Definition of corporate governance

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This chapter is dedicated to developing hypotheses. As discussed in earlier parts, this study is based on agency and organizational theories that are synthesized into a single research framework. Three groups of hypotheses are developed. Scholars comment that complementing agency theory with other perspectives in organizational studies provides deep insight (Eisenhardt, 1989; Daily, et al., 2003). Agency theory has important contributions to organizational theory (Eisenhardt, 1989; Hambrick, et al., 2008). Consistent with agency theory and organizational theory, the first group of hypotheses links corporate governance with firm level contingencies. In the theoretical framework, we have mentioned that firms choose their corporate governance depending on contingency factors. Three main contingency variables are antecedents of corporate governance. Firm growth, firm risk and identity of the largest owner have gained more attention in the empirical corporate governance literature.12 The second group depicts the link between corporate governance and performance that traditional agency researchers often address. Researches that rely heavily on agency theory assume firm performance as a direct consequence of corporate governance. In the third group of hypotheses, we complement the traditional agency research tradition with organizational perspective. Consistent with organizational scholars, we account for the moderating effect of firm level contingencies in the corporate governance-firm performance. Organizational researchers suggest that the effect of corporate governance on firm performance depends on contingency factors that exist within and outside firms.


Hypothesises for the effect of antecedent factors on corporate governance

Agency theory holds that as managers are self-serving and behave in value minimizing way, instituting appropriate governance mechanisms is unquestionable for maximum firm performance (Jensen and Meckling, 1976; Shleifer and Vishny, 1997). Organizational scholars also share the idea that less motivated shareholders or their representatives leads managers to serve their own interests (Eisenhardt, 1989). However, organizational theorists emphasise that governance mechanisms need to consider the demands of the environment imposed on firms (Burton, 2000; Cohen and Cyert, 1973; Pfeffer and Salancik, 1978). The nature of the environment both internal and external to a firm affects the costs and benefits of governance mechanisms adopted by the firm (Agrawal and Knoeber, 2012; Zajac and Westphal, 1994; Agrawal and Knoeber, 2012). Hence, the levels of use of governance mechanisms depend on firm and environmental contingencies.
Several scholars have called for studies that would include antecedent factors to explain variations in the adoption of certain corporate governance mechanisms within firm and between firms (Demsetz and Villalonga, 2001; Demsetz and Lehn, 1985). The central idea is governance mechanisms are endogenously chosen by firms. Observed (Demsetz and Lehn, 1985; Klapper and Love, 2002; Himmelberg, et al., 1999; Holderness, 2003; Black, et al., 2010; Demsetz and Villalonga, 2001) and unobserved firm level characteristics (Himmelberg, et al., 1999), and observed and unobserved industry characteristics (Demsetz and Lehn, 1985; Himmelberg, et al., 1999) determine the adoption of governance mechanism across firms. In fact, cross-country studies show that unobserved country effects explain variations in the strength of corporate governance mechanism (Klapper and Love, 2002).
Holderness (2003) comment that the incentive and capacity of block holders either to monitor management or to expropriate minority shareholders depends on firm level contingencies. Himmelberg et al. (1999) suggest researchers to include observed firm characteristic that relate to potential moral hazard and affect optimal managerial ownership. They show that managerial ownership is predicted by factors of the contracting environment in which the firm operates. More over they find that the cross sectional variation in managerial ownership is largely affected by unobserved heterogeneity. Demsetz and Villalonga (2001) suggest the inclusion of firm and environment factors to explain ownership structure. Klapper and Love (2002) argue that corporate governance mechanisms are endogenously determined can equally work for all governance mechanism. Firms have the discretion to flexibly choose their corporate governance mechanism depending upon contexts (Burton, 2000; Black, et al., 2010; Desender, et al., 2013). Baysinger and Butler (1985) show that optimal board composition varies systematically depending on circumstances. Similarly, Zajac and Westphal (1994) explain that greater agency problems require greater monitoring through higher proportion of outside directors, large percentage of outside director ownership, a separate CEO/board chairperson position, block ownership by a non-board shareholder. They suggest that policy prescriptions for a standard form of the board of directors would be inappropriate, as firms may be different and changing constantly. Demsetz and Lehn (1985) find that the level of private and shared benefits of control differs across industries. Regulated industries are more likely to have diffusely owned firms as regulators substitute the monitoring role of shareholders.
Relevant contingency factors considered as antecedents of corporate governance are firm growth (Bathala and Rao, 1995), Firm risk (Zajac and Westphal, 1994; Bathala and Rao, 1995; Himmelberg, et al., 1999), firm size (Demsetz and Lehn, 1985; Bathala and Rao, 1995), and asset composition (Himmelberg, et al., 1999; Klapper and Love, 2002). Demsetz and Lehn (1985) use firm size, control potential and systematic regulation as antecedents of ownership concentration. Klapper and Love (2002) include country-level measure of shareholder rights and their enforcement, firm growth, and the proportion of intangible assets. Himmelberg et al. (1999) use firm size, capital intensity, R & D intensity, advertising intensity, cash flow, volatility and investment rate as determinants of managerial ownership. Bathala and Rao (1995) study the determinants of the proportion of outsider directors by incorporating leverage, CEO tenure, firm size, firm risk, growth as the factors determining the level of agency problem. The type of governance mechanisms used as a dependent variable does not matter as endogeneity equally applies to all governance forms (Klapper and Love, 2002). The hypotheses for the firm level determinants of corporate governance mainly focus on firm growth, firm risk, and owner identity. Nevertheless, we also address other firm level contingencies roughly.

