NUST Business School



Relationship of Cost of
Governance and Firm’s
      Profitability
          MBA Thesis




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Relationship of Cost of Governance and Firm’s Profitability



                                          By



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Relationship of Cost of Governance and Firm’s 2009
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                © Co...
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DISCLAI...
Relationship of Cost of Governance and Firm’s 2009
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Table ...
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    3.5...
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List of...
1 Introduction
This Chapter focuses on the history of Corporate Governance, its basic premise and the
relationship of Corp...
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1.2 History...
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1.2.5 Early...
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1.3 Cor...
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1.5 Compens...
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identify ...
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The market and...
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2 Litera...
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Shleifer & ...
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The princip...
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Jensen (...
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        (v...
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compensation ...
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3 Research...
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determine ...
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3.4.7 Non Con...
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            ...
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           d...
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where




ar...
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where s is th...
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3.9 Framework
...
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4 Analysis...
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board, the Dir...
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             ...
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     5 ...
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Cash Flows (...
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Compensation ...
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                  Ta...
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6 H2 Diffe...
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The Insurance...
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3. FMCG Indust...
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      ...
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  Ind...
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     ...
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        ...
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7   Conclusi...
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Executives Co...
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8 Limitati...
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Bibliography
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Benston, George, 198...
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Burrough, Bryan, and...
Cost Of Governance Relationship With Firms Profitability
Cost Of Governance Relationship With Firms Profitability
Cost Of Governance Relationship With Firms Profitability
Cost Of Governance Relationship With Firms Profitability
Cost Of Governance Relationship With Firms Profitability
Cost Of Governance Relationship With Firms Profitability
Cost Of Governance Relationship With Firms Profitability
Cost Of Governance Relationship With Firms Profitability
Cost Of Governance Relationship With Firms Profitability
Cost Of Governance Relationship With Firms Profitability
Cost Of Governance Relationship With Firms Profitability
Cost Of Governance Relationship With Firms Profitability
Cost Of Governance Relationship With Firms Profitability
Cost Of Governance Relationship With Firms Profitability
Cost Of Governance Relationship With Firms Profitability
Cost Of Governance Relationship With Firms Profitability
Cost Of Governance Relationship With Firms Profitability
Cost Of Governance Relationship With Firms Profitability
Cost Of Governance Relationship With Firms Profitability
Cost Of Governance Relationship With Firms Profitability
Cost Of Governance Relationship With Firms Profitability
Cost Of Governance Relationship With Firms Profitability
Cost Of Governance Relationship With Firms Profitability
Cost Of Governance Relationship With Firms Profitability
Cost Of Governance Relationship With Firms Profitability
Cost Of Governance Relationship With Firms Profitability
Cost Of Governance Relationship With Firms Profitability
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Cost Of Governance Relationship With Firms Profitability

  1. 1. NUST Business School Relationship of Cost of Governance and Firm’s Profitability MBA Thesis 10/16/2009 Muhammad Jawad Iqbal Khan 2008-NUST-MBA-26 Page | 1
  2. 2. Relationship of Cost of Governance and Firm’s Profitability By Muhammad Jawad Iqbal Khan A Thesis Submitted to the Graduate Faculty of NUST Business School In Partial Fulfilment of the Requirements for the degree of Masters of Business Administration (MBA) Major Subject: Finance and Investment Approved: _________________________________________ Mr. Salman Shehzad, Thesis Advisor NUST Business School H-12 Sector, Islamabad October, 2009 Page | ii
  3. 3. Relationship of Cost of Governance and Firm’s 2009 Profitability © Copyright 2009 By NUST Business School All Rights Reserved Page | iii
  4. 4. Relationship of Cost of Governance and Firm’s 2009 Profitability ACKNOWLEDGEMENT I am thankful to Almighty Allah for blessing me with strength and knowledge to con duct this research. I am grateful to my Thesis Advisor , Mr.Salman Shehzad, for being patient with me and advising me all along the research. I am grateful to Dr.Raheel Gohar for helping me in the research through his own research input and guidance. I am extremely thankful to Mr.Fazli Azam for providing me with relevant research papers, as he gathered them for his own research paper. I have taken a lot of guidance from the research paper of Ms.Rozina Shaheen and her lectures on research methodology in BBA course were extremely helpful. Mr.Shoaib Qureshi will always be the one who introduced me to Corporate Governance and helped me to get the literature from IFC, World Bank. His lectures through Corporate Governance course in MBA are a lightening tower for me in this research. All the research papers in the bibliography are either taken from JSTOR.com or www.ssrn.com. Any author who considers his/her work was not referenced properly can contact the author (jawadiqbalkhan86@yahoo.com), so that it is updated accordingly. I am extremely thankful to all authors for their valuable input into the literature for Corporate Governance, which helped me throughout my research. Page | iv
  5. 5. Relationship of Cost of Governance and Firm’s 2009 Profitability ABSTRACT Corporate Governance is considered as the basic pillar for the long term existence and stability of the firms. Recent falls of one of the biggest corporations in world like Enron and World Call sparked the debate on the importance and practical application of better governance mechanisms in the corporations. The literature has been comprehensively added with the experiences of different industrial countries and the recent collapse of subprime mortgage and subsequent bankruptcies of numerous banks and corporations including Lehman Brothers a nd mortgage giants like Fannie Mae in USA. In Pakistan, Code of Corporate Governance 2002 was a major milestone and different studies have been conducted. This research covers 9 industries and 22 firms including banks, insurance, engineering, cement, fertilizers and chemicals. The focus on the research is to establish a significant relationship between the compensation paid for the mechanisms of Corporate Governance i.e. Directors, CEO and Senior Executives. The compensation data is tested for 6significant relationship with company’s' performance variables including Sales, Assets, Pre Tax Profit, Operating Cash Flows, Selling and Administrative Expenses, Profit as percentage of Sales and Return on Assets. The relationships signify the fact that companies pay the governance bodies in the firm based upon the firms' performance. Different variables are used as indicator of performance in different companies and industries and differences also exists within industries. This study is statistically significant for the time period of 2003-2007. These results can be used to improve the corporate governance compensation paid and profitability generated by the firms. The research confirms the significant relationships between different stakeholders compensation in the organization and performance indicators. Different industries pay according to their own business cycles and also different companies compensate respectively in the same industry as well. Thus compensation management is the solution to Principle Agent Problem in the Corporate Governance framework and understanding it will help companies solve it. Page | v
