Firm Age, Corporate Governance, and Capital Structure

Robert Kieschnick is Associate Professor Finance and Managerial Economics at the Naveen Jindal School of Management at the University of Texas at Dallas; Rabih Moussawi is Assistant Professor of Finance at Villanova University. This post is based on a recent paper by Professor Kieschnick and Professor Moussawi.

This paper is motivated by two considerations. First, prior research argues that as a firm grows older, it should use more debt as it has more assets-in-place and fewer growth options. Second, prior research argues that as firms age after going public, their governance should adapt to their changing needs. Thus, our paper combines both considerations to examine how the age of a firm since going public affects how its governance influences its capital structure choices.

To address this issue, we must confront a number of empirical issues ignored by related prior research. For example, the factors influencing the decision to use debt may differ from the factors that determine how much debt the firm uses. This issue is more serious than often recognized since a large number of U.S. corporations, about 21.8% of Compustat companies during our sample period, use no long-term debt financing and are called “all equity” firms.

Using data on U.S. corporations from 1996 to 2016, we find evidence for the following conclusions. First, firm age, without considering its interaction with different corporate governance features, is negatively correlated with a firm’s use of debt conditional on its using debt. This evidence contradicts extant arguments about the correlation between firm age and corporate capital structures. But, as we show, this negative effect is largely due to the interaction between firm age and governance features that give more power to management.

Second, consistent with Strebulaev and Yang (2013), we find that the corporate governance features that significantly influence whether a firm uses debt or not, differ from those that influence how much debt that a firm uses. More specifically, we find that dual class firms are more likely to be all equity firms initially, but they are also more likely to use debt as they age as public corporations. We interpret this evidence to imply that these firms turn to lower cost sources of external financing to fund their growth since selling new equity might be more expensive for them.

Third, we find evidence the corporate charter provisions of a firm and its board composition are correlated with omitted variables in regression models of how much debt financing that a firm chooses to use conditional on its using debt. In the case of corporate charter provisions, our evidence is consistent with the evidence in Karpoff, Schonlau and Wehrly (2017). More importantly, these omitted factors are negatively correlated with the firm’s use of debt financing and so may account for prior evidence of negative correlations between these governance features and corporate debt use.

Fourth, we find evidence that as a firm ages after going public, its corporate charter restrictions and board composition influence its capital structure choices quite differently than they do when the firm first goes public. Initially, corporate charter restrictions and insider-controlled boards are positively correlated with a company’s use of debt, but as the firm ages, these relationships reverse. This evidence is consistent with the arguments in Filatotchev, Toms and Wright (2006) and Johnson, Karpoff and Yi (2016). Further, these changes largely explain why firm age is negatively correlated with how much debt financing is employed by the firm.

Altogether, we interpret our evidence as suggesting that firms are “dressed for success” when going public, but as they grow older, entrenched managers are able to let their risk preferences play a greater role in their firm’s capital structure decisions, which is in line with recent literature on the role of managerial preferences in corporate decision making (Bertrand and Mullainathan (2003), Morellec (2004), Lewellen (2006), Gow, Kaplan, Larcker, and Zakolyukina (2016)).

The complete paper is available here.

References

Bertrand, M. and S. Mullainathan, 2003, “Enjoying the Quiet Life? Corporate Governance and Managerial Preferences,” Journal of Political Economy 111, 1043-1075.

Filatotchev, I., S. Toms, and M. Wright, 2006,”The firm’s strategic dynamics and corporate governance life-cycle”, International Journal of Managerial Finance 2, 256 – 279

Gow, I., S. Kaplan, D. Larcker, and A. Zakolyukina, 2016, CEO Personality and Firm Policies, Rock Center for Corporate Governance, Working paper series no. 220.

Johnson, W., J. Karpoff, and S. Yi, 2016, “The Lifecycle of Firm Takeover Defenses,” University of Washington Foster School of Business working paper, http://ssrn.com/abstract=2808208

Karpoff, J., R. Schonlau, and E. Wehrly, 2017, “Do Takeover Defense Indices Measure Takeover Deterrence,” Review of Financial Studies 30, 2359-2412.

Lewellen, K., 2006, “Financing decisions when managers are risk adverse,” Journal of Financial Economics 82, 551-590.

Morellec, E. 2004, “Can managerial discretion explain observed leverage ratios?”, Review of Financial Studies 17, 257-294.

Strebulaev, I. and B. Yang, 2013, “The mystery of zero-leverage firms,” Journal of Financial Economics 109, 1-23.

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