The relationship between CEO turnover and the debt-equity ratio

Transcription

1 The relationship between CEO turnover and the debt-equity ratio -Bachelor thesis- By Supervisor dhr. E.J. Schroth de la Piedra Ph.D. Bachelor Economics and Business, Finance & Organization Faculty of Economics and Business University of Amsterdam 21

2 i Abstract The purpose of this thesis is to identify a relationship between CEO turnover and the debtequity ratio. The literature mentions various determinants of CEO turnover, both non-financial and financial. The most important are the characteristics of the CEO, the circumstances in the industry and the performance of the organization. The relationship between CEO turnover and the debt-equity ratio is not mentioned in the literature concerning CEO turnover. The determinants of the debt-equity ratio are explained by various theories. The four most important theories are: the trade off theory, the agency theory, the free cash flow theory and the pecking order theory. The trade off theory and the free cash flows are possible manners to identify the relationship between CEO turnover and the debt level. However, the reasoning of the free cash flow theory is been used for the empirical analysis in this thesis. The hypothesis is that debt could be used as an instrument to mitigate the managerial entrenchment of CEOs, resulting in a better performance and consequently a lower CEO turnover. Concluding, a higher debt-equity ratio results in a lower CEO turnover. Unfortunately, the empirical analysis of this thesis does not prove this relationship, although more extensive research could be done to find support for the reasoning of this thesis.

3 ii Content Abstract i 1. Introduction 1 2. Literature review of CEO turnover Non-financial determinants of CEO turnover Characteristics of the Board of Directors Characteristics of the organization Characteristics of the industry Characteristics of the CEO Characteristics of the previous CEO Financial determinants of CEO turnover 7 3. Hypothesis development Financial distress and debt The trade off theory The agency theory and debt Managerial entrenchment and debt The free cash flow theory Asymmetric information and debt The pecking order theory Empirical analysis Sample selection Data summary Model and results Conclusion 20 References 22 Appendix A: Tables 24 Appendix B: Results of regression analysis 32

4 1 1. Introduction A Chief Executive Officer (CEO) occupies the highest function in the Board of Directors at the top of an organization. Successful CEOs will stay at the organization for a long time, although the tenure depends on more forces. Not only the CEO has influence on his tenure, also the circumstances in the organization and in the industry have influence. Regularly the reason of a CEO change in an organization is retirement, other reasons could be death or illness and forced dismissal. The performance of an organization is the most often mentioned determinant of CEO dismissal. If the performance of the organization is poor, then the CEO faces a higher threat of dismissal. Thereby, CEOs have to act in favour of the organization, however, sometimes they act in favour of their own interests. For example, the CEO might steal money from the organization in order to boost its empire building and personal benefits, called perks, such as private jets, expensive buildings, cars and other fancy gadgets. This behaviour of CEOs is a problem for organizations, because these wasteful expenses might destroy the organizational value and the organizational performance in the end. Several solutions are developed to align the interest of the CEO with the interest of the organizations. Corporate governance plays an important role in this, because it is the way in which an organization is managed, controlled and directed by laws, policies and processes. Instruments, like salaries and bonuses, linked to the performance of the organization should control the behaviour of the CEO. Debt is another instrument that could be used to reduce the bad behaviour of CEOs. An organization can either choose to finance with debt or equity or a combination of both, and several theories try to explain this capital structure choice of organizations. The capital structure is often expressed as the leverage of an organization, also know as the debt-equity ratio, and it illustrates the extent to which an organization relies on debt. Modigliani and Miller (1958) state that in a perfect market the capital structure does not influence the organizations value, and conduct two propositions. And the first proposition concerns the capital structure: MM I: In a perfect capital market, the total value of a firm is equal to the market value of the total cash flows generated by its assets and is not affected by its choice of capital structure (Berk and DeMarzo, 2007, p. 432).

