Tài liệu Firm's histories, managerial entrenchment and leverage ratio from vietnam's listed firms

UNIVERSITY OF ECONOMICS ERAMUS UNIVERSITY ROTTERDAM HO CHI MINH CITY INSTITUTE OF SOCIAL STUDIES VIETNAM THE NETHERLANDS VIETNAM – NETHERLANDS PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS FIRMS’ HISTORIES, MANAGERIAL ENTRENCHMENT & LEVERAGE RATIO FROM VIETNAM’S LISTED FIRMS BY PHAM LE PHUONG LAN MASTER OF ARTS IN DEVELOPMENT ECONOMICS HO CHI MINH CITY, NOVEMBER 2016 Page | i UNIVERSITY OF ECONOMICS INSTITUTE OF SOCIAL STUDIES HO CHI MINH CITY THE HAGUE VIETNAM THE NETHERLANDS VIETNAM – THE NETHERLANDS PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS FIRMS’ HISTORIES, MANAGERIAL ENTRENCHMENT & LEVERAGE RATIO FROM VIETNAM’S LISTED FIRMS A thesis summited in partial fulfillment of the requirements for the degree of MASTER OF ARTS IN DEVELOPMENT ECONOMICS By PHAM LE PHUONG LAN Academic Supervisor: Dr. VO HONG DUC HO CHI MINH CITY, November 2016 DECLARATION I hereby declare that the content of this dissertation is developed, written and completed by myself. The thesis has not been accepted for any degree and institution in my name. Additionally, I certify that this work will not, in the future, be submitted in my name for any other diploma and university. To my best knowledge and belief, my research has not been contained any previously published material, excepting for all carefully and clearly cited references. The thesis has not been finalized without the supervision and guidance of Dr. Vo Hong Duc, Economic Regulation Authority, Western Australia and Open University, Ho Chi Minh City. Any other support and encouragement has been profoundly acknowledged. Ho Chi Minh City, November 2016 Pham Le Phuong Lan Page | ii ACKNOWLEDGEMENT I would first like to express my utmost gratitude for my supervisor, Dr. Vo Hong Duc, for his brilliant guidance and his patience, tolerance, caring and understanding. In addition, his burning motivation, inspiration, enthusiasm and his excellent insight and expertise, from the first lecture on Day one, have been a profound influence on me in every day. He provides me with a valuable opportunity and a great honor to follow his wisdom supervision. Without his persistent guidance and assistance, I could not been able to accomplish my thesis and also better myself. I would like to send my appreciation to the Vietnam Netherlands Programme, to all lecturers for their teaching method and to the staffs and my friends for their magnificent support. Specially, I would like demonstrate my gratitude to Dr. Truong Dang Thuy for sharing constructive comments and econometric technique that improve the manuscript. From the bottom of my heart, I am indebted to my parents and my brother for the unconditional love, endless support, and unlimited tolerance regardless of how imperfect I am. For my whole life, my caring father and my understanding mother are the ones who raise me up whenever I feel sorrow, teach me what is right from wrong and believe in what I choose so that I can pursue my studying. Simply, home is home – the place where I belong to. Page | iii ABSTRACT Corporate governance principles provide the framework for firms to achieve their objectives. The framework is generally considered as the interactions between management, board, and shareholders. Fundamental theories and findings from empirical studies primarily indicate that strong corporate governance successfully promotes a business success in relation to both management and finance by reducing agency conflict and achieving an optimal level of capital structure. The effect of corporate governance on capital structure has been raised and investigated in various empirical studies for an extended period of time. Within the corporate governance framework, the relationship between managerial entrenchment and leverage ratio has attracted great attention from academia, practitioners, and policy makers from developed world. However, this important link has not been sufficiently considered and investigated in the context of developing nations, including Vietnam. Using a sample of 289 non-financial firms listed on Ho Chi Minh Stock Exchange during the period 2006-2015, this study is conducted to provide two major pieces of empirical evidence to fill the following gaps in current research of corporate governance in the Vietnamese context. First, for the first time in Vietnam, the effect of corporate governance, managerial entrenchment, together with the market timing behavior on leverage ratio is considered. In this study, managerial entrenchment is proxied by blockholder holdings, board size, director age, CEO-Chairman duality, board composition, and CEO age. Also, market timing behavior is represented by firms’ histories on leverage ratio which is measured by the ratio between book leverage and market leverage. Second, the impact of managerial entrenchment on firm’s leverage ratio is then classified into two distinct regimes, including a high entrenchment regime and a low entrenchment regime. Furthermore, a two-stage approach is used in this study: (i) to determine the target leverage level; and (ii) to quantify the effects of managerial entrenchment and firms’ histories on the observed leverage level of listed firms in Vietnam. Variety econometric techniques, along with the traditional Ordinary Least Squares (OLS) method, are incorporated such as the Generalized Method of Moments (GMM) and endogenous switching regression method. Key findings achieved from this study can be summarized as follows. Page | iv First, empirical evidence indicates that there is a negative relationship between managerial entrenchment and leverage ratio. Findings from this study confirm the view that entrenched managers’ decision to reduce a leverage ratio by issuing equity is consistent with market timing behavior. Second, the results achieved from the study demonstrate that a negative effect of firms’ histories including financial deficit and