Board Composition and the Cost of Capital

Board Composition and the Cost of

Capital

2 ABSTRACT

This thesis examines whether the composition of boards lowers the cost of capital of firms. In doing this, seven different board variables have been included, whereas the cost of capital is divided into the cost of equity and the cost of debt. Using data from 69 different companies for the period of 2003 until 2006, multiple regression analyses have been performed. The results show that board independence, ethnic diversity and board size are associated with a lower cost of equity. Furthermore, board competence and ethnic diversity are associated with a lower cost of debt. Overall, considerable differences are observed between the effects for the cost of equity and the effects of the cost of debt. Finally, the evidence for a lowering effect on the cost of capital by board composition is limited.

Keywords: Board composition; Corporate governance; Cost of equity; Cost of debt; Agency

3 PREFACE

With the development of this thesis, I have taken the final step in finishing my MSc International Business & Management at the University of Groningen. Over the past six months, I have conducted a large study on the potentially lowering effect of board composition on the cost of capital of firms. In doing this, I have been supported by a number of people.

First of all, I would like to thank my supervisor, André van Hoorn. During the development of my thesis, he provided me with excellent guidance, comments and feedback, with which I was able to continue and, more importantly, improve the report.

Furthermore, during my studies, and especially during the past few months, I have been supported thoroughly by my close friends, for which I would like to thank them.

Finally, and most importantly, I would like to thank my parents and brother for supporting me over the past few years and especially during the development of my thesis.

4 TABLE OF CONTENTS TABLE OF CONTENTS 4 LIST OF TABLES 7 I. INTRODUCTION 8 1.1 Increased attention 9 1.2 Problem statement 10 1.3 Relevance 12 1.4 Report structure 12

II. THEORETICAL BACKGROUND 14

2.1 Corporate goal 14

2.2 Cost of capital 15

2.1.1 Equity and debt 15

2.3 Agency problems 17

2.3.1 Agency costs 19

2.3.2 Influence on cost of capital 19

2.4 Corporate governance 20

2.4.1 Resolving agency problems 20

2.4.2 Lowering the cost of capital 21

2.5 Board of directors 22

2.6 Board of directors and the cost of capital 24

2.7 Conclusion 25

III. BOARD COMPOSITION AND THE COST OF CAPITAL 26

3.1 Board composition: Prevailing theories 27

3.1.1 Agency theory 29

3.1.2 Resource dependence theory 30

3.1.3 Board capital 32

3.2 Hypotheses 34

3.2.1 Board independence 35

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3.2.3 Board diversity 38

3.2.4 Board size 40

IV. DATA AND METHOD 43

4.1 Data 43

4.1.1 Dependent variables 43

4.1.2 Independent variables 45

4.1.3 Control variables 51

4.2 Data collection 51

4.3 Sample and sample selection 52

4.4 Descriptive statistics 53

4.5 Method 55

4.5.1 Empirical model 55

4.5.2 Additional analyses 57

V. RESULTS 60

5.1 Multiple regression analysis 60

5.1.1 Cost of equity 60

5.1.2 Cost of debt 64

5.2 Additional analyses 68

5.2.1 Empirical model ∆2003-2005 69

5.2.2 Regressions excluded indicators 74

5.3 Summary 78

5.3.1 Cost of equity 78

5.3.2 Cost of debt 79

5.3.3 Comparison of cost of equity and debt 81

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6.3.4 Ethnic diversity 90

6.4 Board size 91

6.5 Differences cost of equity and debt 93

6.6 Limited effect size 94

VII. CONCLUSIONS 96

7.1 Practical implications 99

7.2 Limitations 100

REFERENCE LIST 103

7 LIST OF TABLES

Tables

Table 1: Firm-year observations 53

Table 2a: Descriptive statistics 53

Table 2b: Additional descriptive statistics 54

Table 3a: Regression results cost of equity capital 61 Table 3b: Regression results cost of debt capital 65 Table 4a: Regression results ∆2003-2005 cost of equity capital 70 Table 4b: Regression results ∆2003-2005 cost of debt capital 72 Table 5a: Regressions excluded indicators cost of equity capital 75 Table 5b: Regressions excluded indicators cost of debt capital 77

Table 6: Explanatory power comparison 82

Tables Appendix

Table I: Industry categories 110

Table II: Descriptive statistics second empirical model ∆2003-2005 110 Table III: Additional descriptive statistics second empirical model ∆2003-2005 111 Table IV: Regression results board diversity cost of equity capital 112 Table V: Regression results board diversity cost of debt capital 112 Table VI: Regression results board diversity ∆2003-2005 cost of equity 113 Table VII: Regression results board diversity ∆2003-2005 cost of debt 113

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I. INTRODUCTION

Over the past two decades, the business world has been shocked by the occurrence of a large number of corporate scandals in several countries around the World (Aldamen et al., 2010; Cheng et al., 2007). These scandals were the result of firms’ managers participating in unethical conduct by manipulating balance sheets, spreading inaccurate information and, thereby, increasing the value of the firms’ shares far above their actual value (Cunningham & Harris, 2006). As a result, the managers were able to gain private benefits from increases in stock value due to the fact that they were often compensated with stock options (Healy & Palepu, 2003).

Despite the fact that this fraud had been going on for some time in various companies, it did not remain unnoticed. In the early 2000s, the misconduct of several companies was discovered. As a result, these firms’ shares plummeted, resulting in many firms going bankrupt shortly after the discovery. Overall, the consequences for these firms’ stakeholders were devastating. Shareholders lost billions of dollars in share value, while employees lost their jobs and stock-funded pensions. Similarly, debt holders could only retrieve part of their initial investments, if they were able to retrieve anything at all (Brickey, 2003).

9 1.1 Increased attention

Given the fact that shareholders and debt holders were among the parties that were hit hardest, they demanded better protection against the potential wrongdoing by managers (Cheng et al., 2007). Therefore, the concept of corporate governance has received greater attention over the past few years (Aldamen et al., 2010; Ramly, 2009). More specifically, especially the monitoring function of the board of directors has been the subject of debate (Campbell & Minguez-Vera, 2008; Cheng et al., 2007), which has predominantly become a matter of the board’s composition (Cheng et al., 2007;Rose, 2007). In essence, board composition was increasingly recognized as being of considerable importance to the corporate governance of firms (Baysinger & Butler, 1985;Rose, 2007).

