantly. Since board structure is endogenously deter- mined by firm performance, we deal with this problem using two-stage least squares (2SLS) regressions and fixed effect models. Our results are robust when endogeneity issues are controlled for. We also find that independent outside directors who have no professional or business ties with the firm generally increase firm value, while gray outside directors who appear to have or have had professional or business ties with the firm do not. This suggests that the valuation effect of board of directors changes with board independence. Finally, we recognize that the valuation effects of independent outside directors are more evident when information asymmetry is not The Effects of Outside Board on Firm Value Ó 2012 Korean Securities Association 177
  4. 4. so grave at the firm. Taken together, board independence and information transac- tion costs are important factors that decide the valuation effect of boards. The rest of the paper is organized as follows. In Section 2, we present a litera- ture review and develop our hypotheses. We describe our data and the sample in Section 3. In Section 4, we show the empirical design and the test results of our hypotheses regarding the valuation effect of board independence. We provide con- cluding remarks in Section 5. 2. Board Independence and Information Asymmetry A board of directors is believed to serve as an internal watchdog for governance, representing and protecting shareholders’ interests from management who may pur- sue their own interests in modern corporations where ownership and management are separated (Jensen and Meckling, 1976). It is also argued that independent outside directors are crucial in determining the effectiveness of monitoring and disciplining management (Choi et al., 2007). Board independence alone, however, does not guarantee effective monitoring. Maug (1997) argues that it is an optimal choice to give full control to management when information is too costly for outside directors to acquire. On the other hand, when information is not difficult to acquire, boards can intervene in the management of the firm. Furthermore, Raheja (2005) argues that outside directors provide better independent monitoring than insiders but are less informed about the firm. Thus, as the benefits of monitoring increase, boards will do more monitoring leading to more outsiders, while as the costs of monitoring increase, boards will do less monitoring leading to fewer outsiders. Linck et al. (2008) shows that outside directors incur infor- mation acquisition and processing costs in utilizing their expertise for the specific firm for which they serve. As a proxy for information acquisition and processing costs, Linck et al. use market-to-book (MTB) ratio, R&D expenditures, and the standard deviation of monthly returns. The result suggests that board independence decreases if information asymmetry is high. The aforementioned literature mentions that the ben- efit of monitoring and the advisory role played by outside directors decreases with the higher cost of acquiring and processing information. Thus, based on the aforementioned theoretical and empirical works, we can make a prediction that the valuation effect of board independence will decrease with higher information transaction costs. To capture the information acquisition and processing costs, we use two measures. One has grown out of the Glosten and Har- ris (1988) model, and the other is based on the Hasbrouck (1991), Foster and Viswanathan (1993) model in the market microstructure literature. These measures are based on the price impact costs generated by private information and reflect the spirit that information asymmetry widens the bid-ask spread (Glosten and Milgrom, 1985). We test to see how information transaction costs are related to the valuation effect of board independence. Additionally, we examine whether firm characteristics, such as firm size, firm age, analyst reports, institutional ownership, governance, S. W. Joh and J.-Y. Jung 178 Ó 2012 Korean Securities Association
