The Cost of Debt Capital and Corporate Governance Practices

Transcription

1 Asia-Pacific Journal of Financial Studies (2007) v36 n5 pp The Cost of Debt Capital and Corporate Governance Practices Hae-Young Byun ** Seoul National University, Seoul, Korea Received 05 March 2007; Accepted 17 September 2007 Abstract This study examines the association between the cost of debt capital and corporate governance practices. Utilizing a unique data set of firm-level corporate governance practices that is provided by the Korea Corporate Governance Service (KCGS), this study examines whether sound corporate governance practices reduce agency costs and thus the default risk and cost of debt capital of a firm. The findings indicate that corporate governance practices are negatively related to the cost of debt capital after controlling for relevant control variables and that the association between the cost of debt capital and corporate governance practices is more pronounced in firms that have assets of more than 2 trillion won (approximately US$2 billion). Thus, the results strongly suggest that sound corporate governance practices work favorably to lower the cost of external debt financing. Keywords: Cost of debt capital; Corporate governance; Shareholder rights protection; Dividend policies; Audit committee * I gratefully acknowledge the Korea Corporate Governance Service for proving the data on corporate governance practices of Korean listed companies. I thank helpful comments by two anonymous reviewers, Tae-Sik Ahn, Jong-Hag Choi, Lee-Seok Hwang, Woon-Oh Jung, Su-Keun Kwak, Hyun-Han Shin, Seung-Weon Yoo, and Yong-Keun Yoo. Any errors are my own. ** Corresponding Author. Address: Doctoral student of the College of Business Administration, Seoul National University, Bldg 58, Suite 415, Sillim-9dong, Gwanak-gu, Seoul, Korea, ; hb70@snu.ac.kr; Tel: ; Fax:

2 The Cost of Debt Capital and Corporate Governance Practices 1. Introduction This study examines the association between the cost of debt capital and corporate governance practices in Korea. Although one of the key factors that contributed to the 1997 financial crisis in Korea was the heavy debt, incurred by the top Korean conglomerates (hereafter, chaebol groups), relatively few empirical studies have used firm-specific data to examine the relation between the cost of debt capital and corporate governance practices. Since the financial crisis, the poor corporate governance practices of chaebol groups have become a contentious issue. Reform of the governance systems of chaebol groups has been both voluntary and mandatory. Although government regulations have facilitated the reform, there is still doubt that the reform efforts are satisfactory. Scandals about unlawful inheritances and accounting frauds in chaebol groups still make headlines. In addition, according to the results of a survey conducted by the Korea Institute for Industrial Economics and Trade (KIET) in August 2003, managers of 77 Korean listed companies do not consider corporate governance to be an important factor in enhancing firm value or stock price. While this evidence is anecdotal, it provides an important clue about the perspective of those who are responsible for the reform of corporate governance practices. 1) The purpose of this research is to develop hypothesis related to corporate governance systems based on agency theory and to test this hypothesis in the context of the cost of debt capital. There is abundant prior literature on corporate governance systems and firm value (e.g., Mitton, 2002; Fan and Wong, 2002; Classens, Djankov, Fan, and Lang, 2002; Lemmon and Lins, 2003; Joh, 2003; Baek, Kang, and Park, 2004; and Black, Jang, and Kim, 2006a). Many of these studies focus on the relation between corporate governance and equity valuation, and suggest that improved corporate governance practices result in an increase in firm value or stock price. While corporate governance generally benefits shareholders, however, it could also entail different consequences for debtholders. While there is the alignment of interests between debtholders and shareholders, there are also the potential conflicts of interests 1) Of the managers who responded, 66% believe that corporate governance has improved due to government enforcement. However, 45.9% of those who responded believe that the improvement in corporate governance has nothing to do with firm performance. Managers pointed out that one important reason for the lack of influence of corporate governance on firm performance was the weak power of outsider shareholders. The second reason that was given was that the imported global standards of corporate governance do not fit Korean firms well. 766

3 Asia-Pacific Journal of Financial Studies (2007) v36 n5 between them. Therefore, the net impact of strong shareholder governance on debtholders is theoretically unclear and thus remains as an empirical question which needs to be specifically addressed (Anderson, Mansi, and Reeb, 2003b; Klock, Mansi, and Maxwell, 2005; Ashbaugh-Skaife, Collins, and Lafond, 2006; Cremers, Nair, and Wei, 2007). In addition, this study investigates the association between firm value and corporate governance from the perspective of debtholders for the reasons that are outlined by Mansi, Maxwell, and Miller (2004) and Klock et al. (2005). They argue that the debt market is a natural setting to examine the economic impact of corporate governance because; (1) debt represents a significant portion of the value of a typical corporation, and debtholders can provide an equilibrium point between shareholders and managers; (2) the information environment in the debt financing market is characterized by credit rating agencies and banks; and (3) debt pricing is relatively well defined and has small measurement errors compared with equity pricing. Several studies examine the relation between the cost of debt capital and firmspecific governance systems (Sengupta, 1998; Bhojraj and Sengupta, 2003; Anderson et al., 2004; Ashbaugh-Skaife et al. 2006; Klock et al., 2005; Cremers et al., 2007). These studies focus on the effect of one aspect of firm governance systems or information quality on the cost of debt capital of firms. The recent studies of Anderson et al. (2004) and Ashbaugh-Skaife et al. (2006) are particularly relevant to this paper as they find that the cost of debt is reduced in firms that have strong corporate governance practices. This study uses firm-specific corporate governance score data for the period of 2001 to 2004, obtained from the Korea Corporate Governance Service (hereafter, KCGS), an independent non-profit organization that is under the joint sponsorship of six securities-related organizations in Korea. This data set of comprehensive corporate governance practices is divided into five categories: shareholder rights protection, board of directors, corporate disclosure, audit committee, and dividend policies. This study examines four proxies of cost of debt capital industry-adjusted leverage ratio, interest rates, bond ratings, and bond spreads patterned after prior studies (e.g., Faccio, Lang, and Young, 2004; Pitman and Fortin, 2004; Mansi et al., 2004; Bhojraj and Sengupta, 2003). The testable hypothesis predicts that the cost of debt capital is reduced in firms with sound corporate governance practices. Consistent with the hypothesis, this study finds that firms with sound corporate 767