Therefore, in order to protect the rights of shareholders and debt holders, regulators from various countries developed requirements and guidelines regarding the composition of corporate boards. For instance, in both the US and the UK, reforms have focused on increasing board independence (Brammer et al., 2007;Garg, 2007). Similarly, regulators from several countries have tried to encourage board diversity by means of guidelines or quotas (Gul et al., 2010).

10 1.2 Problem statement

As a result of the increased attention and the reforms that followed, the amount of theoretical and empirical research on corporate governance increased considerably. A significant part of this research focused on how firm performance could be influenced by means of better corporate governance. The general conclusion from this research is that strong corporate governance contributes to a firm’s performance and creates shareholder value (Ramly, 2009; Schleifer & Vishny, 1997).

An important determinant of this value creation is the cost of capital (Missionier-Piera & Piot, 2007), which concerns the required rates of return by shareholders and debt holders (Chambers & Lacey, 2008). Given the fact that these providers of capital were major victims of the scandals mentioned earlier, these parties, and their interests, have become a subject for research as well. In other words, the influence of corporate governance on the cost of capital has become an increasingly studied subject. These studies generally point towards a lowering influence of corporate governance on firms’ cost of capital. Stated differently, shareholders and debt holders seem to require lower rates of return in the case of strong corporate governance (Ramly, 2009).

Given the fact that the board of directors has played an important role in the earlier mentioned scandals and has, therefore, become a primary subject of the corporate governance reforms and the increased attention, the concept has taken a more prominent place in research as well. Within this research, especially the composition and size of the board have been studied extensively (Ramly, 2009). As stated before, the former was increasingly regarded as being a way through which corporate governance could be improved (Baysinger & Butler, 1985; Rose, 2007). Therefore, consistent with the research on the concept of corporate governance as a whole, several studies examined the relationship between board composition and various financial indicators of firm performance (Siciliano, 1996). These studies are, however, rather inconclusive regarding the direct influence of board composition.

11 Furthermore, it was already stated earlier that the providers of capital are increasingly showing a preference for certain board characteristics, indicating that a relationship may well be present. Finally, the cost of capital is regarded to be an important determinant of the creation of shareholder value. In other words, if board composition actually lowers a firm’s cost of capital, it may be of importance for the creation of shareholder value as well.

Surprisingly, however, this relationship has not been considered extensively in existing research. In essence, some studies do include one or two board characteristics, however, by including a limited number of variables, it cannot be expected that such a study captures a board’s full potential influence. Furthermore, the extent to which the existing research substantiates the relationship between board composition and the cost of capital by means of appropriate theories is limited. Therefore, the relationship between board composition and the cost of capital is left largely unexamined.

Considering the statements made above, this thesis aims to fill this research gap by examining the potentially lowering effect of board composition on the cost of capital. In doing this, a large number of board characteristics are considered, of which the potentially lowering effect on the cost of capital is substantiated by relevant theories. Then, by means of empirical research, which uses a sample of US companies from the S&P 500, it is determined whether these board characteristics actually lower the cost of capital. This has been formulated into the following research question:

“Does a firm’s board composition lower its cost of capital, and if so, how?”

In order to be able to answer this question, four sub questions have been developed:

1. How does a firm’s corporate governance influence a firm’s cost of capital? 2. How does a firm’s board composition influence a firm’s corporate governance?

3. How can a firm’s board composition lower a firm’s cost of capital from a theoretical point of view?

4. To what extent does a significant relationship exist between a high value for the selected board variables and a lower cost of capital?

12 the first three questions are answered. Ultimately, the answers to the first two questions facilitates determining how board composition and the cost of capital are linked by existing research. Thereafter, the answer to the third question explains how the selected board variables can be expected to lower the cost of capital, by means of four different theories. The theories considered are agency theory, resource dependence theory, human capital theory and social capital theory. From the arguments developed by applying these theories, several hypotheses have been established, which are tested using empirical research. In this final part of the research, an answer is to be found for the fourth, and final, sub question. Using multiple regression analyses, the hypotheses are tested in order to determine whether significant relationships exist. Ultimately, the answers to the four questions makes it possible to give an answer to the main research question.

1.3 Relevance

From a theoretical point of view, this research is relevant for a number of reasons, which have largely been considered earlier. First of all, due to the scandals referred to previously, corporate governance, board composition and the cost of capital have received greater attention, which are the key concepts in this research. Furthermore, the existing research which does examine the relationship between board composition and the cost of capital, is generally limited and not sufficiently substantiated by relevant theories. Concerning the practical relevance of this research, the following can be stated. First of all, the fact that board composition has gained importance over the past decade, makes the matter of composition more important to firms. In other words, firms may want to know what effect certain board members may have on the firm and its cost of capital. Therefore, by conducting this research, firms may get an insight into what effect certain board characteristics may have on their cost of capital and how it may, in fact, be lowered. Ultimately, this may induce firms to revise their board composition from the perspective of lowering their cost of capital.

1.4 Report structure

14

II. THEORETICAL BACKGROUND

In this chapter, all necessary background information is provided in order to be able to explain the relationship being tested in this research, namely between board composition and the cost of capital. The chapter starts by explaining why the cost of capital is important to firms, shareholders and debt holders. Subsequently, a distinction is made between the different types of cost of capital, after which influencing factors are introduced. Here, the importance of agency problems is explained and how corporate governance mechanisms can assist in trying to mitigate these problems and, thereby, influence firms’ cost of capital. Finally, the board of directors and its role are elaborated on, after which the research gap, shortly described in the introduction, emerges.

2.1 Corporate goal

An organization is often referred to as being a nexus of contracts (Fama & Jensen, 1983). By means of these contracts a firm’s management is linked with a variety of stakeholders, among which customers, suppliers, shareholders, debt holders and the state (Laffont & Martimort, 1997). Concerning these contracts, the most well-known and thoroughly studied contract is the contract specifying an organization’s ownership and control. In essence, shareholders, or the owners, provide the managers, who control the organization, with funds which are to be used for the organization and its activities (Ramly, 2009). Therefore, the owners do not have complete control over how their money is being spent while they only retain limited power to interfere in the decision making process. In other words, the managers have a large amount of freedom in their actions.

