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Capital Structure, CEO Dominance, and Corporate Performance

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Abstract

We use agency theory to investigate the influence of CEO dominance on variation in capital structure. Due to agency conflicts, managers may not always adopt leverage choices that maximize shareholders’ value. Consistent with the prediction of agency theory, the evidence reveals that, when the CEO plays a more dominant role among top executives, the firm adopts significantly lower leverage, probably to evade the disciplinary mechanisms associated with debt financing. Our results are important as they demonstrate that CEO power matters to critical corporate outcomes such as capital structure decisions. In addition, we find that the impact of changes in capital structure on firm performance is more negative for firms with more powerful CEOs. Overall, the results are in agreement with prior literature, suggesting that strong CEO dominance appears to exacerbate agency costs and is thus detrimental to firm value.

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Notes

  1. The literature in this area uses several expressions to refer to CEO dominance. In this study, we use CEO power, CEO dominance, and CEO centrality interchangeably.

  2. This view is predicated on an argument made by La Porta et al. (2000) for the substitution effect between corporate governance and dividend payouts.

  3. For instance, Pfeffer (1981) asserts that perceptual measures assume that social actors are knowledgeable about power within their organizations; informants are willing to divulge what they know about power distribution; and such a questioning process will not itself create the phenomenon under study.

  4. CPS could be interpreted as a measure of “tournament incentives”, where executives compete for a promotion with larger CEO pay as the ultimate prize. A large CPS may represent larger tournament incentives that motivate executives to work more diligently to obtain the prize. It is difficult, however, to reconcile this interpretation of CPS with Bebchuk et al.’s (2011) findings that imply governance problems, such as lower firm value, poorer accounting profitability, higher likelihood of awarding the CEO a “lucky” option grant at the lowest price of the month, and lower sensitivity of CEO turnover to firm performance. It is not clear why these empirical results would be related to the tournament incentives.

  5. We identify each industry using the first two digits of the SIC. An industry adjustment is accomplished by calculating the difference between the firm’s raw debt ratio and the median debt ratio of the industry in which the firm operates.

  6. Free cash flow is computed as earnings plus depreciation and amortization minus capital expenditures.

  7. In alternative tests, we use industry-adjusted CPS and obtain similar results although the degree of significance is somewhat lower.

  8. The first two-digits of the SIC are used to identify industries.

  9. The results are not shown but available upon request.

  10. The dependent variable is industry-adjusted book leverage. Using market leverage yields similar results.

  11. In a related study, Liu and Jiraporn (2010) find that staggered boards promote managerial entrenchment and allow managers to adopt sub-optimal leverage. However, the abnormal leverage attributed to staggered boards does not affect firm value.

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Authors and Affiliations

  1. School of Graduate Professional Studies, Pennsylvania State University, Malvern, 19355, PA, USA

    Pornsit Jiraporn

  2. Thammasat University, Bangkok, Thailand

    Pornsit Jiraporn

  3. National Institute of Development Administration (NIDA), Bangkok, Thailand

    Pornsit Jiraporn

  4. Business Administration Division, Mahidol University International College (MUIC), Salaya Nakorn Pathom, Thailand

    Pandej Chintrakarn

  5. University of New Hampshire, Durham, 03824, NH, USA

    Yixin Liu

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  1. Pornsit Jiraporn
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Correspondence to Pandej Chintrakarn.

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Jiraporn, P., Chintrakarn, P. & Liu, Y. Capital Structure, CEO Dominance, and Corporate Performance. J Financ Serv Res 42, 139–158 (2012). https://doi.org/10.1007/s10693-011-0109-8

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