  5. 5. credit ratings, which all proxy for information acquisition and processing costs, are linked to the valuation effect. We expect the low information transaction costs encompassing all these characteristics to be positively related to the valuation impact of board independence. 3. Sample Selection and Data Our sample consists of all Korean firms listed between 1999 and 2006. From this population, we select all non-financial firms that have data available on board com- position and information transaction costs calculated using the GH and HFV mar- ket microstructure models. Omitting financial and utility companies, we then combine the information with annual financial data and monthly stock returns from the FnDataguide. Figure 1 presents the time series of the board composition of the sample. The sample includes 3,927 firm-years from 1999 to 2006. Figure 1 shows that the ratio of outside directors was only about 15% in 1999, when the Korean government introduced the system of outside directors, and it surged thereafter, exceeding 30% in 2006. We include all the sample data on the number of outside directors, while we only include in the sample those independent or gray outside directors whose personal background data is available. The ratio of independent outside directors is the number of outside directors who do not participate in the management of the firm at present or in the past, or who have no business or professional ties with a firm, divided by the total board size. Table 1 presents each sample firm’s descriptive statistics regarding key firm char- acteristics, board, and information asymmetry variables. We use Tobin’s Q as a mea- sure of corporate value, following earlier studies on corporate governance and 0 5 10 15 20 25 30 35 1999 2000 2001 2002 2003 2004 2005 2006 Ratio(%) Year Outside directors Indep outside directors Figure 1 Board Structure Trends: 1999–2006. The sample includes 584 unique firms covering 3,927 firm-years over the period 1999–2006. Figure reports the percentage of outside directors and independent outside directors. Outside directors is the ratio of legally registered outside directors to board size. Independent outside directors (Indep outside directors) is the ratio of outside directors who have no business or professional ties to a firm to board size. The Effects of Outside Board on Firm Value Ó 2012 Korean Securities Association 179
  6. 6. Table 1 Descriptive statistics for sample firms 1999–2006 The sample is drawn from FnDataguide. Data related to board of director characteristics are taken from Korea Listed Companies Association and KISLINE, a database maintained by Korea Investors Service, Inc. (KIS) as well as database of people of JoongAng Ilbo. Data related to GH (HFV) are taken from Trade and Quote (TAQ) database provided by the Institute of Banking and Finance at Seoul National University (IFB ⁄ KSE database) from 1999 to 2004. Tobin’s Q is the ratio of the sum of the market value of common equity, the book value of preferred equity, and the book value of long-term debt to the book value of assets. Outside directors is the ratio of directors who are not employees of the company and have no operational responsibilities within the company to board size. Independent outside directors (Indep outside directors) is the ratio of outside directors who have no business or professional ties to a firm to board size. GH or HFV is information transaction costs estimated by the Glosten and Harris (1988) or Hasbrouck (1991)–Foster and Viswanathan (1993) models. Board size is the total number of directors. Director age is the age of boards as of the year end. Largest ownership is the percentage share- holding of the largest shareholder. CAPEX ⁄ assets is the ratio of capital expenditures to total assets. Leverage is the ratio of total debt to total assets. Firm size is the natural logarithm of (total assets ⁄ 1 000 000). Operating profitability is the ratio of earnings before interest and taxes (EBIT) to beginning total assets. Chaebol dummy is a dummy variable to indicate whether a firm belongs to one of the 50 largest chaebols. The Korea Fair Trade Commission updates the list of the 50 largest chaebols annually. Market risk (beta) is the estimate from market model in which the firm’s monthly returns over the last year are regressed on the KOSPI monthly returns. Analyst report is the natural logarithm of total number of analyst reports in the year. Credit rating dummy for companies with credit ratings for CPs or corporate bonds is set as ‘‘1’’, and for companies without credit ratings for CPs or corporate bonds is set as ‘‘0’’. Firm age is the natural logarithm of the firm’s age. Institutional ownership is the fraction of shares owned by institutions. Governance is the natural logarithm of total Korean corporate governance index (KCGI) which consists of four sub-indices: Shareholder Rights, Disclosure, Audit Committees, and Ownership Parity (excluding Board structure index) between 2002 and 2006. Variable First quartile Mean Median Third quartile Standard deviation Sample size Tobin’s Q 0.321 0.601 0.469 0.702 0.515 3,927 Outside directors 0.020 0.241 0.222 0.300 0.154 3,927 Indep outside directors 0.000 0.186 0.204 0.250 0.152 3,927 GH 0.001 0.016 0.005 0.018 0.343 2,719 HFV 0.001 0.025 