15 (Ramly, 2009). Therefore, the evaluation of management’s performance is based on the height of the value of the shares being held by the owners of the firm. Considering this, existing research regards a firm’s primary goal to be the maximization of shareholder wealth (Eiteman et al., 2010).

2.2 Cost of capital

The goal of shareholder wealth maximization can be attained in various ways. According to Rappaport (1998), a firm’s cost of capital is one of the main drivers of shareholder wealth. Missonier-Piera and Piot (2007) strengthen this statement by arguing that, if a firm is able to reduce its cost of capital, shareholder value is created. In addition, Ramly (2009) argues that, besides being a measure of risk, a firm’s cost of capital should be considered as an important determinant of a firm’s value.

A firm’s cost of capital is defined as the required rate of return by shareholders or debt holders for providing funds at a given amount of risk (Chambers & Lacey, 2008). In other words, the required rate of return by shareholders or debt holders are the minimum costs which firms have to pay for raising capital. Therefore, the required rate of return by shareholders and debt holders is the cost of capital for firms. Both of these providers of capital want their goals to be met, which is elaborated on below. However, these parties are risk-averse. This means that a high probability of not attaining these goals makes shareholders and debt holders less willing to provide funds (Byun, 2007; Ramly, 2009). Consequently, the parties are induced to require higher rates of return to compensate for this probability. From this follows that the higher the risk associated with the firm, the higher the required rate of return by shareholders and debt holders, and therefore the cost of capital, is expected to be (Gul et al., 2010; Missionier-Piera & Piot, 2007).

2.2.1 Equity and debt

16 debt holders do not have any effective control over how the funds they provide are put to use. As mentioned before, shareholders do not have full control either but they do retain the residual rights of disciplining the firm’s management for unsatisfactory performance (Kreptul & Padilla, 2004). In addition, the objectives of the two parties are different. Where shareholders want to see the value of their shares maximized, debt holders want to protect their initial investment plus the interest the parties agreed upon (Anderson et al., 2004). As a consequence of these differences, the dynamics shaping the required rate of return for shareholders and debt holders are fundamentally different. These differences can primarily be seen in the way these parties determine their required rate of return for providing the funds.

In case of equity capital1, shareholders assess a firm’s risk based on the volatility of cash flows and the extent to which the shareholder returns tend to be positive over time (Aldamen et al., 2010; Byun, 2007; Ramly, 2009). In essence, the higher the volatility of a firm’s cash flows, the higher the uncertainty about future returns is. Such uncertainty can be increased in case of a lack of transparency and relevant information. This is referred to as information risk (Aldamen et al., 2010; Ashbaugh-Skaife et al., 2004). Keeping in mind that shareholders want their wealth to be maximized, any uncertainty about future returns makes the investment more risky to shareholders, given the fact that it is more likely that shareholder value is not created (Chambers & Lacey, 2008). To protect themselves against this increased risk, shareholders require a higher rate of return (Gul et al., 2010; Missionier-Piera & Piot, 2007). As a consequence, the firms’ cost of capital increases. To summarize, high uncertainty regarding a firm’s future cash flows and share value result in a higher risk for shareholders and, consequently, a higher required rate of return.

Concerning debt capital2, the risk assessment of a firm is fundamentally different and is of considerable importance for debt holders when determining their required rate of return (Ashbaugh-Skaife et al., 2006; Sengupta, 1998). The debt holders’ main concern is not whether shareholder wealth is maximized but mainly whether their investment, plus interest, will be recovered entirely. Taking this into consideration, debt holders will primarily base

1

Within this research, the beta of firms’ stock returns is used as a proxy for the cost of equity capital.

2

17 their risk assessment of a firm on the extent to which it can be expected that the investment will be recovered or not. The risk associated with this possibility is referred to as a borrower’s default risk, as explained more extensively below (Anderson et al., 2004; Ashbaugh-Skaife et al., 2006; Bhojraj and Sengupta, 2003; Byun, 2007). In addition, due to the debt holders’ reliance on adequate information on which they can base their risk assessment of the firm, information risk is mentioned as a determinant of the cost of debt capital as well (Ashbaugh-Skaife et al., 2006), as elaborated on below.

First of all, default risk is being faced by debt holders. When this risk is high, the probability that a firm defaults is considerable. This is the situation when a firm is unable to fulfill its debt obligations which means that a firm’s debt holders may not retrieve their initial investment (Aldamen et al., 2010). If a firm has a high default risk, due to its reputation, history or recent (financial) developments, debt holders are less willing to provide the firms with funds due to the increased risk. As a consequence, debt holders require a higher rate of return to protect themselves against a potential loss of their investment (Gul et al., 2010; Missionier-Piera & Piot, 2007). In other words, the cost of debt capital is increased for firms.

Secondly, debt holders face considerable information risk, which is larger than for shareholders. This risk occurs when the level and precision of information regarding the firm is different across investors (Aldamen et al., 2010; Easley and O’Hara, 2004). Similar statements are made by Missionier-Piera & Piot (2007), who stress the importance of quality financial reporting for debt holders. As with shareholders, the uncertainty about the firm’s future cash flows, being a result of the inadequacy of the provided information, induces the debt holders to require a higher rate of return for providing funds and the accompanying risks. Consequently, the cost of debt capital is increased for firms (Aldamen et al., 2010).

2.3 Agency problems

18 theory, the separation of ownership and control concerns one party, the principal, who has another party, the agent, perform services on behalf of the principal. In the case of public firms, this means that the owners, or the shareholders, are the principals while the firm’s managers function as the agents (Ramly, 2009). Finally, given the fact that debt holders provide firms with capital, without retaining the rights to the ultimate control of the firm, the interests of this party should be considered as well. This makes the agency theory applicable to debt holders as well.

In essence, by delegating control over the capital provided to firms’ management, information asymmetry is created between the latter party and both shareholders and debt holders. First of all, shareholders of public firms are often small and dispersed, which makes them unable to monitor management’s activities effectively. Furthermore, debt holders are generally inactive in monitoring management and primarily rely on provided financial reports. These facts give management considerable freedom in their actions (Missonier-Piera & Piot, 2007; Ramly, 2009). Secondly, management has information about the firm and its performance which is not directly available to external parties. To make matters worse, management controls the information being disclosed to the providers of capital (Ramly, 2009). Therefore, management may conceal negative messages from which they are able to extract private benefits as well (Anderson et al., 2004). Together with the fact that the decision-making authority has been delegated to the management, this results in two problems that hold for both shareholders and debt holders, as was shown with the scandals referred to in the introduction (Ashbaugh-Skaife et al., 2004; Ramly, 2009).

