Effects of Corporate Governance and Capital Structure on Firms’

Performance: Application of panel VAR approach

BY

Sohail

A RESEARCH PROPOSAL SUBMITTED TO THE SCHOOL OF ACCOUNTING,

ZHONGNAN UNIVERSITY OF ECONOMICS AND LAW

March 2023

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 TABLE OF CONTENTS

1. INTRODUCTION………………………………….…….1

2. LITERATURE REVIEW
2.1 Theoretical literature……………………………………………..6
2.1.1 Agency theory………………………………………………….6
2.1.2 Trade-off theory………………………………………………. 7
2.1.3 Pecking order theory………………………………………...….7
2.2 Empirical literature
2.2.1 Capital structure and firm performance…………………….…..7
2.2.2 Corporate governance and firm performance …………….……8
2.2.3 Corporate governance and capital structure...............................11
2.2.4 Corporate governance, capital structure and firm performance.12

3. RESEARCH METHODOLOGY
3.1 Research design………………………………………………….14
3.2 Research questions and conceptual framework…………....…….14
3.3 Timeframe and statistical analysis model………………………..14
3.4 Research and sampling design………………………………...….14
3.5 Description of the corporate governance disclosure index……….15
3.6 Panel data vector autoregression (PVAR) models………..………15
3.7 Panel unit root test …………………………………….………….17
3.8 Selection order criteria………………………………….…………18

REFERENCES

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Effects of Corporate Governance and Capital Structure on Firms’
Performance: Application of panel VAR approach

1. Introduction
Corporate governance (CG), capital structure (CS), and firm performance (FP) are three critical
features that are connected to each other. Previous studies on the relationship between CG and
CS rely on agency theory to elucidate a firm’s financing assessments (Boateng et al. 2017). Both
are related because agency cost is one of the main features of CS and CG that alleviates agency
conflicts. CS is a CG tool that can support a firm in emerging value by maintaining CG
efficiency (La Rocca 2007). Better CG is generally recognized to advance firm performance
(Beiner et al. 2004; Black and Kim 2012; Padachi et al. 2017; Sheaba Rani and Adhena 2017;
Mansour et al. 2022). However, FP can also influence the level of CG, often measured by means
of the CG disclosure index (CGI) as a proxy for the general quality of CG in diverse countries.
For example, for-profit organizations are expected to have higher levels of compliance and
disclosure than non-profit or less profitable organizations in order to attract new investors and
shareholders. (Suwaidan et al. 2021). Furthermore, on one hand, CS can affect performance
(Doan 2020; Amare 2021) but financial performance, on the other hand, can also affect CS
(Abdullah and Tursoy 2021). Firms with better profitability can obtain debt financing more
easily, perhaps at more competitive interest rates than firms with lower profitability. Researchers
have found that one of the most important elements influencing CS mixing is FP (Iyoha and
Umoru 2017; Cevheroglu-Acar 2018).

In recent years, attention has been paid to the effect of CG on CS and FP and CS on FP.
However, a detailed analysis of the literature reveals important shortcomings. First, the causes of
bias between CG, CS, and FP are rarely considered. Second, although most previous studies have
considered the dynamic nature of financial performance, they have not paid much attention to the
issue of endogeneity and reverse causality in CG, CS, and FP nexus. Third, developing countries
like Pakistan and more specifically South Asian countries have different economic, institutional,
legal and political characteristics than developed countries; therefore, the relationship between

