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Capital Structure, Shareholder Rights, and

Corporate Governance

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 Capital Structure, Shareholder Rights, and Corporate Governance

Pornsit Jiraporn*
Department of Accounting, Economics and Finance
Texas A&M International University
Laredo, Texas 78041
Telephone: (956) 326-2518
Email: pjiraporn@tamiu.edu

Kimberly C. Gleason
Department of Finance
Florida Atlantic University
Boca Raton, Florida 33431
Telephone: (561) 297-1295
Email:kgleason@fau.edu

Date: August 18, 2005

JEL Classification: G30, G32, G34

Keywords: capital structure, shareholder rights, corporate governance

The authors would like to acknowledge the helpful comments from Jacky So, Chip Wiggins, Lara
Bryant, Ky Yuhn, and Pete DaDalt. In addition, the first author extends his thanks to the seminar
participants at the University of Texas at Brownsville; New York Institute of Technology;
Montclair State University; Adelphi University; the University of Maine, Orono; and the
University of South Carolina, Upstate. Part of this research was conducted as a result of a
summer research grant at Texas A&M International University.

* Correspondence author
 Capital Structure, Shareholder Rights, and Corporate Governance

Abstract

We show how capital structure is influenced by the strength of shareholder rights.

The empirical evidence shows an inverse relationship between leverage and shareholder

rights, suggesting that firms adopt higher debt ratios where shareholder rights are more

restricted. This is consistent with agency theory, which predicts that leverage helps

alleviate agency problems. This negative relationship, however, is not found in regulated

firms (i.e., utilities). We contend that this is because regulation already helps alleviate

agency conflicts, and hence, mitigates the role of leverage in controlling agency costs.

JEL Classification: G30, G32, G34

Keywords: capital structure, shareholder rights, corporate governance
 Capital Structure, Shareholder Rights, and Corporate Governance

I. Introduction

We link agency costs to capital structure by examining how the strength of

shareholder rights influences capital structure decisions. Given that agency conflicts are

derived from the divergence of ownership and control, firms where shareholder rights are

severely restricted are likely to suffer higher agency costs because managers are better

able to exploit weak shareholder rights and place their own private benefits ahead of

shareholders’ interests.

Leverage has been argued to alleviate agency costs in several ways. One is to

cause managers to increase their ownership in the firm (Jensen and Meckling, 1976). By

increasing the use of debt financing, effectively displacing equity capital, firms shrink

their equity bases, thereby increasing the percentage of equity owned by management.

Another is to use debt to increase the probability of bankruptcy and job loss. This

additional risk may further motivate managers to decrease their consumption of perks and

increase their efficiency (Grossman and Hart, 1982). Finally, the obligation of interest

payments resulting from debt helps resolve the free cash flow problem (Jensen, 1986).

We hypothesize that because leverage is related to agency costs and those, in turn, are

likely to be related to the strength of shareholder rights, a significant economic

relationship exists between the two.

Following Gompers, Ishii, and Metrick (2003), we use the Governance Index to

gauge the strength of shareholder rights. The Governance Index determines how many

corporate governance provisions exist that restrict shareholder rights. Gompers, Ishii, and

Metrick (2003) demonstrate that firms with stronger shareholder rights earn average

1
abnormal returns of 8.5% per year. This can be attributed to stronger shareholder rights

and lower agency costs, which result in higher firm value. Firms where shareholder rights

are strong suffer a narrower separation of ownership and control and, hence, less severe

agency conflicts.

Our empirical evidence suggests that the strength of shareholder rights affects

financial leverage. The relationship is negative, suggesting that firms where shareholder

rights are weak carry more debt. This evidence is consistent with agency theory, which

predicts that firms with weak shareholder rights incur higher agency costs, and, thus,

carry more debt.

In addition, we show how regulation affects the relationship between shareholder

rights and capital structure. Regulated firms are likely to suffer lower agency costs

because regulation removes a certain degree of managerial discretion (Booth, Cornett,

and Tehranian, 2002; and Kole and Lehn, 1997), making it more difficult for

management to act counter to shareholders’ interests. This additional monitoring also

may affect the role of debt. The empirical evidence demonstrates that the inverse

relationship between shareholder rights and leverage does not exist in regulated firms;

however, it does in industrial (unregulated) firms. It appears that regulation substitutes for

leverage in controlling agency problems in these firms.