First of all, there is the moral hazard problem, which is also referred to as the hidden-action problem. This concerns the situation in which managers are able to perform invisible, self-interested actions due to the existence of information asymmetry between the parties. In other words, managers are able to extract private benefits which come at the expense of the owners and other parties (Ashbaugh-Skaife et al., 2006; Missonier-Piera & Piot, 2007; Ramly, 2009). This is often referred to as a conflict of interest between management, or the agents, and the owners, or the principals (Ramly, 2009).

19 information, problem. Due to the unavailability of relevant information, the investors may invest in firms that are not performing as well as they seem to be doing (Missonier-Piera & Piot, 2007; Ramly, 2009).

2.3.1 Agency costs

Due to the possibility of the problems mentioned above, both shareholders and debt holders are exposed to so-called agency costs. In the case of the first agency problem, a firm may, from the perspective of shareholders and debt holders, perform suboptimal due to management’s ability to perform self-interested actions. As a consequence of such actions, shareholders and debt holders face agency costs, which should primarily be regarded as opportunity costs, that arise from the difference between the envisioned performance and the actual, suboptimal performance (Ashbaugh-Skaife et al., 2004; Ramly, 2009). In other words, the difference between the actual and the envisioned performance are the costs of the agency problem for the shareholders and debt holders.

For the second agency problem, the same holds. Due to the fact that shareholders and debt holders are not able to determine the true value of the firm, these parties are more susceptible to potential losses which were not foreseen due to the information asymmetry. These losses are agency costs to the shareholders and debt holders (Ashbaugh-Skaife et al., 2004).

2.3.2 Influence on cost of capital

20 information is needed to make a proper risk assessment of a firm. Therefore, any information asymmetry between management and external parties will contribute to the information risk, mentioned earlier. Again, this results in an increase in the uncertainty about future performance, which induces debt holders to require a higher rate of return, which raises the firm’s cost of debt capital (Easley & O’Hara, 2004). Ramly (2009) summarizes the statements made above by stating that both shareholders and debt holders bear additional risk due to the existence of agency costs. Given this increased risk, both parties demand a premium for their investments which raises the cost of capital for firms.

2.4 Corporate governance

It was mentioned earlier that having to pay a higher cost of capital is detrimental to the goal of shareholder wealth maximization and, therefore, firm performance. The preceding sections have shown that there are firm-level influences on the cost of capital of firms. More specifically, several agency problems can arise, which result in a higher required rate of return by investors due to the fact that shareholders and debt holders become exposed to agency costs. Consequently, the firm’s cost of capital is increased.

To deal with these conflicts and, consequently, reduce agency costs, so-called corporate governance mechanisms are established. As mentioned earlier, Schleifer and Vishny (1997: 737) define corporate governance as “the ways in which the suppliers of finance to corporations assure themselves of getting a return on their investment”. By means of these mechanisms, managements’ actions and behavior are monitored better and the flow of firm information is improved. Stated differently, through corporate governance, self-interested managers are induced to allocate resources and make decisions for the firm with which value is created for the owners, while debt holders are assured of retrieving their investments.

2.4.1 Resolving agency problems

21 given the increased monitoring and the fact that firms are often required to disclose more information in an appropriate and consistent fashion (Aldamen et al., 2010; Bhojraj and Sengupta, 2003). As a result, capital providers will be better able to determine the actual value of the firm, indicating that the adverse selection, or hidden information, problem is mitigated as well. To conclude, this section indicates that corporate governance can result in mitigated agency problems and, as a result, lower agency costs.

2.4.2 Lowering the cost of capital

Given the fact that corporate governance lowers agency problems and agency costs, the risk associated with the firm is lowered (Ramly, 2009). In other words, shareholders and debt holders will value the firm more favorably, given the fact that the probability that their goals are not attained, or their investments are expropriated, is mitigated. As a result of the lower agency costs for shareholders and debt holders, these parties will not have to protect themselves against these extra risks by demanding a premium. Stated differently, with strong corporate governance in place, shareholders and debt holders will require a lower rate of return. For the firm, this means it will have a lower cost of capital. Ramly (2009) strengthens this statement by arguing that good corporate governance lowers firm risk and, as a consequence, the cost of capital. Similarly, Donker and Zahir (2008) recognize that the cost of capital of firms can be lowered by corporate governance. Likewise, Gul et al. (2010) provide evidence from various empirical studies indicating a lowering effect of corporate governance on the cost of capital of firms (Anderson et al., 2004; Ashbaugh-Skaife et al., 2004).

Concerning the effects of corporate governance on the cost of capital, a distinction can be made between the effects on the two types of cost of capital, which follows from the differences between the types, as identified earlier. Firstly, the effects on the costs of equity capital are discussed.

22 equity capital. Byun et al. (2008) acknowledge this statement. Furthermore, Ramly (2009) finds that having strong corporate governance makes the market for equity capital view a firm favorably, which reduces this firm’s cost of raising equity capital. Missionier-Piera and Piot (2007) add to this that corporate governance is likely to result in the availability of more information, and thus increased transparency. This decreases the information risk being faced by shareholders and lowers their required rates of return. Finally, research has found that better governed firms are associated with a lower cost of equity capital (Cheng et al., 2006; Chen et al., 2003).

Secondly, the effects on the cost of debt capital are discussed. By means of corporate governance, a firm’s default risk is reduced which, as mentioned earlier, is a primary determinant of the cost of debt capital. Furthermore, debt holders experience a lower information risk (Ramly, 2009). The lowered default risk derives from the fact that management’s actions are monitored better and more adequate information should be provided with which debt holders develop their risk assessments, which results in a lowered information risk as well (Aldamen et al., 2010). In addition, a firm’s default risk is lowered due to the lowered variance in the expected cash flows (Aldamen et al., 2010). As a consequence of what is stated above, debt holders will be more willing to offer funds at a lower interest rate (Ramly, 2009). Stated differently, the firm’s cost of debt capital is reduced. Bhojraj and Sengupta (2003) strengthen these statements by arguing that strong corporate governance mechanisms reduce the likelihood that debt holders see their wealth expropriated by the firm’s management, resulting in a lower cost of debt. Missonier-Piera and Piot (2007) add to this that debt holders take into account whether a firm has strong corporate governance or not when making a risk assessment and determining the appropriate risk premium. This statement is strengthened by Blom and Schauten (2006), who found in their research that the cost of debt capital is negatively related to corporate governance. In addition, both Ashbaugh-Skaife et al. (2006) and Anderson et al. (2004) find a lowering effect of strong corporate governance on firms’ cost of debt capital.

