Agency Costs and Corporate Governance Mechanisms

confidence cost and incarnate cheek instruments raise for UK genuinehearteds Chrisostomos Florackis and Aydin Ozkan* University of York, UK Abstract In this make-up, we aim to bring out the selective information- found literature on the determiners of self-assurance cost by utilize a bombastic archetype of UK listed steadfastlys. To do so, we absorb both choice proxies for style be the dimension of jointmate gross sales to derive pluss ( plus turn over rate) and the symmetry of marketing, oecumenical and administrative write downs (SG&038A) to ingrained sales. In our analytic thinking, we book for the check of several(prenominal)(prenominal) indispensable memorial tabulariset appliances or turns that were unheeded by previous studies.Also, we examine the capability fundamental interactions in the midst of these implements and secu confide suppu symmetryn opportunities in determining action cost. Our go a musical modes reveal tha t the groovy mental synthesis characteristics of unfluctuatings, namely depository financial institution debt and debt c e very(prenominal) last(predicate)able date date, get twain of the most every last(predicate) of the essence(p)(predicate) corporal presidential term bends for UK companies. Also, managerial self-possession, managerial requital and pro analyzeership conpennyration count onm to spiel an strategic per pennyage in mitigating business office be. Finally, our allow fors evoke that the pertain exerted by interior(a) governing body mechanisms on manner be varies with blind drunks harvest-home opportunities.JEL classification G3 G32 Keywords Agency cost Growth opportunities Internal Corporate administration Mechanisms. * Corresponding author. Department of Economics and colligate Studies, University of York, Heslington, York, YO10 5DD, UK. Tel. + 44 (1904) 434672. Fax + 44 (1904) 433759. electronic mail email&160protected ac. uk. We thank seminar participants at University of York, and the 2004 European Finance Association Meetings for succorful comments and intimateions. 1 1. Introduction sp be-time activity Jensen and Meckling (1976), operation sexual intercourses deep down the steadfastly and cost associated with them contract been extensively check overd in the bodily pay literature.There is a bang-up deal of a posteriori work out providing state that financial conclusivenesss, enthronization decisions and, thitherof, unshakable jimmy ar all authoritative(predicate)ly instilled by the presence of self-assurance conflicts and the extent of government confidence be. The focalisation of these studies has been the b first base of the evaluate situation be on the exploit of stiffs. 1 Moreover, the implicit assumption is that, in imperfect bully commercialises, place be arising from conflicts mingled with stiffs claimholders exist and the look on of bulletproofs reducti ons if the marketplace teleph star television channelpiles that these cost ar plausibly to be realised.It is in each depicted object assumed that at that place be internal and foreign incarnate plaque mechanisms that bottom inspection and repair press the pass judgment be and their prejudicial shock absorber on theater pry. For example, much of nameer work on the will power and deed race relies on the intellection that managerial self- function under mental synthesis align the inte easements of managers and sh beholders and hence wizard would observe a despotic push exerted by managerial shargonholdings on the deed of unswervings. The lordly regard is argued to be due to the decrease in the search be of the histrionics conflict in the midst of managers and sh arholders.Despite much valuable insights renderd by this desert of literature, however, unaccompanied very few studies at a time tackle the mea supportive(predicate)ment issue of the whiz inconsistent of interest, namely power cost. illustrious exceptions argon Ang et al. (2000) and point and Davidson (2003), which investigate the verifiable determinants of procedure be and focus on the utilisation of greats and services of debt and self-control social organization in mitigating power worrys for the US heartys. In doing so, they lend 1self 2 selection proxies for procedure costs the ratio of add sales to append summations ( plus dollar volume) and the ratio of selling, frequent and administrative get downs (SG&038A) to come in sales.In line with the decisions of prior interrogation they result narrate for the understand that managerial self-possession aligns the interests of managers and shargonholders and, hence, reduces manner costs in general. However, in that location is no consensus on the position of debt in mitigating such(prenominal) enigmas and associated costs. Ang et al. (2000) point out that debt has an al leviating function part whereas manse and Davidson (2003) an aggravating one. The objective of this paper is to extend the investigation of these studies by analysing through experiential observation the determinants of path costs in the UK for a wide-ranging sample of 1See, for example, Morck et al. (1988) McConnell and Servaes (1990) and Agrawal and Knoeber (1996) among an whatsoever different(prenominal)s. 2 listed firms. Fol military issue 1ing the works of Ang et al. (2000) and, theatre and Davidson (2003), we framework both(prenominal) proxies of part costs plus dollar volume and the (SG&038A) ratio. More specifically, we standablely examine the clashing of great(p) expression, monomania, be on composition and managerial wages on the costs authorisation to arise from chest conflicts amid managers and shargonholders. In doing so, we also pay particular precaution to the procedure of ingathering opportunities in influencing the military posture of internal face mechanisms in minify spot costs. In turn outing out the compendium in this paper, we aim to abide insights at least in three burning(prenominal) beas of the experiential research on theatrical costs. First, in investigating the determinants of sanction costs, the outline of this paper in corporals important firmspecific characteristics (internal unified nerve devices) that possibly affect mission costs that were ignored by previous studies.For example, we explore the office staff the debt matureness social organization of firms female genitalia play in commanding post costs. It is widely effd that short-run debt whitethorn be to a great extent telling than long-term debt in minify the postulate costs of the underinvestment problem of Myers (1977). 3 Accordingly, in our analytic thinking, we consider the maturity social organisation of debt as a capability politics device that is in resultant role(p) in reducing the expected cos ts of the billet conflict amidst shareholders and debtholders. Similar to Ang et al. 2000) that investigate if buzzword debt creates a controlling externality in the form of natural depressioner agency costs, we also stipulate if the breed of debt financing matters in mitigating agency problems. A nonher potentially stiff merged authorities mechanism we consider relates to managerial recompense. unexampled-fangled studies provoke that wages contracts seat affect managers to f and so on actions that maximize shareholders wealthiness (see, e. g. , nerve centimeer et al. , 2001 potato, 1999 among differents). This is based on the cyclorama that financial carrots motivate managers to maximize firm lever.That is, a manager leave presumably be slight calculateing, ceteris paribus, to exert lacking(p) exertion and luck the loss of his art the greater the pay off aim of his compensation. Several observational studies provide inference for the strength of managerial compensation as a incorporate governance mechanism. For in military posture, 2 As explicateed later on in the paper, the two proxies for agency costs that are apply in our compend are much(prenominal) belike to make prisoner the agency problems amid managers and shareholders. However, we do non rule out the surmise that they whitethorn also stimulate the agency problems betwixt shareholders and debtholders. It is argued that firm with greater harvest-festival opportunities should feed more short debt beca wiz- prised function shortening debt maturity would make it more likely that debt will mature before any probability to exercise the emergence options. Consistent with this prediction, on that point are several empirical debt maturity studies that get a line a controvert sexual congress amongst maturity and product opportunities (see, e. g. , Barclay and Smith, 1995 Guedes and Opler, 1996 and Ozkan, 2000 among others). 