4 The Cost of Debt Capital and Corporate Governance Practices governance practices have lower industry-adjusted leverage ratios, lower interest rates, and higher bond ratings. The results also provide evidence that the relation between the cost of debt capital and corporate governance practices is more pronounced in firms that have assets of more than 2 trillion won (approximately US$2 billion). Finally, the results indicate that of the five corporate governance practices, dividend policies, shareholder rights protection, and audit committee are significant factors in lowering the cost of debt capital. This study contributes to the extant literature on corporate governance and firm valuation in several ways. First, it investigates whether the corporate governance systems that were adopted in the aftermath of the 1997 financial crisis based on global standards work favorably in Korea s external debt market. The results of this investigation provide the first evidence that global standards of corporate governance have an economic impact on the cost of debt financing. 2) Second, this study can provide independent verification of the usefulness of the KCGS scores. The scores are already used to select firms that demonstrate good corporate governance for inclusion in the Korea Corporate Governance Stock Market Price Index (KOGI). 3) Third, this study is the first comprehensive attempt to examine the relation between corporate governance practices and the cost of debt capital of Korean listed firms. This study also adds to the information on the bond market for potential investors, who conjecture that the Korean bond market is not as efficient as the stock market. 4) This study is organized as follows. Section 2 reviews the literature on the relation between corporate governance and firm value, with a focus on the cost of debt capital. Section 3 describes the research design and the empirical measure of proxies of the cost of debt capital. Section 4 discusses the main results and robustness checks. Section 5 discusses additional analysis, and section 6 concludes the study. 2) Before the 1997 financial crisis, a sound corporate governance mechanism of Korean listed firms did not exist. Since the financial crisis, explicit income shifting measures of chaebol groups, such as cross shareholding, reciprocal debt guarantees, and internal transactions, have been restricted. However, the public is still suspicious of the effect of corporate governance reform by the Korean government. 3) Currently, 50 firms belong to the KOGI. According to a report by the KCGS, the KOGI is used as an underlying index for exchange traded funds, particularly for long-term investors who seek solid returns from equity investments. For the period from January, 2003 to September, 2004, the KOSPI shows a 9% average return with a standard deviation of 1.59%, whereas the KOGI shows a 7% average return with a standard deviation of 1.49% (See Evaluation Results of Corporate Governance in the Korean Stock Market by the KCGS, 2004). 4) See Won (2005). Analysis on bond market liberalization and its impact on the market after financial crisis. Journal of Korean Economic Development 11:

5 Asia-Pacific Journal of Financial Studies (2007) v36 n5 2. Research and Development of the Hypothesis 2.1 Corporate Governance in Emerging Markets Due to the Asian financial crisis, recent researches on corporate governance in emerging markets focus on the relation between corporate governance and firm value. Typical in emerging markets, a concentrated ownership structure (e.g., stock pyramids and cross ownership) makes it difficult for outside shareholders to monitor corporate insiders (e.g., controlling shareholders and their associated managers). A common view supports that weak corporate governance systems impair firm value. Empirical evidence for this argument is presented in several cross-country studies which examine the relation between corporate governance and firm performance (Johnson, Boone, Breach, and Friedman, 2000; Classens, Djankov, and Lang, 2000; Mitton, 2002). Using the ownership structure of 977 companies in seven East Asian economies, Fan and Wong (2002) show that concentrated ownership is related to low earnings informativeness because concentrated ownership forbids the disclosure of the proprietary information of firms to protect their rent-seeking activities. Haw, Hu, Hwang, and Wu (2004) also find that income management which is the result of the separation of the voting rights and cash flow rights of concentrated ownership is greater in countries in which statutory protection of minority rights and extra-legal institutions (i.e., the effectiveness of competition laws, diffusion of the press, and tax compliance) is not high. Poor corporate governance systems are considered a primary reason for the value discount of Korean listed firms. 5) Concentrated ownership of chaebol groups in which there was a large divergence between the voting rights and cash flow rights appeared to play a main role in the poor corporate governance systems before the financial crisis. Joh (2003) examines how controlling shareholders in a concentrated ownership expropriate firm resources even when the ownership concentration is small. Baek et al. (2004) find that changes in firm value during the 1997 financial crisis are associated with firm-specific corporate governance systems. Black et al. (2006a, 2006b) re- 5) According to Kim and Lee (2003), global money managers think that the Korea Discount is due to the poor corporate governance system of Korean companies. See also Choe and Lee (2003) for the association between governance structure and stock returns. 769