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CG, CS, and FP and their reverse causality may be different from that observed in developed
countries. Earlier studies in Pakistan on CG by (Nawaz, K., & Ahmad, N. (2017), Anwar, W.,
Liaqat, S., & Waris, M. (2022), Akbar, M., Hussain, S., Ahmad, T., & Hassan, S. (2020)
emphasis on the level of compliance, whereas (Shahbaz, T., Raja, A. A. K., & Zeeshan, R. A.
2018; and Nizam, K., Nawaz, S., Haq, F. U., Saghir, W., & Khan, M. I. A. 2022), quantitatively
studied the effect of CG on FP using a static model and limited sample size. Previous studies on
CS in Pakistan have focused on the determinants of CS (Nosheen, S., & Sajjad, M. F. 2018;
Javeed, A., & Azeem, M. 2014; Bashir, Z. 2021), and so far, only one study has been conducted
on the effect of CS on FP by (Shahid, M. S., Abbas, M., & Rizwan, M. 2019), with limited
sample and no CG variables engaged as potential factors. Fifth, no research has been done on the
effect of CG on CS and vice versa in Pakistan, and most studies (Nosheen, S., & Sajjad, M. F.
(2018), Javeed, A., & Azeem, M. (2014) have used numerous CG variables as alternatives for
CG. It is rare to use CGI as a measure of overall CG quality to assess impact on CG. As a result,
previous studies have focused mainly on non-financial companies, while financial firms have
been neglected. For several reasons, Pakistan is an interesting research setting to examine the
relationship and interaction between CG, CS and FP. The de facto characteristics of the corporate
environment in Pakistan are quite different from the CG structure used in developed countries,
making Pakistan an interesting case for this study. Furthermore, there is a big difference between
emerging and developed markets in terms of the market and the quality of education, volatility,
and size (Al-Malkawi 2008). In addition, Pakistan's capital market has a concentrated ownership
structure based on equity and a pyramidal ownership structure, as well as an inactive market for
corporate control, namely takeovers. Consolidation of control often comes from a concentrated
ownership structure (Elghuweel et al. 2017). In addition, Pakistan is a heavily indebted country
with high corporate debt, as bank loans outnumber equity and the equity market is inexperienced.
In emerging economies with strong growth prospects, it is important to study the impact of such
high-level structures on FP and vice versa. Pakistani companies are considered small
corporations in the world because of their small size. Finally, as an emerging economy, Pakistan
is growing rapidly and is striving to become an important center of foreign direct investment
with a focus on an innovation-driven framework. Pakistan's steady growth has brought several
new challenges and responsibilities, as well as closer engagement with foreign investors and
global stakeholders, all of which require greater focus on better CG and optimal CS that

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increases FP and helps attract investors. As a result, Pakistan emerged as an important catalyst to
conduct the first research on the dynamics of the relationship between CG, CS and FP of listed
firms as part of realizing the country's vision to compete with its international competitors.
Consequently, this study will aim to add to the existing body of literature by addressing some of
the shortcomings of past studies and offering new empirical findings. First, this study will try to
provide evidence on CS and vice versa with a single measure of overall CG quality in the
developing economy of Pakistan, where such research has not been done. Second, this study will
provide new evidence on the relationship between CG and FP, CS and FP, CG and CS, and
reverse causality in South Asian countries such as Pakistan, which have different characteristics
compared to developed/developing countries. To the author's knowledge, this will be the first
attempt to investigate the dynamic and interdependent relationship between CG, CS, and FP
using the PVAR model, making a new contribution to the existing CG and CS literature. Third,
this study examines the correlation and interaction between CG, CS, and FP in a panel vector
autoregression (PVAR) framework that considers potential dynamics and endogeneity issues and
reveals reverse causality between these variables. Finally, this study will explore the differences
in the relationships and relationships between CG, CS and FP between financial and non-
financial firms. Therefore, this research aims to empirically investigate the relationship between
CG, CS, and FP, namely CS and FP, CG and FP, and CG and CS, using the PVAR approach in
order to determine the direction of causality. PSX Index List of 30 Pakistan Stock Limited
Companies from 2009 to 2019 and performance will be compared with financial and non-
financial companies. The dynamic evaluation will be generated by completing the forecast error
variance decomposition (FEVD) and the impulse response function (IRF). Different
arrangements of variables and an alternative method for estimating the PVAR model, i.e.
XTVAR, will also be examined for robustness testing.