The results of this study show a relationship between leverage and the strength of

shareholder rights, which is also affected by regulation. This study is the first to

investigate the association between leverage and shareholder rights and, therefore, aptly

fits into the literature on agency costs as a determinant of capital structure decisions.

2
 II. Motivation and Hypothesis Development

A. Motivation

Motivated by agency theory, we take advantage of the recently developed

Governance Index (Gompers, Ishii, and Metrick, 2003) to explore agency costs as a

determinant of financial leverage. The Governance Index is interpreted as a measure of

the strength of shareholder rights and has been used to examine situations where agency

costs are relevant. For instance, Klock, Mansi, and Maxwell (2005) relate the Governance

Index to the cost of debt financing. Similarly, Harford, Mansi, and Maxwell (2005)

explain firms’ cash holdings using the Governance Index. Finally, Jiraporn, Kim,

Davidson, and Singh (2005) find a link between corporate diversification and the

Governance Index. We investigate whether debt mitigates agency costs in firms where

shareholder rights are restricted and whether leverage and regulation are alternative

mechanisms for controlling agency costs.

B. Capital Structure and Shareholder Rights

Holding constant the manager’s absolute investment in the firm, increases in the

portion of the firm financed by debt increase the manager’s share of the equity, thereby

better aligning the manager’s and the shareholders’ interests. Moreover, as argued by

Jensen (1986), since debt commits the firm to spend cash, it reduces the amount of “free”

cash available to managers to engage in excessive perquisite consumption.

The severity of agency costs is likely to be inversely related to the strength of

shareholder rights (Gompers, Ishii, and Metrick, 2003). Firms where shareholder rights

are more suppressed are more likely to experience a wider divergence of ownership and

control and are therefore more prone to agency conflicts. Because leverage is related to

3
agency costs and agency costs, in turn, are associated with shareholder rights, we

hypothesize that leverage is influenced by the strength of shareholder rights. Agency

theory predicts that firms where shareholder rights are more limited (and, therefore,

where agency costs are more acute) should adopt higher debt ratios to mitigate the higher

agency costs. Hence, an inverse relationship between leverage and the strength of

shareholder rights is expected.

C. The Potential Impact of Regulation

Because regulators already provide a certain degree of monitoring, managers of

regulated firms should be less able to reap private benefits at the expense of shareholders

(Booth, Cornett, and Tehranian, 2002; Kole and Lehn, 1997). This potential reduction in

agency costs may affect the association between leverage and shareholder rights.

Accordingly, we explicitly distinguish between regulated and unregulated firms. Because

there should be a trade-off between external and internal mechanisms that control agency

costs, regulated firms may rely, to a lesser extent, on debt as a tool to mitigate agency

costs. In other words, regulation and leverage may be substitutes for reducing agency

costs.

III. Sample Selection and Data

A. Sample Selection

The original sample is compiled from the Investor Responsibility Research Center

(IRRC), which collects data on the Governance Index. Because the IRRC collects data

only periodically, our sample is restricted to the years in which the IRRC has data on

corporate governance. We use data from 1993, 1995, 1998, 2000, and 2002. We then

reduce the sample by eliminating firms whose accounting data are not available in

4
COMPUSTAT. The full sample consists of 4,638 firm-year observations1. Table 1 shows

the sample distribution by year.

Two industries are traditionally heavily regulated: financial and utility. The nature

of financial firms, particularly depository institutions, is such that leverage cannot be

interpreted the same way as in industrial firms so we exclude financial firms. Only utility

firms2 are included in the sample as regulated firms. The rest of the sample firms

represent our industrial (unregulated) sample. There are 4,225 firm-year observations in

the industrial sample and 413 in the regulated sample.