0.005 0.018 0.229 2,719 Board size 5.000 8.282 7.000 9.000 7.063 3,927 Director age 51.91 54.44 54.89 57.76 5.379 3,927 Largest ownership 0.199 0.324 0.309 0.442 0.176 3,927 CAPEX ⁄ assets 0.007 0.042 0.026 0.063 0.314 3,927 Leverage 0.354 0.519 0.499 0.645 0.255 3,927 Firm size 4.463 5.503 5.276 6.302 1.481 3,927 Operating profitability 0.007 0.023 0.034 0.068 0.141 3,927 Chaebol dummy 0.000 0.188 0.000 0.000 0.391 3,927 Market risk (beta) 0.438 0.709 0.720 1.004 0.371 3,927 Analyst report 0.000 2.901 0.000 2.000 5.588 3,927 Credit rating dummy 0.000 0.243 0.000 0.000 0.434 3,927 Firm age 3.099 3.324 3.399 3.670 0.567 3,927 Institutional ownership 0.082 0.258 0.199 0.383 0.215 2,860 Governance 4.575 4.704 4.691 4.804 0.209 2,218 S. W. Joh and J.-Y. Jung 180 Ó 2012 Korean Securities Association
  7. 7. performance issues by Morck et al. (1988). Tobin’s Q is the ratio of the sum of the market value of common equity, the book value of preferred equity, and the book value of long-term debt to the book value of assets.1 The mean value of Tobin’s Q is 0.601. The average ratio of outside directors is 0.241, which includes 0.186 for the ratio of independent directors. GH and HFV measures are proxies for information transac- tion costs. We use the Trade and Quote (TAQ) database compiled by the Korea Stock Exchange and prepared by the Institute of Banking and Finance at Seoul National University (IFB⁄KSE database) to measure GH and HFV variables. We confine the data sample for GH and HFV to that of the year 2004 due to data availability. The mean values of the information transaction costs for the sample firms are 0.016 for GH and 0.025 for HFV. A high value of GH or HFV variable implies that directors have to incur a high cost when acquiring information on the firm. Table 2 shows the results of the correlation analysis among the information asymmetry variables, Tobin’s Q, and board independence. The results of this analysis suggest the possibility that multicollinearity may affect the results of regression analyses since variables, or proxies for information asymmetry, such as credit ratings, analyst reports, institutional ownership, and firm age, are highly correlated with firm size. To segregate these effects, we include two commonly used benchmarks for information transaction costs (GH and HFV mea- sures) in the market microstructure literature which are unrelated to firm size. Choe and Yang (2006) argue for the effectiveness of GH and HFV measures by regressing each information asymmetry measure on various firm characteristic variables that are likely to be related to the information asymmetry risk of a firm, i.e., firm size, BE⁄ME, turnover, residual volatility, and analyst coverage. 4. Empirical Design and Results To analyze how information transaction costs impact the valuation effect of board independence, we first examine whether board independence affects firm value. Then we carry out regression analyses using the interaction terms between board independence and the information transaction costs derived from market micro- structure models. We then interact board independence with other firm characteris- tics related to firms’ information transaction costs for a robustness check. 4.1. Measuring the Degree of Information Transaction Costs To determine how information environments influence the valuation effect of board independence, we use several measures of information transaction costs. Traditional measures, such as firm size, firm age, number of analyst reports, governance scores, credit ratings, and institutional ownership, are obtained from financial and non- 1 Additionally, we measured Tobin’s Q using a different method, which Chung and Pruitt (1994) presented, and the results are consistent with the results of our study. The Effects of Outside Board on Firm Value Ó 2012 Korean Securities Association 181
  8. 8. Table2Correlationanalysisamongthevariables ThistablepresentstheSpearmancorrelationsamongthemainvariablesofsamplefirms.ThesevariablesincludeTobin’sQ,Independentoutsidedirectors,GH,HFV, Firmsize,Institutionalownership,Analystreport,Creditratingdummy,andFirmage.Tobin’sQistheratioofthesumofthemarketvalueofcommonequity,the bookvalueofpreferredequity,andthebookvalueoflong-termdebttothebookvalueofassets.Independentoutsidedirectors(Indepoutsidedirectors)istheratio ofoutsidedirectorswhohavenobusinessorprofessionaltiestoafirmtoboardsize.GHorHFVisinformationtransactioncostsestimatedbytheGlostenandHarris (1988)orHasbrouck(1991)–FosterandViswanathan(1993)models.Firmsizeisthenaturallogarithmof(totalassets⁄1000000).Institutionalownershipisthefrac- tionofsharesownedbyinstitutions.Analystreportisthenaturallogarithmoftotalnumberofanalystreportsintheyear.Creditratingdummyforcompanieswith creditratingsforCPsorcorporatebondsissetas‘‘1’’,andforcompanieswithoutcreditratingsforCPsorcorporatebondsissetas‘‘0’’.Firmageisthenaturalloga- rithmofthefirm’sage.Thesampleconsistsof3,927firm-yearsbetween1999and2006(GHorHFVvariableincludesdatafrom1999to2004).