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 2. LITERATURE REVIEW
CG includes mechanisms to ensure that investors in firms receive a return on their investment
(Schleifer and Vishny 1997). Within the CG structure, timely decision-making policies and
practices govern the responsibilities and rights of various stakeholders. Agency theory provides
board members with professional skills to meet these requirements. The board also decided on
the best mix of debt and equity for the firm's future operations. pecking order theory (POT) and
trade-of-theory (TOT) provide guidance to managers in this area.
Based on these three theories, this section shows the relationship between CG, CS and FP.

2.1 Theoretical literature

2.1.1 Agency theory
Agency theory underpins CG practice. The main principle of this theory is that there is a
business relationship in the form of a partnership agreement between the giving party (principal),
which is the investor, and the receiving party, which is the manager. Corporate disputes arise due
to the separation of ownership and control of the company. In the agency relationship, if
economic agents are utility maximizers (Jensen and Meckling 1976), it is reasonable to assume
that the agent (manager) will make decisions that are detrimental to the interests of the principal
(owner). The amount of resources under the manager's control is only one factor that affects how
agency costs affect the composition of CS. According to Jensen (1986), managers can borrow to
increase resources under their control, which can lead to debt service costs such as bankruptcy
costs. CG stands in this context as a tool that facilitates the alignment of interests between the
agent and the principal. There is reason to believe that CG and CS are related (Borges Júnior,
2022). This is based on the idea that agency conflict is influenced by the CG mechanism and that
this mechanism is related to the choice of the composition of the company's financing sources. In
addition, agency theory argues that CG and financial decisions will affect the value of the firm
and should be seen as instrumental for CS and management structure and therefore FP (Bashir et

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al. 2020). According to agency theory, organizations voluntarily disclose additional information
to reduce agency disputes and conflicts between managers and shareholders (Lambert 2001;
Alves et al.; 2012; Ntim and Soobaroyen 2013). Finally, mandatory and voluntary disclosures in
CG can reduce asymmetry of information between agents and owners, allowing shareholders to
better monitor management performance (Beekes et al. 2016).
2.1.2 Trade-off theory
Trade-off theory (TOT) accounts for tax effects and bankruptcy costs. This theory assumes that
firms trade off the benefits of debt financing (favorable tax structure) against the cost of raising
interest rates and bankruptcy to find the optimal CS to find a value-maximizing mixer. TOT
predicts a positive relationship because if a company is profitable, it can borrow more, leading to
larger tax-deductible interest payments (Ponce et al. 2019).

2.1.3 Pecking order theory

Majluf and Myers (1984) developed Pecking Order Theory (POT) which, in contrast to TOT,
implies that there is no ideal CS. Instead, the theory suggests that firms have a hierarchy of
financial preferences. According to Myers (1984), highly profitable firms have low debt levels
because they have more internal financing sources. Because POT assumes that corporations use
their own resources instead of borrowing, they expect a negative relationship. The validity of
POT has been proven in several empirical studies (Acaravci 2015; Paredes Gómez et al. 2016).

2.2 Empirical literature

2.2.1 Capital structure and firm performance
a. Causal effect of capital structure on firm performance Increasing financial strength will
strengthen management, reduce information costs, and reduce inefficiencies, all of which will
increase FP (Jensen 1986; Jensen and Meckling 1976). Financing decisions affect the cost of
capital, which allows companies to optimize their financial performance (Majluf and Myers
1984; Abdullah and Tursoy 2019). Empirical studies show that FP can influence the use of a mix
of two main sources, namely debt and equity (Saona and San Martin 2018; Abdullah and Tursoy
2019). According to the theoretical model, the relationship between CS and FP is not clear
(Miglo 2016). Only a few empirical studies have investigated the effect of leverage, and the
results are variable. Some studies have found that it is related to FP, such as Vijayakumaran

