impact of corporate governance on firm performance

International Research Journal of Finance and Economics

ISSN 1450-2887 Issue 61 (2011)

© EuroJournals Publishing, Inc. 2011

http://www.eurojournals.com/finance.htm

Impact of Corporate Governance on Firm Performance

Evidence from the Tobacco Industry of Pakistan

Khurram Khan

Assistant Professor, Riphah International University, Islamabad, Pakistan

E-mail: [email protected]

Tel: +92-321-5375887

Ali Raza Nemati

Riphah International University, Islamabad, Pakistan


Tel: +92-345-5905581

Moazzam Iftikhar

Assistant Professor, Riphah International University, Islamabad, Pakistan


Abstract

This paper examines the affect of corporate governance on a firm’s performance.

The research has been carried out on the Tobacco industry of Pakistan which is a major

contributor to Pakistan’s Exports. There are several aspects and dimensions of corporate

governance, which may influence a firm’s performance but this study focused on three

aspects namely ownership concentration, CEO duality and Board’s Independence. Firm’s

performance has been measured through Return on Equity (ROE) & Return on Assets

(ROA). Strong and positive impact of corporate governance on firm’s performance has

been seen.

Keywords: Corporate Governance, Firm’s Performance, ROE, ROA, Board

Independence, CEO Duality and Ownership Concentration

Introduction The aim of this research paper is to investigate the importance of corporate governance in firm’s

performance. This study examines that how and in which direction corporate governance can affect

firm’s performance.

Corporate governance provides a structure that works for the benefit of the firm and can help in

increasing firm’s performance .Shleifer and Vishny (1997) states that, “Corporate governance deals

with the ways in which suppliers of finance to corporations assure them of getting a return on their

investment”

The factors that determine corporate governance can be internal factors defined by the officers,

stockholders or the rules of a company, as well as the external forces such as consumer groups and

government regulations. The internal factors affecting corporate governance are, Separation of

ownership and control, ownership concentration, board’s independence whereas & ROA have been

used as measures of performance.

International Research Journal of Finance and Economics - Issue 61 (2011) 8

The tobacco industry of Pakistan has been selected for this study due to its size and importance

to Pakistan’s economy. Tobacco crop in Pakistan, which provides yield well above the world average,

contributes 4.4 %, or over Rs. 27.5 billion, to the national Gross Domestic Product (GDP). It is the

single biggest contributor of excise duty, six times than that from cotton. Over 5 per cent of all taxes

collected in the country come from the tobacco industry. It employs over one million people directly or

indirectly. Further, the industry is a fair mix of multinational and national companies, which makes it a

good sample for subsequent generalization of the findings of this study over the entire industrial sector

in Pakistan.

Literature Review “Governance” as described by J. Wolfensohn, president of the World Bank, “is about promoting

corporate fairness, transparency and accountability" (Financial Times, June 21, 1999).

Mahmood Osman Imam and Mahfuja Malik (2007) state that the need for corporate governance

arises from the potential conflicts of interest among participants (stakeholders) in the corporate

structure .These conflicts of interest often arise from two main reasons. First, different participants

have different goals and preferences. Second, the participants have imperfect information as to each

other’s actions, knowledge, and preferences. Tosi and Gomez-Mejia (1989) state that the challenge of

corporate governance is to set up supervisory and incentive alignment mechanisms that alter the risk

and effort orientation of agents to align them with the interests of principals.

Renato Giovannini (2009) suggests that corporate governance and board ownership as

mechanisms to manage and monitor the firm without missing opportunities that stem from shareholder

base enlargement, rather than pursuing exploitation of outsider director skills.

According to Tricker (1994), corporate governance is an umbrella term that includes specific

issues from interactions among senior management, shareholders, board of directors, and other

corporate stakeholders. Blair (1995) argues that corporate governance implicates, “the whole set of

legal, cultural, and institutional arrangements that determine what publicly traded corporations can do,

who controls them, how that control is exercised, and how the risks and returns from the activities they

undertake are allocated.”

Shleifer & Vishny, (1997) defines corporate governance that “it deals with the ways in which

suppliers of finance to corporations assure themselves of getting a return on their investment”. Jensen

and Meckling (1976) addressed these conflicts by examining the separation of corporate ownership

from corporate management. They noted that this separation, with the absence of other corporate

governance mechanisms, provides executives with the ability to act in their own self-interest rather

than in the interests of shareholders.

