Outside board effect on firm value

The Effects of Outside Board on Firm Valuein the Emerging Market from thePerspective of Information TransactionCosts*

Sung Wook JohCollege of Business Administration, Seoul National University

Jin-Young Jung**Johnson Graduate School of Management, Cornell University

Received 31 August 2011; Accepted 11 January 2012

Abstract

This paper examines whether the problem of high information asymmetry lowers the positive

impact of board independence on firm value. Independent directors are outside directors

who have never had business and professional ties with the firm. We adopt various proxies

for information transaction costs from the market microstructure literature and traditional

measures, such as firm size, firm age, number of analyst reports, governance scores, credit

ratings, and institutional ownership, to see how they interact. Using data on publicly listed

firms and their directors between 1999 and 2006 in Korea, we find that independent directors

are correlated with higher corporate value when the firm has lower information transaction

costs. The results suggest that the monitoring role of independent directors is limited when

transferring firm-specific information is costly.

Keywords Information asymmetry; Outside directors; Market microstructure; Firm value;

Board independence

JEL Classification: G14, G32, G34, G38, K22

*Acknowledgments: We are grateful to Editor Jun-Koo Kang and three anonymous referees.

We are also grateful to the Institute of Banking and Finance, Hyuk Choe, and Cheol-Won

Yang for providing us with the data. We appreciate research grants from the Management

Research Center and Institute of Banking and Finance at Seoul National University. Any

remaining errors are entirely those of the authors.

**Corresponding author: Jin-Young Jung, Visiting Scholar of Finance, Research Associate of

Emerging Markets Institute, Johnson Graduate School of Management, Cornell University,

248 Sage Hall, Ithaca, NY 14853-6201, USA. Tel: +1-607-527-0612, Fax: +1-607-254-4590,

email: [email protected].

Asia-Pacific Journal of Financial Studies (2012) 41, 175–193 doi:10.1111/j.2041-6156.2012.01069.x

� 2012 Korean Securities Association 175

1. Introduction

While outside directors are there to monitor and supervise the management of the

firm to increase firm value and protect shareholder interests, there is no consistent

empirical relationship between outside directors and corporate performance. For

example, in the US, a higher share of outside directors improves monitoring of cor-

porate affairs (Hermalin and Weisbach, 2003), but it might lower firm performance

depending on the roles of the directors (Klein, 1998). With a few exceptions, most

analyses using data outside the US show a positive correlation between outside

directors and firm performance. There are positive effects of outside directors on

firm value in New Zealand (Hossain et al., 2001) and Korea (Choi et al., 2007;

Kim, 2007), while Vafeas and Theodorou (1998) do not find a significantly positive

relationship between the two for UK firms.

In this study, we argue that differences in the effects of outside directors on

firm value come from two sources: independence of outside directors and infor-

mation asymmetry within firms. While outside directors, unlike inside directors,

are understood as non-executive directors, some of them might engage in busi-

ness or professional activities associated with the firm. Outside directors with a

business or professional relationship with the firm might find it difficult to

maintain their independence. Classifying outside directors as independent or gray

directors, we examine whether the higher share of independent directors

increases firm value as the directors would engage in monitoring and supervising

a firm’s management.

We also argue that firm characteristics, such as the degree of information asym-

metry, matters to the effectiveness of outside directors. As Duchin et al. (2010)

argue, when information acquisition cost is high, outside directors are less effective

at monitoring than when it is low. To explore this foundational hypothesis in an

emerging market, we construct firm-specific proxies for information costs and esti-

mate how information costs affect the relationship between performance and board

independence. Using market microstructure-based information measures, our paper

mitigates the problems associated with various proxies that are correlated with firm

size, which is an important contribution to the stream of research on information

asymmetry and firm value.

As noted by Denis and McConnell (2003), board independence depends on sys-

tems and regulations specific to a given country, as well as firm characteristics and

financial conditions (Kaplan and Minton, 1994). We argue that firms with high

information asymmetry would bring in fewer independent directors and solicit less

monitoring from them because transferring firm-specific information to outsiders is

costly (Maug, 1997). Therefore, board independence increases when information

asymmetry costs are low because the costs and benefits of the board’s monitoring

roles are correlated with information asymmetry (Linck et al., 2008).

The purpose of this paper is to examine whether the effects of board indepen-

dence on firm value are different across various information environments in the

S. W. Joh and J.-Y. Jung

176 � 2012 Korean Securities Association

emerging markets by using more refined independence and information asymmetry

measures.

In our empirical analyses, independent outside directors are those who appear

to have no current or past ties with the firm at either a professional or business

level. In other words, independent outside directors are defined as those who have

not accepted any consulting fees from the firm as a lawyer or accountant, for exam-

ple, and have not been employed by the firm or by any subsidiary thereof.

We test how firms with high information transaction costs affect the impact of

board independence on firm value. We construct information transaction cost mea-

sures from several sources. One source is the market microstructure literature based

on the Glosten and Harris (1988) model, and the other is based on the Hasbrouck

(1991), Foster and Viswanathan (1993) (HFV) model. Conceptually, these measures

share the spirit of the Glosten and Milgrom (1985), under which information trans-

action costs widens bid-ask spread. In addition, we also examine how other tradi-

tional proxies for information transaction costs, such as firm size, firm age, the

number of analyst reports, governance scores, credit ratings, and institutional own-

ership, interact with board independence and affect the valuation effect of board

independence.