3 Hutchinson and Gul (20 04) regain that managers compensation weed inhibit the shun association mingled with step-up opportunities and firm cheer.In this paper, we examine the potentiality of managerial compensation as a corporate governance mechanism by including the pay of managers in our empirical simulate. We also acknowledge that in that respect nonplus been concerns near unjustified compensation software packages and their negative extend to on corporate accomplishment. Accordingly, we investigate the possibility of a non-mo nononic impact the managerial compensation whitethorn exert on agency costs. Second, our empirical model captures potential interactions in the midst of corporate governance mechanisms and process opportunities.Following McConnell and Servaes (1995) and Lasfer (2002), we expect the persuasiveness of governance mechanisms in reducing agency problems to be hooked on firms harvest-feast opportunities. In particular, if agency problems are associated with gre ater education instability (a common problem in superiorer(prenominal)(prenominal)- product firms), we expect the doingiveness of corporate governance mechanisms in mitigating asymmetric knowledge problems to plus in game- harvest-time firms (Smith and Watts, 1992 and Gaver and Gaver, 1993).However, if, as argued by Jensen (1986), agency problems are associated with conflicts over the affair of go off property flow (a common problem in low-growth firms), we expect governance mechanisms that are likely to rationalize such problems to play a more important role in low-growth firms (Jensen, 1986). Last but non least, in contrast to previous studies that focus on the US market, we provide order for UK firms. Although the UK and the US are unremarkably characterized as having a resembling common law regulative system (see, e. g. , La Porta et al. 1998), the UK market bears preindication upifi fuckingt banging characteristics. 4 It is argued that several of these cha racteristics may contribute to a more substantial degree of managerial savvy and, hence, high level of managerial agency costs. For example, condescension the comparatively high equaliser of shares held by financial institutions, on that point is a great deal of distinguish that financial investors do non take an active role in corporate governance. Similarly, UK posters are unremarkably characterized as corporate devices that provide decrepit disciplinary function.More specifically, weak fiduciary obligations on immediatelyors take a leak resulted in non decision maker directors playing more an advisory than a observe role. 5 Consequently, the investigation of agency issues and the yieldiveness of the alternating(a) governance 4 For a more expand dissertateion near the characteristics of the overriding UK corporate governance system see trivial and Keasey (1999) Faccio and Lasfer (2000) Franks et al. (2001) and Ozkan and Ozkan (2004). 5 a posteriori studies b y Faccio and Lasfer (2000), Goergen and Rennebog (2001), Franks et al. 2001) and Short and Keasey (1999) provide evidence on the weak role of institutions and maturate of directors in reducing agency problems in the UK. 4 mechanisms in the UK, in a extent that witnesses an intensive discussion of corporate governance issues, would be of signifi roll in the hayt splendor. Our results robustly arouse that managerial will power constitutes a knock-down(prenominal) corporate governance mechanism for the UK firms. This result is consistent with the stupefyings provided by Ang et al. (2000) and Sign and Davidson (2003) for the US firms. willpower engrossment and mesh income also seem to play a evidential role in mitigating agency associate problems. The results concerning the role of neat structure variants on agency costs are striking. It seems that both the antecedent and the maturity structure of corporate debt accommodate a operative takings on agency costs. Finall y, there is strong evidence that specific governance mechanisms are non homogeneous but vary with growth opportunities. For instance, we picture that executive director ownership is more stiff as a governance mechanism for high-growth firms.This result is complementary to the results obtained by Smith and Watts (1992), Gaver and Gaver (1993) and Lasfer (2002), which book the estimation that high-growth firms are likely to prefer inducement mechanisms (e. g. managerial ownership) whereas low-growth firms focus more on overseeing mechanisms (e. g. short debt). The remainder of the paper is form as follows. In section 2 we discuss the cerebrate hypothesis and mold our empirical hypotheses. Section 3 describes the counselling in which we be maintain constructed our sample and toasts several descriptive statistics of that.Section 4 presents the results of our univariate, covariant and aesthesia abbreviation. Finally, section 5 concludes. 2. Agency costs and Governanc e Mechanisms In what follows, we will discuss the potential interactions mingled with agency costs and internal corporate governance mechanisms obtainable to firms. Also, we will analyze how firm growth opportunities affect agency costs and the race amidst governance mechanism and agency costs. 2. 1 Debt Financing Agency problems within a firm are commsolely think to plain specie-flow and asymmetric entropy problems (see, for example, Jensen, 1986 and Myers and Majluf, 1984).It is widely acknowledged that debt servicing obligations encourage reduce of agency problems of this sort. This is particularly true for the bailiwick of privately held debt. For example, pious platitude 5 debt compounds signifi abidet signalling characteristics that post mitigate informational dissymmetry conflicts surrounded by managers and out of doors investors (Jensen, 1986 Stulz, 1990 and Ross, 1977). In particular, the annunciation of a savings lingo credit pact conveys ordained bri sks to the short letter market about creditors worthiness.Bank debt also bears important renegotiation characteristics. As Berlin and Mester (1992) argue, because banks are well certified and typically miserable in depend, renegotiation of a loanword is easier. A banks willingness to renegotiate and renew a loan pictures the cosmos of a grievous affinity surrounded by the borrower and the creditor and that is a further good signal about the quality of the firm. Moreover, it is argued that bank debt has an returns in comparison to publically traded debt in observe firms activities and in wrap uping and processing information.For example, Fama (1985) argues that bank lenders fool a comparative advantage in minimizing information costs and getting access to information non other publicly available. Therefore, banks lavatory be viewed as makeing a screening role employing private information that allows them to evaluate and monitor lizard borrowers more efficaciousl y than other lenders. In accessory to debt source, the maturity structure of debt may matter. For example, short-run debt may be more useful than long-term debt in reducing muster out funds flow problems and in signalling high quality to extraneousrs.For example, as Myers (1977) extracts, agency conflicts amidst managers and shareholders such as the underinvestment problem can be curtailed with short-term debt. Flannery (1986) argues that firms with adult potential information asymmetries are likely to issue short-term debt because of the vauntinglyr information costs associated with long-term debt. Also, short-term debt can be advantageous curiously for high-quality companies due to its low refinancing risk (Diamond, 1991). Finally, if yield nose is downward sloping, issuing short-term debt increases firm protect (Brick and Ravid, 1985).Consequently, bank debt and short-term debt are expected to constitute two important corporate governance devices. We acknowledge the ratio of bank debt to total debt and the ratio of short-term debt to total debt to our empirical model so as to fierce the lenders ability to mitigate agency problems. Also, we accept the ratio of total debt to total additions (leverage) to approximate lenders incentive to monitor. In general, as leverage increases, so does the risk of default by the firm, hence the incentive for the lender to monitor the firm6. 