The effect of firm growth on corporate governance

Both the theoretical and empirical literature document inconsistent relationship between firm growth and corporate governance. Moreover, for a given prediction scholars provide different reasons. Firms respond to their growth potential by instituting appropriate governance system. For instance, firms with high growth opportunities are expected to have high proportion of outside directors in the board (Bathala and Rao, 1995). Moreover, firms may get highly concentrated or have higher proportion of outside directors to signal external financiers that the risk of expropriation by management is less likely (Klapper and Love, 2002). At the same time, growing firms may need appropriate financial management and instituting good corporate governance limits inefficient investments (Bebczuk, 2005). More over a growing firm badly needs external finance and the cost of capital is generally lower for a firm with effective control mechanisms compared to a firm with weak control mechanisms (Bebczuk, 2005). Ownership that is more concentrated is also predicted, as shareholders do not want to handover their control to creditors if the firm raises external finance (Shleifer and Vishny, 1997). Empirical Studies show that firm growth increases the level of agency problem and moral hazard (Bathala and Rao, 1995; Himmelberg, et al., 1999; Klapper and Love, 2002). Klapper and Love (2002) study the effect of firm growth on corporate governance of firms in 14 countries. Using a governance index to represents the multiple dimensions of governance they obtain that past growth rates are positively related to corporate governance. Himmelberg et al. (1999) find that firm growth positively affects the level of managerial ownership. The following hypothesis is developed on the bases of the above argument for positive association between firm growth and corporate governance.
H1a: The higher the growth opportunities of firms the stronger will be their corporate governance.
On the other hand, firm growth may affect corporate governance negatively. Since growing firms operate in volatile environment, managers often use a great deal of subjective decision-making during the strategic making process (Bathala and Rao, 1995). As executives have better information in these situations, managers of high-growth firms may prefer more insiders in their board. This will extend to other governance mechanisms as well (Klapper and Love, 2002). For example, the desire to have freedom of making subject decision, a manager of a growing firm may prefer dispersed ownership, limited disclose of relevant information to both insiders and outsiders, etc. Bathala and Rao (1995) examine the determinants of the proportion of outside directors in a cross section of 261 firms. Using OLS regression they find that sales growth is negatively related to the proportion of outside directors. The following hypothesis is based on the above evidence;
H1b: The higher the growth opportunities of firms the weaker will be their corporate governance.