Our work has hand-collected information on outside directors appointed by all

listed non-financial firms in Korea between 1999 and 2006. We choose Korean firms

and their board directors for our test for a couple of reasons. First, Korean financial

markets are a good example to test for the effect of information transaction costs

on firm value as a representative emerging market vis-a-vis other developed mar-

kets. Hubbard and Palia (1999) choose the 1960s in the US to test for the motive

of internal capital market, arguing that the capital markets during the 1960s were

under-developed and the costs and benefits of information asymmetry risk were

more important. Second, Korean society places great emphasis on the effect of con-

nections in terms of firm activities (Jeon and Ahn, 2001; Kim, 2005; Siegel, 2007;

Johnson et al., 2009), making it possible to better examine the role of board inde-

pendence. Third, The Korean market has had a regulatory requirement regarding

the ratio of outside directors on boards as a key part of governance reform in 1997,

and information transaction costs have become even more important in the after-

math of the Asian financial crisis.

Some of the findings in the study are as follows. First, outside directors affect

firm value positively and significantly. Since board structure is endogenously deter-

mined by firm performance, we deal with this problem using two-stage least squares

(2SLS) regressions and fixed effect models. Our results are robust when endogeneity

issues are controlled for. We also find that independent outside directors who have

no professional or business ties with the firm generally increase firm value, while

gray outside directors who appear to have or have had professional or business ties

with the firm do not. This suggests that the valuation effect of board of directors

changes with board independence. Finally, we recognize that the valuation effects of

independent outside directors are more evident when information asymmetry is not

The Effects of Outside Board on Firm Value


so grave at the firm. Taken together, board independence and information transac-

tion costs are important factors that decide the valuation effect of boards.

The rest of the paper is organized as follows. In Section 2, we present a litera-

ture review and develop our hypotheses. We describe our data and the sample in

Section 3. In Section 4, we show the empirical design and the test results of our

hypotheses regarding the valuation effect of board independence. We provide con-

cluding remarks in Section 5.

2. Board Independence and Information Asymmetry

A board of directors is believed to serve as an internal watchdog for governance,

representing and protecting shareholders’ interests from management who may pur-

sue their own interests in modern corporations where ownership and management

are separated (Jensen and Meckling, 1976). It is also argued that independent

outside directors are crucial in determining the effectiveness of monitoring and

disciplining management (Choi et al., 2007).

Board independence alone, however, does not guarantee effective monitoring.

Maug (1997) argues that it is an optimal choice to give full control to management

when information is too costly for outside directors to acquire. On the other hand,

when information is not difficult to acquire, boards can intervene in the management

of the firm. Furthermore, Raheja (2005) argues that outside directors provide better

independent monitoring than insiders but are less informed about the firm. Thus, as

the benefits of monitoring increase, boards will do more monitoring leading to more

outsiders, while as the costs of monitoring increase, boards will do less monitoring

leading to fewer outsiders. Linck et al. (2008) shows that outside directors incur infor-

mation acquisition and processing costs in utilizing their expertise for the specific firm

for which they serve. As a proxy for information acquisition and processing costs,

Linck et al. use market-to-book (MTB) ratio, R&D expenditures, and the standard

deviation of monthly returns. The result suggests that board independence decreases if

information asymmetry is high. The aforementioned literature mentions that the ben-

efit of monitoring and the advisory role played by outside directors decreases with the

higher cost of acquiring and processing information.

Thus, based on the aforementioned theoretical and empirical works, we can

make a prediction that the valuation effect of board independence will decrease with

higher information transaction costs. To capture the information acquisition and

processing costs, we use two measures. One has grown out of the Glosten and Har-

ris (1988) model, and the other is based on the Hasbrouck (1991), Foster and

Viswanathan (1993) model in the market microstructure literature. These measures

are based on the price impact costs generated by private information and reflect the

spirit that information asymmetry widens the bid-ask spread (Glosten and Milgrom,

1985). We test to see how information transaction costs are related to the valuation

effect of board independence. Additionally, we examine whether firm characteristics,

such as firm size, firm age, analyst reports, institutional ownership, governance,



credit ratings, which all proxy for information acquisition and processing costs, are

linked to the valuation effect. We expect the low information transaction costs

encompassing all these characteristics to be positively related to the valuation

impact of board independence.

3. Sample Selection and Data

Our sample consists of all Korean firms listed between 1999 and 2006. From this

population, we select all non-financial firms that have data available on board com-

position and information transaction costs calculated using the GH and HFV mar-

ket microstructure models. Omitting financial and utility companies, we then

combine the information with annual financial data and monthly stock returns

from the FnDataguide.

Figure 1 presents the time series of the board composition of the sample. The

sample includes 3,927 firm-years from 1999 to 2006. Figure 1 shows that the ratio

of outside directors was only about 15% in 1999, when the Korean government

introduced the system of outside directors, and it surged thereafter, exceeding 30%

in 2006. We include all the sample data on the number of outside directors, while

we only include in the sample those independent or gray outside directors whose

personal background data is available. The ratio of independent outside directors is

the number of outside directors who do not participate in the management of the

firm at present or in the past, or who have no business or professional ties with a

firm, divided by the total board size.

Table 1 presents each sample firm’s descriptive statistics regarding key firm char-

acteristics, board, and information asymmetry variables. We use Tobin’s Q as a mea-

sure of corporate value, following earlier studies on corporate governance and

0

5

10

15

20

25

30

35

1999 2000 2001 2002 2003 2004 2005 2006

Rat

io (%

)

Year

Outside directors

Indep outside directors

Figure 1 Board Structure Trends: 1999–2006.

The sample includes 584 unique firms covering 3,927 firm-years over the period 1999–2006. Figure reports

the percentage of outside directors and independent outside directors. Outside directors is the ratio of

legally registered outside directors to board size. Independent outside directors (Indep outside directors) is

the ratio of outside directors who have no business or professional ties to a firm to board size.