***,**,and*denote statisticalsignificanceatthe1%,5%,and10%levels,respectively. Indep outside directorsGHHFVFirmsize Institutional ownership Analyst report Credit ratingFirmage Tobin’sQ0.097***0.0120.023)0.054***0.0140.156***)0.071***)0.178*** Indepoutsidedirectors)0.016)0.0120.217***0.0200.251***0.087***)0.049*** GH0.885***)0.002)0.009)0.001)0.0210.007 HFV)0.005)0.005)0.008)0.0120.017 Firmsize0.246***0.658***0.456***0.130*** Institutional ownership 0.197***0.126***)0.008 Analystreport0.287***)0.036*** Creditrating dummy 0.098*** S. W. Joh and J.-Y. Jung 182 Ó 2012 Korean Securities Association
  9. 9. financial corporate characteristics. Market microstructure variables are based on the GH and HFV models. Using information on price, quote, and spread, Glosten and Harris (1988) empirically divide the bid-ask spread into permanent components related to information asymmetry cost and temporary components related to order processing cost, inventory cost, etc. We follow the method of Chae et al. (2011). This method can be explained as follows: mt ¼ mtÀ1 þ k1Vt þ et Pt ¼ mt þ w1Qt DPt ¼ k1Vt þ w1ðQt À QtÀ1Þ þ et, ð1Þ where: mt = expected value of a stock under information of time t k1 = information transaction costs with permanent effect Vt = signed trading volume at time t indicated as trade direction (+ if it is a buyer initiated trading, ) if it is a seller-initiated trading) k1Vt = price impact by private information et = a signal of public information Pt = trade price of a stock at time t w1 = temporary component of information transaction costs reflecting order processing cost, etc. Qt = an indicator variable as trade direction (+ if it is a buyer initiated trading, ) if it is a seller-initiated trading). Hasbrouck (1991) and Foster and Viswanathan (1993) consider the effects over time. Their variable has been modified by Brennan and Subrahmanyam (1996). Hasbrouck (1991) uses a vector autoregression (VAR) model to estimate the unpre- dictable component of order flows, which is considered to be a portion of private information as follows. Vt ¼ aq þ X5 i¼1 biDPtÀi þ X5 i¼1 ciVtÀi þ st DPt ¼ ap þ w2DQt þ k2st þ et ð2Þ where: Vt = signed trading volume at time t indicated as trade direction (+ if it is a buyer initiated trading, ) if it is a seller-initiated trading) DPt = change in trade price st = a proxy for private information w2 = temporary component of information transaction costs reflecting order processing cost, etc. DQt = change in an indicator variable as trade direction (+ if it is buyer initi- ated trading, ) if it is seller-initiated trading) k2 = information transaction costs with permanent effect. The Effects of Outside Board on Firm Value Ó 2012 Korean Securities Association 183
  10. 10. Thus, we use the information transaction costs with the permanent effect, k1 (GH) and k2 (HFV), as proxies for information asymmetry risk. Thus, a high value of GH or HFV measure indicates a high risk of information asymmetry. 4.2. Measuring the Degree of Board Independence We limit the sample of directors to those who are legally registered and divide them into insiders and outsiders based on their legal positions. Weisbach (1988) defines independent directors as those who may be independent of current management because of no extensive business dealings with the company or family relationships with management. Choi et al. (2007) define independent outside directors as those with no current or potential business ties with the firms in question. They define gray outside directors as those who appear to have business ties with the firms by virtue of their professions, e.g., lawyers, accountants, consultants, or bank execu- tives. For our study, we take the definition of independent outside directors one step further from that of Choi et al. We consider both professional and business ties with top managers (e.g. CEOs) or owners (controlling shareholders) as well as work experience in the firm or the firm’s affiliates. In other words, in line with the defini- tion of independence in the Sarbanes Oxley (SOX) Act (2002), we define indepen- dent outside directors as those who have neither past nor current professional and business ties (i.e. employees, consultants, lawyers, accountants) with the firm or its affiliates. Nor will they have worked at the same job with the top manager (e.g. CEO) or controlling shareholders of the firms. We arrange independent outside directors using the hand-collected data avail- able on individual work experience. We then use as a proxy for board independence the ratio of the number of independent outside directors on the total number of boards. 