Development Financing and Economic Governance: Analysis of...

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Development Financing and Economic Governance:

Analysis of the Liquidity Crisis and Circularity Debts in Pakistan

Muhammad Irfan Khan

021-09-12088

A Thesis

Submitted in Partial Fulfillment of the Requirements

for the Degree of Doctorate of Philosophy in Business Administration

Iqra University

Main Campus, Karachi

Karachi, Pakistan

November, 2015

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CERTIFICATE

It is certified that a PhD dissertation titled as “Development Financing and Economic

Governance: Analysis of the Liquidity Crisis and Circularity Debt in Pakistan” has been

completed by Mr. Muhammad Irfan Khan, bearing a Registration No. 021-09-12088. It is being

approved for the final submission.

Supervisor,

Dr. Muhammad Ayub Khan Meher

Date:

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DEDICATION

This modest struggle is

Dedicated to my loving parents because of their sacrifices

I was able to nurture and prosper

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ACKNOWLEDGEMENT

First of all, I would like to thank Almighty Allah, who gave me the opportunity to study at Iqra

University Main Campus, Karachi. Then I wish to express my deepest gratitude to my sincer and

honorable supervisor Dr. Muhammad Ayub Khan Meher, who spared his precious time in

preparing this dissertation. I believe that without his consistence guidance and encouragement it

was not possible for me to produce it. The people whom I visited are greatly appreciated for their

support and answers.

So far on this special occasion, I would not forget my family members and friends for their

consistent support and encouragement given to me during the study.

I hope that this dissertation is complete and up to the required standard.

Muhammad Irfan Khan

July 2015

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ABSTRACT

‘Corporate Governance’ is a term which has been used in the literature of management, finance

and economics. It is unfortunate that misunderstanding and use of the terms in misleading

manners has created several gaps in academic conclusions and its practical implications. This

study is an attempt to fill these gaps.

This study is based on the models derived by the researchers to explain the patterns of corporate

governance, firms’ financial policies and liquidity position, so extensive use of references and

financial literature is obvious. A deductive approach has been adopted in the study to reconcile

and examine the different models of corporate governance and firms’ financial policies.

The study showed that corporate savings is a good predictor of the macro level investment in the

country. The magnitude of national investment will increase by improvement in corporate

savings. In fact the corporate savings indicate the expansion in business activities which may be

an indicator of the trust and confidence of private sector. On the other hand it explains the

financial health of corporate sector, which may provide the significant portion of tax revenue to

the government for developing projects in public sector. Government is responsible to create a

business environment where transparent management of public finance becomes possible at the

national level. In case the government regulation is not efficient, rules of conduct for the private

sector are desired. Particularly, improving the corporate social responsibility and relevance of

corporate governance is needed. The direction of causality has been tested before estimation of

this model. Not only may the return on investment but circularity of debt and liquidity position

also affect the corporate savings.

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The study has concluded that corporate governance is a significant variable in determining the

liquidity and circularity debts. In this way corporate governance becomes a crucial determinant

of the national investment. The bad corporate governance may deteriorate the investment

activities at national level, which may damage the economy for a longer term. This study also

indicates that capital structure and the patterns of ownership play important role in the

determination of corporate governance of an institution.

The conclusions of the study have been reconciled with previous findings and the extensive use

of references and discussion on theoretical advancement in the literature of corporate governance

was natural requirement for this purpose. The study has been arrived at the conclusion through a

deductive approach however; the results have been confirmed through empirical evidences. To

analyses the data and empirical evidences, econometric modeling has been followed.

The present research is a blend of economic governance and development financing. It develops

a theorem, identifying antecedent variables which can better expound the given phenomenon. It

has now come into the fact that investment position in a country can be improved if corporate

sector plays its rigorous role to convert its earnings into investment. This earning must be

converted into fixed investment in plant and machinery in order to grow in future. Investment in

current assets will allow CEOs to enjoy freedom of uing this money in their own favor. Agency

costs must be minimized which exists in the form of personal expenses of CEOs of corporations.

This is possible when compensation policy is designed in a manner that it is based on firms’

performance. This will lead a CEO to take decisions which are in the best interest of

shareholders.

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It was deduced from the theorem which states that the state of corporate governance must be

improved in order to minimize the circularity debt problem which is really a governance issue.

Resolution of this issue will lead the corporate sector to raise their liquidity and profitability as

well. Government must focus on the issue of circularity debt from the governance point of view

rather from the perspective of finance.

There were multiple objectives of the dissertation. First, it attempts to investigate the corporate

governance practices being followed in the public listed firms in Pakistan. This is translated as

whether the remunerations of CEOs of corporations are set in accordance with the good

corporate governance practices? Some big families in Pakistan have more than one business.

Transfer of one CEO to another company is a common practice which hinders the corporate

governance practices. Similarly, compensation of CEOs is also biased due to relationship based

corporate governance structure. Salaries and other requisites are not performance based, rather

determined either on political or relation grounds. Secondly, the study aims to examine the issue

of circularity debt exists in the energy sector of Pakistan in relation to corporate governance. In

other words, whether circularity debt issue arises because of bad corporate governance practices

in Pakistan? It is an attempt to explain not only the factors contributing good corporate

governance but also to seek an understanding of its relationship with circularity debt with respect

to liquidity crisis. CEOs of corporate sector are not aligned with the objective of shareholders

and they raise their salaries and other perquisites in the form of salary and other personal

expenses. This constitutes a bad governance state which further enhances the issue of circularity

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debt. Therefore, attention must be diverted towards improving the governance state of the

corporate sector in order to match the objectives of shareholders with the agents.

The dissertation has a fundamental premise that bad corporate governance is responsible for

circularity debt and liquidity crisis. Pakistan has been facing this phenomenon for almost one

decade. There were several solutions given but no one was long run. This study is an endeavor to

recommend a long lasting as well as beneficial solution for both the government as well as all

stakeholders.

It also intended to explore the causes based on which firms decide to retain their earnings and

increase the equity. It is assumed that retained earnings depend on liquidity and after tax earnings

of the company. Finally, the dissertation recommends a path way to a developing country to

progress by increasing the corporate savings as macro level investment in the country depends on

corporate savings. Although, dividend is good in the yes of an investor, emphasize must be made

towards increasing the corporate savings in order to enjoy better earnings in times to come.

Economic governance is the key to improve the economic situation of a country and must be

readdressed with respect to the corporate governance, especially in government owned firms.

There are three integrated theoretical models which have been tested in this study. Corporate

governance which is endogenous variable in first model becomes exogenous in the second

model. Similarly, liquidity which is endogenous variable in the second model becomes

exogenous in the third model. Because of the nature of the models, 3-stage least square

regression is appropriate to explain the phenomenon. The model is non-recursive as there are

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some reciprocal paths between models. In such cases, single equation estimation technique like

2SLS may not provide an efficient estimate as 3SLS. Consequently, 3SLS was employed for the

data analysis as it takes into account the information present within and across the hypothesized

equations.

TABLE OF CONTENTS

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DESCRIPTION PAGE

No.

CERTIFICATION ii

DEDICATION iii

ACKNOWLEDGMENT

iv

ABSTRACT

v

LIST OF TABLES

xiv

LIST OF FIGURES

xv

LIST OF ABBREVIATIONS

xvi

CHAPTER 1: INTRODUCTION

1.1 Overview 1

1.2 Research Problem 4

1.3 Objective of the Study 6

1.4 Corporate Governance 7

1.5 One-Tier Board Model 8

1.6 Two-Tier Board Model 9

1.7 Liquidity 10

1.8 Circularity Debt 11

1.9 Supply Chain of the Circularity Debt in the Energy Sector of

Pakistan

12

1.9.1 The Supplier of the Primary Energy 12

1.9.2 The Power Generation Companies 13

1.9.3 The Power Distribution Companies 13

1.10 Corporate Savings 16

1.11 Organization of the Dissertation 18

CHAPTER 2: LITERATURE REVIEW

2.1 Corporate Governance and Capital Structure 19

2.2 Tradeoff Model and Financing Hierarchy Model 23

2.3 Free Cash Flow Hypothesis 24

2.4 Corporate Governance and Bankruptcy 27

2.5 Corporate Governance, Agency Theory and Management

Compensation

28

2.6 Corporate Control, Take Over and Corporate Governance 33

2.7 Corporate Governance in Emerging Market Economies 35

2.8 Corporate Governance in Developed Market Economies 36

2.9 Ownership Structure and Stewardship Theory 36

2.10 Ownership Structure and Public Announcement’s Disclosure 36

2.11 Corporate Governance and the Performance of Stock Markets 38

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2.12 Corporate Governance and Management Turnover 40

2.13 Corporate Governance and International Trade 42

2.14 Corporate Governance and Survival 43

2.15 Corporate Social Responsibility 45

CHAPTER 3: CORPORATE SAVING DECISIONS

3.1 Retained Earning, Its Economic Determinants and Consequences 49

3.2 Retained Earnings and Stock Prices 57

3.3 Retained Earnings and Asymmetric Information 59

3.4 Savings from other Perspective 60

3.5 Corporate Savings and Tax Policy 60

3.6 Retained Earnings or Dividends 63

3.7 Investment in Pakistan 64

CHAPTER 4: INSTITUTIONAL FRAMEWORK

4.1 Defining the Propositions 68

4.2 State of Economic Governance in Pakistan 68

4.3 Propositions 69

4.3.1 Proposition 1 71

4.3.1.1 Corollary 1 71













4.4 Basic Assumptions of the Model 76

CHAPTER 5: RESEARCH DESIGN AND METHODS

5.1 Data and Variables 78

5.2 Theoretical Model of the Dissertation 79

5.3 Variable Explanations 80

5.3.1 Dependent Variables 80

5.3.1.1 Corporate Governance 80

5.3.1.2 Circularity Debt 85

5.3.1.3 Retained Earnings 85

5.3.1.4 Gross Fixed Capital Formation 86

5.3.2 Firm Specific Explanatory Variables 88

5.3.2.1 Capital 88

5.3.3 Exogenous Variables 89

5.3.3.1 Type of Organization 89

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5.3.3.2 Ownership Concentration 90

5.3.3.3 Distribution of Assets 91

5.3.3.4 Long Term Debt 92

5.3.3.5 Cash Generated during the Year 93

5.3.3.6 Corporate Assets 94

5.3.3.7 Sales 95

5.3.3.8 Return on Equity 96

5.4 Sample Size and Variables 97

5.5 Estimation Techniques 99

CHAPTER 6: CORPORATE GOVERNANCE PHENOMENON

IN PAKISTAN

6.1 Proposition 1 100

6.2 Descriptive nature of the data 100

6.3 Correlation Analysis 105

6.4 Multiple Regression Model 106

6.5 Determination of Corporate Governance 107

6.6 Significant Contribution of each Variables 109

CHAPTER 7: LIQUIDITY CRUNCH AND CIRCULARITY

DEBT




7.4 Multiple Logistic Regression Model 114

7.5 Goodness of Fit of the Model 115

7.6 Reasons of Circularity Debt 116

CHAPTER 8: FINANCING DECISIONS OF CORPORATION



8.3 Regression Model 123

CHAPTER 9: CORPORATE SAVINGS AND TOTAL

INVESTMENT IN A COUNTRY


9.2 Rational behind the Notion 126

9.3 Supply Side Effects 127

9.4 Demand Side Effects 127

9.5 Government Taxes 128

9.6 Banking Channel 128

9.7 Financing the Investment Decisions 129


9.9 Exploring the role of Corporate Savings 131

CHAPTER 10: SUMMARYAND FINDINGS

10.1 Overview of the Study 133

10.2 Findings of Proposition 1 134

10.2.1 State of Corporate Governance in the Govt-Owned 134

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Firms

10.2.2 Role of Ownership Concentration 134

10.2.3 Effects of Capital 134

10.2.4 Distribution of Assets and Corporate Governance 135


10.3.1 Mitigating of Circularity Debt through Corporate

Governance

135

10.3.2 Leverage Effects 136

10.3.3 Cash Generation and Liquidity Problem 136

10.3.4 Negative Effects of Corporate Assets 137

10.3.5 Sales as a Driver of Circularity Debt 137


10.4.1 Predicted Liquidity 137

10.4.2 Profitability 138


CHAPTER 11: CONCLUSION AND RECOMMENDATIONS

11.1 Conclusion 139

11.2 Recommendations 139

11.3 Future Research 141

References 142

Appendix A: List of Companies 158

Appendix B: Results 160

Appendix C: Results 166

Appendix D: Results 171

Appendix E: Results 174

LIST OF TABLES

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TABLES PAGE

No.

1.1 Attributes of One-Tier and Two Tier Corporate Boards 10

1.2 Receivables from DISCOs (Million Rs.) 14

1.3 Receivables of DISCOs from Provinces and AJK (Million Rs.) 15

1.4 Distribution of Circularity Debt Receivables (Billion Rs.) 16

3.1 Investment as a percentage of GDP 65

4.1 list of Abbreviations of Variables 77

5.1 Ownership Concentration of 50 Random Companies for Pakistan for

2003-2007

84

5.2 Financing of Top 50 Listed Manufacturing Companies 86

5.3 Cash Flow from Operations of some Big Companies in the Fuel &

Energy Sector of Pakistan

95

5.4 Variables 98

6.1 Descriptive Analysis 101

6.2 Comparison of Governance Practices across the Energy Sector 103


6.4 Predicting the Corporate Governance 108

6.5 Significant Contribution of each Variable 109


7.2 Comparison of Liquidity across the Energy Sector 113


7.4 Goodness of Fit Measures 115

7.5 Predicting the Liquidity Problem 116

7.6 Classification of Cases 118



8.3 Predicting the Corporate Savings 124


9.2 Predicting the GFCF 131

9.3 Predicting the GFCF 132

LIST OF FIGURES

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FIGURES PAGE

No.

3.1 Investment as Percentage of GDP 66

5.1 An Econometric Model of Corporate Governance and Circularity Debt 81

5.2 Logical Tree of Capital 82

5.3 Corporate Saving Rates 87

5.4 Gross Fixed Capital Formation History in Pakistan 88

6.1 Total Size of the Energy Sector of Pakistan 104

6.2 Corporate Assets of the Energy Sector of Pakistan 105

7.1 Accuracy of Cases 119

8.1 Change in Corporate Saving and Investment Rates – Average Annual Real GDP

Growth Rate 1998- 2007

120

9.1 Economic Upturn 127

9.2 Corporation as a Nexus of Contracts 128

LIST OF ABBREVIATIONS

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2SLS 2-Stage Least Square

3SLS 3-Stage Least Square

AASB Australian Accounting Standards Board

AJK Azad Jammu and Kashmir

AMEX American Stock Exchange

APT Arbitrage Pricing Theory

BoDs Board of Directors

CAPM Capital Asset Pricing Model

CEO Chief Executive Officer

CFOs Chief Financial Officers

CPPA Central Power Purchasing Agency

CSR Corporate Social Responsibility

DISCOs Power Distribution Companies

EPS Earning Per Share

FATA Federally Administered Tribal Area

FCF Free Cash Flow

FDI Foreign Direct Investment

FESCO Faisalabad Electric Supply Company

HESCO Hyderabad Electric Supply Company

IESCO Islamabad Electric Supply Company

IMF International Monetary Fund

GCOs Government Companies

GEPCO Gujranwala Electric Power Company

GDP Gross Domestic Product

GEI Global Environmental Index

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GENCOs Power Generation Companies

GFCF Gross Fixed Capital Formation

IFC International Finance Corporation

IPPs Independent Power Producers

IR International Relation

ISE Islamabad Stock Exchange

KPK Khyber Parktunkhwa

KSE Karachi Stock Exchange

LESCO Lahore Electric Supply Company

LSE Lahore Stock Exchange

M/B Ratio Market to Book Ratio

MBVE Market to Book Value of Equity

MEPCO Multan Electric Power Company

MLPUCOs Medium and Large Public Limited Companies

MLPRCOs Medium and Large Private Limited Companies

MM Modigliani and Miller

NASDAQ National Association of Securities Dealers Automated Quotations

NEI New Institutional Economies

NEPRA National Electric Power Regulation Authority

NPV Net Present Value

NTDC National Transmission and Dispatch Companies

NYSE New York Stock Exchange

OECD Organization for Economic Co-operation and Development

O&GDCOs Oil & Gas Distribution Companies

O&GCOs Oil & Gas Companies

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OLS Ordinary Least Square

OMC Oil Marketing Companies

OREF Oil Refineries

P/E Price to Earnings Ratio

PEPCO Pakistan Electric Power Company

PESCO Peshawar Electric Supply Company

P&EGCOs Power & Electric Generation Companies

QESCO Quetta Electric Supply Company

ROE Return on Equity

SBP State Bank of Pakistan

SEC Security and Exchange Commision

SMEs Small and Medium Enterprises

SPECOs Small Private Limited Companies

SPUCOs Small Public Limited Companies

SRI Socially Responsible Investor

USAID United State Agency for International Development

WAPDA Water and Power Development Authority

WLS Weighted Least Square

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CHAPTER 1

INTRODUCTION

1.1 Overview

Economic governance is a theoretical concept that covers issues in many pastures. It

includes economic development and growth, organizational behavior, political economy and the

like. Williamson (2005) explains the economic governance as the “study of good order and

workable arrangements”. It studies processes which support economic transactions and different

activities while safeguarding the property rights and providing physical and organizational

infrastructure. These processes are followed within formal and informal institutions. The formal

and informal institutions in a country progress to undertake different economic activities. It is

fortunate to state that organizations in Pakistan are formally formed. A legal formal system is in

place to regulate all organizations in order to undertake economic activities. Problem arises when

informal activities are found within the formal system of organizations. These informalities may

be found in any formal system i.e. political system, financial system, economic system and the

like. At times, organizations may be involved in these informal economic activities. They may

take undue benefits of concentrated ownership, poor protection of shareholders in minority and

accepting projects which may destroy the wealth of shareholders. These activities are termed as a

problem of corporate governance. Economic governance studies the institutions and

organizations while corporate governance deals with internal management of a corporation

(Dixit, 2008).

Vitols (1995) compared the New Institutional Economies (NEIs) perspective and economic

governance perspective. The study found that later perspective focuses on macro level. This

thesis takes up economic governance perspective to support the argument that it can lead to

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higher amount of total investment in a country. For this purpose, corporate governance is taken

as one offshoot of the economic governance.

In the neoclassical approach, high rate of investment is directly linked with high rate of savings.

In the non-neoclassical approach, savings are not automatically translated into investment but

have a causal relationship (World Bank, 1991). According to this approach, profits are the

outcome of investments. This thesis takes the non- neoclassical approach where savings and

investment are not directly linked but there are some reasons behind them.

It is astonishing that there is no globally accepted one definition of corporate governance.

It unlocks the door to academic researchers and practitioners to explore the area in depth. Much

of the literature divulges the variety of explanations. Some researchers went on the agency

problem due to the separation of ownership from agent i.e. management (Roe, 1994). Others

discussed the phenomenon with reference to the methods that people employ to guard their

happiness in social exchange (Li & Filer, 2007). Shleifer & Vishny (1997) demonstrated a

comprehensive definition of corporate governance by combining the above two. They explained

it as the usefulness of mechanisms that lessen agency conflicts while putting particular

emphasize on the legal mechanisms that thwart the expropriation of minority shareholders.

Corporate governance in Pakistan is in its developing stage and therefore its definition varies

from institutions to institutions. It is the manner by which companies should be conducted

(Manual of CG, SECP, P5). The OECD provides its principles, addressing the corporate

governance. In short all definitions have a basic idea of a system through which corporations are

directed as well as controlled. Furthermore, corporate governance has many roots to relate,

starting from firms’ performance to economic growth.

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The aim of this thesis has many folds. First, it attempts to investigate the corporate governance

practices being followed in the public listed firms in Pakistan. Some big families in Pakistan

have more than one business. Transfer of one CEO to another company is a common practice

which hinders the corporate governance practices. Similarly, compensation of CEOs is also

biased due to relationship based corporate governance structure. Salaries and other requisites are

not performance based, rather determined either on political or relation based. Secondly, the

study aims to examine the issue of circularity debt exists in the energy sector of Pakistan in

relation to corporate governance. It is an attempt to explain not only the factors contributing

good corporate governance but also to seek an understanding of its relationship with circularity

debt with respect to liquidity crisis. The thesis has a fundamental premise that bad corporate

governance is responsible for circularity debt and liquidity crisis. Pakistan has been facing this

phenomenon for almost one decade. There were several solutions given but no one was long run.

This study is an endeavor to recommend a long lasting as well as beneficial solution for both the

government as well as all stakeholders. It also intends to explore the causes based on which firms

decide to retain their earnings and increase the equity. Finally, the thesis recommends a path way

to a developing country to progress by increasing the corporate savings.

These objectives are interlinked with each other with separate propositions. Dependent variable

in the first proposition becomes explanatory variable in the second proposition. Similarly,

dependent variable in the second proposition takes the position of independent variable in the

third proposition and so on till the forth proposition. Based on a combination of endogenous as

well as exogenous variables, the thesis finally argues that corporate savings are a good indicator

to total investment of a country.

1.2 Research Problem

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There are varying corporate governance systems and models. Relationship-based model

and market model, which differs in relative efficiency, is an essential issue for many corporate

governance researchers (John & Senbet, 1998). This issue becomes more enticement when these

suitable corporate governance systems are selected by emerging markets to seek the

implementation. Generally, market structures of emerging market differ from those of developed

market and conventional governance systems show litter effectiveness. Majumdar and Pradeep

(1999) focused the corporate governance in the India and suggested that state ownership in

financial institutions must be readdressed. Pakistan is a country where ownership is concentrated

which distort the good corporate governance practices. Whenever debt is needed, banking

channel is preferred as loan on a premium interest rate. This leads to a conclusion that

relationship based model of corporate governance is preferred in Pakistan. Managers used to

enjoy the relation with bankers and take loans to increase the market value of the firm which

may result the bankruptcy in future. The only objective of managers is to receive high perquisites

without considering the future outlook of the firm. As compared to external governance

mechanisms, internal governance mechanisms of control are dominated in firms. Capital market

is in its development stage, weak-form of efficient stock market and lack of an active market of

corporate control due to concentrated ownership. Pakistan is a country where relatively

unsophisticated legal and regulatory framework exists. Furthermore, market incentives are poor

due to the existence of market anomalies and misconduct. Due to absence of market based

control measures, ownership-based control have been set up as a core governance mechanism.

The corporate sector of Pakistan is dominated and controlled by founder families or group of

families. For instance, one family owns several firms not only in the same industry but also

diversified in other industry as well. Meaning thereby, they control not only one industry but also

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other as well. Ownership is surrounded among them and their decisions are dictated. Oman, C,

Fries & Buiter (2003) revealed that the main impending conflict of interest in the market of

developing, transition and emerging countries are likely to mount not between manager and

owners of a corporation as seen in the US and the UK but among controlling shareholders and

other scattered shareholders.

Energy sector of Pakistan comprises government as well as Independent Power Producers (IPPs).

The corporate structure of both types of firms is different. As compared to IPPs, bad corporate

governance is practically seen in government organizations where liquidity crisis exists every

time. Management enjoys private benefit at the expense of outside shareholders. This problem is

highlighted in this study whether the salaries and perquisites of management increase with

proportionately to long term debt plus equity hence, referred to as capital. This is hypothesized

that this ratio will be higher in case of government organizations.

Furthermore, the issue of circularity debt is examined in this study. Pakistan has been facing this

issue for many years. Circularity debt shows illiquidity of firms which results when one party

holds the payment of other party in the supply chain. This not only hurts the operation of the

company but country also faces losses in terms of GDP. It is hypothesized that circularity debt

issue arose because of bad corporate governance practices being implemented in Pakistan along

with some other explanatory variables.

1.3 Objectives of the study

As discussed above, the research strives to analyze the nature of economic governance

and its practices being employed by the listed companies of Pakistan. The objectives of the study

are many fold and specified below.

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1. Whether the remunerations of CEOs of corporations are set in accordance with the

good corporate governance practices?

The objective is to examine the corporate governance practices of CEOs through the ratio of

salaries and perquisites to capital. It is hypothesized that this ratio will be higher in case of

government-owned organization. The proposition includes a dummy variable to segregate the

results of these two firms. It takes the value of 1 for government-owned firms and 0 otherwise.

Ownership concentration along with some control variables are also incorporated to reveal the

corporate governance practices. Because of concentrated ownership, managers have discrete

power to use money of shareholders for their personal interests. Managers also employ the

technique of accumulating current liabilities by holding payment of other suppliers to run the

operations. In this scenario, current portion of liabilities increases. As a result of this, market

value increases and managers get benefit out of it.

2. Whether circularity debt issue arises because of bad corporate governance practices in

Pakistan? What are different solutions of the issue?

Pakistan has been facing this issue for many years. This becomes dilemma that this issue is still

not resolved. People of Pakistan are also confronting severe problems of load shading because of

shortage of energy. This is hypothesized that bad corporate governance is responsible for the

issue of circularity debt. This issue is being addressed in this objective which is analyzed while

having corporate governance as exogenous variable along with some control variables. As seen

in the first objective, current liabilities are enhanced by not paying to suppliers which is exactly

the case of circularity debt. The achievement of first objective is directly linked with this second

objective.

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3. Whether retained earnings depend on liquidity and after tax earnings of the company?

The decision of retained earnings epitomizes the financing policy of the company. Firms having

good future investment opportunities retained a large portion of earnings after tax. According to

pecking order theory, firms always put retained earnings as first priority whenever fund is

needed. This phenomenon is examined with liquidity and earnings of the company as

explanatory variables.