  6. 6. Relationship of Cost of Governance and Firm’s 2009 Profitability DISCLAIMER This report is compiled in partial fulfilment of the requirements of Masters of Business Administration Degree at NUST Business School, Islamabad. The author has tried his best to avoid any kind of plagiarism. All sources are cited in the foot notes, references and bibliography section according to the use of the work of other authors. In case, any one is concerned about any idea or reference mentioned in this report, the author will welcome any such query and try to resolve it without any objection. In any case, the author has not intended to represent the intellectual property of other people as his own work. The author can be contacted in case of any issue, through NUST Business School, H-12 Sector, Islamabad, Pakistan. Page | vi
  7. 7. Relationship of Cost of Governance and Firm’s 2009 Profitability Table of Contents 1 Introduction................................................................................................................................1 1.1 Background of Corporate Governance...................................................................................1 1.2 History ................................................................................................................................2 1.2.1 16th Century .................................................................................................................2 1.2.2 17thCentury.................................................................................................................2 1.2.3 1844 ............................................................................................................................2 1.2.4 1931 ............................................................................................................................2 1.2.5 Early 1990s...................................................................................................................3 1.2.6 2002 -2004 ...................................................................................................................3 1.2.7 2004-2007....................................................................................................................3 1.3 Corporate Governance Defined ............................................................................................4 1.4 Pillars of Corporate Governance ...........................................................................................4 1.5 Compensation and Corporate Governance ............................................................................5 2 Literature Review ........................................................................................................................8 3 Research methodology ..............................................................................................................14 3.1 Topic.................................................................................................................................14 3.2 Aim of Study......................................................................................................................14 3.3 Hypothesis ........................................................................................................................14 3.4 Research Design & Methodology ........................................................................................15 3.4.1 Analytical ...................................................................................................................15 3.4.2 Fundamental ..............................................................................................................15 3.4.3 Qualitative and Quantitative .......................................................................................15 3.4.4 Empirical ....................................................................................................................15 3.4.5 Deductive...................................................................................................................15 3.4.6 Co-relational Study .....................................................................................................15 3.4.7 Non Contrived & Minimal Interference ........................................................................16 3.4.8 Unit of Analysis...........................................................................................................16 3.4.9 Cross sectional Time Horizon.......................................................................................16 Page | vii
  8. 8. Relationship of Cost of Governance and Firm’s 2009 Profitability 3.5 Sampling Tools ..................................................................................................................16 3.5.1 Sample.......................................................................................................................16 3.5.2 Time Duration ............................................................................................................17 3.5.3 Sources of Data ..........................................................................................................17 3.6 Variables Identified............................................................................................................17 3.6.1 Firm Performance Variables ........................................................................................17 3.7 Methods used to test the relationship between variables ....................................................18 3.7.1 Spearman Correlation.................................................................................................18 3.7.2 Pearson Correlation....................................................................................................18 3.7.3 Regression Equation ...................................................................................................19 3.7.4 Independent one-sample t-test ...................................................................................19 3.8 Data Analysis .....................................................................................................................20 3.8.1 Software ....................................................................................................................20 3.9 Framework........................................................................................................................21 4 Analysis ....................................................................................................................................22 4.1 CEO Compensation ............................................................................................................22 4.2 Directors Compensation.....................................................................................................22 4.3 Executives Compensation...................................................................................................23 4.4 Total Compensation...........................................................................................................24 5 H1 Compensation for Governance is related to the Firms’ Performance........................................25 5.1 Regression of Variables and Results ....................................................................................27 6 H2 Different Industries follow different performance variables for compensation .........................29 6.1 Industry Wise Correlation Analysis ......................................................................................29 7 Conclusion ................................................................................................................................36 8 Limitations................................................................................................................................38 9 Appendix .................................................................................................................................... I Page | viii
  9. 9. Relationship of Cost of Governance and Firm’s 2009 Profitability List of Figures Figure I CEO Compensation ...............................................................................................................22 Figure II Director’s Compensation ......................................................................................................23 Figure III Executive Compensation .....................................................................................................24 Figure IV Total Compensation Paid by the Company ...........................................................................24 Figure V Sample Summarized Correlation Values ................................................................................25 Figure VI Industry Wise Correlation Summary.....................................................................................32 Figure VII Regression of Total CEO Compensation with Sales ................................................................. I Figure VIII Regression of Total CEO Compensation with Assets .............................................................II Figure IX Regression of Total CEO Compensation with Pre Tax Profit....................................................III Figure X Regression of Total CEO Compensation with Operating Cash Flow .......................................... IV Figure XI Regression of Total CEO Compensation with S&A Expenses.................................................... V Figure XII Regression of Total CEO Compensation with Profit Margin ................................................... VI Figure XIII Regression of Total Director's Compensation with Sales..................................................... VII Figure XIV Regression of Total Director's Compensation with Assets ...................................................VIII Figure XV Regression of Total Director's Compensation with Pre Tax Profit ...........................................IX Figure XVI Regression of Total Director's Compensation with Operating Cash Flow................................ X Figure XVII Regression of Total Director's Compensation with S&A Expenses ........................................XI Figure XVIII Regression of Total Director's Compensation with Profit Margin........................................XII Figure XIX Regression of Total Executive Compensation with Sales .....................................................XIII Figure XX Regression of Total Executive Compensation with Asset..................................................... XIV Figure XXI Regression of Total Executive Compensation with Pre Tax Profit......................................... XV Figure XXII Regression of Total Executive Compensation with Operating Cash Flow ............................ XVI Figure XXIII Regression of Total Executive Compensation with S&A Expenses .....................................XVII Figure XXIV Regression of Total Executive Compensation with Profit Margin.....................................XVIII Figure XXV Regression of Total Compensation with Sales ...................................................................XIX Figure XXVI Regression of Total Compensation with Assets .................................................................XX Figure XXVII Regression of Total Compensation with Pre Tax Profit.....................................................XXI Figure XXVIII Regression of Total Compensation with Operating Cash Flow ........................................XXII Figure XXIX Regression of Total Compensation with S&A Expenses ................................................... XXIII Figure XXX Regression of Total Compensation with Profit Margin .....................................................XXIV Page | ix
  10. 10. 1 Introduction This Chapter focuses on the history of Corporate Governance, its basic premise and the relationship of Corporate Governance with the Compensation Management, highlighting different common types of Compensation mechanisms. 1.1 Background of Corporate Governance Corporate Governance has taken major importance in the literature and business arena after the fall of Enron and World Call. Celebrated as one of the most innovative companies in 1990, 1 Enron collapse was an eye-opener at many fronts, from regulatory failures to Auditor fraudulent activities. Regulatory Frameworks were present before Enron and World Call governance fiasco, such as Cadbury Act in UK and OECD Principles on Corporate Governance, but it forced United States to develop stricter regulations and control through Sarbanes Oxley Act. In Pakistan, in the wake of global regulatory “The system by which actions, Securities and Exchange Commission of Accounting Officers carry out Pakistan issued Code of Corporate Gov ernance their responsibility for ensuring in 2002. This code was the first step towards that effective management the goal, and all listed companies followed the systems, including financial code for regulatory compliance, but only a few monitoring and control systems, of them followed it for the improvement of have been put in place.” company’s governance and increased profitability. Several cases of failure of HM Treasury, U.K. Corporate Governance in the companies which were publishing adherence to the Code in their Annual reports are reported in media. 1 [Online] www.newsweek.com/id/44191 Page | 1
  11. 11. Relationship of Cost of Governance and Firm’s 2009 Profitability 1.2 History 1.2.1 16th Century The Merchant of Venice Act 1 Scene 1 Merchants feared for the safety of their ships: Who sets the direction of the journey? How to exercise control? Oversight? How to protect interests of owners? 1.2.2 17thCentury The East India Company introduces a Court of Directors, separating ownership and control (U.K., the Netherlands) to oversee the company’s management in India. 1.2.2.1 1720 In the UK, governance was enhanced with much regulation following the South Sea Bubble in 1720 with the formation of the incorporated joint stock company (amongst other things) 1.2.2.2 1776 Adam Smith in the “Wealth of Nations” warns of weak controls over and incentives for management (U.K.) 1.2.3 1844 First Joint Stock Company Act (U.K.) 1.2.4 1931 Berle and Means publish their seminal work “The Modern Corporation and Private Property” (U.S.) Page | 2
  12. 12. Relationship of Cost of Governance and Firm’s 2009 Profitability 1.2.5 Early 1990s “Corpora te Governance is a series of First wave of corporate scandals in the U.K. (Polly Peck, stru ctu res and pro cesses for the BCCI and Maxwell), followed by: direction and control of a company.” Stagnation Privatization Sir Adrian Cadbury Globalization Demographic pressures (pension bomb) 1.2.5.1 1992 -1997 First corporate governance codes in the U.K. (Cadbury), followed by, inter alia, S. Africa (King), France (Viénot), the Netherlands (Peters) and finally the U.K. (Combined Code). 1.2.5.2 1999 “In general, *…+ corporate OECD Publishes first international benchmark, the governance structures and OECD Principles of Corporate Governance practices should protect and enhance accountability to, and 1.2.6 2002 -2004 ensure equal financial treatment New wave of corporate scandals in the U.S. (Enron, of, shareholders.” The Council of Institutional WorldCom) and E.U. (Ahold, Hollinger, Parmalat) lead Investors. new corporate governance regulations (Sarbanes- Oxley) 1.2.7 2004-2007 New rise in shareholder activism by pension funds, but likewise, hedge funds and private equity exercise influence on corporate governance agenda Page | 3
  13. 13. Relationship of Cost of Governance and Firm’s 2009 Profitability 1.3 Corporate Governance Defined OECD Principals of Corporate Governance defines it as following: "Corporate governance is the system by which business corporations are directed and controlled. The corporate governance structure specifies the distribution of rights and responsibilities among different participants in the corporation, such as the board, managers, shareholders and other stakeholders, and spells out the rules and procedures for making decisions on corporate affairs. By doing this, it also provides the structure through which the company objectives are set, and the means of attaining those objectives and monitoring performance. “ Corporate Governance 2 is the System by which corporations are directed & controlled Structure that specifies the distribution of rights & responsibilities Among corporate participants, i.e. the board, managers and SHs Spells out the rules and procedures for decision-making Provides structure for setting and attaining company objectives, and monitoring company performance. 1.4 Pillars of Corporate Governance Following are the four pillars3 of Corporate Governance 1. Accountability 2. Fairness 3. Transparency 4. Responsibility 2 IFC, “Module 1-Introduction: Corpo rations and Corpora te Governance”. (Slide 20), 2009. 3 IFC, “Module 1-Introduction: Corpo rations and Corpora te Governance”. (Slide 26), 2009. Page | 4
  14. 14. Relationship of Cost of Governance and Firm’s 2009 Profitability 1.5 Compensation and Corporate Governance The management and shareholders relationship can be understood from the perspective of Principal-Agent Relationship. The economic theory 4 suggests that the appointment of agents and compensation managements should be in the control of the Principal. Major responsibility5 lies on the Directors for the compensation management for the executive management. But who sets the compensation for the directors?? Generally it will be understandable that directors have ownership stake in the firm, so they will try to focus on the benefit of shareholders. Perhaps we should not let any one set of stakeholders 6 to decide the compensation of executives which impacts all the stake holders. Considering shareholders are the prime stake holders due to the reason that they will lose out most in case of total bankruptcy due to claim after the bond holders of the firms. Fred R. Kaen argued that to the extent that managerial compensation can be linked to indirect variables like number of hours put in work, instead of financial variables like Pre Tax Profit, it will reduce the opportunities to shirk by the management. Managers still prefer to use the quantitative variables like return on equity or profit margins for compensation, as these variables increase the stock price of the company which is beneficial for the share holders. Still the problem persists, as how to differentiate between the variables which can be influencing the managerial performance to those which are general business cycle and luck factors. Generally this paradox of variable identification is relatively made easier through using comparative or relative compensation schemes with respect to the industry. This way, firm can 4 Aditya Parthasarathy, Krishnakumar Menon and Debashish Bhattacherjee, 2006. Executive Co mpensation, Firm Performance and Corporate Governance: An Empirical Analysis . Indian Institute of Management Calcutta . 5 Fred R. Kaen, 2003. “A Blu eprin t for Corpo rate Governance Strategy, Accountability, and the Preservation of Shareholder Value”. Chapter 8- Corporate Governance and Managerial Compensation, pg 117. Published by American Management Association. 6 This topic is influenced by Fred R.Kaen, 2003 “A Blueprin t for Co rporate Governance Stra tegy, Accountability, and the Preservation of Shareholder Value”. The views expressed are of the author and should not be counted as a criticism or negation of the views of Fred. R. Kaen. Author is briefly reviewing his work on compensation management in his book. Page | 5