A large proportion of the regulatory changes have focused on boards of directors’ .In order to

define a board of directors or a system of governance. Caselli, S, & Gatti, S. (2007) say that two

elements must be taken into consideration with respect to board of directors: actors and context, by

actors they meant not only directors, but the entire range of stakeholders representing interests and

power within the firm. Their presence guarantees, on the one hand, the creation of value and the

distribution of the value created; on the other, it determines contextual factors, beginning with

governance mechanisms. By context, they meant geographical, cultural, sectoral, and firm specific

differences and variations. Among these are the degree of dispersion in and the nature of firm

ownership, differences in size, lifecycle variations, including crises and the configuration of firm

resources, and CEO tenure and its features and background.

Institutional investor also plays a vital role in the governance of the firm moving from good to

great. Institutional investors are organizations which pool large sums of money and invest those sums

in companies. Institutional investors can be banks, mutual funds, insurance companies and etc. They

can direct the board to protect the rights of the shareholders and improves and can impact the running

governance of the company. If the institutions can more easily select directors, at least for a minority of

board seats, they can hire directors to watch companies on their behalf and be accountable to them.

9 International Research Journal of Finance and Economics - Issue 61 (2011)

Currently, directors are often more loyal to corporate officers than to the shareholders whom the

directors nominally serve Separation of ownership and control can also play an important role .Moshe

Pinto (2006) states that the separation of ownership and control creates an agency problem .The

managers may run the firm in their own, rather than the shareholders' interest, choosing the

maximization of their own utility over the maximization of shareholder value.

Shleifer and Vishny (1988) show, in the context of managerial ownership, that high managerial

ownership may entrench managers, as they are increasingly less subject to governance by board of

directors and to discipline by the market for corporate control. Mace (1971) reports case-study

evidence that suggests that nonexecutive directors will oppose exceedingly poor performance or

obviously bad proposals. Weisbach (1988) finds that non-executive dominated boards are significantly

more likely to respond to poor performance by dismissing the CEO. Koke (2001) finds that German

firms under concentrated ownership have higher productivity growth

Mazumdar (2006) found family owned business, lack of loyalty, misconception about

delegation of authority, and missing internal audit function to be the reasons behind poor corporate

governance in Bangladesh.

Vishny (1997) have observed that strong legal protection of investors and some form of

concentrated ownership are essential elements of a good corporate governance system.

Theoretical Framework Figure 1:

Corporate

Governance

Firm

Performance

CEO Duality

Ownership

Concentration

Board

Independence ROA

Return on Asset

ROE Return on Equity

This model shows the relationship of variables with one another this model assumes that

corporate governance is affected by CEO duality i.e. the holding of both the top offices of the chairman

and the CEO by the same person can affect corporate governance which would have impact on to

firm’s performance. The relationship between the ownership concentration and corporate governance

has also been shown. There is ample evidence in the literature, that the more the ownership

concentration the less would be the effective corporate governance. The impact on another variable that

would be seen on corporate governance is board independence. The literature also supports the

proposition that presence of more independent directors on the board leads to better corporate

governance, which in turn would positively impact the firm’s performance .It has been shown in the

model that firm’s performance would be measured through ROA and ROE.

H1: Better the corporate governance of the firm the better would be firm’s performance.


Sample and Data Collection For the purposes of this study, data from three listed companies of the Tobacco industry, namely

Pakistan Tobacco, Lakson Tobacco and Khyber Tobacco has been used. The required data has been

extracted from the annual reports, of the above named companies, of five years- 2004-2008

Methodology There are a number of factors that may affect corporate governance and a firm’s performance. This

study, however, is confined to the relationship of five factors (variable). These are briefly described

below:

Independent Variables

a. CEO Duality: It is whether a firm has different persons appointed as CEO & Chairman or the

same person assumes both the positions.

b. Ownership Concentration: It is the shareholding pattern of the firm. Whether fewer people

have larger number of shares or shares are diversified to larger number of people.

c. Board’s Independence: It is the presence of non executive directors in the board. The presence

of more independent directors on the board will make the board more independent. An

independent board will be better placed to make independent decisions and hence safe guard

the interests of all the stake holders, particularly the rights of minority shareholders.