4. Whether investment in a country depends on corporate savings?

Finally, it is revealed that investment in the country depends on corporate savings. As all the

objectives are interlinked with each other, investment in the country will become a function of all

variables used in three propositions.

1.4 Corporate Governance

Economic growth is very much connected to good corporate governance. Easy access to

outside capital and performance of the company lead to economic development. The most used

explanation is that it studies the relationship among the management, board of directors,

shareholders, and all other stakeholders. Several firm as well as economy specific determinants

elucidate the corporate governance. Empirical evidence suggests that corporate cash holdings

explain the corporate governance practices. Other researchers describe the corporate governance

through the shareholder’s right in the country. World Economic Forum measures it through some

firm as well as economy specific factors.

The diversity of board roles in the context of corporate governance, differences in the

organizational structure and composition of boards endow with ample prototypes of corporate

models in the Western countries. There are, broadly, two foremost approaches to the

26

organization of corporate boards. Countries like US, the UK and Canada adopted Anglo-Saxon

one-tier board model. Two-tier board model exists in Continental European countries like

Germany, Finland and the Netherland.

1.5 One-Tier Board Model

This model allows executive as well as non-executive directors to work together in one

layer of the hierarchy of the organization. In some cases, executive directors dominate the board

while boards may also be dominated by non-executive directors as well. The model may have

board leadership structure that segregates the CEO and chair positions of the board. On the other

hand, the leadership structure, under this one tier model, may operate that combines the role of

CEO and chairman, called CEO duality. Sheridan & Kendall (1992) suggested a problem exist in

one tier model due to the dispersion of tasks and responsibilities of directors. Role and position

of executive and non-executive CEOs in the US and the UK have no distinction as they face

same legal responsibilities and tackle same legal liabilities. Further, majority of executive

directors in the board leads to the potential conflict of interest between management and

shareholders. Kesner & Johnson (1990) propose the composition of corporate board with non-

executive directors because of the following reasons:

their knowledge and experience

their contacts which may increase the ability of management to secure external resources

their independence from the CEO

This suggests a negative association between the formal independence of corporate board and

one-tier board, dominated by executive directors.

1.6 Two-Tier Board Model

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In organizations’ hierarchy, one additional layer has been designed to disengage the

executive function of the board from its monitoring function. Non-executive supervisory board

enjoys the upper layer of the hierarchy who may represent labor, government and institutional

investors. The lower layer, management board is generally composed of executive managing

directors. There is no possibility that directors can have CEO and chairman position under two

tier board models because CEO does not have any seat in the supervisory board. As practiced in

the Netherland and Germany, supervisory board of the corporation does not contain any

executive managing directors because they are not entitled for the same. This means that the

CEO duality is not possible. The formal independence of board in the two-tier board is not

disputed in the international corporate governance debate. Further differences in the one tier and

two tier boards are depicted in table 1.1 below. These differences are based on some attributes

like composition, committee, organization and CEO duality which are also shown in the same

table

Table 1.1

Attributes of One-Tier and Two-Tier Corporate Boards

Attributes One-Tier board Two-tier board

Composition Executive and non-executive

directors in one board

Executive and non-executive

directors in separate board

Committee Mandatory Recommended

Organization Unitary Binary

CEO duality Possible Impossible

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Previous researches reveal that corporate governance practices, in Pakistan, is not followed. The

ownership is very much concentrated in a small number of hands of large and affluent families

who manage ownership shares through pyramids and tunneling. Business groups usually have

minor transparency and pathetic corporate governance system. Pyramid ownership structures

make it feasible to organize some firms even with a very small contribution of their total capital.

The basic rights of shareholders are protected in Pakistan at least laws in book (Javid & Robina,

2010).

1.7 Liquidity

Investments in liquidity are important for corporation. There are multiple determinants of

liquidity. Transaction costs appeared to be the major determinants of corporate cash holdings in

the literature. Corporations are motivated by various reasons to hold certain amount of liquid

balances. These reasons, in the spirit Keynesian postulations of the money demand, include

precautionary, speculative and transactional purposes. Thus, how much liquid balance is held by

a corporation is influenced by factors such as transaction costs, opportunity costs and

informational asymmetries (Bruinshoofd & Kool, 2004). Informational asymmetries between

firms and capital markets are an important precautionary motive for corporate liquidity demands.

Bruinshoofd & Kool (2004) discussed that liquid balances on balance sheets mean different

things to different groups. Opler et al. (1999) introduced a useful structure for opinion about the

possible factors because of which firms hold cash.

The level of liquid assets kept by a firm depends on the projected future investment needs. It

becomes difficult to forecast these future requirements as they are stochastic in nature. As

management discovers about the firm's need for funds, adjustments in the level of liquid assets of

a firm are made. There is a possibility that liquid assets bring more rigorous agency problems

29

than non-liquid assets. Liquidity of an asset is strongly allied to the reversibility of the outlay in

it. Thus, management of a liquid asset can more easily and less visibly use that asset to advance

its interest at the expense of the asset's owners. Therefore, careful contracting and monitoring are

required. These are expensive arrangements. There may a conflict between managers and

shareholders on the preference of cash or debt. The results may be likely to be influenced by

corporate governance. This thesis also examines whether corporate governance affects the

liquidity position of the firm? The present study takes circularity debt as the proxy of liquidity.

This is a warm issue in Pakistan and has been existed for many years.

1.8 Circularity Debt

The study intends to elucidate that good corporate governance can diminish the issue of

circularity debt exist in Pakistan. Circularity debt arises when one entity faces problems in its

cash inflows and consequently fails to discharge its obligations. Similarly, second entity does not

receive its payments; it further withholds the disbursement to other entity. As a result, this

perturbs all segments of the payment chain. This warm and unresolved issue persists in the

power sector of Pakistan. The amount of reported circularity debt is the sum of the receivables of

each organization which comes up to the amount simply because of double counting. Payable of

one organization becomes receivable for another organization. When subtract one from the other,

these should be canceled out or the difference should be smaller in number. In case of power

sector in Pakistan, this amount was estimated to be Rs.537 billion as on June 30, 2011 and

Rs.872 billion as on June 30, 2012, account for roughly 4% of the nation GDP (Planning

Commission of Pakistan, 2013). This project was completed by the Planning Commission of

Pakistan which was funded by USAID, ranking the poor governance at the top of list as one of

the major reason of increase in circularity debt. This deficiency can be observed at government,

30

corporate and sector level. Political meddling, short term defective policies and unsettled intra

and inter government issues are at the top of the government level. At the corporate level,

ineffective monitoring of performance of DISCOs by the BoDs are the major problems. At the

sector level, NEPRA fails to perform effectively as per the NEPRA Act 1997. To comprehend

these issues, it is imperative to look at the key organizations which involve in the supply chain.

1.9 Supply Chain of the Circularity Debt in the Energy Sector of Pakistan

1.9.1 The suppliers of primary energy

This segment of the chain provides energy to power generation companies. The chain

begins from the exploration of oil and gas. These include companies like OGDCL and PPL.

These companies transfer oil/gas to oil refineries companies which are ARL and PARCO.

Accordingly, oil refineries supply to distribution companies. They supply gas distribution

companies like SNGPL and SSGC and oil distributing companies like PSO and Shell.

1.9.2 The Power Generation Companies

The second step in the chain starts when exploration companies supply energy to this

segment. The companies which are involved in power generations are KESC, IPPs, CPPA,

WAPDA and PEPCO. The core entity in the energy sector is PEPCO which is an umbrella

institution engaged in managing power generation companies (GENCOs), the National

Transmission and Dispatch Companies (NTDC) and power distribution companies (DISCOs).

1.9.3 The Power Distribution Companies

This segment obtains energy from the generation companies and distribute to individuals,

industrial consumers, Government, FATA, etc. These comprise companies like LESCO,

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HESCO, IESCO, MEPCO, FESCO, PESCO, QESCO and GEPCO and are collectively called

DISCOs.

PEPCO is responsible to collect tariffs from its customers and Government as well and disburse

to its suppliers like IPPs, OMC and gas companies. Cash inflows and outflows must be logically

comparable in order to function the business smoothly. Cash outflows of the PEPCO are sure

because these are obligation which has to be fulfilled. Cash inflows are uncertain because of

absence or delay in tariffs payments. Sometimes government delays in subsidies while on the

other hand, some powerful individual and government institutions withhold their payment.

Ultimately this accumulates the receivable amount in the PEPCO account which results delay in

payment to its suppliers which in turn seize payment to top of the segment. This imbalance of

cash flows is one of the reasons of circularity debt. Table 1.2 shows the receivables from all

DISCOs from 2008-09 to 2011-12 alongwith their share in the total receivables.

Table 1.2

Receivables from DISCOs (Million Rs.)

DISCOs 2008-09 2009-10 2010-11 2011-12 % Share

PESCO* 26,809 32,902 41,282 51,360 26%

HESCO* 18,856 25,454 33,344 44,237 22%

QESCO 4,297 5,238 24,780 48,193 24%

LESCO 10,957 15,968 17,081 23,080 12%

GEPCO 3,585 5,322 5,631 5,912 3%

FESCO 3,719 5,676 5,866 7,068 4%

IESCO 2,287 2,286 2,762 2,703 1%

MEPCO 7,252 10,505 11,900 14,638 7%

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Total 77,762 103,351 142,646 197,191 100%

Source: Monthly Economic Review Saturday, 29th November 2014 *PESCO includes TESCO and HESCO includes SEPCO

This is evidenced in the table 1.2 that poor revenue collection by PEPCO is one of the causes of

circularity debt. This problem is not identical in the country as some of the DISCOs have good

track record. One of the reasons which contribute to the hike in receivables is the lack of

accountability of DISCOs. High political interference, low transparency and failure of

accountability do play a significant role, showing corporate governance issue which must be

addressed.

It is reality that there are a bulk amount of receivables in the books of PEPCO from DISCOs but

on the other hand, DISCOs also have a huge amount of receivable from different provinces of

Pakistan. Table 1.3 gives the fact of these receivables. In fact, receivables gradually increased

from 2005 to 2012. Balochistan is the top of the list which has to pay highest amount in the year

of 2012.

Table 1.3

Receivables of DISCOs from Provinces and AJK (Million Rs.)

Province 2005 2006 2007 2008 2009 2010 2011 2012

Punjab (481) (9) (381) 162 (7) 3,263 5,371 5,842

KPK 239 398 652 254 601 1,144 19,427 19,792

Balochistan 538 119 146 709 1,064 2,419 4,662 52,696

Sindh 341 2,382 3,224 7,603 14,241 25,790 39,230 6,200

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AJ&K (50) 485 756 1,216 2,391 4,393 9,888 15,953

Total 587 3,375 4,397 9,944 18,290 37,009 78,578 100,483

Primary Source: PEPCO DISCOs Performance Statistics Report (FY 2005 – FY 2012)

Secondary Source: USAID Report; The Causes and Impact of Circular Debt exist in Power Sector in Pakistan 2013

The study implies that good corporate governance can improve the management of liquid assets

(working capital). Table 1.4 below shows some highlights of the receivables and payables of

public corporation in Pakistan for 2010 and 2011. It can easily be comprehended that receivables

are greater than payables which implies that circularity debt is the governance issue which can be

overcome through good governance.

Table 1.4

Distribution of Circularity Debt Receivables (Billion Rs.)

Company Receivables Payables Net Position Change

30-Apr-11 30-Apr-10

PSO 149 98 51 30 21

SSGCL 51 44 7 -1 8

SNGPL 11 25 -13 -9 -5

PEPCO 304 302 3 -40 42

OGDCL 116 0 116 80 36

PARCO 38 - 38 30 8

KESC 68 40 28 -24 51

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GHPL 10 - 10 11 -1

PPL 22 - 22 26 -4

KW&SB 7 8 -1 0 -1

Grand Total 775 517 259 104 155

Source: Ministry of Finance

1.10 Corporate Savings

One of the components of national savings is the corporate savings which account for a

large portion of it. China’s corporate savings as of GDP in 2003 was 18% or US$700 billion

(China’s National Bureau of Statistics). China is not the only country with higher corporate

savings but other countries like India, Australia and the UK are also on the same line.

J.P.Morgan (2005) and IMF (2005) observed that companies in G-7 economies have presented

an increase in undistributed profit. A typical firm in the U.S. also exhibited a large portion of

cash holdings that it could pay off all debt with some amount of cash left over (Bates, Kathleen

& Rene, 2009). Literature of corporate finance does not believe high corporate savings as

inefficiency or corporate mis-governance. It could be a result of increasing working capital needs

faced by corporations. Fama & French, (2001) studied a pattern of not paying dividend in the

U.S. from 1978 to 1999.

The ultimate objective of a corporation is to maximize shareholder’s wealth. The share price

carries future information about companies’ affairs and business decisions. If share price rises in

spite of the low dividend announcement, it is evidenced that the firm has good investment

opportunities not only from company’s perspective but also in the eyes of investors. Ultimately,

35

shareholders will get benefit from this retained earning in the future. Modigliani & Miller (1958)

suggest that only the required return is relevant from investors’ point of view. If it is fulfilled,

dividend becomes irrelevant.

Corporations are always desirous to achieve an optimal capital structure as well as an optimal

dividend policy. Models like MM Propositions and CAPM provide the theoretical basis to

achieve both under some restricted assumptions. It is only possible in case when symmetric

information is prevailing in the market which does not lead an investor to get abnormal profit.

Asymmetric environment does not lead a firm to make decisions which are align with all the

shareholders. Clientele effect suggests that due to diversity of investors in the market, optimal

level, in any case, is a difficult task. In such circumstances, decisions to retain a large portion of

earnings in the firm, due to good future investment opportunities, will generate mis-governance

of the firm. Some investors infer it as good decisions and other interpret it bad governance.

Earlier is the group of investors who believe in the survival of firm. Later deem in the short term

profit as they are short- term-basis-investors. Those who think about the survival, estimate the

stock price based on future profit of the company which will come from current investment

opportunities.

Pakistan is also a country where dividend is rarely paid. A typical firm did not pay dividend for

eight years but its stock price did not fall. Textile sector infrequently pay dividend.

Pharmaceutical sector regularly pays dividend. There some example in which stock price did not

significantly decline instead of not paying the dividend. Rational investors always look for future

benefit as compare to short term profit.

1.11 Organization of the Dissertation

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The thesis is structured into ten chapters. Chapter two presents the literature review

available on the topic. This chapter illustrates different linkages of corporate governance,

determinants of corporate governance and implication of corporate governance. Chapter three

explains available literature on corporate savings. Chapter four discusses primary propositions

developed. Chapter five discusses the research design, conceptual framework and methodology

employed to examine the dependent variable. Chapter six empirically examines the proposition 1

developed in the chapter 4. Chapter seven evaluates the proposition 2 developed in the chapter 4.

Chapter eight discusses the proposition 3 developed in the chapter 4. Chapter nine examines the

proposition 4. Chapter ten concludes the thesis with some suggestions for future research.

CHAPTER 2

LITERATURE REVIEW

2.1 Corporate Governance and Capital Structure

Zheka (2007) provide evidence that firms which observe good corporate governance

practices benefited from the improved liquidity. Because they were able to quickly incorporate

their financial structure. The relationship between the speed of adjustment of leverage and

corporate governance were found to be statistically and economically significant. Shareholder

right, supervisory board structure and supervisory board procedure were taken as proxy of

corporate governance. Wen, Kami and Jan (2002) also found similar results based on 60 Chinese

listed firms during 1996 to 1998. Results findings suggested that manager tend to have lesser

percentage of leverage when outside directors on the board is higher in terms of percentage or

tenure of the CEO is longer. This result becomes insignificant when relate with board size and

fixed compensation of CEOs.

37

Majumdar & Pradeep (1999) examines the relationship between the debt level in the capital

structure of corporations and their performance on the data set of Indian firms within the context

of corporate governance. They developed a hypothesis to test whether the Western corporate

governance ideas are valid in transition or developing economies. As the suppliers of funds in

India are mostly government owned institutions, the results show negative relationship,

suggesting that the state-ownership of financial institutions situations have to be reassessed in

light of the corporate government context.

Williamson (1988) compared positive agency theory and the governance branch of transaction

cost economies. The study argues that transaction cost economies considers firms as governance

structure while the agency theory assumes it as a nexus of contracts. He further suggests that the

debt and equity principally are governance structures rather than as financial instruments.

Poyry & Benjamin (2009) studied three facets of corporate governance i.e. high ownership

concentration, high frequency of political connected firm and weak legal investor protection in

relation to capital structure. They attempted to explore as to how are Russian publicly traded

firms financed and to what extent do firms enjoy better access to external debt capital in the

presence of three above mentioned governance characteristics. There were 95 firms from 2000 to

2004. All governance variables were found to be significantly affects the capital structure. Firms

where controlling shareholder is a state, use the option of high level debt financing than firms

where controlling shareholders are domestic and private. On the other hand, firms with owners

having political influence to large financial organizations enjoy better access to debt.

Graham, Sonali & Krishnamoorthy (2011) study the Great Depression era to take advantage of

before and after differences in the corporate sector. They attempted to analyze the role of the

board and appraise how board characteristics intermingle with capital structure and investment

38

decisions of complex and simple firms separately during the Depression era. The final sample

data consists of 521 industrial firms from 1926 to 1941. They find the implications of agency

theory. Board size and corporate investment were found to be positively related and debt usage

in sample firms during the Depression period. Furthermore, firms which have suitably aligned

the structure of the board were more seemed to change the president of the firm based on past

meager performance.

Ivashina, Vinay, Anthony, Nadia and Roger (2009) investigate the bank role with respect to

information transmission that may have an effect in the corporate control market. Particularly,

they examined the role of bank debt in relation with corporate governance. They find that the

possibility of takeover bid increases with the greater bank lending intensity to a firm.

Furthermore, the role of lending by banks become strengthens to predict the takeover efforts

where the target and acquirer firms both have a good relationship with the same bank. Taken as a

whole, the evidence suggested the banks play their role to facilitate takeovers through

information production via bank lending and the diffusion of generated information to

prospective acquirers.

D’Souza (2000) compiled the literature of corporate governance of firm in developing and

developed countries. The study found some stylized facts. Firms in developing countries are less

likely to depend on internal finance than firms in developed countries. Indian firms rely more on

external debts than US firms. It seems that Indian financial structure may be a bank-oriented like

the Japanese and German financial systems. The author concluded the ineffectiveness of the

legal system to protect and enforce the control rights of investors in the presence of financial

liberalization in which bankers make lending in priority sectors and high reserve requirements.

During 1970-85, non-financial firms in the UK exhibited 100% retained earnings, 85% in the US

39

and about 60% in Japan and France. During 1980-86, firms in Pakistan showed 58.3% as internal

finance and 53.5% in Zimbabwe.

Klock, Sattar & Willam (2005) examined as to how antitakeover provisions may affect the cost

of capital of firms. Secondly, antitakeover provisions may impact the wealth transfers between

bondholders and shareholders. Furthermore, antitakeover provisions might have an impact on

management actions and decision making, which in turn, affect the firm’s owners. The study

employed governance index, using 1,877 firm-year observations on 678 industrial firms. The

findings suggest that cost of debt financing is lower in case of antitakeover provisions in firms.

They also found that in case of strongest management rights, firms have lower cost of debt

financing while strongest shareholders right are associated with higher cost of debt financing,

after controlling for firm and security specific characteristics.

Rauh & Amir (2010) studied the importance to recognize debt heterogeneity in capital structure.

They categorized debt into straight bond debt, bank debt, convertible bond debt, commercial

paper, mortgage debt and all other debts. Further, they also demonstrate as to how debt structure

differs across the credit quality distribution. The results suggest that most of the firms use bank

and non-bank debt. Moreover, the study shows that firms which follow multi-tiered debt

structure, consisting of both secured as well as subordinated debt issue, usually have more

scattered in their priority structure while having lower credit quality

Kochhar & Michael (1998) examined the relationship between capital structure and corporate

diversification as corporate strategy. Using 3SLS regression, the findings revealed significant

opposite association as discussed in prior researches. Specifically, related diversification is

linked with equity financing and unrelated diversification is associated with debt financing.

40

Brounen Dirk, Abe and Kees (2004) compared the corporate financial practices in the European

countries like the UK, Netherlands, Germany and France by conducting a survey of CFOs of

corporations. There were few international differences in terms of capital structure policy.

Pecking order theory is the important factor while making decision about debt level. Evidence of

static trade-off theory was also revealed. As far as other corporate financial practices are

concerned, payback period criterion is mostly used in capital budgeting decisions in the small

and less oriented European firms. While calculating cost of capital, CFOs employ CAPM

approach.

2.2 Tradeoff Model and Financing Hierarchy Model

Dittmar, Jan and Henri (2003) investigated the importance of corporate governance

practices on an international data set and highlight the importance of country and firm specific

variables on corporate cash holdings. Mainly corporate governance is explained by the

shareholder’s right. Furthermore, there are other control variables to explain the corporate cash

holdings. The study attempted to describe this relationship with the help of tradeoff model and

financing hierarchy model.

The tradeoff theory suggests that firm tradeoff between the costs and benefits of holding cash to

determine optimal cash levels. In this connection, they consider transaction costs motive as well

as the effects of asymmetric information and the agency costs of outside financing on the

demand of holding cash. In contrast, the financing hierarchy theory implies that there is no

optimal level of cash based on the pecking order theory of capital structure. It says that firms do

not demand outside financing as debt decreases and cash increases as they become more

profitable. International data set of approximately 11591 companies, excluding service oriented

firms, from 45 countries is considered for this research. The results of OLS, WLS and multiple

41

regression analysis reveal that shareholder’s right are negatively and significantly explain the

corporate cash holdings, meaning that firms hold more cash when shareholder’s right are weak

or other way around. Other control variables also explain this relationship. The results support

the agency problem to determine the corporate cash holdings.

Yun (2009) explained the role of antitakeover protection on firms’ liquidity choice with the

perspective of corporate governance. There may be conflicting preferences between principals

(shareholders) and agent (management) on the choice of cash and lines of credit. This choice

may be influenced by the practices of corporate governance. The finding of the paper implies

that state level changes in the takeover protections are linked with changes in the use of line of

credit as compare to cash for firms incorporated in those states. Besides, the paper also examined

the effects of changes of take over protection made at state level on governance structure and

capital structure as well. Results do not show any significant changes in ownership by large

block holders or institutional investors and capital structure after the legal change in take over

protections. Findings also suggest that the composition of cash and use of line of credit change

significantly after changes in take over protection. Overall upshot of the paper advocates that

exogenous removal of takeover threats allows poorly governed firms to move from lines of credit

to cash.

2.3 Free Cash Flow Hypothesis

Harford (1999) attempted to explain the firm as well as market specific characteristics of

cash rich firms. The author investigated this relation under the free cash flow hypothesis. The

second objective of the study is to determine whether cash rich firms undertake projects which

lead them to decrease the value of firms. It is assumed that managers use their discretion to make

value-decreasing investment decisions if firms have excess cash. The paper attempts to validate

42

this argument under the free cash flow hypothesis. Investment decision is taken as acquisitions.

The paper ultimately sheds light on agency conflicts. Managers of cash rich firms enjoy freedom

from external financing. Investments like acquisitions may be accomplished through internal

financing which reduces the effectiveness of the control mechanism. In an imperfect capital

market, managers are required to accumulate cash reserves to meet the operating as well as

investment decisions of firms. Over and above the required cash is excess cash which leads to

agency conflicts.

There are two regressions in the study. First is to explain the characteristics of cash rich firms

through multiple regression analysis. Acquisition decisions are investigated through Probit

Regression. Descriptive statistics suggests that as average cash to sales ratio increases, M/B ratio

as well as volatility of cash flows also increase. The results of multiple regressions also confirm

the positive relationship of cash to sales ratio with M/B ratio and volatility of cash flows. The

regressions result of financial sector is different as compared to other sectors and hence is

excluded from the analysis. The findings of second regression model suggest that in terms of size

(total assets), M/B ratio and Leverage, cash rich firms are insignificantly different from the total

population of firms. Further, firms are significantly different in terms of cash to sales ratio and

cash to total asset ratio from rest of the population of firms.

The results of 487 bid announcements reveal that the likelihood of attempting an acquisition is

increasing in the cash richness of the bidder. This result is consistent with the free cash flow

hypothesis. Firms with large in size, higher abnormal returns and higher sales growth are more

likely to become bidders. Further, the dummy variable of years show quick decline in the merger

activity in the early 1990s. The negative coefficient of price to earnings ratio indicates that

managers undertake projects or that leads them to value decreasing of firms. The study also

43

employs the insider ownership as predictor of cash deviation. Cash deviation for low insider

ownership (less than 5%) firms is significant and positive.

In an imperfect capital market, managers are required to accumulate cash reserves for the

operation of the firm. It provides them investment opportunity when internally generated funds

are not sufficient. However, firms accumulate over and above the need of cash become cash rich

firms. Under the free cash flow hypothesis, agency conflicts arise between managers and

stockholders with cash stockpile. It leads manager to undertake value decreasing projects

because of the absence of external monitoring. The results of the paper suggest that cash rich

firms are more likely to make investment decisions like acquisitions. Moreover, it is also evident

that low insider ownership leads to more acquisition activity which is value decreasing in nature.

Faleye (2004) focused on the takeover deterrence effects of corporate liquidity and comments

that proxy contest is an effective alternative control mechanism to address the agency problems

of excessive corporate liquidity. He proposed that dissident shareholders conducting a proxy

fight are not hampered that might prevent a hostile bidder. He finds that target firms hold 23%

cash more than comparable non targets firms. Furthermore, the prospect of a proxy fight is

extensively and positively allied to excess cash holdings. In addition to this, he also suggests that

abnormal return following a proxy fight announcement is significantly and positively related to

excess cash holdings. To measure the excess cash, he applied the OPSW model with other

exogenous variables.