  15. 15. Relationship of Cost of Governance and Firm’s 2009 Profitability identify if the management is really working for company better performance or is it only market forces which are helping them in achieving the target performance. Common compensation scheme in the world is i.e. a fixed base salary is paid to the executive and further compensation is linked to the yearly performance in form of bonuses and increments. A long term component is also used to keep the executives also tuned towards long term profitability of the firm by giving them stock options or long term performance variables. In Pakistan, the two component salary is more prevalent where management is given fixed base salary and variable bonuses. Companies do try to include stocks in the compensation of the management, but it is relatively an outdated version of ESOP in Pakistan, than prevalent in European or American Firms. The analysis of the companies indicates that firms pay according to two component plans. The short term incentive plans linked to company performance i.e. bonus based upon Pre Tax Profit values have multiple short comings like accounting manipulation to window dress the results for higher bonuses, budgeting issues like depreciation calculations are manipulated for increasing profit and potential gaming behavior. The long term incentive plans like stock options comes with own set of problems. The recording of stock options as expenses or otherwise creates a huge difference in the income treatments. Firms tend to abusively manipulate the earnings when stock options are recorded as expenses. EVA or Earned Value Analysis7 is a more popular but slightly technical way of calculating managerial performance. It can be simply understood as the value added by the manager to the firm over and above the cost of capital for the firm. Managers are paid bonuses if the EVA is positive for the firm. It can be calculated by reducing the net income by the equity capital financing charge as determined by calculating the cost of equity for the shareholders and applied on the assets under the management control. 7 EVA or Economic Value Added is a trade marked product of Stern Stewart & Company. Page | 6
  16. 16. Relationship of Cost of Governance and Firm’s 2009 Profitability The market and investors in Pakistan are not technically knowledgeable about the exercise price determination impact on the option valuation and how these derivates can be adjusted to suit the needs of the management, while being neutral and unbiased on the face value. Thus, the market is focusing on the two tier compensation management which is easily understandable by the stakeholders. Page | 7
  17. 17. Relationship of Cost of Governance and Firm’s 2009 Profitability 2 Literature Review This chapter provides an overview on the literature published on the Corporate Governance and Firm’s Profitability. It also focuses on the specific relationships identified by researchers between the compensation management and firm’s profitability. Following 8 are some important statistics and facts regarding Corporate Governance “Corporate Governance streamlines business processes, leading to better operating performance and lower capital expenditures”. (Gompers, Ishii and Metrick, Corporate Governance and Equity Prices, August 2001). “Improves the company’s ROCE, with companies in the top cg quartile averaging 33% and those in the bottom 15% ROCE”. (Credit Lyonnais SA, 2001). “Better share price performance, higher profitability, larger dividend payouts, and lower risk levels than industry peers”. (Lawrence Brown, Georgia State University, Sept. 2003). “There appears to be a substantial and statistically significant correlation between an active, independent board and superior corporate governance performance”. (Mac Avoy /Millstein, The Recurrent Crisis in Corporate Governance, 2004). Financial reforms during 1990s have influenced the pattern of capital structure, dividend policy, risk premia, and compliances to corporate governance (Nishat, 1999). Rozina and Nishat show that poorly governed firms (i.e., those with low Gov Scores) have lower operating performance, lower valuations, and pay out less cash to their shareholders, while better-governed firms have higher operating performance, higher valuations, and pay out more cash to their shareholders. Anderson et al. (2004) show that the cost of debt is lower for larger boards, presumably because creditors view these firms as having more effective monitors of their financial accounting processes. 8 IFC, “Module 1-Introduction: Corpo rations and Corpora te Governance”. Page | 8
  18. 18. Relationship of Cost of Governance and Firm’s 2009 Profitability Shleifer & Vishny (1997) defined Corporate Governance in terms of suppliers of funds 9 as “Corporate Governance deals with the ways in which suppliers of finance to corporations assure themselves of getting a return on their investment”. They also raise the following questions in their research How do the suppliers of finance get managers to return some of the profits to them? How do they make sure that managers do not steal the capital they supply or invest it in bad projects? How do suppliers of finance control managers? Jensen (1986) was of the view that managers reinvest the free cash flows rather returning it back to the investors by using oil industry of 1980s. Oil Producers used free cash flows to search for new unproven oil reserves instead of buying cheaper proven reserves, just to maintain the exploratory activities to satisfy their empire building desires. The difference was $16 per barrel additional cost of investors. The least costly10 of these costs to investors are consumption of perquisites such as company airplanes (Burrough and Helyar, 1990). For example, Victor Posner, a Miami financier, received in 1985 over $8 million in salary from DWG; a public company he controlled, at the time the company was losing money (New York Times, June 23, 1986). Managers tend to pursue the projects which maximize their interest against those which will maximize shareholders interest, Grossman and Hart (1988) described these benefits as the private benefits of control. 9 Andrei Shleifer and Robert W. Vishny, “A Survery of Corpo rate Governan ce”, The Journal Of Finance. Vol. LII, No. 2 . June 1997. 10 Andrei Shleifer and Robert W. Vishny, “A Survery of Corpo rate Governan ce”, The Journal Of Finance. Vol. LII, No. 2 . June 1997. Page | 9
  19. 19. Relationship of Cost of Governance and Firm’s 2009 Profitability The principal agent contract 11 between the shareholders and management of the firm is of great importance. It also creates a lot of problem when issue of residual rights is considered. Principal wants to retain all the residual rights for situations which are not fully explained by the contract, but they cannot do so properly due to lack of insight and experience and thus end up giving up these residual rights to the agent, who in turn uses them as per their own discretion, thus violating the basic premise of principal-agent contract. Jensen and Meckling (1976) argued that managers 12 will undertake inefficient projects instead of returning the free cash flow and this will result in ex post inefficiency. Walkling and Long (1984) proposed that managers tend to resist less to a value increasing takeover if they have direct financial interest through share ownership o r golden parachutes, or they will get to keep their jobs. DeAngelo and Rice (1983) and Jarrell and Poulsen (1988a) suggest13 that public announcements of certain anti-takeover amendments to corporate charters, such as super-majority provisions requiring more than 50 percent of the votes to change corporate boards, reduce shareholder wealth. Ryngaert (1988) and Malatesta and Walkling (1988) find that, for firms who have experienced challenges to management control, the adoption of poison pills-which are devices to make takeovers extremely costly without target management's consent-also reduce shareholder wealth. Comment and Schwert (1995), however, question the event study evidence given the higher frequency of takeovers among firms with poison pills in place. Board of Directors only 14 changes a management when a severe performance disaster occurs (Warner, Watts, and Wruck (1988)). Research on Japan and Germany by Kaplan (1994 a, b) indicate that board of directors act passively unless in extreme situations a nd Mace (1971) and 11 Andrei Shleifer and Robert W. Vishny, “A Survery of Corpo rate Governan ce”, The Journal Of Finance. Vol. LII, No. 2 . June 1997. 12 Andrei Shleifer and Robert W. Vishny, “A Survery of Corpo rate Governan ce”, The Journal Of Finance. Vol. LII, No. 2 . June 1997. 13 Andrei Shleifer and Robert W. Vishny, “A Survery of Corpo rate Governan ce”, The Journal Of Finance. Vol. LII, No. 2 . June 1997. 14 Andrei Shleifer and Robert W. Vishny, “A Survery of Corpo rate Governan ce”, The Journal Of Finance. Vol. LII, No. 2 . June 1997. Page | 10
