Capital structure, equity ownership and firm performance

Abstract

This paper investigates the relationship between capital structure, ownership structure and firm performance using a sample of French manufacturing firms. We employ non-parametric data envelopment analysis (DEA) methods to empirically construct the industry’s ‘best practice’ frontier and measure firm efficiency as the distance from that frontier. Using these performance measures we examine if more efficient firms choose more or less debt in their capital structure. We summarize the contrasting effects of efficiency on capital structure in terms of two competing hypotheses: the efficiency-risk and franchise-value hypotheses. Using quantile regressions we test the effect of efficiency on leverage and thus the empirical validity of the two competing hypotheses across different capital structure choices. We also test the direct relationship from leverage to efficiency stipulated by the Jensen and Meckling (1976) agency cost model. Throughout this analysis we consider the role of ownership structure and type on capital structure and firm performance.

Introduction

This paper uses an estimate of a firm’s production efficiency to assess the role of leverage in addressing agency conflicts within a firm. More specifically, we first assess the direct effect of leverage on firm performance as stipulated by the Jensen and Meckling (1976) agency cost model. Second, we investigate if firm efficiency has an effect on capital structure and whether this effect is similar or not across different capital structure choices. Throughout these analyses we consider explicitly the role of equity ownership on both capital structure and firm performance.

Corporate financing decisions are quite complex processes and existing theories can at best explain only certain facets of the diversity and complexity of financing choices. By demonstrating how competing hypotheses may dominate each other at different segments of the relevant data distribution we reconcile some of the empirical irregularities reported in prior studies thereby cautioning the standard practice of drawing inferences on capital structure choices based on conditional mean estimates. By using productive efficiency as opposed to financial performance indicators as our measure of (inverse) agency costs we are able to carry out tests of the agency theory that are not confounded by factors that may not be related to agency costs.

Our methodological approach is underpinned by Leibenstein (1966) who showed how different principal-agent objectives, inadequate motivation and incomplete contracts become sources of (technical) inefficiency measured by the discrepancy between maximum potential output and the firm’s actual output. He termed this failure to attain the production or technological frontier as X-inefficiency. Based on this we model technology and measure performance by employing a directional distance function approach and interpret the technological frontier as a benchmark for each firm’s performance that would be realized if agency costs were minimized.¹ We then proceed to assess the extent to which leverage acts as a disciplinary device in mitigating the agency costs of outside ownership and thereby contributes to an improvement on firm performance. To properly assess the disciplinary role of leverage in agency conflicts we control for the effect of ownership structure and ownership type on firm performance. We also allow for the possibility that at high levels of leverage the agency costs of outside debt may overcome those of outside equity whereby further increases in debt can lead to an increase in total agency costs.

We turn next to analyze the effects of efficiency on capital structure using two competing hypotheses. Under the efficiency-risk hypothesis, more efficient firms may choose higher debt to equity ratios because higher efficiency reduces the expected costs of bankruptcy and financial distress. On the other hand, under the franchise-value hypothesis, more efficient firms may choose lower debt to equity ratios to protect the economic rents derived from higher efficiency from the possibility of liquidation (Demsetz, 1973, Berger and Bonaccorsi di Patti, 2006).

Thus our paper contributes to the literature in four directions: (1) using X-inefficiency as opposed to financial indicators as a measure of firm performance to test the predictions of the agency cost hypothesis; (2) showing that X-inefficiency as a proxy for (inverse) agency costs is an important determinant of capital structure choices; (3) demonstrating how competing hypotheses may dominate each other at different segments of the leverage distribution; and (4) providing new empirical evidence on the relationship between ownership structure, capital structure and firm efficiency.²

This is to our knowledge one of the first studies to consider the association between productive efficiency, ownership structure and leverage. In a recent study Berger and Bonaccorsi di Patti (2006) examined the bi-directional relationship between capital structure and firm performance for the US banking industry using a parametric measure of profit efficiency as an indicator of (inverse) agency costs while Margaritis and Psillaki (2007) investigated a similar relationship for a sample of New Zealand small and medium sized enterprises using a technical efficiency measure derived from a non-parametric Shephard (1970) distance function. In this paper we use a directional distance function approach on a sample of French firms from three different manufacturing industries to address the following questions³: Does higher leverage lead to better firm performance? Would different ownership structures have an effect on firm performance? Does efficiency exert a significant effect on leverage over and above that of traditional financial measures? Are the effects of efficiency and the other determinants of corporate financing decisions similar across different capital structures? To what extent our results are driven by certain types of owners – e.g., family vs. non-family firms?

The reminder of the paper is organized as follows. The next section discusses the relationship between firm performance, capital and ownership structure. Section 3 outlines the methodology used in this study to construct measures of firm’s efficiency. Section 4 describes the empirical model used to analyze the relationship between efficiency, leverage and ownership. Section 5 describes the data and reports the empirical results. Section 6 concludes the paper.