Harford, Sattar and William (2008) studied the inside ownership and provisions of antitakeover,

using governance metrics. They supported the arguments as to how the use of cash is affected by

firms’ governance. Results revealed that US firms are likely to hold minimum cash reserves

while having weak shareholders rights, measured by Gindex and insider ownership. In other

44

words, equity holders who have strong rights permit the managers to hold large amount of cash

as they feel confidence that this cash will be utilized, in due course of time, to maximize the

wealth of shareholders.

2.4 Corporate Governance and Bankruptcy

Daily and Dan (1994) investigated the effects of corporate governance along with

financial variables on the prediction of corporate bankruptcy with 3 and 5 years lags.

Independent /interdependent board composition and the structure of CEO/board chairperson

positions were taken as proxies of corporate governance. It was assumed that CEO duality and

lower proportions of independent directors on the board lead to bankruptcy of firms. The

bankruptcy variable was the year in which the filing of chapter 11 bankruptcy occurred. Based

on the logistic regression, it was concluded that governance structure do contribute to the

incidence of bankruptcy for both lagged periods beyond financial and size considerations. Daily

and Dan (1994) examined the effects of governance structure and board leadership structure as

predictors on Chapter 11 bankruptcy by corporations, using the data of 50 bankrupt firms and 50

survivor firms. Based on the five years lags, results reveal that firms with joint CEO/board

chairperson structures and that have lower proportions of independent directors are associated

with bankruptcy. The three years lag show that bankrupt firms have far less profitability.

D’Aveni (1990) investigated that because creditors take off their support from top management

team of firm, bankruptcy occurs. Data was collected for five years preceding the bankruptcy. The

sample covered 57 large bankrupt firms and 57 matched firms during 1972 to 1982. Managerial

prestige was the main variable studied. Other control variables were profitability, leverage and

liquidity alongwith some dummy variables. Results revealed that firms might need to have two

forms of capital in order to survive. It must either have monetary capital in the form of financial

45

assets or status capital in the form of prestigious manager alongwith membership in elite

educational circles, political elites and board networks. In an earlier work, D’Aveni (1989)

proposed a new model of firms’ bankruptcy which was based on agency and prospect theory.

Based on the concept of dependability, the model proposed that debtors with low prestigious top

managers, low liquidity ad high debt indicate that they will be not be dependable exchange

partners. The model assumed that firms must maintain minimum level of financial as well as

managerial assets to survive. This minimum level is a necessary but not sufficient condition for

bankruptcy.

Listokin (2007) proposed debt compensation plan to CEOs in the eve of bankruptcy. According

to his study, it is the best plan as compared to stock options. Chitnomrath, Robert and Theo

(2011) studied the governance factors which affect post-bankruptcy reorganization performance

in Thailand. Based on agency theory, the model suggests the improvement in the performance of

restructured firms by incentive planes and active monitoring. Monitoring mechanisms include

ownership concentration and incentive mechanisms include cash compensation and percentage

of shares held by the plane Administrator. All those companies which filed petition of chapter

3/1 bankruptcy under the Thai Bankruptcy Act during January 1999 and December 2002 were

included in the sample.

2.5 Corporate Governance, Agency Theory and Management Compensation

It is generally said that outside directors control the management of large firms. They

closely monitor and evaluate the past and current business information of the firm. Besides, they

also negotiate the compensation with CEO. Several researches have examined that liberality of

the CEO compensation are usually based variables such as CEO duality, the ration of insiders on

46

the board, board member’s stock ownership, ownership of institutions, compensation of directors

and nomination of a director as a CEO.

Cyert, Sok-Hyon and Praveen (2002) examined the top management compensation in the

presence of agency conflicts. The study emphasized factors such as equity ownership of the

largest outside shareholders, firm’s bankruptcy risk, firm size, firm performance, equity

ownership of BOD and BOD structure in the design of compensation contracts. The data of

executive compensation and ownership were collected from proxy statement of all firms listed

on the NYSE, AMEX or NASDAQ National Market System on listed in the DISCLOSURE

database and in 1993 COMUSTAT. The final sample was of 2006 firms. Empirical results show

strong negative relationship of equity ownership of the largest external shareholder, default risk

with the size of the CEO equity compensation.

Jiraporn and Yixin (2008) studied the impact of staggered board on firm leverage in regulated as

well as unregulated firms. The results indicate that firms with a staggered board espouse lower

level of leverage than firms with a unitary board. The results are identical for both regulated and

unregulated firms. Furthermore, the study explored that although staggered boards may permit

manager to take up lower leverage, eventually, firm value does not seem to be detrimentally

affected. Kaplan (1994) examined the relationship of top management turnover and cash

compensation with earnings, changes in earnings, stock returns and sales growth of large

Japanese companies in the 1980s. The study also compares this relationship with those of large

U.S. firms. Both of the predictors (management turnover and cash compensation) have an effect

on all four dependent variables similar in both of the economies. The executive turnover is

negatively related and cash compensation is positively to earnings, stock return and sales

performance. The results are surprising in the sense that shareholdings differ but the turnover-

47

performance and cash compensation-performance are similar. Overall, results indicate that

management turnover in Japan is significantly related to financial performance, stock return,

sales growth and earnings changes and negative earnings. This result is similar in U.S. as well.

Brenner and Joachim (2009) hypothesized that there are two legal determinants which are related

to the diligence of board i.e. the liability rules for directors and anti-director rights. The study

Collected data of medium size firms in 27 developed and advanced countries over the period of

1995 to 2005. The study finds that directors are more constrained by shareholders interest in

countries with higher levels of anti-director rights. They acquire their duty to accomplish the best

possible CEO compensation for shareholders more critically. They also find that director liability

rules may be too weak to exercise the expected influence of the pay setting process.

Chen, Itay & Wei (2008) investigated the determinants of directors’ ownership in the U.S.

mutual fund industry. The study takes the data of 50 top mutual fund families as well as 87

smaller families from 2001 to 2004. The final sample consists of 2,435 unique funds from 137

fund families, covering 39,467 director-fund year pairing and 2,445 director-year observations.

The results are consistent with the optimal contracting view. Directors are inclined to own shares

in funds which they oversee when the benefit from monitoring is expected to be higher

alongwith a lack of other control mechanisms. Directors’ ownership is also less widespread in

funds with large holdings by institutional investors as well as funds with strong flow

performance sensitivity. They also find that family wide policies play a role in shaping the

ownership patterns.

Goel & Anjan (2008) examine the effect of internal organizational governance on the board level

corporate governance that categorizes the manager with the highest ability to be appointed as

CEO. The results suggest that board seems to end up with the pool of overconfident managers

48

from which to choose a CEO. Furthermore, excessively overconfident CEOs overinvest and firm

value is non-monotonic in CEO overconfidence.

Schiehll and Francois (2009) studied the association between the choice to incorporate the non-

financial performance measures such as R&D intensity, growth opportunities and industry

regulations into the CEO bonus plan along with two internal governance mechanisms i.e. CEO

ownership and independence of the board of directors. Sample consists of 184 Canadian public

firms listed on the Toronto Stock Exchange at the end of 2000. Different sectors of sample firms

include manufacturing, utility, services, merchandising and other sectors. Based on multiple

logistic regression models, the empirical results revealed presence of non-financial performance

measures in the CEO bonus plan. The prominent variable is growth opportunity which is

associated with the dependent variable. Board independence and CEO ownership is also

sensitive with firms having high growth opportunities.

Lau, Philip & Sue (2009) investigated the association between the probability of CEO dismissal

and corporate performance in the context of Australian companies. The CEO dismissal is taken

as binary dependent variable as a proxy of corporate governance practices of Australian

companies. Stock return and return on assets (ROA) are taken as a proxy of corporate

performance. Other control variables were also included in the logistic regression model. The

results revealed that the CEO is dismissed as a result of poor corporate performance in the same

year. This suggests that the monitoring of corporate governance practices in Australia is not

inefficient. This association is not affected by other corporate characteristics like CEO share

ownership, CEO tenure, independence of the board and concentration of share ownership.

Elayan, Jingyu and Thomas (2008) discovered some accounting irregularities which exhibit

lower level of transparency and visibility as compared to firms which do not show them. There

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were three objectives of the study. The first was to establish the fact that restatement of income

because of irregularity represents a large economic loss to the firm. The second objective was to

examine different types of irregularities to determine their impact of the firm. The last objective

was to illustrate why executives in the irregularity companies become involved in these types of

activities and also identify factors that lead them to go for that. All these objectives were

accomplished through a statistical comparison of irregularity firm with those firms where

irregularities do not exist. They hypothesized that firms with greater levels of information

asymmetry, greater proportion of equity based compensation, poor performance and relatively

higher levels of leverage are more likely to commit accounting irregularities. Moreover, larger

companies are less likely to commit accounting irregularities. Dependent variable takes the value

of one for accounting irregularity firms otherwise zero for control group. Besides, independent

variables include information asymmetry calculated as volatility in stock price over the period of

250 to 90 days prior to the irregularity announcement. The ratio of total compensation as of total

assets and equity based compensation to total compensation are used as a proxy of management

compensation. Performance of firms was measured by ROE and the comparison of actual EPS

with analysts; forecast. The ratio of total debt to sum of total debt plus market value of equity

was used as a proxy of leverage. The empirical evidence sheds light that overstatements of

revenue, profit, early recognition of revenue and overstatement of sales are revenue enhancing

actions. Irregularity firms also showed significant poor performance in the period leading to the

irregularity announcements. Top executives are found to enjoy a larger portion of their pay

package in the form of equity based compensation. The volatility in stock prices of irregularity

firms are also found in the period preceding the AI announcement. These results suggest that

there is greater information asymmetry in irregularity firms and are less visible.

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Palmer (2008) studied the quality and quantity of disclosures made in compliance with AASB

1047 to check the impact of adopting Australian equivalents to International Financial Reporting

Standards. The particularly focused the effectiveness of a particular regulatory policy by

showing the extent and quality of disclosures by considering the corporate characteristics like

size, auditor size, industry, profitability and leverage. Every sentence in disclosure related to

extent and quality was given a qualitative score based on the perceived informativeness of the

information. The statistical tests provide evidence to support the hypothesis that companies

audited by bigger auditors have higher extent and quality scores. The tests do not support the

hypothesis that the extent or quality of disclosures is different for companies operating in

different industries. The results show supports of the hypothesis that companies having more

debt in their capital structure and those audited by bigger auditors’ disclosure more information.

Aoki (1990) introduced the J Model and distinguished the Japanese model of firms with West

model. He raised difference between the two firms with regard to ownership patterns,

relationship with financers, relationship with suppliers, relationship with employees and

managerial culture perspectives. He described the firm in light of the agency theory.

2.6 Corporate Control, Take Over and Corporate Governance

Ferreira and Paul (2007) investigated the relationship between corporate governance

policy and idiosyncratic risk. It was found that high idiosyncratic risk is associated with fewer

antitakeover provisions by firms. Furthermore, fewer antitakeover provisions also show higher

trading activity, private information flow and information about future earnings in stock prices.

Openness to the market for corporate control leads to more informative stock prices.

Yun (2009) studied the effects of corporate governance on the choice of firms to select cash or

the line of credit to meet their liquidity needs. Anti-takeover laws were found to be the

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significant variable which leads poorly governed firms to increase the cash against the line of

credit. This tendency was not found with good-governed firms. The unused portion of line of

credit was taken as the proxy of line of credit as it provides a liquidity buffer to firms. All the

data of manufacturing firms of the United States were taken from the database of Investor

Responsibility Research Centre (IRRC) for the year 1990, 1993, 1995, 1998 and 2000. Other

control variables were firm size, leverage, market to book asset ratio, cash flow, property, Plant

and equipment, industry sales volatility, net worth and a dummy variable for S&P debt rating.

Cheng, Venky and Madhav (2005) employed the second generation antitakeover legislation to

separate the corporate control value that managers place on stock ownership. It was revealed that

antitakeover legislation increases the probability of managers’ control over the firm. After the

legislation, managers can retain their control by having lesser risky shares than they had before.

The data covered the period of 1984 through 1991 and Forbes 500 firms. Garvey and Gordon

(1999) found that corporations which are protected by the second generation antitakeover laws

considerably reduce their debt level while there is a reverse case with unprotected firms. The

data covered the database of COMPUSTAT and CRSP for all firms in 1990 except financial

firms and firms with incomplete data of last eight years.

2.7 Corporate Governance in Emerging Markets Economies

Gibson (2003) investigated whether corporate governance is ineffective in emerging

markets by estimating the link between CEO turnover and corporate performance. The findings

suggest that poor corporate performance amplify the possibility of CEO turnover. When

incorporating the large domestic shareholder, the results provide the evidence that CEO turnover

does not appear to rise at poorly performing firms in emerging markets. Millar, Tarek, Chong

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and Brian (2005) highlighted the issue that variation in corporate governance structure somewhat

result from differences in institutional arrangements linked to business systems particularly in

Asia’s emerging markets. According to his study, the most common factor to determine the

success of a corporate governance structure is the extent to which it is transparent to market

forces.

Because of dissimilarities in institutional, regulatory and legal environments, emerging markets

differ from developed economies. Bangladesh is one of the emerging market economies which

strive to grow economically. Farooque, Tony, Keitha and AKM. (2007) investigated the

relationship between ownership, as a governance mechanism, and corporate performance in

Bangladesh. This study is unique in the sense that the author has taken ownership as exogenous

as well as endogenous variable. Market to book value of equity is taken as a proxy of corporate

performance. Similarly in the second equation, ownership structure is taken as dependent

variable and market to book ratio of equity and other control variables are taken as predictors.

Findings reveal significant negative effects of board ownership on log of MBVE, using a linear

form of regression. Using cubic form of board ownership, significant non-linear relationship

between the two is discovered.

2.8 Corporate Governance in Developed Market Economies

Aguilera and Gregory (2003) developed a theoretical model which explains corporate

governance diversity across advanced capitalist economies. The study takes three shareholders

group i.e. capital, labor and management as corporate governance proxies. Based on the model, it

was concluded that the institutional differences matter through their capacity to support different

modes of interaction among stakeholders at the firm level.

2.9 Ownership Structure and Stewardship Theory

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Agency theory was challenged by stewardship theory. Stewardship theory/model

distinguishes an array of non-financial causes for managerial behavior, including the need for

achievement and recognition, the intrinsic satisfaction of successful performance, respect for

authority and the work ethics. Hung and Hsiang-Ju (2009) tried to determine the current

minimum shareholding requirement for SMEs in the emerging Taiwan market. The study

suggests that nonlinear relationship between insider ownership and firm value can be elucidated

by the stewardship theory. Instead of using Tobin’s q, the study employed approximate q as a

proxy of market valuation. Deep findings of the study reveal that insiders, in most Taiwanese

SMEs, are controlling family members having a high level of shareholding. The evidence

suggests that family members are likely to show the stewardship qualities rather than tend to be

self-interested.

2.10 Ownership Structure and Public Announcement’s Disclosures

As the quality of disclosure become higher and higher, information asymmetries becomes

lower resulting in fewer agency conflicts between managers and investors. Laidroo (2009)

investigated the role of ownership structure on public announcement disclosures in three

European emerging capital markets in the Baltics i.e. the Tallinn, Riga and Vilnius Stock

Exchanges. The author employed a disclosure quality score based on six disclosure quality

attributes as a proxy of disclosure quality of public announcement. These attributes were selected

on the basis of information theory – informativeness, relevance, precision, rarity, frequency and

unexpectedness with two quantitative disclosure measures – number of sentences and number of

announcements disclosed. Besides, some control variables were also used. For example, size of

the firm, leverage, liquidity, performance, internationality of operations, risk and industry type.

A significant negative association of public announcement disclosure quality was found with the

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ownership concentration and foreign ownership and positive relationship with institutional

ownership. With respect to control variables, strong positive association was found with sales

growth and size of entry barriers and low support to a positive association with profit after tax to

sales.

García-Teruel, Pedro and Juan (2009) examined the effect of accounting quality on cash holding

level of Spanish firms. Accounting accruals were taken as a proxy of accounting quality and

measured by the extent to which current working capital accruals map onto operating cash flows

of the prior, current and future periods. They hypothesized that accounting quality minimizes

information asymmetry meaning thereby that firms with high accounting quality will have lower

level of cash holding. The finding suggests that there is an inverse relation between accruals

quality and the level of cash holdings by firms. The authors used half yearly data of 65 listed

firms from 1995 to 2001. For the purpose of controlling unobservable heterogeneity they have

used GMM methods of estimation.

2.11 Corporate Governance and the Performance of Stock Markets

Picou and Michael (2006) studied whether institutions can take benefit from information

asymmetries by separating institutional investors from the general public. The author

hypothesized that as firms announces the enactment as well as the substance of corporate

governance guideline, the stock price must immediately or after some delay go rising. Over the

77 sample firms which announced in SEC filings the adoption of corporate governance

guidelines during the period of 1994 to 2000 were analyzed. The results revealed that stock

prices rise as the firm announces the enactment of corporate governance guidelines.

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Claessens (1997) investigated the mass privatization scheme of Czech and Slovak Republic in

the context of corporate governance. The program was executed through a voucher scheme with

a distribution of points to citizens based on bidding. Citizens with 18 years of old age were

eligible to buy the voucher equivalent of about $35 a package of vouchers worth of 1000 points.

It was a step to change the corporate governance environment in the two countries. To avoid the

conflicts of interest for the both countries, the author analyzed the effect of ownership by bank

controlled investment funds from concentrated ownership. Size of the bank sponsored fund

ownership relative to the distribution o all ownership was also controlled in the study. There

were 1,491 firms that emerged from the voucher scheme. Strong evidence was found of market

price that more concentrated ownership is related with higher prices. Firms with foreign and state

majority owners do not exhibit higher prices. It suggests that control by these investors entails

costs for minority shareholders. Some evidence was also found that prices were initially

relatively lower for bank sponsored investment fund firms. This reveals that bank sponsored

investment funds may initially have been faced some conflicts of interest.

Johnson, Peter, Alasdair and Eric (2000) have made an extensive study to explain the causes of

Asian crises during 1997 – 98. In the context of corporate governance, the authors argued that

weak enforcement of shareholder rights is the first order importance to determine the extent of

exchange rate loss and stock market collapse in 1997-98. The study took 25 emerging market

data of macroeconomic and corporate governance variables alongwith exchange rate

depreciation and stock market index. The countries include six from Latin America, four from

Eastern Europe, ten from Asia plus Greece and Portugal in Europe, Turkey and Israel in the

Middle East and South Africa. They define the Asian crises to the extent of the nominal

exchange rate depreciation as the key variable to be explained. Besides, stock market collapse

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was also taken into consideration in the definition of Asian crisis. For stock market, they

employed the IFC’s Investable Index. The regressions also include a dummy variable for East

Asia. The empirical results show that government budget deficit in insignificant in the exchange

rate regression either with or without dummy variable. Growth rate of broad money is significant

with or without dummy. When dropped Indonesia and Turkey, money growth in 1996 become

insignificant. Import coverage is also positively and significantly related. Total indebtedness is

insignificant with both with or without dummy. As far as the corporate governance regression in

concerned, all variables are highly significant either with or without dummy variable and remain

so if any of the country is excluded from the data. The third regression was also run with the

dependent variable is change in stock market value in dollar term. All macroeconomic variables

exhibit very little correlation with stock market performance. In contrast to this, governance

variables were stronger and illustrate high correlation with stock market performance. The

findings reveal that corporate governance matters a great deal for the extent of exchange rate

depreciation and stock market decline during 1997-98.

2.12 Corporate Governance and Management Turnover

Gilson (1989) investigated the management turnover in financially distressed firms.

Besides, the study also exhibit evidence that managers’ default related losses are significant.

Firms are selected, consisting of declining in three years cumulative unadjusted stock returns on

the NYSE and AMEX during 1979 to 1984. Final sample equals to 587 firm-years, consisting of

381 firms. Management turnover is taken as any change in the group of individuals who together

hold the positions of CEO, President and Chairman of the board. Financial distress is defined as

the firm’s inability to pay the fixed payment obligations on debt, defaults on debts, bankrupt or

privately restructured its debts to avoid bankruptcy. Leverage is defined as the ratio of debt to

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capital. All firms in the sample are small and highly leveraged as well as unprofitable. Results

show that financially distressed firms face more managerial turnover. Approximately, 80% of the

changes in management are departures which involve more than one manager are relatively

infrequent. Changes as regarded “Forced management change” account for 0.76 of all changes,

changes as a result of appointment of an outsider equals to 0.43. The findings also reveal that

there is a significant personal cost for managers in financially distressed firms. It was also found

that managers departed from financially distressed firms are young having a mean and median

age of 52 and 53 years. Stock ownership of officers and directors in these firms are account for

13.5% and 6.9% respectively. Furthermore, logit regression was also run to identify the marginal

impact of financial distress on turnover. The dependent variable is equal to 1 if a senior

management change is observed in a particular year and zero otherwise. The proxy of financial

distress in the regression was two variables. The dichotomous variable (D) which equals to 1 for

a particular firm-year if the firm is either in default on its debt, bankrupt or restructured it debt to

avoid bankruptcy and zero otherwise. The second was the leverage of the firm (LVG). Return on

common stock was taken as a proxy of firms’ profitability. All the unadjusted returns have a

negative predicted value and only current year returns are statistically significant.

Volpin (2002) discussed the determinants of executive turnover in Italian publicly traded firms.

Particular focused was made on how the ownership and control structure of a firm affects the

sensitivity of the firms’ executive turnover to performance. Moreover, the study also evaluated

the effect of these same variables on the firms’Q ratio as the measure of firm performance. The

data was collected from 1986 to 1997. The findings suggest that probability of turnover and its

sensitivity to performance are significantly lower for top executives who belong to the family of

the controlling shareholder than for other executives. Furthermore, results show that turnover is

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more sensitive to performance when voting syndicate controls the firms. The results of Q ratio

also support the findings. Q is significantly smaller in those firms where the controlling

shareholders are among the top executives. It is larger when control is partially contestable. It

increases with the fraction of cash flow rights owned by the controlling shareholder. The

empirical results revealed that minority shareholders are not likely to play an important

monitoring role with the firm. Finally, executive turnover is not affected by the firm’s

organizational structure.

La Porta, Florencio, Andrei and Vishny (2002) evaluated the corporate valuation by investor

protection and ownership by controlling shareholder. They employed Tobin’s q as a proxy of

corporate valuation. They hypothesized that firms in more protective legal regimes, with higher

cash flow ownership and better investment opportunities should have higher Tobin’s q. out of

539 sample firms, the largest 20 firms based on market capitalization in each of the 27 countries

were collected from 1995 to 1996 and a few from 1997 the results show that common law

countries have higher anti director rights scores than civil law countries do. Findings also suggest

that poor shareholder protection is penalized with lower valuation. Higher cash flow ownership

by controlling shareholder improves valuation.

Weisbach (1988) pointed out that inside and outside directors behave differently in their

decisions to remove top management. Outside dominated boards are significantly more seems

than firms with inside dominated boards to remove the CEO on the basis of performance.

Outside dominated boards are likely to add to firm value through their CEO changes. Accounting

earnings (EBIT) and stock returns were taken as proxy of firm performance. The results were not

affected by differences in the ownership structure of the firm, the size of the firm or the industry

in which the firm operates. The data consisted on board composition for all firms listed on the

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NYSE of total of 495 from 1977 to 1980. Directors were classified as either outside, inside or

grey for each firm. Firm with less than 40% outside directors was taken as insider dominated

firm. Firm with at least 60 of directors are outsiders was taken as outsider dominated firms.

Firms which fall between 40 to 60% outside directors were considered as mixed boards.

2.13 Corporate Governance and International Trade

Li & Darryl (2009) raised a question as to why some countries trade more than others.

They took the arguments that the trade flows can best be determined by the governance

environment of a country which is an important determinant. Rule based countries are likely to

have fewer distortions and lower marginal costs for firms seeking to trade than relation based

countries. Based on the arguments, they hypothesized that Rule-based countries have more

international trade than Relation-based countries. Similarly, the second hypothesis was also

developed that relation based countries can easily export to a rule based countries than vice

versa. They also postulate that countries with similar governance environments trade more with

one another than counties with dissimilar governance environments. The study also took up the

hypothesis that two highly rule based countries show more trade flows than trade flows between

highly relations based countries. Global Environment Index (GEI) was taken as a proxy for

governance environment. Besides, some other control variables were also taken into

consideration in this study. The findings revealed that trade flows can be increased by increasing

the degree of rule based governance. Moreover, countries with differences in governance

environments are likely to trade less with each other. The results also suggest that similar rule

based countries trade more with one another but trade between two relation based countries are

less with each other.

2.14 Corporate Governance and Survival

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Filatotchev & Steve (2003) examined the effects of a change in resource base of

organizations and governance factors on the strategic decision making process in the declining

cotton industry of UK. This industry has seen the corporate transformation during the period of

1950-2000. This study was conducted from 1950 to 1965 as the two model of organizational and

governance structures existed in a single industry. They hypothesized that the strategic

restructuring and survival of a firm in a declining industry is positively related with the extent of

organizational diversity, institutional share ownership and board diversity. Data of strategic

restricting includes raw material inputs, product range, productive equipment and employment

for 45 companies from the cotton industry of the UK. Corporate governance data consisted of

total number of shareholders, ownership structure, and the board characteristics i.e. number of

directors on the board, number of outside directors. There were several financial performance

variables. The study also incorporates a dummy variable that equals to 1 if the firm was

vertically integrated and zero otherwise. Findings indicate that organizational diversity provides

resources / organizational flexibility that may support survival oriented strategies. Strategic

content and outcomes are also affected by the firm’s ownership structure and board

characteristics. As far as the mature and declining industry is concerned, the results suggest that

the board structure may be less important as compared to the board size and diversity.

