Ownership Structure, Investment, and Corporate Value - Essay Example

Ownership Structure, Investment and Corporate Value Introduction A number of studies from different and researchers have found link to the relationship between ownership structure, investment, and corporate value. Generally, the management of a firm tends to prefer investments that will maximize the wealth of shareholders. Accordingly, this paper evaluates the literature that is devoted into linking these three essential factors in a business. Early on, Jensen and Meckling (1976) have examined the effect of management and their behavior on the performance and the corporate value they control. A huge part of such literature talks about the relationship between managerial ownership levels, the direct investment decisions made by management and the natural value of the firm. Moreover, there were many arguing studies done in almost the same year from different authors and researchers. Just like Morck, Shleifer and Vishny (1988), McConnell and Servaes (1990), and Hermalin and Weisbach (1991) provide facts and verification of a significant non-linear relationship between corporate value and managerial ownership. They argue that corporate value increases with management equity holdings to a particular level after which entrenchment behavior becomes dominant, resulting into a decrease in firm value. Out of the three studies, it was only McConnell and Servaes (1990) that have reported no change in the relationship between corporate value and managerial holdings at certain high levels of equity ownership. However, such earlier findings were found to formulate doubts when compared to works of Cho (1998) and Himmelberg, Hubbard and Palia (1999). Cho (1998) showed that managerial ownership had no effect on corporate value and investment but the only the corporate value that had a considerable impact on managerial ownership through the application of a two-stage least squares methodology. Ownership Structure One must choose an ownership structure prior to starting a business. It may come into varying types of ownership whether sole proprietorship, partnership, corporation (for-profit and nonprofit), cooperative, or limited liability company (LLC). Although these types are being utilized by many businesses, there is no one preference that fits for every business. This is for the reason that each of these ownership structures has its certain advantages and disadvantages in a business and thus the choice of ownership structure depends on the form that would best suit and meet its needs. In saying so, there would be a need for a careful evaluation of the most important considerations in choosing the right legal structure for a business. This may include: (1) the possible risks and liabilities of the business; (2) the formalities and expenses in involved in setting up and maintaining the different structures of the business; (3) the income tax situation of the business; and (4) the investment needs of the business (Nolo 2006). Managerial Ownership and Corporate Value At first, the relationship between corporate value and managerial ownership was found to be nonlinear. It was originally perceived that it was due to the onset of managerial entrenchment that had resulted in a decrease of corporate value for increasing levels of managerial holdings (as cited in Davies et al. 2002). However, a study conducted by J.R. Davies, David Hillier and Patrick McColgan (2002) has found to argue this well-documented assertion on the nonlinear relationship between corporate value and managerial ownership. In proposing a more complex structure for the corporate value and using such specification as the basis for their analysis, Davies et al (2002) have gathered evidence that the managerial ownership – corporate value relationship is co-deterministic. This study of Davies et al. (2002) seems to be on head-on with the works of Cho (1998) and Himmelberg et al. (1999) who both reported that corporate value determines managerial ownership but not vice-versa. Individually, Cho (1998) showed that managerial ownership had no effect on corporate value and investment instead corporate value had a significant impact on managerial ownership; while Himmelberg et al. (1999) showed that controlling for endogeneity eliminated the observed relationship between corporate value and managerial ownership but also that a large proportion of the cross-sectional variation in managerial holdings was explained by unobserved firm heterogeneity. Notwithstanding the work of Cho (1998) and Himmelberg et al. (1999), Davies et al. (2002) continued their quest to find proofs that there will be a resurgence of entrenchment behavior at high levels of managerial ownership when external market discipline becomes not effective. Moreover, they argue that managers will have gained inherent control of their company with equity holdings around 50 percent but still do not have objectives completely aligned to external shareholders. Incentives are similar to other shareholders only at very high levels of managerial holdings (Davies et al. 2002). Managerial ownership has a significant impact on corporate value that is directly in contrary with Cho’s (1998) and Himmelberg’s et al. (1999) works. Even though Davies et al (2002) agrees with and consistent to assertion of these authors on the corresponding effect of corporate value on levels of managerial ownership, they made an astounding affirmation that although ownership levels are affected by firm level investment, there is no evidence of the reverse occurring (i.e. having been said by Cho 1998 and Himmelberg et al. 1999). Literature Review At first, one study argues that share ownership would provide managers with an incentive to decrease private advantage consumption (Jensen and Meckling 1976). However, such findings have produced conflicting results compared to empirical research as to the actuality of their proposals. It was the empirical study of Morck et al. (1998) that documented a significant non-linear relation between ownership structure and corporate value conducted in 371 Fortune 500 companies. Their findings evidently showed