-----Insert Table 1 about here-----

B. The Governance Index

The original data for the Governance Index are taken from IRRC, which publishes

detailed listings of corporate governance provisions for individual firms in Corporate

Takeover Defenses (Rosenbaum, 1993, 1995, 1998, 2000, 2002). The data on governance

provisions are derived from various sources, such as corporate bylaws, charters, proxy

statements, annual reports, and 10-K and 10-Q documents filed with the Security and

Exchange Commission (SEC). Table 2 displays the individual governance provisions

included in the construction of the Governance Index3.

For each firm, Gompers, Ishii, and Metrick (2003) add one point for every

provision that restricts shareholder rights (increases managerial power). While this index

1
In additional statistical tests, we include block ownership in our analysis of a subsample of 1,309 firm-
year observations for which data is available from the Wharton Research Data Services (WRDS).
2
SIC codes between 4900 and 4999.
3
The detailed explanation for each governance provision is available in the appendix of Gompers, Ishii,
and Metrick (2003). They classify provisions into the following categories: tactics for delaying hostile
bidders (Delay), voting rights (Voting), director/officer protection (Protection), other takeover defenses
(Other), and state laws (State).

5
may not accurately reflect the relative impacts of the various provisions, it is transparent

and easily reproducible. The index does not require judgments about the efficacy or

wealth effects of any of these provisions; Gompers, Ishii, and Metrick (2003) only

consider the impact on the balance of power.

-----Insert Table 2 about here-----

To clarify the logic behind the construction of the Governance Index, Gompers,

Ishii, and Metrick (2003) include the following example in their paper:

For example, consider classified boards, a provision that staggers the

terms and elections of directors and, thus, can be employed to slow
down a hostile takeover. If management uses this power judiciously, it
could possibly lead to an increase in overall shareholder wealth; if
management, however, uses this power to maintain private benefits of
control, then this provision would diminish shareholder wealth. In
either case, it is apparent that classified boards enhance the power of
managers and weaken the control rights of large shareholders, which is
all that matters for constructing the index. (p. 114)

Most provisions other than classified boards can be viewed similarly. Almost

every provision enables management to resist different types of shareholder activism,

such as calling special meetings, changing the firm’s charter or bylaws, suing directors,

or replacing them all at once. Gompers, Ishii, and Metrick (2003) note, however, that

there are two exceptions: secret ballots (confidential voting) and cumulative voting. A

secret ballot designates a third party to count proxy votes, preventing management from

observing how specific shareholders vote. Cumulative voting enables shareholders to

concentrate their directors’ votes so that a large minority shareholder can ensure some

board representation. These two provisions are usually proposed by shareholders and

opposed by management because they enhance shareholder rights and diminish the power

of management. Gompers, Ishii, and Metrick (2003) add one point to the Governance

6
Index when firms do not have each of these provisions. For all other provisions,

Gompers, Ishii, and Metrick (2003) add one point when firms do have each of them. The

Governance Index is the sum of one point for the presence (or absence) of each

provision; the higher the governance score, the weaker the shareholder rights.

IV. Empirical Results

A. Summary Statistics

Table 3 shows the descriptive statistics for the sample firms. In terms of size, the

average sales for the sample firms are $3,747 million ($1,135 million median). As

previously discussed, we split the whole sample into industrial firms and regulated firms.

The average sales for industrial firms are $3,812 million ($1,103 million median) while

the average for utility firms is $3,076 million ($1,426 million median). The t-statistic

shows that industrial firms are significantly larger on average. In terms of leverage, the

total debt ratio averages 45.72% (45% median) for the whole sample. Regulated firms, on

average, carry significantly more debt. This is preliminary evidence that leverage is

correlated with regulation. The EBIT ratio, which proxies for profitability, averages

15.19% (13.64% median) for the full sample. The average EBIT ratio is significantly

higher for utility firms than for industrial firms. Tobin’s Q, which is used to represent

growth opportunities, averages 1.51 (1.08 median) for the full sample. Regulated firms

appear to have significantly fewer growth opportunities than industrial firms do. On

average, the fixed asset ratio for the entire sample is 35.78% (30% median). Industrial

firms have substantially less in fixed assets than regulated firms do. The non-debt tax

shields ratio averages 4.89% (4% median) for the whole sample with regulated firms

having considerably more non-debt tax shields than industrial firms.