Anand and Harbir (1997) showed their interest in declining industries to investigate. They

hypothesized that consolidation-oriented acquisitions perform better than diversification-oriented

acquisitions in case of declining industries. Further they also assumed higher valuation in case of

more focused firms than non-focused in declining phases of the industry. The study covered the

data of 408 acquisitions for 10 defense dependent industries. Data was collected of the first

announcement data of these acquisitions and daily stock returns from CRSP tapes. Other

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information of variables was collected from COMPUSTAT tapes. Two performance measures of

these acquisitions were calculated. The first measure was the risk adjusted stock return and the

second was pretax cash flow divided by market value of assets. Tobin’s q was also calculated as

a third performance measure to determine the effect of the scope of the firm on its valuation.

Results supported the hypothesis in terms of stock market based and performance measures.

Positive relationship was found between focus firms and Tobin’s q even when the industry is in

decline.

Bethel and Julia (1993) focused the effects of ownership structure on corporate restructuring

through a sample of 93 surviving public Fortune 500 firms during 1981-1987. The study has a

main hypothesis about negative correlation between block holder ownership with corporate

restructuring activities during 1980s. This relationship was also checked with insider ownership

during the same time frame as this was the intense period of corporate restructuring in large U.S.

firms. The results confirmed positive association of block holder ownership with corporate

restructuring.

Gibbs (1993) estimated the effects of corporate restructuring determinants to determine financial

and portfolio restructuring. The model was developed based on free cash flow hypothesis and

agency theory. Determinants include free cash flow, corporate governance and takeover threat.

The data covered the period of 1982 through 1987 of large corporations having total revenues of

$5 billion or more listed in the Business Week 1982 Corporate Scoreboard. Simple analysis of

variance method confirmed that financial and portfolio restructuring are motivated by agency

costs.

2.15 Corporate Social Responsibility

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By looking towards society, the most practicing things which were noticed are corporate

social responsibility, which plays a pivotal role in the society. During the period of ten years

from the end of 1960’s and initial 1970’s, the term called “corporate social responsibility" has

become more conventional. The demand of CSR has increased gradually in recent years. On the

other hand, many corporations have been confused by CSR, whether the CSR brings profits to

corporations or not. Second thing either it is valuable to add organizational resources to CSR, If

yes then how much? These are the questions which created confusion in organization’s behavior

while working with CSR. In the next paragraphs, will try to discuss about the efficiency of CSR

and try to clear the image of CSR that it is useful or useless for the organization. The drawback

of the CSR is that It doesn’t inform the investor when the firms taking decisions about

investment. Hence, the result of this to be sort of demand for CSR in front of consumer and

stakeholder (McWilliams and Siegel, 2001). Geske and Roll (1983), Kaul (1987) and Barro

(1990) uncover the associations between stock returns and future existent action is strong.

CSR has been defined by Wood (1991) as the social behavior of a firm that fulfills social

expectation towards the firm by the proper allocation of corporate resources. Moreover, some

recent studies have modified and extended the idea of CSR by defining it as an extension of

business ethic and management morality, which not only emphasizes legal obligations but also

meeting public pressures and social expectations (Vogel, 2004). Hence the conclusion derived

from the above discussed definition makes CSR a discipline of generating benefits for all

company stakeholders, yet maintaining the principles of business ethics. And for obtaining

sustainable development in economy, corporate and social growth should be equally significant

for appropriate execution.

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Observing the impact of CSR on firm’s performance has shown mixed evidences. Numerous

studies on CSR posits the fact that firms that emphasize to satisfy its social responsibility may

lead to better firm enactment (Maignan and.ferrel, 2005; Verschoor 1998 and Griffin and Mahon

1997). On the contrary, Mahapatra (1984) has evidenced that pollution prevention lead to the

stock return, ultimately enforcing the external investors to behave as rational economic investors

instead of ethical investors. Moreover, regression analysis conducted by McWalliams and Siegel

(2001) also shown that there CSR had no significant impact on firm performance.

The academia has always been investigating the impact of CSR on the performance of firm.

Previous studies conducted in the past had regarded CSR as socially responsible investment of a

firm. For instance: firms that are willing to execute CSR develop the culture of business ethic,

which would prevent firm to incur single, managerial and societal cost, thus prominent to

improved corporate performance (Laczniak and Murphy 1991). This idea has been further

elaborated by Sims and Kroeck (1994) that subsequent the moralities business morals benefit

firms to obtain employee satisfaction and corporate identity, eventually leading to better firm

performance. In addition, Preston and O’Bannon (1997) argued that publically responsible

corporate tends to build an suitable professional system to enhance firm’s performance.

Numerous studies expanding the literature on CSR also argued that creating a culture of CSR

would result in higher stakeholders’ satisfaction and it could reduce corporate operation and

improve competitive advantages (Verschoor, 1998).

There are two different groups of investors as far as the interest of shareholders in CSR is

concerned: one is mainstream and the other is (socially responsible investors) SRI. Mainstream

can be defined as investors who are more likely to prefer social responsibility if that would be

affecting firm’s cost of capital or its obvious results. Infarct the social responsibility is just for

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sake of marketing activity with no genuine substance just to justify legality (Gray and Adams,

1996). On the contrary Socially Responsible Investors (SRI) can be defined as one having

genuine and direct concern for the interest of society, its stakeholders and the interaction

between them and the firm.

There are three distinct types of SRIs which need to be considered:

1. Higher responsibility that may lead to higher value would be the criteria of consideration

when deciding to invest in the firm (positive screening).

2. Industries like arms manufacture or tobacco and other kinds of irresponsible and

unorganized management style would be avoided to invest (negative screening).

(Sharfman, 1996).

3. Engaging in different techniques for the betterment and acting as active and committed in

fulfilling their responsibilities (shareholder engagement). (Lewis and Mackenzie, 2000;

McLaren, 2002; O’Rourke, 2002a).

These three categories of investors may require different information considering different areas

of competition. Marcus and Wallace (1997) argued that three processes exist to evolve the nature

and role of IR. First of all the phase of company’s action is communicated through simple

communication, then the focus shifts on the financial aspect and outcomes and lastly they

emphasize is on the active marketing in more advanced companies. Therefore the present seeks

to determine the three phases that can be applied to IR management in the context of

communicating CSR rather than the general financial outcomes in order to ensure that firms are

fairly valued. If the requirement of CSR persistently to boost in the long run, then there would be

a bigger influence of CSR on stock return within the upcoming years.

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The European Commission (2001) describes corporate social responsibility (CSR) as a notion

adopted by corporations to help and play a vital role in incorporating societal and ecological

concerns in their industry leading to a sustainable environment for the future generations.

Bragdon and Marlin (1972) and Spicer (1978) all bring into play with P/E , EPS, ratios or a

number of the algebraic variations as a smallest extent the dealings of financial performance in

their studies (Bowman and Haire 1975) and (Preston, 1978).

CHAPTER 3

CORPORATE SAVING DECISIONS

3.1 Retained Earnings, Its Economic Determinants and Consequences

The issue of retained earnings may be viewed either from the macroeconomic perspective

or in connection with corporate finance. Economic standpoint of the subject is interested to

examine the cyclical fluctuation of the economy. While corporate finance studies the matter with

a view to the rights and interests of owners and managers of a corporation.

This thesis has a strong proposition that retained earnings are good indicator of development in

the country. By having this proposition, it intends to merge the economic theory with the

corporate finance. The effect of retained earnings on the total investment in the country depends

upon the investment in different type of assets by the company, decisions of capital structure,

liquidity position of the firm, positive cash flow from operations, profitability and corporate

governance practices within the firm. Good corporate governance lead the firm to better liquidity

management, which in turn, let the firm to retain some earnings and invest in the profitable and

positive NPV projects. This will increase the total investment in the country.

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There are favorable as well as unfavorable arguments of the corporate savings. Advocates of

retained earnings assert that it facilitates corporations to accumulate the cash surplus during the

business growth which, in turn, strengthen the firm to resist the adverse effect during the time of

business failures. While challengers of the subject argue that cyclical fluctuations is intensified

by this decisions. Furthermore, they also reiterate that reinvestment of corporate earnings is easy

to misallocate of resources. Having for and against arguments, the decisions of retained earnings

have the following key benefits which are hard to ignore.

1. Accumulation of cash in good times and uses them in bad times.

2. In contrast to external equity, the retained corporate profit reduces the issue cost and

losses because of under-pricing (Chandra, 2002).

3. Retention of earnings is likely to increase new investment in the economy (Dobrovolsky,

1945).

4. Reinvestment of corporate savings does not have same pressure from stockholders to earn

the required return as compare to funds obtain from the capital market. (Dobrovolsky,

1945).

5. There are no transactions as well as bankruptcy costs involved with retained earnings

(Altman, 1993).

Weidenhammer (1933) discussed the eminent role of corporate savings in the capital formation

in the England and Germany. He argued that investment through retained earnings adds high

sub-marginal returns than the funds generated through capital market. It was suggested that

increased percentage of retained earnings with respect to capital formation lead to high

fluctuations in interest rate in the capital market. The study mainly focused on the faulty

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investment of retained earnings and pointed out separation of ownership & control and

management as two major factors behind it.

Myers & Majluf (1984) also talked of the importance of retained earnings of companies in

connection with not only at macro but also at the micro level. They pointed out that corporate

savings are the best source of financing in terms of risk and costs.

Another way to looking at the phenomenon is that if all of the earnings of firms are distributed

among shareholders then it is hard to accept that their savings will increase and consumption will

not increase. In reality, they will consume more and save less and as a result, there will not be

any new investment in the country either from corporations or individuals. On the other hand,

managers of corporations are better able to exploit new opportunities which are not likely to

attract individual investors.

While comparing the retained earnings practices among countries, we observe that during 1995-

96 to 2002-03, total savings rate in India has declined while household savings rate increased. It

implies the role of corporate sector savings which decreased their savings. At the same time,

gross investment rate in the country has also been in declining position. If we compare the

corporate savings rate in different countries, we find that in the year 2001 corporate savings rate

in India was 4.1%, lower than the rate in the UK which was 7.59%. Corporate savings rate in

France was 11.2% while Germany 10.89% in the same year. Japan shows 11.06%, Korea

11.12%, Argentina 8.45 and Mexico 7.76% (IMF Data Base).

Shanta (1982) investigated the importance of corporate sector in the domestic savings in India.

The study found a decline trend in the corporate savings during 1975-76 to 1978-79, indicating a

small share in the overall economy of the India. Bhole & Jitendra (2005) studied the

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determinants of retained earnings in India while taking the data from 1966 through 2000. They

advocated that high rate of economic growth with stability may be achieved if corporate savings

rate become high as well. Significant determinants of retained earnings in this study were profit

after tax, availability of external funds, investment opportunities, cost of borrowing and cost of

equity.

Bhole (1980) in an early study examined the determinants of saving ratio in the Indian

companies during 1960-61 through 1975-76. He selected five different type of companies in the

sample like Medium and Large Public Limited Companies (MLPUCos), Medium and large

Private Limited Companies (MLPRCos.), Small Public limited Companies (SPUCos.), Small

Private Limited Compnaies (SPECos.) and Central Government Companies (GCos.). It was

found that saving ratio in the Indian companies depend on the size, type and industry of the

company. Large firms tend to have high saving ratio as compared to small one. The study also

argued that although saving ratio in Indian corporations has been increased over the period, it is

smaller than the ratio of US companies. The major determinant of saving ratio has come out to

be net profit after tax in case of MLPUCos while cash flow, the availability and cost of external

funds and the price level in case of MLPRCos.

Pandit (1984) studied the corporate savings behavior in Indian listed firms. He found that degree

of capital utilization is the key variable in determining the corporate savings. Wage inflation may

too decrease the savings through its impact on profit. Purohit (1990) explained the corporate

savings by linking it with behavioral hypothesis, allowing the incorporation of investment

expectations and at the same time confines the impact of dividend in a single equation model.

The results were consistent with the previous studies on the same topic in India. The investment

climate was in a declining state during the study period.

69

Keister (2004) investigated the transformation of firm capital structure during the transition

period of China. China started its extensive economic as well as industrial reforms, including

firm finance and the banking system. Firms’ retained earnings, before the reforms, were

equivalent to state funds as they were owned by the state and used to determine the tax rates.

Large part of the retained profits of firms was not available for reinvestment. Results of using

retained earnings shows that manager use it rather than sacrifice autonomy while the same case

is on opposite side in case of China. All of the hypotheses were developed based on the first

decade of reform. To check the hypotheses, panel data of 769 firms during 1980 to 1989 were

obtained from four provinces namely Sichuan, Jiangsu, Jilin and Shanxi. It was analyzed that

whether a firm received capital from any of the five common sources of external borrowing i.e.

bank loans, inter-firm loans, inter-firm investment, public debt and foreign funds. Explanatory

variables include retained earnings measured as previous year log of firms ‘retained earnings,

size as number of workers at the end of a year, profit as revenues less expenses, market

development as dichotomous variable, explaining whether managers sought poor market

development is an important problem. In China, there is a positive relationship between retained

earnings and external credit which suggests that managers are likely to use this retained profit to

create a center of attention to get the capital.

Bayoumi, Hui & Shang (2010) documented the reality of Chinese corporate savings puzzle in an

IMF working paper. They clarified that corporate savings in china was not as much high as in

other countries over the period of 2002 to 2007. The high current account surplus of China was

not because of high corporate savings but there were other factors as well. Furthermore, no

differences were found between state-owned and private listed firms in terms of saving as well as

dividend patterns. The paper adopted a firm level cross country data of 1557 Chinese public

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listed firms and 29330 listed corporations in 51 other countries, including Pakistan. The study

collected the data of 113 Pakistani corporations. Variables of the study include gross savings

over assets, profit to asset, dividend to asset, investment over asset and net saving to asset. The

mean value of gross savings in case of non-state owned firm in China is 0.00 while the mean

score of Asia of the same variable, excluding China, is 0.02.

Whittington (1972) investigated the rates of return of external financing and retained earnings.

Basic data of variables were obtained from the published consolidated audited accounts of

companies which are engaged in manufacturing or distribution businesses in the UK and have a

presence on the UK stock exchange in terms of debt or equity stocks. The sample size consists of

1,955 companies which exist during the period of 1948 to 1960. Variables include profitability

before taxation, dividends or interest, after depreciation, over book value of net assets, growth as

compound annual growth rate of net assets and external growth as annual compound growth rate

at which net assets enhanced due to new external finance. Profitability, growth and external

financing are based on the result of takeovers. A dummy variable was also introduced which

equals to 1 if external grow rate increased by 1% per annum and is 0 otherwise. The results

reveal that retained earnings are likely to be used less profitable than external finance. These

findings were proved when he introduced uncertainty into the model. The study further showed

that the fact of raising funds from market is more important than the amount raised.

The debate of allocating corporate profit between dividend and retained earnings dates back to

the study of Lintner (1956) which argues to drive behavioral relationships of dividend and to

treat retained earnings as residual. Turnovsky (1967) provided a counter argument against the

present studies that retained earnings may be a residual but are still governed by some behavioral

relationship. He estimated dividend equation as well as gross retained earnings equations and

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found that firms strive to find their dividend more urgent but the result is not statistically

significant. Second, last year gross profit in the retained earnings equation is significantly

negative while positive in the current year level, indicating that it changes the profits and current

level which ultimately determines as how much should be retained by the corporations. Thirdly,

retained earnings are determined by the transitory components of profits. Furthermore, the study

also revealed that retained earnings are determined by the current profit which is opposite of

dividend decisions. As far as the decision of investment is concerned, no statistically significant

result was found, implying that investments play a minor role in determining the retained

earnings.

Smith (1963) asserted that corporate savings behavior is an unsettled problem on which little

attention has been paid in economic research. He raised two basic questions and strived to find

out solutions of them. He posed that whether cyclical behavior of corporate savings are

important stabilizer and secondly corporate savings behavior in our society affect adversely or

positively in allocating economic resources? It was revealed the rise of retained earnings in boom

period and fall in recessions. As far as the allocation of resources is concerned, the results did not

show any adjustment in corporate savings to demand for long term investment funds.

Loayza, Klaus & Luis (2000) reviewed different studies conducted by different researchers as a

project of World Bank. It shows that private savings in East Asia rose gradually from 1965-73 to

1985-94. It was more that 30% of gross national disposable income and Sub-Saharan Africa

saved less than 15%. Schmidt-Hebbel, Luis and Andres (1996) were among the team of World

Bank to undertake and complete the said project. They analyzed saving, investment and growth

in terms of correlation and causalities. They find the swift growth in some countries especially in

East Asia but the relationship among these variables is not simple to explore. They find causality

72

among these variables but in different directions. Saving and investment are correlated because

there is low capital mobility, restriction on large current account imbalances and some common

factors that move forward both variables in the same direction.

Leff & Kazuo (1975) formulated a simultaneous equation model for savings in developing

countries. As a sample, they collected the data of five countries namely Brazil, Costa Rica,

Israel, the Philippines and Taiwan. These countries were selected due to diversity with respect to

development experience and country size. Data of Gross National Product, Consumption, Gross

Domestic Investment, Export and Import of real sector were collected from the data base of

World Bank during 1952-69. The results revealed that steady state savings rate should

significantly increase if countries face higher rates of income growth. The model is appropriate

for all sampled countries except for Israel. Because of intense security condition, the authors

developed another model incorporating defense expenditure into it.

Khan and Eric (1993) investigated the relationship between foreign aid, domestic savings and

economic growth for Pakistan. Economic assistance receipts were taken as a proxy of foreign aid

as independent variable while domestic savings and economic growth were taken as dependent

variables. Besides, some control variables like home remittances, real rate of interest, growth rate

of per capita income foreign grants and FDI were also incorporated into the model. The results

reveal that foreign aid has a negative sign with statistically insignificant beta. The author also

made second model in which foreign aid played a pivotal role to determine the behavior of

savings in Pakistan.

Aron & John (2000) developed a model of household and corporate savings behavior in South

Africa covering the period of 1960 through 1997. The model of corporate savings explained that

73

due to rise in inflation during 1960s and late 1980, corporate savings increased. While the

decline in the inflation in the 1990, corporate savings again showed upward trend due to high

real interest rate and liberalization of consumer credit markets. This savings was not affected by

the change in the personal tax rate on dividends. South Africa is the country where government

savings were in the declining position during 1980s. Because of this fall, the country’s domestic

savings declined in the same time period. High corporate savings maintained the private savings

level in the reality of decline in household savings. Private savings accelerated corporate savings

until the mid-1970s when corporate savings increased sharply.

3.2 Retained Earnings and Stock Prices

Harkavy (1953) went on another side of retained earnings and investigated its

relationship with stock prices of large listed firms in the U.S. The study revealed that there is a

positive correlation between average dividend earning ratio in gas and electric firms until 1944.

This asserts the views that the higher the proportion of earnings paid as dividend, higher the

stock price. It was also argued that there is a negative correlation between price earning ratio and

dividend earning ratio. Result shows positive correlation between them for the Cowles

Commission Chemical Index. Retained earnings of 450 companies were also analyzed in terms

of their market stock price appreciation during 1942-51. The findings revealed that companied

retained high amount of their earnings, showed greater price appreciation.

Diamond (1967) studied the impact of dividend and retained earnings on the stock price during

1961 and 1962. The findings suggest that within experienced payout ranges the market has

somewhat little preference for a dollar of retained earnings for moderate to bright growth

potential firms. While for mature firms, a dollar of dividends is preferred by the market. Data

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was collected from McGraw-Hill, consisting of real and financial variables of 255 firms grouped

in eight different sectors.

Srivastava (1968) examined the effect of retained earnings on stock price in India and found no

significant results. The study was conducted while taking six different industries of India like

cotton, tea, electricity, sugar, coal and paper for the year 1961. According to results, investors do

not consider retained earnings while buying shares of the company which contradicts the

previous research of the western studies.

Schworm (1980) examined the impact of capital market imperfections on the capital

accumulation by firms. He proposed a model in which firms do not have option to borrow money

and issue new debt. There is only one financing option for firms and that is retained earnings.

This restriction of the model shows that firms cannot take up profitable projects due to

unavailability of external funds to obtain. Furthermore, this restriction was relaxed and the result

was unchanged. In both of the cases, retained earnings permit the firm to borrow more money

from shareholders. Instead of issuing new shares, corporations retain their earnings with the

objective of appreciation in the existing equity.

Fisher (1961) studied the impact of dividends, undistributed profit of firms and the size of the

company on stock price. Data of five cross sectional samples were collected from London Stock

Exchange during 1949 to 1957. A linear model of dividends and undistributed profit is proposed

with the share price with a proper justification. The author argues that retained earnings allow the

firm to enjoy freedom in terms of funds it can exploit for innovation and develop new markets.

Large current retained earnings are the indicator of healthy dividends in the future. Empirical

findings of the study reveal that last year dividend and last declared undistributed profit

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considerably explain the variation in stock price of the current year. Adding the last year retained

earnings into last year dividends improve the results. Furthermore, the results were stable from

year to year which is different in this study as compared to other similar studies. The past growth

in dividends tends to indicate future prospects and the effect is nominal and uncertain. The

inclusion of size of the company further improves the results.

Levine & Sara (1998) investigated the relationship between stock market development measures,

banking development and long run economic growth. Findings revealed that all are positively

correlated with future economic growth, capital accumulation and productivity growth. Data of

the study was collected from the website of World Bank. Stock market development indicators

with world equity market were based on CAPM and APT models. Stock market development

indicators include Size of the market explained as market capitalization over GDP. Market

Liquidity was calculated from two ways as Turn over divided by the value of listed domestic

shares and Value Traded over GDP. International Integration was also measured through CAPM

as well as APT. Volatility of stock return was measured as 12 months rolling standard deviation.

For banking development, the study takes bank credit measured as value of loans provided by

commercial and other banks to private sector divided by GDP. As a growth indicator, they

employed four growth indicators as gross private savings, output growth, capital stock growth

and productivity growth.

3.3 Retained Earnings and Asymmetric Information

Moore (1993) asserted that retained earnings may be an essential pillar of the capital

structure while ex post information asymmetry is present. As uniqueness, collateral, in this

paper, is determined as exogenously, while availability of earnings to retain is endogenous. The

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author argues that credit terms are improved because of it as it serves as a shield to shelter the

lenders from the risk of default. The ability of the borrower to retain the earnings depends on

current profits. Some short-term disturbances to real activities may be disseminated through the

effects of financial market. As the firm reduces its retained earnings, the possibility of relying on

external fund will increase which will in turn increase the probability of credit rationing.

3.4 Savings from other Perspective

When we relate the savings pattern of different countries, we find that countries which

enjoy average GDP per capital growth rate 2.5% or higher, their saving median rate was 24%.

Against this, countries with average GDP per capital growth rate less than 1% showed their

savings rate 16%. This is another way to look at the saving performance of countries. With the

same view point, Rodrik (2000) studied the corporate savings from different perspective. His

paper concluded that any rise in savings seem to be the outcome of economic growth but not a

determinant of it. He revealed that countries which experience saving transitions phase do not

face sustained increase in growth rates. Instead, countries which undergo growth transitions

because of increased domestic investments and improved terms of trade experience with

permanently higher savings rates. Transition is defined as sustained increase in saving rates of

5% or more.

3.5 Corporate Savings and Tax Policy

Corporate savings are major part of the private savings. In the United States, it is about

half of the private savings although there was a decline in the corporate savings during 1980s.

Whether changes in tax policy brings any change in corporate savings and ultimately in private

savings is a debatable question. Poterba, Robert & Glenn (1987) studied the impact of tax policy

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on corporate savings and consequently the effect of corporate savings on private savings in the

United States. The study included savings of non-financial corporations, financial corporations

and foreign affiliates of U.S. firms as corporate saving. A model was developed incorporating

income before interest and taxes, net real interest payments, dividend payments on common as

well as preferred stock and taxes. The results of the model explained that lower profits and high

interest rate were the major factors of declining corporate savings. Furthermore, lower corporate

tax somewhat compensates the decrease, while corporate savings are only compensated by

opposite directions in personal savings. The authors argued that a higher corporate tax rate is the

way to take out free cash flow from corporations and tighten the control of external capital

market over new investments.

Tax policy has been the central of attention in Britain to increase the investment in the country.

Tax incentives were used to shrink dividend and support corporate savings with a view that it

will enhance the investment. A study of the effect of tax policy on the investment behavior in

Britain was conducted by (Feldstein and Flemming, 1971). This study employed the generalized

neoclassical investment function to examine the effects of tax policy on investment during the

period of 1954 to 1967. The results revealed that tax policies alongwith investment allowances

stimulate saving ratio of firms’ earnings which ultimately impact the investment behavior.

Feldstein (1970) in another study examined the impact of changes in the tax incentive through

estimating the magnitude and time profile of it. Theory and empirical evidences suggest that

corporate investment is reactive to changes in retained earnings. If so, then tax policies may have

essential impacts on economic growth and stability. A dividend equation model presented in this

paper was based on the generalizations of the model suggested by (Lintner, 1956). The equation

was estimated with quarterly data from 1953 to 1964. It was found that differential profit

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taxation policy has a considerable consequence on corporate savings. Moreover, elasticity to tax-

induced changes in opportunity cost of corporate savings seems to be extensively higher than the

elasticity with respect to the ratio of maximum possible net profits over gross profits.