4.3. Valuation Effect of Board Independence This section reports the results of the tests for our hypotheses on the valuation effect of board independence. Our specifications are as follows: Tobin0s Q ¼ a þ b1 (Board independence) þ b2 (Board size) þ b3 (Boards average ageÞ þ b4 (Largest ownership) þ b5 (CAPEX/assets) þ b6 (Leverage) þ b7 (Firm size) þ b8 (Operating profitability) þ b9 (Chaebol dummy) þ b10 (Market risk) þ b11 (Industry dummy) þ b12 (Year dummy) ð3Þ Panel A in Table 3 presents the annual trend of information transaction costs based on the market microstructure model. The trend tells us that GH and HFV variables were virtually constant within the range of 0.02 and 0.04 during the S. W. Joh and J.-Y. Jung 184 Ó 2012 Korean Securities Association
  11. 11. sample period of 1999–2004. Panel B in Table 3 reports the empirical relationship between information transaction costs derived from the market microstructure model and traditional informational measures, such as firm size, governance scores, and credit ratings, in our 1999–2004 sample based on univariate tests. Panel B shows how GH and HFV variables are related to the traditional measures. To show that, we divide the entire sample into a large group and a small group, with median being the basis, for firm size, governance, and credit ratings, and then calculated the means of GH and HFV variables, and finally the t-values for the differences. According to the results of the univariate analysis, GH and HFV variables did not show significant differences between the group with bigger firm sizes and higher Table 3 Characteristics of information transaction costs from market microstructure model This table presents annual trends of information transaction costs from the market microstructure model and the univariate analysis of information transaction costs between 1999 and 2004. GH or HFV is infor- mation transaction costs estimated by the Glosten and Harris (1988) or Hasbrouck (1991)–Foster and Viswanathan (1993) models. Panel A shows the annual trend of GH and HFV variables in the sample period. Panel B presents the relations between GH and HFV variables and traditional informational mea- sures, such as firm size, governance score, and credit ratings, based on univariate tests. The t-statistic of differences between large group and small group of each traditional variable are reported in the table. Firm size is the natural logarithm of (total assets ⁄ 1 000 000). Governance score is the natural logarithm of total Korean corporate governance index (KCGI) which consists of four sub-indices: Shareholder Rights, Disclosure, Audit Committees, and Ownership Parity (excluding Board structure index) between 2002 and 2004. Credit rating score is the credit ratings given to CPs or corporate bonds. Level of signifi- cance is indicated by ** for 5%. Panel A: Annual trend of information transaction costs 0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 1999 2000 2001 2002 2003 2004 GH,HFV Year GH HFV Panel B: Univariate analysis of relationship with traditional measures Firm size Governance score Credit rating score Large Small t-value High Low t-value High Low t-value GH 0.022 0.033 )1.252 0.029 0.035 )0.326 0.007 0.049 )2.486** HFV 0.023 0.032 )1.368 0.029 0.037 )0.436 0.007 0.047 )2.468** The Effects of Outside Board on Firm Value Ó 2012 Korean Securities Association 185
  12. 12. governance scores and the group with smaller firm sizes and lower governance scores. However, when it comes to credit ratings, the values of GH and HFV vari- ables were higher for the firms with lower credit ratings. Table 3 reports the results from the estimation of equation (3), showing evidence that board independence (measured by the ratio of outside directors) positively impacts firm performance (measured by Tobin’s Q). Hermalin and Weis- bach (1991) suggest that board structure and firm performance are likely to be endogenously determined. Our research design uses several approaches to address this concern, as presented in Table 3. 4.4. 