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(2018) in China and Amare (2021) in Ethiopia, while others have found a negative relationship,
such as Li et al. (2018) in SMEs from Austria, Belgium, Finland, France, Germany, Italy,
Portugal, Spain, Sweden and England; and Dorasamy (2021) in East Africa (Kenya, Tanzania
and Uganda). In Mauritius, Seetanah et al. (2014) found a negative effect of CS on Mauritanian
FP firms listed during the period 2005-2011. Abata et al. (2017) reported mixed results in
another study conducted in South Africa.

b. Causal effect of firm performance on capital structure CS can affect FP, but the latter can
affect the company's CS as well (Abdullah and Tursoy 2021). The logic of the inverse causal
relationship between performance and leverage can also be described by using POT and TOT.
Research has found that one of the most important variables that affect CS mixing is FP (Iyoha
and Umoru 2017; Cevheroglu-Acar 2018; Koralun-Berezhnicka 2018). This argument can be
elucidated by TOT, which states that profitable firms have to reduce bankruptcy costs and are
therefore more prone to borrow (Fama and French 2002). In addition, firms with high profits
tend to borrow more to obtain tax benefits (Frank and Goyal 2009). Therefore, FP can have a
positive effect on CS. Previous empirical research findings support TOT claims (Ajibola et al.
2018; Angkasajaya and Mahadwartha 2020; Amare 2021). POT argues that profitable firms rely
more on the surplus produced to finance their assets than on external sources (Myers 1984). As a
result, it is considered that holding the investment rate constant, it has a negative effect on
profitability as evidence from empirical studies suggest such as Jarallah et al. (2019) in Japan
and Doan (2020) in Vietnam.

c. Reverse causality between capital structure and firm performance Previous studies have
investigated the relationship between FP and leverage, but failed to account for the reverse
causality of CS in FP, and the simultaneous equation may be biased (Iyoha and Umoru 2017).
From 2002 to 2012, Jouida (2018) studied the dynamic relationship between CS, Growth and FP
for 412 financial companies in France using the PVAR model and observed two-way causality
between CS and FP after controlling individual factors. He and Guo (2018) studied a sample of
49 global e-commerce firms from 2012 to 2016 and found a negative inverse relationship
between FP and CS consistent with POT, but reverses as leverage increases. Abdullah and
Tursoy (2021) studied the reverse causality between FP and CS of German non-financial firms

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from 1993 to 2016 and found that FP and CS can positively influence each other. Adhari and
Viverita (2015) investigated the reverse causality between CS and FP of 215 firms in Indonesia,
Malaysia and Singapore and observed that CS and FP can positively influence each other.

2.2.2 Corporate governance and firm performance

a. Causal effect of corporate governance on firm performance The CG mechanism can
improve FP through more monitoring, resulting in improved investor protection, which means
that managers invest in value-added projects, the risk of losing their assets by underutilizing
productive assets and receiving lower cost of capital for the company. According to agency
theory, there is a positive correlation between CG and FP values (Jensen and Meckling 1976).
The implementation of appropriate CG mechanisms, as well as voluntary disclosure, will lead to
net reductions in agency costs and an increase in FP (Fama and Jensen 1983; Siddiqi et al. 2013).
CG disclosure is an important tool to ensure that a company's CG operations are kept within the
law in terms of transparency and accountability (Isukul and Chizea 2017). Good CG is often
known to improve FP (Padachi et al. 2017; Bhatt and Bhatt 2017; Sheaba Rani and Adhena
2017; Mansour et al. 2022). Other studies in India such as Rajput and Joshi (2014) and
Adegboye et al. (2019) in Nigeria found a negative correlation between CG and FP, or Hassouna
et al. (2017) in Egypt, Braendle (2019) in Austria or Tarik et al. (2018) in Pakistan, Shao (2018)
in China, Griffin et al. In different countries (2018), Dao and Nguyen (2020) in Vietnam. In
Mauritius, Appasamy et al. (2013) showed that there is a relationship between CG and FP in the
insurance industry between 2009 and 2011, while Padachi et al. (2017) found a significant
positive relationship between CG and FP of 36 listed companies from 2010 to 2014.

