Board Effectiveness and Cost of Debt

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BUSINESS RESEARCH METHODOLOGY

BOARD EFFECTIVENESS AND COST OF DEBT
by :
FARUQ AKURAT
100810251004

ECONOMIC FACULTY
JEMBER UNIVERSITY
2011 / 2012
Board Effectiveness and Cost of Debt

ABSTRACT
Does the board of directors influence cost of debt financing? This study of a sample of Spanish listed companies during the period 2004–2007 provides some evidence about the question. The results suggest that two board attributes – director ownership and board activity – appear to influence in the risk assessment of debtholders because of their ability to reduce agency cost and information asymmetry. We also find a non-linear relationship between board size and cost of debt, suggesting that from certain levels the benefits of large boards may be outweighed by the cost of poorer communication and increased decision-making time.

Previous Literature and Hypotheses
Some studies have specifically addressed the effect of the board of directors on the cost of debt financing (Anderson et al., 2004; Ashbaugh-Skaife et al., 2006; Bhojraj and Sengupta, 2003; Ertugrul and Hegde, 2008; Piot and Missonier-Piera, 2007). Their results are consistent with the argument that debtholders favour monitoring mechanisms that are likely to limit managerial opportunism and consider board monitoring effectiveness as a source of greater assurance with respect to the integrity of accounting numbers, so improving the financial accounting process. Therefore, the quality of monitoring corporate governance devices may mitigate debtholders’ risk and, consequently these creditors allow a reduction in their risk premium.

Board Independence.
The literature has generally posited that independence of the board of directors from management provides effective monitoring and control of firm activities (i.e. Fama and Jensen, 1983). However, a second view is that independent directors may be ineffective, either because they are appointed by company managers or because the board culture discourages conflict (Jensen, 1993; Mace, 1986). The literature on the cost of debt is less controversial in this aspect and there seems to be a strong consensus amongst researchers that creditors value board independence as an effective way to monitor management and consequently mitigate their risk. Anderson et al. (2004) and Piot and Missonier-Piera 614 Carmen Lorca et al. (2007) find that the cost of debt financing is inversely related to board independence. Likewise Bhojraj and Sengupta’s (2003) results showed that bond yields on new debt issues are negatively associated with the fraction of the board made up by outsiders. Ashbaugh-Skaife et al. (2006) observe that firm credit ratings are positively related to overall board independence, resulting in significant debt cost savings for firms. We therefore formulate the following hypothesis in its alternative form: Hypothesis 1: Board independence is associated with corporate cost of debt.

Audit Committee Independence.
In relation to monitoring the financial discretion of management, it is the audit committee that is likely to provide stakeholders with the greatest protection in maintaining the credibility of a firm’s financial statements. In order to perform its role effectively, an audit committee should have adequate resources and authority to discharge its responsibilities. Recent regulations put forth by the major stock exchanges requiring that a minimum of three independent directors serve on the audit, nomination and remuneration committees, suggest that the effectiveness of a committee depends on the extent to which the committee is independent. This is supported by research that demonstrates a relationship between audit committee independence and a higher quality of financial reporting (Carcello and Neal, 2000; Davidson et al., 2005; McMullen and Raghundan, 1996). If audit committee composition influences the financial accounting process, then the corporate cost of debt will exhibit an inverse relation to...
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