Table 1 Descriptive statistics for sample firms 1999–2006

The sample is drawn from FnDataguide. Data related to board of director characteristics are taken from

Korea Listed Companies Association and KISLINE, a database maintained by Korea Investors Service,

Inc. (KIS) as well as database of people of JoongAng Ilbo. Data related to GH (HFV) are taken from

Trade and Quote (TAQ) database provided by the Institute of Banking and Finance at Seoul National

University (IFB ⁄ KSE database) from 1999 to 2004. Tobin’s Q is the ratio of the sum of the market value

of common equity, the book value of preferred equity, and the book value of long-term debt to the book

value of assets. Outside directors is the ratio of directors who are not employees of the company and

have no operational responsibilities within the company to board size. Independent outside directors

(Indep outside directors) is the ratio of outside directors who have no business or professional ties to a

firm to board size. GH or HFV is information transaction costs estimated by the Glosten and Harris

(1988) or Hasbrouck (1991)–Foster and Viswanathan (1993) models. Board size is the total number of

directors. Director age is the age of boards as of the year end. Largest ownership is the percentage share-

holding of the largest shareholder. CAPEX ⁄ assets is the ratio of capital expenditures to total assets.

Leverage is the ratio of total debt to total assets. Firm size is the natural logarithm of (total

assets ⁄ 1 000 000). Operating profitability is the ratio of earnings before interest and taxes (EBIT) to

beginning total assets. Chaebol dummy is a dummy variable to indicate whether a firm belongs to one of

the 50 largest chaebols. The Korea Fair Trade Commission updates the list of the 50 largest chaebols

annually. Market risk (beta) is the estimate from market model in which the firm’s monthly returns over

the last year are regressed on the KOSPI monthly returns. Analyst report is the natural logarithm of total

number of analyst reports in the year. Credit rating dummy for companies with credit ratings for CPs or

corporate bonds is set as ‘‘1’’, and for companies without credit ratings for CPs or corporate bonds is set

as ‘‘0’’. Firm age is the natural logarithm of the firm’s age. Institutional ownership is the fraction of

shares owned by institutions. Governance is the natural logarithm of total Korean corporate governance

index (KCGI) which consists of four sub-indices: Shareholder Rights, Disclosure, Audit Committees, and

Ownership Parity (excluding Board structure index) between 2002 and 2006.

Variable

First

quartile Mean Median

Third

quartile

Standard

deviation

Sample

size

Tobin’s Q 0.321 0.601 0.469 0.702 0.515 3,927

Outside directors 0.020 0.241 0.222 0.300 0.154 3,927

Indep outside directors 0.000 0.186 0.204 0.250 0.152 3,927

GH 0.001 0.016 0.005 0.018 0.343 2,719

HFV 0.001 0.025 0.005 0.018 0.229 2,719

Board size 5.000 8.282 7.000 9.000 7.063 3,927

Director age 51.91 54.44 54.89 57.76 5.379 3,927

Largest ownership 0.199 0.324 0.309 0.442 0.176 3,927

CAPEX ⁄ assets 0.007 0.042 0.026 0.063 0.314 3,927

Leverage 0.354 0.519 0.499 0.645 0.255 3,927

Firm size 4.463 5.503 5.276 6.302 1.481 3,927

Operating profitability 0.007 0.023 0.034 0.068 0.141 3,927

Chaebol dummy 0.000 0.188 0.000 0.000 0.391 3,927

Market risk (beta) 0.438 0.709 0.720 1.004 0.371 3,927

Analyst report 0.000 2.901 0.000 2.000 5.588 3,927

Credit rating dummy 0.000 0.243 0.000 0.000 0.434 3,927

Firm age 3.099 3.324 3.399 3.670 0.567 3,927

Institutional ownership 0.082 0.258 0.199 0.383 0.215 2,860

Governance 4.575 4.704 4.691 4.804 0.209 2,218



performance issues by Morck et al. (1988). Tobin’s Q is the ratio of the sum of the

market value of common equity, the book value of preferred equity, and the book

value of long-term debt to the book value of assets.1 The mean value of Tobin’s Q is

0.601. The average ratio of outside directors is 0.241, which includes 0.186 for the ratio

of independent directors. GH and HFV measures are proxies for information transac-

tion costs. We use the Trade and Quote (TAQ) database compiled by the Korea Stock

Exchange and prepared by the Institute of Banking and Finance at Seoul National

University (IFB ⁄ KSE database) to measure GH and HFV variables. We confine the

data sample for GH and HFV to that of the year 2004 due to data availability. The

mean values of the information transaction costs for the sample firms are 0.016 for

GH and 0.025 for HFV. A high value of GH or HFV variable implies that directors

have to incur a high cost when acquiring information on the firm.

Table 2 shows the results of the correlation analysis among the information

asymmetry variables, Tobin’s Q, and board independence.

The results of this analysis suggest the possibility that multicollinearity may

affect the results of regression analyses since variables, or proxies for information

asymmetry, such as credit ratings, analyst reports, institutional ownership, and firm

age, are highly correlated with firm size. To segregate these effects, we include two

commonly used benchmarks for information transaction costs (GH and HFV mea-

sures) in the market microstructure literature which are unrelated to firm size. Choe

and Yang (2006) argue for the effectiveness of GH and HFV measures by regressing

each information asymmetry measure on various firm characteristic variables that

are likely to be related to the information asymmetry risk of a firm, i.e., firm size,

BE ⁄ ME, turnover, residual volatility, and analyst coverage.

4. Empirical Design and Results

To analyze how information transaction costs impact the valuation effect of board

independence, we first examine whether board independence affects firm value.

Then we carry out regression analyses using the interaction terms between board

independence and the information transaction costs derived from market micro-

structure models. We then interact board independence with other firm characteris-

tics related to firms’ information transaction costs for a robustness check.

4.1. Measuring the Degree of Information Transaction Costs

To determine how information environments influence the valuation effect of board

independence, we use several measures of information transaction costs. Traditional

measures, such as firm size, firm age, number of analyst reports, governance scores,

credit ratings, and institutional ownership, are obtained from financial and non-

1Additionally, we measured Tobin’s Q using a different method, which Chung and Pruitt

(1994) presented, and the results are consistent with the results of our study.