b. Causal effect of firm performance on corporate governance Profitable firms have more
financial resources to support increased administrative costs for meeting performance and
increasing CG compared to less profitable firms. In addition, FP is considered as a determinant
of CG level by strengthening the CG code and disclosing it to stakeholders. Many disclosure
studies show a positive relationship between corporate profitability and CG disclosure (Elfeky
2017; Cunha and Rodrigues 2018). Agency theory posits that high-income company executives
disclose special information to gain exclusive benefits, justify salary packages, improve their

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reputation in the labor market, and strengthen their position (Alnabsha et al. 2018). In addition,
profitable organizations are expected to have a higher level of compliance / disclosure than
profitable or less profitable organizations to attract new investors and shareholders (Suwaidan et
al. 2021). However, according to Ben-Amar and Boujenoui (2007), even those with weak
financial performance have strong incentives to attract investment and improve their financial
performance. In addition, increased disclosure may be associated with lower levels of
profitability because corporations are less legally liable if they share unfavorable information or
"bad news" about themselves (Skinner 1994). This means that there may also be a negative
relationship between profitability and corporate disclosure (Zeghal and Moussa 2015; Suwaidan
et al. 2021). Although previous studies have investigated the relationship between CG and FP,
bidirectional causality between these two variables is rarely considered, which may lead to a
biased version of the equation.

c. Reverse causality between corporate governance and firm performance Love (2011)
indicates that some previous studies show that causality flows from management to performance,
while others argue that causality flows in the opposite direction from performance to
management. There are several reasons to believe that the reason may range from assessment to
management. On the one hand, organizations with higher business results or greater market value
may decide to use better management practices that lead to the opposite effect. On the other
hand, companies with poor performance are more likely to adopt additional takeover measures
associated with poor governance. Alternatively, businesses can adopt stronger governance
processes to predict future success or improve internal parties' adherence to ethical behavior. The
role of management signaling, rather than management itself, will be more important for the
stock price in this case. The reverse case can occur through institutional or international investors
favoring companies with high market value, which can lead to better management practices.
Lamiry et al. (2008) investigated the reverse causality between different board characteristics
and FP from a panel of 36 Tunisian firms surveyed between 2004 and 2006, and their results
concluded that the board influences FP and that firms change their governance structure in
response to FP. Perez de Toledo (2011) evaluated the relationship between the quality of CG,
proxied by CGI, and the market value of 106 Spanish firms surveyed between 2005 and 2007,
and showed that CG has a positive effect on firm value, but there is no evidence to the contrary.

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That is, the price that affects the CG firm. Ingriyani and Chalid (2021) examined 51 Indonesian
manufacturing companies listed between 2014 and 2018 and concluded that executive
compensation, CG and FP are related. They found that CG has a positive effect on FP and more
FP tends to reduce the number of boards of directors and the supervisory role of commissioners,
but increases the proportion of independent directors.

2.2.3 Corporate governance and capital structure

a. Causal effect of corporate governance on capital structure The choice of CS CEOs is one
of the most important business policy decisions (Boateng et al. 2017). This is because credit
decisions are subject to agency problems and affect firm risk and performance (Jensen and
Meckling 1976). Jensen and Meckling (1976) argue that the separation of principal and agent
roles in firms causes conflict of interest (agency cost) between shareholders and management
leading to the idea of CG. This is where the two concepts of CG and CS come together.
According to agency theory, organizational managers with low CG experience are more likely to
experience agency problems, so they will try to use optimal leverage to exploit free cash flow.
Higher levels of governance are a good substitute for weaker governance practices (Mwambuli
2019). In this case, firms with low CG experience should use greater power to reduce agency
costs and align the interests of company managers and shareholders.
Some studies have shown some evidence for the above assertion, showing that CG frameworks
have a significant impact on the decisions of listed companies (Morellec et al. 2012). For
example, a questionnaire-based CG index developed by Haque et al. (2011) studied the
relationship between CG and business practices of non-financial firms listed in Bangladesh.
They found that the quality of management at the management level has a significant impact on
the performance of firms, with weakly managed firms having a high level of debt financing.
Mwambuli (2019) studied the role of CG as measured by CGI in the CS of 32 non-financial
listed firms in the East African region from 2006 to 2015 and found a significant effect of CG on
CS decisions. Most studies (Herlambang et al. 2018; Chow et al. 2018) use some CG variables as
proxies for CG, and rarely use CGI as an overall quality measure to assess the effect on CS.

