Discussion Conclusion Proceeding E Book 4A Turky

1246 support the hypotheses tested. Future research that includes more companies and years is needed to provide a robust set of results. The hypothesized relationship between cash flowvoting rights and cost of equity is not supported. The comparison between Claessens 1998b sample and the samples under study provides an insight why this is so. Table 4.5 indicates that even the minimum voting rights found in the samples in this study is quite close to the mean of 28 in Claessens 1998b study. Seventy five percent of companies in the samples have ultimate controlling party with voting rights above 3638. Similarly the mean cash flow rights in all samples in this study are almost twice that reported in Claessens 1998b. 75 of the companies have ultimate controlling party with cash flow rights above 28. Similar pattern is observed in Fan and Wong 2002 whose study includes 177 Malaysian companies. The mean voting rights is 31 whilst the mean cash flow rights is reported to be 26. As in Claessens et al 1998b study the reported mean CFVR is 85. Further both Claessens et al 1998b and Fan and Wong 2002 capped the voting rights at 50. They stopped analyzing the voting rights of the ultimate controlling party once the voting rights breaches 50. So the maximum voting rights for the companies in the sample is 50. Certainly the off setting effect of increasing cash flow rights and increasing voting rights is complex and merit more research. Previous research such as Claessens 1998b found that at a higher level of control the tendency to expropriate, which is expected in information asymmetry situations, is higher. However the insignificant result in this study suggests that even though the disparity between cash flow and voting rights exists, at higher level of control and even higher level of cash flow, market does not price the disparity because the ultimate controlling party is not expected to expropriate or inhibit information as the cash consequence of his action is more significant. 1247 Finally the lack of significant association between cash flowvoting rights disparity and the cost of equity, could be due to the effective presence of a substantial shareholder. As found, substantial shareholders‘ voting rights, SSVR, is fairly consistent in showing negative association with cost of equity. The significant negative relationship with cost of equity suggests that a lower percentage holding of substantial shareholder poses information risk. This is consistent with the theory in general, as an increase in voting rights afford the substantial shareholder more bargaining power for inclusion in the decision making process such as being a member of the board of directors. Therefore this increase the chance of more information flow to the public, information which otherwise would be in the proprietary control of the ultimate controlling party. This result contributes towards the ‗information argument‘ Fan Wong β00β. That is the presence of others other than the controlling party increase the likelihood that proprietary knowledge of the company is shared to the others and decrease the likelihood that it is concentrated to certain individual which leads to opacity of information. The wider the set of informed individuals the greater the likelihood that information ‗leaks‘ to the public and thus reduce the company‘s information risk. Previous researches Jung and Kwon 2002, Koh 2003 and Chung, Firth and Kim β004 associate substantial shareholder‘s voting rights with earnings quality measure. The cost of equity effect, that is the information risk effect, has never been examined. The finding that substantial shareholders‘ shareholding is priced is a new and significant contribution not only in the Malaysian context but also elsewhere. Thus not only substantial shareholder is an important mechanism, it is also perceived as such by the market. The hypothesis that there is a cost of equity effect of earnings quality is largely supported. There is nothing new in this finding except that this study examines 1248 companies in an emerging market. Therefore even in an emerging market investors are sophisticated and do price earnings quality with low earnings quality being perceived as information risks. Whilst there have been many studies on Malaysian companies that examine earnings quality, especially abnormal accruals in relation to many variables such as board characteristics, managerial ownership, etc. there has never been any Malaysian studies that prove that abnormal accruals are priced. The consequence of this is that the preparer may gain in manipulation of accounts but they stand to lose in terms of higher required return by investors. This research has looked at one dimension of the ultimate controlling party and that is the cash flowvoting rights disparity. However the ability and potential to inhibit information may be explained by another layer of control and that is control obtained by direct possession of knowledge regarding the operations. This is achieved by direct involvement with operation or close relationship with those in direct involvement. This research has not differentiate the ultimate controlling party who are and are not in executive position. In the same line of argument this research has not separated out the substantial shareholders who are in actual fact a partner of the ultimate controlling party and the substantial shareholders who are really an outsider. Obviously the presence of the former may impair its monitoring role and thus may not ‗leak‘ information to the public. REFERENCES Aboody D., Hughes J. and Liu J. 2005 Earnings quality, insider trading and cost of capital. Journal of Accounting Research. 435,p.651-673 Berle, A., and Means, G., 1932. The modern corporation and private property. New York:Harcourt, Brace World. 1249 Botosan, C.A. 1997. Disclosure level and the cost of equity capital. The Accounting Review.723,p.323-349 Botosan,C.A. and Plumlee,M.A. 2001.A Re-examination of disclosure level and the expected cost of equity capital. Journal of Accounting Research.401,p.21-40. Chen K.C.W.,Chen Z. and Wei K.C.J.2003. Disclosure, corporate governance and the cost of equity : Evidence from Asia‘s emerging markets. Working Paper. Chung R., Firth M. and Kim J. B. 2004. Earnings management, surplus free cash flow and external monitoring. Journal of Business Research.586,p.766-776 Claessens,S., Djankov, S., and Lang,L.H.P.2000. The separation of ownership and control in East Asian corporations. Journal of Financial Economics.58, p.81-112 Claessens,S., Djankov, S., Fan, J.P.H. and Lang,L.H.P. 1998a. Corporate diversification in East Asia: The role of ultimate ownership and group affiliation. World Bank Working Paper. Claessens,S., Djankov, S., Fan, J.P.H. and Lang,L.H.P.1998b. Expropriation of Minority Shareholders : Evidence from East Asia. World Bank Working Paper. Companies Act 1965 Dechow,P.M. and Dichev,I.D. 2002. The quality of accruals and earnings: The role of accruals estimation errors. The Accounting Review.77,p.35-59. Dechow,P.M, Sloan R.G. and Sweeney, A.P. 1995. Detecting earnings management. The Accounting Review.702,p.193-225. Easly, D. and O‘Hara, ε. β001. Information and the cost of capital. Cornel University Working Papers. Edwards E. and Bell P. 1961. The theory and measurement of business income.Berkeley, CA:University of California Press Fan, J.P.H and Wong, T.J., 2002.Corporate ownership structure and the informativeness of accounting earnings in East Asia. Journal of Accounting and Economics.33,p.401-425. 1250 Feltham G. and Ohlson J. 1995. Valuation and clean surplus accounting for operating and financial activities. Contemporary Accounting Research. Spring,p.689-731 Francis,J., LaFond,R., Olsson, P. and Schipper, K. 2004. Costs of equity and earnings attribute. The Accounting Review.794,p.967-1010. Francis,J., Schipper, K. and Vincent,L.2005. Earnings and dividend informativeness when cash flow rights are separated from voting rights. Journal of Accounting and Economics.39,p.329-360 Grossman,S. and Hart, O.1988. One shareone vote and the market for corporate control. Journal of Financial Economics.20,p.175-202 Harris, M. and Raviv, A.1988. Corporate governance: voting rights and majority rules. Journal of Financial Economics.20,p.203-235 Jensen, M.C. and Mekling, W.H. 1976.Theory of the firm: managerial behavior, agency costs and ownership structure. Journal of Financial Economic.3,p.305-360 Jones J. 1991. Earnings management during import relief investigations. Journal of Accounting Research.29,p.193-228. Kaplan, S. N. and Minton, B. A.1994. Outside activity in Japanese companies: determinants and managerial implications. Journal of Financial Economics.36, p.225- 258. Leuz, C. and Verrechia, R.E. 2005. Firm‘s capital allocation choices, information quality, and the cost of capital. Working Paper Mock, R., Shleifer, A. and Vishny, R., 1988. Management ownership and market valuation: an empirical analysis. Journal of Financial Economics.20,p.293-315 Mohd Saleh, N 2003 Accounting policy choice by firms undergoing debt renegotiation. Phd Thesis, La Trobe University. Pound, J. 1988. Proxy contest and the efficiency of shareholder oversight. Journal of Financial Economics. p.293-315. 1251 Prowse S.1998. Corporate Governance: Emerging issues and lessons from East Asia. World Bank. Rajan R. and Zingales L 1998. Which capitalism? Lessons from the East Asian crisis. Journal of Applied Corporate Finance Shleifer, A. and Vishny, R., 1986. Large shareholders and corporate control. Journal of Political Economy. 94,p.461-488. Shleifer, A. and Vishny, R., 1997. A survey of corporate governance. Journal of Finance. 52,p.737-783 Tabachnick. B. G. and Fidell L. S.2001. Using Multivariate Statistics. Allyn and Bacon 1252 THE EFFECT OF MANAGERIAL OWNERSHIP ON THE COST OF DEBT: EMPIRICAL EVIDENCE FROM JAPAN Akinobu Shuto, Kobe University Norio Kitagawa, Kobe University First version: June 2009 Abstract: We examine the effect of managerial ownership on interest rate spread on corporate bonds for Japanese firms. First, we find that managerial ownership is positively associated with interest rate spread after controlling for other aspects of the Japanese ownership structure, cross-shareholding and stable shareholdings by financial institutions. Second, by employing factor analysis to measure the agency cost of debt based on financial variables, we find that managerial ownership has a higher correlation with interest rate spread when the agency cost of debt at the time of bond issue is larger. Our results suggest that prospective bondholders use managerial ownership information to anticipate a firm‘s future agency cost of debt, and estimate it to be higher when the current agency cost of debt at bond issue is larger. Further, our results indicate that accounting information is useful for estimating the agency cost of debt and increasing the efficiency of bond contracts. Keyword: managerial ownership; agency cost of debt; bond yield spread. Data Availability: Data are publicly available from sources identified in the paper. 1253