The effect of firm risk on corporate governance

There is a growing belief that firms operating in volatile environments have greater agency problems that require adoption of stronger corporate governance mechanisms (Demsetz and Villalonga, 2001). Agency theory emphasises the importance of firm risk in explaining efficient contracts (Eisenhardt, 1989). Daily et al. (2003) suggest that the volatility of operations firms face recently gives researchers a room to study the governance mechanism such firms adopt. Results from such studies add to the knowledge we have about corporate governance. Volatility in a firm‟s environment is unfavourable as it limits a firm‟s ability to understand its environment (Cohen and Cyert, 1973). Decisions tend to be more subjective and conflicts are more likely higher (Cohen and Cyert, 1973). Environment volatility increases the severity of agency problems and thus demands tighter monitoring of management (Demsetz and Lehn, 1985; Thomsen and Pedersen, 2000; Demsetz and Villalonga, 2001).
Demsetz and Lehn (1985) and (Demsetz and Villalonga, 2001) argue that the wealth gain obtained by shareholders through strong monitoring of managerial performance depends on conditions of the firm‟s environment. For a firm that operates in a dynamic environment, the manager is expected to make timely decisions (Galbraith, 1973). However, it is difficult to identify whether firm performance is directly attributed to managerial behaviour. The situation makes monitoring managerial behaviour in volatile environments difficult. Thus, the greater the volatility of the environment the greater the wealth gain by shareholders from tighter controls (Demsetz and Lehn, 1985; Demsetz and Villalonga, 2001). Moreover, since monitoring has the advantage of linking rewards with the behaviour of managers more concentrated ownership (Agrawal and Knoeber, 2012) and greater managerial ownership aligns the interests of managers and shareholders in more volatile environment (Zahra, 1996).
Studies show that firm risk has positive effect on optimal structure of ownership structure (Thomsen and Pedersen, 2000; Demsetz and Villalonga, 2001), proportion of outside directors (Bathala and Rao, 1995), and company disclosure (Abrahamson and Park, 1994). Based on the discussion the following hypothesis is developed.
H2a: The higher the risk of firms the stronger will be their corporate governance.
On the other hand volatile environment increases performance variability (Zahra, 1996). Since managers are risk averters (Jensen and Meckling, 1976), they prefer more compensation (Agrawal and Knoeber, 2012). Managers prefer rewards based on the quality of their decisions in making strategic choices rather than the actual outcomes of the decision (Bathala and Rao, 1995). Outside directors reward managers based on outcomes and such outcomes are volatile. On the other hand, inside board members reward mangers based on the processes managers follow to make decisions. Therefore, managers of firms operating in volatile environment are more likely to prefer high proportion of inside board members. In addition, managers tend to resist disclosing organizational outcomes as volatility may affect firm performance adversely (Abrahamson and Park, 1994) or may resist incentives directly linked with performance (Zajac and Westphal, 1994).
The information processing perspective of organizational theory emphasises the link between the environment and information processing demand of a firm. Risky environments require executives to process large amount of information (Galbraith, 1973), that tend to require innovativeness and use of a large amount of subjectivity (Cohen and Cyert, 1973; Bathala and Rao, 1995). In this, situation insiders possess important information (Zahra, 1996; Harris and Raviv, 2008) and hence the agency costs associated with insiders is lower relative to the costs of information loss when the board is dominated by outsiders (Harris and Raviv, 2008; Agrawal and Knoeber, 2012). Moreover, the degree of interference on the manager‟s decisions decreases with more inside directors and smaller board size (Agrawal and Knoeber, 2012). Studies have reported negative association between risk and corporate governance (Bathala and Rao, 1995). This calls for an inverse relationship between firm risk and corporate governance.
H2b: The higher the risk of firms the weaker will be their corporate governance.