2.5 Board of directors

23 existing research generally refers to the market for corporate control, or the takeover market, the legal system (Campbell & Minguez-Vera, 2008) and the role of capital markets (Ramly, 2009; Stulz, 1999). In contrast, a firm’s ownership structure and the degree of information disclosure (Stulz, 1999) are known to be internal governance mechanisms. The most important internal governance mechanism is, however, a firm’s board of directors (Campbell & Minguez-Vera, 2008). This is also being recognized by Stulz (1999), who regards the board of directors to be the most direct monitoring mechanism.

A board of directors consists of directors who have been appointed to the board by the owners of the firm (Ramly, 2009). In essence, these directors represent the first channel through which the owners, and potentially other parties, can defend themselves against a potential expropriation of the provided funds by management. Furthermore, the board can be regarded as a channel through which important information can be shared with the owners and other parties (Anderson et al., 2004).

24 As Ingley and Van der Walt (2003) state, a board of directors consists of directors which individually contribute capital to the organization. The combination of the competencies and capabilities of all these directors should enable the board to perform its functions. However, as the authors recognize, the capital contributed by directors can take various forms. In addition, each of these forms can be expected to contribute to the board’s functioning differently. Taking this into account, firms are expected to select directors with certain capabilities or competencies of which it is known that they contribute to the board’s functioning. Following this, the question becomes what capabilities and competencies, being possessed by appointed directors, contribute most to the corporate governance performed by the board of directors. This is strengthened by Campbell and Minguez-Vera (2008), who state that a board’s functioning is influenced by its composition. Rose (2007) and Baysinger and Butler (1985) add to this that board composition is of considerable importance to the corporate governance of firms.

2.6 Board of directors and the cost of capital

25 2.7 Conclusion

26 III. BOARD COMPOSITION AND THE COST OF CAPITAL

A large amount of research exists on the link between board composition and firm performance. Several studies have identified both positive and negative relationships between the characteristics of board members and various financial indicators of firm performance. For instance, Baysinger and Butler (1985) report findings which indicate the existence of a positive relationship between board independence and firm performance. However, results from other studies, referred to by Siciliano (1996), support the opposite relationship. Furthermore, Hermalin and Weisbach (1991) show results which are inconclusive regarding the relationship.

Similarly, the link between gender diversity and firm performance has been studied. Brammer et al. (2007) provide findings from a study which links female directors to more shareholder wealth, whereas contrasting findings were reported in studies referred to by Campbell and Minguez-Vera (2008).

Finally, the concept of board size has been related to firm performance. Again, existing research proposes contrasting evidence. Both Garg (2007) and Fields et al. (2011) list several studies which provide contrasting evidence on the relationship between the earlier mentioned concepts.

Given the fact that existing research identifies both positive and negative effects of several board characteristics, it can be stated that existing research is inconclusive regarding the link between board composition and firm performance. Still, fact is that these studies do generally show the presence of a link between the two subjects. The direction, or sign, of this link, however, remains largely uncertain. The inconclusiveness of the results is recognized by Baysinger and Butler (1985), who argue that certain attributes, contributed by individual directors, can influence a firm’s financial performance and success, in either direction.

27 concepts are related theoretically, it is surprising that the existing empirical research on the relationship is so limited.

Furthermore, the studies which do intend to explain the aforementioned relationship merely include one or two board characteristics within a larger framework of corporate governance mechanisms. In essence, it cannot be expected that a board’s entire potential influence is captured by such a limited number of board characteristics. An example of such research is the study performed by Missonier-Piera and Piot (2007), who examined the relationship between corporate governance and the cost of debt capital, for which they included board independence. Ashbaugh et al. (2004) used similar variables in explaining the relationship with the cost of equity. In addition, Aldamen et al. (2010) use both board size and independence in their research on how corporate governance influences the cost of equity financing. Finally, Gul et al. (2010) examined a relatively new relationship in this field by linking gender diversity and firms’ cost of debt capital.

In addition to the fact that the above-mentioned studies do not provide an analysis of the possible influence of multiple board characteristics, the arguments for the relationships are not substantiated by relevant theories either. Therefore, it is not possible to determine in what theoretical context the observed relationship should be viewed.

Considering these limitations of the small amount of existing research, this thesis includes several board characteristics which are used to determine the influence of board composition on the cost of capital, while providing arguments which are sufficiently substantiated by appropriate theories from the field. In the next section, these theories are introduced and explained, after which the subsequent section applies the theories to the relationships being examined.

3.1 Board composition: Prevailing theories

28 it is. Taking into consideration that neither theory provides a complete view of the relationship between the board’s functioning and firm performance, this research combines these two theories as proposed by Dalziel and Hillman (2003).

First, the agency theory is applied, which was introduced in the previous chapter. This theory mainly concerns the monitoring functions being performed by the board members, with which the self-interested behavior of management is to be mitigated (Ashbaugh-Skaife et al., 2004; Ingley & Van der Walt, 2003). Secondly, the resource dependence theory is often utilized for explaining the link between board composition and firm performance. This theory deals with how the board contributes resources to the firm and its strategies for maintaining relationships with various stakeholders. Within the context of this research, the essence of the application of this theory does not specifically lie on the directors’ provision of resources but more on how directors contribute to improving firms’ relationships with its shareholders and debt holders. In essence, both perspectives propose a direct relationship between the board and firm performance (Holder-Webb & Sharma, 2008), indicating that a direct relationship between the board and the cost of capital may be present as well.

