FIRM RISK, CORPORATE GOVERNANCE AND FIRM PERFORMANCE

Marion Hutchinson
Deakin University, School of Accounting & Finance
221 Burwood Highway, Burwood, Vic, 3125, Australia
Tel: 61 3 9244 6913; Fax: 61 3 9244 6283
Email: hutch@deakin.edu au

Abstract: Tosi and Gomez-Mejia, (1989) suggest that the challenge of corporate governance is to set up
supervisory and incentive alignment mechanisms that alter the risk and effort orientation of agents to align
them with the interests of principals. Therefore, the objective of this study is to determine the efficiency of
monitoring and incentive contracts given certain characteristics of the firm. That is, the study sets out to
determine whether risk firms with higher monitoring and levels of incentives are associated with higher
firm performance.

The results of this study of 282 firms demonstrate how the relationship between firm risk and performance
is associated with the monitoring and incentive contracts used by these firms. In particular, the results of
this study showed that the negative relationship between firm risk and firm performance is weakened by a
higher proportion of non-executive directors on the board, higher levels of executive remuneration and the
inclusion of shares in executives’ compensation contracts.

Keywords: Risk, corporate governance, firm performance.

Data Availability: Data is available from the sources identified in the text and from the author.

INTRODUCTION
Agency theory suggests that, given certain characteristics of the firm and the organisational environment,
firms adopt particular corporate control systems to eliminate agency costs (Bathala & Rao, 1995).
However, prior research on the consequences of controls has failed to provide strong support for the
relationship between the control type and firm performance (Hermalin & Weisbach, 1991; Jensen &
Murphy, 1990; Kosnik et al, 1992). A potential explanation for these conflicting and/or weak results may
be the failure to consider the effect of the characteristics of the organisational environment on the link
between the firm’s control system and performance.

Because governance controls are a firm-level response to a complex environment, they may not impact on
financial performance, which may be a function of the dynamics of the industry (Gomez-Mejia & Wiseman,
1997). Control mechanisms are simultaneously and endogenously determined so that economies in agency
costs are attained. Therefore, links to performance are not necessarily directional as other factors may
determine the level of control mechanism. Therefore, the objective of this research is to determine the
efficiency of monitoring and incentive contracts given the characteristics of the firm.

In this study, it is suggested that different monitoring and incentive contracts are optimal for different firms,
for the simple reason that each firm faces its own management problems, and hence finds its own solution.
“Each firm has different governance needs depending on its economic and regulatory environment, as well
as exogenously determined market forces that may also discipline management” (Vafeas & Theodorou
1998, p. 384).

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Using regression analysis of a cross section of 282 Australian firms, the results of this study showed that the
relationship between corporate governance controls and firm performance is associated with the level of
firm risk. In particular, the results of this study showed the importance of a non-executive director
dominated board on the efficiency of the risky firm. The results also demonstrate that higher levels of
shares in executives’ compensation contracts weaken the negative relationship between firm risk and firm
performance. When testing whether the relationship between executives’ remuneration and firm
performance is associated with the level of firm risk, the result demonstrated the negative relationship
between risk and performance is weakened by higher levels of executive remuneration. This result suggests
that firm performance increases when executives are compensated for increased levels of risk.

This study adds to prior research by looking at the firm’s monitoring and incentive contracts as a collection
of controls available to firms, accordingly this study overcomes some of the limitations of prior research. In
addition, this research adds to corporate governance-firm performance literature by demonstrating that the
corporate governance and performance relationship is associated with the organizational environment.

BACKGROUND AND HYPOTHESES DEVELOPMENT

Firm risk and corporate governance
Firm risk affects the forecasting and planning activities of decision-makers, thus related to both the
principal and the agent’s monitoring and compensation contracting preferences. Typically, firm risk refers
to variability in organizational returns and increased chance of corporate ruin (Bloom and Milkovich,
1998). Indeed, prior research has found a significantly negative relationship between firm risk and
performance (e.g. Bloom & Milkovich, 1998; Core et al, 1999). The measure of firm risk adopted in this
study refers to the underlying volatility in the firm’s earnings stream. This interpretation of firm risk is
adopted because managers are exposed to both systematic and unsystematic risk. Managers typically have
limited opportunity to diversify, partly due to the fact that they receive shares in their own company.
Therefore the risk that they are exposed to is the total risk1 rather than the systematic risk intrinsic in a
diversified portfolio (Carr 1997). Shareholders can select a diversified portfolio that eliminates the
unsystematic risk2 . This implies that the agent, whose compensation mix includes firm-specific stock, has
to bear the total risk. Therefore executives are interested in the variance in their own firm's stock and
earnings; hence variance is the appropriate measure when testing the principal-agent model (Aggarwal &
Samwick, 1999).