6 The Cost of Debt Capital and Corporate Governance Practices port that after the financial crisis, corporate governance is an important factor in explaining the market value of Korean listed companies. In fact, firms that have 50% or more outside directors have an approximately 40% higher share price. 2.2 The Effect of Corporate Governance on Debt pricing Several studies examine the effect of corporate governance systems on debt pricing. Using disclosure scores as proxies for asymmetry of information in the market, Sengupta (1998) finds that firms with high disclosure quality ratings from financial analysts enjoy a lower effective interest cost of issuing debts; firms with more timely and informative disclosures are perceived to have a lower likelihood of hiding bad information. As a result, it is expected to be charged a lower risk premium by debtholders. Bhojraj and Sengupta (2003) argue that effective monitoring of management affects bond yields and ratings through its impact on the default risk of firms. Specifically, firms with greater institutional ownership and stronger outside control of the board have lower bond yields and higher ratings of their bond issues. Anderson et al. (2004) presume that the control of financial reporting quality by the board of directors is the most important thing, since debtholders count on accounting based covenants in their loan agreements. Consistent with the conjecture, they confirm the significantly negative relation between the cost of debt capital and the existence of an independent board and audit committee. Ashbaugh-Skaife et al. (2006) also find that the credit ratings of firms are positively related to board independence, board stock ownership, and board expertise by monitoring management. This indicates that better board structure and processes lead to strong monitoring of management that restrict managerial opportunism. Furthermore, financial transparency such as accrual quality and earnings timeliness is positively associated with credit ratings. However, firms with strong shareholder rights have lower credit ratings and a higher cost of debt financing because shareholders can exercise their influence to affect wealth transfers from bondholders through asset substitution or exposure to takeover. Similarly, Anderson et al. (2003b) and Klock et al. (2005) examine the impact of weak shareholder rights such as founding family ownership or various anti-takeover provisions on the cost of debt capital, respectively. The results indicate that founding 770

7 Asia-Pacific Journal of Financial Studies (2007) v36 n5 family ownership or strong anti-takeover provisions are associated with a lower cost of debt financing. This means that founding family ownership or strong anti-takeover provisions, although not beneficial to shareholders, are viewed favorably in the bond market. Cremers et al. (2007) provide additional evidence on the anti-takeover provisions on the cost of debt capital. They find that shareholder control is associated with higher (lower) bond yields if the firm is exposed to (or protected from) takeovers. They also argue that these results are derived from the interest divergence between shareholders and bondholders and that the role of bond covenants is important to decrease the conflict between shareholders and debtholders. 2.3 Development of the Hypothesis This paper investigates the effects of corporate governance systems on debtholders. It is assumed that a well-designed corporate governance system can reduce the possibility of information asymmetry and managerial opportunistic behavior, and therefore outside investors (i.e., shareholders and debtholders) discount of the future firm value at a lower rate of return. Based on the agency theory, this paper offers the directional hypothesis that the cost of debt capital is reduced in firms with sound corporate governance practices. Ashbaugh-Skaife et al. (2006) explain debt pricing based on agency theory. They address that bondholders, and more generally debt stakeholders, face two types of agency conflicts that increase the probability of default. First, agency conflict happens in the relation between management and bondholders since self-interest managerial behavior induces information asymmetry and creates moral hazard problems. Second, agency conflict that bondholders face occurs in the relation between shareholders and bondholders since shareholders in levered firms have incentives to make decisions that can transfer wealth from bondholders to themselves. This wealth transfer can affect the persistence of the firm s future cash flows and thus increase the probability of default. 6) According to Ashbaugh-Skaife et al. (2006), some of the corporate governance attributes may protect the interests of bondholders by mitigat- 6) Ashbaugh-Skaife et al. (2006) refer to the role that governance plays in mitigating the agency conflicts between management and all stakeholders as the management disciplining hypothesis. Alternatively, they refer to the role that governance features that weaken shareholder rights as the wealth redistribution hypothesis. 771