Harris & Deen (1999) develop a residual income model to examine whether taxes on dividends

has an impact on the valuation of retained earnings versus contribute equity. While taking the

final sample of 27647 company-years from 1975-1994, the study suggests that dividend taxes

have a sizeable impact on the relative valuation weighs investors assign to equity versus

earnings. Interestingly, this effect differs from the pre 1987 to the post 1986 tax regimes. Collins

& Deen (2000) revealed the empirical evidence that capital gains and dividend taxes reduce the

valuation of the reinvested part of earnings. As against, dividend taxes minimize the distributed

earning (dividend) valuation, but capital gains taxes do not so. Furthermore, dividend taxes

separately reduce the valuation of retained earnings equity. This study obtained the sample of all

domestic firms available on either 1995 or 1998 Compustat primary and research files from 1975

to 1997. Variables of the study consist of year end stock price, reinvested net income, total

common stock equity and dividends, all on per share basis. The final sample was made on

68,283 firm-year observations.

Masulis and Brett (1988) studied the relationship between cash dividend payouts and firm

investments in real assets with a fact of a personal tax disadvantage to dividends. It was shown

that dividend deferral in a benefit to investor who are in positive tax brackets. For these

investors, the required rat of a project acceptance is lower when the project is financed with

internally generated funds. This confirms that investment decisions depend on the source of the

funds. Moreover, unlimited dividend deferral is costly as it seeks a firm either to invest in a

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project which have decreasing marginal rates of return or in securities that require payment of

either an explicit tax on stock or an implicit tax on municipal bonds.

3.6 Retained Earnings or Dividends

Broadly, there are three schools of thoughts of dividend policy. First school of thought,

labeled as Gorden Model considers dividend policy has an impact on the firm value. The second

school of thought developed in 1960s suggests that dividend policy is irrelevant because it will

not increase the firm value. The third school of thought has a mix results with positive as well as

negative impact of firm value. Later, Lintner (1956) and Brittain (1964) also supported the first

second school of thought.

Higgins (1972) hypothesized that firms’ dividend policy as opposed to capital gains reduce the

shareholders’ wealth. While employing the corporate dividend-saving model, he argued that

shareholders should prefer capital gains over dividend income in a world of differential taxes and

transactions costs. Moreover, he discussed that firms should adopt a value-maximizing dividend

policy which must reduce the sum of costs involved in distributing the dividend payment among

shareholders.

Dividend payment is assured in years in which firms have not enjoyed profits if they have

accumulated earnings of the past years. In profitable years, the firm may decide to retain all or

some of earnings within the firm. In this scenario, they have an option to announce stock

dividend. Schall & Haley (1983) examined that new and fast growing firms are likely to adopt

the policy of 100% retention of their profits while firms with lesser growth opportunities and low

expansion tend to distribute large portion of their earnings as dividends.

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Thirumalaisamy (2013) discussed about Indian firms’ growth which is, in most of the time,

financed by retained earnings. Cash flow and dividend were the most significant variables to

explain this phenomenon. The data of seven major Indian industries was collected from

PROWESS data base for the period of 1996-2010. Sample firms were selected on the basis of

sales growth which was treated as a proxy of firms’ growth. The study concluded that growth

rate of firms influence the level of retained earnings because firms with low investment

opportunities tend to distribute their profit as dividends.

3.7 Investment in Pakistan

The flows of foreign direct investment as well as domestic investments in GDP remain

slow during 1990s and 2000s. Even the share of domestic investment in GDP was continuously

declining. Most of the time it is argued that investment in a country also depend on FDI and

other remittances. Table 1 shows some facts of the history of investment in Pakistan as

percentage of GDP either in the form of foreign direct investment (FDI) or domestic investment

(GFCF). Examination of the table 1 reveals that there is no relationship between the two

economic variables. If one increases another decreases. Reading the table from top to down, we

come to know that FDI as percentage of GDP increased from 0.61 to 1.03 from the year 1990-91

to 2007-08. GFCF as percentage of GDP, in the same number of years, decreased from 17.30 to

15.55. Besides, each variables show opposite directions every time during the time span of 1990-

91 to 2007-08. For instance, in the year 1990-91 the FDI as of GDP was 0.61 while GFCF as of

GDP was 17.30. In the next year 1991-92, FDI decreased to 0.57 but the GFCF increased to

Table 3.1

Investment as a percentage of GDP

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Year FDI as of GDP Domestic Investment (GFCF)

1990-91 0.61 17.30

1991-92 0.57 17.47

1992-93 0.69 18.69

1993-94 0.68 19.24

1994-95 0.81 17.97

1995-96 1.19 17.03

1996-97 1.46 17.38

1997-98 1.15 16.34

1998-99 0.81 15.04

1999-00 0.84 13.93

2000-01 0.42 16.01

2001-02 0.54 15.84

2002-03 1.15 15.46

2003-04 0.65 15.27

2004-05 1.16 15.63

2005-06 1.97 15.26

2006-07 1.43 15.40

2007-08 1.03 15.55

Source: World Bank (2007)

17.47. Similarly, in the 1994-95 FDI as of GDP was 0.81 and GFCF as of GDP was 17.97. In the

next year 1995-96, the FDI as of GDP increased to 1.19 while GFCF as of GDP declined to

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17.03. Mean values are far from each other, showing for FDI 0.9533 while for GFCF is 16.3783.

Moreover, there is negative insignificant statistical correlation between the two, showing -0.261

insignificant correlation.

1990s was the starting ear where government of Pakistan, with some exceptions, allowed the

same rules to foreign investors as being applied to domestic investors. In the 2000s, investment

policy was based on the principles of privatization, liberal remittances and the like by the

government of Pakistan.

Figure 3.1

Investment as Percentage of GDP

Figure 3.1 above also strong our understanding about no relationship between FDI and GFCF as

percentage of GDP. The magnitude of both of the variables is far from each other. In most of the

time, both variables went on opposite directions.

0

5

10

15

20

25

199

0-9

1

1991

-92

199

2-9

3

199

3-9

4

199

4-9

5

199

5-9

6

199

6-9

7

199

7-9

8

199

8-9

9

199

9-0

0

2000

-01

200

1-0

2

2002

-03

200

3-0

4

2004

-05

200

5-0

6

200

6-0

7

200

7-0

8

FDI as of GDP

Domestic Investment(GFCF) as of GDP

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It gives little evidence that investment in Pakistan is not dependent only upon the FDI but other

sources are also having importance. Out of these other important sources, corporate savings are

the main source of investment in Pakistan or elsewhere.

CHAPTER 4

INSTITUTIONAL FRAMEWORK

4.1 Defining the Propositions

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The preceding chapters discussed relevant previous research about governance, liquidity

and corporate savings. Different objectives were explained where the ultimate objective is to

prove the dependency of gross fixed capital formation on corporate savings. This chapter

elaborates some propositions and their corollaries. All propositions are proved by the derivations,

starting from model 1 to model 4. As discussed in chapter one that corporate governance is an

offshoot of economic governance, the proposition starts with the notion of economic governance.

4.2 State of Economic Governance in Pakistan

Before we start to state propositions, it is imperative to elaborate the governance state in

Pakistan. The expectations of economic achievements are linked with the economic governance

of a country. Quality of economic governance along with capacity of institutions for decision

making is the means to achieve this goal to an economy. Pakistan is a country which faced

macro-economic instability because of the poor governance with continuing decline in the

institutional capacity. The implementation of goals of economic governance requires a long

period of time whereas elected governments have a short time span. Every new elected

government designs new policies and as the time comes to get them implemented, it has to step

down before the completion of its time.

Institutions in a country require a long time to foster. All new and feasible projects, taken by

institutions are spread over a long period of time. Their impacts are seen with a substantial time

lag. Frequent changes of political governments made this situation worsened. Therefore,

corporations start practicing of governance which is not in line with the rest of stakeholders.

Ownership concentration is common in Pakistan. Financing decisions may be hijacked by the

CEO-owner dual role. Any resource of the firm may be in use by a director. For instance, excess

85

level of cash may be used to undertake projects to ignore the monitoring by external

stakeholders. Liquidity position of the company may be destroyed to increase the personal

expenses of directors and the like. Some but not all of these type of problems are being raised in

the following propositions.

4.3 Propositions

The intention of the study is to evaluate factors that ascertain the development in the

country through increased investment. This is being proved through a theorem. It begins with the

measurement of corporate governance practices being implemented by listed organizations in

Pakistan. Salaries and other perquisites of CEOs over capital are taken as the proxy of corporate

governance. There is government as well as private-owned firms in the oil & gas sector of

Pakistan. Governance structures of both of the firms are different. To distinguish these

differences, we take a dummy variable which equals to one if the firm is government-owned and

0 otherwise. In firms, ownership is very much concentrated which hinders the performance of the

company. Financing as well as investing decisions are made to favor this ownership. The choice

of debt of a firm is a strategic decision which must be taken by the board of directors. According

to trade-off model, debt must be taken into consideration after the careful analysis of the benefit

of debt against the cost of debt of agency problem. Pecking order theory assumes that retained

earnings are the good mode of financing before the debt is used. Because retained earnings are

cheap to use in any investment projects, debt is the second priority as it carries some costs.

Furthermore, debt also increases the agency cost in terms of monitoring and control. As

concentrated ownership distorts the corporate governance, it may be assumed that these issues

are ignored.

86

Then it proves that bad corporate governance is the cause of hike in circularity debt in the

economy. Failure of some corporations like Enron and others conveyed the importance of good

institutional framework. The choice of capital structure may be influenced by the institutional

setting and firm specific uniqueness. Growing firms are normally financed by equity as they do

not have cash flow problem. They accumulate retained earnings and invest them as needed

instead of using the options of debt or stock issue. While mature firms employ the option of bank

financing as they have good access (Shleifer and Vishny, 1997). The oil & gas sector has been

facing the catastrophe of circularity debt for many years. It emerges when one firm does not pay

its liabilities to second firm. As a result, the second firm also fails to pay off its debt to the third

firm and so on. This results in the accumulation of circularity debt as one party is to receive its

payment and second is to pay its obligation. This issue may be resolved when serious efforts are

made to improve the governance state in these firms. Instead of having a large portion of

available cash flows, companies do not pay this short term liability. Increase in credit sales also

further raises these receivables. It is hypothesized that if this liquidity problem is resolved

through better corporate governance, then firms will be able to make retention decision to

capture the growth opportunities available in the market. This decision of corporate savings will

improve the investment position of the country in the form of gross fixed capital formation. All

these discussions are summarized in the following propositions.

4.3.1 Proposition 1

Firm specific factors explain corporate governance practices.

Firm specific factors include type of the organization (ORGTYP), ownership concentration

(OWNCONCT), log of capital (LOGCAP) and distribution of Assets (CAFA).

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CAFALOGCAPOWNCONCTORGTYPCG 43210 [4.1]

Where is the parameter

This proposition leads to the following corollaries.

4.3.1.1 Corollary 1

Public sector ownership of a firm affects the pattern of institutional governance.

The corollary (1) explains that firm specific variables- type of organization determine the

governance practices. The governance practices may differ in the fully private organization from

the public sector organization.

The institutional settings of government and privately owned firms are different. Governance is

weaker in government-owned corporations as compared to privately-owned firms. Salary and

other perquisites of CEOs in government corporations are higher as compared to the IPPs in

private sector due to political influence in public sector.

4.3.1.2 Corollary 2

Ownership concentration distorts the corporate governance practices.

The higher concentration of ownership may derail the goal of value maximization of a firm. The

value of a firm has a direct relation with the wealth of shareholders. The role of directors in

highly concentrated firms may force the management to pay personal expenses of directors in

indirect ways. The entertainment cost, travelling, special benefits and cost of living allowances

may be included in these personal expenses. It is the additional agency cost paid by the highly

concentrated firms. It is obvious that directors may save their personal income by shifting the

personal expenditures in firms’ accounts. The personal savings of the directors increase their

88

personal wealth and this practice may create a dichotomous between the directors and

shareholders’ objectives.

The probability of such practices is higher in small firms as compared to the large firms. In

global comparison and categorization of companies in Pakistan, the majority of companies in the

energy sector is classified as small firms.

4.3.1.3 Corollary 3

The combination of debt and equity plays a pivotal role in determining the governance

practices.

A high leverage firm will force the company to reduce its expenditures. The increment in salaries

and fringe benefits are included in these expenditures. The firm has to pay interests on its debt

liabilities and the redemption of liabilities will also affect the liquidity of the company. It is

obvious that to manage the financial resources, a firm has to scarify its liberty to increase the

expenditure on payments of fringe benefits to the directors of top level management. Therefore, a

negative correlation may be assumed between the governance practices and leverage ratio of a

firm.

4.3.1.4 Corollary 4

High amount of current assets lead to higher expenditures on top management.

The higher proportionate of current assets in the total assets of a company will lead to more

liberty to the directors and top level management to increase their salaries and other benefits. If

large part of the capital is invested in the form of fixed assets, it will restrict the liberty to

89

increase in the expenses on salaries and benefits. Higher magnitude of current ratio can be

transformed into cash either by recovering of receivables or sale of inventories.

4.3.2 Proposition 2

Good corporate governance leads to better liquidity management in a firm.

Circularity debt (CD) is the proxy of liquidity

LOGSALESTCAPEXPTNASCFTNASTLOGLTDCGCD 543210 [4.2]

By incorporating model 1 into it, we have;

LOGSALESTCAPEXPTNAS

CFTNASTLOGLTDCAFALOGCAPOWNCONCTORGTYP

54

324321010 )(

So we have

LOGSALESTCAPEXPTNASCFTNAST

LOGLTDCAFALOGCAPOWNCONCTORGTYP

543

214131211100

While CG is the predicted values of corporate governance taken from model 1

Where and β are the parameters

Followings are the corollaries of the model 2

4.3.2.1 Corollary 1

Circularity debt problem can be mitigated by good corporate governance practices. It will

lead them to take decisions, for instance leverage, which is aligning with all the shareholders of

the firm.

4.3.2.2 Corollary 2

90

Decisions of board of directors like investment in fixed assets, management of cash flow

and growth in sales are very much related to liquidity management.

4.3.3 Proposition 3

Better liquidity management leads to retention decisions (LOGRE) by the managers.

ROECDLOGRE 210 [4.3]

CD is the predicted values of circularity debt taken from model 2. By incorporating model 2 into

it, we have;

ROELOGSALESTCAPEXPTNASCFTNASTLOGLTD

CAFALOGCAPOWNCONCTORGTYPC

25432

14131211010

)

(

So we have

ROELOGSALESTCAPEXPTNASCFTNASTLOGLTD

CAFALOGCAPOWNCONCTORGTYPC

251413121

141131121111010

Let 010 C = C1

Because this is constant or intercept of the model

ROELOGSALESTCAPEXPTNASCFTNAST

LOGLTDCAFALOGCAPOWNCONCTORGTYPCLOGRE

2543

214321111

)

()(

ROELOGSALESTCAPEXPTNASCFTNAST

LOGLTDCAFALOGCAPOWNCONCTORGTYPCLOGRE

2543

24321111

]

)([


Therefore, retained earning is an exponential function to measure.

91

)])([(

2543

24321111ROELOGSALESTCAPEXPTNASCFTNAST

LOGLTDCAFALOGCAPOWNCONCTORGTYPC

eRE

Followings corollaries have been established based on above derivation.

4.3.3.1 Corollary 1

Corporate savings will be a function of good liquidity management and equity earnings.

4.3.3.2 Corollary 2

Firm specific variables will escort the corporations to make decisions which can reduce

the agency conflicts.

4.3.4 Proposition 4

A higher level of corporate savings will lead to higher investment in the country.

Total investment in the country is Gross Fixed Capital Formation (GFCF) and corporate savings

is retained earnings (LOGRE) by corporations.

LOGREGFCF 10 [4.4]


And RE equals to

)])([(

2543



eRE

That’s why

)])([(

102543



eGFCF

92

4.3.4.1 Corollary 1

Development in terms of macro level investment in a country depends on corporate

savings by corporate sector.

4.3.4.2 Corollary 2

Firms with good corporate governance practices will lead in the macroeconomic

development in a country.

4.4 Basic Assumptions of the Model

1. There are only two types of firms i.e. public limited and private limited.

2. Investment of retained earnings must be utilized in either merchandise inventory and/or

fixed assets.

3. Good corporate governance practices in necessary to achieve the objective of firms.

4. All firms in the market are levered.

Table 4.1

List of Abbreviations of Variables

S.NO. Variable Description

1 CG Corporate Governance

2 ORGTYP Type of the Organization

3 OWNCONCT Ownership Concentration

4 LOGCAP log of Capital

5 CAFA Current Assets divided by Current Liability

6 CD Circularity Debt

7 LOGLTD Log of Long Term Debt

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8 CFTNAST Cash Flow to Net Assets

9 CAPEXPTNAST Capital Expenditure to Net Assets

10 LOGSALES Log of Sales

11 LOGRE Log of Retained Earnings

12 ROE Return on Equity

13 GFCF Gross Fixed Capital Formation as Macro

Level Investment in a Country

CHAPTER 5

RESEARCH DESIGN AND METHODS

5.1 Data and Variables

This research is aimed at studying and exploring the dependency of investment in a

country on the corporate savings through a theorem. This is systematically examined through a

derivation of four interlinked theoretical models. First, it is aimed at studying and exploring the

dependency of corporate governance on some exogenous explanatory variables in the context of

energy sector of Pakistan as well as other companies facing the liquidity problem in the form of

circularity debt. It also aims to reveal the problem of circularity debt through corporate

94

governance and some other control variables. In other words by taking corporate governance as

endogenous as well as exogenous variable, it intends to explore the area of corporate governance

in a developing country like Pakistan and tries to address the problem of circularity debt. The

research also intends to present the dependency of retained earnings on liquidity and earnings of

firms. Finally, the research is extended to check the impact on the total investment of the country

through corporate savings.

In order to achieve these objectives, secondary data was collected through audited annual

accounts of sampled companies. Besides, companies in the energy sector of Pakistan, PIA,

Pakistan Steel Mills, Pakistan Railway and others are companies which are facing the

phenomenon of circularity debt. Except the PIA, no data is available for rest of the companies as

they do not disseminate their financials to the public. In order to separate government-owned

firms from IPPs, firms with more than 60% shares are assumed to be government owned. Data

of Gross Fixed Capital Formation (GFCF) as the proxy of total investment in the country was

collected from various issues of the economic survey of Pakistan. Data collected from these

sources was then analyzed and interpret with the support of literature. There is much literature

available, explaining the phenomenon of governance. Most of them were studied in the context

of developed economies. Very little efforts were made to explore the area in developing or third

world countries. This research is a value addition in the literature of economic governance

particularly in Pakistan as the circularity debt issue only exists in Pakistan.

This chapter exhibits research design and methods used in studying the objectives of the study. It

illustrates the theoretical models, primary propositions, sample, method of data collection,

measurement of variables and statistical methods for data analysis employed for empirical

95

investigation carried out in this study.

5.2 Theoretical Model of the Dissertation

As discussed above, the ultimate objective of the thesis is to systematically prove the

dependency of total investment in the country on retained earnings by corporations. The

responsibility of social as well as economic development has now been partially shifted from

government to private sector. It is, therefore, imperative to recognize the importance of

corporations in order to attract more investment in the country. The theorem starts from the

premise that corporate governance, as one offshoot of the economic governance can be explained

by firm specific as well as some exogenous variables. Any change in any of the exogenous

explanatory variable will automatically change the corporate governance settings, and hence

economic governance.

The second part explains the causes of circularity debt which results the liquidity problem among

firms. These causes are exogenous variables along with the predicted values of corporate

governance taken from the first model. It is hypothesized here that corporate governance can

mitigate the problem of rising circularity debt exist in the economy.

The third part attempts to examine that retained earnings by corporations is a function of equity

earnings and the predicted values of liquidity taken from the second model. It must be kept in

mind here that predicted values of liquidity also include predicted values of corporate

governance. Therefore, it must be interpreted within the context of corporate governance.

Finally, corporate savings is assumed to be a predictor of total investment of the country. Since

all part of the model is interlinked with each other, corporate savings cannot be viewed

separately. It is systematically deduced through a derivation sated in chapter 4.

96

5.3 Variable Explanations

5.3.1 Dependent variables

5.3.1.1 Corporate Governance

It is practically experienced in Pakistan particularly and the world, in general, that the

corporate governance practices in organizations differs significantly. In every country, there are

companies which are being operated with different ownership structure, capital structure, board

size, number of independent directors and the like. Because of these variations, it becomes

thorny to predict the companies’ future outlook. Millar, Tarek, Chong and Brian (2005)

confirmed these variations which occur as a result of differences in institutional arrangements

connected to business systems. These differences were also confirmed by Aguilera and Gregory

(2003) and concluded that institutional differences matter by their capacity to support different

modes of interaction among stakeholders at the firm level.

In proposition 1, corporate governance is taken as dependent variable. This equals to the ratio of

salary & other perquisites of executive officers of the corporations over capital.

This is also given in the equation 1 below.

Capital

PerqsSalCG

& [5.1]

Where:

CG = Corporate Governance Sal & Perqs = Salary & Other Perquisites of Executives Officers Capital = Long term debt plus equity

97

The basic premise behind this variable is the notion that salary and other perquisites of

management should not increase with relation to raise in capital. If we deeply look at the

component of capital, we can realize why the executives’ compensation is practically linked with

capital. Below is the logical tree of capital.

A firm’s financing choice is a strategic decision which involves board of directors. Since the

board does not run the business operations, it only supervises the management in order to

achieve the business’s objectives. The performance of management is directly linked with firm’s

performance in terms of market values. Picou and Michael (2006) proposed that market price in

terms of stock price arise as corporations announce the consent to implement corporate

governance guidelines. Volpin (2002) documented that firm performance in terms of Q is smaller

where controlling shareholders are among top executives.

Figure 5.1

An Econometric Model of Corporate Governance and Circularity Debt

CORPORATE

GOVERNANCE

TYPE OF ORGANIZATION

OWNERSHIP

CONCENTRATION

CAPITAL

DISTRIBUTION OF

ASSETS

CIRDULARITY DEBT /

LIQUIDITY

CORPORATE

GOVERNANCE

LONG TERM DEBT

98

CASH GENERATED

DURING THE YEAR

CORPORATE ASSETS

SALES

CORPORATE SAVINGS

CIRDULARITY DEBT /

LIQUIDITY

ROE

MACRO LEVEL

INVESTMENT IN THE

COUNTRY

CORPORATE SAVINGS

Figure 5.2

Logical Tree of Capital

\

CAPITAL

Short Term

Debt

Long Term Debt Equity

A/C

PAYABLE

ACCRUALS BANK

LOANS BONDS RETAINED

EARNINGS

SHARES

99

If this market value increases in the form of equity, the salary and other perquisites must increase

proportionately. This depicts good corporate governance practices. When firms strive to

maximize their market values while increasing short term or long term debt, the management’

salary and perquisites must not increase. If so, it reflects bad corporate governance practices.

According to pecking order theory, debt is the first priority of firms after retained earnings to

increase the market value. This must be directly negatively linked with the perquisites of

management. Therefore, there is negative relationship between the debt issue and perquisites of

management in the pecking order theory. Trade-off theory suggests that managers must be aware

of the benefit and cost of enhancing debt. It is evidenced that debt increases the chances of cost

of bankruptcy while giving the opportunity to enjoy the tax benefit. This advocates that there is a

positive relationship between issue of debt and perquisites of management as they must ignore

projects of having high cost and less benefit of using debt. Elayan, Jingyu and Thomas (2008)

carried out a research and have taken total compensation over total assets and equity based

compensation to total compensation as a proxy of management compensation. Results revealed

that CEOs enjoy a major portion of their pay in form of equity based compensation.

The first proposition includes exogenous variable like type of organization, concentration of

ownership, capital and distribution of assets calculated as a ratio of current asset to fixed assets.

It is deduced that CG practices varies with the differences in the ownership concentration. The

requirements of capital depend upon the decision of board which may or may not be hijacked by

CEO duality. Ownership concentration in Pakistan is very high as most of the big shareholders

are family members (Javid and Robina, 2010). Table 5.1 below shows some statistics of

ownership concentration in Pakistan. As shown, there are companies where more than 50 percent

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shares were held by top three shareholders and more than 62% by top five shareholders during

the period of 2003-2007.

Firms’ investment and financing policy are affected when ownership is concentrated. Because of

the domination in the board, they may take decisions which are not in the benefit of other

shareholders. The proposition 1 illustrates the combined effects of ownership concentration

alongwith capital structure choice of firms when corporate governance is measured as the ratio of

salary & other perquisites of executives to capital. Type of organizations reveals whether the

firm is state-owned or privately-owned.

5.3.1.2 Circularity Debt

The issue of Circularity Debt in the power sector of Pakistan becomes crucial at present.

It occurs when one party does not pay its obligation to another because of cash flow problem.

This affects the cash flow of other party in the supply chain which holds the cash of other part ies,

resulting crisis in operations. Circularity Debt is taken as a proxy of liquidity. It takes the value

of 1 if the firm faces the problem of circularity debt and zero otherwise. Because of the binary

dependent variable, logit model is applied here.

Table 5.1

Ownership Concentration of 50 Random Companies of Pakistan for

2003-2007

Mean Median Minimum Maximum S.D

T3 52.0 50.70 2.5 96.8 21.0

T5 62.39 64.23 3.5 99.00 21.17 T3: Percentage of ownership shares held by top three shareholders T5: Percentage of ownership shares held by top five shareholders.