I. Introduction

This study examines the effect of managerial ownership on the cost of debt. Specifically, it investigates the relationship between managerial ownership and the cost of debt as measured by the interest rate spread on corporate bonds for Japanese firms. Agency theory predicts that the shareholdings of managers help align the managers‘ interests with those of the shareholders Jensen and Meckling 1976. This incentive alignment effect is expected to have a greater impact as managerial ownership increases. This suggests that as managerial ownership increases, corporate performance also increases Morck et al. 1988. On the other hand, however, the theory also suggests that managerial shareholdings lead to a conflict between shareholders and bondholders Jensen and Meckling 1976; Myers 1977. In particular, limited liability shareholders ma y have an incentive to expropriate bondholders‘ wealth through investments and financial decisions aimed at reducing the value of the firm‘s outstanding debt. For example, owner-managers by levered firms may have an incentive to invest in projects that are riskier than those specified by bondholders. This is commonly called the ―risk-shifting problem.‖ Further, owner-managers have an incentive to conduct wealth transfers by financing activities such as changes in the dividend policy and the issuance of additional debt. In an efficient market, rational bondholders should recognize owner- managers‘ incentives to increase shareholder wealth at the expense of their wealth and should accordingly adjust the required yield. Some empirical investigations support the prediction of agency theory. Ortiz- Molina 2006 and Bagnani et al. 1994 empirically tested the implication of the risk- shifting problem . Ortiz-Molina 2006 provides evidence that managerial ownership is 1254 positively correlated with the yield spread of corporate bonds. Bagnani et al. 1994 indicate that an increase in managerial ownership increases the cost of debt measured by bond return premia when managerial ownership is low. Consistent with the implication of the theory, these results suggest that bondholders obtain price protection against the potential agency cost of debt. Furthermore, the authors argue that the relation between shareholdings by managers and the cost of debt is nonmonotonic, and they provide some evidence in support of their argument. Our study is also related to the studies focusing on the effect of the corporate governance structure on the cost of debt. Anderson et al. 2003 investigate the impact of the founding family ownership structure on the agency cost of debt and indicate that family ownership is associated with a lower cost of debt financing. Bhojraj and Sengupta 2003 explore the link between governance mechanisms and bond yields and ratings. They reveal that the cost of debt on new debt issues is negatively associated with the percentage of shares held by the institutions and the fraction of the board comprising non- officers i.e., stronger external control of the board. Overall results indicate that corporate governance mechanisms could affect the cost of debt by mitigating agency costs. The first research objective of this study is to examine the relationship between managerial ownership and the cost of debt for Japanese firms. Following the empirical implication of the theory, we hypothesize that managerial ownership is positively associated with the interest rate spread. In addition to managerial ownership, we explore the effect of other ownerships in the Japanese corporate ownership structure on the cost 1255 of debt because it is often argued that Japanese ownership structures have unique characteristics as compared to those of other countries. We control the effect of two institutional ownerships: cross-shareholding and stable shareholding by financial institutions. Cross-shareholding, which refers to mutually exchanging equity shares in a pair of firms, has been a common practice in Japan. Further, stable shareholding by financial institutions, mainly represented by the main bank, is a unique practice and was a grave concern during the 1990s in Japan. We examine the functioning of these Japanese ownership structures in a bond market setting. We find support for the hypothesis that managerial ownership has a positive association with interest rate spread. The results suggest that prospective bondholders in Japan perceive managerial ownership as a structure that increases the potential conflict between shareholders and bondholders, and they incorporate this perception in the pricing of new corporate bond issues. Moreover, we find that stable shareholding is positively associated with interest rate spread, while cross-shareholding exhibits no significant correlation in this regard. The findings are consistent with the argument that stable shareholdings by financial institutions play an active role in reducing managerial opportunism and mitigating the wealth transfer problem between bondholders and shareholders. The second research objective of this study is to examine the effect of the potential agency cost of debt of bond-issuing firms at the time of issue on the relation between managerial ownership and the cost of debt. As predicted by the theory, managerial shareholdings may induce opportunistic behavior by firm managers aimed at increasing 1256 their benefits at the expense of bondholders‘ wealth. Our first result is consistent with the implication of the theory. If firm managers have already engaged in moral hazard behaviors or have a wide range of options for this purpose at the time of bond issue, bond investors would estimate a higher future agency cost of debt and default risk for the firm because prospective bondholders consider that such managers exhibit a high probability to conduct actions that transfer the wealth of bondholders to them after bond issue, which results in an increase of the interest rate spread. Therefore, we hypothesized that managerial ownership has a higher correlation with the interest rate spread when the agency cost of debt at issuing bonds is already larger. To measure the agency cost of debt of bond issuing firms, we reduce six financial variables related to the agency cost of debt to a single index by using factor analysis. Our results indicate that managerial ownership has a stronger effect on interest rate spread when the agency cost of debt is larger, which supports our hypothesis. Further, we conduct some analyses to verify the validity of our hypothesis because a part of our results is not consistent with the results of prior studies. Bagnani et al. 1994 indicate that managerial ownership is nonmonotonically related to the cost of debt. They advocate that at high ownership levels, managerial ownership is negatively correlated to the cost of debt because of two reasons: the first reason is that large shareholdings by managers could induce firm managers to be more concerned about the nonsystematic risk of firms, which reduces the risk-shifting problem. The second reason is that when managerial ownership is high, managers can become entrenched and their risk choice is not dependent on the preference of shareholders. Both arguments assume 1257 that at high ownership levels, the positive effect of managerial ownership on managerial risk-taking can be weaker, and as a result, managerial ownership is expected to be nonlinearly associated with the cost of debt. To address the possibility of this nonlinear relationship, we perform regression analyses by employing the quadratic form regression model. The result does not indicate that the relation between managerial ownership and interest rate spread is nonmonotonic, as indicated by Bagnani et al. 1994. The result reveals that managerial ownership is positively and linearly associated with interest rate spread. In the subsequent section, we present possible explanations as to why our results differ from those of Bagnani et al. 1994. To ensure the robustness of our results, we conduct further analyses such as those on bond rating and the potential endogeneity problem and those conducted using the Fama and Macbeth 1973 approach. We find that our results are robust under these additional analyses. This study makes several contributions to the literature on finance and accounting, and the understanding of practice of the Japanese bond market. First, our results suggest that Japanese bond investors use managerial ownership information to anticipate a firm‘s future agency cost of debt, and that they incorporate this prediction in determining the bond yield spread. In addition, the results indicate that bond investors estimate a firm‘s future default risk to be higher when the agency cost of debt at issuing bond is already larger. Therefore, our results indicate that managerial ownership is an important determinant of bond yield spread in the processes of the Japanese bond market. 1258 Second, this study contributes to prior studies by clarifying that the agency cost of debt at the time of bond issue affects the anticipation of the future potential agency cost of debt that reflects the interest rate spread. While prior studies consider managerial opportunistic behaviors arising from the conflict between bondholders and shareholders only from the perspective of the risk-shifting problem Ortiz-Molina 2006; Bagnani et al. 1994, this study develops hypotheses based on inclusive opportunistic behaviors by managers and constructs a composite measure for the degree of the agency cost of debt. These procedures contribute to the verification of the validity of theoretical hypothesis based on the agency cost of debt, and they discriminate the alternative hypotheses. Further, these results support the utility of accounting information in debt contracting because they suggest that prospective bondholders use financial information to anticipate the potential agency cost of debt in decision making for bond investments. Although we already know that accounting information provides ex post benefits to bondholders through accounting-based debt covenants in the debt contracting process Watts and Zimmerman 1986, our results indicate the ex ante role of accounting information in the debt contracting process. This acts as evidence suggesting that accounting information plays an important role in increasing the efficiency of bond contracts. Finally, this is the first study that examines the effect of Japanese corporate ownership on the cost of debt in the Japanese bond market. It is often advocated that the Japanese ownership structure is quite different from that of other countries. Previous studies have investigated the impact of the Japanese ownership structure on firm performance Prowse 1992; Lichtenberg and Pushner 1994; Morck et al. 2000. Our 1259 study contributes to these studies by resolving the functioning of the Japanese ownership structure in a bond contract setting. Further, it should be noted that in our result, managerial ownership has a strong effect on the interest rate spread after controlling for other aspects of ownership structure, cross-shareholding and stable shareholding by financial institutions, which are often emphasized as characteristics of the Japanese ownership structure. Although previous studies examining the Japanese ownership structure generally focus on the findings related to the unique aspects of ownership structure, such as cross-shareholding and main banks, our results reveal that the empirical implication of the traditional agency theory on managerial ownership is supported by the analyses for the Japanese bond market, which is consistent with the findings of analyses for US firms Ortiz-Molina 2006; Bagnani et al. 1994. The remainder of this paper is organized as follows. Section II describes the theoretical background and develops the hypotheses. Section III explains the research model for testing our hypotheses. Section IV outlines the sample selection procedure and describes the variables used in this analysis. Section V reports the empirical results on the relation between managerial ownership and interest rate spread. Section VI summarizes the results of additional analyses. Finally, Section VII concludes the study with a summary.