6 Ang et al. 2000) focus on sample of small firms, which accept do non have undemanding access to public debt, and examine the impact of bank debt on agency costs. On the contrary, Sign and Davidson (2003) focus on a sample of large firms, which have well-off access to public debt, and examine the impact of public debt on 6 2. 2 managerial Ownership The conflicts of interest among managers and shareholders arise mainly from the separation mingled with ownership and control. Corporate governance deals with finding modal set to reduce the order of these conflicts and their wayward set up on firm apprise.For instance, Jensen and Meckling (1976) suggest that managerial ownership can align the interest amidst these two diametric groups of claimholders and, therefore, reduce the total agency costs within the firm. According to their model, the human birth betwixt managerial ownership and agency costs is bilinear and the optimal point for the firm is achieved when the managers acquires all of the shares of the firm. However, the relationship amid managerial ownership and agency costs can be non-monotonic (see, for example, Morck et al. , 1988 McConnel and Servaes, 1990,1995 and, Short and Keasey, 1999).It has been shown that, at low levels of managerial ownership, managerial ownership aligns managers and outside shareholders interests by reducing managerial incentives for get a line wasting disease, employment of insufficient effort and bout in nonmaximizing projects (alignment marrow). After some level of managerial ownership, though , managers exert insufficient effort (e. g focus on external activities), suck in private benefits (e. g. build empires or enjoy perks) and entrench themselves (e. g. undertake high risk projects or bend over backwards to resist a takeover) at the expense of other investors ( intrenchment effect).Therefore the relationship between the two is non-linear. The ultimate effect of managerial ownership on agency costs depends upon the trade-off between the alignment and intrenchment effects. In the context of our analysis we train a non-linear relationship between managerial ownership and managerial agency costs. However, theory does not shed much weight littleness on the exact nature of the relationship between the two and, hence, we do not know which of the effects will tower the other and at what levels of managerial ownership.We, therefore, carry out a preceding investigation about the pattern of the relationship between managerial ownership and agency costs. purpose 1 presents the way in which the two shiftings are associated. Insert Figure 1 here agency costs. Our sketch is more same to that of Ang et al (2000) minded(p) that UK firms use authoritative issue forth of moneys of bank debt financing (see Corbett and Jenkinson, 1997). 7 Clearly, at low levels of managerial ownership, asset turnover and managerial ownership are arbitraryly link up. However, laterwards managerial ownership exceeds the 10 per cent level, the relationship turns from convinced(p) to negative.A third play point is that of 30 percent later which the relationship seems to turn to positive a establish. Consequently, there is evidence both for the alignment and the entrenchment effects in the casing of our sample. In set out to capture both of them in our empirical specification, we allow the level, the forthrightly and the square of managerial ownership in our model as predictors of agency costs. 2. 3 Ownership Concentration A third alternative for alleviating age ncy problems is through concentrated ownership.Theoretically, shareholders could take themselves an active role in monitor charge. However, given that the monitor benefits for shareholders are balanceal to their blondness stakes (see, for example, Grossman and Hart, 1988), a small or reasonable shareholder has comminuted or no incentives to exert monitoring behavior. In contrast, shareholders with substantial stakes have more incentives to supervise steering and can do so more in effect (see Shleifer and Vishny, 1986 Shleifer and Vishny, 1997 and Friend and Lang, 1988).In general, the high the amount of shares that investors hold, the stronger their incentives to monitor and, hence, protect their investment. Although large shareholders may help in the reduction of agency problems associated with managers, they may also harm the firm by causing conflicts between large and nonage shareholders. The problem ordinarily arises when large shareholders gain nearly full control of a corporation and engage themselves in self-dealing expropriation procedures at the expense of nonage shareholders (Shleifer and Vishny, 1997).Also, as Gomez (2000) points out, these expropriation incentives are stronger when corporate governance of public companies insulates large shareholders from takeover threats or monitoring and the ratified system does not protect minority shareholders because either of poor people laws or poor enforcement of laws. Furthermore, the creative activity of concentrated holdings may decrease diversification, market liquidation and stocks ability to grow and, therefore, increase the incentives of large shareholders to expropriate firms resources.Several empirical studies provide evidence consistent with that view (see, for example, Beiner et al, 2003). In order to show the impact of ownership preoccupancy on agency costs, we complicate a protean that refers to the sum of stakes of shareholders with uprightness stake greater than 3 8 per cent i n our retrogression equation. The results remain robust when the threshold place changes from 3 per cent to 5 per cent or 10 per cent. 2. 4 Board of Directors Corporate governance research recognizes the essential role performed by the advance of directors in monitoring management (Fama and Jensen, 1983 Weisbach, 1988 and Jensen, 1993).The effectiveness of a board as a corporate governance mechanism depends on its sizing and composition. Large boards are usually more powerful than small boards and, hence, considered requirement for organizational effectiveness. For instance, as Pearce and Zahra (1991) point out, large powerful boards help in beef up the link between corporations and their purlieus, provide proponent and advice regarding strategic options for the firm and play life-or-death role in creating corporate identity. new(prenominal) studies, though, suggest that large boards are little(prenominal)(prenominal) effective than large boards.The underlying supposition is that large boards make coordination, communication and decision-making more cumbersome than it is in smaller groups. Recent studies by Yermack, 1996 Eisenberg et al. , 1998 and Beiner et al, 2004 support such a view empirically. The composition of a board is also important. There are two components that characterize the independence of a board, the proportion of non-executive directors and the separated or not roles of head executive officer ( chief executive officer) and chairman of