7
 Finally, the summary statistics reveal that the Governance Index averages 9.16 (9

median), which suggests that, on average, firms impose 9.16 governance provisions that

restrict shareholder rights. Gompers, Ishii, and Metrick (2003) characterize a firm where

the Governance Index is greater than fourteen as a “dictatorship” and one where the

Governance Index is less than five as a “democracy.” It appears that the sample, with

Governance Index ranging from two to eighteen, includes some “dictatorial” and

“democratic” firms.

-----Insert Table 3 about here-----

B. Univariate Analysis

Following Gompers, Ishii and Metrick (2003), we construct two extreme

portfolios: one in which corporate governance is severely restrictive (the Governance

Index is greater than or equal to fourteen) and the other in which governance is

particularly liberal (the Governance Index is less than or equal to five). As in Gompers,

Ishii and Metrick (2003), we refer to the restrictive portfolio as the “dictatorship”

portfolio and the liberal one as the “democracy” portfolio. The univariate results are

displayed in Table 4.

The evidence shows that firms in the dictatorship portfolio are considerably more

leveraged than those in the democracy portfolio. The average total debt ratio for the

dictatorship portfolio is 49.26% (48% median), whereas the average for the democracy

portfolio is only 44.36% (43.50% median). The difference is statistically significant at the

1% level. To ensure that the difference is not driven by industry effects, we also compare

8
the industry-adjusted leverage4. The average industry-adjusted total debt ratio for the

dictatorship portfolio is 3.67%, while that for the democracy portfolio is -1.15% -a highly

significant difference. Thus, it appears that restrictive corporate governance is associated

with a higher debt ratio. Firms where shareholder rights are particularly weak carry

significantly more debt than those where shareholder rights are especially strong. This

supports the agency theory’s prediction that debt helps control agency problems in firms

where shareholder rights are weak and are therefore vulnerable to agency costs.

-----Insert Table 4 about here-----

C. Regression Analysis

We employ two regression models to determine the effect of shareholder rights on

leverage. We use industry-adjusted leverage (the ratio of total debt to total asset) as the

dependent variable. The Governance Index is an independent variable and the focus of

the analysis. Morck, Shleifer, and Vishny (1998) report a nonlinear association between

firm value and managerial ownership and Schooley and Barney (1994) document a U-

shaped relationship between dividend yield and CEO ownership. Therefore, to better

control for nonlinearities, we use dummies representing democracy (zero to four), low

(five to seven), and medium (eight to thirteen) governance scores5. High governance

scores (i.e., dictatorships with weaker shareholder rights) are above thirteen.

We use ordinary least squares (OLS) modeling leverage as a function of

democracy, low-, and medium-governance dummies6. We also use other control variables

4
The industry-adjusted total debt ratio is computed as the difference between the total debt ratio of a given
firm and the median total debt ratio of the industry in which the firm operates. The first two digits of the
SIC are used to identify the industry.
5
Alternative ranges for low and medium were also used, such as five or below as low and six to thirteen as
medium, to be consistent with democracy and dictatorship definitions, with similar results.
6
We thank an anonymous reviewer for this suggestion.

9
based on past empirical research regarding capital structure. Numerous studies have

argued that leverage may be positively affected by firm size. Following Titman and

Wessels (1988) and Johnson (1997), we use the natural logarithm of sales to proxy for

firm size. The composition of the firm’s assets has been found to affect capital structure

decisions (Titman and Wessels, 1988 and Mehran, 1992). Hence, we include the fixed-

asset ratio in the regression analysis. As in Johnson (1997), the fixed-asset ratio is

property, plant, and equipment to total assets. Myers (1977) identifies growth

opportunities as a significant determinant of capital structure. Similarly, Rozeff (1982)

finds empirical support for growth opportunities as a relevant variable. We control for

growth opportunities by using Tobin’s Q, which is computed according to Chung and