Tab

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financial corporate characteristics. Market microstructure variables are based on the

GH and HFV models. Using information on price, quote, and spread, Glosten and

Harris (1988) empirically divide the bid-ask spread into permanent components

related to information asymmetry cost and temporary components related to order

processing cost, inventory cost, etc. We follow the method of Chae et al. (2011).

This method can be explained as follows:

mt ¼ mt�1 þ k1Vt þ et

Pt ¼ mt þ w1Qt

DPt ¼ k1Vt þ w1ðQt � Qt�1Þ þ et ,

ð1Þ

where:

mt = expected value of a stock under information of time t

k1 = information transaction costs with permanent effect

Vt = signed trading volume at time t indicated as trade direction (+ if it is a

buyer initiated trading, ) if it is a seller-initiated trading)

k1Vt = price impact by private information

et = a signal of public information

Pt = trade price of a stock at time t

w1 = temporary component of information transaction costs reflecting order

processing cost, etc.

Qt = an indicator variable as trade direction (+ if it is a buyer initiated

trading, ) if it is a seller-initiated trading).

Hasbrouck (1991) and Foster and Viswanathan (1993) consider the effects over

time. Their variable has been modified by Brennan and Subrahmanyam (1996).

Hasbrouck (1991) uses a vector autoregression (VAR) model to estimate the unpre-

dictable component of order flows, which is considered to be a portion of private

information as follows.

Vt ¼ aq þX5

i¼1

biDPt�i þX5

i¼1

ciVt�i þ st

DPt ¼ ap þ w2DQt þ k2st þ et

ð2Þ

where:

Vt = signed trading volume at time t indicated as trade direction (+ if it is a

buyer initiated trading, ) if it is a seller-initiated trading)

DPt = change in trade price

st = a proxy for private information

w2 = temporary component of information transaction costs reflecting order

processing cost, etc.

DQt = change in an indicator variable as trade direction (+ if it is buyer initi-

ated trading, ) if it is seller-initiated trading)

k2 = information transaction costs with permanent effect.



Thus, we use the information transaction costs with the permanent effect, k1

(GH) and k2 (HFV), as proxies for information asymmetry risk. Thus, a high value

of GH or HFV measure indicates a high risk of information asymmetry.

4.2. Measuring the Degree of Board Independence

We limit the sample of directors to those who are legally registered and divide them

into insiders and outsiders based on their legal positions. Weisbach (1988) defines

independent directors as those who may be independent of current management

because of no extensive business dealings with the company or family relationships

with management. Choi et al. (2007) define independent outside directors as those

with no current or potential business ties with the firms in question. They define

gray outside directors as those who appear to have business ties with the firms by

virtue of their professions, e.g., lawyers, accountants, consultants, or bank execu-

tives. For our study, we take the definition of independent outside directors one

step further from that of Choi et al. We consider both professional and business ties

with top managers (e.g. CEOs) or owners (controlling shareholders) as well as work

experience in the firm or the firm’s affiliates. In other words, in line with the defini-

tion of independence in the Sarbanes Oxley (SOX) Act (2002), we define indepen-

dent outside directors as those who have neither past nor current professional and

business ties (i.e. employees, consultants, lawyers, accountants) with the firm or its

affiliates. Nor will they have worked at the same job with the top manager (e.g.

CEO) or controlling shareholders of the firms.

We arrange independent outside directors using the hand-collected data avail-

able on individual work experience. We then use as a proxy for board independence

the ratio of the number of independent outside directors on the total number of

boards.

4.3. Valuation Effect of Board Independence

This section reports the results of the tests for our hypotheses on the valuation

effect of board independence. Our specifications are as follows:

Tobin0s Q ¼ aþ b1 (Board independence)þ b2 (Board size)

þ b3 (Boards average ageÞ þ b4 (Largest ownership)

þ b5 (CAPEX/assets)þ b6 (Leverage)þ b7 (Firm size)

þ b8 (Operating profitability)þ b9 (Chaebol dummy)

þ b10 (Market risk)þ b11 (Industry dummy)þ b12 (Year dummy)

ð3Þ

Panel A in Table 3 presents the annual trend of information transaction costs

based on the market microstructure model. The trend tells us that GH and HFV

variables were virtually constant within the range of 0.02 and 0.04 during the



sample period of 1999–2004. Panel B in Table 3 reports the empirical relationship

between information transaction costs derived from the market microstructure

model and traditional informational measures, such as firm size, governance scores,

and credit ratings, in our 1999–2004 sample based on univariate tests. Panel B

shows how GH and HFV variables are related to the traditional measures. To show

that, we divide the entire sample into a large group and a small group, with median

being the basis, for firm size, governance, and credit ratings, and then calculated the

means of GH and HFV variables, and finally the t-values for the differences.

According to the results of the univariate analysis, GH and HFV variables did not

show significant differences between the group with bigger firm sizes and higher

Table 3 Characteristics of information transaction costs from market microstructure model

This table presents annual trends of information transaction costs from the market microstructure model

and the univariate analysis of information transaction costs between 1999 and 2004. GH or HFV is infor-

mation transaction costs estimated by the Glosten and Harris (1988) or Hasbrouck (1991)–Foster and

Viswanathan (1993) models. Panel A shows the annual trend of GH and HFV variables in the sample

period. Panel B presents the relations between GH and HFV variables and traditional informational mea-

sures, such as firm size, governance score, and credit ratings, based on univariate tests. The t-statistic of

differences between large group and small group of each traditional variable are reported in the table.

Firm size is the natural logarithm of (total assets ⁄ 1 000 000). Governance score is the natural logarithm

of total Korean corporate governance index (KCGI) which consists of four sub-indices: Shareholder

Rights, Disclosure, Audit Committees, and Ownership Parity (excluding Board structure index) between

2002 and 2004. Credit rating score is the credit ratings given to CPs or corporate bonds. Level of signifi-

cance is indicated by ** for 5%.