2SLS Models Controlling for Endogeneity Issues To mitigate the endogeneity problem, we examine the robustness of our results after including lagged values of our dependent variables (outside directors) and estimate our models in a simultaneous equations framework, following the method employed by Linck et al. (2008). In the regressions presented in Table 4, the coeffi- cients of outside directors are all positive and significant, which does not alter their valuation effect. Regression (5) in Table 4 shows the results when we define board independence more precisely with past career paths taken into account, and examine whether there is a difference in positive impact. According to regression (5) in Table 4, this positive impact is significant when outside directors are independent. Therefore, we suggest that independent outside directors who have neither business nor profes- sional ties with a firm have a strong valuation effect, proving that the independence of outside directors is important in the emerging market, as emphasized by the SOX Act of 2002. 4.5. Influence of Information Transaction Costs on the Valuation Effect of Board Independence Recently, there have been a few articles examining the tendency of firms with a high information asymmetry risk to decrease board independence (Linck et al., 2008). They argue that outside directors incur information acquisition and processing costs while tailoring their general expertise for the specific firm they serve. They suggest that board independence decreases with the cost of information acquisition and processing. They use the MTB ratio, the level of R&D spending, and the standard deviation of stock returns as the costs of information acquisition and processing, following the method of Fama and Jensen (1983), and Gaver and Gaver (1993). Since Linck et al. (2008) show that information asymmetry is negatively related to board independence, we expect the valuation effect of board independence to be negatively related to information asymmetry risk. We use, as proxies for information transaction costs, two market micro-struc- tural variables (GH, HFV) as well as the other firm characteristics used in existing studies, i.e., firm size, firm age, analyst reports, institutional ownership, governance, and credit ratings. S. W. Joh and J.-Y. Jung 186 Ó 2012 Korean Securities Association
  13. 13. Table4Effectsof(independent)outsidedirectorsonfirmvalue Thistablepresentslinearordinaryleast-squaresregressionanalysesofeffectsof(independent)outsidedirectorsonfirmvaluebetween1999and2006.Thedependent variableisTobin’sQ,whichistheratioofthesumofthemarketvalueofcommonequity,thebookvalueofpreferredequity,andthebookvalueoflong-termdebt tothebookvalueofassets.Outsidedirectorsistheratiooflegallyregistereddirectorswhoarenotemployeesofthecompanyandhavenooperationalresponsibilities withinthecompanytoboardsize.Independentoutsidedirectors(Indepoutsidedirectors)istheratioofoutsidedirectorswhohavenobusinessorprofessionaltiesto afirmtoboardsize,whenconsideringtheirpastcareerpaths.Boardsizeisthenaturallogarithmoftotalnumberofdirectors.Directorageisthenaturallogarithmof theageasoftheyearend.Largestownershipisthepercentageshareholdingofthelargestshareholder.CAPEX⁄assetsistheratioofcapitalexpenditurestototalassets. Leverageistheratiooftotaldebttototalassets.Firmsizeisthenaturallogarithmof(totalassets⁄1000000).Operatingprofitabilityistheratioofearningsbefore interestandtaxes(EBIT)tobeginningtotalassets.Chaeboldummyisadummyvariabletoindicatewhetherafirmbelongstooneofthe50largestchaebols.Market risk(beta)istheestimatefrommarketmodelinwhichthefirm’smonthlyreturnsoverthelastyearareregressedontheKOSPImonthlyreturns.Regression(1)shows theresultsofbasicregressionandregressions(2)and(3)showfixedeffectregressionsoffirmperformanceandoutsidedirectors.Regressions(4)and(5)showsimul- taneousequationanalysisoffirmvalueandtheratioof(independent)outsidedirectors,usingthetwo-stageleastsquaresmethod.Instrumentsincludelagged(inde- pendent)outsidedirectorvariable.Standarderrorsareshowninparenthesesunderparameterestimates.Levelsofsignificanceareindicatedby***,**,and*for1%, 5%,and10%,respectively. Variable(1)(2)(3)(4)(5) Outsidedirectors0.245***(0.060)0.092*(0.056)0.141***(0.052)0.400***(0.108) Indepoutsidedirectors0.364***(0.099) Boardsize)0.009(0.022))0.001(0.024))0.009(0.022)0.028(0.022)0.026(0.022) Directorage)1.194***(0.092))0.781***(0.130))1.200***(0.092))1.151***(0.094))1.191***(0.092) Largestownership)0.001(0.044)0.019(0.058))0.005(0.044)0.009(0.045)0.004(0.044) CAPEX⁄assets0.001(0.023))0.003(0.021)0.001(0.023)0.024(0.025))0.001(0.023) Leverage)0.069(0.036)0.078*(0.046))0.063*(0.036))0.090**(0.038))0.074**(0.036) Firmsize0.028***(0.008)0.019(0.016)0.032***(0.008)0.024***(0.009)0.032***(0.008) Operatingprofitability0.053(0.057)0.158***(0.055)0.051(0.058))0.008(0.060)0.050(0.058) Chaeboldummy0.042*(0.022)0.102(0.065)0.042*(0.022)0.039(0.023)0.043*(0.022) Marketrisk(beta)0.040*(0.022))0.017(0.022)0.040**(0.023)0.066***(0.024)0.041*(0.023) IndustrydummyYesYesYesYes YeardummyYesYesYesYes IndustryfixedeffectsYes YearfixedeffectsYes Numberoffirms3,9273,9273,9273,2933,927 Adj.R2 0.2390.5780.2440.2490.247 The Effects of Outside Board on Firm Value Ó 2012 Korean Securities Association 187