various timing measures together with stock price histories on leverage ratio of Vietnam’s listed firms is found over the research period. Third, the impact of high managerial entrenchment regime and low managerial entrenchment regime and firms’ histories on book leverage ratio and market leverage ratio is found in this study. The results confirm that high-entrenched managers pay attention on the market timing and benefit from the equity market. As a result, they reduce a leverage ratio utilized in their firms. Fourth, the results present that the high managerial entrenchment regime is in relation to larger number of block-holders, larger boards, older CEOs with CEO-Chairman duality and more outside directors. Fifth, findings from this study also reveal empirical evidence to support the view that the change of leverage ratio is a negative response to financial deficit, profitability, timing measures – yearly timing and long-term timing and an alternative timing measure – insider sales, and stock price returns. Considerably, the downward adjustment of debt ratio results from the high managerial entrenchment effect. Sixth, high authority of entrenched managers to the board could be linked to weak corporate governance in the Vietnamese context. This observation is based on the reports of International Finance Corporation and the State Securities Commission Vietnam (2006) and International Finance Corporation and the State Securities Commission Vietnam (2012). Key words: Managerial entrenchment, Firms’ histories, Leverage ratio, GMM, Endogenous switching regression model, HOSE. Page | v TABLE OF CONTENTS DECLARATION ................................................................................................................. ii ACKNOWLEDGEMENT.................................................................................................. iii ABSTRACT ......................................................................................................................... iv TABLE OF CONTENTS ................................................................................................... vi LIST OF TABLES ............................................................................................................... x LIST OF FIGURES ............................................................................................................ xi CHAPTER 1 INTRODUCTION ................................................................................... 1 1.1. Problem statement ................................................................................................... 1 1.2. Research objectives .................................................................................................. 3 1.3. Research questions ................................................................................................... 3 1.4. Research scope ......................................................................................................... 4 1.5. The thesis structure ................................................................................................. 4 CHAPTER 2 2.1. LITERATURE REVIEW ....................................................................... 5 Literature review ..................................................................................................... 5 2.1.1. Corporate governance framework .................................................................... 5 2.1.1.1. Corporate governance principles .......................................................... 5 2.1.1.2. Why does corporate governance matter for an organization?............... 5 2.1.2. The theoretical framework of corporate governance ........................................ 6 2.1.2.1. Agency theory ....................................................................................... 6 2.1.2.2. Signaling theory .................................................................................... 7 2.1.3. The capital structure theory .............................................................................. 8 2.1.4. Managerial entrenchment and capital structure decisions theory ................... 11 Page | vi 2.1.5. 2.2. Market timing and capital structure theory ..................................................... 12 Empirical evidence ................................................................................................. 14 2.2.1. The influence of managerial entrenchment and leverage ratio ....................... 14 2.2.2. The impact of firms’ histories on leverage ratio ............................................. 15 2.3. 2.2.2.1. Financial deficit and Leverage ratio.................................................... 15 2.2.2.2. Market timing and Leverage ratio ....................................................... 15 2.2.2.3. Stock price returns and Leverage ratio ............................................... 26 Hypotheses .............................................................................................................. 17 2.3.1. 2.3.1.1. Block-holder holdings and Leverage ratio .......................................... 17 2.3.1.2. Board size and Leverage ratio ............................................................. 18 2.3.1.3. Director age and Leverage ratio .......................................................... 18 2.3.1.4. CEO-Chairman duality and Leverage ratio ........................................ 18 2.3.1.5. Board composition and Leverage ratio ............................................... 19 2.3.1.6. CEO age and Leverage ratio ............................................................... 19 2.3.2. 2.4. Managerial entrenchment and Leverage ratio ................................................ 17 The relationship between firms’ histories and leverage ratio ......................... 20 2.3.2.1. Financial deficit and Leverage ratio.................................................... 20 2.3.2.2. Market timing measures and Leverage ratio ....................................... 