Pruitt (1994). Profitability may be relevant to capital structure decisions. Myers (1984)

suggests that managers have a pecking order in which retained earnings represent the first

choice, followed by debt financing, then equity. Thus, the pecking order hypothesis

would imply a negative relationship between profitability and leverage. We employ the

earnings before interest and taxes (EBIT) ratio7 to control for profitability. DeAngelo and

Masulis (1982) contend that nondebt tax deductions substitute for the tax shield benefits

of debt. As a result, firms with greater non-debt tax shield would be expected to have

lower levels of debt. We define non-debt tax shields as the ratio of the sum of

depreciation and amortization to total assets.

Endogeneity poses a problem for many governance studies (Bhagat and Jefferis,

2002). We use two-stage least squares (2SLS) estimation to supplement the regressions8.

7
The EBIT ratio is earnings before interest and taxes scaled down by total assets.
8
To address this concern, we first conduct a Hausman test and determine that a simultaneity problem is
present. We also use the Hausman test to identify the appropriate model specification, and cannot reject the
null hypothesis that the error term is uncorrelated with the regressors. Furthermore, we found that 2SLS

10
In the 2SLS estimation, industry-adjusted leverage ratios and corporate governance

quality are modeled simultaneously, with the industry-adjusted leverage as the dependent

variable in the second-stage regression. Based on the literature on outside blockholder

monitoring and agency conflicts, we use blockholder ownership as an instrumental

variable, which we regress on the Governance Index. We test to ensure that blockholder

ownership is uncorrelated with the residual from the regressions on leverage, i.e., that it is

exogenous, meeting this criteria as an instrumental variable9. We present both the second-

stage regression from the 2SLS estimation and the dummy variable regression.

-----Insert Table 5 about here-----

Table 5 shows the results of the regression analysis. The dependent variable is the

industry-adjusted total debt ratio. We present two models for the full sample and two for

each subsample: the 2SLS and dummy variable regressions. In model 1, the coefficient of

the predicted Governance Index (from the first pass regression) is positive and highly

significant, indicating that firms with higher governance scores (i.e., weak shareholder

rights) exhibit the highest levels of debt. Hence, the 2SLS regression results strongly

support our hypothesized inverse association between leverage and the strength of

shareholder rights. Our regression substantiates the hypothesis that firms with weak

shareholder rights have higher debt ratios. The democracy score (below five) dummy

provides a better fit than OLS, three stage least squares (3SLS), or full information maximum likelihood
(FIML) estimation procedures. Bhagat and Jefferis (2002) summarize several studies using 3SLS and 2SLS
to examine economic relationships involving ownership, such as Bhagat and Black (2001) and Demsetz
and Villalonga (2002).
9
In other words, we use blockholder ownership as an independent variable in the first-stage regression
model (where governance is the dependent variable). We also include size (log of sales) as a control
variable to properly identify the model. In the second-stage regression, we control for governance quality
using predicted governance quality from the first-stage regression. Thus, we estimate a cross-sectional
second-stage regression where leverage is the dependent variable, with predicted governance quality
estimated from the first stage as one of the independent variables. The model is estimated for the full
sample, as well as the industrial and regulated subsamples.

11
variable has a negative coefficient, indicating that for firms with the best governance

(scores between two and four, the democracy firms), debt is significantly lower than for

those with high governance scores. Furthermore, the dummy variable representing the

second set of governance quality firms (low governance score), with scores between five

and seven, also has a negative and significant coefficient. Finally, a third dummy variable

representing medium governance scores between eight and thirteen is also significant and

negative for the entire sample. Taken together, these results imply that firms with lower

governance scores (i.e., high governance quality firms) have the lowest levels of debt,

and those with high governance scores (i.e., dictatorships with weak shareholder rights)

have the highest level of debt. This result is consistent with our hypothesis regarding

shareholder rights and debt and with the 2SLS estimation results.