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b. Causal effect of capital structure on corporate governance CS can affect the level of CG
through greater adherence to the CG code and more transparent information. Jensen and
Meckling (1976) and Masum et al. (2020), highly leveraged firms tend to provide additional
information to satisfy the needs of external capital providers and reduce borrowers' concerns
about the ability to transfer resources from debt holders to managers and shareholders. Finally,
the agency theory shows a strong relationship between the disclosures of CS firm (Jensen and
Meckling 1976) because the presence of creditors at the disposal of a firm (especially in highly
leveraged firms) exacerbates the agency problem (and therefore increases the cost of control). It
aims to reduce these costs by disclosing additional information in its annual report. These
companies need to increase the level of transparency to restore the confidence of investors and
creditors and ultimately reduce the impact of bankruptcy risk. A significant positive relationship
between exposure to CS and CG was found by Al-Moataz and Hussaini (2013) in Saudi Arabia
and Elfeky (2017) in Egypt, Zeghal and Moussa (2015) in several countries, Elgattani and
Hussaini (2020) in eight countries. (Bahrain, Syria, Qatar, Sudan, Jordan, Palestine, Oman and
Mauritius) and Suwaidan etc. (2021) in Jordan. However, some studies conducted by Mallin and
Ow-yong (2009) in England and Cunha and Rodrigues (2018) in Portugal found a significant
negative relationship, but Alves et al. (2012) reported that such relationships were not
significant. ) in Portugal and Spain, and Allegrini and Greco (2013) in Italy.

c. Reverse causality between corporate governance and capital structure CS affects CG and
vice versa. Management chooses to use debt as a source of financing, whether it is to reduce
problems related to asymmetry of information and transactions, to improve the efficiency of
company management decisions, or to demand an increase in the level of debt by shareholders as
a tool. Streamlining behavior and providing effective CG. On the one hand, changes in debt and
equity management affect CG practices by changing the incentive structure and management
control. With a mix of debt and equity, where different investors are all tied up in the company
with different levels of influence on management decisions, managers will usually have an
advantage when they determine that one of these categories will dominate when determining the
company's CS. . More importantly, the effectiveness of CG can be significantly improved
through careful design of debt and equity contracts. On the other hand, CG also affects CS
decisions. Myers (1984) and Majluf and Myers (1984) suggest that management make firm

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financing decisions based on demand; in this case, if the manager chooses the source of
financing, it can be considered that the latter avoids reducing the decision-making ability by
agreeing to the rule of thumb. Funding from internal sources allows managers to keep outsiders
out of the decision-making process. By allocating internal resources, management can prevent
external influences from influencing decision making. De Ongong (2002) describes how
managers in the Netherlands try not to use debt so that their decision-making abilities are not
checked, while Zwiebel (1996) found that managers are forced to issue debt through other
management mechanisms because they cannot freely accept it. . "Sequence" of debt (cited in La
Rocca 2007). Jensen (1986) argued that the decision to increase the company's debt was made
voluntarily by management in an effort to "incentivize" them to focus on whether the managerial
decision was "right". Empirical research on the bidirectional relationship between CG and CS is
scarce.