  14. 14. In Table 5, we examine the relationship between the valuation effect of board independence and information transaction costs derived from the market micro- structure model. Our regressions include interaction terms between the outside director ratio and the GH (HFV) measure. In regressions (1) and (2), the Table 5 Valuation effect of board independence and information transaction costs This table reports results from regressing firm value on board independence and various firm characteris- tics from 1999 to 2004. The dependent variable is Tobin’s Q, which is the ratio of the sum of the market value of common equity, the book value of preferred equity, and the book value of long-term debt to the book value of assets. Outside directors is the ratio of directors who are not employees of the com- pany and have no operational responsibilities within the company to board size. Independent outside directors (Indep outside directors) is the ratio of outside directors who have no business or professional ties to a firm to board size, when considering their past career paths. GH or HFV is information transac- tion costs estimated by the Glosten and Harris (1988) or Hasbrouck (1991)–Foster and Viswanathan (1993) models. See Table 4 for exact definitions of the variables. Industry dummies and Year dummies are employed to control for industry compensation practices and economy-wide shocks. Standard errors are shown in parentheses under parameter estimates. Levels of significance are indicated by ***, **, and * for 1%, 5%, and 10%, respectively. Variable (1) (2) (3) (4) Outside directors 0.284*** (0.056) 0.286*** (0.055) Indep outside directors 0.233*** (0.053) 0.236*** (0.052) Board size )0.014 (0.020) )0.014 (0.020) )0.015 (0.020) )0.015 (0.020) Director age )0.897*** (0.093) )0.895*** (0.092) )0.892*** (0.093) )0.889*** (0.092) Largest ownership )0.024 (0.043) )0.019 (0.043) )0.024 (0.043) )0.019 (0.043) CAPEX ⁄ assets 0.009 (0.023) 0.008 (0.023) 0.009 (0.023) 0.008 (0.023) Leverage )0.126*** (0.040) )0.130*** (0.039) )0.120*** (0.040) )0.124*** (0.039) Firm size 0.029*** (0.007) 0.030*** (0.007) 0.032*** (0.007) 0.033*** (0.007) Operating profitability 0.300*** (0.067) 0.300*** (0.065) 0.302*** (0.067) 0.302*** (0.066) Chaebol dummy 0.001 (0.021) )0.002 (0.021) 0.002 (0.022) 0.001 (0.021) Market risk (beta) 0.054** (0.023) 0.054** (0.023) 0.058** (0.023) 0.058** (0.023) GH 0.142*** (0.052) 0.151*** (0.051) HFV 0.162*** (0.055) 0.179*** (0.055) Outside director · GH )0.367 (0.223) Outside director · HFV )0.444* (0.234) Indep outside director · GH )0.556** (0.286) Indep outside director · HFV )0.688*** (0.288) Industry dummy Yes Yes Yes Yes Year dummy Yes Yes Yes Yes Number of firms 2,719 2,719 2,719 2,719 Adj. R2 0.238 0.236 0.236 0.235 S. W. Joh and J.-Y. Jung 188 Ó 2012 Korean Securities Association
  15. 15. coefficients of the interaction terms are not significant for the GH measure and marginally significant for the HFV measure. However, if we change the variable from an outside director to independent outside directors, the results turn more significant. Regressions (3) and (4) in Table 5 show the analysis results using the interaction term between the GH (HFV) measure and board independence, using our refined board independence measure (refer to 4.2.), which takes professional- or business-level independence into consideration. In columns (3) and (4), independent outside directors have a more positive val- uation effect with low information transaction costs. This is consistent with our hypotheses, according to which board independence is less effective for monitoring when it is costly for independent outsiders to acquire information on the firm. Therefore, we can predict that the valuation effects of independent boards with no professional or business relationships with a firm, its affiliates, CEO, or controlling shareholders may vary with a firm’s information transaction costs. Consequently, the valuation effect of independent outside directors, i.e., an increase in firm value, decreases under high information asymmetry because the costs of tailoring information are high, while the valuation effect increases under low information asymmetry because of increased benefits of tailoring information. Using traditional measures of information transaction costs, Table 6 presents the results of regressions using other conditions under which the firms’ information environments change. The results on the effects of independent directors on firm value are consistent with the results presented in Table 5. In other words, a large firm with a long corporate history, more analyst reports, high credit ratings, large institutional ownership, and good governance has more positive valuation effect of board independence because it incurs lower information transaction costs, which decreases the costs of monitoring and advisory activities. Therefore, our estimation from Table 6 indicates that the association between the valuation effect of board independence and information transaction costs is definite. 