20 2.3.2.3. Stock price returns and Leverage ratio ............................................... 21 2.3.2.4. Profitability and Leverage ratio .......................................................... 21 2.3.2.5. Leverage deficit and Change in target leverage .................................. 22 Analytical framework ............................................................................................ 23 CHAPTER 3 3.1. RESEARCH METHODOLOGY AND DATA ................................... 24 Vietnam’s corporate governance and securities market framework ................ 24 3.1.1. Vietnam’s corporate governance and institutional background ..................... 24 Page | vii 3.1.1.1. Vietnam’s adoption of corporate governance standards ..................... 24 3.1.1.2. Vietnam’s corporate governance framework ...................................... 24 3.1.2. The background of Vietnam’s securities market ............................................ 26 3.2. Data sources............................................................................................................ 28 3.3. Research methodology ........................................................................................... 28 3.3.1. The two-stage approach in determining leverage ratios ................................. 28 3.3.1.1. The target leverage ratio estimation .................................................... 28 3.3.1.2. Model specification ............................................................................. 30 3.3.1.3. Measurement of variables ................................................................... 31 3.3.2. The Generalized Method of Moments (GMM) .............................................. 36 3.3.3. Endogenous switching regression method ...................................................... 39 3.3.3.1. The selection equation ........................................................................ 39 3.3.3.2. The structural equations ...................................................................... 39 CHAPTER 4 4.1. THE EMPIRICAL RESULTS ............................................................. 42 Data descriptions.................................................................................................... 42 4.1.1. Descriptive statistics ....................................................................................... 42 4.1.2. Correlation ...................................................................................................... 46 4.2. The target leverage estimation.............................................................................. 50 4.3. The influence of managerial entrenchment effect and firms’ histories on Vietnam firms’ leverage ratio ............................................................................... 51 4.3.1. The choosing of time period (t-n) – lag order selection for the model specification .................................................................................................... 51 4.3.2. Multicollinearity, autocorrelation and heteroskedasticity test ........................ 52 4.3.3. Endogeneity test.............................................................................................. 53 4.3.4. Managerial entrenchment effect, firms’ histories and leverage ratio ............. 54 Page | viii 4.4. The relationship of managerial entrenchment in both high and low entrenchment regime and firms’ histories on Vietnam firms’ leverage ratio .. 60 CHAPTER 5 CONCLUSION AND POLICY IMPLICATIONS ............................ 66 5.1. Concluding remarks .............................................................................................. 66 5.2. Policy implications ................................................................................................. 69 5.2.1. Implications for Vietnam’s listed firms .......................................................... 69 5.2.2. Implications for Vietnam’s investors.............................................................. 71 5.2.3. Recommendations for the Government of Vietnam and relevant authorities 71 5.3. The limitation and further improvement ............................................................ 73 REFERENCES................................................................................................................... 74 Page | ix LIST OF TABLES Table 3.1. Measurement of variables........................................................................ 35 Table 4.1. Descriptive statistics ................................................................................ 44 Table 4.2. Correlation among managerial entrenchment proxies ............................. 46 Table 4.3. Correlation among managerial entrenchment, firms’ histories and firms’ leverage ratio ........................................................................................... 47 Table 4.4. The target leverage ratio estimation ........................................................ 50 Table 4.5. Levin-Lin-Chu (2002) test ....................................................................... 51 Table 4.6. The selection criteria ............................................................................... 52 Table 4.7. Multicollinearity ...................................................................................... 52 Table 4.8. Autocorrelation ........................................................................................ 53 Table 4.9. Heteroskedasticity ................................................................................... 53 Table 4.10. Endogeneity test ...................................................................................... 53 Table 4.11. The Generalized Method of Moments regression of leverage ratio with timing measures – yearly timing and long-term timing .......................... 58 Table 4.12. The Generalized Method of Moments regression of leverage ratio with timing measure – insider sales ................................................................. 