8 The Cost of Debt Capital and Corporate Governance Practices ing either the conflict between management and bondholders or the conflicts between shareholders and bondholders. However, corporate governance systems that protect the interest of shareholders will not necessarily be aligned with the interest of debtholders. Using KCGS s framework, this paper investigate corporate governance practices that potentially affect firm s debt pricing. KCGS develops a comprehensive framework for evaluating corporate governance that is based on five governance categories; shareholder right protection, board of directors, corporate disclosure, audit committee, and dividend policy. This paper also investigates the effect of dividend policy on debtholders because dividend policy is treated as one of corporate governance practices by KCGS. Prior literature explains dividend policy as a consequence of agency conflicts. Dividends reduce the cash flow that is under the control of managers or controlling owners and their power to spend on negative net present value projects (Jensen and Meckling, 1976; Jensen, 1986). Furthermore, dividends may impose additional monitoring by forcing the managers to address the external financing market, and may be useful in adjusting the level of risk taken by managers (Easterbrook, 1984). 7) Managers even signal superior future performance to decrease information asymmetry by increasing dividends (Bhattacharya, 1979; Miller and Rock, 1985; John and Williams, 1985). 8) However, there is no prior study that documents the impact of dividend policy on bondholders directly when better monitoring of management occurs. In general, shareholders and bondholders have a conflicting interest over dividend policy. If shareholders demand direct payouts of firm assets (dividends or share repurchases) as opposed to supporting the manager s investments in positive net present value projects, then the mean of a firm s future cash flow distribution could be lower. Consequently, the reduction in a firm s expected future cash flows increases bondholders default risk, thereby reducing bond prices (Easterbrook, 1984). According to prior studies, the net impact of corporate governance practices including dividend policy on debtholders is unclear and the effects of overall corporate governance systems on deb- 7) Jensen (1986) also explains the benefit of debt in reducing agency costs of free cash flow. He notes that debt financing enables managers and their organizations to be more efficient in paying out future cash flow. Thus, debt reduces the agency costs of free cash flow as an effective substitute for dividends. He also emphasizes that this control function of debt is especially important for shrinking firms with large cash flows and low growth opportunities. 8) As a relevant theory on dividend policy, empirical paper has examined the use of changes in dividends as a signal of the future prospects of a firm. The argument that dividends signal the well-being of the firm to investors and so promote confidence is called signaling theory. 772

9 Asia-Pacific Journal of Financial Studies (2007) v36 n5 tholders are ultimately an empirical issue. 9) 3. Model Development and Research Variables 3.1 The Regression Models This paper sets the main models using the corporate governance score (CGSCORE) constructed by the KCGS to estimate the relevance of the four proxies of the cost of debt capital. Each dependent variable has a different set of control variables. All of the control variables are derived from the prior literature. The four pooled crosssectional models are as follows. ADJ_LEV1 = α + β1cgscore (FAC1 ~ FAC5) + β2lntasset + β3altman + β4tobinq + β5 SGROWTH + β6collat + β7beta + β8perform + β9year Dummy + β10 Industry Dummy + ε (1) INT_RATE = α + β1cgscore (FAC1 ~ FAC5) + β2lntasset + β3sgrowth + Β4COLLAT + Β5INT_COV + β6cashflow + β7lev + β8year Dummy + β9 Industry Dummy + ε (2) WRATING = α + β1cgscore (FAC1 ~ FAC5) + β2lntasset + β3beta + β4bm + β5lev + Β6RETVOL + β7perform + β8wtmature + β9lwtisize + β10year Dummy + β11industry Dummy + ε (3) WSPREAD = α + β1cgscore (FAC1 ~ FAC5) + β2lntasset + β3sgrowth + Β4 BETA + Β5 BM + Β6LEV + β7retvol + β8perform + β9lwtisize + β10 WDURAT + β11 WCONVEC + β12wbage + Β13Year Dummy + β14 Industry Dummy + ε (4) 3.2 Research Variables Dependent Variables ADJ_LEV1 = industry-adjusted leverage ratio estimated as each corporation s leverage ratio minus the median of the ratio in the same industry; 9) Ahmed, Billings, Morton, and Stanfors-Harris (2002) find that firms facing more severe conflicts over dividend policy tend to use more conservative accounting. Furthermore, accounting conservatism is associated with a lower cost of debt capital. 773

10 The Cost of Debt Capital and Corporate Governance Practices INT_RATE WRATING WSPREAD = interest rates on the firm s debt measured by interest expenses divided by the firm s average short-term and long-term financial debt; = the weighted average bond rating; = the weighted average spread estimated using the difference between the weighted average yield to maturity of the firm s outstanding traded bonds and the yield to maturity of treasury bonds with a similar time to maturity. Test Variables CGSCORE FAC1 FAC2 FAC3 FAC4 FAC5 = corporate governance overall score consisting of five categories; = shareholder rights protection score; = board of directors score; = corporate disclosure score; = audit committee score; = dividend policies score. Control Variables LNTASSET = firm size measured by the natural log of the total assets of the firm; ALTMAN = Altman s Z score estimated using Altman s equation (1968); TOBINQ = Tobin s Q measured by the market value of equity plus the book value of debt scaled by total assets; SGROWTH = sales growth computed as the percentage change in sales amount; COLLAT = asset tangibility as a ratio of fixed to total assets; PERFORM = firm performance estimated as income before extraordinary items to total sales; INT_COV = interest coverage as a ratio of the income before extraordinary items and interest expenses divided by interest expenses; CASHFLOW = firm profitability measured by cash flow from operations scaled by total assets; BETA = stock beta calculated by the capital asset pricing model over a 60 monthperiod; RETVOL = return volatility estimated as the standard deviation of residuals from the market model regression using daily returns over a one-year period; BM = book to market as a ratio of the book value of equity to the market value of equity; LEV = leverage estimated as the long-term debt scaled by the market value of equity; WTMATURE = the weighted average time to maturity of bonds; LWTISIZE = log of the weighted average bond issue size; WDURAT = the weighted average bond duration; WCONVEC = the weighted average bond convexity; WBAGE = the weighted average bond age computed as the difference between the observation year and the issue year. 774

