Role of Additional Factors Affecting the CGVF Relationships in a Developing

As discussed in Chapter 1, there are additional factors affecting the CGVF relationships in developing financial markets. This factor makes the process by which the value of a firm is affected by corporate governance different from that of the developed financial markets. The details of these additional factors are as follows.

2.6.1 Information Asymmetry

Information asymmetry plays an important role in deteriorating the performance of a firm in a developing financial market (Grossman and Hart, 1982) and hampers the economic growth in both developing and developed markets as argued by Lins (2000) and Lins and Servaes (2002). Information asymmetry in the developing market is

triggered by poor managerial performance, inefficiency in the market and different accounting standards (Dallas, 2004; Nam and Nam, 2004).

The developing market follows the hybrid system of corporate governance. The market for corporate control does not exist and shareholding is concentrated as only a few families dominate in controlling the affairs of a firm. Finally, the relationship among company, stakeholders and shareholders is based on trust, as the regulatory authorities are limited in their role of monitoring. Thus, these futures increase the risk as there is no prudent regulatory network in developing market (Berghe, 2002).

Information asymmetry in these markets is also created by the irresponsibility of managers as suggested by Mehran (1995). The management of the firms of developing market is often involved in manipulating the financial reports thus creating informational asymmetry in this market. Local and foreign investors also face barriers in gathering and analysing the financial information about the firms in developing markets due to presence of information asymmetry in these markets.

The accounting standards in developing markets are different from those of the developed market. Due to these differences, investors cannot judge the true performance of a firm in developing financial markets and are unable to make rational investment decisions, which further reduce the value of a firm (World Bank, 1998b).

2.6.2 Agency Cost

La Porta et al. (1998) highlight the role of agency cost in affecting the value of a firm in developing financial markets. According to Jensen and Meckling (1976) and Matos (2001), the different types of agency cost in a financial market are as follows.

Bonding Cost

The first type of agency cost in a firm is known as bonding cost. The cost includes the appointing an independent auditor and associated expenses such as salaries paid in the process of implementing corporate governance principles in a firm.

Residual Cost

The second type of agency cost in a firm is known as residual cost. The residual costs are incurred by a firm in appointing an independent board and in carrying out the companies’ corporate social responsibility. The cost of appointing an independent board includes the expenses incurred both in their appointment and incentives to them.

Monitoring Cost

Finally, the monitoring cost is borne by a firm in the process of monitoring the activities of managers. The shareholders bear these costs initially, but later on these costs are recovered from the management’s compensation plans. Better management requires less monitoring costs so that the value of the shareholders can be improved.

Due to market imperfections, the adverse role of majority shareholders and inadequate management and corporate financial policies in developing financial markets, the above mentioned agency costs were triggered and affected the value of a firm in a negative manner.

2.6.3 Role of Banks in Affecting the Value of a Firm in Developing Financial Markets

Banks can play an important role in the implementation of corporate governance in developing market as argued by La Porta et al. (1998). Banks in the developing market have played a detrimental role in the implementation of corporate governance. They are inefficient in delivering their services of transferring funds from savers to users. In addition, they have not had appropriate criteria for lending and so could not use leverage as a tool to implement corporate governance (Fry, 1995).

The responsibilities of banks as a monitor are higher in developing markets compared to developed financial markets. Banks are better monitors of firms compared to family monitoring in developing markets (Heinrich, 1999). The monitoring by a bank is less costly compared to public monitoring where all the shareholders are doing the

same job. Banks as creditors play the role of a monitor and eliminate the free rider problem from the market thereby reducing the duality of effort as argued by Diamond (1984) and Admati, Pfleiderer and Zechner (1994).

In addition, bankruptcy laws also play an important role in improving the value of a firm. Bankruptcy laws in developing markets are different from those found in developed markets. The firms in developing markets are highly leveraged so there is a need for managing agency costs between creditors and shareholders. In the developing market, bankruptcy law is tough on borrower as it is important to look after the financial safety of banks that provide a large amount of funding to the firms of the developing market (Heinrich, 2002).

2.7 The Relationship between Corporate Governance and Corporate Finance (Operational, Financial and Capital Structure)

As we have discussed in Section 2.5, corporate governance has a relationship with the value of a firm. Similarly, corporate governance is also related to financial decisions, and financial decisions also have implications for corporate governance (Hirschey, John and Makhija, 2003).

Corporate governance is related to the operational, financial and capital structure of a firm (Bishop et al., 2004). The details are as below.

2.7.1 Operational and Financial Structure

Operational structure of a firm is related to the size of a firm, factors of production (capital and labour mix) and weighted average cost of capital. Whereas, financial structure is related to executive remuneration, dividend policy and the debt-equity structure of a firm. The firm can effectively use operational and financial instruments to improve its value (Dewatripont and Tirole, 1994; Copeland, Weston and Shastri, 2005).

2.7.2 Capital Structure and Theories of Capital Structure

Optimal capital structure can also be used as a powerful tool to improve the value of a firm. The capital structure or amount of leverage chosen by the top management also depends on the level of incentives attached to the value of a firm. The executives will choose for higher risk to capture higher returns if they receive higher benefits after improving the value of a firm (Morin and Jarrell, 2001). There are different theories of capital structure related to corporate governance and the value of a firm.

The first theory in the literature of finance is about the capital structure and is known as the Modigliani and Miller hypothesis (1958, 1963). According to this theory, capital structure is irrelevant in improving the value of a firm as argued by Elton and Gruber (1975). There is neither agency cost related with high leverage and no interest rate, transaction cost nor bankruptcy cost as firms operate in a perfect market. Also, there is a tax benefit associated with debt and this assumption makes the optimal capital structure as 100% debt.

The second theory is called the trade-off theory. This theory states that the tax benefits associated with leverage is offset by the agency cost of the debt and the cost of financial distress. It is further argued that tax benefits achieved at the corporate level are offset by tax disadvantages at the individual level (Morin and Jarrell, 2001).

The final theory of capital structure is the second trade-off theory. This theory suggests that debt can be used as a double-edge sword. It has advantages in terms of solving the free cash flow problem as the free cash flow in a firm can be used to pay off the debt (Ogden, Jen and O’Connor, 2003). However, there are also disadvantages such as cost of financial distress and agency cost between creditors and managers (Miller, 1977).