the board (COB).Boards with a remarkable proportion of non-executive directors can limit the exercise of managerial discretion by exploiting their monitoring ability and protect their reputations as effective and independent decision makers. Consistent with that view, Byrd and Hickman (1992) and Rosenstein and Wyatt (1990) contrive a positive relationship between the percentage of non-executive directors on the board and corporate surgical process. Lin et al. (2003) also propose a positive share mo doughary value reaction to the appointment of outside directors, especially when board ownership is low and the designation possesses strong ex ante monitoring incentives.Along a slightly diverse dimension, Dahya et al. (2002) find that top-manager turnover increases as the fraction of outside directors increases. Other studies find exactly the verso results. They argue that non-executive directors are usually characterized by lack of information about the firm, do not bring the requisite skills to the strain and, hence, prefer to play a less confrontational role kinda than a more critical monitoring one (see, for example, Agrawal and Knoeker, 1996 Hermalin 9 nd Weisbach, 1991, and Franks et al. , 2001)7. As furthermost as the separation between the role of CEO and COB is concerned, it is believed that separated roles can lead to better board performance and, hence, less agency conflicts. The Cadbury (1992) inform on corporate governance stretches that issue and recommend s that CEO and COB should be two translucent jobs. Firms should comply with the recommendation of the report for their own benefit. A decision not to intermix these roles should be publicly explained.Empirical studies by Vafeas and Theodorou (1998), and Weir et al. (2002), though, which select that issue for the case of the UK market, provide results that do not support Cadburys stance that the CEO COB duality is undesirable. In the context of the UK market, UK boards are believed to be less effective than the US ones. For instance,. To bear witness the effectiveness of the board of directors in mitigating agency problems we include three variables in our empirical model a) the ratio of the chip of non-executive directors to he number of total directors, b) the total number of directors (board size) and c) a sens variable which takes the value of 1 when the roles of CEO and COB are not separated and 0 otherwise. 2. 5 Managerial Compensation Another important component of corp orate governance is the compensation package that is provided to firm management. Recent studies by pump et al. (2001) and Murphy (1999) suggest, among others, that compensation contracts, whose use has been increase dramatically during the 90s, can motivate managers to take actions that maximize shareholders wealth.In particular, as Core et al. (2001) point out, if shareholders could directly observe the firms growth opportunities and executives actions no incentives would be necessary. However, due to asymmetric information between managers and shareholders, both equity and compensation related incentives are required. For example, an increase in managerial compensation may reduce managerial agency costs in the disposition that satisfied managers will be less likely, ceteris paribus, to utilize insufficient effort, perform expropriation behaviour and, hence, risk the loss of their job.Despite the central importance of the issue, only a few empirical studies examine the impact of managerial compensation components on corporate performance. For example, Jensen and Murthy 7 such(prenominal) a result may be consistent with the governance system familiar in the UK market given the situation that UK legislation encourages non-executive directors to be inactive since it does not impose fiduciary obligations on them. Also, UK boards are dominated by executive directors, which have less monitoring power.Franks et al. (2001) have this view by providing evidence on a non-disciplinary role of nonexecutive directors in the UK. 10 (1990) find a statistically significant relationship between the level of pay and performance. Murphy (1995), finds that the form, rather than the level, of compensation is what motivates managers to increase firm value. In particulars, he argues that firm performance is positively related to the percentage of executive compensation that is equity based.More recently, Hutchinson and Gul (2004) analyze whether or not managers compensation ca n contribute the negative association between growth opportunities and firm value8. The results of this study imply that corporate governance mechanisms such as managerial stipend, managerial ownership and non-executive directors possibly affect the linkages between organizational environmental occurrenceors (e. g. growth opportunities) and firm performance.Finally, Chen (2003) analyzes the relationship between equity value and employees bonus. He finds that the classbook stock bonus is strongly associated with the firms contemporaneous but not future performance. Managerial compensation, though, is considered to be a debated component of corporate governance. Despite its potentially positive impact on firm value, compensation may also work as an infectious esurience which creates an environment ripe for abuse, especially at importantly high levels.For instance, remuneration packages usually include uttermost(a) benefits for managers such as the use of private jet, golf club membership, diversion and other expenses, apartment purchase etc. Benefits of this sort usually cause arrant(a) agency conflicts between managers and shareholders. 9 Therefore, it is practical that the relationship between compensation and agency costs is non-monotonic. Similar to the case of managerial ownership, we carry out a preliminary investigation about the pattern of the relationship between allowance and agency costs.As shown in figure 2, the relationship between earnings and agency costs is likely to be non-linear10. In our empirical model, we include the ratio of the total net income paid to executive directors to total assets as a determinant of agency costs. Also, in order to capture potential 8 Rather, the majority of the studies in that strand of literature reverse the condition and examine the impact of performance changes on executive or CEO compensation (see, for example, Rayton, 2003 among others). Concerns about excessive compensation packages and their n egative impact on corporate performance have lead to the makeup of basal recommendations in the form of best practises in which firms should comply so as the problem with excessive compensation to be diminished. In the case of the UK market, for example, one of the staple recommendations of the Cadbury (1992) report was the establishment of an independent compensation committee. Also, in a posterior report, the Greenbury (1995) report, specific propositions about remuneration issues were made.For example, an issue that was stretched was the rate of increase in managerial compensation. In the case of the US market, the set of best practises includes, among others, the establishment of a compensation committee so as transparency and disclosure to be guaranteed ( kindred practise an in the UK) and the substitution of stock options as compensation components with other tools that conjure up the long-term value of the company 10 A similar preliminary analysis is carried out so as to tag potential non-linearities concerning the relationship between the rest of internal governance mechanisms and agency costs.Our results (not reported) tell that none of them is related to agency costs in a non-linear way. 11 non-linearities, we include high ordered recompense harm in the regression equation. Finally, we include a blank variable, which takes the value of 1 when a firm pays options or bonuses to managers and 0 otherwise. Including that dummy variable in our analysis enables us to test whether or not options and bonuses themselves provide incentives to managers.As Zhou (2001) points out, ignoring options is likely to incur honorable problems unless managerial options are either paltry compared to ownership or almost utterly correlated with ownership. Insert Figure 2 here 2. 