Even though these theories are commonly accepted as being the main perspectives on how a board’s functioning is shaped by its board composition, two additional theories are included. The third theory to be considered is the human capital theory, while the fourth and final theory is the social capital theory. Here, human capital is referred to as directors’ skills and abilities, whereas social capital concerns directors’ ties to external parties, such as demographic groups. The main idea behind these theories is consistent with arguments by Dalziel and Hillman (2003), who state that having both human and social capital on the board is essential in order for the earlier mentioned functions to be executed in a satisfying manner. More specifically, the authors argue that ignoring board capital would prevent the development of a complete understanding of a board’s functioning. Therefore, this research regards board capital to be an important aspect to be considered in the examination of the relationship between board composition and the cost of capital.

29 3.1.1 Agency theory

The first theory to be discussed is agency theory. The theory was already introduced earlier, but in this section it will solely be applied to the subject of board composition and its influence on a firm’s cost of capital. In essence, as stated earlier, agency problems can arise due to the separation of ownership and control. According to Donaldson and Muth (1998) this follows from the fact that managers cannot be trusted given their ability to reap private benefits. In trying to mitigate such self-interested actions, the board of directors performs an important function. As Ingley and Van der Walt (2003) state, the board monitors management in order to protect shareholders’ interests from the self-interested aspirations of the managers. More specifically, Ashbaugh-Skaife et al. (2004: 12) argue that boards should “provide independent oversight of management and hold management accountable to shareholders for its actions.”

In order to be able to evaluate management’s performance, the board should be able to judge whether or not management acts in compliance with these parties’ interests. However, if the board of directors is closely related to management, it will not be able to provide objective judgments due to pressures from management. Considering this, the board is required to provide judgments which are independent of the firm’s management (Ashbaugh-Skaife et al., 2004). This critical importance of having an independent board is recognized by Carter et al. (2002). To conclude, in determining board composition, the agency theory stresses the importance of including directors which are able to monitor and provide judgments which are independent from management.

30

3.1.2 Resource dependence theory

As Dalziel and Hillman (2003) state, the board’s second function concerns providing resources to the firm. This function is derived from the resource dependence theory, which proposes that the board is a critical link between a firm and the key resources with which the firm is able to perform to its maximum (Ingley & Van der Walt, 2003). Finance is one of these resources (Singh, 2007). As stated before, this theory is not applied to the letter. To clarify, this thesis does not specifically use the argument that directors provide a firm with links to resources. In essence, the focus is on the relationship with the providers of such resources or, in the case of the cost of capital, the shareholders and debt holders. Therefore, the theory is used to determine how the relationship with shareholders and debt holders can be improved in order to have these parties lower their required rates of return.

According to the resource dependence theory, four different benefits can be extracted from boards and the capital contained within them. First of all, the board can provide advice and counsel. Board members have different backgrounds, created by their education, demographics and experience. Given these differing backgrounds, directors bring varying types of expertise, experience and skills to the board, which facilitate the provision of advice and counsel from different perspectives (Dalziel & Hillman, 2003). Consequently, one can expect that this facilitates better problem solving and more valuable contributions to a firm’s strategies.

31 Thirdly, due to the directors’ individual contributions to the board’s capital, various channels of communication and informational sources are created between the firm and institutions, organizations and demographic groups which are represented on the board. As a result, a firm has access to a larger amount of information and is able to interact better with the aforementioned parties (Siciliano, 1996; Singh, 2007). Pfeffer and Salancik (1978) add to this that board linkages with external parties provide channels for communication and the possibility for advice and support from important stakeholders. In strategic terms, such a larger pool of information facilitates the development of strategies which account for a larger amount of possible pitfalls and opportunities. Consequently, one can assume that the environmental uncertainty is mitigated and firm performance improves.

Finally, the fourth benefit concerns the acquisition of resources from external parties by having a link between a board and such parties. Due to such a link, these parties become more committed and involved with the firm, which facilitates a provision of resources at more favorable terms (Hitt et al., 1993). In addition, Kiel and Nicholson (2007) propose that having a high number of links with the external environment, created by the board of directors, increases the access to a higher number of varying resources. From a strategic perspective, being linked to a larger amount of resources improves a firm’s ability to manage environmental uncertainty and respond with appropriate strategies accordingly.

32 3.1.3. Board capital

Neither of the two functions specified by the theories above can be performed without the presence of sufficient board capital (Dalziel & Hillman, 2003). This notion is especially deeply rooted in the resource dependence theory, however it is a requirement for the fulfillment of the first board function, specified by the agency theory, as well (Dalziel & Hillman, 2003). Therefore, theories on board capital are included separately. Existing literature on board capital recognizes the existence of two key components of board capital, which are specified by two different theories. First of all, the human capital theory stresses the importance of the human capital being contributed by individual directors. This is the first theory to be discussed. Secondly, individual directors own social capital, also referred to as relational capital, which is the second and final theory to be explained.

Human capital theory

According to the human capital theory, a board of directors comprises a mix of human capital, being created by a combination of contributions by individual directors, which is drawn upon for exercising the board’s governance functions (Ingley & Van der Walt, 2003). Here, human capital is defined as “the skills, general or specific, acquired by an individual in the course of training and experience.” (Ingley & Van der Walt, 2003). A similar explanation is provided by Singh (2007), who states that an individual’s human capital accumulates based on one’s talents and backgrounds. Such human capital being contributed by individual directors can take various forms and is created in different ways. Besides other aspects, directors’ age, gender, independence, expertise and ethnicity are mentioned as being part of an individual’s human capital contribution to a firm (Ingley & Van der Walt, 2003) which indicates that each individual contribution to a firm differs. According to Singh (2007), this human capital benefits both the individual and the organization.

33 and Nicholson (2007), add to this that a lack of basic abilities cannot be substituted for by anything else.

Given the differing individual contributions of human capital, mentioned above, the second point arises. In order for a firm to extract maximum benefits from the human capital being contributed to the board, it is preferable to have variety in the human capital being provided. As a result, the board’s stock of human capital is increased and more (business) areas are covered, assuming that the individual directors who have been selected provide sufficient depth in their knowledge of these areas (Ingley & Van der Walt, 2003). Singh (2007) adds that human capital should be considered to be a key resource to a firm, which facilitates better team problem solving due to the presence of a variety of perspectives.

Taking these arguments into consideration, the human capital theory adds to the previously explained theories given its focus on individual directors’ abilities. As stated above, the theory explains the link between board composition and the cost of capital in two ways, which can both be regarded as being requirements for a board to be effective. In other words, a board should consist of skilled board members who have different types of skills and abilities. One can assume that this is appealing to both shareholders and debt holders, given the fact that a board which has a larger stock of human capital is more likely to achieve satisfactory performance on the functions described earlier.