Agents are assumed to be self-interested, utility-maximizing, risk and effort averse and must therefore be
persuaded to act in the best interests of shareholders, that is, to engage in behaviors that maximize
shareholder wealth. Consequently, firms use supervisory and incentive alignment mechanisms that alter the
risk and effort orientation of agents to align them with the interests of principals (Tosi & Gomez-Mejia,
1989). This contract is designed to motivate a risk and effort-averse agent to exert unobservable effort in an
environment characterized by uncertainty (Banker et al, 1996; Brickley et al, 1997). The control question
encompasses how this risk is shared between the principal and the agent.

Prior research testing the relationship between firm risk and corporate controls has been mixed. For
instance, some researchers found a decreased incidence of incentives such as share ownership and stock
options were associated with firm risk (Aggarwal & Samwick, 1999; Beatty & Zajac, 1994; Bloom &
Milkovich, 1998). In contrast, others found a positive relationship between risk and the use of incentives
and stock options (Sanders & Carpenter, 1998; Stroh, 1996). In addition, Bathala and Rao (1995) found
that board composition was affected so that the number of external members reduced with the level of risk.

Corporate governance and firm performance

The efficiency of employment contracts is dependent on several factors. In particular, Beatty and Zajac
(1994, p. 313) suggest the following. (1) The ability of firms to use executive compensation contracts to
address managerial incentive problems is hampered by risk-bearing concerns that stem from the risk

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aversion of top executives. (2) This problem is particularly severe for riskier firms. (3) Firms seek to
address this problem by structuring their boards of directors to ensure sufficient monitoring of managerial
behavior, given the magnitude of the agency problem.

Previous research investigating the relationship between corporate controls and firm performance has been
mixed and often weak (Agrawal and Knoeber 1996; Baliga et al 1996; Bloom and Milkovich 1998; Core et
al 1999; Dalton et al 1998; Evans and Weir 1994; Hermalin and Weisbach 1991; Jensen and Murphy 1990;
Kren and Kerr 1997; Kosnik et al 1992).

Board monitoring. Prior research has failed to arrive at a consensus regarding the relationship between
board monitoring and firm performance (see Dalton et al 1998 for a summary). For example, Evans and
Weir (1995) only found support for the relationship between frequency of meetings and profitability.
Baliga et al (1996) found no evidence of a relationship between duality and firm performance. Agrawal and
Knoeber (1996) found control mechanisms were interdependent and that outside board membership was
negatively related to firm performance. In contrast, Kren and Kerr (1997) did not find that a higher
proportion of outsiders maintains a closer link between corporate performance and executives’ pay.

Incentive contracts. Agency theorists argue that incentive contracts may be designed in response to agency
problems (Fama & Jensen, 1983; Jensen & Meckling, 1976). Incentives, both compensation and equity, are
governance controls which provide targets, such as financial results, for managers to achieve. This type of
control approximates a market contracting arrangement, entailing little monitoring or security holder
direction. The princ ipal's objective is to construct an incentive contract that aligns the agent's interests with
those of the principal. However, even an efficient system of incentive alignment will still result in some
interest divergence, that is, the residual loss. Therefore, the incentive compensation, the cost of monitoring
and the residual loss represent the agency costs.

This study sets out to determine whether board monitoring and incentives employed by firms with volatile
earnings is associated with financial pe rformance. Two forms of incentives are considered in this study,
compensation and share ownership. The research question is whether the owner-manager conflict is
reduced by board monitoring and the extent that incentive contracts contain shares and higher remuneration.