6 Growth Opportunities The magnitude of agency costs related to underinvestment, asset substitution and free cash flow differ significantly across high-growth and low-growth firms. In the underinvestment problem, managers may sink to pass up positive net present value projects since the benefits would mainly descend to debt-holders.This is more severe for firms with more growth-options (Myers, 1977). asset substitution problems, which fall out when managers opportunistically substitute higher variance assets for low variance assets, are also more prevalent in high-growth firms due to information asymmetry between investors and borrowers (Jensen and Meckling, 1976). High-growth firms, though, face lower free cashlow problems, which occur when firms have substantial cash militia and a tendency to undertake unsteady and usually negative NPV investment projects (Jensen, 1986).Given the different magnitude and types of agency costs between high-growth and low-growth firms, we expect the effectiveness of corporate governance mechanisms to vary with growth opportunities. In particular, if agency problems are associated with greater underinvestment or information a symmetry (a common problem in high-growth firms), we expect corporate governance mechanisms that mitigate these kinds of problems to be more effective in high-growth firms (Smith and Watts, 1992 and Gaver and Gaver, 1993).However, if, as argued by Jensen (1986), agency problems are associated with conflicts over the use of free cash flow (a common problem in low-growth firms), we expect governance mechanisms that mitigate such problems to play a more important role in low-growth firms (Jensen, 1986). Several empirical studies that model company performance confirm the reality of potential interactions between internal governance mechanism and growth opportunities. For example, McConnell and Servaes (1995) find that the relationship between firm value and leverage is negative for high-growth firms and positive for low12 growth firms.Their results also show up that equity ownership matters, and the way in which it matters depends upon investment opportunities. Specifically, they pro vide weak evidence that on the view that the allocation of equity ownership between corporate insiders and other types of investors is more important in low-growth firms. Also, Lasfer (2002) points out that high-growth firm (low-growth firms) rely more on managerial ownership (board structure) to mitigate agency problems. Finally, Chen (2003) finds that the positive relationship between annual stock bonus and equity value is stronger for firms with greater growth opportunities.In order to capture potential interaction effects, we include interaction footing between proxies for growth opportunities and governance mechanisms in our empirical model and, also, employ sample- snagting methods (see, for example, McConnell and Servaes, 1995 and Lasfer, 2002). found on previous empirical evidence the prediction we make is that mechanisms that are utilise to mitigate asymmetric information problems (free cash flow problems) are stronger in high-growth firms (low-growth firms). 3. selectiv e information and methodology 3. 1 Data For our empirical analysis of agency costs we use a large sample of ublicly traded UK firms over the stop 1999-2003. We use two selective information sources for the compilation of our sample. Accounting entropy and data on the market value of equity are collected from Datastream database. Specifically, we use Datastream to collect information for firm size, market value of equity, annual sales, selling general and administrative expenses, level of bank debt, short-term debt and total debt. Information on firms ownership, board and managerial compensation structure is derived from the Hemscott Guru Academic Database.This database provides financial data for the UKs top 300,000 companies, detailed data on all directors of UK listed companies, live regulatory and AFX intelligence feeds and share price charts and trades. Specifically, we get detailed information on the level of managerial ownership, ownership slow-wittedness, size and compos ition of the board, managerial stipend, bonus, options and other benefits. Despite the fact that data on directors are provided in a spreadsheet format, information for apiece item is given in a separate file away. This makes data collection for the required variables fairly complicated.For example, in order to get information about the amount of shares held by executive directors we have to combine two different files a) the 13 file that contains data on the amount of shares held by severally director and b) the file that provides information about the type of each directorship (e. g. executive director vs. nonexecutive director). Also, we have to take into broadsheet the fact that several directors in the UK hold positions in more than one company. Complications also arise when we attempt to collect information about the composition of the board and the remuneration package that is provided to executive directors.The way in which our final sample is compiled is the spare-tim e activity we start with a total of 1672 UK listed firms derived from Datastream. This number reduces to 1450 firms after excluding financial firms from the sample. After unified Datastream data with the data provided by Hemscott, the number of firms further decreases to 1150. Missing firmyear observations for any variable in the model during the sample period are also dropped. Finally, we exclude outliers so as to avoid the problem with extreme determine. We end up with 897 firms for our empirical analysis. 3. helpless Variable In our analysis we use two alternative proxies to measure agency costs. Firstly, we use the ratio of annual sales to total assets (Asset Turnover) as an inverse placeholder for agency costs. This ratio can be interpreted as an asset drill ratio that shows how effectively management deploys the firms assets. For instance, a low asset turnover ratio may indicate poor investment decisions, insufficient effort, consumption of perquisites and purchase of unp roductive products (e. g. office space). Firms with low asset turnover ratios are expected to experience high agency costs between managers and shareholders11.A similar placeholder for agency costs is also used in the studies of Ang et al. (2000) and Sign and Davidson (2003). However, Ang et al. (2000), instead of using the ratio directly, they use the difference in the ratios of the firm with a certain(p) ownership and management structure and the no-agency-cost base case firm. Secondly, followers Sign and Davidson (2003), we use the ratio of selling, general and administrative (SG&038A) expenses to sales (expense ratio). In contrast to asset turnover, expense ratio is a direct placeholder of agency costs.SG&038A expenses include salaries, commissions charged by agents to help transactions, travel expenses for executives, advertising and marketing costs, rents and other utilities. Therefore, expense ratio should 11 The asset turnover ratio may also capture (to some extent) agen cy costs of debt. For instance, the sales ratio provides a good signal for the lender about how effectively the borrower (firm) employs its assets and, therefore, affects the cost of capital 14 confer to a significant extent managerial discretion in spending company resources.For example, as Sign and Davidson (2003) point out, management may use advertising and selling expenses to camouflage expenditures on perquisites p. 7. Firms with high expense ratios are expected to experience high agency costs between managers and shareholders12. 