Panel A: Annual trend of information transaction costs

0.00

0.01

0.02

0.03

0.04

0.05

0.06

0.07

0.08

1999 2000 2001 2002 2003 2004

GH

, HF

V

Year

GH

HFV

Panel B: Univariate analysis of relationship with traditional measures

Firm size Governance score Credit rating score

Large Small t-value High Low t-value High Low t-value

GH 0.022 0.033 )1.252 0.029 0.035 )0.326 0.007 0.049 )2.486**

HFV 0.023 0.032 )1.368 0.029 0.037 )0.436 0.007 0.047 )2.468**



governance scores and the group with smaller firm sizes and lower governance

scores. However, when it comes to credit ratings, the values of GH and HFV vari-

ables were higher for the firms with lower credit ratings.

Table 3 reports the results from the estimation of equation (3), showing

evidence that board independence (measured by the ratio of outside directors)

positively impacts firm performance (measured by Tobin’s Q). Hermalin and Weis-

bach (1991) suggest that board structure and firm performance are likely to be

endogenously determined. Our research design uses several approaches to address

this concern, as presented in Table 3.

4.4. 2SLS Models Controlling for Endogeneity Issues

To mitigate the endogeneity problem, we examine the robustness of our results after

including lagged values of our dependent variables (outside directors) and estimate

our models in a simultaneous equations framework, following the method

employed by Linck et al. (2008). In the regressions presented in Table 4, the coeffi-

cients of outside directors are all positive and significant, which does not alter their

valuation effect.

Regression (5) in Table 4 shows the results when we define board independence

more precisely with past career paths taken into account, and examine whether

there is a difference in positive impact. According to regression (5) in Table 4, this

positive impact is significant when outside directors are independent. Therefore, we

suggest that independent outside directors who have neither business nor profes-

sional ties with a firm have a strong valuation effect, proving that the independence

of outside directors is important in the emerging market, as emphasized by the

SOX Act of 2002.

4.5. Influence of Information Transaction Costs on the Valuation Effect of Board

Independence

Recently, there have been a few articles examining the tendency of firms with a high

information asymmetry risk to decrease board independence (Linck et al., 2008).

They argue that outside directors incur information acquisition and processing costs

while tailoring their general expertise for the specific firm they serve. They suggest

that board independence decreases with the cost of information acquisition and

processing. They use the MTB ratio, the level of R&D spending, and the standard

deviation of stock returns as the costs of information acquisition and processing,

following the method of Fama and Jensen (1983), and Gaver and Gaver (1993).

Since Linck et al. (2008) show that information asymmetry is negatively related to

board independence, we expect the valuation effect of board independence to be

negatively related to information asymmetry risk.

We use, as proxies for information transaction costs, two market micro-struc-

tural variables (GH, HFV) as well as the other firm characteristics used in existing

studies, i.e., firm size, firm age, analyst reports, institutional ownership, governance,

and credit ratings.



Tab

le4

Eff

ects

of

(in

dep

end

ent)

ou

tsid

ed

irec

tors

on

firm

valu

e

Th

ista

ble

pre

sen

tsli

nea

ro

rdin

ary

leas

t-sq

uar

esre

gres

sio

nan

alys

eso

fef

fect

so

f(i

nd

epen

den

t)o

uts

ide

dir

ecto

rso

nfi

rmva

lue

bet

wee

n19

99an

d20

06.

Th

ed

epen

den

t

vari

able

isT

ob

in’s

Q,

wh

ich

isth

era

tio

of

the

sum

of

the

mar

ket

valu

eo

fco

mm

on

equ

ity,

the

bo

ok

valu

eo

fp

refe

rred

equ

ity,

and

the

bo

ok

valu

eo

flo

ng-

term

deb

t

toth

eb

oo

kva

lue

of

asse

ts.

Ou

tsid

ed

irec

tors

isth

era

tio

of

lega

lly

regi

ster

edd

irec

tors

wh

oar

en

ot

emp

loye

eso

fth

eco

mp

any

and

hav

en

oo

per

atio

nal

resp

on

sib

ilit

ies

wit

hin

the

com

pan

yto

bo

ard

size

.In

dep

end

ent

ou

tsid

ed

irec

tors

(In

dep

ou

tsid

ed

irec

tors

)is

the

rati

oo

fo

uts

ide

dir

ecto

rsw

ho

hav

en

ob

usi

nes

so

rp

rofe

ssio

nal

ties

to

afi

rmto

bo

ard

size

,w

hen

con

sid

erin

gth

eir

pas

tca

reer

pat

hs.

Bo

ard

size

isth

en

atu

ral

loga

rith

mo

fto

tal

nu

mb

ero

fd

irec

tors

.D

irec

tor

age

isth

en

atu

ral

loga

rith

mo

f

the

age

aso

fth

eye

aren

d.

Lar

gest

ow

ner

ship

isth

ep

erce

nta

gesh

areh

old

ing

of

the

larg

est

shar

eho

lder

.C

AP

EX

⁄ass

ets

isth

era

tio

of

cap

ital

exp

end

itu

res

toto

tal

asse

ts.

Lev

erag

eis

the

rati

oo

fto

tal

deb

tto

tota

las

sets

.F

irm

size

isth

en

atu

ral

loga

rith

mo

f(t

ota

las

sets

⁄100

000

0).

Op

erat

ing

pro

fita

bil

ity

isth

era

tio

of

earn

ings

bef

ore

inte

rest

and

taxe

s(E

BIT

)to

beg

inn

ing

tota

las

sets

.C

hae

bo

ld

um

my

isa

du

mm

yva

riab

leto

ind

icat

ew

het

her

afi

rmb

elo

ngs

too

ne

of

the

50la

rges

tch

aeb

ols

.M

arke

t

risk

(bet

a)is

the

esti

mat

efr

om

mar

ket

mo

del

inw

hic

hth

efi

rm’s

mo

nth

lyre

turn

so

ver

the

last

year

are

regr

esse

do

nth

eK

OSP

Im

on

thly

retu

rns.