Firm risk, board composition and firm performance

As prior research investigating the relationship between board monitoring and firm performance have been
mixed it is likely that board composition is unlikely to have a direct impact on firm performance. Rather, it
is feasible that the relationship between board composition and firm performance is associated with the
level of firm risk. It has been suggested in the literature that firms with high risk are subject to greater
agency conflic ts and therefore need more external board membership monitoring (Bathala & Rao, 1995).
However, Bathala and Rao, (1995) found a negative relationship between the proportion of outsiders and
volatility 3 .

With a higher percentage of executive directors on the board and the volatility of the firm’s income stream
it becomes difficult to assess the outcome of management’s decisions. This gives rise to higher agency
costs associated with the potential for opportunistic behaviour. Therefore, it is likely that high-risk firms
will have lower performance as a result of the inability to monitor managers’ behavior.

In order to safeguard their investment in the firm, shareholders and debtholders of high-risk firms will
demand a higher proportion of non-executive directors to monitor managers’ actions to ensure their actions
are value increasing. Managers will be unable to fund future projects unless they can make a credible
commitment to shareholders and/or creditors that agency costs will be controlled. Obviously one way to do
this is to have non-executive directors appointed to the board. Therefore, it is expected that firm
performance will increase as a function of risk and non-executive director board-dominance. In other words
a positive relationship among higher firm risk, proportion of non-executive directors and firm performance

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is expected. In addition, previous research has struggled to find a significant relationship between board
composition and firm performance (see a summary in Dalton et al, 1998). This could be due to the failure
of previous studies to consider whether the relationship between board composition and firm performance is
associated with the characteristics of the firm. The previous arguments lead to the following proposition:

H 1: The negative relationship between the level of firm risk and firm performance is weakened by
a higher proportion of non-executive directors on the board.

Firm risk, remuneration and firm performance

Researchers have argued that CEO’s will pursue their own interests rather than shareholders when their
reward does not coincide with that of shareholders (e.g. Jensen and Murphy, 1990). Subsequently, prior
research has tested the sensitivity of CEO pay to changes in performance. This argument suggests that an
effective governance mechanism that aligns the goals of management with shareholders will be one where a
change in shareholder wealth will lead to a significant change in CEO compensation. However, prior
research has failed to find consistent and significant relationships between executives’ remuneration and
firm performance (e.g. Crawford, Ezzell, and Miles 1995, Jensen and Murphy 1990b, Murphy 1993).

In addition, the results of prior studies testing the relationship between risk and compensation contracts
have been mixed. Beatty and Zajac (1994) found that riskier firms have a lower proportion of incentive
compensation to total compensation. Munter and Kren (1995) found that uncertainty was negatively related
to outcome-based compensation schemes. Stroh et al (1996) found that during high levels of risk,
organisations use variable pay rather than higher fixed cash compensation. Aggarwal and Samwick (1999)
found that executives in volatile firms have less performance-based compensation. Bloom and Milkovich
(1998) found that three of four measures of risk4 were negatively related to the use of incentive pay. Core
et al (1999) suggests that firm risk, in terms of information and operating environment, is an important
determinant of the level of CEO compensation.

Prior research (e.g. Aggarwal and Samwick, 1999, Core et al. 1999) suggests that executives of volatile
firms will receive higher remuneration to encourage them to accept higher uncertainties, of their
environment and subsequently of their compensation. Subsequently, managerial risk aversion would imply
that managers of firms with volatile earnings would receive higher compensation as recompense for
accepting uncertainty. Therefore, the higher level of compensation will weaken the negative relationship
between firm risk and performance. That is, the higher levels of remuneration will act as an incentive to
accept the risk of the firm. This leads to the following hypothesis:

H 2: The negative relationship between firm risk and performance will be weaker for firms with
higher levels of executive total remuneration.

Firm risk, management share ownership and firm performance

Share ownership can be an important source of incentives and power for executives as well as outside
shareholders. It typically bestows voting rights, which can give internal and external shareholders a voice
in the governance of a corporation. Distribution of stock among these stakeholders can, therefore, have a
significant impact on corporate actions that are dependent on shareholder voting. It therefore follows that
share ownership aligns the interests of executives with shareholders as executives are less likely to engage
in actions that are not in the interests of shareholders.

