Corporate governance and capital structure in developing countries: a case study of Bangladesh

Abstract

This paper investigates the influence of firm-level corporate governance on the capital structure pattern of non-financial listed firms, using a case study of Bangladesh. The agency theory suggests that better corporate governance will reduce agency costs and improve investor confidence, which in turn will enhance the ability of a firm to gain access to equity finance, reducing dependence on debt finance. Conversely, the controlling shareholders of poorly governed firms are likely to prefer debt, in order to retain absolute ownership and control rights. The OLS regression framework uses a questionnaire-survey based Corporate Governance Index (CGI). The study results seem to support agency theory, with a statistically significant inverse relationship between corporate governance quality and the total as well as long-term debt ratios.

Notes

¹ Shleifer and Vishny (1997, p. 737) define corporate governance as ‘the ways in which suppliers of finance to corporations assure themselves in getting a return on their investment’.

² Chowdhury (2004) investigates the determinants of debt finance, but does not take into account the governance issues.

³ Note that capital structure, leverage and debt finance are used interchangeably throughout the article.

⁴ Jensen (1986) argues that the obligation of paying debt along with its interest reduces free cash flow and thus managers refrain from using the free cash for nonoptimal activities. Grossman and Hart (1982, cited in Harris and Raviv, 1991) also observe that debt finance increases the probability of costly bankruptcy and subsequent job loss, and thus encourages managers to work harder, consume fewer perquisites and make better investment decisions.

⁵ Several studies (e.g. La Porta et al., 1997; Shleifer and Vishny, 1997) suggest that corporate governance and associated better shareholder and creditor rights enhance the firm's ability to gain access to external finance.

⁶ According to the pecking order theory of corporate finance, retained earnings tend to be the most favoured forms of a firm's financing, followed by debt and then equity finance (Singh, 2003).

⁷Black et al. (2005) explain two different perspectives of firm level endogeneity: reverse causality and signalling effect. Reverse causality refers to the notion that firms with better financial performance prefer to adopt best practices of governance rather than vice-versa, whereas signalling effect explains that firms adopt better governance practices to signal high quality.

⁸ Among others, Klapper and Love (2004) and Drobetz et al. (2004) argue that adding appropriate control variables can be one way to mitigate the problem of omitted variables, endogeneity or reverse causality.

⁹ The financial sector appears to dominate the market behaviour of the DSE, with nearly 52% (including banking firms with 47%) of the total market capitalization, and 53% of the total turnover (DSE Review Dec. 2004).

¹⁰ A sub-index is constructed by summing up the values of all variables (between 1 and 0, with 1 being the compliance with better governance, and 0 otherwise) within that index, which is divided by the number of ‘nonmissing’ variables. The ratio is then multiplied by 20 to have the sub-index value between 0 and 20. The overall CGI is finally constructed by adding up the values of all five sub-indices, and it carries a value between 0 and 100, with higher index scores denoting the better-governed firms.

¹¹ Note that the firm-specific scoring of the corporate governance practices in Bangladesh might not be comparable to international governance ratings. Given the persistent inefficiency in the legal and enforcement structures, the study is intended to measure the relative voluntary activism and/or legal compliance of the firm in corporate governance matters.

¹² Note that the regression specification of column 3 is estimated by substituting the CGI with each of the five governance sub-indices, which is not shown in the article. The regression results suggest that all five sub-indices are negatively associated with the debt ratio, and all but the ownership sub-index coefficient is statistically significant.

¹³ Alternatively, better corporate governance reduces agency cost of equity, which in turn enhances the firm's ability to raise equity finance and reduces the firm's reliance on debt.

¹⁴ Also, the country's stock market, with its small size (the ratios of market capitalization to GDP in 2003 and 2004 were around 2.42 and 4.11%) does not seem to have any significant contribution to the firm's financing.

¹⁵ See also Sobhan and Werner (2003).