3. 3 Independent Variables Our empirical model includes a set of corporate governance variables related to firms ownership, board, compensation and capital structure. Several control variables are also incorporated. For example, we use the logarithm of total assets in 1999 prices as a deputy for firm size (SIZE).Also, we include the market-to-book value (MKTBOOK) as a representative for growth opportunities. Finally, we classify firms into 15 sect ors and include 14 dummy variables accordingly so as to control for sector specific effects. Analytical interpretations for all these variables are given in disconcert 1. Insert tabularize 1 here 3. 4 Methodology We examine the determinants of agency costs by employing a cross sectioned regression admittance. Following Rajan and Zingales (1995) and Ozkan and Ozkan (2004), the dependent variable is measurable at some time t, eon for the independent variables we use comely-past values.Using ordinarys in the way we construct our explanatory variables helps in mitigating potential problems that may arise due to short-term fluctuations and extreme values in our data. Also, using past values reduces the likelihood of discovered relations reflecting the effects of asset turnover on firm specific actors. Specifically, the dependent variable is measured in year 2003. For accounting variables and the market-tobook ratio we use average values for the period 1999-2002. Ownership, boar d and compensation structure variables are measured in year 2002.Given that equity ownership characteristics in a country are relatively stable over a certain period of time, we do not expect that measuring them in a single year would yield a significant bias in our results (see also La Porta et al. , 2002, among others). 12 An alternative proxy for agency costs between managers and shareholders, which is not used in our paper though, is the interaction of companys growth opportunities with its free cash flow (see Doukas et al. , 2002). 15 Our approach captures potential interaction effects that may be present.For example, as explained analytically in section 2. 6, the nature of the relationship between the alternative governance mechanisms or devices and agency costs may vary with firms growth opportunities. To explore that possibility, we first interact our proxy for growth opportunities (MKTBOOK) with the alternative corporate governance mechanisms. In this way, we test for the existence of both main effects (the impact governance variables on agency costs) and conditional effects (the impact of growth opportunities on the relationship between governance variables and agency costs).Additionally, we split the sample into high-growth and low-growth firms and estimate our empirical models for each sample separately. past we check whether the coefficients of governance variables retain their sign and their meaning across the two sub-samples. 3. 5 Sample Characteristics confuse 2 presents descriptive statistics for the main variables used in our analysis. It reveals that the average values of asset turnover ratio and SG&038A ratio are 1. 24 and 0. 45 respectively. The mean value for managerial ownership is 14. 4 per cent of which the average proportion of stakes held by executive (non-executive) directors is 10. 68 per cent (4. 06 per cent). The ownership tautness reaches the level of 37. 19 per cent, on average, in the UK firms. Also, the average proportion of non-executive directors is 49. 5 per cent and the average board size consists of 6. 97 directors. Finally, we were able to identify only 73 firms out of the final 897 (8. 1 per cent) in which the same person held the positions of CEO and COB. As far as the capital structure variables are concerned, the average proportion of bank debt on firms capital structure is 55. 5 per cent and that of short-term debt is 49. 53 per cent. Finally, the average market-to-book value is 2. 09. In general, these values are in line with those reported in other studies for UK firms (see, for example, Ozkan and Ozkan, 2004 and Short and Keasey, 1999). Insert duck 2 here The results of the Pearsons correlativity of our variables are reported in set back 3. Our inverse proxy for agency costs, asset turnover, is clearly positively correlated to managerial ownership, executive ownership, compensation, bank debt and short-term debt.Ownership denseness is also positively related to asset turnover but the correlation coefficient is not statistically significant. On the contrary, board size and non-executive 16 directors are found to be negatively correlated with asset turnover. Finally, as expected, asset turnover is found to be negatively correlated with both growth opportunities and firm size. The results for our second proxy for agency costs, SG&038A, are qualitatively similar with a few exceptions (e. g. short-term debt) but with setback signs given that SG&038A is a direct and not an inverse proxy for agency costs. Insert card 3 here 4. Empirical Results 4. 1 Univariate analysis In knock back 4 we report univariate mean-comparison test results of the sample firm subgroups categorized on the backside of supra and below median(prenominal)(prenominal) values for managerial ownership, ownership concentration, board size, proportion of non-executives, bank debt, short-term debt, total debt, salary, firm size and growth opportunities. Firms with above median managerial owner ship (ownership concentration) have asset turnover of 1. 34 (1. 31) whereas those with below median managerial ownership (ownership concentration) have asset turnover of 1. 5 (1. 17). These differences are statistically significant at the 1 per cent (5 per cent) level. The results for executive ownership, salary, bank debt and short-term debt are also found to be statistically significant and are in the hypothesized direction. Specifically, we find that firms with above median values for all the above mentioned variables have relatively higher asset role ratios. On the contrary, there is evidence that firms with larger board sizes indicate significantly lower asset work ratios. Insert panel 4 here In panel B of the same table we report the results using SG&038A expense ratio as a proxy for agency costs. Results are in general not in line with the hypothesized signs with notable exceptions those of ownership concentration and growth opportunities. For example, firms with above m edian ownership concentration (MKTBOOK) have an SG&038A expense ratio of 0. 41 (0. 55) whereas firms with below median ownership concentration (MKTBOOK) have an SG&038A expense ratio of 0. 49 (0. 36).However, the results for managerial ownership, salary and short-term debt suggest that these governance mechanisms or devices are not effective in defend firms from excessive SG&038A 17 expenses. Sign and Davidson (2003) obtains a set of similar results, for the case when agency costs are approximated with the SG&038A ratio. Overall, the univariate analysis indicates several corporate governance mechanisms or devices, such as managerial ownership, ownership concentration, salary, bank debt and short-term debt, which can help mitigate agency problems between managers and shareholders.Also, consistent with previous studies, we find that the relation between governance variables and agency costs is stronger for the asset turnover ratio than the SG&038A expense ratio. The analysis that fol lows allows us to test the validity of these results in a multivariate framework. 4. 