Two views are expressed regarding the impact of managerial share ownership on shareholder welfare.
Some authors (e.g. Beatty & Zajac, 1994; Stulz, 1988) have argued that managerial share ownership should
be viewed with caution because substantial managerial share ownership can have undesirable risk-bearing
properties. That is, as executives have already invested their non-diversifiable human capital in the firm,
increased share ownership transfers additional risk to executives. This approach suggests that this additional

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risk can lead to risk avoiding behavior on the part of executives, which is not in the interest of shareholders.
This argument suggests that executives would have low share ownership in firms with high risk.

In contrast, theoretical and empirical works based on a positivist approach to agency theory have advocated
stock ownership as a means to align the interest of top executives with that of shareholders (Jensen and
Meckling, 1976; Singh and Harianto, 1989). That is, if executives own stock in a company they are less
likely to take actions that are not in the interests of shareholders.

Several factors suggest that the relationship between the firm’s risk and executive share ownership may be
associated with firm performance. Management share-ownership will ensure managers undertake risk-
bearing strategies that will increase firm performance. As firms with volatile earnings have the potential to
yield large earnings and the realization of the earnings may be delayed, deferred management earnings via
share ownership will act as an effective incentive and alignment mechanism. Therefore, it is likely that
managerial share ownership has the potential to motivate management to undertake risky projects so that
performance will be greater for these firms. In addition it is expected that, low risk firms have stable
earnings and as a consequence, there will be less need to motivate executives to seek out risky but profitable
investments. This leads to the following hypothesis:

H 3: The negative relationship between firm risk and firm performance will be weaker at higher
levels of executive share ownership.

RESEARCH DESIGN
Data. Archival data on firms’ financial characteristics, executives remuneration and executive directors’
share ownership was acquired from 1998/9 company financial reports provided by Connect 4, an electronic
database of the top 500 Australian company annual reports 5 . Risk measures were obtained from the
Australian graduate school of management risk measurement service of the University of New South
Wales.

Independent variables
Executives’ remuneration is measured as total reported remuneration divided by the number of executives,
which equals the average total remuneration of executives6 . This measure therefore controls in part for size
as a contributing factor to the total remuneration paid to executives. Management share ownership is
measured as the total number of ordinary shares held by executive directors divided by the total number of
issued ordinary shares and labeled EDs SHARE %. Consistent with prior research, executive directors are
used as a proxy for executives7 (see Morck et al. 1988).

The traditional measure of the monitoring by board members is the proportion of external directors to
internals directors. Prior research has identified external board members as non-executive directors
(Conyon and Peck, 1998; Weir, 1997). Board composition is measured as the ratio of non-executive
directors to executive directors on the board of directors. NEDs = non-executive directors divided by total
number of directors. The higher the ratio, the greater the proportion of non-executive directors on the
board. Following the Australian stock exchange listing rule 3C, non-executive and executive directors are
identified and disclosed in either the corporate governance statement or the director’s report in the
company’s annual report.

Prior research has used the standard deviation of monthly returns and beta as a measure of firm risk
(Aggrawal & Samwick 1999; Carr 1997). Therefore, the relevant proxies for firm risk are total variance
measures (Core et al, 1999). The primary measure of risk used in this study is the total risk of the firm.
This is measured as the standard deviation of the rate of return on equity for the company and labeled
RISK. It is expressed as a rate of return per month, and is computed from the (continuously compounded)
equity rates of return for the company’s equity 8 . Such rates of return are distributed approximately
normally. This measure encompasses both systematic and unsystematic risk (Carr, 1997). To test the

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validity of the results BETA was also used. Beta is the slope coefficient from a simple linear regression of
the company equity rate of return on that of the market index, where both are measured as deviations from
the risk free rate.

Dependent variable
Performance measures include, among other things, ROE, EPS, Tobin’s Q and Profit margin. Previous
studies (e.g. Gomez-Mejia et al, 1997) have suggested using factor analysis to integrate various measures of
firm performance. However, it may be suggested (Carr, 1997) that one measure should be used
independently as many of the measures are highly correlated because they are derived from the same
financial data. Firm performance is measured using return on equity (ROE) for 1999, to demonstrate the
relationship between the corporate governance controls adopted in 1998 and the subsequent firm
performance in 1999. ROE is measured as income after tax and before abnormal items is divided by total
equity minus outside equity interests. Although managerial discretion may affect accounting returns
through smoothing and accounting manipulations in the short run, in the long run accounting and market
measures of returns should reflect the same economic factors for the firm (Carr, 1997).

