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Political connections and corporate financial decision making

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Abstract

This paper investigates whether and how political connections influence managerial financial decisions. Our study reveals that those firms that have a politician on its board of directors are highly leveraged, use more long-term debt, hold large excess cash and are associated with low quality financial reporting compared to their non-connected counterparts. These effects escalate with the strength of the connected politician and whether he or his party is in power. The winning party effect is observed to be stronger than victory by the politician himself. Overall, our paper provides strong evidence that political connection is a two-edged sword. It is indeed a valuable resource for connected firms, but it comes at a cost of higher agency problems.

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Notes

  1. The only notable exceptions are Faccio (2010) and Boubakri et al. (2013). Faccio examines the impact of political connections that firms can have on leverage, taxation, market share, productivity and performance, whereas Boubakri et al. report the effects of political connectedness on a firm’s leverage and operating performance.

  2. The existing literature puts forth two main arguments for holding large cash balances: the transaction cost motive and the precautionary cost motive (Hill et al. 2014; Ozkan and Ozkan 2004). The former emphasises that firms incur higher transaction costs to generate cash reserves and, therefore, tend to hold larger cash reserves. On the other hand, the latter motive asserts that firms accumulate liquid assets to meet unexpected contingencies and also to finance the future investments if the cost of external finance is prohibitively high. In contrast, Jensen (1986) argues that large internal funds may increase the agency costs by enhancing the entrenched manager’s autonomy, which consequently weakens the market discipline.

  3. As discussed in Sect. 2, in the last two and half decades, six elected governments were dissolved—a direct reflection of political instability and state of uncertainty in the Pakistani institutional setting.

  4. We also assess the robustness of our results to the instrumental variable technique (Heckman two-stage analysis), which will be discussed in the Sect. 6.

  5. To avoid human error, the sample selection process (matching of politicians with the names of directors) is performed by applying programming-code.

  6. The Trade-off theory originated with Modigliani and Miller’s (1958) famous proposition, while the Pecking order theory was developed by Myers and Majluf (1984) and Myers and Majluf (1984).

  7. We are grateful to the referee for pointing out this issue.

  8. However, Chen and Zhao (2006) contend that the relation between the growth opportunities (market-to-book ratio) and leverage is non-monotonic.

  9. We follow Javorcik and Spatareanu (2011) and Kimura and Kiyota (2007) in defining foreign ownership.

  10. We are grateful to the referee for pointing this out.

  11. We also conducted the regression analysis for the impact of a politician on short-term and long-term debt separately. Our results (untabulated) show a statistically insignificant impact of corporate political connections on short-term debt, whereas a positive and significant effect is found on long-term debt.

  12. Recall that a positive sign on Connected indicates that connected firms have greater incentives to manipulate earnings for political purposes, which in turn deteriorate the accruals quality.

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Authors and Affiliations

  1. Cranfield University, Cranfield, UK

    Yacine Belghitar

  2. Middlesex University, London, UK

    Ephraim Clark

  3. COMSATS University, Islamabad, Pakistan

    Abubakr Saeed

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  1. Yacine Belghitar
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  2. Ephraim Clark
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Belghitar, Y., Clark, E. & Saeed, A. Political connections and corporate financial decision making. Rev Quant Finan Acc 53, 1099–1133 (2019). https://doi.org/10.1007/s11156-018-0776-8

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