11 Asia-Pacific Journal of Financial Studies (2007) v36 n5 The industry-adjusted leverage ratio (ADJ_LEV1) serves as a proxy for the potential cost of capital concerns and incentives of firms to strengthen their financial reporting interest (Newberry and Mills, 2005). ADJ_LEV1 is also used as a proxy of the agency cost of debt for the expropriation of controlling shareholders who facilitate more debt resources to use for their private interest (Faccio et al., 2004). This estimate is the broadest proxy of the cost of debt capital and uses total debt and total assets. This study adds the alternative leverage measure, ADJ_LEV2, which is the ratio of total debt to total debt and equity. Interest rates (INT_RATE) is a less broad proxy than ADJ_LEV1, as only interestbearing liabilities of short-term debt and long-term debt are estimated. As discussed in Pittman and Fortin (2004), INT_RATE may be a noisy proxy of the cost of debt capital because of the indirect way of estimating the dependent variable. They handle the noisy problem by dropping the extreme observations. Following Pittman and Fortin (2004), this study drops the extreme observations that are outside the 1st or 99th percentiles of INT_RATE to alleviate the measurement error. The proxies that are related to bond pricing (e.g., WRATING and WSPREAD) are the narrowest proxies and use only publicly traded debt securities. Specifically, bond ratings (WRATING) are measured by conversion numbers using one value from 1 to 10 that represents the KIS-NET bond ratings from AAA to BBB-. 10) The weighted average bond spread (WSPREAD) of a firm is calculated by multiplying each bond spread with its equivalent weight, which is computed as the amount outstanding for each bond divided by the total amount outstanding for all publicly traded bonds. The corporate governance score that is used in this study has a distinct advantage over other corporate governance variables that have been used in prior studies (Sengupta, 1998; Bhojraj and Sengupta, 2003). Prior studies investigate just one variable of corporate governance, which can cause the correlated omitted variables problem and in turn, biased estimates. The KCGS s overall score of corporate governance in- 10) Anderson et al. (2003b, 2004) use credit rating as a control variable for their spread analysis. They point out a potential problem in that credit rating can incorporate the impact of test variables (e.g., family ownership or board structure). To alleviate this concern, they use an error term as an estimate of the debt credit ratings by regressing credit ratings on those components. However, this study does not use bond ratings as a control variable for bond spread analysis. If bond ratings are included in the model as a control variable, the incremental effect of the test variable (i.e., the CGSCORE) may be lessened (Bhojraj and Sengupta, 2003). To deal with this issue, this study presents the main results using an extensive set of control variables, which are derived from prior literature on the determinants of corporate bond ratings, to capture the default risk of firms. 775

12 The Cost of Debt Capital and Corporate Governance Practices tegrates a number of aspects of corporate governance practices within reasonable limits. This solves the correlated omitted variables problem as each of the five categories that are correlated with each other predicts the cost of debt capital separately. Therefore, this study can examine the overall and respective effects of corporate governance practices on the cost of debt capital. Ashbaugh-Skaife et al. (2006) address the same issue and use a broad set of corporate governance practices in their study. The corporate governance scores are divided into five categories. Shareholder rights protection (FAC1) consists of three parts: shareholder rights provisions, controlling ownership structure, and related party transactions. Board of directors (FAC2) consists of two parts: the board structure and the meeting procedure. Corporate disclosure (FAC3) comprises management transparency and the voluntary and mandatory disclosure behaviors of the corporation. Audit committee (FAC4) includes the structure and procedures of the audit committee. Dividend policies (FAC5) comprises the dividend yield, dividend payout ratio of the past three years, and treasury stock purchases. Firms with better corporate governance systems have higher scores. This paper includes Appendix for more detail information on survey questions. 11) Control variables include both firm characteristics and bond characteristics. To mitigate endogeneity concerns, this study uses one-year lagged data for firm characteristics. For bond characteristics, however, contemporaneous data are used. Firm size (LNTASSET) is associated with the cost of debt capital of a firm either positively or negatively. Firm size is a proxy for both the reduced probability of bankruptcy risk and the better information environment of large firms. Thus, it is hard to predict the 11) The score should be credible based on the purpose of the KCGS survey. The KCGS established the survey to choose well-governed firms for the KOGI, which encourages listed companies to improve their corporate governance. Especially, the survey for 2003~2004 is well constructed by an objective question format that is based on the inclusion or omission of approximately 100 items of corporate governance practices. Several papers use same data set to investigate the effect of the corporate governance system on various topics. Yoon and Oh (2005) examine the effects of corporate governance on the firm s performance, market value and market returns of Korean listed companies. They find that a firm s performance and market value are highly correlated with its corporate governance score. Furthermore, they conclude that an investment strategy using the information on corporate governance score can produce excess returns. Park, Park, and Hwang (2005) also use the same data set to investigate the relation between corporate governance and wealth redistribution to shareholders. They find that firms with sound corporate governance practices are associated with both high firm value and high dividend payments, suggesting that sending out positive signal to the market by paying out high dividends can achieve the goal of lower cost of capital in the long run. Choi and Yoon (2006) also examine the effects of corporate governance on the conservativeness of accounting information. In general, they find that firms with a high overall corporate governance index report more conservative accounting information and that foreign investor ownership contributes to improve the conservativeness of accounting information. 776