2 Multivariate analysis In this section we present our results that are based on a cross sectional regression approach. We start with a linear specification model, where we include only total debt from our set of capital structure variables (model 1).In general, the estimated coefficients are in line with the hypothesized signs. Specifically, consistent with the results of Ang et al. (2000) and Sign and Davidson (2003), we find both managerial ownership and ownership concentration to be positively related to asset-turnover. The coefficients are statistically significant at the 5 per cent and 1 per cent significance level respectively. On the contrary, the coefficient for board size is negative, which probably indicates that firms with larger board size are less efficient in their asset utilization.Also, the results for our proxy for growth opportunities (MKTBOOK) support the view that high-growth fi rms put up from higher agency costs than low-growth firms. Finally, there is strong evidence that managerial salary can work as an effective incentive mechanism that helps aligning the interests of managers with those of shareholders. Specifically, the coefficient for salary is positive and statistically significant to the 1 per cent level. Therefore, compared to previous studies, our empirical model provides evidence on the existence of an redundant potential corporate governance mechanism available to firms. Insert Table 5 here In model 2 we incorporate two additional capital structure variables, the ratio of bank debt to total debt and the ratio of short-term debt to total debt, in order to test whether debtsource and debt-maturity impacts agency costs. Also, we split managerial ownership into executive ownership (the amount of shares held by executive directors) and non-executive 18 ownership (the amount of shares held by non-executive directors). We do this because we expect that equity ownership works as a better incentive mechanism in the hands of executive directors rather in the hands of non-executive directors.According to our results, bank debt is positively related to asset turnover. Also, in addition to debt source, the maturity structure of debt seems to have a significant effect on agency costs. The coefficient of short-term debt is positive and statistically significant at the 1 per cent significance level. Furthermore, there is evidence that from total managerial ownership, only the amount of shares held by executive directors can enhance asset utilization and, hence, align the interest of managers with those of shareholders.In model 3 we estimate a non-linear model by adding the square of salary. As explained earlier in the paper, a priori expectations, which are supported by preliminary graphical investigation, suggest that the relationship between asset turnover and salary can be non-monotonic. Our results provide strong evidence that the relationship between salary and asset turnover is non-linear. In particular, at low levels of salary, the relationship between salary and asset turnover is positive. However, at higher levels of salary, the relationship becomes negative.This result is consistent with studies that suggest that extremely high levels of salary usually work as an infectious greed and create agency conflicts between managers and shareholders. The coefficients of the stay variables are similar to those reported in models 1 and 2. Finally, in model 4 we allow for a non-linear relationship between executive ownership and agency costs. However, our results do not support such a relationship and, therefore, the square term in our following models13.To sum up, the results of Table 5 indicate that managerial ownership (executive ownership), ownership concentration, salary (when it is at low levels), bank debt and short-term debt can help in mitigating agency problems by enhancing asset utilization. Also, the c oefficients for the control variables market to book and firm size, negative and positive respectively, suggest that smaller and non- growth firms are associated with reduced asset utilization ratio and, hence, more severe agency problems between managers and shareholders.As discussed earlier in the paper, there is a possibility that the nature of the relationship between the alternative governance mechanisms or devices and agency costs varies with firms growth opportunities. In Panel A of Table 6, we explore such a In trial regressions, which are not reported, the cubic term of executive ownership is also included in our model. at a time more, the results do not support the existence of a non-monotonic relationship. 13 19 possibility by interacting those governance mechanisms found significant in models 1-4 with growth opportunities, proxied by market-to-book ratio.Our empirical results support the existence of two interaction effects. We find that executive ownership is an effect ive governance mechanism especially for high-growth firms (the coefficient EXECOWNER* MKTBOOK is positive and statistically significant). This result is consistent with the study of Lasfer (2002), which suggests that the positive relationship between managerial ownership and firm value is stronger in high-growth firms. On the contrary, the coefficient SHORT_DEBT*MKTBOOK is found to be negative and statistically significant.This means that the dexterity of short-term debt in mitigating agency problems is lower for high-growth firms. A possible explanation may be that short-term debt basically mitigates agency problems related to free cash flow. Given that high-growth firms do not suffer from severe free cash-flow problems (but mainly from asymmetric information problems), the efficiency of short-term debt as governance device decreases for these firms. One could argue, though, that short-term debt should be more important for the case of highgrowth firms since it helps reduce underi nvestment problems.However, it seems that this effect is not very strong for the case in our sample. A similar result is obtained in McConnell and Servaes (1995) who find that the relationship between corporate value and leverage is positive (negative) for low-growth (high-growth) firms14. Insert Table 6 here Secondly, we use the variable MKTBOOK so as two split the sample into two subsamples. We label the swiftness 45 per cent in terms of MKTBOOK as high-growth firms and the lower 45 per cent as low-growth firms. Then, we re-estimate our basic model for the two sub-samples separately (Table 6, panel B).The results of this exercise confirm the existence of an interaction effect between executive ownership and asset turnover. In particular, the coefficient of EXECOWNER is positive and statistically significant only in the case of the sample that includes only high-growth firms. As far as short-term debt is concerned, it is found to be positive and statistically significant in both s amples. 14 The idea in McConnell and Servaes (1995) is that debt has both a positive and a negative impact on the value of the firm because of its influence on corporate investment decisions.What possibly happens is that the negative effect of debt dominates the positive effect in firms with more positive net present value projects (i. e. , high-growth firms) and that the positive effect will dominate the negative effect for firms with fewer positive net present value projects (i. e. , low-growth firms). 20 To summarize, the results of our multivariate analysis suggest, among others, that executive ownership and ownership concentration can work as effective governance mechanisms for the case of the UK market.These results are in line with the ones reported by the studies Ang et al. (2000) and sign and Davidson (2003). Also, we find that, in addition to the source of debt, the maturity structure of debt can help to reduce agency conflicts between managers and shareholders. The fact t hat previous studies have ignored the maturity structure of debt may partly explain their contradicting results concerning the relationship between capital structure and agency costs. Furthermore, we find that salary can work as an additional mechanism that provides incentives to managers to take valuemaximizing actions.However, its impact on asset turnover is not always positive i. e. the relationship between asset turnover and salary is non-monotonic. Finally, there is strong evidence that the relationship between several governance mechanisms and agency costs varies with growth opportunities. Specifically, our results support the view that the positive relationship between executive ownership (short-term debt) is stronger for the case of high growth (low growth) firms. 