II. Hypothesis development

Managerial ownership and the cost of debt 1260 Our first research objective is to examine the effect of managerial ownership on the cost of debt. Prior studies indicate that shareholdings held by managers create a conflict of interest between shareholders and bondholders Jensen and Meckling 1976; Myers 1977. This conflict induces owner-managers to take investment and financing decisions that benefit them at the expense of the bondholders. With respect to the investment decisions, owner-managers have an incentive to transfer wealth to shareholders from bondholders by taking excessive risk, which is referred to as risk-shifting or asset substitution. Consequently, according to the theory, it is expected that as managerial ownership increases, firm managers become more likely to make investment decisions involving higher risks that are consistent with the interests of the shareholders, at the expense of the bondholders. The other source of conflicts of interest between shareholders and bondholders involves financing decisions such as dividend policy and the issuance of new debt. Owner-managers have an incentive to distribute cash funds themselves when firms are financed partially by debt Myers 1977. For instance, firm managers may forgo positive net present value projects, and instead, pay dividends to shareholders or repurchase shares. Furthermore, managers could sell existing business assets and distribute the proceeds to shareholders by dividends or share repurchase. In the extreme case, such managerial behaviors could sell off all business assets through a discretionary dividend policy, leaving the bondholders with an ―empty corporate shell.‖ Finally, it is often argued that the issuance of additional debt also transfers wealth from the original bondholders to the managers and consequently creates costs that reduce the value of the firms Watts and Zimmerman 1986. In practice, the owner-managers can 1261 issue additional corporate bonds after the original bond is issued. The issuance of new debt dilutes the value of existing debt. The dilution is particularly strong if the new debt is either secured or senior to the original debt Tirole 2006. Since rational bondholders know that their interests might conflict with the interests of owner-managers, they would demand a higher interest rate on corporate bonds as a compensation for the added risk on the risk-shifting and discretionary financing behaviors by owner-managers. This higher interest rate is the way bondholders obtain price protection against the possibility that owner-managers will take actions that benefit shareholders but harm bondholders. 196 Thus, this argument leads to our first hypothesis that shareholdings of managers increase the cost of debt. Hypothesis 1: Managerial ownership is positively associated with the cost of debt. The effect of the potential agency cost of debt on the relation between managerial ownership and the cost of debt Our second research objective is to examine the effect of the potential agency cost of debt of bond issue firms at the time of issue on the relation between managerial ownership and the cost of debt. In the development of the first hypothesis, we assume that owner-managers take investment and financing decisions that benefit them at the expense of bondholders, and that bondholders use managerial ownership information to predic t a firm‘s future agency cost of debt. 196 Another way to reduce conflicts of interest between bondholders and shareholders is to write bond covenants that restrict the owner- managers‘ behaviors to harm bondholders‘ wealth Smith and Warner 1979. However, McDaniel 1986 indicates that while the use of bond covenants reduces the agency cost of debt, the protection offered by these covenants cannot totally eliminate the conflicts between bondholders and shareholders. 1262 If firm managers have already engaged in opportunistic behavior that increases the agency cost of debt or have a wide range of options for this purpose at the time of bond issue, prospective bondholders are likely to anticipate a higher future agency cost of debt and default risk for the firm. The behaviors of managers, such as highly risky investment, excessive dividend payment, and frequent insurance of debt before the corporate bond issue, would make prospective bondholders more sensitive to firms‘ future agency costs of debt arising from shareholding by managers. The bondholders would consider that such managers have a high incentive in transferring the wealth of bondholders to them after the bond issue. In reality, although it is difficult for the bond inventors to completely grasp the agency cost of debt, they can estimate it by using accounting information in financial statements to a certain extent. Prior studies indicate that some financial variables are useful in measuring the potential conflict between bondholders and shareholders Long and Malits 1985; Titman and Wessels 1988; Prowse 1990; Hwang and Kim 1998; Ahmed et al. 2002. We expect that prospective bondholders can grasp the agency cost of debt by observing financial variables at the time of bond issue and incorporate their estimation in the pricing of new corporate bond issues. Therefore, we expect that the shareholding of managers has a stronger effect on the cost of debt when the potential agency cost of debt at issuing bonds is larger. Hypothesis 2: Managerial ownership has a higher correlation with the interest rate spread when the agency cost of debt at the time of bond issue is larger. 1263 The alternative hypotheses We should note that some prior studies reveal the possibility that managerial ownership is nonlinearly associated with the cost of debt, which suggests the existence of alternative hypotheses. Bagnani et al. 1994 and Ortiz-Molina 2006 argue that at low ownership levels, managerial ownership is positively correlated to the cost of debt due to the risk-shifting problem, which is consistent with our first hypothesis. However, they also advocate that at high ownership levels, managerial ownership has a negative correlation with the cost of debt. Consequently, it is expected that the relation between managerial ownership and the cost of debt is nonmonotonic. The aforementioned studies present two possible explanations about the negative relation between managerial ownership and the cost of debt at high ownership levels. First, as managerial shareholding increases, the firm managers would be more concerned with the nonsystematic risk of the firms because their wealth is less diversified Saunders et al. 1990, which reduces the risk-shifting problem. Second, at high ownership levels, managers can become entrenched because they can use their control of votes to protect their position, and thus, their decisions regarding risk-taking are not dependent on the preferences of the shareholders Morck et al. 1988. Both theoretical considerations suggest that managerial ownership is not positively associated with the cost of debt at high ownership levels. The empirical results remain mixed and inconclusive. Bagnani et al. 1994 indicate that the relation between managerial ownership and bondholder returns is nonmonotonic according to their hypothesis. On the other hand, Ortiz-Molina 2006 provides evidence that although the shareholdings of managers, including stock option 1264 holdings, are nonlinearly associated with yield spread, managerial ownership does not have a nonmonotonic relationship with yield spread. Overall, with respect to the empirical investigation on the effect of managerial ownership, only the findings of Bagnani et al. 1994 indicate a nonlinear effect of managerial ownership on the cost of debt. With regard to the reason for the inconclusive results mentioned above, numerous points about the validity of their hypothesis development on nonmonotonic relationships can be considered. While this study develops hypotheses based on the inclusive implication of the theory of agency cost of debt, they discuss the effect of managerial ownership only from the perspective of the risk-shifting problem and do not consider other managerial behaviors such as financing decisions. This lack of consideration may reduce the validity of their hypothesis because the expected effect of managerial ownership related to financing decisions does not clearly suggest that the relation between managerial ownership and the cost of debt is nonmonotonic. Further, with respect to the managerial entrenchment effect that the aforementioned studies depend upon in their hypotheses development, we can derive an opposite prediction about the relation between managerial ownership and the cost of debt. Prior studies provide evidence that entrenched managers decrease firm performance because of their opportunistic behaviors Morck, Shleifer, and Vishny 1988; McConnell and Servaes 1990; Short and Keasey 1999. 197 Since such opportunistic behaviors decrease firm values and increase the default risks of the firms, we also expect that managerial ownership increases the bond yield spread, following the implication of the managerial 197 With regard to Japanese firms, prior studies have clarified the entrenchment effect from some perspectives: firm performance Teshima 2004, earnings management Teshima and Shuto 2008, and accounting conservatism Shuto and Takada 2008. 1265 entrenchment effect, which implies a positive association between managerial ownership and the cost of debt. Thus, this leads to an empirical question whether there is a nonmonotonic relation between managerial ownership and the cost of debt. Hence, in Section VI, we conduct an additional examination assuming that there is a nonmonotonic relation between managerial ownership and interest rate spread and compare the obtained results with those of prior studies.