59 Table 4.13. The endogenous switching regression of leverage ratio with timing measures – yearly timing and long-term timing ...................................... 64 Table 4.14. The endogenous switching regression of leverage ratio with timing measure – insider sales ............................................................................ 65 Page | x LIST OF FIGURES Figure 2.1. Determination of the optimal ratio of outside equity to debt .................... 9 Figure 2.2. Analytical framework .............................................................................. 23 Figure 4.1. Managerial entrenchment effect .............................................................. 49 Figure 4.2. Firm characteristics ................................................................................. 49 Figure 4.3. Market timing effect ................................................................................ 49 Page | xi CHAPTER 1 INTRODUCTION 1.1. Problem statement Corporate governance principles provide the structure for firms to achieve their objectives, and help those companies to shape instruments to maintain their objectives and to control the firms’ performance. The framework is generally considered as the interactions between management, board, and shareholders. Theoretical framework and empirical evidence primarily indicate that strong corporate governance successfully promotes a success of firms in association with both management and finance by reducing agency conflict and achieving an optimal level of capital structure (Jensen 1986; Klock et al. 2005; G20/OECD principles of corporate governance 2015). The effect of corporate governance on capital structure has been raised and investigated in various empirical studies for an extended period of time. Within the corporate governance framework, the relationship between managerial entrenchment and leverage ratio has attracted great attention from academia, practitioners, and policy makers. According to Berger, Ofek and Yermack (1997), managerial entrenchment occurs when managers, fail to experience the corporate governance disciplines, are able to manipulate financing decisions to support their own interests rather than those of shareholders. On one hand, it is believed that managerial entrenchment is related to an increase in leverage. In their seminal paper, Jensen and Meckling (1976) considered that entrenched managers do not always use the value-maximizing level of debt to implement capital structure. Those managers may increase debt ratios beyond the optimal level to prevent them from takeover risks, to strengthen their longevity with their firms, and to pass anti-takeover laws (Harris and Raviv 1988; Stulz 1988; Wald and Long 2007). Similarly, Qi and Wald (2008) present that the stronger anti-takeover efforts are linked to the more increase in leverage ratio. On the other hand, it is expected that managerial entrenchment is in associated with less leverage level. Welch (2004) shows that after obtaining benefits from large stock returns, entrenched managers are willing to issue equity rather than debt, contributing to a decrease in debt ratio. Moreover, John et al. (2008) find that for fear of a severe financial distress, managers tend to avoid debt by pursuing conservative investment choices. Page | 1 Nevertheless, the relationship between managerial entrenchment and market timing behavior on leverage ratio has not much been investigated. The market timing activity is considerably explained by managers’ financing decisions through which companies choose to raise debt or equity to finance their investment opportunities. Thus, the managerial entrenchment and the market timing behavior should be simultaneously examined in this study. As mentioned, entrenched managers are seemingly to narrow down debt level and are willing to carry out responsible investment decisions due to bankruptcy. Since bankruptcy resulting from an increase in debt ratio helps those managers get rid of takeover threats effectively (Zwiebel 1996). Unfortunately, avoiding debt probably limits firms from accessing one of the low cost funds stemming from tax-shield benefits. Instead, when it comes to meeting external financing demands, entrenched managers are likely to issue substantial amounts of equity when the equity market is perceived to be more favorable (Graham and Harvey 2001). This is consistent to the market timing theory that capital structure is the cumulative outcome of past attempts to time the equity market (Baker and Wurgler 2002). Specifically, Kayhan and Titman (2007) find that the past attempts – firms’ histories such as financial deficits, timing measures and stock price returns significantly reflect the market timing behavior, contributing to crucial roles in determining a firm’s leverage ratio. In Vietnam, few studies have examined the influence of managerial entrenchment and the market timing effect via firms’ histories on choosing a firm’s leverage ratio. Also, there are in lack of empirical evidences analyzing the market timing effect on leverage ratio although many studies applied the trade-off theory and the pecking order theory, for example, Vo and Tran (2015). Since the Vietnam’s securities market has just been reaching an early stage of development, information asymmetry and agency problem may lead to a drawback for firms on estimating stock prices and deciding an optimal leverage level. Nguyen (2015) found that the market timing has the short-term and long-term effects on a determination of the leverage level for the Vietnamese IPO firms. Although the paper indicated that a sector’s value deviation along with past stock prices is an important factor explaining for issuing equity and timing the market, managerial entrenchment and firms’ histories have been ignored in this study. Hence, this paper is conducted to provide empirical evidence on the above issues which