Source: (Javid, 2010)

It is hypothesized that circularity debt arises because of poor corporate governance. Zheka

(2007) suggested positive relationship between improved liquidity position and good corporate

101

governance practices. García-Teruel, Pedro and Juan (2009) found inverse relation between

accounting accruals quality and the cash level by firms.

5.3.1.3 Retained Earnings

The decision of retained earnings reflects the capital structure policy of firms. This

internal financing ratio during 1970-1985, was 100% in the non-financial firms of the UK. In the

US, this ratio was 85% while around 60% in Japan. Firm in Pakistan showed 58.3% in the same

period (D’Souza, 2000). Firms with high amount of circularity debt tend to hold high percentage

of earnings to efficiently run the business operations. Table 5.2 illustrates the percentages of

internal financing ratio of top 50 manufacturing companies in different countries.

Table 5.2

Financing of Top 50 Listed Manufacturing Companies

Period Country Internal Finance

Long Term

External Finance

Equity

Average

External

Finance Long

Term Debt

Change in

Internal Finance

1980-87 Korea 12.8 40.3 45.4 7.6

1980-86 Pakistan 58.3 12.3 16.1 -4.6

1980-87 Jordan 5.8 84.1 16.4 -24.1

1983-87 Thailand 17.3 Na Na 23.1

1984-88 Mexico 17.1 76.0 2.9 14.9

1980-88 India 36.1 11.0 45.6 -12.6

1982-87 Turkey 18.1 60.5 15.5 13.2

1983-87 Malaysia 42.4 31.4 2.1 -7.7

1980-88 Zimbabwe 58.5 43.0 0.0 16.8

Source: Singh and Hamid (1992), Table III. 10, p 43.

Corporate savings cannot be considered as bad signal to investors. It is a step ahead to improve

the investment position of a country and hence the GDP. An increase in investment in a country

boosts the production which ultimately led the GDP to improve. Companies in developed

102

countries retain a large portion of their earnings in order to cope with new opportunities available

in the market. Figure 5.3 shows two of them.

Both of the giant counties have increasing trend in corporate savings over the period of 2000

through 2012. As the time passes, GDP also improved.

5.3.1.4 Gross Fixed Capital Formation (GFCF)

Formerly known as gross domestic investment, covers the investment in fixed assets of

the economy as well as net changes in the inventory level. Fixed assets comprise plant,

machinery, land improvement, equipment, and construction of road, railways, schools, hospitals,

and private as well as commercial buildings. Inventories include stocks of goods taken by firms

to meet day to day fluctuations in sales, production or work in progress.

Figure 5.3

Corporate Saving Rates

103

Sources: National Bureau of Statistics of Chnia, United Nations Statistics Division

Empirically, society, as a whole, does not take quick benefit out of it but contribute in making

goods as discussed above to largely increase the efficacy of productive endeavor. It is confirmed,

through the economic theory and experience that the differences in the economic development as

well as growth are intertwined with the differences in the composition level of capital stock. This

capital stock is buildup by the capital formation accumulation. Thus, economists have been using

the estimation of capital formation and capital stock to analyze the results of productive activity.

As compared to developed countries, developing countries like Pakistan have shortage of capital

and natural resources. Therefore, the central problem in these countries is the accumulation of

capital formation. The thesis is aimed at confirming the dependency of GFCF on corporate

savings. All of these stated investments in the country are made either by state-owned or private-

owned firms. An increase in retained earnings by firms can boost the capital investment in the

104

country. Figure 5.4 below depicts the history of GFCF in Pakistan over the period of 1960 to

2011. Increase in the investment in GFCF started somewhere in 1982 and reached at its peak in

the year 2011. Consistent increase shows the interest of government in this respect as shown in

table 5.2, almost 58% of the investment in Pakistan came from internal financing.

Figure 5.4

Gross Fixed Capital Formation History in Pakistan

5.3.2 Firm Specific Explanatory Variables

5.3.2.1 Capital

Trade-off theory suggests that firms have optimal capital structure that comes from the

tradeoff between the tax shield savings and agency cost of debt (Jensen and Meckling, 1976).

This balance may be affected if owners of the corporation have political contracts outside the

company. With the passage of time firms make adjustments in their leverage from the estimated

level to desired level which largely depends on the effectiveness of corporate governance

systems (Zheka, 2007). Firms should strive to create such a governance environment where

managers make decisions for the capital structure while keeping the best interest of all

105

shareholders in mind. The agency theory of capital structure proposes that growth firms normally

employ lower debt level because they face the risk of agency conflicts between the equity and

debt holders. Shleifer & Vishny (1997) found that growing firms have a propensity to rely more

on equity than debt. With the assumption of presence of corporate governance, Majumdar and

Pradeep (1999) examined the relationship between debt level and firm performance. There was

negative relationship between the two stated variables as most of the funds suppliers in India are

government-owned institutions, suggesting the reforms of corporate governance phenomenon.

Firms having excellent growth opportunities should move up outside financing to get bigger and

get it optimal to progress their corporate governance. The fundamental notion is that superior

governance and good protection of minority shareholders tend to lead lesser cost of capital.

Debt plus equity, hence refer to as capital, is taken as an explanatory variable to predict

the governance state of firms in the energy sector of Pakistan. The choice of capital structure

depend whether the firm is privately owned or government owned. Generally, government

owned firms are more financed by debt. Privately owned firms may use more debt if they are

matured in the market.

5.3.3 Exogenous Variables

5.3.3.1 Type of Organization

Corporate governance structure of government organizations differs from public limited

firms in private sector. Government interventions as well as political interest are evidenced in the

106

government-owned firms. Whereas, private limited firms are operated by different organizational

structures and environment. The binary variable, type of the organization, is taken as explanatory

variable to predict the governance state of companies. The data takes the value of 1 for

government organization and zero otherwise. As already stated above, the ratio of dependent

variable is assumed to be higher in case of government-owned firms; the dummy variable will

verify this assumption.

5.3.3.2 Ownership Concentration

Board of directors is assumed to play a pivotal role in corporate governance, particularly

in monitoring the top management team. Directors are believed to look into the actions of

management, confer advice and veto poor decisions. This proxy is taken as the number of shares

held by directors. It may be assumed that directors are in line with the objective of the

shareholders. If so, then they should have smaller number of shares so that ownership becomes

dispersed. Holding of larger part of shares by directors is a signal of weak corporate governance.

The ownership concentration is negatively related to quality of corporate governance practices.

Laidroo (2009) found significant negative relationship between public announcement disclosure

quality and ownership concentration and foreign ownership while positive relationship with

institutional ownership. Agency problem arises from the ownership concentration and executive

compensation by having insider ownership, top management pay mix and institutional holdings.

We attempt to control this agency problem through ownership concentration. Jensen and

Meckling (1976) recommend that in the presence of ownership separation and control, managers

have power over firms’ resources and use their power to follow actions that can directly or

indirectly confiscate wealth from other shareholders and stakeholders. Shleifer and Vishny

(1997) recommend that major shareholders or block holders play an important role to resolve

107

some of the agency problems faced by firms. For instance, they can mitigate the free-rider

problem, minimize the managerial opportunism and perform a monitoring function. Chen, Itay

and Wei (2008) recommended that directors own larger number of shares where benefit from

monitoring is likely to be higher in case of control mechanisms lacking. On the contrary, they

own less number of shares where institutional shareholdings are high.

5.3.3.3 Distribution of Assets

Investment decisions of firms are monitored by the board of directors. Firms with greater

growth opportunities emphasize investment more in research & development and plant &

equipment. Instead, carrying heavy amount of cash and other current assets lead the firm to be

monitored by external shareholders and other interest groups. According to pecking order theory,

firms give priority to retained earnings in case of investment in fixed assets. If all or major part

of the profit is distributed among shareholders then debt issue is preferred over stock issue. As in

case of Pakistan, most of the firms do not pay or pay lesser amount of dividend and retained a

large part of profit. This profit is reflected in the form of investment in fixed assets, including

purchase of land, building and machinery. Firms with concentrated ownership are not governed

by the board of directors but some family members who are the members of the board. They

make investment decisions which are in the best interest of some controlling shareholders at the

cost of large dispersed shareholders. Current assets to fixed asset are taken as the proxy of

distribution of assets by firms. An increase in this ratio, due to high investment in current assets

as compared to fixed assets, will lead the conclusion of bad corporate governance practices

within the firms, as our model assumes no investment or lesser investment in current assets and a

great amount of investment in fixed assets. Decline in this proxy means that investment decisions

are made in the best interest of shareholders.

108

5.3.3.4 Long Term Debt (LTD)

Total value of debt is not a good indicator of whether the firm is at default risk in the

future. It also does not mirror interest cost liabilities as it includes accounts payables. They may

be used as transaction purposes than financing (Bevan & Danbolt, 2002). Williamson (1988)

proposed that debt and equity are two governance structures than the financial instruments.

Therefore, LTD is taken instead of total amount of debt. Having a long term debt in the capital

structure restricts the company to hold payments of others. It also means that the firm must keep

some amount aside to repay the debt with interest on the promised period. Cost of debt may also

be a concern to firms. The optimal level of leverage is achieved when marginal costs of debt is

offset the marginal benefits which ultimately lead to maximize the firms’ value (Jensen, 1986).

Klock, Sattar and Willam (2005) documented the lower cost of debt if management rights are

strong and high if the shareholders rights are strongest. In case of Pakistan, shareholders rights

are ignored and concentrated ownership does not let managers to make financing decisions. As a

result, the cost of debt depends upon the relationship with banks.

Debt can produce value by allowing the management the prospect to gesture its motivation to

distribute cash flows and to be observed by lenders. Consequently, we also incorporate leverage

as an added control device. Conversely, it must be kept in mind that the argument that debt can

make sure good corporate governance is significantly weakened with having the reality that

retained earnings are essential source of finance for companies. Typically, as discussed by

Hellwig (1998a), large firms do not have to face nuisance in meeting their debt payments. Both

pecking order and free cash flow theories predict negative relationship between leverage and

cash holdings by companies. It is assumed here that long term debt may be a cause of pilling up

the circularity debt in the economy.

109

5.3.3.5 Cash Generated during the Year

Efficient firms generate positive cash flow from operations which transfers optimistic

signals to stock markets. Firms’ future investments largely depend on positive cash flows. If

most of this cash is used to finance the assets of the company, the resulting cash will be

insufficient to meet the short term obligations. This results in hike of circularity debt. It is

hypothesized that as the ratio of cash flow to noncash assets increases, the circularity debt also

rises. Al-Amarneh (2013) investigated the determinants of cash holdings of industrial firms in

the Jordanian firms. The study included cash flow to net assets as one of the determinant of

firms’ cash holdings. Findings revealed that cash flow positively affect the cash holdings of

companies, confirming the pecking order theory. Pecking order theory suggests a positive

relationship between cash holdings and cash flows. Trade-off theory explains the phenomenon as

negative relationship between them. Companies in the supply chain hold the payment of others

and hence accumulate their cash. Harford (1999) assumed in his research that mangers of excess

cash firms use their discretion to undertake value decreasing investment projects. Jensen (1986)

documented the theory which suggests the benefits of debt to reduce the agency costs of free

cash flow. Particularly, when firms generate generous free cash flow, the conflict among

shareholders and managers become cruel.

Theoretically, firms which are generating large amount of cash flow from operation must not

face the circularity debt problem. In Pakistan, most of the firms in the energy sector have a

problem of circularity debt in spite of a large portion of cash flow from operation, appearing in

the financial statement of the company. This leads to a conclusion of bad corporate governance

practices in the energy sector of Pakistan. Table 5.3 below gives some highlights of this fact for

some big companies in this sector. An increase of more than 100% can be seen in the table 3.4.

110

Among them, KESC, SSGC, OGDC and PPL are the companies where circularity debt problem

exists, instead of having a huge cash flow from operations.

5.3.3.6 Corporate Assets

Investment in fixed assets by corporations is a cash outflow which may augment the

problem of circularity debt in the economy. Firms always have a priority of disbursing cash to

many resources. Most of the firms in the Energy sector of Pakistan are privately-owned. They

are supposed to have a hawk eye on the long term growth opportunities exist in the market.

These opportunities may lead the firm to diversify their business. Kochhar and Michael (1998),

by using 3SLS, revealed that unrelated diversification is financed by debt while related

diversification is financed by equity.

According to pecking order theory, firms set priorities for financing decision. Debt is the second

priority after retained earnings. Brounen, Abe and Kees (2004) examined the financial practices

of European countries through a survey and found the pecking order theory as an important

factor. It is hypothesized that firms avail these opportunities either related or unrelated

diversifications and increase their investment in fixed assets, resulting to hold the payment of

other parties in the supply chain, thereby increase the payable in the form of circularity debt.

Table 5.3

Cash Flow from Operations of some big companies in the Fuel & Energy Sector of

Pakistan

Name of Company Year CFFO (Rs.)

Karachi Electric Supply Corporation

2005 4,303,880

2011 10,077,433

Mari Gas Company Ltd 2005 1,444,613

111

2011 2,527,117

OGDC

2005 40,176,724

2011 67,924,141

Sui Southern Gas Company Ltd

2005 2,740,166

2011 13,097,157

BYCO Petroleum Pakistan

2005 27,375

2011 3,186,089

National Refinery Ltd.

2005 4,935,342

2011 12,497,013

Pakistan Petroleum Ltd.

2005 10,081,794

2011 3,013,0644

5.3.3.7 Sales

Firm size plays a significant role in explaining the phenomenon of liquidity problem

within the organization. Apart from total assets of a firm, sales are also considered as a good

proxy of firm size. Since total assets are presented in the historical costs, sales are shown as the

current market price, hence is a good proxy. Firm size is also considered as a proxy for

information asymmetry between the capital market and the insiders. Larger firms in terms of size

are also carefully monitored by a large number of analysts.

Increase in sales is a caution that operating as well as fixed costs may also increase. Major parts

of the firms’ sales are on credit, hence creates receivables. On the one hand, an increase in sales

is a good signal of the demand of the product; on the other hand, increase in receivables is also

the cause of circularity debt. If the increase in sales is greater than the increase in costs, the

112

marginal profit will help to reduce the burden of circularity debt. It is assumed that sales will

further increase the circularity debt problem.

Governance structure also plays pivotal role in terms of size of the firm. Lloyd, Hand and

Modani (1987) examined that the firm’s market value to sales ratio in greater in case of owner-

controlled firms with concentrated ownership. Leach and Leahy (1991) also concluded the same

results in their study. Thomsen and Torben (1997) examined the impact on economic

performance of firms due to ownership structure and other control variables. They found that

firms where the largest owner is a family or another firms have higher sales growth.

5.3.3.8 Return on Equity (ROE)

There are investors in the market with various expectations. Short term investors require

immediate return while investors who believe sustainability of firms wait for long time to get

benefit. In both of the cases, they analyze their investment in terms of returns. Firm also consider

different profitability ratios to explain the operations of the company. Among them, return on

equity (ROE) is also a good proxy of profitability. It satisfies not only firms to have a profit

indication but also investors to further go with the organization. It is hypothesized that as the

ROE increases, there will also be an increase in the retained earnings of the company.

5.4 Sample Size and Variables

We have collected the data of public limited firms listed on KSE, LSE and ISE stock

exchange of Pakistan. Since some of government owned firms do not get their financials and

113

other information disseminated, we have included only those firm for which audited annual

accounts are available. Mainly, we focused on energy sector as it has been facing the liquidity

problem in terms of circularity debt for many years. Data of all variables were collected through

audited financial statements of firms from 2005 to 2011. Table 5.4 depicts the list of variables

and their computations. There are firms which are involved only in oil and gas exploration while

others are engaged in oil and gas marketing. Since all the firms (exploration and marketing) are

part of the supply chain, all are victimized with respect to circularity debt. For instance, OGDC

only explores the oil and gas from Pakistan territory while others like PSO and Shell are engaged

only in marketing of oil and gas in Pakistan. None of the power generation firm is operating with

full production capacity which may be caused by the lake of proper cash inflows. It may be

argued that as firms hold the payment of other party in the supply chain, they stop generating

more oil and gas. This is the reason why government of Pakistan has to involve resolving the

issue.

Table 5.4

Variables

Dependent Variable Determinants Independent Variables Determinants

Corporate Governance

A Ratio of

Salary & Other

Perquisites of

Directors to

Capital

Type of the

organization

Ownership

Concentration

Capital

Distribution of

Assets

Government or Non-

government

Percentage of shares

held by directors

LTD+Equity

Current Asset / Fixed

Assets


Liquidity Circularity Debt

1= circularity

Corporate

Governance

From Model 1

114

debt exist 0=

otherwise

LTD

Cash Generated

during the year

Corporate Assets

Sales

Long Term Debt

Cash Flow to

Noncash Assets

Fixed Assets to

Noncash Assets

Log of Sales


Retention Retained

Earnings

Liquidity

Earnings

From Model 2

ROE


Macro Level

Investment in the

Country

Gross Fixed

Capital

Formation

Corporate Savings Retained Earnings

5.5 Estimation Techniques

There are three integrated theoretical models to be tested. Corporate governance which is

endogenous variable in first model becomes exogenous in the second model. Similarly, liquidity

which is endogenous variable in the second model becomes exogenous in the third model.

Because of the nature of the models, 3-stage least square regression is appropriate to explain the

phenomenon. The model is non-recursive as there are some reciprocal paths between models. In

such cases, single equation estimation techniques like 2SLS may not provide an efficient

estimate as 3SLS (Judge, Griffiths, Hill, Luthepohl and Lee 1985). Consequently, 3SLS was

employed for the data analysis as it takes into account the information present within and across

the hypothesized equations.

115

CHAPTER 6

CORPORATE GOVERNANCE PHENOMENON IN PAKISTAN

6.1 Proposition 1

This chapter presents the empirical analysis and findings of propositions 1 developed in

chapter 4. All the data collected from sampled companies are analyzed and discussed. The

analysis starts with the descriptive nature of the data and correlation between corporate

governance and all other explanatory variables as well as among variables. We, then start with

the proposition which explains the corporate governance phenomenon in the context of public

limited companies of the energy sector listed in KSE, LSE and ISE. To better explain the

phenomenon of corporate governance in Pakistan, we divided the proposition into four models

each of them has one additional explanatory variable.

6.2 Descriptive nature of the data

116

Table 6.1 depicts the descriptive statistics for the variables used in the analysis. Analysis

includes mean and standard deviation for corporate governance (LOGCG), type of organization

(TORG), ownership concentration (OWNCON), capital (LOGCAP) and the corporate assets

(CA/FA).

It shows that ownership concentration (OWNCON) and capital (LOGCAP) have same mean

score while distribution of assets (CA/FA) has a mean value more than of all variables with

different standard deviations. The mean value of OWNCON is 7.423338 with standard deviation

of 16.4881571 while LOGCAP has a near mean value of 7.0515 with a very small deviation of

0.68123. Ownership concentration is the number of shares held by directors and capital means

long term debt plus equity. Since both variables do not have same unit of analysis, no proper

explanation can be justified. A distribution of assets (CA/FA) has a mean value of 99.4167 with

the standard deviation of 12.45824. The mean value of this variable indicates that this ratio

reaches almost 100% which shows heavy investments by firms in the form of liquid assets like

cash or marketable securities. The type of organization (TORG) is a dummy variable which has a

value of either 0 or 1, hence cannot be compared with rest of other variables.

Table 6.1

Descriptive Analysis

Variables Mean Standard Deviation No. of observations

LOGCG -0.052466 0.5636108 167

TORG 0.41 0.493 167

OWNCON 7.42338 16.4881571 167

LOGCAP 7.0515 0.68123 167

CA/FA 99.4167 12.45824 167

117

Energy sector of Pakistan is divided into four different functions. The supply line starts with the

exploration of oil & gas. Companies which involve in the exploration then supply to oil

refineries for further processing. Oil refineries then deliver to power and electric generation

companies to make them available to oil and gas distribution companies. Although, the functions

of involved firms are different, we can still assume the governance practices to be equally likely.

With this assumption, we further assume the similarity of other variables in each of the involved

firms. Table 6.2 gives some interesting findings of this notion. Similarity of corporate

governance practices is found as predicted. Companies in the energy sector, although with

different functions, have the same propensity to focus on their salary and other perquisites

against capital. We have included an additional variable of total asset to see the effects of size.

There is negative relationship between size of firms and concentration of ownership. Oil & Gas

Exploration and Distribution companies are bigger in terms of size but have a low ownership

concentration. As against this, Oil Refineries and Generation companies are low in terms of size

but have a high concentrated ownership. All oil & gas exploration companies are government-

owned while there are 40% companies which are government owned in the distribution

companies. There is half government and half privately owned companies in the oil refineries

while the government-owned firms in the power generation are only 8%. As far as capital is

concerned, all have almost same mean values, indicating the financing choice of these firms.

Poyry and Benjamin (2009) confirmed that in firms where state is the controlling shareholders,

debt financing is seen more as compared to equity financing. Further he revealed that because of

heavy political influence to financial institutions, they enjoy better access to debt. Both of these

scenarios exist in Pakistan, government organizations in the energy sector have a political

influence and use a large portion of debt in their capital structure. Because of similarity in the

118

governance practices of firms, corporate assets (CA/FA) also have a trend of investment mainly

in the current assets as against in fixed assets. Investigation of table 6.2 reveals that economic

governance system in the energy sector of Pakistan must be readdressed on the priority basis in

order to boost the sector and hence the economy.

Table 6.2

Comparison of Governance Practices across the Energy Sector

Mean values Variables Oil & Gas

Exploration Co. Oil Refineries Power & Electric

Generation Co. Oil & Gas

Distribution Co. Total Assets 7.3081 3.0493 2.7353 7.2061 Log of Corporate Governance

7.6632 7.3810 6.6700 7.6618

Ownership Concentration

0.0080 0.2960 22.3276 1.6294

Log of Capital 7.5554 6.0746 6.6055 7.2889 Corporate Assets 102.55 108.33 90.9187 108.78

This can also be depicted by figure 6.1 below. Oil & Gas Distribution (O&GDCOs) companies

are at the top in terms of total assets. Power & Electric Generation (P&EGCOs) are the second

bigger companies in terms of size measured as total assets. Oil & Gas Exploration (O&GCOs)

companies are near to P&EGCOs companies but Oil Refineries (OREF) are at the lowest.

119

Figure 6.1

Total Size of the Energy Sector of Pakistan

Similarly, figure 6.2 also shows some insights about position of distribution of assets (CA/FA) of

the energy sector of Pakistan. P&EGCOs companies heavily invest in current assets as against

fixed assets, showing bad governance state. Rests of other players in the sector do not heavily

invest but there are some evidence in the figure that they do so more as compared to fixed assets.

-

50,000,000

100,000,000

150,000,000

200,000,000

250,000,000

300,000,000

350,000,000

400,000,000

P&EG O&GE O&GD OREF

120

Figure 6.2

Distribution of Assets of the Energy Sector of Pakistan

6.3 Correlation Analysis

Further, the analysis proceeds towards the correlation analysis among variables.

Ownership concentration (OWNCON) has a negative and significant correlation with corporate

governance. This result supports the discussion shown in the literature review. Unlike to

ownership concentration, capital (LOGCAP) is positively correlated with corporate governance

-

200.00

400.00

600.00

800.00

1,000.00

1,200.00

P&EG O&GE O&GD OREF

121

but the correlation is insignificant. The current asset to fixed asset (CA/FA) is positively and

significantly correlated to corporate governance. It seems that the investment decision of firms

do have some association with the salary & perquisites of executive officers. The table 6.3

further reveals that the CA/FA is not only significantly correlated with corporate governance but

also with rest of other explanatory variables. It may be derived from the examination of this table

that concentrated organization has a negative relationship with investment decision. Similarly,

ownership concentration has also negative and significant correlation not only with corporate

governance but also with type of organization (TORG) which is a dummy variable.

Table 6.3

Correlation Analysis

Variables LOGCG TORG OWNCON LOGCAP CA/FA No. of

Obs

LOGCG

167

TORG 0.231

(0.001)

167

OWNCON -0.386

(0.000)

-0.368

(0.000)

167

LOGCAP 0.057

(0.231)

0.517

(0.000)

-0.433

(0.000)

167

CA/FA 0.398

(0.000)

0.118

(0.065)

-0.151

(0.026)

0.007

(0.463)

167

6.4 Multiple Regression Model

LOGCG = α + α1TORG + α2OWNCON + α3LOGCAP + α4CA/FA + + ɛ [6.1]

Where

LOGCG is the log of corporate governance.

122

TORG is the binary variable equal to 1 in case of government-owned firms and 0 otherwise.

OWNCON is ownership concentration

CA/FA is current asset divided by fixed assets as a proxy of corporate assets.

α is the parameters

ɛ is the error term

6.5 Determination of Corporate Governance

Table 6.4 illustrates the regression results of proposition 1. As discussed, type of

organization is introduced as a dummy variable, taking the value of 1 in case of government-

owned listed firm and 0 for private-owned listed firms. The results in table 6.4 show that in the

absence of private-owned listed firms, there is positive and significant relationship with the

corporate governance proxy. It reveals that directors in the government-owned listed firms get

benefit by increasing their salary and other perquisites while this is not in case of private-owned

listed firms. This evidence is supportive of the general arguments prevailed in the market and

among institutional as well as individual investors. This depicts the bad corporate governance

practices being practiced in government-owned firms. This is also one of the reasons as to why

this sector is not helping common people in the form of providing proper electricity in the

country.

Ownership concentration has a negative impact on corporate governance practices of firms.

Corporations with concentrated ownership allow directors to get maximum benefit from the firm.