Regulation may substitute for debt in alleviating agency costs, so the association

between leverage and shareholder rights may differ in regulated firms. Accordingly, we

segregate the whole sample into industrial firms and regulated firms. Utility firms are

used to represent regulated companies. In models 3 and 4, we estimate the 2SLS and

OLS regressions on the industrial sample, excluding the utility firms. Like the results in

model 1 for the full sample, the predicted Governance Index from the first pass

regression has a positive and statistically significant coefficient in model 3 (the second

stage of the 2SLS regression). In model 4, the three governance dummies are significant

and negative, suggesting that for unregulated firms where shareholder rights are strongest

(i.e., an index of less than twelve), the need for debt as a monitoring mechanism is lower.

It appears that the results from the industrial sample are similar to those for the whole

sample.

12
 We analyze the regulated sample in models 5 and 6. The Governance Index does

not show a significant coefficient either in model 5 (the second stage regression from the

2SLS estimation) or model 6 (the dummy variable regression). The evidence suggests

that the significant negative association between leverage and shareholder rights does not

exist in regulated firms as it does in industrial unregulated firms10. This is in accordance

with the notion that regulation provides additional monitoring, which reduces agency

costs. Hence, the role of debt in mitigating agency conflicts is rendered less relevant in

regulated firms. There appears to be a trade-off between external and internal

mechanisms in controlling agency problems.

V. Concluding Remarks

The empirical results reveal an inverse relationship between capital structure and

the strength of shareholder rights. Debt seems to help mitigate agency costs in firms

where shareholder rights are restricted. In these firms, the debt ratio is positively related

to the degree of restrictiveness of corporate governance – the more suppressive the

governance, the weaker the shareholder rights and the higher the debt ratio. Further

analysis indicates that regulation substitutes for shareholder rights to reduce agency costs.

Specifically, there appears to be no relationship between leverage and shareholder rights

in regulated firms. We argue that this is the case because regulation already allays agency

costs (Kole and Lehn, 1997), hence, the role of debt in mitigating agency problems is less

10
A number of robustness checks are conducted. Although outliers are not particularly a problem, we
nevertheless exclude the extreme 1% of the observations and re-estimate the regressions. The results
remain similar. We also replace total leverage with long-term leverage and obtain qualitatively similar
results, although the degree of statistical significance is lower in some regressions. Moreover, to control for
variation across time, we create year dummies and include them in the regressions. The results remain
similar and, therefore, appear to be robust.

13
necessary in regulated firms. Regulation and debt seem to substitute for each other in

controlling agency costs.

14
 References

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MIT Press.

Bhagat, S., and B. Black, 2002, The non-correlation between board independence and
long term firm performance, Journal of Corporation Law 27, 231-273.

Booth, J., M. Cornett, and H. Tehranian, 2002, Board of Directors, Ownership, and
Regulation, Journal of Banking and Finance 26, pp 1973-1996.

Chung K. and S. Pruitt, 1994, A simple approximation of Tobin’s q, Financial

Management 23, 70-75.

DeAngelo, H. and R. Masulis, 1980, Leverage and dividend irrelevancy under corporate
and personal taxation, Journal of Finance 35, 453-464.

Demsetz, H. and B. Villalonga, 2002, Ownership structure and firm performance, UCLA
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Gompers, P., J. Ishii, and A. Metrick. 2003. Corporate governance and equity prices.
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Harford, J., S. Mansi, and W. Maxwell, 2005, Corporate governance and firms’ cash
holdings, Working paper, University of Washington, Seattle.

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Jiraporn, P., Y.S. Kim, W.N. Davidson, and M. Singh, 2005, Corporate governance,
shareholder rights, and firm diversification, Journal of Banking and Finance,
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Management 28, 47-56.

Klock, M., S. Mansi, and W. Maxwell, 2005, Does corporate governance matter to
bondholders? , Journal of Financial and Quantitative Analysis, forthcoming.

15
Kole, S. and K. Lehn, 1997, Deregulation, the evolution of corporate governance
structure and survival, American Economic Review, 87, 421-425.