2.2.4 Corporate governance, capital structure and firm performance Previous research has
examined the relationships between CG, CS, and FP, but such research (Roy and Pal 2017;
Nawaz K. and Nawaz A. 2019; Shahzad et al. 2022) analyzed each association separately, in one
direction, and using different mechanisms. To my knowledge, no study has examined the
interrelationship and interdependence among these three variables simultaneously in Pakistan,
and furthermore using a single composite measure of CG level. The impacts of CG and leverage
mechanisms on FP from previous studies have mixed results and it is interesting to explore the
current interrelationships and interdependencies between these three variables in the unique
economic, political and social context of a small and developing economy like Mauritius. as a
reference for the main economic aspects (including good governance) in the African region.

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3. RESEARCH METHODOLOGY

3.1 Research design

This section will discuss the design and philosophy of the prospective study, sources of
disclosure, CGI measurement, data collection, sample selection, PVAR model, and statistical
tests that will be used.

3.2 Research questions and conceptual framework

The study’s objectives are to analyse:
1. Interdependencies and correlation between CG, CS and FP of the PSX 30 index companies
listed, and
2. Any dissimilarities in the degree and impact of their interrelationships and interdependencies
between PSX 30 financial and non-financial listed firms.

3.3 Timeframe and statistical analysis model

A sample of companies listed on the PSX 30 from 2009 to 2019 will be examined. The PVAR
approach will be used to obtain several variables associated with the sample, according to the
relevant literature discussed in "Literature Review". STATA 16 software will be used to analyze
the data to generate descriptive statistics and PVAR models.

3.4 Research and sampling design

This research will use a balanced panel data approach to examine a sample of companies listed
on the PSX from 2009 to 2019. The survey data will be collected manually from four financial
(including banks due to the difference in CG opening requirements) and 26 Non-financial

14
companies listed on the PSX. The annual report before 2009 will not be included due to the 2008
financial crisis in order to have a balanced panel of all 30 firms. The years 2020 and 2021 will
also be not included due to the global economic crisis caused by the COVID-19 pandemic, which
does not reflect the true financial performance of the companies in the selected list.

3.5 Description of the corporate governance disclosure index

CGI will be measured as a ratio of compliance with each CG practice of all 30 companies in the
selected sample, consisting of six components/sub-indexes. Annual reports from 2009 to 2019
will be used to determine whether each of the 67 management practices recommended in the
checklist will be suitable for the company in accordance with Pakistan's CG Code. A value of
one is given for a 'yes' answer in the form of compliance with appropriate management practices,
and a value of zero is given for a 'no' answer in the form of non-compliance. CGI will be
calculated by adding this price to each company annually. Given that weighted and unweighted
index scores have many elements and have yielded similar results (Chow and Wong-Boren,
1987; Sharma, 2014), an unweighted index is used to assess exposure levels according to
previous studies (Cunha and Rodrigues 2018; Masum) et al. 2020). In addition, the unweighted
approach gives equal weight to each disclosure element in the annual report and contains
subjectivity issues (Healy and Palepu 2001). Cronbach's alpha test of the reliability of the above
six indicators that make up the CGI will also be used.