5 2 In 1963 Modigliani and Miller found that the capital structure does have influence on the organizational value, which is described by the trade off theory. To determine the optimal level of debt, the trade off theory weighs the costs and benefits of debt (Modigliani and Miller, 1963, pp ). This thesis thus contains two research objects, namely the CEO turnover ratio and the debtequity ratio. The CEO turnover ratio is the number of CEOs in a certain period divided by the number of years. And the debt-equity ratio is the amount of debt, short and long-term, divided by the total amount of equity. The line of thought is that the capital structure of an organization affects the dismissal of the CEO. Therefore the main question of this thesis is: What kind of relationship exists between the CEO turnover and the debt-equity ratio? The hypothesis is that a higher debt level will result in a lower CEO turnover ratio. This is mainly because debt could be used as an instrument to give incentives to the management of the organization. A CEO might have the incentive to spend money on perks and wasteful investments. In the end, these expenses might destroy the organizational value and due to this poor performance the CEO might be dismissed. Debt could be used to limit the freedom of CEOs to spend money on wasteful investments. Debt obligates the CEO to make periodically interest payments and to pay back the debt resulting in that less money is available to the CEO, which could be spend on perks. As a consequence, the organizational value will not be destroyed and the CEO will face a lower probability of dismissal. However, if an organization has a too large amount of debt, then it might happen that the organization is not able to pay back the debt. As a consequence, the organization could end in financial distress resulting in a higher threat of dismissal for the CEO. There is thus a trade off between the costs and benefits of debt. The remainder of the paper proceeds as follows. Chapter 2 will review literature concerning CEO turnover. It entails the description of the determinants of CEO turnover, and the relation with the debt-equity ratio. Chapter 3 will be a review of what literature stipulates about the debt-equity ratio, and the relation with CEO turnover. Further, it will describe the hypothesis development. Chapter 4 contains an empirical analysis and its results. Data is collected from twenty-five organizations listed on the two Dutch indices: AEX and AMX. After the debtequity ratio and the CEO turnover ratio of the organizations are determined, the results of the regression points out whether a relationship exists between the two objects. Finally, conclusions and suggestions for further research will be drawn in chapter 5.

6 3 2. Literature review of CEO turnover Several reasons might exist for a CEO to leave an organization, though in this thesis the definition of CEO turnover is considered to be any case of a change of CEO. The succession of a CEO depends on many aspects, inside and outside the organization. This chapter discusses the determinants of CEO turnover and tries to identify whether debt is one of the determinants. The next sections of this chapter provide the description of the determinants of CEO turnover. First, the non-financial determinants are described, followed by the financial determinants. Finally, the relation with the debt-equity ratio will be discussed. 2.1 Non-financial determinants of CEO turnover The performance of the organization, a financial determinant, is often labelled as the most important determinant of dismissal of the CEO. According to Fredrickson et al. (1988), there also are non-financial determinants of CEO turnover. These are the circumstances around the CEO: the Board of Directors, the organization itself, the industry, the CEO himself and the previous CEO. These parts of the organizations have certain characteristics that influence the CEO turnover. The board, the organization, the CEO himself and the previous CEO, will internally influence the dismissal of the CEO, and the industry externally. The characteristics of these four influences will be described in the following sections Characteristics of the Board of Directors The Board of Directors has a significant impact on CEO turnover. First, the board chooses the CEO, and secondly, the board could also fire the CEO. Their different values, interests and beliefs of the members influence the behaviour of board members. Corresponding with the research of Fredrickson et al. (1988), large boards cause a higher threat of dismissal, because the CEO has to convince more people of his duty and will be in the middle of

7 4 disagreements and discussions. Members of the board have also different reasons for willing to be a member of the board, and due to this they will judge the performance of the CEO differently. For example, if a board member holds a significant stock holding, then this one will be more critically on the CEO compared to the members who do not have so many stocks. Further, it is clear that inside members and outside members will act different in situations by reason of their different relationships with the organization. Insiders are less objective in comparison to outsiders, they are more loyal to the organization and the CEO, which might result in a lower CEO turnover. This difference will mitigate for the reason that an outsider will act as an insider after some time (Fredrickson, et al., 1988, pp ) Characteristics of the organization According to Fredrickson et al. (1988), the reasoning of large boards passes also for the size of organizations: the larger an organization, the more frequent a CEO will be replaced. Large organizations have a great supply of internal management, so there are enough alternatives when the CEO needs to be replaced. The same holds for older organizations due to two reasons. First, older organizations have executives who have a lot of knowledge collected in those years, thus another executive could easily replace a CEO. And secondly, it appears that older CEOs are on board in older organizations meaning that there will be a higher turnover due to death, illness and retirement. Many researches state that the actions of the CEO, determined by his characteristics, shape the organization. In contrast, Dutta and Guthrie (1994) state that the strategy of the organization shapes the CEO. The CEO, with its specific expertises and functional track experiences, will be selected on bases of the chosen strategies of the organization. It seems a valid analysis, because a CEO has to adjust himself to the structure and culture of the organization. However, when the fit between the CEO and the organization is poor after all, the possibility of dismissal increases. Therefore, it is not that the organization shapes the CEO or that the CEO shapes the organization, it is a combination of both. Concluding, the likelihood of a dismissal increases when the fit between the both is not superior Characteristics of the industry Both Fredrickson et al. (1988) and Comte and Mihal (1990) point out in their research that the circumstances in the industry influence the vulnerability of the CEO, especially when the

8 5 environment is complex and volatile. Some circumstances increasing the chance of a CEO change are self-evident. First, large industries are attended with a great supply of alternative CEOs, which means that organizations in large industries can easily replace its CEO. Second, if there is a high degree of uncertainty concerning the future of the industry and its performance, then the CEO is more vulnerable resulting in a higher probability of dismissal. Finally, this passes also for a high degree of concentration and competition, because the organization will replace the CEO immediately when he is doing a worse job in these circumstances Characteristics of the CEO It is logically that the persons occupying the function of CEO have some characteristics in common. Although, it is remarkable that only Datta and Guthrie (1994) mention the education level as an important characteristic of a CEO. Most CEOs have a high level of education by which it seems that the education level is an important determinant. Thereby, the board also checks the education level of a CEO at the beginning of the selection, to be able to assess the fit of the candidate with the job requirements. Every board will choose the candidate with superior grades and with a good reputation and work experiences. These superiorities might result in a better fit and therefore better behaviour of CEOs resulting in a lower CEO turnover. Both Datta and Guthrie (1994) and Arnold et al. (2005) list personal traits, such as intelligence, reputation, self-confidence, background and experiences, as important characteristics through which leaders outperform non-leaders. Adding to this, Brookman and Thistle (2009), Comte and Mihal (1990) and Fredrickson et al. (1988) all agree that the power of a CEO has a great impact on CEO turnover: the more power a CEO has, the less likely it will be that the CEO might be replaced. CEOs derive power from different sources, like large stockholdings, reputation and also his tenure, and all of them result in more control over and loyalty from the board reducing the chance of dismissal. Furthermore, CEO turnover will be lower in organizations when the CEO is an insider due to advantages of insiders in comparison with outsiders. Insiders already have organizational-specific knowledge and are familiar with the policies and working-method. Thereby, the board does already know the qualities and performances of the insider, and will only choose the one with the best qualities and performances resulting in a lower chance of choosing the wrong person as CEO (Datta and Guthrie, 1994, pp ).

9 Characteristics of the previous CEO Only Fredrickson et al. (1988) mention the influence of the previous CEO on CEO turnover. There are various manners in which the previous CEO influences the tenure of the new CEO. First of all, the previous CEO leaves a mark in the organization, which will influence the circumstances that the new CEO will face at the beginning. The longer the tenure of the predecessor is, the more difficult it will be for the new CEO to prove himself. The board will compare his results, actions and behaviour to the performances of his predecessor who might have built loyalty to and a relationship with the board. Further, the state of affairs under which the predecessor left has influence on the CEO turnover. If the predecessor left with a lot of tumult or the board fired him, then there are effects on short-term for the new CEO. For example, when the board was divided about the dismissal they will be more hesitant to the new CEO in relation to the case in which the board was undivided. The CEO turnover will be higher in organizations with a divided board, because the new CEO will be in the middle of a struggle between the members of the board. Finally, previous CEOs could still be connected with the organization after their dismissal. For instance, he could get another function in the organization. Due to this connection, the new CEO will be monitored and influenced by his predecessor. This will especially be the case when the previous CEO is the founder of the organization or has a major stock holding. It is proven that periods of high turnover exist after the founder of the organization is dismissed (Fredrickson et al., 1988, pp ). To sum it up, several non-financial forces in the organization, both internal and external, stimulate CEO turnover. The characteristics of the new CEO are the most important internal influences, especially his power and education level. Externally have the circumstances of the industry most impact on CEO turnover: if the circumstances are well, then CEO turnover will be lower relative to the situation in which the circumstances are poor. The next section describes the financial determinants and the conclusion will be made whether the literature concerning CEO turnover identifies a relationship with the debtequity ratio.

10 7 2.2 Financial determinants of CEO turnover It is a general agreement that a CEO dismissal follows poor organizational performance, and as a consequence the performance is often labelled as the most important determinant of CEO turnover. The board compares the actual performance with the expected performance, which is determined by analysts, and will replace the CEO in case of poor performance. It is a complex process to determine the expected performance by reason of the fact that it is subjected to forecast errors and uncertainty. If there is a lot of uncertainty in de industry, then it is more difficult to set goals that are comparable to the previous goals or the goals of other organizations in the industry resulting in a larger probability of a forecast error. If an organization performs poor relative to other organizations in this situation, the chance of dismissal will be great. Concluding, the combination of poor performance and a great uncertainty in the industry concerning the future might result in a higher CEO turnover (Farrel and Whidbee, 2003, pp ). Fredrickson et al. (1988) also argue that organizations facing poor performance in the previous years have a higher CEO turnover ratio. An explanation for this could be that the new CEO has little margin when an organization faces poor performance for a few years meaning that the new CEO could afford fewer mistakes. Concluding, a high probability of poor performance results in a higher chance of dismissal (Fredrickson, et al., 1988, p. 263). It appears that CEO turnover is influenced by various determinants, both non-financial and financial. The section concerning the non-financial determinants points out that the most important internal determinants are the characteristics of the new CEO, and the most important external determinants are the circumstances in the industry. The section concerning the financial determinants points out that the performance of the organization tends to be the most significant determinant of the CEO dismissal. The conclusion could be made that the combination of non-financial and financial determinants will determine the CEO turnover. Unfortunately, the debt-equity ratio is not mentioned in the literature as a determinant of CEO dismissal. In the next chapter the determinants of the debt-equity ratio will be described, and the hypothesis will be developed.

11 8 3. Hypothesis development In the previous chapter there is no relationship found between CEO turnover and the debtequity ratio. This chapter describes the determinants of debt-equity and the development of the hypothesis for the empirical analysis in chapter 4. In the introduction the two propositions of Modigliani and Miller (1985) are mentioned. Nowadays, many researchers have done extensive research on the capital structure of organizations and developed several theories. In this chapter four theories will be discussed: the trade off theory, the agency theory, the free cash flow theory and the pecking order theory. Finally, this chapter ends with inferences concerning the relationship between CEO turnover and the debt-equity ratio resulting in a hypothesis for the empirical analysis in chapter Financial distress and debt When an organization faces financial distress, there are high costs involved, both direct and indirect costs. Indirect costs are often larger than direct costs. Direct costs arise because several professionals are needed in the event of distress, like accountants and consultants that are expensive. Berk and DeMarzo (2007) list the indirect losses: the loss of customers, suppliers, employees, receivables and forced sales. Adding to this, Jensen and Meckling (1976) argue if organizations face a higher probability of default in comparison with other organizations, then it much harder to find executives that are willing to work in those organization. In these circumstances, the level of job security is low, which results in a higher CEO turnover. The cause of financial distress could be debt, this is the case when an organization has too much debt and is unable to meet the obligatory fixed payments on debt. This is a disadvantage of debt, however, debt involves also a tax advantage. The trade of theory weighs these costs and benefits to determine the optimal level of debt.

12 The trade off theory A trade off exists between present values of the benefit of debt (tax shield), and the cost of debt (financial distress). The probability of financial distress and the height of the costs determine the present value of distress. The higher the amount of liabilities the organization holds, the higher this probability will be. It also increases with the volatility of the cash flows and the assets values (Berk and DeMarzo, 2007, pp ). Myers (1984) illustrate that organizations have to adjust their capital structure through substituting debt for equity and the reverse to maximize the organizational value. Figure 1 shows the trade off between debt and equity according to Myers (1984). The optimum level of debt, illustrated by the dotted line, is the level at which the organizational value is maximized and this is where de present value of the interest tax shield is higher than the present value costs of financial distress. Figure 1: The trade off theory of capital structure (Myers, 1984, p. 577) Managers of organizations are searching for the optimal level of leverage to maximize this trade off. Adding to this, Friend and Lang (1988) state that CEOs have an incentive to lower the amount of debt outstanding, this is self-evident because the lower the debt holdings the lower the chance of financial distress. This view is also consistent with the conclusions of Marsh (1982) and Castianias (1983), which state that bankruptcy risk is an important

13 10 determinant of the debt level. Thereby, in the event of financial distress CEOs face a higher threat of dismissal. From this view, the inference could be drawn that a too high debt-equity might cause financial distress, resulting in a higher CEO turnover. This is consistent with the results of Gilson (1989), the debt-equity ratio is higher in organizations that are financial distressed and these organizations face a higher CEO turnover too. 3.2 The agency theory and debt The agency theory arose when ownership and control got separated, and contains a relationship between a principal and an agent whereby the principal engages the agent. Every organization has to deal with a lot of people and parties, which have various interests that might not be in line with each other. These conflicts of interest might result in high agency costs. According to Jensen and Meckling (1976), there are two types of conflicts. The first conflict is the conflict between equity holders and managers due to the fragmentation of ownership. Organizations with a high degree of ownership dilution hold more debt relative to organizations with less dilution. If a lot of shareholders are involved beyond the CEO, then the CEO will be monitored more closely. In this case, the CEO will be less able to adjust the debt level in its own interest in comparison to the situation in which the CEO owns a larger part of the outstanding shares. As mentioned in the previous chapter, the CEO has more power when he holds a large stock holding resulting in a lower probability of dismissal. The second conflict is the conflict between debt holders and equity holders. As a consequence of debt, equity holders will not invest optimally. If the investment financed with debt is successful, then the equity holders gain from this. However, if the investment fails, then the debt holders bear all the consequences. The equity holders thus have an incentive to overinvest due to the fact that they will not bear the negative consequences at short notice when the investment fails. This will result in contracting negative NPV (net present value) projects that will destroy the overall value of the organization, also know as the asset substitution effect. Ultimately, the equity holders will bear the costs, because the destroyed organizational value will harm their investment (Harris and Raviv, 1991, pp ). Reputation and persuasiveness of the organization are playing a significant role in the amount of debt that an organization could receive. If the organization has a good reputation of repaying its debt or has a great power of persuasion, then the lower the borrowing cost will

14 11 be and could lend more. New and small organizations have to build reputation and will bear higher costs of issuing debt. CEOs consider also their own reputation and are rather to choose a safe project that will enforce their reputation than another more risky project with higher returns, which would benefit the equity holders. Thus, organizations with CEOs vulnerable for their reputation tend to hold more debt, because they choose safer projects (Harris and Raviv, 1991, pp ). This might lower the CEO turnover, because choosing safer projects contains less risk of failure and default. However, if the debt holding is so large that the organization cannot satisfy the payments to the debt holders, then the CEO turnover might increase due to a higher probability of financial distress. 3.3 Managerial entrenchment and debt In the previous section the separation of ownership and control is discussed, and as a result of this occurrence there is also a possibility of management entrenchment. This means that there is little threat for the managers, including the CEO, to be dismissed. If this happens, then managers will act in their self-interest instead of the organization s interest and are more willing to spend money on perks, such as expensive buildings and wasteful investments. This will be strengthened when there is a high degree of ownership dilution, because the CEO will receive less gain from investments in comparison to the case in which he is the only shareholder (Berk and DeMarzo, 2007, pp ). This view is supported by the free cash flow theory, described in the next sub-section The free cash flow theory The free cash flow hypothesis states that cash flows are available to managers, when all positive NPV projects are already taken and all the payments to debt holders are done. Managers might spend this amount of free cash on perks and wasteful, negative NPV investments. These investments might destroy the organizational value resulting in poor performance and perhaps even in a higher CEO turnover. A solution to reduce the free cash flows is leverage. The reasoning is that debt obligates the managers to make interest payments and to pay off the debt through which less free money will be available to the managers to spend wastefully (Berk and DeMarzo, 2007, pp ).

15 12 When there is a high probability of default, debt holders will also monitor the CEO more closely and as a consequence CEOs are less willing to spend money on perks. This is not proven by the research of Titman and Wessels (1988), although, it is proven by Jensen (1986) and Berk and DeMarzo (2007). According to Jensen (1986), debt is a substitute for dividends, however dividend payouts are not obligatory while debt payments are. An organization can purchase its own shares by issuing debt, which mitigates the entrenchment of the managers. As a result, first, there is less dilution of shares resulting in more power to the CEO and a lower CEO turnover. Second, more debt increases monitoring by the debt holders and decreases the free cash flows available to the CEO. Finally, this purchase policy involves tax advantages because the interest payments on debt are tax deductible. This policy does only apply to organizations with large free cash flows and low growth opportunities (Jensen, 1986, p ). Overall, the conclusion could be drawn that large free cash flows increases the leverage ratio to reduce the entrenchment of management. The line of thought is that debt will be used as an incentive and control instrument to mitigate the entrenchment of the CEO, due to the obligatory, periodically payments. As a consequence, less free cash is available for CEOs that could be spend on value destroying projects resulting in better performance, which will lower the threat of dismissal. 3.4 Asymmetric information and debt Parties involved in organizations do not have the same information, CEOs know more about the organization than outsiders, and this could result in a problem. For example, if an organization would like to issue equity, then investors have a disadvantage because they have less information and as a consequence investors are willing to pay less. Berk and DeMarzo (2007) call this appearance adverse selection, and it could be avoided by using funds that will not be undervalued due to asymmetric information, like internal funds or riskless debt. As a result, to finance project debt will be used instead of equity, resulting in a higher debt-equity ratio. Thereby, organizations could also use their fixed assets as collateral for debt implicating that organizations with few fixed assets will hold less debt. The use of collateral debt avoids the problem of asymmetric information, because the values of the assets are known resulting in a fair valuation. This view is not proven by Titman and Wessels

16 13 (1988), however it is supported by Marsh (1982). Collateral debt has two advantages. First, the borrower must use the amount of debt for a specified project so that the money could not be used to finance wasteful projects. Second, as a consequence of collateral debt an organization could finance with more debt, and higher debt levels means a higher probability of financial distress. Debt holders will in this case monitor the organization more closely with the consequence that less unprofitable expenses will be done (Marsh, 1982, pp ). The signalling theory of debt is also in favour of financing with debt, it states that debt signals credibility to investors because organizations are obligated to make periodically future payments as a consequence of debt. Furthermore, a claim by a manager in its own interest is only credible when the manager who falsely signal will personally suffer (Gilson, 1989, p. 242). Asymmetric information seems to result in a preference of organizations to choose debt instead of equity, and this preference is explained by the pecking order theory The pecking order theory Not only equity has to contend with the adverse selection problem, it also applies to debt. In general the pecking order theory is relevant in the choice of capital structure. The capital structure is determined by the desire to finance first with internal sources, then with low-risk debt, and finally equity will be issued as last resort (Harris and Raviv, 1991, p. 306). Two aspects explain the pecking order of organizations. First, organizations prefer to rely on internal funds when issuing equity is too expensive, because the investors undervalued the stock price due to asymmetric information. In this case, organizations will pass positive NPV projects when it does not have enough internal funds. To finance this positive NVP projects organization could use debt instead, however investors are not naïve and anticipate on this behaviour of the organization. Investors do not buy equity until the organization has no debt capacity left, which means that it is costly to issue more debt. This explains why organizations prefer debt in favour of equity (Myers, 1984, pp ). The determinants of the capital structure are described in this chapter by means of four theories: the trade off theory concerning the costs and benefits of debt, the agency theory identifying the consequences of the conflicts of interest between various parties, the free cash flow theory explaining managerial entrenchment and the pecking order theory explaining the sequence of financial funds.

17 14 The trade off theory could partly explain a relation between the two research objects. If the costs of debt are higher than the benefits of debt, then the organization could face financial distress resulting in a higher threat of CEO dismissal, and thus a higher CEO turnover ratio. However, it is not a direct relationship because more aspects have influence on the degree of financial distress, and with this also on the CEO turnover. The free cash flow theory could be a better explanation for the relationship between CEO turnover and the choice the capital structure. From this theory the inference could be drawn that a higher debt-equity ratio results in a lower CEO turnover. The reasoning is that the CEO has less free cash to spend on value destroying investments when there is more debt, and will consequently act more in favour of the whole organization reducing the threat of a dismissal. The CEO self has in this situation a lot more influence on his dismissal in comparison with the trade off theory. The reasoning behind the free cash flow theory is therefore more interesting to use in the empirical analysis in the next chapter, in which the relationship between the two research objects will be analyst. Concluding, the literature concerning CEO turnover does not stipulate anything about an existing relationship between CEO turnover and the debt-equity ratio. The literature about the capital structure of organizations is more useful to find support for this relationship, especially the section concerning managerial entrenchment. In the next chapter an empirical analysis will be made. The starting point of the empirical analysis will be the hypothesis that the debtequity ratio influences the CEO turnover.

18 15 4. Empirical analysis The relationship between CEO turnover and the debt-equity ratio is not proven in earlier research. This empirical analysis attempts to identify the relationship between the two research objects. The hypothesis is that the CEO turnover is influenced by the debt-equity ratio. In the introduction two ways are described in which the relationship might exist. First, the higher the debt-equity ratio, the lower the CEO turnover. The line of reasoning is that debt is used as an incentive instrument to limit freedom of the CEO. If a CEO has too much freedom to spend money, then the CEO might have the incentive to use the money for perks and other wasteful investments. The free cash flow theory supports this hypothesis. Second, if the debt-equity ratio is too high, then the CEO turnover might increase, which opposes the above reasoning. The costs of debt are described above in the literature review concerning the capital structure of an organization. It states that if the debt holding of an organization is too large, then it might result in the problem that the organization cannot satisfy the payments to the debt holders and risks financial distress. When this is the case, the probability of dismissal of the CEO will increase, which is supported by the trade off theory. Thus, the two hypotheses are: I: A high debt-equity ratio results in a lower CEO turnover II: A high debt-equity ratio results in a higher CEO turnover The second hypothesis will not be tested in this thesis, because more variables should be included in the model, such as the costs of debt and the probability of default. The purpose of this thesis is to identify a direct relationship between CEO turnover and the debt-equity ratio. Thereby, in the previous chapter it is concluded that the CEO has more influence on his dismissal in the situation of managerial entrenchment. It is therefore more interesting to use this reasoning in the analysis, thus only the first hypothesis will be tested. The next section describes the selection of the sample, followed by a summary of the data. Finally, the last section of this chapter exhibits the model and the results.

19 Sample selection The sample consists of twenty-five organizations listed on two Dutch stock exchanges: the AEX (Amsterdam Exchange Index) and the AMX (Amsterdam Midkap Index). The AEX is the most important index in the Netherlands containing the big stocks, and the AMX contains the medium-sized stocks. The organizations chosen are listed on one of the indices and are randomly chosen. Some of the organizations have been listed on the AEX and as well on the AMX, since the third of sixteen of the selected organizations are listed on the AEX and nine on the AMX. Table 1 contains the randomly chosen organizations and on which index these are listed. The following section will summarize the data. Table 1: The selected sample Organization Index () Aegon N.V. AEX AkzoNobel N.V. AEX ASM International N.V. AMX ASML Holding N.V. AEX CSM N.V. AMX Fugro N.V. AEX Heineken N.V. AEX Imtech N.V. AMX ING Group N.V. AEX Nutreco Holding N.V. AMX Océ N.V. AMX Ordina N.V. AMX Randstad Holding N.V. AEX Royal Ahold N.V. AEX Royal BAM Group N.V. AEX Royal Boskalis Westmister N.V. AEX Royal DSM N.V. AEX Royal KPN N.V. AEX Royal Philips Electronics N.V. AEX Royal Vopak N.V. AMX Royal Wessanen N.V. AMX TNT N.V. AEX Unilever N.V. AEX USG People N.V. AMX Wolters Kluwer N.V. AEX

20 Data summary The thesis contains two research objects: the CEO turnover ratio and the debt-equity ratio. These variables are analysed over the 1999 through 2008 time period. The sources of all the data are the database Amadeus of Bureau van Dijk Electronic Publising (BvDEP) and the Annual Reports of the selected organizations. The amount of equity is defined as the shareholders funds, containing the balance posts capital and other shareholders funds. Debt exists of current liabilities containing loans, creditors and other current liabilities, and noncurrent liabilities containing long-term debt and other non-current liabilities. Appendix A contains the tables with the amount of debt and equity of the organizations, including the debt-equity ratio and CEO turnover ratio. The debt-equity ratio is defined as the amount of debt divided by the amount of equity. The number of CEO changes determines CEO turnover during the period of ten years. The CEO turnover ratio is defined as the number of CEOs divided by ten years, and table 2 demonstrates this ratio. Table 2: CEO turnover ratios Organization CEO turnover ratio Organization CEO turnover ratio Aegon N.V. 0,3 Royal Ahold N.V. 0,3 AkzoNobel N.V. 0,2 Royal BAM Group N.V. 0,2 ASM International N.V. 0,2 Royal Boskalis Westmister N.V. 0,2 ASML Holding N.V. 0,3 Royal DSM N.V. 0,3 CSM N.V. 0,2 Royal KPN N.V. 0,3 Fugro N.V. 0,2 Royal Philips Electronics N.V. 0,2 Heineken N.V. 0,3 Royal Vopak N.V. 0,4 Imtech N.V. 0,2 Royal Wessanen N.V. 0,3 ING Group N.V. 0,3 TNT N.V. 0,2 Nutreco Holding N.V. 0,2 Unilever N.V. 0,2 Océ N.V. 0,2 USG People N.V. 0,2 Ordina N.V. 0,2 Wolters Kluwer N.V. 0,4 Randstad Holding N.V. 0,2 The data shows that the minimum CEO turnover ratio is 0,2 and the maximum is 0,4. Only two organizations have this maximum turnover ratio, however, 60% of the selected organizations have had two different CEOs during the period of ten years, and 32% of the organizations have a turnover ratio of 0,3. The hypothesis holds that a high debt-equity ratio

21 18 will result in a low CEO turnover ratio. If this hypothesis is correct, then those fifteen organizations with a CEO turnover ratio of 0,2 should have a high debt-equity ratio relative to the other organizations. And according to this hypothesis, the two organizations with a turnover ratio of 0,4 should have a relative low debt-equity ratio. The next section describes the model and points out whether the results support the hypothesis. 4.3 Model and results To identify the relationship between the two, the following model is conducted: CEO = α + ß * D/E + ε CEO = CEO turnover ratio α = constant term ß = coefficient of the independent variable D/E D/E = average debt-equity ratio ε = disturbance term This model brings an implication along. The CEO turnover rate is a constant variable while the debt-equity ratio varies during the period of ten years. To make it possible to run a regression, the debt-equity ratio must be adapted to a single number meaning that the average of the debt-equity ratios will be used in the regression. The implication of this adaption is that relative high and low ratios will be smoothened through which the results will be influenced and are less accurate. Appendix B contains the results from the regression. To test whether there is indeed a relationship between the variables a scatter plot of them is formed. The scatter plot reproduces the relationship between the CEO turnover ratio and the debt-equity ratio, and the outcome of this plot is figure 2.

22 19 Figure 2: Scatter plot of the CEO turnover ratio and the debt-equity ratio If hypothesis I holds, then the scatter plot should illustrate that the debt-equity ratio is high when the CEO turnover ratio is low. This will be case when the dots of the organizations with a CEO turnover ratio of 0,2 lie in the left corner at the top and the dots of the organizations with a CEO turnover of 0,4 lie in the right corner at the bottom. But the scatter plot does not show this picture, which means that hypothesis I does not hold. Thereby, the scatter plot does not identify another relationship at all because the dots do not appear in a certain pattern. From this could be concluded that the relationship between the CEO turnover ratio and the debt-equity ratio does not exist in this sample. Highlighted this sample, because even though the results are disappointing with this sample it does not mean immediately that there is no relationship between the two variables at all. A different sample could prove the opposite, perhaps when a larger sample is used or a sample containing organizations of a particular industry. The main problem of this empirical analysis is that it tries to identify a relationship between only two variables. This implicates, often, that too much information is desired out of a regression of only two variables. Due to this, the probability of success is small because then there should be a direct link between CEO turnover and the debt-equity ratio. Nevertheless, it does not mean that there is no relationship at all between the two ratios.

23 20 The recommendation for further empirical research on this topic is that a larger sample could be used, and perhaps more variables could be included in the model to find empirical evidence for a relationship. In this analysis the only purpose was to identify a direct relationship: the debt-equity ratio influences the CEO turnover ratio. Thus, if in another research more variables are included, and which does not focus only on a direct influence of debt on CEO turnover, then it is perhaps possible to identify a relationship, either direct or indirect. Thereby, a larger sample might be desired so that more data is included in the regression analysis. In this thesis organizations also operate in different industries, it might be desired to select organizations in the same industry. Organizations in the same industry will roughly have the same structure and investments, thus perhaps a relationship could be identified sooner and a better comparison could be made. 5. Conclusion The purpose of this thesis was to identify a relationship between the CEO turnover and the debt-equity ratio. The determinants of both research objects are described. Various variables influence the turnover ratio of CEOs, both non-financial and financial determinants. There are internal and external non-financial determinants. The most important internal determinants are the characteristics of the new CEO, and the most important external determinants are the circumstances in the industry. The performance of the organization is labelled as the most important financial determinants: if the performance of the organization is poor, then the CEO faces a high threat of dismissal. The conclusion could be made that the combination of nonfinancial and financial determinants will determine the CEO turnover. However, there is no relationship described between CEO turnover and the debt-equity ratio by the literature concerning CEO turnover. The determinants of debt-equity ratio are explained by four different theories. First, the trade off theory states that the capital structure depends on the costs and benefits of debt. Second, the agency theory explains the capital structure as a consequence of conflicts of interest between various parties, which have a relationship with the organization. Third, the free cash flow theory state that debt could be used as an incentive instrument to mitigate

24 21 the entrenchment of the CEO. Finally, the pecking order theory explains that organizations prefer internal funds and debt to equity. Both the trade of theory and the free cash flow theory could be used to accomplish a relationship between CEO turnover and the debt-equity ratio. However, the CEO has more influence on his dismissal in case of the free cash flow theory. This theory is therefore chosen as underlying reasoning for the empirical analysis. The reasoning is that if free cash flows are available to CEOs, then they might spend this free money on value destroying investments. On the long run, these investments might cause a reduction in performance and creates financial problems. As a consequence of the poor performance, the CEO will be dismissed. Debt could be used in this case to mitigate the entrenchment of the CEO due to the obligatory payments that debt brings along. The CEO is not able anymore to spend a lot of money on perks through which the chance of poor performance reduces and thereby the probability of dismissal decreases too. Concluding, a higher debt-equity ratio results in a lower CEO turnover, which is the hypothesis of the empirical analysis. Unfortunately, the empirical analysis in this thesis does not prove the relationship between CEO turnover and the debt-equity ratio. The model had a few implications. The average of the debt-equity ratio had to be used to run a regression as a consequence of the constant CEO turnover ratio. It is also difficult to find a relationship between two variables, because too much information is desired out of a regression of just only two variables. However, this disappointing result does not rule out a relationship between CEO turnover and the debtequity ratio. The recommendation for further research is that more variables could be included in the model and a larger sample could be taken. So far, the answer on the main question is that it could be concluded that no direct relationship is found between CEO turnover and the debt-equity ratio. The only thing that could be said is that underlying idea of the free cash flow theory might explain a relationship, reasoning that the use of more debt mitigates managerial entrenchment resulting in a lower CEO turnover. Although it is not supported by the empirical analysis in this thesis, more extensive research might support the reasoning of this thesis.

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