  20. 20. Relationship of Cost of Governance and Firm’s 2009 Profitability Jensen (1993) are of view that as general rule corporate boards are influenced by management in United States. Roe (1994) found that large shareholding is relatively uncommon due to legal restriction on high ownership in United States. However, the ownership is not completely diversified (Eisenberg (1976), Demsetz (1983), Shleifer and Vishny (1986b)). Manne (1965), Jensen (1988), Scharfstein (1988) suggest that takeovers address the governance issues. Takeovers increase the combined value of both firms and create synergies (Jensen and Ruback (1983)). It is also found out by Palepu (1985), Morck, Shleifer, and Vishny (1988a, 1989) that takeover targets are often poorly performing firms. Anderson, Bates, Bizjak and Lemmon (2000) suggest15 that structure of corporate governance is sensitive to level of diversification. Diversified firms have higher fraction of outsiders on their board, similar ownership by outside block holders and a similar sensitivity of managerial turnover to performance relative to their single segment counterparts. Kato and Long (2005) concluded from their research 16 on Chinese listed firms that (i) Even if the firm is listed in Stock Exchanges, there is no significant and negative link between CEO turnover and firm performance unless the listing is accompanied by an ownership change from state to private (ii) The presence of a large controlling shareholder makes CEO turnover more sensitive to firm performance (iii) The appointment of independent directors enhances turnover-performance sensitivities; (iv) CEO turnover-performance sensitivities are weaker for listed firms with CEOs who also hold positions in the controlling shareholders 15 Ronald C. Anderson, Thomas W. Bates, John M. Bizjak, Michael L. Lemmon, “Corpora te Governance and Firm Diversification”, Financial Management, Vol. 29, No. 1 (Spring, 2000), pp. 5-22. 16 Takao Kato and Cheryl Long, “CEO Turnover, Firm Perfo rman ce, and Corpo rate Governan ce in Chinese Listed Firms”,March 2005. Page | 11
  21. 21. Relationship of Cost of Governance and Firm’s 2009 Profitability (v) Firm performance will improve significantly after the replacement of the CEO and the improvement will be greater for privately controlled firms than for state controlled firms. Ishii and Metrick (GIM, 2003) find that stock returns of firms with strong shareholder rights outperform, on a risk-adjusted basis, returns of firms with weak shareholder rights by 8.5 percent per year during this decade. (Parthasarathy, Menon and Bhattacherjee, 2006) argue that none of the profitability measures is significant determinant of total CEO pay. Firm Size is a significant variable for the understanding of Total CEO Pay and the proportion of variable or incentive pays that a CEO receives. CEOs who are owners or promoters of the firm receive higher compensation as compared to peer CEOs in the industry as the incentive to work for the company is more these CEOs. (Kato and Long, 2005) Among other firm performance measures, it is found that sales growth is linked to executive compensation in China’s listed firms and those Chinese executives are penalized for making negative profit although they are neither penalized nor rewarded for changes in profit in so far as it is positive. David Dicks, 2009 argues that pay and governance are substitutes. If you increase the governance, it will reduce the cost of compensation for the management or vice versa so that management is focused on the shareholders’ wealth maximization either through higher compensation or higher governance. The CEO compensation is increasing with the firm size while the pay- performance sensitivity decreases in firm size. The cost of governance for smaller firms is high, so it reduces the value of the firm. The optimal corporate governance regulation is ignoring the small firms. (Bebchuk, Fried and Walker, 2002)Executive Compensation is viewed as an arm’s length bargaining by the Principal with the Agent, while in practice executives do have a substantial influence on setting up their own compensation, thus seeking rent from the firm. Thus Page | 12
  22. 22. Relationship of Cost of Governance and Firm’s 2009 Profitability compensation management is not the solution to the Principal Agent problem; rather it is a problem in itself and aggravates the complexity of the relationship. It is concluded that management influences the compensation management process for there own benefit. Stephan Sapp, 2007 Concludes that family owned firms and firms with a controlling shareholder pay their CEOs less. Weaker Boards or where CEO dominates the Board, the compensation paid to the CEO is higher than deserved by him by industry norms. If the CEO is the chairman of the board, it increases the executive compensation and if he has the shareholding of the company, it reduces the compensation. Christian and Walker, 2008 analyze the effect of committee formation on how corporate boards perform two main functions: setting CEO pay and overseeing the financial reporting process. The stock based incentive schemes induces the CEO to manipulate earning for the extra compensation. If the compensation management is up to the Board, then they tend to decide an insensitive compensation scheme to reduce the subsequent monitoring. The formation of compensation committee also creates some problems as the burden of oversight is borne by the audit committee for the compensation management. Page | 13
  23. 23. Relationship of Cost of Governance and Firm’s 2009 Profitability 3 Research methodology This chapter details the methodology used for the research. The theoretical framework, hypothesis and nature of study are detailed in this section. 3.1 Topic The topic for research is Relationship of Cost of Governance and Firm’s Profitability (Cost of Governance is only related to the compensation paid to the CEO, Directors, Executives and Total Compensation paid to the Firm. It do not include other costs of implementation of governance, as values are taken from Annual Report which do not detail such private information for the firm) 3.2 Aim of Study The aim of study is to find out the relationship between the efforts done by a firm to improve its corporate governance and its impact on profitability. By linking the salaries of the executive team and directors to the performance of the firm, it can be identified if such link is strictly followed by the companies or not. 3.3 Hypothesis H1- Compensation for Governance is related to the Firms’ Performance The hypothesis will focus on identifying the relationship between the variables given below. The significance of the results will be depicted through regression analysis. The objective is to find out a significant relationship between the two sets of variables. H2- Different Industries follow different performance variables for compensation The hypothesis will focus on identifying the differences in the compensation paid to different stakeholders in the governance mechanism across different industries. The objective is to Page | 14
  24. 24. Relationship of Cost of Governance and Firm’s 2009 Profitability determine that companies adjust the compensation management to suit their business needs and cycles. 3.4 Research Design & Methodology 3.4.1 Analytical The research is analytical as secondary data of company’s performance from their annual financial statements will be used along with other sources to identify critical trends and evaluate them for statistical significance. 3.4.2 Fundamental It is a fundamental research as solution to a particular problem is not searched. A general understanding of the corporate governance relationship with the firm’s performance is the basic purpose of the research. 3.4.3 Qualitative and Quantitative It is a mix of qualitative and quantitative research, as corporate governance val ues are to be developed by the researched. The theoretical analysis of the phenomenon governing corporate governance in a firm is done through the qualitative research. The statistical significance for the phenomenon is calculated through quantitative research. 3.4.4 Empirical The research study is empirical in nature. It is based on observations from the real life companies and will be analyzed through statistical measures to confirm or reject the hypothesis, which are representatives of theoretical analysis. 3.4.5 Deductive This study is deductive in nature. Theoretical background is formed through the literature review, which results in hypothesis building. Data is collected for the testing of hypothesis and results are discussed to confirm or reject the hypothesis. 3.4.6 Co-relational Study The study is co-relational as correlation between corporate governance and firm performance is checked. Page | 15
  25. 25. Relationship of Cost of Governance and Firm’s 2009 Profitability 3.4.7 Non Contrived & Minimal Interference The study is non- contrived as the interference of the researcher is minimum. This is due to the fact that performance data of firms is already published and past data is used to analyze the relationship between corporate governance and firm’s performance. 3.4.8 Unit of Analysis The unit of analysis is group. Group of companies are analyzed collectively after their results are obtained from statistical tests. 3.4.9 Cross sectional Time Horizon The data is collected for the selected sample companies once in the start, and then this data is used for hypothesis testing and analysis. 3.5 Sampling Tools 3.5.1 Sample The sample is taken from listed companies at Karachi Stock Exchange. Priority is given to 100 Companies in the KSE 100 Index as of 1 st July 2009. Yearly Annual Reports of the companies are used for data collection. The companies included in the research according to industries are as following Industry Company 1 Insurance Adamjee Insurance 2 Insurance EFU life Insurance limited 3 Banks Allied Bank Limited 4 Banks Askari Bank Limited 5 Banks Bank Alfalah Limited 6 Banks Bank Alhabib Limited 7 Banks Bank of Punjab Limited 8 Cement Best Way Cement 9 Cement DG Cement 10 Cement Fauji Cement 11 Cement Lucky Cement Page | 16