Control variables
A firm that has high leverage is likely to be viewed as a firm that may have liquidity problems and therefore
potentially more risky. DEBT is measured as current and non-current borrowings divided by total equity.
This ratio ind icates how firms choose to finance operations. The lower the ratio, the greater the protection
for lenders, who rank before shareholders. Because book values are used to write debt contracts this
measure more accurately proxies for debt holder and shareholder conflicts than market-based measures
(Skinner, 1993).

Firm size is included as a control variable in the analysis because it has been found to be associated with
various firm characteristics. Firm size is measured as the book value of total assets. A natural logarithmic
transformation is performed to normalize data and the transformed variable is labeled LNASSET.

It is likely that specific industries adopt particular corporate governance practices. Therefore it would be
expected that there would be an association with industry type and board composition and directors’
shareholdings. To account for this relationship industry type is included as a control variable. The
INDUSTRY variable is categorized according to the 24 Australian stock exchange (ASX) codes for each of
the listed companies in the sample.

The current financial performance of the firm is likely to be associated with future performance. Following
preliminary testing, to improve the robustness of the model, ROE for 1998 was include d in the regression
model. Including this variable creates a lagged variable, which captures, at least in part, the dynamic
adjustment of ROE.

RESULTS AND DISCUSSION

Data screening. The criteria used to develop the sample for testing the hypotheses is presented in Table 1.
Following the elimination of firms that did not have values on all criteria, the sample size was reduced to
282. Panel B shows the frequency of industries in the sample which is representative of the total sample.
** Insert Table 1 about here **

Descriptive statistics and correlations are provided in Table 2. The mean score for the standard deviation of
monthly returns (firm risk) is 10.48, suggesting the volatility of the firm’s income. Executive directors own
7% of the sample d firms’ total issued shares and receive $216,920 per annum in total remuneration. The
firms’ average size ($1,194,233,000), Debt (56%) and ROE (1%) for 1999 (7% for 1998) is also shown in
the table. The average proportion of non-executive directors (NED) is 69%, as disclosed in the 1998 annual
reports.

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The Pearson’s correlation coefficients for the variables of interest are given in the Table 2 below. The
correlation matrix reveals a negative correlation between RISK and firm performance (ROE 99) providing
support for the proposition of a negative association between risk and firm performance. Performance taken
together with the negative association with size suggests that risky firms are small and struggling firms.
Risk is also negatively associated with board monitoring (NEDS) and executives’ total remuneration. ROE
99 is positively correlated with assets (size).
** Insert Table 2 about here **

Multivariate tests. Regression analysis is used to test and evaluate the contribution and significance of the
hypotheses. The regression tests whether the negative association between firm performance and firm risk
is associated with corporate controls.

The results of testing the hypotheses are reported in Table 3. The model explains 29% of the variation in
the sampled firms’ ROE. The results reported in Table 3 reveal that the performance of the firm is
negatively and significantly related to firm risk. The results of testing the stated hypotheses suggest that
the negative association between firm risk and firm performance is weakened at higher levels of monitoring
and incentives. More specifically, a higher proportion of non-executive directors on the board successfully
monitor managers’ behavior. Higher levels of firm performance confirm this conclusion, therefore H1 is
supported. The results also show that the negative relationship between risk and performance is weakened
at higher levels of executive remuneration suggesting that executives who are compensated for accepting
firm risk improve the firm’s performance. The result was significant, thus supporting H2 . The results
reported in Table 3 also demonstrate a significant and positive interaction of RISK and executive directors’
shareholdings on firm performance. The result shows that firm performance increases at higher levels of
firm risk and executive directors’ shareholdings, thus supporting H3 .

Sensitivity analysis. To test the validity of the results of testing the hypotheses, the regression was run
using BETA as the measure of ma rket risk. However, the interactions when testing these hypotheses were
not significant9 .