Their salary and other perquisites are increased for nothing. If some controlling shareholders are

dominant in the firm, they will enjoy this opportunity to be benefited from this option. As seen in

table 6.2, oil & gas exploration companies are all government-owned with lesser concentrated

123

ownership among four sub-sectors but governance practices are those of highest concentrated

ownership like oil refineries.

Capital also has negative and significant impact on corporate governance state of the company.

As the capital increases, the ratio of salary and other perquisites of directors will be in a

declining position and vice versa. Capital may be enhanced by increasing the debt or by issuing

shares and raising the capital. Debt increase will also enhance the fixed costs of the company and

can lead to bankruptcy position in future. It also strikes investors to start demanding higher

equity return in the market. Share issue has an initial costs but feasible to most of the investors. It

is, therefore, difficult to explain that this negative relationship is due to debt or equity level in the

capital.

Investment decisions show the strategic direction of a firm. Larger investment in liquid assets

restricts the firm to get benefit from growth opportunities exist in the market. Moreover, liquid

assets also include cash balance which may be used to undertake any project without going into

the market, hence no more monitoring by outside investors are needed. The result reveals that

firms heavily invest in current assets as compared to fixed assets. It may be deduced that

directors use this money on their discretion.

Table 6.4

Predicting the Corporate Governance

Variables Model

Coefficient Std. Error

Intercept -0.462 0.584 TORG 0.175*

(1.941)

0.090

OWNCON -0.012*

(-4.744)

0.003

124

LOGCAP -0.148*

(-2.200)

0.067

CA/FA 0.015*

(4.868)

0.003

No. of

Observations 166

Adjusted R2 0.276

F Statistics 16.837 * Significant at the 5 percent levels

t statistics are in parenthesis .

6.6 Significant Contribution of each Variable

Further, to check the significant contribution of each variable in the proposition, this is

divided into four models, explaining the corporate governance phenomenon in details as

presented in table 6.5. The first model shows that corporate governance is positively affected by

the type of organization. Since the dummy variable takes the value of 1 in case of government

organization, this is evidenced now that government influences over the implementation of

corporate governance practices. Salaries & other perquisites to capital are used as a proxy of

corporate governance. This suggests that this ratio is higher in case of government organization,

explaining bad corporate governance practices being implemented there.

Table 6.5

Significant Contribution of each Variable

Proposition 1 - LOGCG

Variables Model 1 Model 2 Model 3 Model 4

Coefficient Std. Error Coefficient Std. Error Coefficient Std. Error Coefficient Std. Error

Intercept -0.160 0.055 -0.012 0.062 1.248 0.498 -0.462 0.584 TORG 0.264

(3.050)*

0.087

0.118

(1.334)

0.088 0.222*

(2.315)

0.096 0.175*

(1.942)

0.090

OWNCON -0.012*

(-4.514)

0.003 -0.014*

(-5.149)

0.003 -0.012*

(-4.744)

0.003

LOGCAP -0.183*

(-2.552)

0.072 -0.148*

(-2.200)

0.067

CA/FA 0.015*

(4.868)

0.003

No. of 166 166 166 166

125

Observations

Adjusted R2 0.053 0.148 0.175 0.276

F Statistics 9.30 15.384 12.771 16.837 * Significant at the 5 percent levels


In addition to type of organization, the second model also incorporates the ownership

concentration but the TORG variable becomes insignificant here. Ownership concentration gives

evidence of negative impact on corporate governance. As stated earlier that Pakistan is the

country where concentration is evidenced, this result was as expected. Model 3 incorporates

capital in addition to above two explanatory variables. All three variables are significant. As

expected, the sign of ownership concentration is negative. Type of organization is significant in

this model because of inclusion of capital. This is again evidence that government organizations

heavily invest in salaries & other perquisites of managers. The negative sign of capital indicates

that as the capital deceases, the proxy of corporate governance increases which shows bad

corporate governance practices. Finally model 4 includes all explanatory variables, showing

significant results. Corporate assets (CA/FA) have a positive impact on the corporate

governance, indicating that firms heavily invest in current assets instead of fixed assets.

126

CHAPTER 7

LIQUIDITY CRUNCH AND CIRCULARITY DEBT

7.1 Proposition 2

Firms maintain an appropriate level of cash balance for several motives such as

speculative, precautionary, transactional, tax and agency. According to speculative motive,

corporations hold cash balances to enjoy the benefit of bargain purchase that may arise (Besley

& Brigham, 2005). Transactional motive suggest that firms hold lesser amount of cash as there

are economies of scale involved when firms incur transaction costs (Mulligan, 1997). When

access to capital market becomes costly, firms hold cash to cope with undesirable events. This is

consistent with the precautionary motive of holding cash balance by firms. Opler, Pinkowitz,,

Stulz and Williamson (1999) studied and revealed that firms which have riskier cash flows with

poor access to capital markets hold more cash.

This chapter presents the empirical findings of the proposition II developed in chapter 4.

According to the proposition, liquidity, which is considered as the circularity debt phenomenon

in the economy of Pakistan, is affected by some exogenous variables. Companies in the Energy

sector of Pakistan have been facing liquidity problem, in the form of circularity debt, for many

years. They have riskier cash flows but good access to capital market. Analysis starts with the

descriptive statistics in table 7.1.


127

Examination of table 7.1 reveals some interesting facts. Mean score of long term debt

(LOGLTD) and sales (LOGSALES) are more or less same. Mean value of LTD is 6.004 while

LOGSALES is 7.350. This result may be interpreted that long term debt of companies in the

energy sector of Pakistan is, on average, near to total sales of the sector. This situation is

supportive of the problem of circularity debt. As the credit sales increase, it becomes difficult to

recover from the customers. To avoid the situation of lower cash inflows, companies in the

payment chain starts borrowing from banks and increase the debt.

Table 7.1



PREDCG -0.0903 0.343 177

LOGLTD 6.004 1.451 180

CFTNA 11.425 29.942 167

CAPEXTNAST 146.962 966.940 175

LOGSALES 7.350 0.961 182

If all of the cash flows, generated through sales, are used to pay off the long term debt,

companies will be unable to meet its short term obligations, resulting inefficient operations.

Mean value of cash flow to noncash asset (CFTNA) is 11.425 while capital expenditure to net

asset is 146.962. As discussed in chapter 6, there are four functions of the energy sector of

Pakistan. This function starts with the exploration of oil & gas, transfers the oil to refineries for

further process. Refineries supply to power and energy companies and then distribution

companies to end consumers. As the circularity debt is the problem of the entire energy sector of

Pakistan, it is hypothesized that all companies regardless of the functions, are responsible for this

dilemma. Table 7.2 sheds light in this respect. Mean values across the energy sector reveals

128

motivating results. Oil & gas exploration companies are more prone to take long term debt as

compared to other two sub-sectors. It is also interesting to note that these two sub-sectors are

passive in terms of investment in fixed assets. This fact is highlighted with evidence of low cash

and cash equivalent as against to other two sub-sectors. Oil refineries relatively hold more cash

and cash equivalent and hence invest more in the fixed assets. The cash level of power

generation companies is relatively low but investment in fixed assets is higher among all. This is

understandable when we look at the position of long term debt which is higher after exploration

companies.

Table 7.2

Comparison of Liquidity across the Energy Sector

Mean Values

Variables Oil & Gas Exploration Co.

Oil Refineries Power & Electric Generation Co.

Oil & Gas Distribution Co.

Total Assets 7.3081 3.0493 2.7353 7.2061

Long Term Debt 9.7667 1.3685 7.7485 1.5568 CF to Noncash Assets

27.4725 21.9198 3.7459 11.6920

CAPEXP To Noncash Assets

42.0248 56.4540 261.4152 46.4265

Sales 5.9753 8.4353 1.8984 2.1728

Cash & Cash Equivalent to Total Assets

12.7117 20.0484 2.0536 11.9619

Cash & Cash Equivalent

4.4197 5.5616 596999.8146 3.6096

Sales of oil refineries are higher and hence cash and cash equivalent. These facts are enough to

conclude that there is no problem of cash flow or cash level to any of the above companies. The

only issue which we have hypothesized is the practices of corporate governance alongwith

129

proper management of all these exogenous variables. Regression result is also supportive of this

view point.

7.3 Correlation Analysis

Table 7.3 presents the correlation of dependent and independent variables and among

variables as well. There is statistically significant and positive correlation of long term debt

(LOGLTD) and sales (LOGSALES) with the binary dependent variable. Rest of other variables

does not show significant correlation.

Table 7.3


Variables CD PREDCG LOGLTD CFTNAST CAPEXTNAST LOGSALES

CD

PREDCG 0.090 0.120 0.186* -0.234** 0.580**

LOGLTD 0.451** ` 0.055 -0.131 0.515**

CFTNAST 0.075 0.015 0.083

CAPEXTNAST -0.045 -0.190*

LOGSALES 0.430**

* Significant at 5% level

**Significant at 1% level

It can be concluded that credit sales further increase the receivables in the form of circularity

debt. Increase in long term debt is used to finance new projects or investment in fixed assets.

This amount is not used to pay off the liabilities.

7.4 Multiple Logistic Regression Model

Following the theorem of the thesis, we test the hypothesized association between the

circularity debt phenomenon and exogenous variables. The model includes following variables.

130

Logit[P(CD=1)] = β0 + β1PREDCG + β2LOGLTD + β3CFNTAST + β4CAPEXNTAST +

β5LOGSALES + ɛ [7.1]

Where

CD is the dependent variable with a value of 1 if the firm faces the circularity debt problem and

0 otherwise.

PREDCG is the predicted values taken from model 1.

LOGLTD is the long term debt.

CFNTAST is cash flow to noncash assets.

CAPEXNTAST is capital expenditure to noncash assets and

LOGSALES is total sales of the firm.

α and β are the parameters

ɛ is the error term

Before looking at the regression results, it must be cleared whether the overall model is

statistically significant. There are some statistical tests which describe the goodness of fit of the

overall model. Table 7.4 presents these measures which meets all the requirements of model fit.

Insignificant value of Chi-square shows that the model is acceptable for further process.

7.5 Goodness of Fit of the Model

Table 7.4

Goodness of Fit Measures

-2LL Cox and Snell

R2

Nagelkerke

R2

Hosmer and lemeshow Test

Chi-Square Sig

85.509 0.460 0.681 2.829 0.945

131

Since dependent variable in the proposition II is dichotomous, we applied logistic regression.

Circularity debt is taken as a proxy of liquidity problem exists in the energy sector of Pakistan. It

takes the value of 1 if any company faces this phenomenon and 0 otherwise. Table 7.5 presents

the results of logistic regression.

7.6 Reasons of Circularity Debt

Table 7.5

Predicting the Liquidity Problem

Variables Model

Coefficient Std. Error Wald

Intercept -45.893 8.291 30.638 PREDCG -2.547 1.294 3.877 LOGLTD 1.845 0.464 15.799 CFTNAST 0.041 0.016

6.736

CAPEXTNA

ST -0.014 0.008 3.628

LOGSALES 4.201 0.952 19.490 No. of

Observations 182

* Significant at the 5 percent levels


As expected, the negative sign of the corporate governance shows the acceptance of our

hypothesis that circularity debt exists because of bad corporate governance in the energy sector

of Pakistan. As noted in chapter 1, figures of circularity debt are the accounting treatment of

receivables and payables. Since table 1.4 in chapter 1 shows positive difference, it is evidenced

that this problem is not because of financial management but of corporate governance. Corporate

governance (PREDCG) is the predicted values taken from model 1 which means that it is itself

the function of some exogenous variables. In other words, variables which explain the

phenomenon of corporate governance is badly managed which causes the increase in circularity

debt.

132

It is Interesting to note that an increase in long term debt is linearly related to the problem of

circularity debt. Debt is used to finance any new project which is supposed to generate positive

net present value in order to maximize shareholders’ wealth. If LTD is used for this purpose,

then there is economic significance of this result. This result does not follow either pecking order

or free cash flow theory. The evidence of trade-off theory with respect to leverage is unknown.

Cash flow to noncash assets is also significantly positive which means circularity debt tends to

increase with cash flows. This is consistent with the pecking order theory which implies that

when cash flows are high, corporations use this cash to finance new projects, settle their

liabilities, pay dividends and finally accumulate cash to manage working capital requirements.

When we look at the result of capital expenditure to noncash assets (CAPEXTNAST), it is

significantly negative, showing evidence that firms with high cash flows invest in fixed assets

which cause to accumulate the amount of circularity debt. The remaining cash is kept a side for

day to day activity. Due to heavy investments in fixed assets, companies in the energy sector do

not pay their short term liabilities to suppliers and hence, increase the circularity debt in the

economy. This result is consistent with the free cash flow theory which suggests that companies

avail the growth opportunities exist in the market due to high cash flow. Pecking order and free

cash flow theory suggest positive relationship between cash level and size of firms while trade-

off theory suggests negative relationship, when we take total assets as a proxy of size of firms.

We have taken sales as a proxy of size of firms. Since both variables are used as a proxy of

firms, all theories can be applied on sales as well. Results show that an increase in sales also

helps circularity debt to pile up. Since all sales are made on credit, we assume this result is as per

our expectations. These credit sales are not converted into cash in near future, the amount of

circularity debt increases. In other words, this result is following the pecking order as well as free

133

cash flow theory. We can conclude this result by combining all variables into consideration.

Companies make credit sales and somehow generate operating cash flows to fulfill the working

capital requirements. Since this cash is not enough to finance new profitable projects, due to

increase in receivables, they have to take long term loans.

Table 7.6 shows the classification of accuracy. Relatively a large percentage of correct cases are

found which support the overall model of the thesis.

Table 7.6

Classification of Cases

Observed Circularity

Debt

Predicted Circularity Debt

0 1 Percentage Correct

0 117 9 92.9%

1 10 32 76.2%

Overall Percentage 88.7%

The result shows that regression classified 88.7% cases correctly. In case of government-owned

firms, 76.2% cases are correctly classified while for private-owned firms, this ratio reaches to

92.9%. Both of the ratios are large enough to accept the model accuracy.

Figure 7.1 below supports this accuracy. Based on cur off value of 0.50, all cases are correctly

classified. Three cases of government-owned firms are found in non-government-owned firms.

Figure 7.1

Accuracy of Cases

134

CHAPTER 8

FINANCING DECISIONS OF CORPORATIONS

135

8.1 Proposition 3

The role of corporate savings has received relatively minute attention in the literature.

Most of the time, analysis was done with the objective of increased saving by households.

Nevertheless, the increasing trend of corporate savings has also been witnessed. This fact is

depicted in figure 8.1 of six Asian countries alongwith some other emerging countries and

developed countries over the period of 1998 through 2007.

Figure 8.1

Change in Corporate Savings and Investments Rates – Average Annual Real GDP Growth

Rate 1998-2007

Source: World Bank, CEIC United Nations

Notes: Emerging Asia: China, India, Philippines, Republic of Korea, Thailand, and Taiwan.

Other emerging countries: Czech Republic, Kazakhstan, Kyrgyzstan, Mexico, Poland, Republic

of Moldova, Tunisia, and Ukraine. Figures are GDP-weighted.

As a result of increasing trend in corporate savings, the GDP growth rate also rose. GDP-

weighted average as of corporate saving rate in six emerging Asian countries rose by 8.10% over

the given period. This increase is much larger as against in other emerging or even developed

countries. Similarly, investment change is also appealing as it increased to 4.94% in case of

136

Asian countries. An impressive GDP growth rate can also be seen in case of Asian countries.

This implies the importance of corporate savings which must be taken into consideration.

Earnings of corporations may be retained for a number of motives. Some of them are definite

and hence understandable while others are hard to measure. The analysis may be made with the

objective of viewing past trend of retained earnings or plan for the future. Past investment of

retained earnings on existing assets may be evaluated by their performance. Future plan is

always based on investment or growth opportunities available in the market. Earnings to be

retained are based on dividend policy of firms while retained earnings in the form of cash are

based on the working capital management policy of firms. Good dividend policy attracts more

investors as they can expect the return in the form of dividend. Working capital policy allows

firms to decide the level of current assets and current liabilities at any given point of time.

The energy sector of Pakistan has been facing liquidity problem in the form of circularity debt

for many years. If properly managed, this sector can boost up the GDP of Pakistan by increasing

investment in the country. Before assessing this situation, it is imperative to examine the

determinants of corporate savings in case of energy sector of Pakistan. The discussion is based

on a theorem developed in chapter 5 where model 3 describes the determinants of retained

earnings.

This chapter starts with the results of proposition III developed in chapter 4. It was hypothesized

that corporate savings are the function of liquidity and profitability. The results begin with the

descriptive statistics of variables used. Table 8.1 presents this result.


Table 8.1

137



LOGRE 5.9146 0.915 114

PREDLIQ 0.266181 0.336 114

ROE 34.1135 26.512 114

Mean of retained earnings and return on equity are far from each other. Mean value of

ROE (34.1135) is six times more of the mean of LOGRE (5.9146). It may be assumed that

corporations have a possibility to increase the retained earnings while setting the dividend policy

in line with the companies’ objective. Available growth opportunities can be availed only if a

firm has sufficient cash management. Retained earning is the economical option to opt any new

project by a firm. Profitability can be an objective of an investor who is present in the market for

a very short span of time. Rational investors always look for far future in terms of the

sustainability of the firm. A firm can be sustained in the market if it also depends on its earnings

rather than sources outside the firm.

PREDLIQ is the predicted values of liquidity taken from model 2. Hence, this model must be

explained in relation with previous models.

Correlation analysis is depicted in table 8.2 below

Table 8.2


Variables LOGRE PREDLIQ ROE No. of

Obs

LOGRE 114

PREDLIQ 0.509 167

ROE 0.653 0.216 167

138

Both of the variables are positively and significantly related to retained earnings of firms.

However, the magnitude of profitability (0.653) is higher as compared to liquidity (0.509). As

ROE increases, there is a chance that corporations may decide to increase their retained portion

of earnings. Regression results are shown in table 8.3.

8.3 Regression Model

LOGRE = 0 + 1CD + 2ROE + ɛ [8.1]

Where

LOGRE is the log of retained earnings

CD is the predicted values of liquidity taken from model 2

ROE is return of equity

Both of the predictors positively and significantly explain the variation in corporate savings.

Overall model is significant and explaining 56.10% variation. Liquidity is the predicted value

taken from model 2 which is itself a function of some exogenous variables. The magnitude of

ROE is greater than the magnitude of liquidity.

Table 8.3

Predicting the Corporate Savings

Variables Model


Intercept 4.964

(50.865

0.098

PREDLIQ 1.051*

(6.044)

0.174

ROE 0.020* 0.002

139

(8.924) No. of

Observations 113

Adjusted R2 0.561



CHAPTER 9

CORPORATE SAVINGS AND TOTAL INVESTMENTS IN A COUNTRY

9.1 Proposition 4

The study of economic variables requires deep understanding of their various roots in

order to appropriately justify. Gross fixed capital formation (GFCF) as a proxy of total

140

investment in a country has different linkages when relate with the corporate sector. Second

problem is determining the suitable time lag between dependent and explanatory variables. This

thesis has a basic premise that corporate savings are a good predictor of total investment in a

country in form of GFCF. As a result of increasing retained earnings by corporations, the country

may face a rapid growth in terms of investments. It is a strategic decision by firms to decide

about retained earnings and requires the approval of Board of directors (BoD). The time lag

between the approval of BoD and actual capital expenditure is a crucial problem. Lund and

Holden (1968) discussed the total lag pertaining to a particular investment in fixed assets by a

firm consist of a fixed and a distributed component and it becomes further complicated when

looking at an aggregate level like industry or the whole economy. He proposed a capital stock

adjustment model and found satisfactory to explain the private gross fixed capital formation in

the UK during 1923 to 1938. Companies in various industries respond to a situation with

different lags based on time-varying cash flows, risk involved in that particular capital

expenditure, time lapses between capital expenditure today and benefits to be anticipated in

future and the like. Firms in the same industry respond differently in term of dividend

announcement and retained earnings. Since mechanism of every industry is different, it is hard to

decide which tame lag is an appropriate one. The nature of both of the variables in the last

proposition of this thesis is time series which have different implications at each time lag. It is

assumed that investment in fixed assets by corporations will be a part of total investment of a

country in the next year. Corporate savings are assumed to have one lag to explain the variation

in GFCF of Pakistan. The regression model is given in equation 9.1 of this notion.

LOGREGCF 10 [9.1]

Where

141

GFCF is gross fixed capital formation

RE is the retained earnings by corporations

is the parameter

The data has been taken from various issues of economic survey of Pakistan and balance sheet

analysis of joint stock companies published by SBP. The data covers the period of 1975 through

2013.

9.2 Rational behind the Notion

The responsibility of social welfare has been partially shifted from government to private

sector of the economy worldwide. A corporation is meant an institution which must fulfill, at

least, the basic needs of common people. Although government is accountable to do the same,

with the development of economy it is assumed that this job is done by corporate sector as well.

Corporation is a nexus of different contracts with the society associated with it (Jensen and

Meckling, 1976). It is not simply a firm to make profit but also an institution to have a

responsibility of social wellbeing of common people. An investment decision by a corporation is

taken as a strategic direction which may lead the firm to outperform in the market. As a result of

this decision, several changes can be observed in the society which can be traced from several

perspectives. Since the purpose is to enhance the investment in the country, it can be achieved

from different steps. Some of them are explained below.

9.3 Supply Side Effects

Investment decisions may escort the firm to start more production for which it needs

more raw materials from its suppliers. The suppliers will start buying more raw materials from

within or outside the country to meet the requirement of firms. Suppliers will be benefited from

142

increasing their sales of raw materials. More production will increase the supply of the product in

the market which will help stabilize the inflation in the country. Normally a firm has more than

one supplier in its value chain. Inbound logistic of the firm will be developed which will help

alleviate unemployment in the country. This can also be depicted in figure 9.1.

9.4 Demand Side Effects

As a result of more production, distributors will be given chance to distribute the product

into the market. Outbound logistic of the firm will be benefited and distributors will enjoy more

profit as compared to previous experience. An increase in supply of the product requires more

labor that makes it possible to distribute the product into the market. Labor force will be

increased at the outbound logistic level which will help minimize the ratio of unemployment in

the country.

Figure 9.1

Economic Upturn

Output Employment GDP Per Capita Income Demand Side Pressure

9.5 Government Taxes

More production will create the possibility of enhanced profit before taxes. It will further help

increase the government’s share in terms of direct and indirect taxes.

9.6 Banking Channel

Buying and selling transactions are done through banking channels. It may be assumed

that all transactions are channeled through banks and hence banks’ ability to lend money will

increase. This will create an investment environment in the country which may boost up the GDP

143

growth rate. This whole process can also be depicted by figure 1 below. The two side arrows

show that both of the parties in the process will get benefit.

Figure 9.2

Corporation as a Nexus of Contracts

9.7 Financing the Investment Decision

This investment decision may be financed either by equity issue or debt instruments. A

third alternative is the retained earnings which have been accumulated over the period of firm’s

business life. It is a general practice of corporations to retain a large part of their earnings to

undertake positive NPV projects in order to maximize shareholders’ wealth. The benefits of

using retained earnings have already been mentioned in chapter 3. The point to be discussed here

is how retained earnings can increase the total investment in the country.

Corporation

Suppliers

Distributors

Employment

Govt.Taxes

Banks

General Public

144

If all of the firms’ earnings are distributed among shareholders, then the firm will have two

options to start any new project or make investment in any new business. It can either go for

share issue or bank borrowing. Bank borrowing will cost the firm in terms of interest payments.

Share issue will be the alternate of retained earnings. After disbursing the dividend to existing

shareholders, now the firm will demand this cash from new shareholders. This process will cost

the firm in terms of undertakers’ cost. Thus the decision of investment from retained earnings

will be beneficial for both i.e. the firm as well as shareholders. This investment will increase the

magnitude of total investment in the country as reflected in the form of gross fixed capital

formation (GFCF).

Any change in dividend policy may significantly affect the allocation of capital resources. In

case the external financing is absent, capital expansion of any industry or even firm will be

limited within its own reinvested profit. If the demand of the product goes up and more

production is required, than additional funds for capital expenditure cannot be attained from

capital market. This required fund must be obtained either through cut in dividend or increase in

profit. Reduction in dividend means that new financing was arranged by the existing

shareholders. An increase in profit means that new funds were contributed by the consumers of

the firms’ product. In both of the situation, there are some costs associated with them.

It is generally argued by corporate managers that policy of retained earnings facilitates them to

make the dividend payment stabilized. Some part of the earnings is kept within the organization

in the expansion years. The same payment is used as dividend in the contraction years. This

practice of stabilizing dividend is likely to smooth out the cyclical pattern of the shareholders’

personal income; the effect of total national income is far from certain (Dobrovolsky, 1958). If

all of the net income is distributed in dividends during the expansion phase of the cycle, one can

145

assume less pronounced enhancement in corporate investments. Against this argument, if no

dividend is paid during contraction phase, a firm can, at least, make efforts towards minimum

investments required.


We start the empirical part of the chapter by explaining the descriptive part of the data.

At lag 1, both of the variables have far reach mean scores. When taking second lag of retained

earnings, the mean values of both of the variables come to nearest of each other. It shows that

any investment by corporations will be part of the investment of the country after one and two

years. Later results are much supportive as compared to earlier one.

Empirical results are given in table 9.2. It shows evidence of the proposition 4 that total

investment in a country depends on the corporate savings. This effect comes into play after one

year lag.

Table 9.1


Lag 1 Lag 2

Variables Mean Std.Dev. Variables Mean Std.Dev.