are still missing from previous studies in the Vietnamese context. Page | 2 1.2. Research objectives The study is conducted to investigate the impact of managerial entrenchment and the market timing effect through the firm’s histories on leverage ratio. The four main objectives are presented as follows: Analyzing the determinants of managerial entrenchment together with firms’ (i) characteristics that influence leverage ratio of Vietnam firms. (ii) Evaluating the target leverage ratio of Vietnam firms. (iii) Estimating the effect of managerial entrenchment and the market timing presented through firms’ characteristics on leverage ratio. (iv) Examining the relationship of managerial entrenchment in both high and low entrenchment regime and firm’s histories on leverage ratio in Vietnam firms. This study is different from other previous studies on the following grounds:  First, for the first time in Vietnam, managerial entrenchment together with the market timing effect represented by firms’ histories on leverage ratio for all listed firms in Ho Chi Minh Stock Exchange is considered.  Second, the effect of managerial entrenchment on firm’s leverage ratio is classified as high entrenchment regime and low entrenchment regime.  Third, various measurements of firms’ characteristics is incorporated including (i) financial deficits, (ii) leverage deficits, (iv) timing measure, and (v) stock price returns and so on. Especially, insider sales can be used as an alternative proxy for timing measure.  Fourth, various econometric techniques including the Ordinary Least Squares (OLS), the Generalized Method of Moments (GMM) and endogenous switching regression method are employed in this study. 1.3. Research questions In attempts to achieve the above objectives, the following four research questions have been raised: (i) What are the determinants of managerial entrenchment and which are firms’ factors that significantly influence leverage ratio in Vietnam firms? (ii) Do Vietnam firms use target leverage and apply the market timing theory to determine leverage ratio? Page | 3 (iii) How do managerial entrenchment and the market timing effect presented through firms’ histories affect leverage ratio in Vietnam firms? (iv) How do managerial entrenchment in both high and low entrenchment regime and firm’s histories affect leverage ratio in Vietnam firms? 1.4. Research scope This study uses a dataset of 289 non-financial firms collected from Ho Chi Minh Stock Exchange (HOSE) during the period of 2006 to 2015. The secondary dataset is extracted from several sources such as annual reports, financial statements, and available firms’ information on websites – cafef.vn, cp68.vn, and vietstock.vn. All financial firms are eliminated from the sample for a reason that banks, insurances and investment funds possess a different capital structures compared to those of firms in non-financial sector. 1.5. The thesis structure This thesis comprises five chapters. The main content of each chapter is organized as follows:  Chapter 1 introduces an overview of the thesis containing the problem statement, the research objectives, questions, and the research scope.  Chapter 2 begins with the existing theories and the empirical evidence focusing on agency conflicts, managerial entrenchment, market timing and firms’ characteristics. Later, the chapter identifies the research hypotheses and the conceptual framework of the influences to firms’ leverage ratio.  Chapter 3 describes the methodology including the data measurements and quantitative models employed in the thesis. Additionally, econometric technique used to achieve the research objectives will be elaborated.  Chapter 4 expresses the empirical results. In particular, main findings are revealed and compared to other empirical evidences.  Chapter 5 provides the key findings and the discussions. The implications are delivered to shed light on the policy purposes. Finally, the chapter indicates the limitations for future improvements. Page | 4 CHAPTER 2 LITERATURE REVIEW In this section, Chapter 2 begins with corporate governance framework, the background of Vietnam securities market, the existing theoretical framework of corporate governance and capital structure, and the empirical evidence of managerial entrenchment behavior and market timing effect through firms’ characteristics on leverage ratio. Later, the chapter identifies the research hypotheses and the conceptual framework of these influences to firms’ leverage ratio. 2.1. Literature review 2.1.1. Corporate governance framework 2.1.1.1. Corporate governance principles Corporate governance principles provide the framework for companies to achieve their objectives, and help those enterprises to shape instruments to maintain their objectives and to control the firms’ performance. The framework is generally associated with interactions between management, board, and shareholders. Strong corporate governance is primarily believed to successfully promote a success of firms in relation to both management and finance by reducing agency conflict and achieving an optimal level of capital structure. Consequently, the principles support policy makers with effective instruments to sustain economic growth efficiency and financial stability (Jensen 1986; Klock et al. 2005; G20/OECD principles of corporate governance 2015). The corporate governance principles do not provide the “perfect” role model for all countries to follow. Rather, the principles synthesize some common elements that are existed from different corporate structures. Furthermore, a variety of objectives and means to achieve a suitable corporate governance structure is provided. In this way, based on an appropriate and flexible orientation, the managements are freely to set up their own corporate governance frameworks in response to their shareholders and debtholders’ expectations (G20/OECD principles of corporate governance 2015). 