CONCLUSIONS
The results of testing the hypotheses suggest that assuming an agent is risk-averse does not capture the full
range of attitudes and behaviors agents’ exhibit under risk. The results may suggest that executives have
greater risk bearing preference due to their level of skill. In other words, executives self-select firms that
offer incentives and higher levels of total remuneration. In addition, the results demonstrate that a positive
association between corporate controls and firm performance is associated with level of firm risk.

This study tested the effectiveness of monitoring and incentive contracts for firms with risk, that is, the
relationship of monitoring and incentive contracts to firm performance given the level of firm risk. The
positive relationship between risk and share ownership on ROE shows that using share ownership as an
incentive to align agent and principal goals may reduces agency costs and risk avoiding behaviour. This
result suggests that decision-makers in high-risk firms adopt value-increasing strategies when they have
some ownership in the firm.

The results of testing the hypotheses also showed that higher levels of executive remuneration are positively
associated with the level of risk and firm performance. This result suggests that executives are
compensated to accepting higher levels of uncertainty of their environment which in turn leads to
executives adopting value inc reasing strategies.

Limitations and future research. Limitations of this study include sample bias and cross-sectional
analysis. The sample was not randomly chosen as the data was collected from the top 500 (in terms of
market capitalization) Australian publicly listed companies. A wider sample of firms, both small and large,
might add additional information for testing the relationships posited in this study.

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Cross-sectional analysis of the data does not determine causality of association. Ideally the data collection
should cover at least two to five years. The hypotheses presented in this research also imply that firms will
change their incentive contracts over time as the relative level of firms’ risk varies. If the risk changes for a
given firm over time, theory predicts changes associated with the firm’s incentives. To test the preference
of firms for a particular incentive contract would require time -series analysis.

This research tested the notion that risk is a major variable that is associated with an individual’s motivation
and acceptance of incentive contracts and is therefore related to firm performance. Risk can be measured in
many ways. The measure used in this study is designed to indicate the total risk of the firm. However, a
multidimensional measure of risk may indicate a stronger association with incentive contracts and firm
performance. This research has shown that risk is associated with firms’ strategic performance
relationships. Researchers may gain a better understanding of the conditions under which agency
predictions hold and test the efficiency of contracts by examining different sources of risk and how they are
related to corporate governance decisions. A fertile area of research is to examine the dimensions of risk
and their relationship to organisational strategies and outcomes.

Despite the limitation of this research due to the experimental design, the findings provide insight into the
choice of board monitoring and incentive contracts adopted by firms and the efficacy of the controls in
terms of firm performance. The particular contribution of this study is to show that not all incentives
available to firms are value increasing to all firms. Rather greater firm performance is associated with the
characteristics of the firm that endogenously determine the mix of monitoring and incentives selected by the
firm.

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 Table 1
Screening criteria and firm observations

Panel A : Screens applied to data for

Number Firm observations
1 Financial statement data reported in Connect 4 437
Observations eliminated because:

2 Missing values for ROE 1999 42

395
3 Missing values for RISK 36
359
4 Missing values for EDS SHARE% 24
335
5 Missing values for TR 31
304
6 Missing values for DEBT 22
TOTAL 282
Firm observations
Panel B: Industry type per ASX code
Frequency Percent
Alcohol & tobacco 10 3.5
Chemicals 14 5.0
Developers & contractors 16 5.7
Diversified industrials 12 4.3
Diversified resources 5 1.8
Energy 23 8.2
Engineering 8 2.8
Food and household 8 2.8
Gold 34 12.1
Health care & biotechnology 13 4.6
Infrastructure & utilities 5 1.8
Investment & financial services 17 6.0
Media 18 6.4
Miscellaneous industrials 36 12.8
Other metals 15 5.3
Paper & packing 5 1.8
Property trusts 3 1.1
Retail 13 4.6
Telecommunications 5 1.8
Tourism & leisure 12 4.3
Transport 4 1.4
TOTAL 282 100%

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 TABLE 2
Pearsons’ correlation and descriptive statistics (N = 282)