III. Research design

Research model to test hypothesis 1 To test hypothesis 1, we examine the association between managerial ownership and bond yield spread by estimating the following model: SPREAD = C + 1 MO + 2 CROSS + 3 FSTABLE + 4 MARGIN + 5 DER + 6 INCR + 7 LNASIZE + 8 BSIZE + 9 MATURE + 10 BCFIRM + 11 RISKP + YEAR + ε, 1 where SPREAD = the interest rate spread on the first straight bond issued of the fiscal year; the spread is the difference between the interest rates on the bond issued by the firm and on government bonds MO = the fraction of the shares owned by directors at the end of fiscal year t 1266 CROSS = the fraction of the shares owned by cross-shareholders at the end of fiscal year t FSTABLE = the fraction of stable shareholdings by financial institutions at the end of fiscal year t MARGIN = the operating income divided by net sales at the end of fiscal year t DER = the debt equity ratio at the end of fiscal year t INCR = the interest coverage ratio at the end of fiscal year t LNASIZE = the natural log of total assets at the end of fiscal year t BSIZE = the log of the issue size MATUR = the number of years till maturity BMCOMP = an indicator variable that takes the value of one if a bond management company is established, and zero otherwise RISKP = the risk premium the average values of SPREAD on RI‘s A bonds for the month of issue We use the interest rate spread on straight bond issues SPREAD to measure the cost of debt. As a proxy for managerial ownership MO, we use the ratio of the shares owned by the directors on the board. The ratio of the shares owned by all directors should be used in this study because prior studies such as Aoki 1990 and Milgrom and Roberts 1992 argue that the Japanese corporate governance system functions more through consensus than through a CEO-dominated system, as is the case in the US. Further, they argue that Japanese board members make decisions as a group. Teshima and Shuto 2008 examine the effect of managerial ownership on the earnings management behavior 1267 for Japanese firms. They also use the ratio of the shares owned by all directors as a proxy for managerial ownership. 198 If the relationship between managerial ownership and the cost of debt is similar to the prediction of hypothesis 1, the coefficient of MO would be expected to be positive. Institutional ownership could also influence managerial behavior, and for Japanese firms, the influence of cross-shareholding CROSS and stable shareholdings FSTABLE by financial institutions is noticeable Prowse 1990; Lichtenberg and Pushner 1994; Isagawa 2007. The stable shareholdings by financial institutions, mainly represented by main banks, would have a positive effect on the cost of debt. Since the stable shareholders, including main banks, have superior information and ability to monitor the inefficient behaviors of firm managers, the cost of debt of firms with a high number of stable shareholders is expected to be lower. Shareholders that are cross-owned are also expected to have an incentive to monitor firm managers because they share a relationship with the firms as trade partners Osano 1996; Isagawa 2007. Further, cross-shareholding strengthens the stability of firm management by decreasing the threat of a hostile takeover, permitting managers to develop operations according to a long-term perspective. The perspective may be consistent with the interests of the bondholders, and it may lower the cost of debt. 199 In contrast, we can also predict that cross-shareholding would have a negative effect on the cost of debt. It is often argued that cross-shareholding enhances managerial 198 Further, prior studies examining executive compensation for Japanese firms usually employ total cash compensation data of the board directors as a proxy for executive compensation and present significant results Kaplan 1994; Joh 1999; Shuto 2007. This is consistent with the above argument. 199 Anderson et al. 2003 examine the relation between founding family ownership and the cost of debt, and argue that the family‘s strong interest in the firm‘s long-term survival could mitigate the divergence of interests between bondholders and shareholders. 1268 entrenchment Prowse 1992; Sheard 1994; Isagawa 2007 , and the increased agency costs associated with managerial opportunism may increase the cost of debt. Therefore, while the coefficient on FSTABLE is expected to be negative, the expected sign on CROSS cannot be predicted. Following Sengupta 1998 and Shuto et al. 2009, we set the control variables for the cost of debt. 200 The cost of debt can be explained in the following terms: 1 characteristics of the issuer, 2 characteristics of the issued bonds, and 3 market conditions. For the variables controlling the characteristics of the issuer, we employ the operating income divided by net sales MARGIN, debt equity ratio DER, interest coverage ratio INCR, and natural log of the total assets LNASIZE. Firms with a higher profit margin and interest coverage ratio are expected to enjoy a lower SPREAD. Further, asset-rich firms are expected to have a lower SPREAD because of their solvency. Therefore, the expected signs of the coefficients on these control variables MARGIN, INCR , and LASSET are all negative. In contrast, we expect that the firms with a higher debt equity ratio have a higher SPREAD because the debt equity ratio reflects the default risk of the firm. The coefficient on DER is expected to be positive. As a proxy for the characteristics of issued bonds, we use the log of the total amount of the bond BSIZE, the number of years till maturity MATURE, and the dummy variable BMCOMP that takes the value one if the bond management company that monitors the bond on behalf of the bondholders is established, else, its value is zero. Following the economies of scale in underwriting, the issue size would be negatively 200 Sengupta 1998 examines the effect of disclosure quality on the bond interest rate for US firms, and Shuto et al. 2009 investigate the bond yield spread for Japanese firms. 1269 related to SPREAD. Bonds with a longer maturity period are expected to have a higher SPREAD because of their greater default risk exposure. Bonds that are monitored by a bond management company would enjoy a lower SPREAD because the establishment of the bond management company is expected to contribute toward protecting the bondholder. The expected signs of the coefficients of BSIZE and BMCOMP are negative, and the expected sign of the coefficient of MATURE is positive. Finally, we use risk premium RISKP as a control variable proxy for market conditions. RISKP denotes the average values of SPREAD on bonds that are rated as A by Rating and Investment Information Inc. RI for the month of issue of the bonds. 201 We expect the sign of the coefficient of RISKP to be positive because this variable is expected to capture the time series variation in the risk premium over the business cycle. Research model to test hypothesis 2 To measure the potential conflict between bondholders and shareholders i.e., the agency cost of debt, we construct a composite measure of the degree of the agency cost of debt. Specifically, we reduce the following six financial variables related to the agency cost of debt into a single index by using factor analysis: ACD 1 = RD expendituresales ACD 2 = 1 – fixed assetstotal assets ACD 3 = cash and marketable securitiestotal assets 201 Sengupta 1998, p.464 calculated this variable on the basis of the interest rate of εoody‘s AAA bonds. However, we could not calculate the average SPREAD for the month of issue because there were insufficient issued bonds with the AAA rating to calculate RISKP in our sample. Following Shuto et al. 2009, we then used SPREAD on RI‘s A bonds to compute RISKP. 1270 ACD 4 = common dividendstotal assets ACD 5 = the standard deviation of ROA net incometotal assets for the past five years ACD 6 = the standard deviation of leverage total debttotal assets for the past five years These financial variables are expected to capture the severity of potential agency conflict between shareholders and bondholders. The first three variables ACD 1, ACD 2, and ACD 3 are widely used in prior studies and are expected to measure the extent to which firm managers with risk-shifting incentives can engage in wealth-transferring investment policies that cannot be easily detected by the bondholders Long and Malits 1985; Titman and Wessels 1988; Prowse 1990; Hwang and Kim 1998. ACD 1 is the measure of the research and development intensity of the firms. ACD β is the proportion of the firm‘s assets not involved in fixed plant and equipment. These assets can be regarded as sources for the potential agency cost of debt because firm managers with risk-shifting incentives are likely to have a wide range of options for discretionary behavior and use these assets for other risky investments. ACD 3 measures the short- term liquidity of the firm‘s assets. C ash and marketable securities are expected to be another source of agency conflicts because of the risk-shifting incentives of managers because managers can substitute these assets for risky assets with relative ease. The last three variables ACD 4, ACD 5, and ACD 6 are generally based on the definition of Ahmed et al. 2002 who employ proxies for bondholder-shareholder conflicts over dividend policy. ACD 4 is the level of dividends, measured as a percentage of the assets. If a firm pays a high level of dividend, then the bondholders are more likely 1271 to be concerned about the firm‘s dividend policy. Paying a high level of dividend is a typical moral hazard problem, and it possibly indicates more severe bondholder- shareholder conflicts over dividend policy. ACD 5 is the proxy for the firm‘s operating uncertainty measured by the standard deviation of its return on assets. Watts 1993 and Ahmed et al. 2002 argue that greater uncertainty about future profits implies a greater risk that excess dividends based on temporarily inflated earnings may be paid to shareholders. Thus, greater uncertainty in this regard is likely to increase bondholder-shareholder conflicts over dividend policy. Finally, we calculate ACD 6, as measured by the standard deviation of leverage total debttotal assets, for grasping the moral hazard behaviors of managers on debt financing decisions. Firm managers can issue other debt instruments after the original debt is issued. The issuance of additional debt transfers wealth from the original debt holders to the managers, and in the process, creates a cost that reduces the value of firms Watts and Zimmerman 1986. We use the volatility of leverage to measure the agency cost of debt on debt financing decisions because the frequent issuance of additional debt is likely to increase it. Prior studies assume that each of these variables can be proxy for the potential agency cost of debt and obtain the results that are consistent with their assumption. In practice, however, it is likely that rational bondholders estimate the agency cost of debt of issuer firms by considering various types of moral hazard behaviors of managers simultaneously and take investment decisions. Focusing on a single variable does not completely capture the conflict between bondholders and shareholders, the agency cost of debt. Therefore, to comprehensively estimate the agency cost of debt of issuer firms, we 1272 construct a composite measure of the degree of the agency cost of debt by using factor analysis to reduce the above six financial variables into a single index. Insert Table 1 about here Factor analysis assumes that attribute measures are intercorrelated and that they exert load on a single factor. Panel A of Table 1 reveals that the correlations among the six financial variables are all positive and most of the correlations are significant as expected. Panel B of Table 1 shows that a single factor loaded by these six attribute measures justifies around 33.5 of the cumulative variance. Panel C of Table 1 reports the factor loadings, all of which have positive signs as expected. Overall, the results suggest that our factor analysis provide useful composite measures for the degree of the agency cost of debt. 202 To test hypothesis 2, we estimate the following models by using a calculated composite measure of the agency cost of debt ACD: SPREAD = C + 1 MO + 2 MOACD + 3 CROSS + 4 FSTABLE + 5 MARGIN + 6 DER + 7 INCR + 8 LNASIZE + 9 BSIZE + 10 MATURE + 11 BCFIRM + 12 RISKP + YEAR + ε, 2 where ACD = the agency cost of debt, computed using factor analysis based on six financial variables: 1 RD expendituressales, 2 1 – fixed assetstotal assets, 3 cash 202 Although we also conduct factor analysis on a year-by-year basis for our sample and calculate the ACD by each year 1996 –2003, the results are generally consistent with those of the body. 1273 and marketable securitiestotal assets, 4 common dividendstotal assets, 5 the standard deviation of ROA net incometotal assets for the past five years, and 6 the standard deviation of leverage total debttotal assets for the past five years. The positive negative coefficient of MOACD provides evidence that the association between managerial ownership and interest rate spread is greater smaller when the agency cost of debt at issuing corporate bonds is larger smaller. Therefore, the expected sign of the coefficient of MOACD for supporting hypothesis 2 is positive.

IV. Sample selection and descriptive statistics

Sample selection The sample of Japanese firms was selected on the basis of the following criteria: i The firms issued straight bonds from April 1997 to March 2004. ii Banks, securities firms, insurance firms, and other financial institutions are eliminated from this study. iii The fi rms‘ financial year ends in εarch. iv The financial statements, stock prices, and bond issue data necessary for this study are available from the respective databases mentioned below. The data on bond issues during the sample period are collected from the Bond database issued by I-N Information Systems Ltd. This database provides detailed security-specific information on corporate bonds, including interest rate spread, total 1274 amount of the bond, number of years till maturity, and credit rating. We collected data regarding managerial ownership, financial statements, and stock prices from Nikkei NEEDS - Financial QUEST of Nikkei Media Marketing. The other corporate ownership variables, cross-shareholdings and stable shareholdings, were obtained from the NLI Research Institute, the Data Package of Cross-Shareholding and Stable Shareholding. Cross-shareholders include all domestic companies listed on the Japanese stock markets at the end of the fiscal year. The stable shareholdings are defined as the fraction of the shares that are owned by stable shareholders at the end of the fiscal year. Stable shareholders include financial institutions, trust banks, and other financial institutions i.e., brokerage companies and securities finance companies. 203 Bond information must be matched with corporate ownership and financial statement data. If the firm issues the bond for fiscal period t, then corporate ownership and other financial statement data for the period t – 1 are matched with the bond. The accounting data is based on consolidated financial statements. 204 In order to ensure that the results are not sensitive to extreme values, observations in the highest and lowest one percent of SPREAD and of each accounting variable were omitted. The final sample consisted of 643 firm-year observations. Descriptive statistics Table 2 presents descriptive statistics for the variables used in this study. It shows that the mean median yield spread of a corporate bond over a government bond having 203 These also include parent companies. 204 We also conducted robustness tests by using unconsolidated financial statements because consolidated financial statements were not required for primary financial statements under the Securities and Exchange Law of Japan before March 2000 Shuto 2009. The results based on unconsolidated financial statements data are consistent with those of the analyses of the body. 1275 the same characteristics is about 0.61 0.51, with a standard deviation of 0.425. For our sample, the mean median percentage of managerial ownership MO is 0.007 0.001, which exhibits fair skewness distribution. This value is lower than that of prior studies that have examined the managerial ownership of Japanese firms Teshima 2004; Shuto and Takada 2008; Teshima and Shuto 2008. Insert Table 2 about here In our opinion, the lower value arises from the fact that our sample is restricted to firms that issue corporate bonds. Since it is likely that the firms that issue bonds are relatively large and mature, the managerial ownership of these firms is expected to be smaller. 205 Further, we can observe that the value of managerial ownership in the sample of Ortiz-Molina 2006 for US firms is considerably smaller than that of prior studies. The value of cross-shareholding ownership CROSS is 12.6, whereas that of stable shareholding ownership FSTABLE is 16. Insert Table 3 about here Table 3 indicates the correlations matrix for the variables on the analysis of cost of debt. The lower left-hand portion of the table reports the Pearson correlations, and the 205 Prior studies that examine Japanese firms indicate that managerial ownership is negatively correlated with firm size, which support our consideration. For example, Shuto and Takada 2008, which examines Japanese firms from 1990 and 2005, indicate that managerial ownership is negatively and significantly correlated with firm size The coefficient of spearman correlation = – 0.438, p-value = 0.000. In our sample, Table 3 also indicates that MO is negatively correlated with LNASIZE. 1276 upper right-hand portion presents the Spearman rank-order correlations. The Pearson correlations reveal that MO is positively correlated with SPREAD 0.16, as expected. Table 3 also shows that MO is positively correlated with ACD 0.13, and that ACD is positively correlated with SPREAD 0.30. The results suggest that managerial ownership is positively associated with the agency cost of debt for the fiscal year immediately preceding the bond issue, and that the agency cost of debt is positively associated with interest rate spread.