Intervening Variable

a. Corporate Governance

Dependent Variable

a. Firm’s Performance

Firm’s performance has been measured by:

a. ROA (Return on Asset): It is the net income divided by the total assets of the firm.

b. ROE (Return on Equity): It is the net income divided by shareholder’s equity of the

firm.

Analysis Figure 2:

Tobacco Industry of Pakistan (Corporate Governance)

Variables CEO Duality

Ownership

Concentration Board Independence

Pakistan Tobacco

2004 N N Y

2005 N N Y

2006 N N Y

2007 N N Y

2008 N N Y

Lakson Tobacco

2004 Y Y Y

2005 Y Y Y

2006 Y Y Y

2007 Y Y Y

2008 Y Y Y

Khyber Tobacco

2004 N N N

2005 N N N

2006 N N N

2007 N N N

2008 N N N


Figure 3a:

Pakistan Tobacco Return On Asset (ROA)

Years 2004 2005 2006 2007 2008

Net income 1,277.744 1,321.919 1,904.988 1,300.517 1,361.422

Total assets 5,022.410 7,968.453 8,734.400 9,826.232 10,395.041

Return On assets 25.44 % 16.59 % 21.81 % 13.24 % 13.10 %

Figure 3b:

Pakistan Tobacco Return On Equity (ROE)

Years 2004 2005 2006 2007 2008

Net income 665.227 1,321.919 1,904.988 1,300.517 1,361.422

Share Holders Equity 3,262.823 3,639.414 4,139.187 4,022.857 3,608.331

Return On assets 20.39 % 36.32 % 46.02 % 32.33 % 37.73 %

Figure 4a:

Lakson Tobacco Return On Asset (ROA)

Years 2004 2005 2006 2007 2008

Net income 1,277.744 2,571.950 1,554.885 1,737.633 1,105.400

Total assets 5,022.410 5,692.861 5,981.003 6,593.209 9,439.784

Return On assets 25.44 % 45.18 % 26.00 % 26.355 % 11.71 %

Figure 4b:

Lakson Tobacco Return On Equity (ROE)

Years 2004 2005 2006 2007 2008

Net income 1,277.744 2,571.950 1,554.885 1,737.633 1,105.400

Shareholder’s Equity 2,554.806 4,145.491 4,956.281 5,566.993 5,993.961

Return On assets 50.01 % 62.04 % 31.37 % 31.21 % 18.44 %

Figure 5a:

Khyber Tobacco Return On Assets (ROA)

Years 2004 2005 2006 2007 2008

Net income 0.635 1.935 1.856 9.940 5.760

Total Assets 26.086 9.127 5.093 9.709 35.317

Return On assets 02.43 % 21.20 % 36.44 % 102.44 % 16.31 %

Figure 5b:

Khyber Tobacco Return On Equity (ROE)

Years 2004 2005 2006 2007 2008

Net income 0.635 1.935 1.856 9.944 5.760

Shareholder's Equity (60.029) (42.685) (41.423) (31.480) (25.720)

Return On assets -01.06 % -04.53 % -04.48 % -31.59 % -22.39 %

Year Pakistan Tobacco Lakson Tobacco Khyber tobacco

ROA-% ROA-% ROA-% ROA-% ROA-% ROA-%

2004 25.4 20.4 25.4 50.0 02.43 -01.0

2005 16.6 36.3 45.1 62.0 21.20 -04.5

2006 21.8 46.0 26.0 31.4 36.4 -04.5

2007 13.2 32.3 26.4 31.2 102.4 -31.6

2008 13.1 37.7 11.7 18.4 16.3 -22.4


Discussion The performances of the organizations included in this study have been measured by Return on Assets

and Return on Equity. Table 6 shows that Khyber Tobacco has shown negative Return on Equity for all

the five years under study. This has been resulted from the huge losses accumulated over the years.

The accumulated losses in 2008 had grown to Rs. 41,050,782, creating negative equity. There could be

number of factors which have caused these losses. However, if the picture is looked at from the

Corporate Governance, the Annual Reports of the company for the year 2008-09 reveal serious lapses

in, or lack of Corporate Governance.