13 Asia-Pacific Journal of Financial Studies (2007) v36 n5 sign of firm size. Because managers with investment opportunities may choose lower debt or more debt, this study does not predict the signs of TOBINQ or SGROWTH (Rajan and Zingales, 1995; Titman and Wessels, 1988). 12) Asset tangibility (COLLAT) is also unclear. Interest rates increase for riskier borrowers who must provide collateral for their loans (Pittman and Fortin, 2004). Due to their information value, however, tangible assets can lower the interest rate of a firm (Harris and Raviv, 1990). PERFORM, INT_COV, and CASHFLOW, proxies of firm profitability, are expected to have a negative association with the cost of debt capital. Bond characteristics are computed as the summation of the weighted value of all bonds for each firm, with the weight being the amount that is outstanding for each bond issue divided by the total amount that is outstanding for all publicly traded bonds of the firm. Prior studies have hypothesized that bonds with longer maturity and less liquidity have higher spreads and lower ratings as their greater interest risks exposure (Anderson et al., 2003b). However, Mansi et al. (2004) argue that firms with higher risk typically issue shorter term bonds with higher coupon rates. In that case, a negative relation between duration (or time to maturity) and bond spread is expected. This study also predicts a negative association between WTMATURE and WRATING, and between WDURAT and WSPREAD. The proxy of economies of scale in underwriting, LWTISIZE, is expected to have a negative sign (Bhojraj and Sengupta, 2003; Anderson et al., 2003a, 2003b, 2004; Kolck et al., 2005). Industry and year effects are controlled for because unobserved factors that may influence the cost of capital can be significant across industries and by year. 4. Sample Selection, Descriptive Statistics, and Empirical Results 4.1 Sample Selection This study uses a given corporate governance score based on KCGS surveys for the period The response rate is relatively high, and the total number of respondents for four years is 1,647. Financial statements data are taken from the KIS- FAS database, stock price and return data are taken from the KIS-SMAT database, 12) To find out more about the relation between leverage and Tobin s Q, see McConell and Servaes (1995) and Faccio et al. (2004). 777

14 The Cost of Debt Capital and Corporate Governance Practices and bond-related data are taken from the KIS-NET database. Table 1. Distribution of Samples by Year and by Industry Panel A : Sample Distribution by Year No.of Survey Respondents (1) ADJ_LEV1 (2) INT_RATE (3) WRATING (4) WSPREAD Total 1,647 1,423 1, Panel B : Sample Distribution by Industry Industries (1) ADJ_LEV1 (2) INT_RATE (3) WRATING (4) WSPREAD Fishing Mining Manufacturing 1,079 1, Utilities Construction Wholesale and Retail Transportation Telecommunication Real Estate and Rental Service 3 3 Business Services Education Services 3 2 Recreation, Culture, and Health services Total (Firm) 1,423 (560) ,329 (524) 336 (150) 331 (152) The sample consists of corporate governance-scored nonfinancial firms listed on the Korea Stock exchange (KSE) during the period 2001 to 2004, ranging from 331 to 1,423. This study obtains observations from various sources, including the Korea Corporate Governance Service (KCGS), KIS FAS data base, KIS SMAT data base and KIS-NET data base. Panel A presents sample distribution by year. Panel B presents sample distribution by industry, using one-digit Korean SIC codes. Model (1), the industry-adjusted leverage ratio, has 1,423 firm year observations; model (2), interest rates, has 1,329 firm-year observations; model (3), bond ratings, has 336 firm-year observations; and model (4), bond spreads, has 331 firm-year observations. 778