ROE ROE DEBT LNASSET NED EDS TR RISK

98 99 SHARE %

1 2 3 4 5 6 7 8
1 1.00 .341** .031 .112 -.024 -.049 -.076 -.010
2 .341** 1.00 .019 .166** .107 .038 .040 -.197**
3 .031 .019 1.00 .287** .088 .089 .135* -.089
4 .112 .166** .287** 1.00 .265** -.196** .445** -.510**
5 -.024 .107 .088 .265** 1.00 -.320** .103 -.262**
6 -.049 .038 .089 -.196** -.320** 1.00 -.064 .099
7 -.076 .040 .135* .445** .103 -.064 1.00 -.195**
8 -.010 -.197** -.089 -.510** -.262** .099 -.195** 1.00

9
Mean .075 .014 .561 1,194,233 .693 .072 216,921 10.480
Median .098 .090 .444 201,274 .750 .002 186,322 8.850
Std. Dev. .575 .883 .679 4,293,288 .204 .140 145389 5.279
Min. -3.142 -13.724 .00 2,726 .00 .00 .00 3.30
Max. 7.939 3.356 8.08 54,484,000 1.00 .89 1,127,579 32.90
Percentiles
25 .037 .035 .171 72,672 .600 .0001 150,163 6.80
50 .098 .090 .444 201,274 .750 .002 186,322 8.850
75 .149 .149 .722 692,678 .833 .069 242,594 12.83

1. ROE 98 = ROE for 1998

2. ROE 99 = Earnings after tax before abnormals/ total equity for 1999
3. DEBT = Current and non current borrowings/total equity
4. LNASSET = Log of assets to normalise
5. NED = Ratio of non-executive directors to total directors
6. EDs SHARE % = Executive directors share holdings to total shares
7. TR = Executives total remuneration/ number of executives earning > $100 000
8. RISK = The standard deviation of the rate of return on equity for the company
9. TOTAL ASSETS = total assets $’000 (unlogged)

**Correlation is significant at the 0.01 level (1-tailed)

*Correlation is significant at the 0.05 level (1-tailed)

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 TABLE 3
Regression model for interactive effects of RISK on ROE (N = 282)

Predicted Standardized
sign Coefficients
Explanatory variables Beta t Sig. VIF
CONSTANT .700 .485
ROE 98 + .454 7.215 .000 1.390
DEBT - -.080 -1.341 .181 1.240
LNASSET + .104 1.332 .184 2.128
NED ? -.199 -1.511 .132 6.099
EDS SHARE % ? -.375 -2.289 .023 9.423
TR ? -.219 -1.675 .095 5.989
RISK - -.843 -4.702 .000 11.316
INDUSTRY* ? -.237 -2.390 .018 3.472
OTHER METALS
Experimental variables
RISK * NEDS + .507 2.928 .004 10.553
RISK * EDS SHARE % + .523 3.117 .002 9.916
RISK * TR + .275 1.888 .060 7.458

R2 .289
Adjusted R2 .201

RISK * NEDS = Interactive term = risk * ratio of non-executive directors to total

directors
RISK * EDS SHARE % = Interactive term = risk * percentage of executive directors share
holdings to total shares
RISK * TR = Interactive term = risk * executives’ total remuneration

* all other industries were not significantly related to ROE.

1
Total risk consists of systematic risk, which is a measure of how the asset (share) covaries with the economy, and
unsystematic risk, which is independent of the economy.
2
CAPM theory suggests that shareholders can diversify away all risk except the risk of the economy as a whole, which
is undiversifiable (Copeland & Weston, 1988).
3
Volatility was measured as the coefficient of variation of earnings before interest and tax.
4
Both systematic and unsystematic income stream volatility and systematic stock market return volatility.
5
The top 500 companies in terms of market capitalization.
6
Annual reports include the total remuneration paid to executives earning greater than $100,000.
7
Firms only report executive directors’ share ownership in the financial reports as part of the corporate governance
disclosure requirements of the Australian stock exchange.
8
It is measured over the four-year period ending in the last month of 1998. All measurable monthly returns in the
four-year interval are included. Individual monthly returns measure total shareholder returns for the company,
including the effects of various capitalization changes such as bonus issues, renounceable and non-renounceable
issues, share splits, consolidations, and dividend distributions.
9
Beta*neds: p = .619; beta*eds share %: p = .302; beta*execs tr: p = .853.

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