Reg

ress

ion

(1)

sho

ws

the

resu

lts

of

bas

icre

gres

sio

nan

dre

gres

sio

ns

(2)

and

(3)

sho

wfi

xed

effe

ctre

gres

sio

ns

of

firm

per

form

ance

and

ou

tsid

ed

irec

tors

.R

egre

ssio

ns

(4)

and

(5)

sho

wsi

mu

l-

tan

eou

seq

uat

ion

anal

ysis

of

firm

valu

ean

dth

era

tio

of

(in

dep

end

ent)

ou

tsid

ed

irec

tors

,u

sin

gth

etw

o-s

tage

leas

tsq

uar

esm

eth

od

.In

stru

men

tsin

clu

de

lagg

ed(i

nd

e-

pen

den

t)o

uts

ide

dir

ecto

rva

riab

le.

Stan

dar

der

rors

are

sho

wn

inp

aren

thes

esu

nd

erp

aram

eter

esti

mat

es.

Lev

els

of

sign

ifica

nce

are

ind

icat

edb

y**

*,**

,an

d*

for

1%,

5%,

and

10%

,re

spec

tive

ly.

Var

iab

le(1

)(2

)(3

)(4

)(5

)

Ou

tsid

ed

irec

tors

0.24

5***

(0.0

60)

0.09

2*(0

.056

)0.

141*

**(0

.052

)0.

400*

**(0

.108

)

Ind

epo

uts

ide

dir

ecto

rs0.

364*

**(0

.099

)

Bo

ard

size

)0.

009

(0.0

22)

)0.

001

(0.0

24)

)0.

009

(0.0

22)

0.02

8(0

.022

)0.

026

(0.0

22)

Dir

ecto

rag

e)

1.19

4***

(0.0

92)

)0.

781*

**(0

.130

))

1.20

0***

(0.0

92)

)1.

151*

**(0

.094

))

1.19

1***

(0.0

92)

Lar

gest

ow

ner

ship

)0.

001

(0.0

44)

0.01

9(0

.058

))

0.00

5(0

.044

)0.

009

(0.0

45)

0.00

4(0

.044

)

CA

PE

X⁄a

sset

s0.

001

(0.0

23)

)0.

003

(0.0

21)

0.00

1(0

.023

)0.

024

(0.0

25)

)0.

001

(0.0

23)

Lev

erag

e)

0.06

9(0

.036

)0.

078*

(0.0

46)

)0.

063*

(0.0

36)

)0.

090*

*(0

.038

))

0.07

4**

(0.0

36)

Fir

msi

ze0.

028*

**(0

.008

)0.

019

(0.0

16)

0.03

2***

(0.0

08)

0.02

4***

(0.0

09)

0.03

2***

(0.0

08)

Op

erat

ing

pro

fita

bil

ity

0.05

3(0

.057

)0.

158*

**(0

.055

)0.

051

(0.0

58)

)0.

008

(0.0

60)

0.05

0(0

.058

)

Ch

aeb

ol

du

mm

y0.

042*

(0.0

22)

0.10

2(0

.065

)0.

042*

(0.0

22)

0.03

9(0

.023

)0.

043*

(0.0

22)

Mar

ket

risk

(bet

a)0.

040*

(0.0

22)

)0.

017

(0.0

22)

0.04

0**

(0.0

23)

0.06

6***

(0.0

24)

0.04

1*(0

.023

)

Ind

ust

ryd

um

my

Yes

Yes

Yes

Yes

Yea

rd

um

my

Yes

Yes

Yes

Yes

Ind

ust

ryfi

xed

effe

cts

Yes

Yea

rfi

xed

effe

cts

Yes

Nu

mb

ero

ffi

rms

3,92

73,

927

3,92

73,

293

3,92

7

Ad

j.R

20.

239

0.57

80.

244

0.24

90.

247



In Table 5, we examine the relationship between the valuation effect of board

independence and information transaction costs derived from the market micro-

structure model. Our regressions include interaction terms between the outside

director ratio and the GH (HFV) measure. In regressions (1) and (2), the

Table 5 Valuation effect of board independence and information transaction costs

This table reports results from regressing firm value on board independence and various firm characteris-

tics from 1999 to 2004. The dependent variable is Tobin’s Q, which is the ratio of the sum of the market

value of common equity, the book value of preferred equity, and the book value of long-term debt to

the book value of assets. Outside directors is the ratio of directors who are not employees of the com-

pany and have no operational responsibilities within the company to board size. Independent outside

directors (Indep outside directors) is the ratio of outside directors who have no business or professional

ties to a firm to board size, when considering their past career paths. GH or HFV is information transac-

tion costs estimated by the Glosten and Harris (1988) or Hasbrouck (1991)–Foster and Viswanathan

(1993) models. See Table 4 for exact definitions of the variables. Industry dummies and Year dummies

are employed to control for industry compensation practices and economy-wide shocks. Standard errors

are shown in parentheses under parameter estimates. Levels of significance are indicated by ***, **, and

* for 1%, 5%, and 10%, respectively.

