Chapter 3 Previous Empirical studies and Hypotheses development
3.2 Board characteristics and Capital Structure
3.2.2 Board size
A board is ‘the shareholders first line of defense against incompetent management,’ (Weisbach, 1988). A board is responsible for monitoring current projects, deciding on
new projects, and making CEO succession decisions. A board consists of insiders and
outsiders. Insiders have a higher level of information about the company, while outsiders
are able to use the power of CEO succession to ensure insiders reveal information as
required, to ensure decisions are able to be made with all the information available.
There is no standard board size, FTSE 100 companies have a board size of between 6 and
18 members, and FTSE 250 companies tend to have a smaller board size (Davis, 2011).
The Higgs report (2003) recommends the reduction in the number of executives on the
board. The composition of board members has altered since the introduction of the
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recommendation includes the requirement that the percentage of NEDs as a percentage of
the total number of board members should be 50% or more, including the Chairman. The
increase in the board size has an impact on coordination, communication and conflict
resolution of the board, decreasing productivity, and rendering the board a bureaucratic
forum (Jensen, 1993) so the combined role (Duality) is no longer an issue.
Findings on the relationship between the size of the board and firm performance (Jensen,
1993), suggest that a board size of seven or eight board members has a higher level of
functionality, and becomes easier for the CEO to chair. The degree of communication,
coordination and decision-making are likely to be less effective the larger the board
becomes. Board size should be limited to avoid co-ordination issues that result from
unmanageable directors on the board (Yermack, 1996). The measure of company
performance is researched through Tobin’s Q, the calculation of the market valuation of the company. Previous studies that support Jensen are Yermack (1996), based on 452 US
companies during the period 1984-1991, and Eisenberg et al. (1998), which is based on
Finnish firms over a two-year period (1992-1994). The mean and median board size is 12
for Yermack’s study, the number of board members range from 4 to 34. While a study conducted in Singapore and Malaysia companies (Mak and Kusnadi, 2005) find a mean
and median of 7, with a range of between 4 and 14. These studies are all in support of the
negative relationship between board size and company performance, the link with
leverage is with the efficiency of the assets of the company. Yermack concludes that the
largest losses in companies occur when a move from a small to medium sized board
occurs. Evidence from five European countries (Conyon and Peck, 1998) identifies costs
associated with large boards, such as monitoring; these findings support Yermack. The
speed of decision-making, combined with levels of risk, can lead to larger boards taking
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finds evidence to support the negative relationship between board size and company
performance. A variation of company performance is the variability of company
performance, determined by the monthly share returns; a study by Cheng (2008) provides
evidence that firms with larger boards have a lower variability of corporate performance.
Companies with a larger board size have the impact of creating pressure on managers to
reduce the debt to capital ratio, to ensure good performance results are achieved.
The relationship between the size of the board and capital structure is based upon Agency
theory (Jensen and Meckling, 1976) and entrenchment theory (Bebchuk and Fried, 2005).
Berger et al. (1997) find a negative relationship between the years 1984 and 1991, in
which the leverage level is lower where there is a higher number of directors. The reason
for the relationship is due to the higher levels of monitoring, and the strong pressure from
the Board of Directors to make managers pursue the lower leverage levels in order to
achieve good performance results. There is an added level of supervision through the
supervisory board; their role is to supervise the Board of Directors and the senior
management. Companies who have high levels of leverage within their capital structure
are likely to be more complex than those companies whose capital structure contain more
equity; the increase in complexity requires a higher level of advisory requirements
(Pfeffer, 1972; Klein, 1998). Hence, the Board of Directors is likely to benefit from
being larger, and consist of a higher percentage of NEDs with expertise and experience
(Coles et al., 2008). Vafeas and Theodorou’s (1998) findings follow the US studies, and
whilst inconsistent relationships have been found, it does provide a starting point for
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3.2.2.1 Board Size Hypothesis
The relationship between board size and leverage has remained relatively under
researched, focusing on the relationship between board size and company performance.
Research in line with Agency theory (Jensen and Meckling, 1976) establishes that
managers do not always adopt capital structures with the value-maximising level of debt.
Through entrenchment, managers are able to protect themselves against internal and
external corporate governance mechanisms. Entrenchment is defined as a lack of
discipline from the corporate governance and control mechanisms. For example,
monitoring by the Board of Directors, threat of dismissal, threat of being taken over, and
compensation based performance incentives (Berger et al., 1997).
The implications on capital structure are those managers and CEOs who are entrenched,
have a higher level of discretion over the company’s capital structure decisions. The desire to reduce company risk, and protect their undiversified human capital may result in
managers preferring less than optimal levels of debt in their capital structure (Fama,
1980). While the avoidance of performance pressures that are associated with higher
levels of debt occurs (Jensen, 1986). While in contrast, Harris and Raviv (1988), and
Stulz (1988), propose that entrenchment motives could encourage managers to increase
leverage levels beyond the optimal level. The effect is to reduce the risk of takeover
attempts, and inflate the voting power of their equity stakes (Berger et al., 1997). The
impact is managers who are entrenched, take out excessive leverage that preempts
takeover attempts by demonstrating a signal of commitment to sell assets, and/or
restructure (Berger et al., 1997).
This study will extend previous UK studies (Vafeas and Theodorou, 1998; Faccio and
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following the issuance of several corporate governance reports, a negative relationship
still exists. In line with Berger et al. (1997) and Agency theory (Jensen and Meckling,
1976), a negative relationship is expected due to the increases in the level of monitoring.
The hypothesis is:
H8: There is a negative relationship between board size and leverage.