Leland, H. and D. Pyle, 1977, Information asymmetries, financial structure, and financial
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Mehran, H., 1992, Executive incentive plans, corporate control, and capital structure,
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16
Table 1: Sample Distribution by Year

Year Full Sample Industrial Firms Utility Firms

1993 750 666 84

1995 804 722 82
1998 1,057 972 85
2000 990 913 77
2002 1,037 952 85
Total 4,638 4,225 413

Note: The sample includes firms whose corporate governance data are available from the Investor
Responsibility Research Center (IRRC). Firms that do not have sufficient financial data on COMPUSTAT
are excluded. The IRRC collect data only periodically; therefore, the governance data are available only for
1993, 1995, 1998, 2000, and 2003. Financial firms are not included. Firms whose SIC codes fall between
4900 and 4999 are classified as utility firms.

17
Table 2: Individual Governance Provisions Included in the Construction of the
Governance Index

Delay Other
Blank Check Anti-greenmail
Classified Board Directors' duties
Special Meeting Fair Price
Written Consent Pension Parachutes
Poison Pill
Protection Silver Parachutes
Compensation Plans
Contracts State
Golden Parachutes Anti-greenmail Law
Indemnification Business Combination Law
Liability Cash-out Law
Severance Directors' Duties Law
Fair Price Law
Voting Control Share Acquisition Law
Bylaws
Charter
Cumulative Voting
Secret Ballot (Confidential Voting)
Supermajority
Unequal Voting

Note: The detailed explanation for each governance provision is available in the Appendix of Gompers,
Ishii, and Metrick (2003).

18
Table 3: Summary Statistics: Industrial vs. Utility Firms

Full Sample Industrial Firms Utility Firms Difference

(t-statistics)
Sales
Mean 3,747 3,812 3,076 2.90***
Median 1,135 1,103 1,426
Max (Min) 244,524 244,524 61,257
(0.00) (0.00) (5.30)
Standard Deviation 9,426 9,703 5,154
Leverage
Mean 45.72% 45.38% 49.22% -6.78***
Median 45.00 45.00 47.00
Max (Min) 199.64 199.64 79.33
(0.00) (0.00) (14.33)
Standard Deviation 0.22 0.22 0.12
EBIT Ratio
Mean 15.19% 14.07% 26.62% -16.38***
Median 13.64 12.75 26.63
Max (Min) 414.96 414.96 75.30
(-0.99) (-0.99) (-0.99)
Standard Deviation 0.189 0.199 0.144
Tobin’s Q
Mean 1.51 1.57 0.91 25.55***
Median 1.08 1.13 0.89
Max (Min) 30.93 30.93 1.62
(-0.33) (-0.33) (0.15)
Standard Deviation 1.49 1.54 0.21
Fixed-Asset Ratio
Mean 35.78% 32.89% 65.39% -40.78***
Median 30.00 28.00 68.00
Max (Min) 97.00 97.00 89.00
(0.00) (0.00) (12.00)
Standard Deviation 0.23 0.21 0.15
Non-Debt Tax Shields
Mean 4.89% 4.99% 3.86% 13.96***
Median 4.00 4.00 4.00
Max (Min) 42.06 42.06 11.00
(0.00) (0.00) (0.01)
Standard Deviation 0.027 0.031 0.013
Governance Index
Mean 9.16 9.11 9.68 -4.33***
Median 9.00 9.00 10.00
Max (Min) 18.00 18.00 17.00
(2.00) (2.00) (2.00)
Standard Deviation 2.77 2.79 2.51

N 4,638 4,225 413

Note: Leverage is defined as total debt divided by total assets. The EBIT ratio is earnings before interest
and taxes divided by total assets. Tobin’s Q is as defined in Chung and Pruitt (1994). The fixed-asset ratio
is property, plant, and equipment to total assets. Non-debt tax shields are the ratio of the sum of
depreciation and amortization to total assets.