V. Main results

Managerial ownership and interest rate spread We estimate regression model 1 to test hypothesis 1, the results of which are summarized in Table 4. The reported t-statistics are based on the heteroscedasticity- corrected covariance matrix by White 1980. In model 1, the coefficient of MO is 1.829 and significantly positive at the less than 0.01 level, as expected. This result holds after controlling for the other ownership structure, characteristics of the issuer, characteristics of the issued bonds, and market conditions. Thus, managerial ownership has an incremental explanatory power for the cost of debt when the other ownership structure and control variables are given. The result suggests that prospective bondholders interpret an increase in managerial ownership as an increase in the conflict of interest between bondholders and shareholders. This supports our first hypothesis. Insert Table 4 about here 1277 Further, we find that the coefficient on FSTABLE is significantly negative at the less than 0.01 level. The result is consistent with our prediction that stable shareholdings by financial institutions have a favorable impact on the cost of debt through efficient monitoring. This finding indicates that firms facing stronger external and effective monitoring by financial institutions are rewarded with lower yield spreads. The coefficient on CROSS is not significant, which suggests that cross-shareholdings have no impact on the cost of debt in the presence of other ownerships and control variables. With respect to control variables, they have their expected signs, except for INCURE and MATUR , and are statistically significant at conventional levels. Agency cost of debt, managerial ownership, and interest rate spread Table 5 shows the regression result of model 2 to test hypothesis 2. To support hypothesis 2, we expect the coefficient of MOACD to be positive in the model. In model 2, the coefficient of MOACD is 3.839 and significantly positive at the less than 0.01 level, as hypothesized. We also find that the coefficient on MO is no longer positive. The result indicates that managerial ownership has a stronger effect on interest rate spread when the agency cost of debt at the time of corporate bond issue is larger. This finding is consistent with hypothesis 2. We observe that our control variables have their expected signs, except for MATUR, and that most of the variables are statistically significant at conventional levels. Insert Table 5 about here 1278 Overall, the evidence from Section V suggests that prospective bondholders use managerial ownership information to anticipate a firm‘s future agency cost of debt and default risk, and then they incorporate this prediction in the pricing of new corporate bond issues. Further, bond investors are likely to estimate a firm‘s future agency cost of debt and default risk higher when managers have already engaged in an action that transfers wealth from the bondholders to the shareholders or when managers have a wide range of options for this purpose at the time of bond issue.

VI. Additional analyses

The nonlinearity of managerial ownership and the cost of debt As discussed in Section II, some prior studies suggest the possibility that managerial ownership is nonmonotonically related to the cost of debt Bagnani et al. 1994; Ortis-Molina 2006. To address the possibility of the nonlinearity of managerial ownership and the cost of debt, we estimate the following model. SPREAD = C + 1 MO + 2 MO 2 + 3 CROSS + 4 FSTABLE + 5 MARGIN + 6 DER + 7 INCR + 8 LNASIZE + 9 BSIZE + 10 MATURE + 11 BCFIRM + 12 RISKP + YEAR + ε,3 where MO 2 = the square of the fraction of the shares owned by directors 1279 Although a piecewise regression model is used in the prior studies Bagnani et al. 1994; Ortis-Molina 2006, we use the quadratic form mentioned above. Short and Keasey 1999 argue that the empirical application of the piecewise regression model has a drawback: it allows the coefficients of the managerial ownership variables to change only at predetermined levels of ownership. Since there is no theoretical guidance for the choice of the turning points on the piecewise regression model, we test the relationship between managerial ownership and the cost of debt using the quadratic form, which allows the turning points to be determined endogenously. Insert Table 6 about here Table 7 indicates the regression results. It shows that while the coefficient of MO is significantly positive, the coefficient of MO 2 is not significant. It also reveals that the explanatory power adjusted R² of model γ is 0.56β, which is slightly lower than that of model 1 in Table 1 0.563. These results suggest that MO 2 has no incremental explanatory power for interest rate spread and is not consistent with the assumption that the relation between the cost of debt and managerial ownership is nonmonotonic. In addition to the discussion regarding Section II, we can suggest two possible reasons for our results being different from those of Bagnani et al. 1994. First, as stated above, Bagnani et al. use a piecewise regression model to test the hypothesis. Second, we also indicate the possibility of sample selection biases because they obtained the sample from the list of Fortune 500 companies, which comprises only those firms whose revenues are extremely high. 1280 The effect of bond rating on the relation between managerial ownership and the cost of debt Our results are consistent with hypothesis 2 indicating that the association between managerial ownership and interest rate spread is greater when the agency cost of debt at the time of corporate bond issue is larger. To verify the robustness of the results, we estimate the regression model using the bond rating instead of ACD because the bond rating is often assumed to reflect an agency cost of debt and a firm‘s default risk Sengupta 1998; Bhojraj and Sengupta 2003; Shuto et al. 2009. Further, Bhojraj and Sengupta 2003 argue that the influence of corporate governance mechanisms would be more critical when dealing with debts of poor quality than otherwise. For high- risk firms, bondholders would rely more on the firm‘s governance structure because traditional measures of past profitability and leverage may not be very informative about future cash flows. Thus, we expect that the ownership structure should have a greater effect on bond yield spread for poorly rated bonds than on high-quality bonds. In particular, we estimate the following regression model: SPREAD = C + β 1 MO + β 2 MORATE + β 3 CROSS + β 4 FSTABLE + β 5 MARGIN + β 6 DER + β 7 INCR + β 8 lnASIZE + β 9 BSIZE + β 10 MATURE + β 11 BCFIRM + β 12 RISKP + YEAR + ε,4 1281 where RATE takes the value 1 through 10, representing the bond ratings of AAA, AA + , AA, AA – , A + , A, A – , BBB + , BBB, and BBB – , respectively. 206 We expect the coefficient on MORATE to be negative in model 4. The result of the regression with the interaction term is given in Table 7. In model 4, the coefficient of MORATE is positive and statistically significant at the 0.05 level, as expected. The result reveals that managerial ownership has stronger effects on bond yield spread for lower rated bonds, which is consistent with the results of the previous section and the implication of the theory. Insert Table 7 about here Endogeneity of managerial ownership and the cost of debt Our results suggest that shareholding of managers increase the cost of debt because rational bondholders use managerial ownership information to anticipate a firm‘s future agency cost of debt and default risk. While interpreting the results, we should consider the joint determination of managerial ownership and the cost of debt. Firm managers may consider the cost of capital of the firms when deciding whether or not to hold stocks of their firms . If MO and SPREAD are jointly determined, the estimated results are biased and difficult to interpret. To solve this simultaneity problem, we use a simultaneous equation model in which the shareholding of managers and the interest rate spread are jointly determined. Specifically, we consider the following system of equations: 206 The bond rating used in this analysis is from Rating and Investment Information Inc RI, the most comprehensive and popular database on bond ratings in Japan. 1282 SPREAD = C + β 1 MO + β 2 CROSS + β 3 FSTABLE + β 4 MARGIN + β 5 DER + β 6 INCR + β 7 lnASIZE + β 8 BSIZE + β 9 MATURE + β 10 BCFIRM + β 11 RISKP + YEAR + ε 5 MO = C + β 1 SPREAD + INSTRUMENTS + ε6 We estimate model 5 by conducting a two-stage regression. In the first stage, we regress MO on all exogenous variables from models 5 to 6. The estimation of this regression requires the construction of a set of variables INSTRUMENTS associated with managerial ownership. We use two variables as the instruments: sales growth and 1 – fixed assetstotal assets. In the second stage, we estimate model 5 instead of MO using the fitted value from the first stage. This value is labeled as MOFIT. 207 Insert Table 8 about here The results of the estimation of the second-stage regression are summarized in Panel A of Table 8. These results are consistent with those in the previous section: The coefficient of MOFIT is positive and statistically significant. We also test hypothesis 2 207 Using the Hausman 1978 test, we also assess whether the two variables MO and SPREAD are jointly determined. To conduct this test, we run the second-stage regression, while including both the actual variables and the predicted value from the first-stage regression. The test rejects the null hypothesis that the coefficient of the predicted value is zero p-value = 0.000, which implies that the simultaneity problem does exist. 1283 by using a two-stage regression. 208 Panel B indicates that the coefficient of MOACD is significantly positive, which supports our second hypothesis. These results suggest that our findings do not merely reflect the simultaneity between managerial ownership and interest rate spread. Robustness of the results Finally, we describe the analyses conducted further to verify the robustness of our results. First, we conduct a regression analysis on a year-by-year basis for our sample and estimate the t-value based on the approach used by Fama and Macbeth 1973. Since these empirical analyses are based on eight years of pooled cross-sectional data in which the same firm can appear multiple times in the sample, these observations may not be independent. This procedure may involve cross-sectional and autocorrelational problems. It is well known that the Fama and Macbeth 1973 approach can solve these problems and provide a better inference on the estimates. Insert Table 9 about here The results are summarized in Table 9. Panel A summarizes the results for hypothesis 1. We are mostly able to obtain the same results: the coefficient of MO is 208 Specifically, we consider the following system of equations: SPREAD = C + 1 MO + 2 MOACD + 3 CROSS + 4 FSTABLE + 5 MARGIN + 6 DER + 7 INCR + 8 LNASIZE + 9 BSIZE + 10 MATURE + 11 BCFIRM + 12 RISKP + YEAR + ε7 MO = C + β 1 SPREAD + INSTRUMENTS + ε6 1284 significantly positive. With respect to the test of hypothesis 2, the regression results are summarized in Panel B of Table 9, which provides evidence supporting hypothesis 2 that the coefficient of MOACD is significantly positive. Our results are robust under the Fama and Macbeth 1973 approach. Finally, we also examine the relationship between managerial ownership and the cost of equity capital. If managerial ownership reflects the bondholder-shareholder conflict in our research setting, it is expected that managerial ownership would not be positively associated with the cost of equity capital because we cannot correctly predict how the severity of bondholder-shareholder conflict affects the cost of equity capital. 209 We use the cost of equity capital measured using the three-factor model based on the study by Fama and French 1993. 210 With regard to control variables, we added the logarithm of the market value of equity MV and capital asset pricing model CAPM beta estimated using data from 60 months preceding the most recent month of April BETA to model 1 and deleted the variables of the characteristics of the issued bonds from the model. Our untabulated result shows that the coefficient of MO is negative and not significant, which is consistent with our prediction.