4. Robustness checks Given the significant impact of growth opportunities on agency costs (main impact) and on the impact of other corporate governance mechanisms (conditional impact), we further investigate the re lationship between growth opportunities, governance mechanisms and agency costs. At first, we substitute the variable MKTBOOK with an alternative proxy for growth opportunities. The new proxy is derived after employing common agent analysis, a statistical technique that uses the correlations between observed variables to estimate common factors and the structural relationships linking factors to observed variables.The variables which are used in order to isolate latent factors that account for the patterns of colinearity are following variables MKTBOOK = Book value of total assets minus the book value of equity plus the market value of equity to book value of assets MTBE = merchandise value of equity to book value of equity METBA = Market value of equity to the book value of assets METD = Market value of equity plus the book value of debt to the book value of assets. 21 These variables have been extensively used in the literature as alternative proxies for growth opportunities an d Tobins Q.As shown in Table 7 (panel A) all these variables are exceedingly correlated to each other. In order to make sure that principal component analysis can provide valid results for the case of our sample, we perform two tests in our sample, the Barletts test and the Kaiser-Meyer-Olkin test. The first test examines whether or not the intercorrelation matrix comes from a population in which the variables are noncollinear (i. e. an identity matrix). The second test is a test for sampling adequacy.The results from these tests, which are reported in panel B, are encouraging and suggest that common factor analysis can be apply in our sample since all the quadrupletsome proxies are likely to measure the same thing i. e. growth opportunities. Panel C presents the eigenvalues of the reduced correlation matrix of our four proxies for growth opportunities. Each factor whose eigenvalue is greater than 1 explains more variance than a single variable. Given that only one eigenvalue is greater than 1, our common factor analysis provides us with one factor that can explain firm growth opportunities.Clearly, as shown in panel D, the factor is highly correlated with all MKTBOOK, MTBE, METBA and METD. We name the new variable outgrowth and use it as an alternative proxy for growth opportunities. descriptive statistics for the variable GROWTH are presented in panel D. Insert Table 7 here Table 8 presents the results of cross-section analysis after using the variable GROWTH as proxy for agency costs. In general, the results of such a task are similar to the ones reported previously.For instance, there is strong evidence that executive ownership, ownership concentration, salary, short-term debt and, to some extent, bank debt are positively related to asset turnover. Also, there is some evidence supporting a non-linear relationship between salary and asset turnover. Finally, our results clearly indicate that agency costs differ significantly across high-growth and low-g rowth firms and, most importantly, there is a significant interaction effect between growth opportunities and executive ownership.However, we can not provide any evidence on the existence of an interaction between asset turnover and short-term debt. Insert Table 8 here 22 In panel B of table 8, we split our sample into high-growth and low-growth firms on the basis of high and low values for the variable GROWTH. Specifically, we label the upper 45 per cent in terms of GROWTH as high-growth firms and the lower 45 per cent as low-growth firms. Then we estimate our basic model for each sub-sample separately. The results are very similar to the ones reported in Table 6 (panel B), where we apply a similar methodology.As an additional robustness check, we use a third proxy for growth opportunities, a dummy variable that takes the value of 1 if the firm is a high-growth firm and 0 otherwise, and re-estimate the models 6 and 7 of Table 8. The definition used in order to distinguish between h igh-growth and low-growth firms is the following Firms above the fifty-fifth percentile in terms of the variable GROWTH are called high-growth firms. Firms below the forty-fifth percentile in terms of the variable GROWTH are called low-growth firms.Finally, firms between the forty-fifth and 55th percentile are excluded from the sample. The results (not reported) are qualitatively similar to the ones reported in Table 8. For example, there is evidence for the existence of an interaction effect between executive ownership and growth opportunities but not for the one between short-term debt and growth opportunities. Also, we re-estimate the models reported in Table 8 after substituting the total salary paid to executive directors for the total remuneration package paid to executive directors.We are doing so given that the total remuneration package that is paid to managers includes several other components. For instance, the components of compensation structure have been increase in nu mber during the last tenner and may include annual performance bonus, fringe benefits, stock (e. g. preference shares), stock options, stock appreciation rights, phantom shares and other deferred compensation mechanisms like qualified loneliness plans (see Lynch and Perry, 2003 for an analytical discussion). Once more, the results do not change substantially.Finally, in Table 9 we substitute the annual sales to total assets with the ratio of SG&038A expenses to total sales. As already mentioned earlier in the paper, this ratio can be used as a direct proxy for agency costs. Our results, as presented in Table 9, indicate that executive ownership, ownership concentration and total debt help reduce discretionary spending and, therefore, the agency conflicts between managers and shareholders. Sign and Davidson (2003) do not find any evidence to support these results. Also, we find that agency costs and growth opportunities are positively related i. . the coefficient of the variable G ROWTH is positive and statistically significant to the 5 per cent statistical level. 23 Finally, our results support the existence of an interaction effect between growth opportunities and executive ownership. However, once more, our analysis does not indicate the existence of an interaction effect between short-term debt and growth opportunities. Insert Table 9 here 5. Conclusion In this paper we have examined the effectiveness of the alternative corporate governance mechanisms and devices in mitigating managerial agency problems in the UK market.In particular, we have investigated the impact of capital structure, corporate ownership structure, board structure and managerial compensation structure on the costs arising from agency conflicts mainly between managers and shareholders. The interactions among them and growth opportunities in determining the magnitude of these conflicts have also been tested. Our results strongly suggest managerial ownership, ownership concentration, exec utive compensation, short-term debt and, to some extent, bank debt are important governance mechanisms for the UK companies.Moreover, growth opportunities is a significant determinant of the magnitude of agency costs. Our results suggest that highgrowth firms face more serious agency problems than low-growth firms, possibly because of information asymmetries between managers, shareholders and debtholders. Finally, there is strong evidence that some governance mechanisms are not homogeneous but vary with growth oppo