*, **, *** represents statistical significance at the 1%, 5%, and 10% levels, respectively

19
Table 4: Dictatorship vs. Democracy Portfolios.

Dictatorship Democracy Difference

(t-statistics)

Leverage 49.26% 44.36% 3.33***

(48.00) (43.50)

Leverage (Industry-adjusted) 3.67% -1.15% 3.33***

(2.50) (-2.50)

Sales 3,060 3,754 -0.86

(1,705) (670)

EBIT Ratio 14.83% 15.04% -0.17

(12.71) (14.22)

Tobin’s Q 1.20 1.69 -5.16***

(1.02) (1.16)

Fixed-Asset Ratio 37.95% 32.73% 3.15***

(33.00) (27.00)

Non-Debt Tax Shields 4.85% 4.74% 0.51

(5.00) (4.00)

Governance Index 14.57 4.46 178.28***

(14.00) (5.00)

N 265 492

Note: Firms whose Governance Index is greater than or equal to fourteen are placed in the dictatorship
portfolio, whereas firms whose Governance Index is less than or equal to five are included in the
democracy portfolio. Leverage is defined as total debt divided by total assets. The EBIT ratio is earnings
before interest and taxes divided by total assets. Tobin’s Q is as defined in Chung and Pruitt (1994). The
fixed-asset ratio is property, plant, and equipment to total assets. Non-debt tax shields are the ratio of the
sum of depreciation and amortization to total assets. Means are displayed in the table; medians in
parentheses.

*, **,*** statistically significant at the 10%, 5%, and 1% levels, respectively

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 Table 5: Regressions Analysis
Full Sample Industrial Firms Utility Firms
1 2 3 4 5 6
2SLS OLS 2SLS OLS 2SLS OLS

Intercept 0.105 -0.118 0.019 -0.122 0.295 0.095

(3.25)*** (-7.05)*** (0.37) (-6.97)*** (4.33)*** (2.24)**

Governance 0.034 - 0.039 - 0.086

Pred (3.56)*** (3.84)*** (1.27)

Democracy - -0.040 - -0.043 - 0.038

(-2.62)*** (2.70)*** (1.20)

Gov Low - -0.024 - -0.025 - 0.002

(-2.86)*** (-2.45)** (0.14)

Gov Med - -0.022 - -0.024 - -0.008

(-2.622)*** (-2.71)*** (-0.60)

Firm Size 0.060 0.021 0.065 0.022 0.046 0.009

(9.12)*** (11.30)*** (9.06)*** (10.69)*** (1.08) (2.38)**

Profitability -0.166 -0.137 -0.192 -0.141 -0.074 -0.191

(-5.54)*** (-9.11)*** (-5.90)*** (-8.77)*** (-1.41) (-6.21)***

Fixed-Asset -0.004 -0.025 -0.018 -0.049 -0.298 -0.232

Ratio (-0.19) (-1.90)* (-0.69) (-3.06)*** (-4.68)*** (-6.93)***

Growth -0.018 -0.011 -0.017 -0.010 0.108 0.072

Opportunities (-7.29)*** (-5.65)*** (-6.65)*** (-5.03)*** (2.47)** (3.00)***

Non-Debt Tax 0.649 0.787 0.756 0.914 -0.744 0.007

Shields (4.35)*** (8.17)*** (9.06)*** (8.66))*** (1.47) (0.02)

F-statistics 44.11*** 44.12*** 41.84*** 41.15*** 5.64*** 17.01***

Adjusted R2 16.50% 6.90% 16.82% 7.10% 22.10% 23.70%

N 1,309 4,637 1,210 4,224 99 412

Note: Governance Pred is the predicted Governance Index from the first-stage regression. Leverage is
defined as total debt divided by total assets. The EBIT ratio is earnings before interest and taxes divided by
total assets. Tobin’s Q is as defined in Chung and Pruitt (1994). The fixed-asset ratio is property, plant, and
equipment to total assets. Non-debt tax shields are the ratio of the sum of depreciation and amortization to
total assets. Firms whose SIC codes fall between 4900 and 4999 are classified as utility firms. Democracy
represents governance scores between zero and four. Gov Low represents scores between five and seven.
Gov Med represents governance scores between eight and thirteen. Results are shown from the second
stage regression of the 2SLS where outside affiliated block ownership is used in the first pass regression.
The t-statistics are shown in parentheses.

*, **, and *** statistically significant at the 10%, 5%, and 1% levels, respectively

21

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