Ownership structure – separation of ownership and control, and information

1226 this is represented by voting power. While ownership is the right to cash flows of the company and is proportionate to shareholdings. In general, the separation of ownership and control of companies results in information asymmetry and agency related problems namely moral hazards, between those in control of and those who are not. In early studies such as Berle and Means 1932 and Jensen and Meckling 1976, the problem has always been characterized along the conflict of interest between a manager who is in control and shareholders who own the company and bears the cash flow consequences of any action. Managers do not own significantly any shares. However more recent studies characterize the conflict as between the controlling shareholders who could also be the manager, i.e shareholders who have acquired sufficient number of shares to be able to affect decisions, and the other or non- controlling shareholders Shleifer Vishny 1997. However as the cash flow rights of controlling party increases, there is more wealth maximizing benefits to the company as there would be less expropriating tendency by the controlling party and less monitoring costs Jensen and Meckling 1976. The results of the following empirical studies are consistent with this analysis. Claessens, Djankov, Fan and Lang 1998a, examine expropriation of non- controlling shareholders‘ wealth in the context of corporate diversification policy for β000 companies in nine East Asian countries in the period between 1991 and 1996. They found that diversification is associated with the disparity between cash flow and control rights. Further, there is evidence that the larger the disparity the more the diversification. This is proven true especially at higher level of control. The larger the disparity the more incentive to expropriate as the link betwe en the controlling shareholders‘ wealth and the company performance is weaker. In a separate study, Claessens, Djankov, Fan and Lang 1998b, establish the existence of expropriation by examining the association between each of cash flow and 1227 control rights, and market value. The study is a cross sectional study of 2658 companies in East Asia in 1996. The found negative association between control rights and market value, and positive association between cash flow rights and market value. This is especially so when cash flow rights are low and control rights are high, which they conclude, suggest expropriation of non- controlling shareholders‘ wealth. Ownership could become separated from control through holdings of shares with different voting power, or through holdings of shares in a pyramid structure. This latter type of control is reported to be more common in East Asia, for example in Malaysia as described earlier. Harris and Raviv 1988 and Grossman and Hart 1988, analyze theoretically the separation of control and ownership problem through the holdings of dual class of shares. They conclude that such separation leads to lower accountability and specifically lead to situations where the controlling party could take actions to maximize his utility while bearing costs not in proportion to the shareholdings. There has not been any studies in the US that test ownership structure and the cost of equity. This is so because in the US ownership is diffused and if disparity of cash flow and voting rights exists they are through the existence of dual class shares and at low level of control. Also the existence of dual class shares requires disclosure and therefore is transparent. Fan and Wong 2002 although examine ownership structure and earnings informativeness, it is on the premise that concentrated ownership through pyramidal ownership structure inhibits information to the public. Whilst earnings quality poses risk in terms of reliabilityprecision of information, ownership structure poses risk in terms of amount of information that is private. The more private the information the higher the required return. This is the essence of the theoretical studies of Easley and O‘Hara β004 and δeuz and Verrecchia β004 as discussed in Francis et al 2004. 1228 A study by Chen et al 2003 examine the effects of various corporate governance mechanisms and disclosure level on the cost of equity. They found significant negative association between corporate governance mechanisms and disclosure level, and cost of equity. T heir study was on Asia‘s emerging markets which include 4β εalaysian listed companies.

2.3 Earnings quality and information risk

A number of researches explore the link between information quality as proxied by a number of measures, and cost of equity. As most studies focus on the usage of information by equity investors, the measure for required return is the cost of equity. Botosan 1997 examines the relationship between disclosure level and cost equity. She developed a voluntary disclosure index from information in annual reports as proxy to disclosure level or quality. Estimates of cost of equity are based on the valuation formula developed by Edwards and Bell 1961, Ohlson 1995 and Feltham and Ohlson 1995 which states that market price of a company‘s share is equal to the sum of expected dividends discounted at the company‘s cost of equity. Botosan 1997 found a negative association between disclosure level and cost of equity, after controlling for market risk beta and company‘s size for companies that attract a low analyst following. However no significant association was found for companies that have high analyst following. The reason for this is that the disclosure index may not capture fully the level of information provided to investors as analysts play a significant role in disclosure. Botosan and Plumlee 2001 reexamine the association between disclosure and cost of equity by segregating different forms of disclosure quality i.e level and timely. Findings for relationship between disclosure level and cost of equity confirm previous results. However a positive association was found between timely disclosure and cost of 1229 equity which is contrary to theoretical assertion. An explanation for this is that timely disclosure increases volatility of share prices and hence cost of equity. Francis et al 2004 examine the relationship between earnings attributes as proxy to information quality and cost of equity. Earnings attributes are categorized as market based and accounting based, each as described earlier. As a whole their findings confirm previous results of negative relationship between earnings quality and cost of equity. When considered individually the accounting based earnings attributes, in particular accrual quality, have larger effect on cost of equity than market based attributes. 3. Methodology 3.1 Data sources The required accounting data, market value, book to market value, prices and beta are obtained from Datastream data base for the financial year end 2004 or as at financial year end 2004 as applicable. For the purpose of estimating accrual quality accounting data for year 2003 and 2005 are also required. Estimated earnings per share for years 2005 and 2006 required for calculating cost of equity are downloaded from Bloomberg data base services in January 2005.

3.2 Sample profile

The sample comprises of companies with IBES‘s estimated earnings per share for year 2005 and 2006. The sample size is first reduced due to the availability of data for the estimation of cost of equity Table 3.1. Since the data requirements varies for the calculation of the earnings quality measures, the composition of companies are further reduced into two samples- 1 ABRES and 2 ABSDATCAABSDATA Table 3.2.