GFCF 5.65700 6.8923300 GFCF 5.81200 6.9289000

REt-1 1.00300 2.4724500 REt-2 7.607600 2.0276500

9.9 Exploring the role of Corporate Savings

146

Today, energy sector of Pakistan needs more attention in terms of investments in

electricity plants, water dams and new technologies to generate more electricity in the country.

These investment decisions by corporations in this sector can also boost up total investment in

the country in the form of GFCF. Corporations can only take these decisions when they have

sufficient available cash. Therefore, it may be deduced here that corporate savings are an

important strategic decisions to prosper the country.

Table 9.2

Predicting the GFCF

Variables Model


Intercept 3.89100

(3.981)

9.77300

REt-1 17.601

(4.748)

3.707

No. of

Observations 35

R2 0.399



This is also tested by taking the second lag of retained earnings but results are still supportive of

this notion. This is given in table 9.3. Second lag of retained earnings make the results more

strong as the magnitude of the coefficient becomes more significant as compared to first lag. It

shows that the results of second lag are more pronounced than the results of first lag.

Table 9.3

Predicting the GFCF

Variables Model


Intercept 4.21900 1.00500

147

(14.197) REt-2 20.942

(4.455)

4.701

No. of

Observations 34

R2 0.357



CHAPTER 10

SUMMARY AND FINDINGS

10.1 Overview of the Study

Generally, it is assumed that a legal official system exists to work in an impartial

manner. All economic transactions are carried out while following this system. Problem occurs

when some informal activities are found within the formal legal system. Since economic

governance is a widespread topic, we take only corporate governance as one of its offshoot. We

148

strived to identify and explain the reasons because of which corporate governance becomes

weak. Economic development is linked with corporate governance which is important especially

for emerging markets.

This dissertation has a basic premise that total investment in a country, in the form of Gross

Fixed Capital Formation (GFCF) can be raised if corporations are encouraged to retain a large

portion of their earnings to cater the future growth opportunities. A theorem of four interacted

models was developed to prove this notion. All predictors were identified on a priory basis as

these variables have not only shown some evidence in previous literatures but also logical

grounds. The theorem starts with the idea that economic governance in a country can be

improved if corporations play their vigorous role to ensure good corporate governance practices.

10.2 Findings of Proposition 1

10.2.1 State of Corporate Governance in the Govt-Owned Firms

Results of this model are supportive of this notion. Corporate governance practices are

deteriorating in case of government-owned firms as they raise their salaries and other perquisites

for nothing. Positive coefficient of this dummy variable illustrates that CEOs of government-

owned firms are responsible for the worsening conditions of governance within the firms. CEOs

in the government-owned firms are generally politically elected. They have political links

outside the firm and this is the reason they enjoy a freedom to take decisions which are not in the

149

interest of widespread shareholders of the firm. Because of political linkages of CEOs of

government-owned firms, their remunerations are not linked with the performance of the firm.

Since performance of market share is not a deciding factor to set their remunerations, they show

their lack of motivation to perform their duties in the best interest of shareholders.

10.2.2 Role of Ownership Concentration

Ownership concentration further worsens the governance state in a firm. The goal of

value maximization of a corporation becomes hard to achieve in case of concentrated ownership.

Result of this variable is supportive of this reality.

10.2.3 Effects of Capital

The choice of a target capital structure, maturity of debt and type of financing leads a

firm to make capital structure decisions. Actual size of debt and equity may vary over the time

period, but the objective of meeting the average target capital structure is met. A high levered

firm is more inclined to reduce its expenditures because of high amount of interest payments.

Among others, salaries and other benefits are included in these expenditures. Sometimes, firms

do not opt for the option of debt rather go for either equity issue or retained earnings. Negative

coefficient of capital (LOGCAP) suggests that a firm has to increase salary and benefits of

directors in order to manage the financial resources of firms. There is no target level of capital

structure in the energy sector of Pakistan as the CEOs are interested in their remunerations which

is not based on firms’ performance.

10.2.4 Distribution of Assets and Corporate Governance

150

Firms in the energy sector do not rely on employed capital but heavily depend on current

assets. As the CEOs of firms are interested in the raise of their salaries and personal expenses,

they heavily relay on investment in current assets rather than fixed assets. Current assets can

easily be converted into personal use. If heavy investment is made in fixed assets, this bad

corporate governance practices may be stopped.


Pakistan has been facing the dilemma of circularity debt for many years. It arises when

one party in the payment chain holds the payment of other and it goes on till the end of the

payment chain. One party has to receive its receivables and the second one has to pay its

obligations. As shown in table 1.4, receivables are more than payables, showing evidence that it

is not a finance issue but a governance one.

10.3.1 Mitigation of Circularity Debt through Corporate Governance

Second proposition states that liquidity crunch in terms of circularity debt can be

vanished or even minimized if the corporate governance state is good. Therefore, predicted

values of corporate governance, in the derivation of second proposition is used as an explanatory

variable alongwith some other variables. Results indicate that as the state of corporate

governance becomes worsened, liquidity problem arose. As already discussed in the first

proposition above, directors are more inclined towards raising their salaries and other fringe

benefits and do not strive to manage the liquidity position of the company. In other words, they

are not at risk of losing their remuneration as it is not based on the firm performance.

10.3.2 Leverage Effects

151

Result of LTD does not follow either pecking order or free cash flow theory. It may be

deduced here that firms do not invest this long term debt, as evidenced in the derivation of first

proposition. Heavy amount of investment in current assets lead to this conclusion that firms in

the energy sector of Pakistan use leverage not for investment purposes but to increase the salaries

and other personal expenses of directors as an additional agency cost.

10.3.3 Cash Generation and Liquidity Problem

One can presume that positive cash flow can be managed in a manner that a firm should

not face accumulation of short term debt. Surprising result is found of cash flow to noncash

assets. Positive coefficient of this variable indicates that firms fulfill the working capital

requirements to meet day to day business activities, showing the trend of pecking order theory.

This cash in not used to pay off the liabilities.

10.3.4 Negative Effects of Corporate Assets

Furthermore, investment decisions negatively affect the liquidity of a firm as expected. It

means that firms do invest in the plant and machinery but the magnitude is not as large as of

distribution of assets in the first proposition.

10.3.5 Sales as a Driver of Circularity Debt

Since sales are made on credit, it creates receivables. This receivable further accumulates

circularity debt as the other party does not pay it. Increasing the debt level in the capital structure

brings the firm in a place of bankruptcy which hurts sales. This, in turn, reduces the net profit

152

after tax. It appears that firms in the energy sector of Pakistan are not at the verge of bankruptcy.

This is also evidenced by the fact that CEOs are more interested to increase their salaries and

other fringe benefits which are possible when firms have a huge amount of cash flows.

Bankruptcy reduces this wastage of cash flows which increase FCF.


10.4.1 Predicted Liquidity

According to the third proposition, retained earnings are the function of better liquidity

management of a corporation. It must be noted here that liquidity itself is a function of some

explanatory and exogenous variables derived from the previous two propositions. On one hand,

credit sales increase receivables which ultimately transform into circularity debt, on the other

hand it augment the possibility of increased liquidity in a firm. As can be seen in the second

proposition, firms do not face liquidity crunch because they generate positive cash flow from

operations.

10.4.2 Profitability (ROE)

Both of the explanatory variables i.e. liquidity and profitability show significant and

positive impact on retained earnings.


Finally, it is argued that GFCF is a function of corporate savings which is the ultimate

objective of this dissertation. Both lags of the corporate savings show positive impact on GFCF.

Successful and sustained economic growth has been witnessed in case of East Asian countries,

including Japan, after the World War II. These counties have achieved high rates of savings and

153

investments and it happed due to outsized private corporate savings and investments. Particularly

Japanese firms enjoyed higher profits and hence high investment due the policy of low dividend

payout ratio (Singh, 1998).

Results are supportive of this premise that total investment in a country may be enhanced by

raising corporate savings.

CHAPTER 11

CONCLUSION AND RECOMMENDATIONS

11.1 Conclusion

The present research is a blend of economic governance and development financing. It

develops a theorem, identifying antecedent variables which can better expound the given

phenomenon. It has now come into the fact that investment position in a country can be

improved if corporate sector plays its rigorous role to convert its earnings into investment. It was

deduced from the theorem which states that the state of corporate governance must be improved

154

in order to minimize the circularity debt problem which is really a governance issue. Resolution

of this issue will lead the corporate sector to raise their liquidity and profitability as well.

Government must focus on the issue of circularity debt from the governance point of view rather

from the perspective of finance.

CEOs of corporate sector are not aligned with the objective of shareholders and they raise their

salaries and other perquisites in the form of salary and other personal expenses. This constitutes a

bad governance state which further enhances the issue of circularity debt. Therefore, attention

must be diverted towards improving the governance state of the corporate sector in order to

match the objectives of shareholders with the agents.

11.2 Recommendations

Followings are some point wise recommendations to policy makers.

Economic governance is the key to improve the economic situation of a county and must

be readdressed with respect to the corporate governance, especially in government owned

firms.

Earnings of a firm must be converted into fixed investment in plant and machinery in

order to grow in future. Investment in current assets will allow CEOs to enjoy freedom of

using this money in their own favor.

The problem of circularity debt is not an issue of finance rather a governance one.

Government must take actions to emphasize this area in order to get rid of this dilemma.

Agency costs must be minimized which exists in the form of personal expenses of CEOs

of corporations.

155

The compensation policy must be designed in a manner that it is based on firms’

performance. This will lead a CEO to take decisions which are in the best interest of

shareholders.

Although, dividend is good in the eyes of an investor, emphasize must be made towards

increasing the corporate savings in order to enjoy better earnings in times to come.

Government is responsible to create a business environment where transparent

management of public finance becomes possible at the national level.

In case the government regulation is not efficient, rules of conduct for the private sector

are desired. Particularly, improving the corporate social responsibility and relevance of

corporate governance is needed.

All power generation companies (GENCOs), the national transmission and dispatch

companies (NTDCs) and power distribution companies (DISCOs) are managed and run

by the Pakistan Electric and Power Company (PEPCO). It is a core entity in the power

sector but its audited accounts are not available to a common man. There is a need to

form it as a corporation in order to get more useful data of the energy sector of Pakistan.

Similarly, water and power development authority (WAPDA) is a key player in power

generation but its audited accounts are not publicly available. There is a need that it must

be formed as a corporation so that its financial statements become available.

11.3 Future Research

Since economic governance is a widespread topic, future research may be conducted

while covering other areas which have not been taken up in this dissertation. Researchers are

suggested to take other sector of the economy as the current dissertation only took energy sector.

156

Economic governance also includes participation, transparency, credibility, rule of law,

efficiency and accountability which must be explored in a developing country like Pakistan.

It was not the objective of the study but it is suggested that future research may be conducted by

the taking the span of an elected government as an explanatory variable to examine the economic

governance of a country. A short span of time is given to any elected government in which long

term objectives of economic governance are not achieved.

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Appendix A

List of Companies

Attock Petroleum Limited

Attock Refinery Limited

Altern Energy Limited

BYCO Petroleum Limited

Ideal Energy Limited

Japan Power Generation Limited

Karachi Electric Supply Limited

Kohinoor Energy Limited

173

Kohinoor Power Company Limited

Kot Adu Power Company Limited

Mari Gas Company Limited

National Refinery Limited

Nishat Chunain Power Company Limited

Oil & Gas Development Corporation

Pakistan International Airline

Pakistan Oilfield Limited

Pakistan Petroleum Limited

Pakistan Refinery Limited

Pakistan State Oil Company Limited

S.G. Power Company

Sitara Energy Limited

Shell Pakistan Limited

Southern Electric Power Company Limited

Sui Northern Gas Company Limited

Sui Southern Gas Company Limited

The Hub Power Company Limited

174

Appendix B

Result Output (Proposition 1)

Descriptive Statistics

Mean Std. Deviation N

LOGCG -.052466 .5636108 167

TYPE OF ORGANIZATION .41 .493 167

CONCENTRATION OF

OWNERS

7.423338 16.4881571 167

LOG OF CAPITAL 7.0515 .68123 167

CURRENT ASSETS/FIXED

ASSETS

99.4167 12.45824 167

Correlations

LOGCG

TYPE OF

ORGANIZATION

CONCENTRATION

OF OWNERS LOG OF CAPITAL

CURRENT

ASSETS/FIXED

ASSETS

175

Pearson Correlation LOGCG 1.000 .231 -.386 .057 .398

TYPE OF ORGANIZATION .231 1.000 -.368 .517 .118

CONCENTRATION OF OWNERS -.386 -.368 1.000 -.433 -.151

LOG OF CAPITAL .057 .517 -.433 1.000 .007


ASSETS

.398 .118 -.151 .007 1.000

Sig. (1-tailed) LOGCG . .001 .000 .231 .000

TYPE OF ORGANIZATION .001 . .000 .000 .065

CONCENTRATION OF OWNERS .000 .000 . .000 .026

LOG OF CAPITAL .231 .000 .000 . .463


ASSETS

.000 .065 .026 .463 .

N LOGCG 167 167 167 167 167

TYPE OF ORGANIZATION 167 167 167 167 167

CONCENTRATION OF OWNERS 167 167 167 167 167

LOG OF CAPITAL 167 167 167 167 167


ASSETS

167 167 167 167 167

Model Summary

Model R R Square

Adjusted R

Square

Std. Error of the

Estimate

Change Statistics

R Square

Change F Change df1 df2 Sig. F Change

1 .542a .294 .276 .4794974 .294 16.837 4 162 .000

a. Predictors: (Constant), CURRENT ASSETS/FIXED ASSETS, LOG OF CAPITAL, CONCENTRATION OF OWNERS, TYPE OF

ORGANIZATION

ANOVAb

Model Sum of Squares df Mean Square F Sig.

1 Regression 15.484 4 3.871 16.837 .000a

Residual 37.247 162 .230

Total 52.731 166

a. Predictors: (Constant), CURRENT ASSETS/FIXED ASSETS, LOG OF CAPITAL,

CONCENTRATION OF OWNERS, TYPE OF ORGANIZATION

b. Dependent Variable: LOGCG

Coefficientsa

176

Model

Unstandardized Coefficients

Standardized

Coefficients

t Sig. B Std. Error Beta

1 (Constant) -.462 .584 -.791 .430

TYPE OF ORGANIZATION .175 .090 .153 1.941 .054

CONCENTRATION OF

OWNERS

-.012 .003 -.357 -4.744 .000

LOG OF CAPITAL -.148 .067 -.179 -2.200 .029


ASSETS

.015 .003 .328 4.868 .000

a. Dependent Variable: LOGCG

Residuals Statisticsa

Minimum Maximum Mean Std. Deviation N

Predicted Value -1.446183 .517814 -.052466 .3054172 167

Std. Predicted Value -4.563 1.867 .000 1.000 167

Standard Error of Predicted

Value

.049 .251 .079 .027 167

Adjusted Predicted Value -1.037994 .499098 -.049384 .2960008 167

Residual -1.6749824 1.8099575 .0000000 .4736851 167

Std. Residual -3.493 3.775 .000 .988 167

Stud. Residual -3.532 3.849 -.003 1.007 167

Deleted Residual -1.7128658 1.8820673 -.0030822 .4930066 167

Stud. Deleted Residual -3.666 4.026 -.002 1.021 167

Mahal. Distance .723 44.638 3.976 4.541 167

Cook's Distance .000 .527 .009 .042 167

Centered Leverage Value .004 .269 .024 .027 167

a. Dependent Variable: LOGCG

180

Appendix C


Logistic Regression

Dependent Variable Encoding

Original Value Internal Value

.00 0

1.00 1

Block 0: Beginning Block

Classification Tablea,b

Observed

Predicted

CIRCULARITY DEBT Percentage

Correct .00 1.00

Step 0 CIRCULARITY DEBT .00 126 0 100.0

1.00 42 0 .0

Overall Percentage 75.0

a. Constant is included in the model.

b. The cut value is .500

Variables in the Equation

B S.E. Wald df Sig. Exp(B)

Step 0 Constant -1.099 .178 38.019 1 .000 .333

Variables not in the Equation

Score df Sig.

Step 0 Variables PREDCG 1.148 1 .284

LOGLTD 34.717 1 .000

CFNTAST .748 1 .387

CAPEXNTAST .403 1 .525

LOGSALES 32.887 1 .000

Overall Statistics 47.004 5 .000

Block 1: Method = Enter

181

Omnibus Tests of Model Coefficients

Chi-square df Sig.

Step 1 Step 103.436 5 .000

Block 103.436 5 .000

Model 103.436 5 .000

Model Summary

Step -2 Log likelihood

Cox & Snell R

Square

Nagelkerke R

Square

1 85.509a .460 .681

a. Estimation terminated at iteration number 9 because parameter

estimates changed by less than .001.

Hosmer and Lemeshow Test

Step Chi-square df Sig.

1 2.829 8 .945

Classification Tablea

Observed

Predicted

CIRCULARITY DEBT Percentage

Correct .00 1.00

Step 1 CIRCULARITY DEBT .00 117 9 92.9

1.00 10 32 76.2

Overall Percentage 88.7

a. The cut value is .500

Variables in the Equation

B S.E. Wald df Sig. Exp(B)

Step 1a PREDCG -2.547 1.294 3.877 1 .049 .078

LOGLTD 1.845 .464 15.799 1 .000 6.325

CFNTAST .041 .016 6.736 1 .009 1.042

CAPEXNTAST -.014 .008 3.628 1 .057 .986

LOGSALES 4.201 .952 19.490 1 .000 66.766

Constant -45.893 8.291 30.638 1 .000 .000

a. Variable(s) entered on step 1: PREDCG, LOGLTD, CFNTAST, CAPEXNTAST, LOGSALES.

182

Step number: 1

Observed Groups and Predicted Probabilities

80 +

+

|

|

|

|

F |

|

R 60 +0

+

E |0

|

Q |0

|

U |0

|

E 40 +0

+

N |0

|

C |0

|

Y |0

|

20 +0

+

|0

|

|0

|

|000 00 1 1 0 1

1 1 |

Predicted ---------+---------+---------+---------+---------+---------+-------

--+---------+---------+----------

Prob: 0 .1 .2 .3 .4 .5 .6

.7 .8 .9 1

Group:

00000000000000000000000000000000000000000000000000111111111111111111111111111

11111111111111111111111

Predicted Probability is of Membership for 1.00

The Cut Value is .50

Symbols: 0 - .00

1 - 1.00

Each Symbol Represents 5 Cases.

/MISSING=PAIRWISE.

Correlations

183



PREDCG -.090392 .3435686 176

LOG OF LTD 6.0047 1.45188 177

CASH FLOW TO NET ASSETS 11.425722 29.9428504 180

CAP EXP TO NET ASSETS 146.962778 966.9405280 180

LOG OF SALES 7.3504 .96195 175

CIRCULARITY DEBT .2308 .42249 182

Correlations

PREDCG LOG OF LTD

CASH FLOW TO NET

ASSETS CAP EXP TO NET ASSETS LOG OF SALES CIRCULARITY DEBT

PREDCG Pearson

Correlation

1 .120 .186* -.234** .580** .090

Sig. (2-tailed)

.116 .014 .002 .000 .235

N 176 173 176 176 171 176

LOG OF LTD Pearson

Correlation

.120 1 .055 -.131 .515** .451**

Sig. (2-tailed) .116

.468 .081 .000 .000

N 173 177 177 177 172 177

CASH FLOW TO NET ASSETS Pearson

Correlation

.186* .055 1 .015 .083 .075

Sig. (2-tailed) .014 .468

.842 .274 .320

N 176 177 180 180 175 180

CAP EXP TO NET ASSETS Pearson

Correlation

-.234** -.131 .015 1 -.190* -.045

Sig. (2-tailed) .002 .081 .842

.012 .544

N 176 177 180 180 175 180

LOG OF SALES Pearson

Correlation

.580** .515** .083 -.190* 1 .430**

Sig. (2-tailed) .000 .000 .274 .012

.000

N 171 172 175 175 175 175

CIRCULARITY DEBT Pearson

Correlation

.090 .451** .075 -.045 .430** 1

Sig. (2-tailed) .235 .000 .320 .544 .000

N 176 177 180 180 175 182

*. Correlation is significant at the 0.05 level (2-tailed).

**. Correlation is significant at the 0.01 level (2-tailed).

184

Appendix D


Regression



LOG RETAINED EARNINGS 5.9146 .91537 114

LIQUIDITY FROM MODEL 2 .266181 .3362549 114

RETURN ON EQUITY 34.1135 26.51258 114

Correlations

LOG RETAINED

EARNINGS

LIQUIDITY FROM

MODEL 2

RETURN ON

EQUITY

185

Pearson Correlation LOG RETAINED EARNINGS 1.000 .509 .653

LIQUIDITY FROM MODEL 2 .509 1.000 .216

RETURN ON EQUITY .653 .216 1.000

Sig. (1-tailed) LOG RETAINED EARNINGS . .000 .000

LIQUIDITY FROM MODEL 2 .000 . .011

RETURN ON EQUITY .000 .011 .

N LOG RETAINED EARNINGS 114 114 114

LIQUIDITY FROM MODEL 2 114 114 114

RETURN ON EQUITY 114 114 114

Variables Entered/Removed

Model Variables Entered

Variables

Removed Method

1 RETURN ON

EQUITY,

LIQUIDITY FROM

MODEL 2

. Enter

a. All requested variables entered.

Model Summaryb

Model R R Square

Adjusted R

Square

Std. Error of the

Estimate

1 .754a .569 .561 .60668

a. Predictors: (Constant), RETURN ON EQUITY, LIQUIDITY FROM MODEL 2

b. Dependent Variable: LOG RETAINED EARNINGS

ANOVAb


1 Regression 53.828 2 26.914 73.124 .000a

Residual 40.854 111 .368

Total 94.682 113

a. Predictors: (Constant), RETURN ON EQUITY, LIQUIDITY FROM MODEL 2

b. Dependent Variable: LOG RETAINED EARNINGS

Coefficientsa

186

Model


Standardized

Coefficients

t Sig.

Collinearity Statistics

B Std. Error Beta Tolerance VIF

1 (Constant) 4.964 .098 50.865 .000

LIQUIDITY FROM MODEL 2 1.051 .174 .386 6.044 .000 .953 1.049

RETURN ON EQUITY .020 .002 .570 8.924 .000 .953 1.049

a. Dependent Variable: LOG RETAINED EARNINGS

Collinearity Diagnosticsa

Model Dimension Eigenvalue Condition Index

Variance Proportions

(Constant)

LIQUIDITY FROM

MODEL 2

RETURN ON

EQUITY

1 1 2.343 1.000 .05 .07 .05

2 .449 2.285 .08 .92 .15

3 .208 3.356 .86 .01 .80




Predicted Value 4.9009 7.5521 5.9146 .69018 114

Residual -1.89751 1.94406 .00000 .60129 114

Std. Predicted Value -1.469 2.372 .000 1.000 114

Std. Residual -3.128 3.204 .000 .991 114


Charts

187

Appendix E


Regression



GCF2 5.6570E11 6.89233E11 36

LAGRETEAR 1.0034E10 2.47245E10 36

Correlations

188

GCF2 LAGRETEAR

Pearson Correlation GCF2 1.000 .631

LAGRETEAR .631 1.000

Sig. (1-tailed) GCF2 . .000

LAGRETEAR .000 .

N GCF2 36 36

LAGRETEAR 36 36

Variables Entered/Removedb


Variables

Removed Method

1 LAGRETEARa . Enter


b. Dependent Variable: GCF2

Model Summaryb

Model R R Square

Adjusted R

Square

Std. Error of the

Estimate Durbin-Watson

1 .631a .399 .381 5.42274E11 .508

a. Predictors: (Constant), LAGRETEAR


ANOVAb


1 Regression 6.628E24 1 6.628E24 22.541 .000a

Residual 9.998E24 34 2.941E23

Total 1.663E25 35



Coefficientsa

Model


Standardized

Coefficients


1 (Constant) 3.891E11 9.773E10 3.981 .000

LAGRETEAR 17.601 3.707 .631 4.748 .000

a. Dependent Variable: GCF2


189


Predicted Value 1.7543E11 2.0603E12 5.6570E11 4.35182E11 36

Residual -3.67690E11 1.70440E12 -.00006 5.34471E11 36

Std. Predicted Value -.897 3.435 .000 1.000 36

Std. Residual -.678 3.143 .000 .986 36


Regression



GCF3 5.8121E11 6.92890E11 35

LAGRETEAR 7.6076E9 2.02765E10 35

Correlations

GCF3 LAGRETEAR

Pearson Correlation GCF3 1.000 .613

LAGRETEAR .613 1.000

Sig. (1-tailed) GCF3 . .000

LAGRETEAR .000 .

N GCF3 35 35

LAGRETEAR 35 35

Variables Entered/Removedb


Variables

Removed Method

1 LAGRETEARa . Enter



Model Summaryb

Model R R Square

Adjusted R

Square

Std. Error of the

Estimate Durbin-Watson

1 .613a .376 .357 5.55755E11 .350



ANOVAb


190

1 Regression 6.131E24 1 6.131E24 19.849 .000a

Residual 1.019E25 33 3.089E23

Total 1.632E25 34



Coefficientsa

Model


Standardized

Coefficients


1 (Constant) 4.219E11 1.005E11 4.197 .000

LAGRETEAR 20.942 4.701 .613 4.455 .000




Predicted Value 1.6767E11 2.1191E12 5.8121E11 4.24637E11 35

Residual -3.94663E11 1.69075E12 -.00002 5.47522E11 35

Std. Predicted Value -.974 3.622 .000 1.000 35

Std. Residual -.710 3.042 .000 .985 35


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