VII. Conclusion

Agency theory predicts that shareholdings of managers create a conflict of interest between shareholders and bondholders Jensen and Meckling 1976; Myers 1977. 209 If the incentive alignment effect on managerial ownership dominates in this setting, we can expect that managerial ownership is negatively associated with the cost of equity capital because the effect has a potential to increase the shareholder value of firms and decrease the cost of equity capital. 210 For details on the estimation method of the cost of equity capital, see Appendix. 1285 δimited liability shareholders may have an incentive to expropriate bondholders‘ wealth by taking investment and financial deci sions aimed at reducing the value of the firm‘s outstanding debt. Rational bondholders would demand a higher interest rate to compensate for the added risk on owner- managers‘ behaviors. To test the implication of the theory, we investigate the relationship between managerial ownership and the cost of debt, as measured by the interest rate spread on corporate bonds for Japanese firms. We find that managerial ownership is positively associated with interest rate spread on corporate bonds, as expected. We also find that stable shareholding has a significantly positive association with the interest rate spread, while cross-shareholding is not significantly correlated with it. Further, we expect that the effect of managerial ownership on the cost of debt strengthens when the potential agency cost of debt of firms at the time of bond issue is larger. By employing factor analysis to measure the current agency cost of debt, we find that managerial ownership has a higher correlation with interest rate spread when the potential agency cost of debt at the time of bond issue is larger. The results are robust with respect to additional analyses, including the possibility of a nonlinear relationship, bond ratings, endogeneity problems, and the Fama and Macbeth 1973 approach. Consequently, our results suggest that prospective bondholders in the Japanese market anticipate a firm‘s future agency cost of debt by using managerial ownership information and incorporate this prediction in the pricing of new corporate bond issues. Further results suggest that the prospective bondholders estimate a higher firm‘s future agency cost of debt because of managerial behavior that benefits the managers at the expense of bondholders‘ wealth when the current agency cost of debt at the time of bond 1286 issue is already larger. Our results also suggest that prospective bondholders perceive stable shareholdings of financial institutions to be mitigating the wealth transfer problem between bondholders and shareholders. Overall, our results suggest that managerial ownership is an important determinant of bond yield spread in the Japanese bond market. The results also suggest that bond investors focus on the current agency cost of debt at the time of bond issue to determine the interest rate in the bond contract. Further, the results show that accounting information is useful in estimating the agency cost of debt. Finally, we find that agency theory on the conflict between shareholders and bondholders applies to the practice of the Japanese bond market after controlling for the unique Japanese ownership structure, cross-shareholding, and stable shareholding of financial institutions. While previous studies generally focus on the findings related to the unique ownership structure in Japan, our results indicate that the empirical implication of the traditional agency theory on managerial ownership is also supported by analyses for the Japanese bond market. 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Econometrica 48 4: 817 –838. 1291 TABLE 1 Factor analysis results on measuring agency cost of debt Panel A: Pearson correlation matrix ACD 1 ACD 2 ACD 3 ACD 4 ACD 5 ACD 6 ACD 1 1.000 ACD 2 0.247 1.000 ACD 3 0.018 0.615 1.000 ACD 4 0.128 0.102 0.149 1.000 ACD 5 0.225 0.282 0.090 0.011 1.000 ACD 6 0.201 0.115 0.183 0.158 0.315 1.000 Panel B: Total variance explained Component Eigenvalue of Variance Cumulative 1 2.008 33.460 33.460 2 1.183 19.721 53.181 3 0.999 16.650 69.831 4 0.852 14.200 84.030 5 0.656 10.929 94.959 6 0.302 5.041 100.000 Panel C: Component Matrix Factor loadings Loading ACD 1 0.476 ACD 2 0.783 ACD 3 0.682 ACD 4 0.330 ACD 5 0.557 ACD 6 0.533 Note: Table reports the results from computing the agency cost of debt ACD measure using factor analysis based on following six financial variables: ACD 1 = RD expendituressales ACD 2 = 1 fixed assetstotal assets ACD 3 = cash and marketable securitiestotal assets ACD 4 = common dividendstotal assets ACD 5 = the standard deviation of ROA net incometotal assets for the past five years ACD 6 = the standard deviation of leverage total debttotal assets for the past five years Principal components method is used for extraction method Statistically significant at the 0.01 level of significance using a two-tailed t-test Statistically significant at the 0.05 level of significance using a two-tailed t-test 1292 TABLE 2 Descriptive statistics Mean Median Max Min SD Skewness Kurtosis N SPREAD 0.606 0.510 1.990 0.050 0.425 0.833 2.945 643 MO 0.007 0.001 0.405 0.000 0.031 8.969 99.797 643 CROSS 0.126 0.120 0.486 0.000 0.088 0.475 3.059 643 FSTABLE 0.160 0.138 0.690 0.000 0.131 1.522 5.968 643 MARGIN 0.043 0.037 0.332 -0.032 0.042 3.533 21.700 643 DER 4.059 3.026 33.479 0.514 3.949 3.427 19.761 643 INCR 7.521 3.069 230.670 -1.230 17.315 7.061 67.591 643 LNASIZE 13.689 13.735 16.532 11.028 1.227 0.017 2.378 643 BSIZE 23.336 23.026 25.734 21.640 0.740 0.527 3.209 643 MATUR 7.398 7.000 20.000 2.000 3.870 1.764 6.388 643 BCFIRM 0.229 0.000 1.000 0.000 0.420 1.292 2.671 643 RISKP 0.711 0.560 1.318 0.175 0.350 0.334 1.566 643 ACD 0.000 0.030 4.397 -2.012 1.000 0.365 3.602 589 Note: SPREAD = the interest rate spread on the first straight bond issued of the fiscal year; the spread is the difference between the interest rate on the bond issued by the firm and that on government bonds MO = fraction of the shares owned by directors CROSS = fraction of the shares that are cross-owned by non-financial companies cross-shareholdings. FSTABLE = fraction of the stable shareholdings by financial institutions MARGIN = the operating income divided by net sales DER = the debt equity ratio INCR = the interest coverage ratio LNASIZE = the natural log of the total assets BSIZE = the log of the issue size MATUR = the years to maturity BMCOMP = an indicator variable that takes the value of one if a bond management company is established, and zero otherwise RISKP = the risk premiumμ the average values of SPREAD on RI‘s A bonds for the month of issue ACD = the agency cost of debt, computed using factor analysis based on six financial variables; 1 RD expendituressales, 2 1 fixed assetstotal assets, 3 cash and marketable securitiestotal assets, 4 common dividendstotal assets, 5 the standard deviation of ROA net incometotal assets for the past five years, 6 the standard deviation of leverage total debttotal assets for the past five years 1293 TABLE 3 Correlations matrix SPR EAD MO CRO SS FSTA BLE MAR GIN DER INCR LNA SIZE BSIZE MAT UR BCF IRM RIS KP ACD SPREAD 1 0.34 0.13 0.01 -0.31 0.03 -0.02 -0.40 -0.41 -0.46 -0.19 0.54 0.32 MO 0.16 1 0.18 0.05 0.04 -0.31 0.30 -0.67 -0.46 -0.25 -0.16 0.06 0.22 CROSS 0.08 -0.10 1 0.20 -0.04 -0.17 0.05 -0.26 -0.24 -0.03 -0.19 0.07 0.12 FSTABLE 0.01 -0.14 0.04 1 0.06 -0.17 0.06 -0.25 -0.10 0.00 -0.04 0.10 0.03 MARGIN -0.13 0.31 -0.11 0.03 1 -0.36 0.58 -0.08 0.12 0.21 0.15 -0.07 -0.06 DER 0.05 -0.06 -0.22 -0.22 -0.21 1 -0.67 0.53 0.16 0.04 0.27 -0.03 -0.54 INCR 0.01 0.31 -0.15 -0.06 0.62 -0.11 1 -0.40 -0.13 -0.13 -0.27 -0.02 0.46 LNASIZE -0.36 -0.12 -0.24 -0.23 -0.10 0.39 -0.09 1 0.65 0.31 0.19 -0.05 -0.35 BSIZE -0.37 -0.05 -0.22 -0.09 0.06 0.09 0.01 0.68 1 0.34 0.21 -0.02 -0.19 MATUR -0.40 -0.11 -0.06 -0.05 0.06 0.00 -0.12 0.37 0.33 1 0.02 -0.08 -0.33 BCFIRM -0.10 0.01 -0.18 -0.07 0.06 0.16 -0.11 0.19 0.22 0.12 1 -0.12 -0.34 RISKP 0.54 -0.01 0.05 0.12 -0.05 -0.01 -0.03 -0.02 -0.01 -0.07 -0.14 1 0.06 ACD 0.30 0.13 0.10 0.08 -0.01 -0.43 0.38 -0.36 -0.16 -0.39 -0.32 0.05 1. Note: Spearman Pearson correlations are above below the diagonal. SPREAD = the interest rate spread on the first straight bond issued of the fiscal year; the spread is the difference between the interest rate on the bond issued by the firm and that on government bonds MO = fraction of the shares owned by directors CROSS = fraction of the shares that are cross-owned by non-financial companies cross-shareholdings. FSTABLE = fraction of the stable shareholdings by financial institutions MARGIN = the operating income divided by net sales DER = the debt equity ratio INCR = the interest coverage ratio LNASIZE = the natural log of the total assets BSIZE = the log of the issue size MATUR = the years to maturity BMCOMP = an indicator variable that takes the value of one if a bond management company is established, and zero otherwise RISKP = the risk premiumμ the average values of SPREAD on RI‘s A bonds for the month of issue ACD = the agency cost of debt, computed using factor analysis based on six financial variables; 1 RD expendituressales, 2 1 fixed assetstotal assets, 3 cash and marketable securitiestotal assets, 4 common dividendstotal assets, 5 the standard deviation of ROA net incometotal assets for the past five years, 6 the standard deviation of leverage total debttotal assets for the past five years CEC = the cost of equity capital measured using the three factor model based on Fama and French 1993 MV = the logarithm of the market value of equity BETA = CAPM beta estimated using 60 months of data prior to the most recent April 1294 TABLE 4 Regression results on the relationship between managerial ownership and bond spreads Dependent variable = SPREAD Independent variable Expected sign Model 1 Coefficient t -value Constant 3.359 7.804 MO + 1.829 4.164 CROSS + 0.065 0.488 FSTABLE – -0.247 -2.978 MARGIN – -1.380 -3.203 DER + 0.012 3.278 INCR – 0.001 0.871 LNASIZE – -0.069 -4.401 BSIZE – -0.087 -3.821 MATUR + -0.025 -7.599 BCFIRM + 0.079 2.179 RISKP + 0.500 8.558 Adj. R 2 0.563 N 643 Note: SPREAD = the interest rate spread on the first straight bond issued of the fiscal year; the spread is the difference between the interest rate on the bond issued by the firm and that on government bonds MO = fraction of the shares owned by directors CROSS = fraction of the shares that are cross-owned by non-financial companies cross-shareholdings. FSTABLE = fraction of the stable shareholdings by financial institutions MARGIN = the operating income divided by net sales DER = the debt equity ratio INCR = the interest coverage ratio LNASIZE = the natural log of the total assets BSIZE = the log of the issue size MATUR = the years to maturity BMCOMP = an indicator variable that takes the value of one if a bond management company is established, and zero otherwise RISKP = the risk pre miumμ the average values of SPREAD on RI‘s A bonds for the month of issue Indicator variables for the year Year are included but not reported. t -statistics are provided in parentheses. They are based on White‘s 1λ80 heteroskedasticity-consistent standard errors and covariance. Statistically significant at the 0.01 level of significance using a two-tailed t-test Statistically significant at the 0.05 level of significance using a two-tailed t-test 1295 TABLE 5 Result of the differential effect of the agency cost of debt on the relationship between managerial ownership and bond spreads Dependent variable = SPREAD Independent variable Expected sign Model 2 Coefficient t -value Constant 3.118 7.279 MO + -1.131 -1.652 MOACD + 3.839 4.666 CROSS + 0.102 0.768 FSTABLE – -0.175 -2.053 MARGIN – -1.496 -3.567 DER + 0.032 5.389 INCR – -0.002 -1.602 LNASIZE – -0.105 -6.485 BSIZE – -0.055 -2.420 MATUR + -0.025 -7.370 BCFIRM + 0.018 0.464 RISKP + 0.475 8.073 Adj. R 2 0.607 N 589 Note: SPREAD = the interest rate spread on the first straight bond issued of the fiscal year; the spread is the difference between the interest rate on the bond issued by the firm and that on government bonds MO = fraction of the shares owned by directors ACD = the agency cost of debt, computed using factor analysis based on six financial variables; 1 RD expendituressales, 2 1 fixed assetstotal assets, 3 cash and marketable securitiestotal assets, 4 common dividendstotal assets, 5 the standard deviation of ROA net incometotal assets for the past five years, 6 the standard deviation of leverage total debttotal assets for the past five years CROSS = fraction of the shares that are cross-owned by non-financial companies cross-shareholdings. FSTABLE = fraction of the stable shareholdings by financial institutions MARGIN = the operating income divided by net sales DER = the debt equity ratio INCR = the interest coverage ratio LNASIZE = the natural log of the total assets BSIZE = the log of the issue size MATUR = the years to maturity BMCOMP = an indicator variable that takes the value of one if a bond management company is established, and zero otherwise RISKP = the risk premiumμ the average values of SPREAD on RI‘s A bonds for the month of issue Indicator variables for the year Year are included but not reported. t -statistics are provided in parentheses. They are based on White‘s 1λ80 heteroskedasticity-consistent standard errors and covariance. Statistically significant at the 0.01 level of significance using a two-tailed t-test Statistically significant at the 0.05 level of significance using a two-tailed t-test Statistically significant at the 0.1 level of significance using a two-tailed t-test 1296 TABLE 6 Regression results on the nonlinear relationship between managerial ownership and bond spreads Dependent variable = SPREAD Independent variable Expected sign Model 3 Coefficient t -value Constant 3.356 7.795 MO 1.939 2.019 MO 2 -0.364 -0.119 CROSS + 0.065 0.491 FSTABLE – -0.245 -2.951 MARGIN – -1.383 -3.238 DER + 0.012 3.272 INCR – 0.001 0.874 LNASIZE – -0.068 -4.269 BSIZE – -0.087 -3.812 MATUR + -0.025 -7.587 BCFIRM + 0.079 2.180 RISKP + 0.500 8.552 Adj. R 2 0.562 N 643 Note: SPREAD = the interest rate spread on the first straight bond issued of the fiscal year; the spread is the difference