15 Asia-Pacific Journal of Financial Studies (2007) v36 n5 Firms are excluded if they belong to the financial service industry, as regulated firms have more strict corporate governance systems than do unregulated firms. All of the firms in the sample have the requisite data on the cost of debt capital and corporate governance score and control variables. 13) To alleviate potential measurement error problems, observations that fall within one percent of the top or bottom of the dependent variables are deleted, except bond ratings. All of the control variables are also winsorized at the 1st or 99 th percentile to reduce the influence of extreme values. As outlined in panel A of Table 1, the number of final observations totals 331 through 1,423 firm-year observations over the 2001~2004 period for four regression models. Panel B of Table 1 provides the distribution of sample firms across different industries, using one-digit Korean SIC codes. All of the models are heavily concentrated in the manufacturing industry, ranging from 64.04% to 75.83%. 4.2 Descriptive Statistics and the Pearson s Correlations of Variables Descriptive Statistics Table 2 presents the summary statistics of the regression variables. The mean (median) of industry-adjusted leverage (ADJ_LEV1) is -2.11% (-1.71%) with a standard deviation of 18.77%. The mean (median) of interest rates (INT_RATE) is 7.65% (7.06%), ranging from a lowest score of 0.4% to a highest score of 34.6%. The mean (median) value of bond ratings (WRATING) is 7.36 (8.00), ranging from 1 (AAA) to 10 (BBB-). The mean (median) of bond spreads (WSPREAD) is 1.70% (1.00%) with a standard deviation of 2.50%. The mean of firm size (LNTASSET) is (approximately 1 trillion won) with large variation across the sample. The mean (median) of Altman s Z score, an indicator 13) To estimate the weighted average bond spreads, a calculation process of several phases is carried out. First, the median value of each bond spread from a total of 167,967 daily trade spreads is taken (both the median and mean spread are estimated, but the summary results are not much different). After this is done, there are a total of 3,251 bond-year observations for the period 2001~2004. Bonds that carry protective options are eliminated. Next, the equivalent weight of each bond for individual firms is calculated, and each spread is multiplied with the equivalent weight. Then all of the weighted spreads are summed up by year, and through this calculation, a total of 950 firm-year bond ratings and spreads remain. Negative spreads are also eliminated. After the last merging process, with the corporate governance score, the firm-year sample is reduced further due to the great number of unmerged bond data. The non-investment level is also deleted as high-risk non-investment grade bonds are not traded frequently in Korea s bond market and typically carry more protective options. After being truncated, 331 observations for bond ratings and 336 observations for bond spreads remain in the final sample. 779

16 The Cost of Debt Capital and Corporate Governance Practices Panel A : Dependent Variables TABLE 2. Descriptive Statistics for Variable Measures N MEAN STD MIN Q1 MEDIAN Q3 MAX ADJ_LEV1 1, INT_RATE 1, WRATING WSPREAD Panel B : Test Variables CGSCORE 1, FAC1 1, FAC2 1, FAC3 1, FAC4 1, FAC5 1, Panel C : Control Variables LNTASSET 1, ALTMAN 1, TOBINQ 1, SGROWTH 1, COLLAT 1, PERFORM 1, BETA 1, INT_COV 1, CASHFLOW 1, LEV 1, PRIME 1, BM RETVOL WTMATURE LWTISIZE WDURAT WCONVEC WBAGE The variables are defined as follows. ADJ_LEV1 = industry-adjusted leverage ratio estimated as each corporation s leverage ratio minus the median of the ratio in the same industry; INT_RATE = interest rates on the firm s debt measured by interest expenses divided by the firm s average short-term and long-term financial debt; WRATING = the weighted average bond rating; WSPREAD = the weighted average spread estimated using the difference between the weighted average yield to maturity on the firm s outstanding traded bonds and the yield to maturity on the treasury bonds with similar time to maturity; CGSCORE = corporate governance overall score consisting of five categories: 780

17 Asia-Pacific Journal of Financial Studies (2007) v36 n5 FAC1 = shareholder rights protection score; FAC 2 = board of directors score; FAC3 = corporate disclosure score; FAC4 = audit committee score; FAC5 = dividend policies score; LNTASSET = firm size measured by the natural log of the total assets of the firm; ALTMAN = Altman s Z score estimated using Altman s equation (1968); TOBINQ = Tobin s Q measured by the market value of equity plus the book value of debt scaled by total assets; SGROWTH = sales growth computed as percentage change in sales amount; COLLAT = asset tangibility as the ratio of fixed to total assets; PERFORM = firm performance estimated as income before extraordinary items to total sales; INT_COV = interest coverage as the ratio of the income before extraordinary items and interest expenses divided by interest expenses; CASHFLOW = firm profitability measured by the cash flow from operations scaled by total assets; BETA = stock beta calculated by the capital asset pricing model over a 60-month period; RETVOL = return volatility estimated as the standard deviation of residuals from the market model regression using daily returns over a one-year period; BM = book to market as a ratio of the book value of equity to the market value of equity; LEV = leverage estimated as the long-term debt scaled by the market value of equity; WTMATURE = the weighted average time to maturity of the bond; LWTISIZE = log of the weighted average bond issue size; WDURAT = the weighted average bond duration; WCONVEC = the weighted average bond convexity; WBAGE = the weighted average bond age computed as the difference between the observation year and the issue year. of the financial condition of a firm, is 0.94 (0.87). The mean (median) scores of Tobin s Q, sales growth, and firm performance are 0.81 (0.75), 2.92% (4.74%), and 4.68% (4.33%), respectively, which shows a business slowdown for the sample period. Turning to proxies for bond characteristics, the mean (median) time to maturity is 2.93 (3.0) years, the mean (median) duration is 1.27 (1.27) years, and the mean (median) bond age is 1.35 (1.33) years. On average, corporate bonds have a short time to maturity; furthermore, bonds that are primarily traded in the Korean bond market are those that have a short outstanding length. 781