  26. 26. Relationship of Cost of Governance and Firm’s 2009 Profitability 12 Fertilizer Fauji Fertilizer Company Limited 13 Chemicals ICI Pakistan Limited 14 Automobiles Indus Motors Company Limited 15 Automobiles Atlas Honda Company Limited 16 FMCG Nestle Pakistan Limited 17 Oil and Gas OGDCL 18 Oil and Gas SNGPL 19 Oil and Gas Pakistan OilFields 20 Engineering Pak Elektron Limited 21 Engineering Siemens Engineering Limited 22 Tobbacco Pakistan Tobacco 3.5.2 Time Duration The time duration is 2004-2007 which makes a time period of four years. 3.5.3 Sources of Data The secondary source of data is Companies Annual reports for financial performance and CG variables. Stock prices data is taken from KSE website and Business Recorder website. 3.6 Variables Identified 3.6.1 Firm Performance Variables The variables are grouped together in two categories 1. Compensation for Governance a. Managerial Compensation b. Director’s Fee c. Allowances and Perquisites d. Total Compensation for the year 2. Firm’s Performance a. Sales b. Assets c. Operating Cash Flow Page | 17
  27. 27. Relationship of Cost of Governance and Firm’s 2009 Profitability d. Pre Tax Profit e. Selling and Administrative Expenses f. Profit Margin g. Return on Assets 3.7 Methods used to test the relationship between variables Using Pearson and Spearman correlations for governance score and firms profitability. 3.7.1 Spearman Correlation In principle, ρ is simply a special case of the Pearson product-moment coefficient in which two sets of data Xi and Yi are converted to rankings x i and yi before calculating the coefficient. In practice, however, a simpler procedure is normally used to calculate ρ. The raw scores are converted to ranks, and the differences di between the ranks of each observation on the two variables are calculated. If there are no tied ranks, then ρ is given by: where: di = xi − yi = the difference between the ranks of corresponding values Xi and Yi, and n = the number of values in each data set (same for both sets). 3.7.2 Pearson Correlation The statistic is defined as the sum of the products of the standard scores of the two measures divided by the degrees of freedom. Based on a sample of paired data (Xi, Yi), the sample Pearson correlation coefficient can be calculated as Page | 18
  28. 28. Relationship of Cost of Governance and Firm’s 2009 Profitability where are the standard score, sample mean, and sample standard deviation (calculated using n − 1 in the denominator). 1. Regression analysis for variables relationship. 3.7.3 Regression Equation The regression equation deals with the following variables: The unknown parameters denoted as β; this may be a scalar or a vector of length k. The independent variables X. The dependent variable, Y. Regression equation is a function of variables X and β. The user of regression analysis must make an intelligent guess about this function. 2. T- Test for significance of variables used for the model 3.7.4 Independent one-sample t-test In testing the null hypothesis that the populations mean is equal to a specified value μ0, one uses the statistic Page | 19
  29. 29. Relationship of Cost of Governance and Firm’s 2009 Profitability where s is the sample standard deviation of the sample and n is the sample size. The deg rees of freedom used in this test is n − 1. 3.7.4.1 Slope of a regression line Suppose one is fitting the model where xi, i = 1, ..., n are known, α and β are unknown, and εi are independent normally distributed random errors with expected value 0 and unknown variance σ2, and Yi, i = 1, ..., n are observed. It is desired to test the null hypothesis that the slope β is equal to some specified value β0 (often taken to be 0, in which case the hypothesis is that x and y are unrelated). 3.8 Data Analysis 3.8.1 Software The software used is MS Excel for data analysis, MS Word for Report and MS Power Point for Presentations. Page | 20
  30. 30. Relationship of Cost of Governance and Firm’s 2009 Profitability 3.9 Framework Cost of Corporate Governance and Firm’s Performance Cost of Governance Literature Review Firm’s Performance Managerial Sales Compensation Statistical Methodologies Assets Allowances and Operating Cash Flow Perquisites Correlations Pre Tax Profit Directors’ Fee Regression Analysis Selling and Total Compensation for T-tests Administrative Expenses the year F-test Profit as percentage of R square significance for Sales Correlations Return on Assets Data for the Variables Annual Reports of the Firms KSE website Analysis and Results Conclusion Page | 21
  31. 31. Relationship of Cost of Governance and Firm’s 2009 Profitability 4 Analysis The analysis is done with respect to each hypothesis. The results are discussed with reference to the data used and conclusions are summarized. The analysis focuses on the data sets and summary values from the MS Excel for the respective analysis. 4.1 CEO Compensation The industry wide CEO compensation and breakup into base salary and variable bonuses is shown in Figure I- CEO Compensation. The base salary and bonuses variates in the different ranges across different industries and companies. The highest bonus based compensation is paid to CEO of Bank of Punjab. We can also observe that compensation to CEO within industries is different across the companies. Figure I CEO Compensation 4.2 Directors Compensation The director’s compensation is shown in Figure II, where the break up of compensation is shown for Director’s Fee, Allowances and Perquisites and Managerial Compensation. Across the Page | 22
  32. 32. Relationship of Cost of Governance and Firm’s 2009 Profitability board, the Director’s Fee forms the lower portion of the compensation while allowances are an indirect way of compensating the Director’s for their governance, forming major part of the compensation. Figure II Director’s Compensation 4.3 Executives Compensation The Executive Compensation breakup is given in Figure III. Managerial Remuneration and Allowances form equal parts of the compensation across the sample companies. Lucky Cement pays highest allowances and perquisites to its executives. The large percentage of compensation other than base salary indicates that variable compensation is used as a major governance tool by the companies. Page | 23
  33. 33. Relationship of Cost of Governance and Firm’s 2009 Profitability Figure III Executive Compensation 4.4 Total Compensation The total compensation trend in the sample of companies is shown in Figure IV. The log of values is taken so that the variation across the companies can be standardized and easy for analysis. The highest compensation is paid by Fauji Fertilizer Company. Figure IV Total Compensation Paid by the Company Page | 24
  34. 34. Relationship of Cost of Governance and Firm’s 2009 Profitability 5 H1 Compensation for Governance is related to the Firms’ Performance The data of 22 companies in the 10 industries, was used to calculate the correlations among the CEO Compensation, Directors Compensation, Executive Compensation and Total Compensation of the firm with the Sales, Assets, Pre Tax Profit, Operating Cash Flows, Selling and Administrative Expenses, Profit and percentage of Sales and Return on Assets. The Correlation results in the Table V indicate many different facts which are explained as below. Figure V Sample Summarized Correlation Values Chief Executive Directors Executives MR A&P Total Fee MR A&P Total MR A&P Total Total Sales 0.57 0.54 0.63 0.03 0.20 0.18 0.20 0.53 0.20 0.51 0.54 Assets 0.57 -0.05 0.54 -0.06 0.04 -0.07 0.01 0.81 -0.09 0.66 0.67 Pre Tax Profit 0.55 0.21 0.56 0.18 0.26 0.08 0.22 0.75 0.04 0.65 0.67 Operating Cash 0.70 -0.02 0.66 0.02 0.00 -0.06 -0.01 0.83 0.05 0.72 0.73 flow S&A Expenses 0.54 0.23 0.55 0.12 -0.01 -0.04 -0.02 0.59 0.38 0.62 0.63 Profit Margin 0.19 -0.08 0.17 -0.07 0.39 0.21 0.35 0.42 -0.09 0.33 0.34 Return on Assets 0.08 -0.04 0.07 -0.04 0.57 0.67 0.62 -0.06 -0.04 -0.06 -0.03 Log Data Sales 0.28 0.39 0.34 0.13 0.10 0.09 0.10 0.31 0.19 0.32 0.33 Assets 0.38 0.27 0.41 0.07 0.11 0.02 0.10 0.55 0.07 0.48 0.49 Pre Tax Profit 0.38 0.32 0.42 0.13 0.35 0.24 0.33 0.49 0.13 0.46 0.48 Operating Cash 0.37 0.28 0.40 0.20 0.05 -0.01 0.04 0.67 0.37 0.68 0.67 flow S & A Expenses 0.54 0.23 0.55 0.12 -0.01 -0.04 -0.02 0.59 0.38 0.62 0.63 Profit Margin 0.13 -0.05 0.12 0.00 0.31 0.20 0.29 0.24 -0.03 0.19 0.20 Return on Assets 0.06 0.09 0.08 0.09 0.35 0.33 0.36 0.03 0.12 0.06 0.08 The MR of CEO was correlated highest (0.70) to the Operating Cash Flows, followed by Sales (0.57), Assets (0.57) and Pre Tax Profit 90.55). It has slightly positive correlation with Profit Margin (0.19) and Return on Assets (0.08). On the contrary, the CEO Allowance and Perquisites were correlated highest to Sales (0.54) and it was slightly negatively correlated to Operating Page | 25