Social capital theory

34 In general, social capital is regarded as an asset being held by an entire group, which is created due to individual contributions being made by board members (Cannella & Kim, 2008). In the case of external social capital, these contributions consist of linkages with external parties like suppliers, investors, politicians and other organizations. According to Singh (2007) and Hillman and Shropshire (2007), however, these ties can also be purely demographic.

Having such linkages provides the board and the firm with a competitive advantage over firms who do not have such a network. The biggest advantage of such linkages is that, by means of these ties with external parties, the board is able to secure resources and information (Dalziel & Hillman, 2003) from its direct environment which can be used for aligning the firm with its environment (Cannella & Kim, 2008). Consequently, the firm is able to decrease its environmental uncertainty, as proposed by the resource dependence theory (Holder-Webb & Sharma, 2008; Siciliano, 1996). Furthermore, as stated earlier, having such an extensive pool of information facilitates the development of better strategies (Ingley & Van der Walt, 2003). Finally, being linked to certain demographic groups by means of the board of directors may provide the firm with legitimacy with its stakeholders. For instance, societal pressures may be at work which, if not complying, may damage a firm’s reputation and result in a decrease in firm performance (Dalziel & Hillman, 2003).

In explaining the link between board composition and the cost of capital, this theory adds another perspective to the previous theories. In essence, the more external social capital a director has, the better it is for the board and the firm (Cannella & Kim, 2008). Given the requirement to have as many external social capital as possible, boards should, as with human capital theory, consist of various types of directors with different backgrounds and, consequently, different ties to external parties. As a consequence, the board’s network is increased and far more information and resources can be extracted from the parties with which the firm is linked through its board of directors.

3.2 Hypotheses

35 several board characteristics and the types of cost of capital. Ultimately, these arguments result in the formulation of several hypotheses, which are to be tested.

3.2.1 Board independence

Existing research on the relationship between board composition and firm performance often discusses the influence of having a large degree of independent directors on the board. These directors are also referred to as non-executives or outside directors. Given the existence of multiple descriptions for this type of directors, it is hard to determine a suitable definition (Cheng et al., 2007). In this report, these directors are defined as board members who do not have personal ties within the firm (Missionier-Piera & Piot, 2007) and have not been employed by the firm either (Aldamen et al., 2010), which makes them independent from management. In other words, these directors are able to independently judge management’s performance without being influenced by the management of the firm. In essence, the arguments made below generally consider board independence to contribute to corporate governance. However, it cannot be denied that some negative consequences may be present. For instance, non-independent directors, or insiders, may have more firm-specific information and expertise (Fama & Jensen, 1983). Furthermore, insiders can be expected to remain at a firm longer and, therefore, develop strong relationships with shareholders and debt holders (Fields et al., 2011; Hitt et al., 1993). In this thesis, however, the positive consequences are assumed to be of greater significance than the negative consequences. Below, these positive consequences are linked to the cost of capital using the agency theory.

This theory stresses the importance of the board’s monitoring function, for which, according to Ramly (2009), a high ratio of independent directors should be present on the board, which will result in a larger degree of board independence from management. Cheng et al. (2007) strengthen this argument by stating that a board of directors should consist of a majority of independent directors, in order to enhance the board’s monitoring responsibilities.

36 Given this improved monitoring, management is less able to pursue self-interested behavior. In other words, the hidden-action problem is decreased. Furthermore, higher board independence is associated with better information disclosure, which decreases the information asymmetry between the firm’s management and the suppliers of finance. Stated differently, a higher degree of board independence mitigates the agency problems. To conclude, shareholders and debt holders will face less uncertainty regarding future cash flows. As a result, the firm’s default risk is reduced (Bhojraj & Sengupta, 2003) and shareholders are more certain about their stock returns. Therefore, both parties will face lower agency costs and will, consequently, be less inclined to require a high rate of return for providing a firm with capital. More specifically, both the cost of equity and debt capital are lowered. Taking this into account, the following hypotheses have been developed:

Hypothesis 1a: The higher the degree of board independence, the lower the cost of equity capital.

Hypothesis 1b: The higher the degree of board independence, the lower the cost of debt capital.

3.2.2 Board competence

The next board characteristic to be considered is the competence of the board. This concept refers to the individual directors’ skills, abilities and resources being contributed to the board, which enable the board to perform its functions. In this research, however, board competence concerns the educational backgrounds of directors, indicating that the arguments presented below should be considered in this context.

In essence, the arguments made below generally point towards a positive influence of board competence on corporate governance. However, Anderson et al. (2004) do argue that directors with strong educational backgrounds may lack the necessary business experience and, as a consequence, be less effective as a director. Within this thesis, however, the positive consequences are considered to offset these potential negative implications. Below, all theories are used to explain the link between these positive consequences and the cost of capital.

37 (2005) propose that directors with better expertise and education are more likely to provide reliable information and, therefore, reduce the information asymmetry. This argument is strengthened by Anderson et al. (2004), who regard the relationship between director expertise and monitoring effectiveness to be positive as well. Haleblian et al. (2011) add to this by stating that competent boards, containing high levels of both human and social capital, will provide higher quality information and improve the processing of information. These consequences are, given their reliance on the availability of reliable information, especially important to debt holders.

In addition to its influence on a board’s monitoring function, board competence is of importance for the execution of the board’s second function, which concerns the provision of resources. When applying the resource dependence theory, several benefits arise from having a more competent board.

First of all, one can assume that more skilled directors are more likely to provide valuable advice and counsel than do less skilled directors (Dalziel & Hillman, 2003). Furthermore, having a larger variety of skills being contributed facilitates the development of better advice and counsel as well (Siciliano, 1996).

Secondly, having a more competent and prestigious board is assumed to provide the firm with legitimacy and a better reputation. Due to the inclusion of such directors, stakeholders receive a confirmation of the firm’s value (Dalziel & Hillman, 2003), making them less uncertain about the firm.

Thirdly, directors contribute social capital, which concerns the ties to external parties. Such ties provide access to information from the firm’s environment, with which the firm is able to develop strategies which anticipate the pitfalls and opportunities being present in the firm’s environment. In order to take advantage of these linkages, however, it becomes a matter of having the necessary abilities, or human capital, to be able to do this (Cannella & Kim, 2008). This is where directors’ educational backgrounds may be of importance.