a positive impact on corporate value for ownership levels between 0 percent and 5 percent managerial ownership and a negative effect between 5 percent and 25 percent. In view of this change in sign is attributed to managerial placement, by the time they gain enough power in order to be able to practice their own objectives at the cost of shareholder value. Managerial behavior is still dominated by entrenchment even though managerial interests will converge to that of shareholders as their equity stake grows. Morck et al. (1988) found that the arrangement of objectives turned out to be prominent and increases in ownership were connected with higher levels of corporate value at levels of ownership higher than 25 percent. On a supporting study, McConnell and Servaes (1990) reported a considerable quadratic relation between corporate value and managerial ownership. They have found that as ownership increases, corporate value also increases. Nevertheless, their 1976 and 1986 samples in equity holdings of above 50 percent and 40 percent have showed a decline in firm value. Their interpretation is attributed to initially increased managerial incentives but with entrenchment prevailing at higher levels of ownership (Davies et al. 2002). In the same way, a non-monotonic relationship between corporate value and ownership has been reported but with a different turning points (Hermalin and Weisbach (1991). Independently, Cho (1998) examines the interdependence of managerial ownership, investment, and corporate value and initially reported the same non-monotonic relation between ownership structure and corporate value originally found by Morck et al. (1988). Additionally, on page 114 of his work, Cho (1998) asserts that there is same relation between levels of ownership and corporate investment that is of great help in realizing the objective of this paper. Cho (1998) then suggests that ownership structure affects investment and so does the corporate value. Nevertheless, through simultaneous analysis, it was found that ownership structure was endogenously established by corporate value. Moreover, it was also reported that investment and not managerial ownership extensively influenced corporate value. Cho (1998) then made a final point that managers in firms with better investment opportunities tend to hold a higher fraction of their firm’s shares. Even so, no evidence was found to prove the causal effect of managerial ownership on investment or corporate value. Investment and Managerial Ownership There was a contention that firms with high investment spending will have high managerial ownership to alleviate the monitoring problem caused by discretionary managerial spending (Himmelberg et al. 1999). With this statement, Jensen (1986) argued that firms might over-invest as a result of an earnings retention conflict, rather than under-invest. Jensen (1986) further noted that when a firm is in such a situation, managers may be able to take full advantage of their size-related compensation, but are conscious that this may ultimately trim down the value of their shareholdings. In part, this certain study would explain the negative relation between investment and ownership. Further analysis of Cho (1998) presented evidence of investment insignificantly declining in general with managerial ownership. As a support, managerial ownership is found to have no impact on firm level investment (Davies et al. 2002, p. 27). On the other hand, this may reflect optimality in that investment policy may be one way in which managers affect value, but not the only means, added Davies et al. (2002). Conclusion Based on the above-mentioned arguing statements, there appears to be an apparent systematic and predictable relationship between ownership structure, investment, and corporate value. A lot of studies on the relationship of ownership structure, investment, and corporate value are still in arguing sides leaving the issue still unresolved. Even though several authors are with opposing findings with each other, it would be important to rely on the findings from a more recent study. This paper has found more confidence in the study of Davies et al. (2002) for the reason that it is more current. A more recent study, like that from Davies et al. (2002) is usually based on what has been found earlier and thus provides clarification and confirmation on the systematic relationship between ownership structure, investment, and corporate value with the comparison from earlier studies. This paper agrees to the conclusion made by Davies et al. (2002) that the causal relation between ownership and corporate value is of greater significance than the lack of a relation between ownership and investment. References Davies, J.R., Hillier, D. and McColgan, P. (2002 October 24). Ownership Structure, Managerial Behavior and Corporate Value. Department of Accounting & Finance, University of Strathclyde, Glasgow. Cho, M.H. (1998). Ownership structure, investment, and the corporate value: an empirical analysis. Journal of Financial Economics. 47, pp. 103-121. Hermalin, B. & Weisbach, M. (1991). The effects of board composition and direct incentives on firm performance. Financial Management. 20, pp. 101-112. Himmelberg, C.P., Hubbard, R.G., and Palia, D. (1999). Understanding the determinants of ownership and the link between ownership and performance. Journal of Financial Economics. 53, pp. 353-384. Jensen, M.C. (1986). Agency costs of free cash flow, corporate finance and takeovers. American Economic Review. 76(2), pp. 323-329. --- & Meckling, W.H. (1976). Theory of the Firm: managerial behavior, agency costs and ownership structure. Journal of Financial Economics. 3(4), pp. 305-360. McConnell, J.J. & Servaes, H. (1990). Additional evidence on equity ownership and corporate value. Journal of Financial Economics. 27, pp. 595-612. Morck, R., Shleifer, A., & Vishny, R.W. (1988). Management ownership and market valuation: an empirical analysis. Journal of Financial Economics. 20(1-2), pp. 293-315. NOLO (2006). Legal and Business Books, Forms and Software. Retrieved 10 May 2006 from http://www.nolo.com/article.cfm/objectID/. Read More