Fig. 1
CAPITAL STRUCTURE

CORPORATE
GOVERNANCE FIRM PERFORMANCE

3.6 Panel data vector autoregression (PVAR) models

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A summary of variable definitions and measurements based on previous literature is shown in
Table 1.
Based on limitations in previous studies, three variables CGI, CS and ROE will be used in this
study. Bhagat et al. (2008) argue that the development of CGI is useful because it combines
various components of a company's management structure into a single number that can be used
to assess management effectiveness. Correlation/relationship between CG, CS and FP will be
investigated using PVAR methodology. The PVAR method will be particularly suitable for this
study because it seeks to model the evolution of the variable system of interest-CG, CS, and FP-
in a set of firms that differ significantly in various dimensions, such as financial, non-financial,
and size, age, type of industry and listing status. The PVAR approach is a mixed econometric
methodology that combines the traditional VAR method, where all variables in the model are
considered endogenous, with a panel data method that allows the explicit inclusion of fixed
effects in the structure (Shank and Vianna 2016). PVAR can cause both static and dynamic
interactions (Canova and Ciccarelli, 2013). This setup will also allow us to study how different
shocks will affect the Impulse Response Function and other inequalities. In future studies, the
model in the PVAR approach will be limited to only endogenous variables and control variables
will be included according to previous studies (Shank and Vianna 2016; Comunale 2017; Jouida
2018; Traoré 2018; Apostolakis and Papadopoulos 2019; Trofimov 2021).
In a generalised method of moments (GMM) framework, the PVAR model selection, estimation,
and inference will be used, as proposed by Abrigo and Love (2016). Considering Abrigo and
Love (2016), the following k-variable homogeneous panel VAR of order p, with panel-specific
fixed effects characterised by the following system of linear equations:

Yit = Yit – 1A1 + Yit – 2A2 +⋯⋯⋅ +Yit − p + 1Ap − 1 +Yit − pAp + XitB+ ui + eit

i ∈ {1, 2, . . ., 42}, t ∈ {2009, 2010, . . . , 2019}, (1)

where Y is a (1 × k) vector of dependent variables, X is a (1 × l) vector of exogenous covariates,
and ui and e are (1 × k) vectors of dependent variable-specific panel fixed-effects and
idiosyncratic errors, respectively. The (k × k) matrices A1, A2, …, Ap − 1, Ap, and the (l × k)
matrix B are the parameters to be estimated.

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Table 1 Description of variables
Variables Description Details Sources

ROE Firm performance Net profit after tax to total shareholders’ Bhatt and Bhatt (2017)
equity Dao and Nguyen (2020)

CGI Overall corporate governance The ratio of overall corporate governance (Cunha and Rodrigues (2018)
disclosure index
disclosure items Masum et al. (2020)

CS Firm leverage The ratio of total debt to book value of equity Renders et al. (2010)

It will be presumed that the innovations have the following attributes: E (eit) = 0, E (e’iteit) = Σ,
and E (e’iteis) = 0, and for all t > s. According to Abrigo and Love (2016), the PVAR describes
in Eq. (1) has problems with dynamic interdependencies and cross-sectional heterogeneities.
Finally, the fixed effect variable is the only variable that captures the heterogeneity between
different units. Since the month-specific effect term is related to the error term in the dynamic
panel, the ordinary least squares (OLS) method cannot be used because the estimation by OLS
leads to a biased coefficient (Jouida 2018). To solve this problem, the PVAR model is specified
in the 11-year study of 42 registered Mauritian companies using the GMM-estimation equation.
This method is very useful. Arellano-Bond is used to produce a uniform constant effective
average coefficient for short panels (N > T). Consequently, findings often control for time-
invariant characteristics that are often addressed in empirical studies. On the left-hand side of
each equation is the first difference of endogenous variables, and on the right-hand side is the
first difference of all lagged endogenous variables.

3.7 Panel unit root test

The Augmented Dickey and Fuller (ADF) (1981), Levin, Lin, and Chu (LLC) (2002) and Im,
Pesaran, and Shin (IPS) (2003) test for data stability will be used to indicate nonstationarity of

17
data. This model is stationary at the level because the p-value is below the 5% level. Given that
there is no unit root, it is possible to analyze the causality between the three variables.

3.8 Selection order criteria

The steps in Abrigo and Love (2016), which present a control package in STATA for learning
the PVAR model, will be followed. To perform the PVAR analysis, the panel VAR specification
and the optimal regression model for the moment condition will be used. Because the first order
panel VAR (one lag) is the smallest MBIC (Bayesian information criterion, Schwarz, 1978),
MAIC (Akaike information criterion, Akaike, 1969) and MQIC (Hannan-Quinn information
criterion, Hannan and Quinn, 1979).

18
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