  35. 35. Relationship of Cost of Governance and Firm’s 2009 Profitability Cash Flows (-0.02). It indicates that the basic salary of the CEO is dependant upon the Operating Cash flows of the firm and they get performance bonus and variable compensation based upon on the increase in sales. Similarly the total compensation the CEO is highly correlated to Sales and Operating cash flows due to the breakup of the compensation paid to CEO. The Director Fee is positively correlated to Pre Tax Profit (0.18) while the MR is highly correlated to Return to Assets (0.57). Similarly A&P of Directors is also highly correlated to Return on Assets (0.67). These correlations identify that Directors are the guardians of the firms’ equity as well as liabilities as the best Corporate Governance advocates and as the return on assets is increased, they are able to generate more value for the shareholders. Thus their compensation is highly based on return on assets. The Executives Compensation, similar to CEO, is highly correlated to Operating Cash Flow (0.83), followed by Pre Tax Profit (0.75). The A&P of Executives are highly correlated to S&A Expenses, which indicate the firms try to park the extra compensation for executives through the S&A Accounts for tax purposes. The Total Compensation is positively correlated to almost all the variables but it is highest with Operating Cash Flows (0.73) followed by Pre Tax Profit and Assets (0.67). Thus, Operating Cash flow forms one of the major indicators of the performance of the management of the firm. To avoid the statistical errors in the correlations due to the magnitude of the values of performance variables of the firm, log of the values is taken to minimize the error and identify the correlations. It reduces the correlation value and removes the fluctuation impact of the variable values. We can see from the Figure V, which the differences in correlations between different variables are magnified and now ranking for the relationships among the variables can be easily identified. The CEO compensation is highly correlated to Pre tax Profit (0.42), closely followed by Assets (0.41). It is marked difference from the earlier results of data without log values where the compensation was highly correlated to Operating Cash Flow instead. The Directors Page | 26
  36. 36. Relationship of Cost of Governance and Firm’s 2009 Profitability Compensation is showing similar results that it is highly correlated to Return on Assets (0.33). The Executive Compensation also shows same results where it is highest correlated to Operating Cash Flow (0.68). The Total Compensation of the firm is highly correlated to Operating Cash Flows (0.63). Thus, the log of values of data helps us to identify the correlations more clearly and without error caused due to the fluctuations in the high values of the variables. 5.1 Regression of Variables and Results In all the regression analysis, the X axis variables are the Company Performance Variables and Y axis variable are the Compensation Variables. All these regressions are run on the Total Compensation in each category i.e. CEO, Directors and Executives and the Total Compensation of the firm. The summary results are given below, for detailed tables see Appendix-Regression Analysis. Table 1 summarizes the Regression statistics. The Significant values of F are greater than 2.5, for T-stat significant values are above 1.64 and for p value, the significant values are below 0.05 for 95 percent confidence. The closer the value of R Square to 1, the higher is the significance of the correlation between the variables. We can identify from the Table 1 results that CEO Compensation indicate that it has significant model and variable relationship for Sales, Assets, Pre Tax Profit, Operating Cash Flows, S&A Expenses , except for Profit as Percentage of Sales. Directors Compensation is only significant with respect to model and variables for Pre Tax Profit and Profit as Percentage of Sales. The Executive Compensation and Total Compensation variables are significant for all independent variables of performance i.e. Sales, Assets, Pre Tax Profit, Operating Cash Flows, S&A Expenses and Profit as percentage of Sales. Page | 27
  37. 37. Relationship of Cost of Governance and Firm’s 2009 Profitability Table 1 Regression Summary Table Variables R Square F T Stat P value Chief Executive Officer Compensation Sales 0.396569 56.51844 7.517875 4.94E-11 Assets 0.286792 34.58193 5.880641 7.61E-08 Pre Tax Profit 0.309645 38.57367 6.210771 1.81E-08 Operating Cash Flows 0.439192 67.35012 8.206712 2.02E-12 S&A Expenses 0.303797 37.52721 2.62E-08 0.005199 Profit as Percentage of Sales 0.027863 2.464864 1.569989 0.12009 Directors Compensation Sales 0.041923 3.763182 1.939892 0.05567 Assets 0.000152 0.013065 0.114301 0.909265 Pre Tax Profit 0.049525 4.481054 2.11685 0.037161 Operating Cash Flows 0.000179 0.015436 -0.12424 0.901413 S&A Expenses 0.000347 0.02985 -0.17277 0.863237 Profit as Percentage of Sales 0.125451 12.33639 3.51232 0.00071 Executives Compensation Sales 0.255658 29.53829 5.434914 5.04E-07 Assets 0.435243 66.27786 8.141122 2.74E-12 Pre Tax Profit 0.421182 62.57869 7.910669 8.02E-12 Operating Cash Flows 0.515056 91.34004 9.557198 3.61E-15 S&A Expenses 0.378379 52.34793 7.235187 1.81E-10 Profit as Percentage of Sales 0.110577 10.69188 3.269844 0.001549 Total Compensation Sales 0.289336 35.01365 5.917233 6.5E-08 Assets 0.446537 69.38538 8.329789 1.14E-12 Pre Tax Profit 0.445395 69.06531 8.310554 1.24E-12 Operating Cash Flows 0.537065 99.77104 9.988545 4.8E-16 S&A Expenses 0.392416 55.54426 7.452802 6.67E-11 Profit as Percentage of Sales 0.115845 11.26803 3.356788 0.001176 Page | 28
  38. 38. Relationship of Cost of Governance and Firm’s 2009 Profitability 6 H2 Different Industries follow different performance variables for compensation 6.1 Industry Wise Correlation Analysis The Industry Wise Correlation Analysis of relationships among cost of governance and firms’ profitability is done on the basis of results in the Figure XXX. This table indicates that the industries follow different compensation policies in different industries. Insurance Industry pays the CEO highest on Asset increase (0.97) and Sales (0.95), while the Banking Industry pay the CEO on Sales (0.76) i.e. the Net Interest Income generated by the bank. Cement Industry pays the CEO on Profit Margin (0.76), as this industry is dependant upon the profit margin in the cost of goods sold and sale price. Fertilizer Industry pays the CEO on the basis of Sales (0.73), while Chemicals industry pays on the basis of Assets Increase (0.99). Automobile Industry pays the CEO on the basis of Operating Cash Flows generated for the firm. FMCG Industry pays the CEO as per Pre Tax Profit (0.73). The Oil and Gas Industry pays the CEO on the basis of gross revenue generated for the firm (0.49). The Engineering industry pays on the basis of Pre Tax Profit (0.87). The Director Compensation depicts the same fact that all companies compensate the directors as per industry and business nature. Insurance industry pays the directors according to Operating Cash Flows (0.54). The director fee is related to Pre Tax Profit (0.91) but other compensation is paid with respect to operating cash flows. The banking industry pays the directors with respect to Profit Margin (0.75), while Cement Industry pays the directors according to Return on Assets (0.77). Chemical Industry pays the directors as per Sales increase (0.96). Automobile industry pays the directors according to the Pre Tax Profit (0.61).Oil and Gas Industry pays according to Sales (0.52) while engineering Industry pays according to Pre Tax Profit (0.85). Page | 29
  39. 39. Relationship of Cost of Governance and Firm’s 2009 Profitability The Insurance, Banking and Cement Industries pay the executives according to Assets (0.98), (0.93) and (0.60) respectively. The Fertilizer Industry pays according to Return on Assets (0.93) and the Chemicals Industry pays according to Pre Tax Profit (0.86). The Automobile Industry pays with respect to Profit Margin (0.47). The FMCG Industry pays according to the Sales (0.99) as generated by executives of the firm. Oil and Gas Industry pays according to Profit Margin (0.33) and Engineering Industry pays as per Pre Tax Profit (0.97). The Total Compensation by the Insurance Industry, Chemicals Industry and Banking Industry as cost of governance according to the Assets increase of the firm (0.98), (1.00) and (0.91) respectively. The cement industry cost of compensation is dependant upon the Profit Margin (0.55). The Fertilizer industry pays according to the Return on Assets (0.93). The Automobiles Industry pays according to the Pre Tax Profit (0.49). The FMCG Industry pays according to the Sales (1.00) while Oil and Gas Industry pays according to Profit Margin (0.33). The Engineering Industry pays according to the Pre Tax Profit (0.96). This analysis indicates that the industries which has a manufacturing concern pays the costs of governance according to the margin based variables i.e. pre tax profit or Profit Margin. These industries include the following 1. Cement Industry 2. Fertilizer Industry 3. Oil and Gas Industry 4. Engineering Industry 5. Automobile Industry While the industries which have a service sector background or the manufacturing process is shorter than one year use Sales or Assets increase as compensation policy. These industries include the following 1. Insurance Industry 2. Banking Industry Page | 30
  40. 40. Relationship of Cost of Governance and Firm’s 2009 Profitability 3. FMCG Industry 4. Chemicals Industry Page | 31