38 importance for both shareholders and debt holders as well. In essence, it is argued that having a competent board is more likely to result in a satisfying execution of the monitoring function and an increased flow of information. Consequently, both the hidden action and adverse selection problems are mitigated. As a result, the firm’s default risk is reduced and the firm’s actual value and expected future cash flows can be estimated more precisely. Furthermore, having a more competent board is more likely to result in better strategies which are based on better information and better decision-making. Consequently, firms with such competent boards can be expected to perform better and remain sustainable. Furthermore, firms with competent boards are more likely to have strong reputations. Given this, it can be assumed that both shareholders and debt holders are more willing to provide the firm with finance and, consequently, require lower rates of return. Stated differently, both the cost of equity and the cost of debt are expected to be lower. This has been reformulated in the following hypotheses:

Hypothesis 2a: The more competent a board is, the lower the cost of equity capital. Hypothesis 2b: The more competent a board is, the lower the cost of debt capital.

3.2.3 Board diversity

An issue which has, over the past decade, increasingly been linked to the functioning of corporate boards is board diversity. This can be regarded as the extent to which variety is present among the board members. Several types of diversity exist. In this research, gender, age, nationality and ethnic diversity are considered. For each of these types, different proxies are used, as described in the next chapter.

39 stated otherwise. For explaining the relationship between board diversity and the cost of capital, several theories are used.

First of all, the agency theory can be applied. As stated earlier, this theory requires the board of directors to monitor management and provide independent oversight. According to Carter et al., (2002), having a diverse board makes the board more independent. Cheng et al. (2007) strengthen this statement by arguing that more diverse boards bring up more diverse perspectives which makes them more independent from management. In addition, having female directors on the board is associated with better financial reporting and information disclosure, which is especially appealing to debt holders (Gul et al., 2010).

Secondly, the resource dependence theory can be used. By increasing board diversity, firms are able to reap several benefits. The first benefit which may be appealing to a firm´s shareholders and debt holders is the improved advice and counsel being provided in the case of increased board diversity. Generally, having a more diverse board is associated with a larger diversity in the board’s stock of human capital which, consequently, is associated with a larger number of differing perspectives being contributed to the board. According to Campbell and Minguez-Vera (2008), this results in a broader view of the environment and the market place, which facilitates the development of better strategies, being in the best interest of both shareholders and debt holders. Ingley and Van der Walt (2003) strengthen this argument by stating that a lack of diversity can result in a lack of critical perspectives. Besides this first benefit, having a larger degree of board diversity may provide the firm with legitimacy and an improved reputation. In essence, firms are subject to pressures from society and other organizations. Given this, a firm will gain both legitimacy and reputation if it complies with such pressures (Hillman & Shropshire, 2007).

40 This section has shown that diversity in corporate boards has several benefits. These benefits can be linked to firms’ cost of capital in several ways. First of all, board diversity is assumed to improve a board’s independence and, consequently, its monitoring functions. As a consequence, a firm’s management is less able to perform self-interested actions and expropriate investments at the expense of shareholders and debt holders. Secondly, by having a variety of directors, different board capital is contributed. This results in a larger pool of information, an improved reputation and the provision of better advice and counsel. In other words, one can expect that the firm´s strategies are better and the firm remains sustainable and profitable. This is positive for both shareholders and debt holders.

When taking the above mentioned arguments into account, one can expect that both shareholders and debt holders are more willing to provide a firm with funds given the improved monitoring, decision-making and reputation of the firm. As a result, shareholders and debt holders lower their required rates of return which, as mentioned before, indicates a lower cost of capital for the firm. This can be formulated in the following hypotheses:

Hypothesis 3a: The more diverse a firm’s board is, the lower its cost of equity capital. Hypothesis 3b: The more diverse a firm’s board is, the lower its cost of debt capital.

3.2.4 Board size

Given the assumed importance of board composition for a firm’s cost of capital, another matter which becomes important is the size of the board. This refers to the amount of directors being present within the board. According to Ramly (2009) this final element is an essential determinant of the board’s functioning.

41 First of all, the agency theory can be used. Anderson et al. (2004) state that larger boards are more effective monitoring mechanisms and improve the financial reporting of the firm. More specifically, due to the fact that a large board consists of a larger number of directors, the work load, coming from work on committees, can be spread among them. Cheng et al. (2007) strengthen this statement. As a consequence, the directors have more time left for actually monitoring the firm’s management. Furthermore, Cheng et al. (2007) argue that larger boards are more likely to have a higher degree of board diversity and better board expertise (Anderson et al., 2004). Following the earlier sections, and hypotheses, it is expected that this larger diversity and expertise is associated with more board independence and better monitoring.

Secondly, the resource dependence theory can be used for explaining the relationship between board size and the cost of capital. As with the previous argument for agency theory, the main point to be considered here is the fact that having more directors results in a larger stock of both human and social capital. For instance, Anderson et al. (2004) argue that larger boards have more expertise. Similarly, Cheng et al. (2007) state that board diversity is higher in the case of a larger board size. Considering this, it can be expected that larger boards develop better advice and counsel, as a result of the larger stock of human capital. As a result, firms’ strategies may improve. Furthermore, according to Siciliano (1996), having more directors on the board increases the firm’s access to resources while, at the same time, being able to represent more parties. This final note is consistent with earlier arguments which were in favor of increasing board diversity. Furthermore, assuming that a larger board has more ties to external parties, it is expected that larger boards are better informed, given their larger pool of information. Taking these arguments into account, it can be assumed that firms with larger boards are able to extract more benefits from their board capital.

42 Secondly, by using the resource dependence theory it is assumed that a larger board size increases the firm’s human and social capital. As a result, better advice and counsel may be developed and more unique information can be extracted from the larger number of ties to external parties.

Taking the above mentioned arguments into account, both shareholders and debt holders are assumed to lower their required rates of return. In essence, these parties will attach lower levels of risk to these firms given the mitigation of agency problems, the development of better strategies and the decreased uncertainty as a result of the ties to external parties. Consequently, these firms’ cost of capital is assumed to be lowered. This has been formulated in the following hypotheses: