New insights on the importance of agency costs for corporate debt maturity decisions

This study provides new insights on the relationship between corporate debt maturity and agency costs by investigating empirically the impact of managerial ownership and the divergence between control and cash-flow rights on debt maturity. A significant negative effect of managerial ownership on debt maturity is observed. Moreover, the results reveal that the wedge between control and cash-flow rights also exerts a negative influence. The analysis further suggests that the negative effect of managerial ownership decreases in widely-held firms and increases with the discrepancy between control and cash-flow rights.


I. Introduction
The relationship between debt maturity and agency costs of corporate financial decisions has been an important issue in the capital structure literature. Specific attention, in this context, has been paid to the role of debt maturity in reducing the so-called underinvestment problem, described in Myers (1977), which arise from the agency conflicts between a firm's shareholders and debtholders. It is widely acknowledged that short-term debt may be more effective than long-term debt in reducing the expected agency costs of the underinvestment problem.
However, prior empirical research on debt maturity does not say much on the implications of the potential interactions between debt maturity and other central agency conflicts within the firm. For example, to the present authors' knowledge, there is no previous empirical work that investigates the effects of the fundamental agency problem of the separation of ownership and control on debt maturity structure. Similarly, the influence of managerial incentives on debt maturity has not been investigated. This paper therefore aims to provide new insights on such issues by taking a closer look at managerial ownership and the divergence between control and cash flow rights. By doing so, this study extends the earlier analyses and enhances understanding of the role agency concerns play in determining debt maturity decisions.
To investigate these issues empirically, a sample of 780 UK firms is used. The results point to a significant negative influence of managerial ownership on debt maturity. However, managers in widely-held firms tend to hold more long-term debt. It is also found that firms with greater divergence between control and cash-flow rights seem to hold more short-term in their capital structure. Furthermore, the results reveal that the negative impact of managerial ownership on debt maturity increases with the discrepancy between control and cash-flow rights.
The paper is organized as follows. Section II outlines the possible theoretical interactions between managerial incentives, divergence between control and cash-flow rights and debt maturity. Section III briefly explains other control variables used in the empirical analysis. Section IV explains the data, Section V presents the results. Finally, Section VI concludes the paper.

II. Debt Maturity and Ownership Characteristics
The underinvestment problem of Myers (1977), which has received a great deal of attention in the corporate finance literature, is due to the outstanding debt in the firm's capital structure. The agency problem arises between shareholders and debtholders because firms with risky debt may have incentives to pass up some of the valuable growth options. One of the mechanisms to address the underinvestment problem is the firm's debt maturity structure. It is argued that firms with greater growth opportunities should have more short-term debt because shortening debt maturity would make it more likely that debt will mature before any opportunity to exercise the growth options. 1 Another central issue relating to agency conflicts concerns the role of managerial ownership and managerial discretion in influencing financing and investment decisions of firms. Prior research points out that the firm's resources may be diverted by managers for their private benefits (Jensen and Meckling, 1976;Jensen, 1986). This can take alternative forms such as excessive salaries, dilution of the ownership of outsiders, and commitment of resources to unprofitable investment projects.
It is noted that the severity of agency conflicts between managers and shareholders is likely to differ across firms depending on managerial shareholdings. It is argued that as managerial ownership increases, the ability of outside investors to monitor managers declines. This, in turn, may lead to a greater degree of managerial control and entrenchment of managers (McConnell and Servaes, 1990). Accordingly, managerial ownership may act as a proxy for the conflicts of interests between managers and outside shareholders, and the associated costs. Furthermore, shortening debt maturity can be effective because it can act as a disciplinary device on managers as it increases the risk of liquidity and premature liquidation of the firm's assets. 2 This line of argument leads to the following hypothesis.
Prediction 1. There is a negative relationship between managerial ownership and debt maturity 3 However, the possibility is not ruled out that managers may also have incentives to have more long-term debt than optimal in some circumstances. For example, to the extent that managers of widelyheld firms have greater discretion, one could argue that managers in such firms may attempt to escape the discipline provided by short-term debt and hence issue more long-term debt. This reduces the probability of bankruptcy and may enable managers to use excess cash for their benefit. This can happen even if short-term debt is more beneficial to an average shareholder in the presence of costly agency conflicts. The benefits to managers through the reduced expected agency costs would be limited because, by definition, their shareholdings in widely-held firms are relatively small. The above discussion leads to the following prediction.
Prediction 2. In widely-held firms, the negative impact of managerial ownership on debt maturity decrease Furthermore, it is recognized that there are other measures that can be used to proxy for agency costs. For example, one such measure is the discrepancy between ownership (cash-flow rights) and control-rights. It is argued that the agency costs in firms with greater discrepancy are expected to be higher (Harvey et al., 2004). This is mainly because cash-flow rights of shareholders are related to the positive incentive effect, while control-rights relate to the negative entrenchment effect on firm value (see, e.g. Claessens et al., 2002). Then, one would expect firms with shareholders whose cash-flow rights are significantly less than their control-rights to choose more short-term debt in an attempt to curtail the negative impact of agency costs on firm value.
Prediction 3. There is a negative relationship between the divergence of control-rights from cash-flow rights of shareholders and debt maturity

III. Other Control Variables
What follows briefly explains the control variables used in the empirical analysis.

Leverage
Bankruptcy concerns due to high leverage may cause long-term debt choice to hedge against bankruptcy risk (Morris, 1992). However, leverage and maturity can be negatively related as agency costs of underinvestment can be mitigated by reducing leverage as well as shortening maturity (Dennis et al., 2000). Leverage is measured as the ratio of book value of total debt to total assets.

Liquidity
Due to their ability to meet borrowing restrictions, firms with higher liquidity balances will be able to lengthen their debt maturity (Morris, 1992). This would imply a positive relation between liquidity and maturity. Liquidity is measured as the ratio of current assets to current liabilities.

Asset maturity
Myers (1977) argues that the underinvestment problem can be reduced by matching the maturity of a firm's debt to that of its assets. This leads one to predict a positive relationship between debt and asset maturities. Asset maturity is measured as the ratio of net property, plant and equipment to annual depreciation expenses.

Earnings variability
The association of debt maturity with earnings variability is expected to be inverse so that the firm does not have to rebalance its capital structure as often to moderate expected bankruptcy costs when the earnings volatility decreases. Variability in earnings is measured as the standard deviation of earnings before interest, tax and depreciation (EBITD) divided by average total assets.

Growth opportunities
It is suggested that firms with more growth options are associated with more use of short-term debt in their debt maturity mix (Myers, 1977). The counter argument, however, is that firms with substantial growth opportunities might borrow long-term to avoid liquidation of their valuable projects (Diamond, 1991). Growth opportunities are measured by the market-to-book ratio, which is the book value of total assets minus the book value of equity plus the market value of equity to book value of total assets.

Size
Smaller firms with potentially severe agency problems have much more difficult access to the capital markets, which proposes a direct relation between firm size and debt maturity. Firm size is measured as logarithm of total assets in 1996 prices.

IV. Data Description
A sample of listed UK firms for the period from 1996 to 2000 is used. Data for the shareholdings of directors and company accounts were collected from Datastream. Data for the ultimate controllers of firms were obtained from Faccio and Lang (2002).
After some data filtering, we were left with 780 matched firms for the present analysis. Table 1 provides a brief analysis of the ultimate ownership structure of the UK companies included in the sample. Companies are mainly classified into two groups: widely-held, which have no owners with significant control rights, and those with controlling owners. The results are reported for two different cut-off levels for controllers, namely 10% and 20% thresholds (for a detailed discussion see Faccio and Lang, 2002). Also, controlling owners are further classified into six categories: widely-held corporations, financial institutions, family, unlisted companies, state, and miscellaneous.
Panel A of Table 1 presents percentage and number of firms controlled by different categories of owners at both cut-off levels. At the 10% level, only 24.36% of firms are widely-held. Family-controlled firms comprise 26.67% of firms in our sample, which makes it the largest category. Furthermore, 20.38% of firms are controlled by financial institutions. Another important category is the unlisted companies that control 18.72% of firms.
In Panel B we report summary statistics on the control rights of the largest controlling owner in each category of controller, where the ultimate control threshold is 10 percent. The average percentage values of control rights of the largest controlling shareholder are 38.35 and 29.52 for firms that are controlled by widely-held corporations and family, respectively. The average percentage is 20.20 percent for firms where the largest controlling shareholder is a financial institution. Table 2 provides descriptive statistics for the variables used in the analysis. The average long-term debt, defined as the ratio of debt matures in more than one year to total debt, is about 52%. The table also reveals that, on average, directors own about 12% of total shareholdings in the UK companies. Finally, the mean ratio of control rights to cash-flow rights is nearly 1.72.

V. Empirical Results
The following provides the results of several crosssectional debt maturity models using the average values of the explanatory variables (except variability and ownership variables) over the period 1996-1999. The dependent variable (debt maturity) in 2000 is measured. This is done in an attempt to mitigate problems that might arise due to short-term fluctuations or extreme values in one year. Using past values also reduces the likelihood of observed relations reflecting the effects of debt maturity on firm-specific factors (see also Rajan and Zingales, 1995, for a similar methodology). Ownership variables are measured in 1997. Given that equity ownership structure of firms is relatively stable over a certain period of time, we do not expect that measuring ownership characteristics in a single year would yield a significant bias in our results (see also La Porta et al., 2002, among others).
Under all specifications in Table 3, debt maturity decisions are proxied by the ratio of debt that matures in more than one year to total debt. We begin our investigation of the agency determinants  Faccio and Lang (2002). Notes: Maturity is defined as the ratio of debt that matures in more than one year to total debt. Leverage is the ratio of book value of total debt to book value of total assets. Market-to-book is the ratio of book value of total assets minus the book value of equity plus the market value of equity to book value of total assets. Size is the natural logarithm of total assets in 1996 prices. Asset maturity is the ratio of net property, plant and equipment to annual depreciation expense. Variability is the standard deviation of earnings before interest, tax and depreciation (EBITD) divided by average total assets. Liquidity is the ratio of current assets to current liabilities. Man_Own is the total percentage of equity ownership by directors. Divergence is the ratio of control rights to cash flow rights. of debt maturity decision by focusing on the impact of managerial shareholdings. Column (1) of Table 3 reports the regression results for the basic model that includes the control variables described earlier and the managerial ownership variable (Man_Own). The results reveal that the impact of managerial ownership on debt maturity is negative and significant (at 5% level). This can be taken as evidence for the view that firms prefer more short-term debt when the expected agency costs of managerial ownership are higher. 4 As also mentioned earlier, the negative effect may be due to the managerial incentives to reduce the likelihood of takeover attempts by making the firm riskier to outside investors. In column (2) the present study additionally tests whether the debt maturity decisions of widely-held firms are different from those of the firms with controllers. It also tests if the negative impact of managerial ownership changes in widely-held firms. To do so, two additional variables are incorporated into the model, namely Widely_Held, a dummy variable that takes a value of one if the firm is widely-held, and an interaction variable Man_Own * Widely_Held to measure the conditional impact of managerial ownership on the firm's debt maturity structure. This would allow one to test whether the effect of managerial ownership varies between widely-held and controlled firms.
The results for model (2) suggest that the main effect of managerial ownership is still negative but the conditional effect is positive and significant (at the 10% level). This suggests that the negative impact of managerial ownership on debt maturity decreases in widely-held firms. As discussed earlier, managerial discretion in widely-held firms may be greater and hence managers of such firms may prefer to issue more long-term debt.
In order to provide more insight into the impact of agency costs on debt maturity structure the results with an additional variable (Divergence) that measures the wedge between control and cash-flow rights are presented in column (3). The estimated coefficient  Notes: Maturity is defined as the ratio of debt that matures in more than one year to total debt. Leverage is the ratio of book value of total debt to book value of total assets. Market-to-book is the ratio of book value of total assets minus the book value of equity plus the market value of equity to book value of total assets. Size is the natural logarithm of total assets in 1996 prices. Asset maturity is the ratio of net property, plant and equipment to annual depreciation expense. Earnings variability is the standard deviation of EBITD divided by average total assets. Liquidity is the ratio of current assets to current liabilities.
Man_Own is the total percentage of equity ownership by directors. Widely_Held takes the value of 1 if the firm has no controller. Divergence is the ratio of control rights to cash flow rights. Standard errors robust to heteroscedasticity are in the parentheses. (*), (**) and (***) show that the estimated coefficients are significant at 10%, 5% and 1% levels respectively. of this variable is negative and significant (at the 1% level), possibly providing further evidence for the notion that, other things being equal, firms with greater expected agency costs prefer short-term debt to mitigate the negative effects of these costs on firm value. This also points to the effective role of debt maturity as an internal corporate governance mechanism. Finally, the study examines in column (4) whether the impact of managerial ownership on debt maturity changes with the discrepancy between control and cash-flow rights of large shareholders by interacting Man_Own with Divergence. The estimated coefficient is negative and significant (at the 5% level), suggesting that the negative impact of managerial ownership on debt maturity is greater in firms where the divergence between control and cash-flow rights is larger. In other words, managers of firms with greater discrepancy between control and cash-flow rights of shareholders prefer to have more short-term debt. This is possibly due to an increase in the expected costs of managerial ownership arising from reduced incentives of large shareholders to control the management.

VI. Conclusions
This study provides new results with regard to the impact of agency costs on corporate debt maturity. In doing so, specific attention is paid to the relation between debt maturity and managerial ownership and divergence between control and cash-flow rights of large shareholders. The main finding is that managerial ownership plays an important role in determining debt maturity. The findings reveal that there is a negative relationship between managerial ownership and debt maturity. However, the negative impact decreases in widely-held firms. The results also reveal a negative relationship between debt maturity and the ratio of control rights to cash flow rights. Furthermore, the negative impact of managerial ownership on debt maturity increases when the divergence increases.
The results of this analysis suggest that the agency conflict between shareholders and debtholders, i.e. the underinvestment problem, may not be the only agency factor that affects debt maturity decisions. It seems that one needs to consider other potential agency problems, namely the one between insiders (managers) and outside investors, in analysing corporate debt maturity decisions.