Variable (1) (2) (3) (4)

Outside directors 0.284*** (0.056) 0.286*** (0.055)

Indep outside

directors

0.233*** (0.053) 0.236*** (0.052)

Board size )0.014 (0.020) )0.014 (0.020) )0.015 (0.020) )0.015 (0.020)

Director age )0.897*** (0.093) )0.895*** (0.092) )0.892*** (0.093) )0.889*** (0.092)

Largest ownership )0.024 (0.043) )0.019 (0.043) )0.024 (0.043) )0.019 (0.043)

CAPEX ⁄ assets 0.009 (0.023) 0.008 (0.023) 0.009 (0.023) 0.008 (0.023)

Leverage )0.126*** (0.040) )0.130*** (0.039) )0.120*** (0.040) )0.124*** (0.039)

Firm size 0.029*** (0.007) 0.030*** (0.007) 0.032*** (0.007) 0.033*** (0.007)

Operating

profitability

0.300*** (0.067) 0.300*** (0.065) 0.302*** (0.067) 0.302*** (0.066)

Chaebol dummy 0.001 (0.021) )0.002 (0.021) 0.002 (0.022) 0.001 (0.021)

Market risk (beta) 0.054** (0.023) 0.054** (0.023) 0.058** (0.023) 0.058** (0.023)

GH 0.142*** (0.052) 0.151*** (0.051)

HFV 0.162*** (0.055) 0.179*** (0.055)

Outside

director · GH

)0.367 (0.223)

Outside

director · HFV

)0.444* (0.234)

Indep outside

director · GH

)0.556** (0.286)

Indep outside

director · HFV

)0.688*** (0.288)

Industry dummy Yes Yes Yes Yes

Year dummy Yes Yes Yes Yes

Number of firms 2,719 2,719 2,719 2,719

Adj. R2 0.238 0.236 0.236 0.235



coefficients of the interaction terms are not significant for the GH measure and

marginally significant for the HFV measure. However, if we change the variable

from an outside director to independent outside directors, the results turn more

significant. Regressions (3) and (4) in Table 5 show the analysis results using the

interaction term between the GH (HFV) measure and board independence, using

our refined board independence measure (refer to 4.2.), which takes professional-

or business-level independence into consideration.

In columns (3) and (4), independent outside directors have a more positive val-

uation effect with low information transaction costs. This is consistent with our

hypotheses, according to which board independence is less effective for monitoring

when it is costly for independent outsiders to acquire information on the firm.

Therefore, we can predict that the valuation effects of independent boards with no

professional or business relationships with a firm, its affiliates, CEO, or controlling

shareholders may vary with a firm’s information transaction costs.

Consequently, the valuation effect of independent outside directors, i.e., an

increase in firm value, decreases under high information asymmetry because the

costs of tailoring information are high, while the valuation effect increases under

low information asymmetry because of increased benefits of tailoring information.

Using traditional measures of information transaction costs, Table 6 presents

the results of regressions using other conditions under which the firms’ information

environments change. The results on the effects of independent directors on firm

value are consistent with the results presented in Table 5. In other words, a large

firm with a long corporate history, more analyst reports, high credit ratings, large

institutional ownership, and good governance has more positive valuation effect of

board independence because it incurs lower information transaction costs, which

decreases the costs of monitoring and advisory activities. Therefore, our estimation

from Table 6 indicates that the association between the valuation effect of board

independence and information transaction costs is definite.

5. Conclusion

This paper examines the effects of independent outside directors on firm value from

the perspective of information transaction costs in Korea, one of the most promi-

nent emerging markets.

Our empirical results indicate that independent outside directors have a signifi-

cant and positive effect on firm value. We also find that the valuation effect of inde-

pendent outside directors varies with the degree of information asymmetry at a

firm. The higher a firm’s information asymmetry risk, the weaker the valuation

effect of board independence; the lower the information asymmetry risk, the stron-

ger the valuation effect.

We test for our hypothesis using information transaction cost measures from

various sources, including traditional measures and measures estimated by the mar-

ket microstructure model. We find that firms with low information transaction



Tab

le6

Var

iou

sfi

rmch

arac

teri

stic

san

dva

luat

ion

effe

cto

fb

oar

din

dep

end

ence

Th

ista

ble

rep

ort

sre

sult

sfr

om

regr

essi

ng

firm

valu

eo

nb

oar

din

dep

end

ence

and

vari

ou

sfi

rmch

arac

teri

stic

s.T

he

dep

end

ent

vari

able

isT

ob

in’s

Q,

wh

ich

isth

era

tio

of

the

sum

of

the

mar

ket

valu

eo

fco

mm

on

equ

ity,

the

bo

ok

valu

eo

fp

refe

rred

equ

ity,

and

the

bo

ok

valu

eo

flo

ng-

term

deb

tto

the

bo

ok

valu

eo

fas

sets

.In

dep

end

ent

ou

tsid

ed

irec

tors

(In

dep

ou

tsid

ed

irec

tors

)is

the

rati

oo

fo

uts

ide

dir

ecto

rsw

ho

hav

en

ob

usi

nes

so

rp

rofe

ssio

nal

ties

toa

firm

tob

oar

dsi

ze.

Inth

ere

gres

sio

n(1

),F

irm

size

isa

du

mm

yva

riab

leth

ateq

ual

s1

iffi

rmsi

zeis

larg

erth

anth

em

edia

no

fal

lsa

mp

lefi

rms.

Fir

mag

eis

the

nat

ura

llo

gari

thm

of

the

firm

’sag

e.A

nal

yst

rep

ort

is

the

nat

ura

llo

gari

thm

of

tota

ln

um

ber

of

anal

yst

rep

ort

sin

the

year

.C

red

itra

tin

gd

um

my

for

com

pan

ies

wit

hcr

edit

rati

ngs

for

CP

so

rco

rpo

rate

bo

nd

sis

set

as‘‘

1’’,

and

for

com

pan

ies

wit

ho

ut

cred

itra

tin

gsfo

rC

Ps

or

corp

ora

teb

on

ds

isse

tas

‘‘0’

’.In

stit

uti

on

alo

wn

ersh

ipis

the

frac

tio

no

fsh

ares

ow

ned

by

inst

itu

tio

ns.

