Powerful CEOs, debt financing, and leasing in Chinese SMEs: Evidence from threshold model

Abstract

This study investigates the impacts of CEO power on firm financing policies (i.e. debt financing and operating leasing) using the Caner and Hansen (2004) instrumental variable threshold regressions approach. The sample consists of a panel of 297 Chinese listed small and medium sized enterprises (SMEs) over the period 2009–2012. The empirical results indicate that there are threshold effects in the CEO power-debt relationship and CEO power-operating lease relationship. In particular, we find that firms tend to use more debt financing (and operating leasing) when CEO power index below a certain threshold level; beyond the threshold level, CEO tends to manipulate firm capital structure to pursue their own interests, thus using less debt financing and operating leasing. In addition, our estimation results suggest a positive relationship between debt and operating leases when CEO power is smaller than certain threshold, while it becomes negative if the power index exceeds the threshold level.

Introduction

Since the seminal work of Modigliani and Miller (1958), several theories have been developed explaining the determinants of capital structure, including the agency theory (Jensen & Meckling, 1976) and the trade-off theory (Miller, 1977). Building on these theories, previous empirical studies have provided evidence that firm- and industry-level characteristics play important roles in shaping firms’ financing decisions. The majority of existing evidence is based on firms in industrialised countries with little attention to emerging markets. Some of financial economists argue that the previously identified factors in the developed countries studies are also crucial in developing countries (e.g., Booth et al., 2001, Demirgüç-Kunt and Maksimovic, 1999). Therefore, a growing number of recent studies have intensively examined whether the classic theories as well as evidence derived from developed countries also work in emerging-market countries. However, to date, little attention has been paid on investigating the role of individual executives in affecting corporate financing policies, particularly in developing countries (Jiraporn et al., 2012, Liu and Jiraporn, 2010). This is surprising given the capital structure decision is one of the main decisions made by executives (Bertrand & Schoar, 2002). Thus, this study aims to examine the effects of CEO characteristics on firms’ financing decisions, specifically, the relationship between CEO power and Chinese SMEs’ capital structure.

The imperfect alignment of interests between executives of the firm and owners of the firm can lead to agency costs (i.e. type I agency problem). For example, CEOs may be subject to self-serving behaviours such as using corporate resources to enhance their own benefits instead of investing in good investment projects that can benefit shareholders. One prescription for alleviating such agency problem is to use more debt-type financing, because interest payments impose constraints on CEOs’ control over the free cash flows (Jensen, 1986). In addition, the use of debt-type financing can increase the probability of bankruptcy and job loss. As a result, the additional risk might motivate the CEO to work efficiently (Grossman & Hart, 1982). However, CEOs with more power might manipulate the level of debt ratio to avoid the potential risk as well as constraints. The contradict arguments suggest a non-monotonic association between CEO power and capital structure. A firm with less powerful CEO tends to use more debt or high leverage. However, as CEO having more power and beyond a certain threshold, he/she might impose significant influence on firm’s financing decisions, thereby using less debt-type financing. In line with this, previous study by Chintrakarn, Jiraporn, and Singh (2014) shows an inverted U-shape relationship between CEO power and leverage in US firms.

The present paper provides new evidence that sheds light on the impact of CEO power on capital structure through employing the dataset outside US. Specifically, we explore whether there exist threshold levels of index in the CEO power-capital structure relationship. To this end, this paper uses the instrumental variables threshold regressions approach proposed by Caner and Hansen (2004). This method does not split the sample of firms according to some predetermined rule, but allows the data to determine which regime a firm belongs to. Apart from debt, our study also takes into account lease financing. Lease is perceived as a fixed-claimed financing which can help reduce agency costs by forcing pay-out of free cash as well as exposing greater personal risk, thereby ensuring CEOs to use corporate resources more efficiently and work harder (Mehran, Taggart, & Yermack, 1999). In addition, treating leases as taking a similar role to debt is in line with the lease-debt substitutability theory (Minhat & Dzolkarnaini, 2015).

Our study extends the emerging literature in the following ways. First, we use instrumental variable threshold regression model of Caner and Hansen (2004) to analysis the nonlinear impact of CEO power on firm financing decisions. The attractiveness of this approach stems from the fact that it treats the sample split value (threshold parameter) as unknown. That is, it internally sorts the data on the basis of some threshold determinants into groups of observations, each of which obeys the same model. While threshold regression is parsimonious it also allows for increased flexibility in functional form. This sample-splitting methodology has the advantage of endogenously determining the threshold, as opposed to simple parametric approaches that set the threshold exogenously (for instance as a function of a third variable). To the best of our knowledge, ours is the first major study of this subject by employing this method. Second, we study the relationship between CEO power and capital structure containing both debt and lease. The previous literature heavily raised the issue of debt in SMEs; the ignorance of lease in capital structure in previous studies may affect the findings on capital structure decisions (Huang & Yildirim, 2006). Third, our study focuses on Chinese firm data, thus adding to current discussion on capital structure in emerging market. By focusing on China, where the institutional background is vastly different from that of developed markets, we test the boundaries of important claims in the capital structure literature, and extend the existing literature on CEO power and capital structure that focuses mainly on developed countries (Chintrakarn et al., 2014)). Leasing can be more important to emerging economies compared to developed economies because the insufficiency of capital goods investment and lack of financial resources are more common among small- and medium-sized enterprises (SMEs) in these emerging economies. By developing additional financial tools such as leasing, emerging economies are able to deepen the financial activities by introducing new products and/or industry players. Having recognized this fact, the International Finance Corporation (IFC) has been introducing, leading, and imple- menting programs to develop leasing worldwide and, accordingly, has invested over 100 leasing companies in 50 countries (Fletcher, Freeman, Sultanov, & Umarov, 2005).

The paper is organized as follows. Section 2 provides the overview of Chinese firms and institutional features. In Section 3, we review the related studies and develop the hypotheses. Section 4 describes the sample selection and the methodology. Section 5 reports the research findings, and Section 6 provides the conclusion.