2.1.1.2. Why does corporate governance matter for an organization? Hart (1995) believes that corporate governance problems result from two circumstances. The first one is known as the agency relationship which is the conflict Page | 5 interest between the owners and the managements of the organization. The second factor comes from agency cost which is the result of agency conflict and is not narrowed by signing an agreement. The corporate governance principles are constructed to moderate these above issues. Thanks to the globalization, the conflict interests of the owners and the managements will be mitigated by welcoming and gaining substantial benefits from global capital markets. When companies build up a robust relation to international capital flows such those from high-developed countries, corporate governance agreements will be widely accepted and will fit in with international principles. With the aid of implementing effective supervision and mechanisms, the confidence of shareholders and debtholders will be earned and the cost of capital will be declined, significantly improving wealth of the owners and the managements. Definitely, this leads to a win-win relationship for the both parties (G20/OECD principles of corporate governance 2015). 2.1.2. The theoretical framework of corporate governance 2.1.2.1. Agency Theory In their seminal paper, Jensen and Meckling (1976) develop the agency theory that indicates the agency relationship between the owners and the top management of the firm mainly results from the separation of ownership and control. The shareholders and debtholders are represented for the principals while top managers are viewed as the agent. The agency relationship is defined as an agreement of the principals and the agent. The agent is the representative of the principals to execute some decision making authority which maximizes the owners’ wealth. As a matter of fact, the best interests of the principals should not always be achieved by the agent owing to the utility maximizing relationship. In attempts to protect their interests from divergences, the principals restrain the abnormal behaviors of the agent by promoting incentives. First, the encouragement is designed to increase the managerial ownership. Due to the rise of managerial ownership, managers are forced to take full responsibilities for trading off shareholders’ wealth to pursue their own interests. Nonetheless, once holding such the considerable power, managers are likely rescued from being replaced and punished by the principals, causing managerial entrenchment. Entrenched managers have a tendency to utilize their privileges Page | 6 to manipulate firms’ investment opportunities to preserve their well-beings (Morck, Shleifer and Vishny 1988). Additionally, the stimulation is existed in the form of an escalation in leverage or debt creation (Grossman and Hart 1982; Jensen 1986). Debt financing seems to be a powerful “penalty” in mitigating managers’ building empire desires (Hart 1995). For fear of posing bankruptcy threats from debt financing, managers are motivated not only to operate firms’ cash flows efficiently but also to supervise investment projects carefully, generating cash flows in order to pay out future interest and principle disbursements. 2.1.2.2. Signaling Theory According to signaling theory, not merely the agency relationship comes from interest conflicts among the owners and the managements, but also results from the asymmetric information between the insiders and the outsiders. The insiders represent the top managers whereas the outsiders signify the shareholders and debtholders. Managers are supposed to obtain more information about firms’ investment opportunities than outsiders (Ross 1977). To collect symmetric information, outsiders try their best to get the information they need from a variety of sources. In truth, the permission to access to the real value of firm’s present and future investment is limited and the reliability of information is in need of verification. In this way, shareholders and debtholders are likely subject to any financing change made by insiders. A modification of capital structure is in relation to an alteration of the firm’s performance. When debt level is determined to be boosted up, outsiders receive a signal from the firm that the promise of high future cash flow is expected (Ross 1977). On the contrary, since firm’s investment is financed with new equity issuing, outsiders will perceive the firm’s performance to be declined and share the losses with newcomers. Hence, outsiders attribute the complete confidence of managers in the future firm’s performance to the surge in leverage. Page | 7 2.1.3. The capital structure theory In their well-known study of corporate governance, Jensen and Meckling (1976) highlight that the capital structure theory is rather known as the theory of ownership structure. As a matter of fact, the vital capital structure proxies are not simply the accumulations of debt and equity but also the amounts of the equity of the manager. Therefore, three determinants of the capital structure is incorporated to illustrate the theory for a given size firm. The total market value of the equity is calculated as: 𝑆 = 𝑆𝑖 + 𝑆0 The total market value of the firm is measured by: 𝑉 =𝑆+𝐵 where:  Si: inside equity (held by the manager),  S0: outside equity (held by outside investors of the firm),  B: debt (held by outside investors of the firm). The theory is developed to determine the optimal ratio of outside equity to debt (Jensen and Meckling 1976). The determination of the optimal ratio of outside equity to debt is S0 ⁄B. The size of the firm is assumed to be constant. V presents for the actual value of the firm and depends on the agency costs. Therefore, V ∗ refers to the value of the firm at a given scale when agency costs are zero. The amount of outside financing (B + S0 ) is held constant. The optimal fraction of outside financing obtained from equity E ∗ is determined by E ∗ ≡ S ∗ ⁄(B + S0 ). Page | 8