  41. 41. Relationship of Cost of Governance and Firm’s 2009 Profitability Figure VI Industry Wise Correlation Summary Industry Variable Chief Executive Directors Executives Total MR A&P Total Fee MR A&P Total MR A&P Total Total Insur ance Sales 0.95 0.94 0.95 0.55 0.22 0.22 0.30 0.94 0.95 0.95 0.95 Insur ance Assets 0.96 0.97 0.97 0.77 0.12 0.12 0.24 0.99 0.96 0.98 0.98 Insur ance Pre Tax 0.90 0.93 0.92 0.91 -0.15 -0.15 -0.01 0.95 0.91 0.94 0.94 Profit Insur ance Operating 0.47 0.40 0.45 -0.21 0.56 0.56 0.54 0.39 0.44 0.41 0.42 Cash flow Insur ance S&A 0.49 0.41 0.46 -0.25 0.48 0.48 0.45 0.39 0.45 0.42 0.42 Expenses Insur ance Profit -0.63 -0.60 -0.63 -0.28 -0.30 -0.30 -0.35 - -0.61 -0.62 -0.62 Margin 0.61 Insur ance Return on 0.89 0.88 0.90 0.78 -0.31 -0.31 -0.20 0.90 0.85 0.89 0.88 Assets Bank Sales 0.76 -0.25 0.76 -0.15 0.08 -0.19 0.08 0.66 -0.26 0.66 0.68 Bank Assets 0.55 -0.45 0.55 -0.28 0.36 -0.35 0.36 0.93 -0.48 0.93 0.91 Bank Pre Tax 0.53 0.41 0.57 -0.38 0.40 0.31 0.39 0.25 0.22 0.25 0.45 Profit Bank Operating 0.71 -0.34 0.71 -0.21 0.18 -0.27 0.18 0.88 -0.36 0.88 0.88 Cash flow Bank S&A 0.74 -0.29 0.74 -0.18 0.06 -0.22 0.06 0.65 -0.30 0.65 0.67 Expenses Bank Profit 0.08 -0.31 0.08 -0.19 0.75 -0.24 0.75 0.51 -0.33 0.51 0.48 Margin Bank Return on -0.22 0.35 -0.22 -0.11 0.24 0.12 0.24 - 0.02 -0.35 -0.34 Assets 0.35 Cement Sales -0.14 0.94 -0.06 -0.32 -0.31 -0.26 -0.31 0.37 0.60 0.49 0.13 Cement Assets -0.16 0.99 -0.06 -0.33 -0.32 -0.27 -0.32 0.46 0.71 0.60 0.18 Cement Pre Tax 0.53 0.41 0.57 -0.38 0.40 0.31 0.39 0.25 0.22 0.25 0.45 Profit Cement Operating -0.10 0.74 -0.03 -0.26 -0.25 -0.21 -0.25 0.10 0.24 0.17 -0.03 Cash flow Cement S&A 0.42 -0.17 0.40 0.58 0.42 0.32 0.41 0.11 -0.06 0.04 0.30 Expenses Cement Profit 0.76 -0.22 0.75 -0.22 0.74 0.66 0.76 0.14 -0.04 0.06 0.55 Margin Cement Return on 0.75 -0.22 0.73 -0.21 0.72 0.78 0.77 0.10 -0.06 0.03 0.54 Assets Fertilizer Sales 0.94 0.51 0.73 -0.35 - - -0.35 0.87 0.85 0.86 0.86 Page | 32
  42. 42. Relationship of Cost of Governance and Firm’s 2009 Profitability Industry Variable Chief Executive Directors Executives Total Fertilizer Assets 0.51 -0.34 -0.03 -0.76 - - -0.76 0.76 0.79 0.78 0.78 Fertilizer Pre Tax 0.69 -0.13 0.19 -0.69 - - -0.69 0.88 0.90 0.89 0.89 Profit Fertilizer Operating -0.71 -0.83 -0.86 -0.03 - - -0.03 - -0.39 -0.42 -0.42 Cash flow 0.44 Fertilizer S&A 0.82 0.46 0.65 -0.46 - - -0.46 0.73 0.71 0.72 0.72 Expenses Fertilizer Profit -0.76 -0.87 -0.91 -0.09 - - -0.09 - -0.45 -0.47 -0.47 Margin 0.50 Fertilizer Return on 0.80 0.04 0.35 -0.62 - - -0.62 0.93 0.94 0.93 0.93 Assets Chemicals Sales 0.87 0.84 0.87 - 0.98 0.87 0.96 0.36 0.96 0.71 0.78 Chemicals Assets 0.99 0.99 0.99 - 0.88 0.99 0.93 0.85 0.93 0.99 1.00 Chemicals Pre Tax 0.95 0.96 0.95 - 0.79 0.95 0.86 0.92 0.86 1.00 0.99 Profit Chemicals Operating 0.98 1.00 0.98 - 0.87 0.98 0.92 0.81 0.92 0.97 0.98 Cash flow Chemicals S&A 0.98 0.96 0.98 - 0.98 0.98 1.00 0.63 1.00 0.89 0.94 Expenses Chemicals Profit 0.89 0.90 0.89 - 0.67 0.89 0.76 0.97 0.76 0.98 0.95 Margin Chemicals Return on 0.92 0.92 0.92 - 0.72 0.92 0.80 0.95 0.80 0.99 0.97 Assets Automobiles Sales -0.18 - -0.18 - 0.17 -0.35 -0.07 - -0.27 -0.26 -0.23 0.21 Automobiles Assets 0.33 - 0.33 - 0.72 0.00 0.49 0.35 0.17 0.32 0.37 Automobiles Pre Tax 0.45 - 0.45 - 0.83 0.09 0.61 0.45 0.27 0.44 0.49 Profit Automobiles Operating 0.52 - 0.52 - 0.45 0.52 0.57 0.19 0.59 0.38 0.45 Cash flow Automobiles S&A 0.41 - 0.41 - 0.74 0.05 0.52 0.54 0.19 0.47 0.50 Expenses Automobiles Profit 0.43 - 0.43 - 0.54 0.26 0.50 0.44 0.35 0.47 0.49 Margin Automobiles Return on 0.38 - 0.38 - 0.76 0.02 0.52 0.38 0.19 0.36 0.41 Assets FMCG Sales 0.67 0.71 0.70 - - - - 0.99 0.99 0.99 0.99 FMCG Assets 0.51 0.62 0.60 - - - - 0.95 0.96 0.96 0.96 FMCG Pre Tax 0.73 0.74 0.74 - - - - 0.98 0.98 0.98 0.98 Profit FMCG Operating 0.05 -0.04 -0.02 - - - - 0.57 0.45 0.52 0.52 Page | 33
  43. 43. Relationship of Cost of Governance and Firm’s 2009 Profitability Cash flow Industry Variable Chief Executive Directors Executives Total FMCG S&A 0.69 0.74 0.73 - - - - 0.99 1.00 1.00 1.00 Expenses FMCG Profit -0.26 -0.37 -0.35 - - - - - -0.87 -0.90 -0.89 Margin 0.91 FMCG Return on 0.06 -0.12 -0.08 - - - - - -0.60 -0.62 -0.61 Assets 0.63 Oil and Gas Sales 0.56 0.03 0.49 0.52 - - 0.52 - -0.51 -0.59 -0.59 0.53 Oil and Gas Assets -0.29 0.81 0.11 0.24 - - 0.24 - 0.35 0.09 0.09 0.48 Oil and Gas Pre Tax -0.37 0.80 0.03 0.04 - - 0.04 - 0.34 0.12 0.13 Profit 0.38 Oil and Gas Operating -0.51 0.72 -0.12 0.05 - - 0.05 - 0.36 0.13 0.13 Cash flow 0.40 Oil and Gas S&A 0.59 -0.70 0.20 0.14 - - 0.14 0.13 -0.60 -0.42 -0.42 Expenses Oil and Gas Profit -0.60 0.71 -0.20 0.01 - - 0.01 - 0.55 0.33 0.33 Margin 0.26 Oil and Gas Return on -0.46 0.76 -0.06 0.01 - - 0.01 - 0.41 0.19 0.19 Assets 0.35 Engineering Sales 0.70 0.69 0.69 0.59 0.62 0.85 0.69 0.95 0.96 0.95 0.90 Engineering Assets 0.75 0.80 0.78 0.73 0.73 0.92 0.79 0.84 0.79 0.84 0.84 Engineering Pre Tax 0.87 0.85 0.86 0.78 0.82 0.91 0.85 0.97 0.99 0.97 0.96 Profit Engineering Operating -0.61 -0.63 -0.62 -0.72 -0.69 -0.37 -0.62 - -0.16 -0.18 -0.30 Cash flow 0.18 Engineering S&A 0.96 0.94 0.95 0.92 0.94 0.91 0.95 0.92 0.94 0.92 0.95 Expenses Engineering Profit -0.19 -0.18 -0.18 -0.04 -0.09 -0.47 -0.18 - -0.64 -0.63 -0.52 Margin 0.63 Engineering Return on -0.32 -0.39 -0.36 -0.34 -0.32 -0.54 -0.38 - -0.33 -0.40 -0.40 Assets 0.41 Tobacco Sales -0.66 - -0.66 - -0.25 -0.52 -0.44 - -0.44 -0.30 -0.36 0.22 Tobacco Assets -0.88 - -0.88 - -0.14 -0.71 -0.48 - -0.48 -0.38 -0.45 0.32 Tobacco Pre Tax -0.68 - -0.68 - -0.21 -0.51 -0.41 - -0.41 -0.27 -0.34 Profit 0.19 Tobacco Operating -0.94 - -0.94 - 0.08 -0.71 -0.35 - -0.35 -0.29 -0.36 Cash flow 0.25 Tobacco S&A -0.64 - -0.64 - -0.17 -0.46 -0.36 - -0.36 -0.21 -0.28 Page | 34
  44. 44. Relationship of Cost of Governance and Firm’s 2009 Profitability Expenses 0.13 Industry Variable Chief Executive Directors Executives Total Tobacco Profit -0.57 - -0.57 - -0.08 -0.35 -0.24 - -0.24 -0.09 -0.16 Margin 0.01 Tobacco Return on -0.59 - -0.59 - -0.20 -0.42 -0.35 - -0.35 -0.20 -0.26 Assets 0.12 Page | 35
  45. 45. Relationship of Cost of Governance and Firm’s 2009 Profitability 7 Conclusion The findings from this research are focused on the cost of corporate governance (compensation for governance) and the result of such costs in generating profit for firm, which is judged through Firm’s Performance. The expectation was to find a significant relationship between these two variables and identify the significant relationship among the cost of compensation and firm’s performance variables. Both the hypothesis are accepted and null hypothesis i.e. no significant relationship exists between cost of governance and firm’s profitability and different industries pays differently and according to their own business cycles. Every industry pays according to its own background and business nature. The relationship between firms’ profitability and cost of compensation is highly significant and it proves that firms pay according to the profitability of the organization. Thus, each stakeholder in the compensation mechanism will be focusing on the ultimate goal of maximizing shareholders value by increasing the profitability on year on year basis. The compensation of CEO, Directors’, Executives and Total Compensation varies across the industry and the relationship among the variables also differs. Executive compensation largely consists of variable salary component i.e. bonuses and perquisites indicating the role of variable compensation in governance mechanisms. The basic salary of CEO is dependant upon operating cash flows and the variable compens ation is dependant upon sales primarily. The compensation of Directors is highly correlated to Assets which is indicates their guardianship towards the total assets i.e. liability claims as well as equity claims. CEO compensation relationships with Sales, Assets, Pre Tax Profit, Operating Cash Flows, S&A Expenses are significant but not with Profit Margin and Return on Assets. Directors’ Compensation relationship with Sales, Assets, S&A Expenses and Operating Cash Flows is insignificant but it is significant with Pre Tax Profit, Profit Margin and Return on Assets. Page | 36
  46. 46. Relationship of Cost of Governance and Firm’s 2009 Profitability Executives Compensation and Total Compensation of the firm has significant relationship with all performance variables. The Industry based correlation analysis indicates that every industry follows its own norms of business for compensation management. It also indicates that service sector industries pay according to Sales and turnover performance variables while manufacturing based industries compensate on the margin based performance variables. This research identifies significant relationships between compensation variables and company performance and paves way for further research in this regard in the corporate governance arena of Pakistan. Page | 37
  47. 47. Relationship of Cost of Governance and Firm’s 2009 Profitability 8 Limitations The limitations of the research are as following The topic, itself is qualitative. Corporate Governance cannot be fairly analyzed through companies’ annual reports or secondary data. Thus, the scores associated with CG variables are up to the researcher, and may include a bias towards better ope rating companies as judged by the researcher. The sample size (less than 100 companies) and time period (5 years) will not capture all the aspects of business cycle for many firms as well as it may not reflect true practices of corporate governance keeping in view the infant stage of CG in Pakistan. The study only focuses on the basic relationship of compensation with firm’s performance. Further In-depth analysis of board structure impact on compensation, role of CEO in compensation, role of committees in compensation management and areas related to compensation need to be analyzed for fine details of the relationships among the variables. Page | 38
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