The effect of owner identity on corporate governance

The consensus among scholars in agency theory is that owners are expected to aspire for the maximization of their wealth (Jensen and Meckling, 1976). Research based on agency perspective treat shareholders as a homogenous group of individuals with identical risk exposure and goal preference. This assumption works well when markets are perfect i.e. when all the risk is diversifiable (Thomsen and Pedersen, 2000). When markets are imperfect, due to the differential risks and returns they assume, owners may disagree on company strategy. As organizational scholars such as Mintzberg (1984) and Drucker (1988) suggest the forces that influence modern corporations are too complex to explain in a simple principal-agent dichotomy that agency theory maintains. Vickers and Yarrow (1988) further noted that, even in the absence of uncertainty, information asymmetry and imperfect markets, shareholder interests do not coincide. Second, owners such as institutional investors, banks, non-financial companies and governments are intermediate agents of the ultimate owners that may not have similar objectives (La Porta, et al., 1999). Hence, like managers owners may maximize their utility at the expense of the overall value of the company. Although, large owners engage themselves with corporate governance more actively (Shleifer and Vishny, 1997), they may also inefficiently redistribute wealth from other investors to themselves (La Porta, et al., 1999). In this case the question is not about the conflict of interest between share holder and managers but it is about how large investors dominate the decision making process of the company in such a way that performance is affected either positively or negatively (Go’rriz and Fum’as, 1996).
The evidence tells us little about who monitors controlling owners (La Porta et al., 1999) and owner identity is the key to discover the risk and return preferences of the various categories of owners and resulting corporate governance choices and firm performance. In this direction, pushing the analysis beyond the traditional principal-agent relationship is vital. Further research aimed at providing clear understanding of the goal preferences and risk profiles of key shareholders is required (Gedjavlovich, 1989). Specifically further research that can discriminate between management, family, government, company and bank ownership categories is required.
Thomsen and Pedersen (2000) identify most notable owner category that invest in and control publicly held corporations: families, banks, institutional investors, government and other non-financial companies. Distinguishing which of these owner categories dominate firms provides information on the degree of expropriation minority holders are exposed to. It expands the analysis beyond the traditional manager-shareholder conflict and to the conflict of interest between majority and minority shareholders.
a. Management ownership
Agency theory assumes significant ownership by managers aligns their interests with that of shareholders (Jensen and Meckling, 1976). Nevertheless, managerial ownership may lead them to entrench themselves and act contrary to shareholder interests. Generally, companies with entrenched managers have higher agency problems. Management ownership is a predominant structure in Ethiopia. In at least 50% of sampled companies, managers are the largest shareholders. This may not be common in other countries particularly in developed markets. Since there are no formal corporate governance institutions in the country, managers with significant ownership may misuse firm resources. It is also possible that significant ownership reduces the agency problems as managers could bear large part of the costs (Agrawal and Knoeber, 2012). Therefore, this special ownership structure provides a fertile ground to study the role of management ownership to governance mechanisms.
b. Family ownership
Even though whether family ownership eliminates or creates agency cost is an empirical question, the relationship between family ownership and agency cost has conflicting theoretical predictions (Abdullah, 2006a). Thomsen and Pedersen (2000) explain that due to their firm specific investment, family owners have long-term commitment. Cronqvist and Nilsson (2003) argue that family controlled firms have the highest agency costs than firms controlled by other categories of owners. This is because family owners may entrench themselves and gain personal benefits by controlling much of the decision power of the company.
Other researchers claim that their findings show an indirect association between family ownership and the prevalence of agency cost. For example, Abdullah (2006a) find that the ratio of family members in the board of directors is positively related to the quality of financial reports. They pose that family owners have the expertise on the firm‟s condition and to monitor the activities of the firm. Similarly, Go’rriz and Fum’as (1996) comment that family ownership reduces the agency and contractual costs. Since family members themselves are agents, the necessity of disciplining and monitoring agents is eliminated. That does not however prove that the dominance of family ownership across the world is due to lower agency cost of family control (La Porta, et al., 1999). In the study of the largest companies of 27 wealthy countries of the world, La Porta, et al. (1999) find that family owners do not monitor management as top management is a part of the family owners.
c. Bank ownership
Significant ownership by banks lets them influence the company through board representation and lending (La Porta, et al., 1999). Banks have professional managers who are not entrenched themselves to expropriate other shareholders (Cronqvist and Nilsson, 2003). Jensen (1989) poses that joint ownership of debt and equity by large informed investors such as banks results in strong managerial monitoring and creates incentive for managers to pursue activities that maximize shareholders value.
d. Government ownership
Government‟s influence is more obvious than others‟ are (Gedjavlovich, 1989). Government may influence the democratization of corporations. Through various initiatives, it gives direction on how corporations are run (Mintzberg, 1984). For example, if the government holds shares it may require „public interest‟ representations in the board of directors. Thus with substantial ownership government may serve as an alternative governance mechanism (Thomsen and Pedersen, 2000). Similarly, Shleifer and Vishny (1997) comment that companies under the process of privatization may not have large investors. In this context, managers of these firms would end up with high control and discretion. This is particularly interesting for Ethiopia. Little after the current government took power, many state owned companies have been privatized. The privatization agency requires companies to undergo series of clearing procedures before allowing full control by private owners. In the mean time, the government maintains its position as a shareowner. On the other hand, government may not be sensitive to corporate governance matters in the case where there is high asymmetric information on the side of the society. The lack of information about its role in governance systems, a government may not have high reputation and re-election impact to motivate it enroll in monitoring the activities of management in a profit maximizing way (La Porta, et al., 1999).
e. Company ownership
Company block holders exhibit unique behaviors that are not common to individual block holders. Company ownership usually forms business groups each of which are found at different stages of the value chain (Thomsen and Pedersen, 2000). Reports show that the effect of company ownership on corporate governance is not as clear as ownership by other categories of owners. For example, Thomsen and Pedersen (2000) explain that the advantage of transfer of knowledge when companies own other companies along a given industry value chain may be outweighed by risk of lack of mutual monitoring. In this case, the agency cost of company dominance is expected to be high.
From the above discussion, the role of family and company ownership to corporate governance is not clear. There are some reasons that indicate the incentive of government to monitor management. We may also suspect this as government may not know its role in governance systems. Bank ownership is an undisputed predictor of corporate governance. Since managers (executives and directors) are the largest owners in half of the sampled companies, they serve as a reference group in the analysis. Therefore, the following hypotheses are developed.
H3a: the impact of owner identity on corporate governance is positive for bank and government ownership relative to management ownership.
Hypothesis 3a would be weak as the theoretical prediction for government ownership is not consistent as it is for bank ownership. Hypothesis 3b is supposed to resolve this by emphasising more on the role of bank ownership than government ownership.
H3b: the positive impact of owner identity on corporate governance is greater for bank ownership than government ownership relative to management ownership.