• Khyber Tobacco: The external auditors of the company, in their audit report pertaining to the

financial 2008-09, have noted “Without qualifying our opinion, we draw your attention to the

matter that Karachi and Lahore Stock Exchanges have put the name of the company on

‘Defaulting Companies List’ due to non-registration with Central Depository Company”. The

auditors have further noted that, “The company has adopted a depreciation policy which is not

in compliance with the requirements of IAS-16, “Property, Plant, and Equipment”, IAS-36,

“Impairment of Assets” read with TR-II (reformatted 2004)”.

The auditors, in their review report, have also highlighted the following two significant points:

i. All directors are not tax payers

ii. No internal audit report was available as the internal audit did not find any discrepancy

to report.

• The company has also been fined by the Security and Exchange Commission of Pakistan, the

corporate watch dog’ for violating the provisions of the Companies Ordinance- 1984, by not

holding the Annual General Meeting of the company with the prescribed period.

Though the above referred financial report states that five directors, out of total seven directors

of the board, are independent and non-executive directors, but some of the independent directors

(number not provided) are non-tax payers. This only goes to reflect that such non-taxing paying

directors could be insignificant personalities from whatever professions they may belong to. They

could hardly be expected to forcefully pursue the independent stance at the board meetings. It finds

further credence from the auditors note that no internal audit report was available with the company,

proving thereby that either the Audit Committee is either nonexistent or remained ineffective during

the year.

Share Capital 12,018,410

General Reserves 3,312,465

Total 15,330,875

Accumulated Losses (41,050,782)

Equity (25,719,907)

Pakistan Tobacco has consistently outperformed its competitors during the entire period

covered by this study (i.e. five years from 2004 to 2008) on both performance measures.

When we look at the corporate governance parameters, we find that, here again, Pakistan

Tobacco presents strong indicators of good corporate governance. Table 2 above provides comparative

positions of the corporate governance parameters.

CEO Duality • Pakistan Tobacco has different persons as the CEO and the Chairman (No CEO duality)

• Lakson Tobacco has the same person as the CEO and the Chairman (CEO duality)

Ownership Concentration & Board of Directors

• Pakistan Tobacco’s ownership is divided among British American Tobacco (Investment)

Company Ltd. (BAT) which holds 94.7% of the equity while the balance equity is held by


individuals. BAT being an institutional investor, which represents the interests of its own wide

spectrum of shareholders, is not considered as one owner for measuring the ownership

concentration. Therefore, this study has not taken Pakistan Tobacco as an organization whose

ownership is concentrated in one or few hands of related shareholders (e.g. family ownership).

• Pakistan Tobacco- the Board, consisting of 12 directors, has four (4) executive directors and

eight (8) independent directors. The independent director’s account for one highly respected

legal practitioner, two well reputed high ranking bureaucrats, retired from Government of

Pakistan Service, one retired general (retired) turned industrialist and four successful

businessmen of Pakistan. The Audit Committee of the board is well defined with detailed terms

of reference and is chaired by an independent director. Six other independent directors are also

members of the committee whereas CEO and the Chief Financial Officers are invited to the

meetings of the committee as non-members, having no voting rights. Similarly, the Technical

Committee and Human Resource Committee, having adequate number of independent directors

as members, are also functioning in accordance with their respective Terms of Reference.

• Lakson Tobacco has ownership concentration within their shareholding pattern however they

have independent board of directors so there is never a conflict between agent and principle this

problem arises it has always been solved resulted in the optimum performance of the

organization because of good corporate governance.

Limitations The study, based on the data of Tobacco Industry of Pakistan, has proved the hypothesis that,” Better

the corporate governance of the firm the better would be firm’s performance”. However, the study is

based on a simplistic model of corporate governance that has taken into account only three aspects,

namely, ownership concentration, CEO duality and Board’s Independence. There are other factors,

internal as well as external that also may affect state of corporate governance in an organization. A

further study may be carried out including more factors in the model and by expanding its scope to

other industries for better understanding and generalizing of the findings. Further, an organization’s

performance has been measured through Return on Equity (ROE) & Return on Assets (ROA). Other

Key Performance Indicators (KPI) may also be introduced in the model for more authentic

measurement of a firm’s all round performance.


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impact of corporate governance on firm performance

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