between the interest rate on the bond issued by the firm and that on government bonds MO = fraction of the shares owned by directors MO 2 = square of the fraction of the shares owned by directors CROSS = fraction of the shares that are cross-owned by non-financial companies cross-shareholdings. FSTABLE = fraction of the stable shareholdings by financial institutions MARGIN = the operating income divided by net sales DER = the debt equity ratio INCR = the interest coverage ratio LNASIZE = the natural log of the total assets BSIZE = the log of the issue size MATUR = the years to maturity BMCOMP = an indicator variable that takes the value of one if a bond management company is established, and zero otherwise RISKP = the risk premiumμ the average values of SPREAD on RI‘s A bonds for the month of issue Indicator variables for the year Year are included but not reported. t -statistics are provided in parentheses. They are based on White‘s 1λ80 heteroskedasticity-consistent standard errors and covariance. Statistically significant at the 0.01 level of significance using a two-tailed t-test Statistically significant at the 0.05 level of significance using a two-tailed t-test 1297 TABLE 7 Result of the differential effect of bond ratings on the relationship between managerial ownership and bond spreads Dependent variable = SPREAD Independent variable Expected sign Model 4 Coefficient t -value Constant 3.104 6.915 MO + 0.489 1.194 LOWRATEMO + 2.029 2.420 CROSS + 0.103 0.769 FSTABLE – -0.227 -2.627 MARGIN – -1.570 -2.750 DER + 0.013 2.700 INCR – 0.003 2.230 LNASIZE – -0.068 -4.231 BSIZE – -0.078 -3.437 MATUR + -0.021 -6.289 BCFIRM + 0.048 1.145 RISKP + 0.465 7.360 Adj. R 2 0.596 N 520 Note: SPREAD = the interest rate spread on the first straight bond issued of the fiscal year; the spread is the difference between the interest rate on the bond issued by the firm and that on government bonds MO = fraction of the shares owned by directors LOWRATE = an indicator variable that takes the value of one if RI‘s bond ratings are A or BBB, and zero otherwise i.e. AAA or AA. CROSS = fraction of the shares that are cross-owned by non-financial companies cross-shareholdings. FSTABLE = fraction of the stable shareholdings by financial institutions MARGIN = the operating income divided by net sales DER = the debt equity ratio INCR = the interest coverage ratio LNASIZE = the natural log of the total assets BSIZE = the log of the issue size MATUR = the years to maturity BMCOMP = an indicator variable that takes the value of one if a bond management company is established, and zero otherwise RISKP = the risk premiumμ the average values of SPREAD on RI‘s A bonds for the month of issue Indicator variables for the year Year are included but not reported. t -statistics are provided in parentheses. They are based on White‘s 1λ80 heteroskedasticity-consistent standard errors and covariance. Statistically significant at the 0.01 level of significance using a two-tailed t-test Statistically significant at the 0.05 level of significance using a two-tailed t-test 1298 TABLE 8 The results from the estimation of the second-stage regression on MO Panel A: The test of hypothesis 1 Dependent variable = SPREAD Independent variable Expected sign Model 5 Coefficient t -value Constant 1.945 3.842 MOFIT + 22.255 5.387 CROSS + 0.830 4.148 FSTABLE – 0.635 3.607 MARGIN – -4.310 -6.368 DER + 0.017 3.824 INCR – -0.009 -3.313 LNASIZE – -0.034 -1.949 BSIZE – -0.079 -3.310 MATUR + -0.011 -2.775 BCFIRM + 0.016 0.439 RISKP + 0.550 9.348 Adj. R 2 0.569 N 626 Panel B: The test of hypothesis 2 Dependent variable = SPREAD Independent variable Expected sign Model 7 Coefficient t -value Constant 4.317 8.914 MOFIT + -39.172 -5.128 MOACD 40.940 5.534 CROSS + 0.126 0.929 FSTABLE – -0.393 -3.923 MARGIN – -3.265 -6.088 DER + 0.037 6.469 INCR – -0.003 -1.910 LNASIZE – -0.178 -7.904 BSIZE – -0.057 -2.501 MATUR + -0.021 -6.076 BCFIRM + 0.099 2.390 RISKP + 0.450 7.697 Adj. R 2 0.627 N 586 Note:SPREAD = the interest rate spread on the first straight bond issued of the fiscal year; the spread is the difference between the interest rate on the bond issued by the firm and that on government bonds MO = fraction of the shares owned by directors ACD = the agency cost of debt, computed using factor analysis based on six financial variables; 1 RD expendituressales, 2 1 fixed assetstotal assets, 3 cash and marketable securitiestotal assets, 4 common dividendstotal assets, 5 the standard deviation of ROA net incometotal assets for the past five years, 6 the standard deviation of leverage total debttotal assets for the past five years CROSS = fraction of the shares that are cross-owned by non-financial companies cross-shareholdings. FSTABLE = fraction of the stable shareholdings by financial institutions MARGIN = the operating income divided by net sales DER = the debt equity ratio INCR = the interest coverage ratio LNASIZE = the natural log of the total assets BSIZE = the log of the issue size MATUR = the years to maturity BMCOMP = an indicator variable that takes the value of one if a bond management company is established, and zero otherwise RISKP = the risk premiumμ the average values of SPREAD on RI‘s A bonds for the month of issue Indicator variables for the year Year are included but not reported. 1299 t -statistics are provided in parentheses. They are based on White‘s 1λ80 heteroskedasticity-consistent standard errors and covariance. Statistically significant at the 0.01 level of significance using a two-tailed t-test Statistically significant at the 0.05 level of significance using a two-tailed t-test TABLE 9 Regression results on the relationship between managerial ownership and bond spreads: Fama and Macbeth 1973 approach Panel A: The test of hypothesis 1 Dependent variable = SPREAD Independent variable Expected sign Model 1 Coefficient t -value Constant 3.016 4.740 MO + 2.317 3.182 CROSS + 0.237 2.207 FSTABLE – -0.278 -3.011 MARGIN – -1.122 -2.636 DER + 0.015 2.591 INCR – 0.001 0.647 LNASIZE – -0.058 -2.458 BSIZE – -0.076 -2.070 MATUR + -0.026 -5.644 BCFIRM + 0.060 1.841 RISKP + 0.217 1.631 Adj. R 2 0.424 N 643 Panel B: The test of hypothesis 2 Dependent variable = SPREAD Independent variable Expected sign Model 2 Coefficient t -value Constant 2.875 4.465 MO + -13.468 -1.511 MOACD + 14.918 2.550 CROSS + 0.349 2.137 FSTABLE – -0.253 -2.190 MARGIN – -0.866 -2.374 DER + 0.039 5.192 INCR – -0.005 -1.489 LNASIZE – -0.102 -5.452 BSIZE – -0.046 -1.379 MATUR + -0.024 -5.254 BCFIRM + 0.005 0.134 RISKP + 0.194 1.538 Adj. R 2 0.476 N 589 Note: SPREAD = the interest rate spread on the first straight bond issued of the fiscal year; the spread is the difference between the interest rate on the bond issued by the firm and that on government bonds MO = fraction of the shares owned by directors CROSS = fraction of the shares that are cross-owned by non-financial companies cross-shareholdings. FSTABLE = fraction of the stable shareholdings by financial institutions MARGIN = the operating income divided by net sales DER = the debt equity ratio INCR = the interest coverage ratio LNASIZE = the natural log of the total assets BSIZE = the log of the issue size 1300 MATUR = the years to maturity BMCOMP = an indicator variable that takes the value of one if a bond management company is established, and zero otherwise RISKP = the risk premiumμ the average values of SPREAD on RI‘s A bonds for the month of issue t -statistics are provided in parentheses. They are based on White‘s 1λ80 heteroskedasticity-consistent standard errors and covariance. Statistically significant at the 0.01 level of significance using a two-tailed t-test Statistically significant at the 0.05 level of significance using a two-tailed t-test Statistically significant at the 0.1 level of significance using a two-tailed t-test Appendix Estimation method for the equity cost of capital To calculate a firm‘s estimated equity cost of capital ECC, we estimate the following equation. , , , , , , , , ˆ ˆ ˆ t i t f t RMRF i t M f t SMB i t t HML i t ECC R R R SMB HML            ,1 where R m – R f is the monthly return of the market portfolio in excess of the risk-free rate. HML and SMB are the monthly returns to the book-to-market and size factor mimicking portfolios, as described in Fama and French 1993. First, we calculate each factor‘s average monthly return over a period of 60 months before month m. And then, we estimate the expected annual factor returns, R m – R f , HML, and SMB, by compounding the resulting average monthly returns over a period of 12 months before the beginning of the fiscal year. Second, we estimate the betas associated with the firm‘s return to each of the three factors by estimating the following monthly time series regression, as described in Fama and French 1993. We estimate the following equation by considering the period of the latest 60 months preceding the beginning of the firm‘s fiscal year.   m i m i HML m i SMB m f m M i RMRF i m f m i HML SMB R R R RET , , , , , , , ,             2 1301 FINANCING ALTERNATIVES AND INCENTIVES FOR RENEWABLE ENERGY, FROM THE VIEW POINT OF TURKEY’S MEMBERSHIP TO THE EU Cem Berk, Marmara University Summary In this paper we discuss the approaches to financing conventional energy sources and renewable energy projects from the standpoint of EU-Turkey relation, by focusing on how these transactions differ from more conventional oil trade at the other part of the world. Main features of conventional energy sources and renewable energy are analysed, from the strategic point of view and Turkey‘s regional position to the surrounding oil and gas producing countries. Strategic alignment and future oriented advantage of the increasing interest for Caspian and Mediterranean oil transfers to EU countries, has been critically evaluated. The incentives and tax-breaks used in EU including Turkey have been studied to illustrate principles and insure understanding. Attention is also given to different financing instruments and -methods. Finally, quantitative analysis and model on the energy incentives in Turkey are also presented in the paper. 1. Introduction Global warming will result in major environmental, social and economic problems. These negative consequences of are already occurring, and others are inevitable even if the emission of atmospheric greenhouse gases could be stabilized at present levels. In the light of global warming, the political leaders of many countries have accepted that there is an urgent need to reduce greenhouse gas emission on a worldwide scale. At the same time, there is a potential for reducing such emissions by economies in energy use, energy efficiency and by energy generation from alternative, non-carbon-based sources. Turkey as an emerging market will continue its effort to increase diversifies energy sources and the energy requirements. At present, most of Turkey‘s home-produced energy is generated from lignite and poor-quality coal; these are problematic in terms of carbon dioxide emission, so there is the possibility that Turkey‘s contribution to anthropogenic atmospheric carbon dioxide will grow over the coming years. More positively, Turkey has great potential for generating energy from renewable sources. For example, there is considerable possibility of using more hydropower. In addition, many regions of the country are suitable for wind power, and it has been calculated that Turkey could meet a large part of its energy needs from wind farms that could be located along its western seaboard. There are, however, potential barriers to the implementation of such a strategy. Apart from the financial investment that will be needed, there will need to be public support too. 211 See Appendix 1 for Turkish Energy Sector Details Historically, feed-in laws have been the primary mechanism used to support renewable energy RE development in both Europe and the US, where there is a track record of some two decades of experience. At present, they are being applied in 16 EU member countries. 212 Green pricing programs allow electricity customers to express their willingness to pay for renewable energy development through direct payments on their monthly utility bills. 2. Energy Market and –policy 211 Kilinc, Stanistreet, Boyes; Incentives and disincentives for using renewable energy: Turkish students‘ ideas; Renewable and Sustainable Energy Reviews;β008. 212 European PV Association Position Paper On a Feed-in Tariff for Photovoltaic Solar Electricity;; p.3; 2005. 1302 The attributes of energy policy may include legislation, international treaties, incentives to investment, and guidelines for energy conservation, taxation and other public policy techniques. Frequently the dominant issue in the energy policy is the risk of supply-demand mismatch. Current energy policies also address environmental issues. Some governments state explicit energy policy, but, declared or not, each government practices some type of energy policy. The main elements intrinsic to an energy policy are:  The energy self-sufficiency  Energy pricing  The goals for future energy intensity,  Ratio of energy consumption to GDP  Environmental externalities  The diversification of energy recourses  The national policy drive province, state and municipal functions  The incentives accelerating energy sustainability and  Security of supply. Gas is an important input for electricity generation in the energy industry and therefore wholesale natural gas and electricity markets are vertically interrelated. The same is true for wholesale and retail electricity markets since retailers buy electricity from wholesalers. Vertical integration is widespread among European energy firms. Moreover, the merger activity appears to be accelerating as competition opportunities expand, incentive regulation diffuses more widely, and regulators have become less hostile to mergers. As a result, the vertically integrated firm can increase profits by raising both its end-user market share and price. Collaborative incentives, however, not only encourage cooperation but may also enhance free riding. Indeed, rewards based on aggregate profits hinder the identification of individual performances. As a consequence, individuals have more incentives to avoid hoping that the others will compensate. 213