Go

vern

ance

isth

en

atu

ral

loga

rith

mo

fto

tal

Ko

rean

corp

ora

tego

vern

ance

ind

ex(K

CG

I)w

hic

hco

nsi

sts

of

fou

rsu

b-i

nd

ices

:Sh

areh

old

erR

igh

ts,

Dis

clo

sure

,A

ud

itC

om

mit

tees

,an

d

Ow

ner

ship

Par

ity

(exc

lud

ing

Bo

ard

stru

ctu

rein

dex

)b

etw

een

2002

and

2006

.Se

eT

able

4fo

rex

act

defi

nit

ion

so

fth

eva

riab

les.

Ind

ust

ryd

um

mie

san

dY

ear

du

mm

ies

are

emp

loye

dto

con

tro

lfo

rin

du

stry

com

pen

sati

on

pra

ctic

esan

dec

on

om

y-w

ide

sho

cks.

Stan

dar

der

rors

are

sho

wn

inp

aren

thes

esu

nd

erp

aram

eter

esti

mat

es.

Lev

els

of

sign

ifica

nce

are

ind

icat

edb

y**

*,**

,an

d*

for

1%,

5%,

and

10%

,re

spec

tive

ly.

Var

iab

le(1

)(2

)(3

)(4

)(5

)(6

)

Ind

epo

uts

ide

dir

ecto

rs)

0.14

0(0

.095

)0.

069

(0.0

78)

0.00

2(0

.064

)0.

040

(0.0

70)

0.05

8(0

.089

)0.

033

(0.1

18)

Bo

ard

size

0.02

1(0

.020

)0.

002

(0.0

22)

)0.

002

(0.0

21)

)0.

001

(0.0

22)

)0.

006

(0.0

22)

0.08

3**

(0.0

33)

Dir

ecto

rag

e)

1.16

6***

(0.0

91)

)1.

153*

**(0

.092

))

1.03

8***

(0.0

91)

)1.

188*

**(0

.092

))

0.94

6***

(0.1

01)

)1.

260*

**(0

.123

)

Lar

gest

ow

ner

ship

)0.

015

(0.0

44)

)0.

021

(0.0

44)

0.04

3(0

.043

))

0.01

1(0

.044

))

0.09

2*(0

.049

)0.

061

(0.0

59)

CA

PE

X⁄a

sset

s0.

004

(0.0

23)

)0.

007

(0.0

23)

0.00

2(0

.022

)0.

003

(0.0

23)

0.00

4(0

.033

))

0.01

9(0

.026

)

Lev

erag

e)

0.06

4*(0

.035

))

0.06

8*(0

.035

))

0.03

8(0

.035

))

0.05

8(0

.036

)0.

042

(0.0

36)

)0.

417*

**(0

.058

)

Fir

msi

ze)

0.03

5(0

.026

)0.

035*

**(0

.008

))

0.03

8***

(0.0

09)

0.04

0***

(0.0

08)

0.00

9(0

.008

)0.

039*

**(0

.011

)

Op

erat

ing

pro

fita

bil

ity

0.06

5(0

.057

)0.

034

(0.0

57)

0.03

9(0

.056

)0.

032

(0.0

57)

0.09

8*(0

.059

))

0.40

9***

(0.0

85)

Ch

aeb

ol

du

mm

y0.

067*

**(0

.021

)0.

043

(0.0

22)

0.00

7(0

.022

)0.

054*

*(0

.022

)0.

018

(0.0

24)

0.08

7***

(0.0

30)

Mar

ket

risk

(bet

a)0.

054*

*(0

.022

)0.

031

(0.0

23)

0.02

4(0

.023

)0.

050*

*(0

.023

)0.

018

(0.0

24)

0.11

5***

(0.0

33)

Fir

mag

e)

0.12

0***

(0.0

24)

An

alys

tre

po

rt0.

025*

**(0

.003

)

Cre

dit

rati

ng

du

mm

y)

0.12

9***

(0.0

26)

Inst

itu

tio

nal

ow

ner

ship

0.16

4***

(0.0

57)

Go

vern

ance

0.02

1(0

.036

)



Tab

le6

(Con

tin

ued

)

Var

iab

le(1

)(2

)(3

)(4

)(5

)(6

)

Ind

epo

uts

ide

dir

ecto

r·

Fir

msi

zed

um

my

0.48

0***

(0.1

09)

Ind

epo

uts

ide

dir

ecto

r·

Fir

mag

e

0.14

9*(0

.091

)

Ind

epo

uts

ide

dir

ecto

r·

An

alys

tre

po

rt

0.01

1**

(0.0

06)

Ind

epo

uts

ide

dir

ecto

r·

Cre

dit

rati

ng

du

mm

y

0.24

9***

(0.0

89)

Ind

epo

uts

ide

dir

ecto

r·

Inst

itu

tio

nal

ow

ner

ship

0.37

5*(0

.231

)

Ind

epo

uts

ide

dir

ecto

r·

Go

vern

ance

0.23

2*(0

.142

)

Ind

ust

ry(Y

ear)

du

mm

yY

esY

esY

esY

esY

esY

es

Nu

mb

ero

ffi

rms

3,92

73,

927

3,92

73,

927

2,86

02,

218

Ad

j.R

20.

239

0.24

50.

275

0.27

70.

274

0.29

1



costs show a more positive impact of board independence, while firms with high

information asymmetry show a lower or negative impact of board independence.

Our empirical results are generally consistent with the hypothesis that the valua-

tion effect of board independence varies with the cost of information transactions.

In a broader sense, the effects of monitoring can increase when a firm has low

information transaction costs. Firms with high information transaction costs

generally have a lower valuation effect of independent boards, while large firms,

well-governed firms, and firms with good credit ratings tend to have a higher valua-

tion effect of independent boards.

Overall, our results caution against regulatory frameworks imposing one-size-

fits-all requirements on board structure. Further, our results suggest that policy

makers and researchers should pay special attention to the effect of mandated

reforms on small, poorly governed firms with high information transaction costs.

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Outside board effect on firm value

Economy & Finance

Transcript of Outside board effect on firm value