5. Conclusion This paper examines the effects of independent outside directors on firm value from the perspective of information transaction costs in Korea, one of the most promi- nent emerging markets. Our empirical results indicate that independent outside directors have a signifi- cant and positive effect on firm value. We also find that the valuation effect of inde- pendent outside directors varies with the degree of information asymmetry at a firm. The higher a firm’s information asymmetry risk, the weaker the valuation effect of board independence; the lower the information asymmetry risk, the stron- ger the valuation effect. We test for our hypothesis using information transaction cost measures from various sources, including traditional measures and measures estimated by the mar- ket microstructure model. We find that firms with low information transaction The Effects of Outside Board on Firm Value Ó 2012 Korean Securities Association 189
  16. 16. Table6Variousfirmcharacteristicsandvaluationeffectofboardindependence Thistablereportsresultsfromregressingfirmvalueonboardindependenceandvariousfirmcharacteristics.ThedependentvariableisTobin’sQ,whichistheratioof thesumofthemarketvalueofcommonequity,thebookvalueofpreferredequity,andthebookvalueoflong-termdebttothebookvalueofassets.Independent outsidedirectors(Indepoutsidedirectors)istheratioofoutsidedirectorswhohavenobusinessorprofessionaltiestoafirmtoboardsize.Intheregression(1),Firm sizeisadummyvariablethatequals1iffirmsizeislargerthanthemedianofallsamplefirms.Firmageisthenaturallogarithmofthefirm’sage.Analystreportis thenaturallogarithmoftotalnumberofanalystreportsintheyear.CreditratingdummyforcompanieswithcreditratingsforCPsorcorporatebondsissetas‘‘1’’, andforcompanieswithoutcreditratingsforCPsorcorporatebondsissetas‘‘0’’.Institutionalownershipisthefractionofsharesownedbyinstitutions.Governance isthenaturallogarithmoftotalKoreancorporategovernanceindex(KCGI)whichconsistsoffoursub-indices:ShareholderRights,Disclosure,AuditCommittees,and OwnershipParity(excludingBoardstructureindex)between2002and2006.SeeTable4forexactdefinitionsofthevariables.IndustrydummiesandYeardummies areemployedtocontrolforindustrycompensationpracticesandeconomy-wideshocks.Standarderrorsareshowninparenthesesunderparameterestimates.Levelsof significanceareindicatedby***,**,and*for1%,5%,and10%,respectively. Variable(1)(2)(3)(4)(5)(6) Indepoutsidedirectors)0.140(0.095)0.069(0.078)0.002(0.064)0.040(0.070)0.058(0.089)0.033(0.118) Boardsize0.021(0.020)0.002(0.022))0.002(0.021))0.001(0.022))0.006(0.022)0.083**(0.033) Directorage)1.166***(0.091))1.153***(0.092))1.038***(0.091))1.188***(0.092))0.946***(0.101))1.260***(0.123) Largestownership)0.015(0.044))0.021(0.044)0.043(0.043))0.011(0.044))0.092*(0.049)0.061(0.059) CAPEX⁄assets0.004(0.023))0.007(0.023)0.002(0.022)0.003(0.023)0.004(0.033))0.019(0.026) Leverage)0.064*(0.035))0.068*(0.035))0.038(0.035))0.058(0.036)0.042(0.036))0.417***(0.058) Firmsize)0.035(0.026)0.035***(0.008))0.038***(0.009)0.040***(0.008)0.009(0.008)0.039***(0.011) Operatingprofitability0.065(0.057)0.034(0.057)0.039(0.056)0.032(0.057)0.098*(0.059))0.409***(0.085) Chaeboldummy0.067***(0.021)0.043(0.022)0.007(0.022)0.054**(0.022)0.018(0.024)0.087***(0.030) Marketrisk(beta)0.054**(0.022)0.031(0.023)0.024(0.023)0.050**(0.023)0.018(0.024)0.115***(0.033) Firmage)0.120***(0.024) Analystreport0.025***(0.003) Creditratingdummy)0.129***(0.026) Institutionalownership0.164***(0.057) Governance0.021(0.036) S. W. Joh and J.-Y. Jung 190 Ó 2012 Korean Securities Association
  17. 17. Table6(Continued) Variable(1)(2)(3)(4)(5)(6) Indepoutsidedirector· Firmsizedummy 0.480***(0.109) Indepoutside director·Firmage 0.149*(0.091) Indepoutsidedirector· Analystreport 0.011**(0.006) Indepoutsidedirector· Creditratingdummy 0.249***(0.089) Indepoutsidedirector· Institutionalownership 0.375*(0.231) Indepoutside director·Governance 0.232*(0.142) Industry(Year)dummyYesYesYesYesYesYes Numberoffirms3,9273,9273,9273,9272,8602,218 Adj.R2 0.2390.2450.2750.2770.2740.291 The Effects of Outside Board on Firm Value Ó 2012 Korean Securities Association 191
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