Further test of the relation between SOA and the quality of corporate

IV.2. Speed of adjustment and corporate governance in whole sample

IV.2.1. Further test of the relation between SOA and the quality of corporate

In Subsection IV.1.1., above we posited that even a good governance firm might decide not to rebalance if the deviation does not exceed certain range on either side of the target. We apply a similar premise in this subsection and argue that even a good-governance firm may decide to apply a slow SOA up to certain deviation. However, when the deviations are extreme, this firm is expected to adopt a significantly higher speed than its weaker counterpart. We test this hypothesis in this subsection by equation (2). We are interested in λ, the speed of adjustment of firm i in time t. We define stronger governance when a firm’s GovIndex score is 5 or above and

weaker governance when the score is 1 or below. A firm is considered severely underleveraged (overleveraged) when its leverage is more than -1.5 (+1.5) standard deviations away from the target. The empirical results are shown in Table 8.

Table 8. Speed of Adjustment in Governance Status

The table reports the results from estimating equation (2):

it it

it Lev Lev Lev

Lev  _₁( *  _₁)~ _whereLevitis the leverage ratio of firm i at the end of year

t, Lev_it* is the target leverage estimated from equation (3) and λ is the speed of adjustment.

Strong governance status is defined as GovIndex equal to 5 and 6 and weak governance status is defined as GovIndex equal to 0 and 1. A firm is considered severely underleveraged (overleveraged) when its leverage is more than -1.5 (+1.5) standard deviations away from the target. P-values are reported in parenthesis. *, **, *** indicates the statistical significance at the 10 percent, 5 percent, and 1 percent level, respectively for the regression specification.

Panel A. Extremely Underleveraged Subsample

Strong Gov Weak Gov

λ (SOA) 0.4564** [0.0385] 0.2594

[0.1158]

N 46 95

Adj R2 _0.0732 _0.0159

Panel B. Extremely Overleveraged Subsample

Strong Gov Weak Gov

λ (SOA) 0.3788** [0.0135] -0.0967 [0.3524] N 79 131 Adj R2 _0.0646 _-0.001

Panel A of Table 8 presents the SOAs employed by the stronger and weaker governance systems for the extremely underleveraged group. The SOA for extremely underleveraged firms with strong governance is 0.46. The SOA of the weaker governance group is not significantly different from zero. Panel B of Table 8 presents SOAs employed by the two governance groups for the extremely overleveraged group. The SOA for extremely overleveraged firms with strong

governance is 0.3812_{compared to the SOA of the weaker group which once again is not}

significantly different from zero. Both of these findings provide additional support for our second hypothesis.

12_{The half life of leverage deviation is 1.12 years for extremely underleveraged firms with strong governance. The} half life of leverage deviation is 1.45 years for extremely overleveraged firms with strong governance, which is 0.33 year longer than extremely underleveraged firms with strong governance.

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A good corporate governance system promotes the alignments of interests between managers and owners of a firm. To attain this goal, a good system is expected to minimize avoidable costs. We posit that costs facing a firm related to deviations from its target capital structure are a function of the extent of deviations. Based on this premise, we hypothesize that a firm with strong a governance system in place will maintain a shorter deviation and employ a higher speed of adjustment than its counterpart with weak governance. Specifically, we argue that the absolute deviation from the target will have a negative relation and the speed of adjustment to the target has a positive relation with the quality of corporate governance.

We find that the stronger the governance structures in a company the shorter is its deviation from the target. In further confirmation of this finding, we find that the two extreme leverage deviation subsamples are dominated by firms with weak governance. Our results regarding the speed of adjustments are largely consistent with our hypothesis. Again, in further support of the second hypothesis, we show that the speed employed by firms with stronger governance is substantially higher in both extremely under- and overleveraged situations than their weaker peers, the SOA of which is not significantly different from zero.

In conclusion, this study extends the partial adjustment literature by incorporating the effect of corporate governance. This paper also contributes to literature by measuring corporate governance in three different ways to possibly capture the influence of corporate governance on capital structure.

A caveat on the paper is in order. The estimation method (OLS) used to measure the speed of adjustment might be considered too basic. For future study, a sophisticated estimation on the

speed of adjustment might provide further insight into the relation between capital structure and corporate governance.

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In document Two Essays: “Does Corporate Governance Affect the Adjustment Speed towards Target Capital Structure?” and “Do Option Traders on REITs and Non-REITs React Differently to New Information?” (Page 47-56)