18 The Cost of Debt Capital and Corporate Governance Practices Pearson s Correlations among Regression Variables Panel A of Table 3 shows the Pearson s correlations of the dependent variables. The costs of debt capital are almost positively correlated with each other, but some of correlations with INT_RATE are not significant. ADJ_LEV1 is positively and significantly correlated with WRATING (0.409) and WSPREAD (0.235), INT_RATE is positively and significantly correlated with WRATING (0.135), and WRATING is positively and significantly correlated with WSPREAD (0.469). All of the dependent variables are negatively associated with the CGSCORE, but just two of them (WRATING and WSPREAD) are statistically significant, which suggests that firms with a higher CGSCORE have higher ratings and lower spreads. Panel B of Table 3 provides the Pearson s correlations between the dependent variables and the independent variables. ADJ_LEV1 is positively related to LNTASSET, TOBINQ, and BETA and negatively related to PERFORM. Large or growth firms tend to acquire more debt whereas profitable firms need less external debt financing. INT_RATE is positively correlated with leverage and the annual prime rate. WRAT- ING and WSPREAD are negatively correlated with LNTASSET and PERFORM, which suggests that large or profitable firms deserve higher ratings and lower spreads. In addition, WRATING and WSPREAD are negatively correlated with time to maturity (WTMATURE) and duration (WDURAT), which suggests that firms that issue large or long-term bonds usually have higher bond ratings and lower spreads. Panel C of Table 3 reports the Pearson s correlations among the test variables for the period 2003~ ) The corporate governance overall score (CGSCORE) is positively correlated with each category at a 1% significance level. FAC1 (shareholder rights protection) has a positive correlation with FAC2 (board of directors) and FAC4 (audit committee) at a 1% and 5% significance level, respectively. This means that the improvement of shareholder rights protection is achieved together with these two categories. FAC2 (board of directors) is positively correlated with all of the categories, and its correlations with FAC3 (corporate disclosure) and FAC4 (audit committee) are especially high. Furthermore, FAC2 is also highly correlated with the CGSCORE, perhaps due to the enforcement of this element of corporate governance by the government 14) The survey construction for 2001~2002 is somewhat different from the survey construction for 2003~ This study reports the correlation table of test variables only for the 2003~2004 period because the survey structure is more consistent and stable. 782

19 Asia-Pacific Journal of Financial Studies (2007) v36 n5 Table 3. Pearson s correlations of regression variables Panel A : Pearson s Correlations of Dependent Variables ADJ_LEV1 INT_RATE WRATING WSPREAD INT_RATE WRATING ** WSPREAD CGSCORE Panel B : Pearson s Correlations of Regression Variables LNTASSET ALTMAN TOBINQ SGROWTH COLLAT INT_COV ADJ_LEV ** * ** INT_RATE * * WRATING WSPREAD * ** ** CGSCORE CASHFLOW BETA BM PERFORM LEV PRIME_RATE ADJ_LEV INT_RATE ** WRATING WSPREAD CGSCORE RETVOL WTMATURE LWTISIZE WDURAT WCONVEC WBAGE ADJ_LEV * INT_RATE ** ** WRATING WSPREAD CGSCORE ** Panel C : Pearson s Correlations of Test Variables for 2003~2004 CGSCORE FAC1 FAC2 FAC3 FAC4 FAC5 FAC FAC ** FAC FAC ** FAC Note) See Table 2 for the variable definitions., **, and * denote the significance of the p-values at the 0.01, 0.05, and 0.10 levels, respectively. 783

20 The Cost of Debt Capital and Corporate Governance Practices under the Securities and Exchange Act of ) That is, firms are usually required to reform the structure and procedures of their board of directors first, because the board composition and increased responsibility of board members have been regarded as the most important measures to mitigate agency problems. 4.3 Main Empirical Results Regression Results of the Costs of Debt Capital on the Corporate Governance Overall Score Table 4 and Table 5 present four regression results of the costs of debt capital on the corporate governance score using the pooled sample. The statistical significance of the reported coefficients is based on the heteroscedasticity-consistent covariance matrix (White, 1980). 16) First of all, Table 4 shows regression results of book-based measures, such as industry-adjusted leverage ratio and interest expenses. In Table 4, The CGSCORE is strongly negatively significant in model (1) (coefficient = , t = -3.69) and marginally negatively significant in model (2) (coefficient = , t = -1.78). The signs of the control variables are almost as predicted. In model (1), firm size (LNTASSET), ALTMAN, and Tobin s Q have positively significant coefficients, which indicates that large or growth firms usually have a higher debt ratio (Rajan and Zingales, 1995; Titman and Wessels, 1988). Consistent with the prediction, PERFORM has a negative sign, which supports the theory that profitable firms prefer internal funds over external debt financing (Harris and Raviv, 1990). 17) An interesting finding for model (2) is that the firm s fixed assets (COLLAT) are inversely related to the interest rate, which shows that a firm s tangible assets have information value and lower the risk 15) Under the Securities and Exchange Act of 2000, large firms with total assets of more than 2 trillion won must have a board of directors with at least three outside directors and 50% outside directors, an audit committee with at least two-thirds outside members and an outside director as the chairperson, and an outside director nominating committee. 16) Each model is estimated again with Newey-West (1987) standard errors, because this study uses panel data for which the error term and regressor may be autocorrelated. All results remain robust after correcting for heteroscedasticity and serial correlation. 17) An additional robustness test for model (1) is performed by using an alternative dependent variable, ADJ_LEV2, in which the denominator includes total debt and shareholder equity. The results are consistent with the full sample in Table 4, which suggests that the CGSCORE is negatively associated with ADJ_LEV2. 784