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Table of Contents
List of tables
List of figures
1.1 Introduction
1.2 Problem Statement
1.3 Aim and Objectives
1.4 Hypotheses
1.5 Rationale
1.6 Delineation of field and Scope of the Study
1.7 Importance of the Study
1.8 Limitations of the study
1.9 Study Environment
1.10 Clarification of Concepts and Constructs
1.11 Plan of the Study
2.1 Introduction
2.2 Agency Theory
2.3 Organizational theory
2.4 Synthesizing agency theory and organizational theory
2.5 Conclusion
3.1 Introduction
3.2 Definition of corporate governance
3.3 Corporate governance mechanisms of reducing managerial discretion
3.4 Antecedents of corporate governance
3.5 Conclusion
4.1 Introduction
4.2 Hypotheses
4.3 Conclusion
5.1 Introduction
5.2 Research type
5.3 Target Population and sample
5.4 Data sources and data collection instrument
5.5 Variables and variable measurement
5.6 Research models
5.7 Data analysis techniques
5.8 Testing For Violations of Assumptions
5.9 Conclusion
6.1 Introduction
6.2 Descriptive and correlation statistics
6.3 The effect of firm contingencies on corporate governance
6.4 The effect of corporate governance on financial performance
6.5 The moderating effect of firm growth on the corporate governance-firm performance relationship.
6.6 The moderating effect of firm risk on the corporate governance-firm performance relationship.
6.7 The moderating effect of owner identity in the corporate governance-firm performance relationship
6.8 Conclusion
7.1 Introduction
7.2 Discussions
7.3 Conclusions
7.4 Recommendations

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