3. Developing Energy Project

The use of non-conventional renewable energy system technologies have received strong incentives in developed countries, especially after the third conference of the parties of Kyoto Protocol. One of the main reasons for these incentives was the existence of a climate change, with global consequences, and with anthropogenic causes mainly related to the use of fossil fuels. As this impact was not included in the fuel prices, the governments that signed the protocol is obligated to give economic incentives for clean technologies, and especially for RE. Kyoto protocol was a compromise between the industrialized countries and Russia who decided to reduce the CO2 emissions a 5.4 with respect to the 1990 emissions, for 2010. EU- countries like Denmark 29 of RE on its energy matrix Germany 9.4, Spain 3.4 and Holland 4 are clear examples where strong incentives for RE were applied, with successful results. 214 If properly regulated and supported, the expansion of renewable energy could make unquestionable contributions in many areas. But if only left to the market forces, the expected effects may never occur or may even become problems to the society. As sites for renewable energy projects become scarcer and energy demand continues to grow, a derived demand for sites could be explained on the basis of the trade-off between their distance and their productivity. In particular, in a competitive market the change from one isoprofit to another by means of 213 Micola, Estanol, Bunn; Incentives and Coordination in Vertically Related Energy Markets; Journal of Economic Behavior Organization; 2008 214 Valencia M. Leonardo; New scenario of the non-conventional renewable energies on Chile after the incentives created on the ‗‗Short δaw I‘‘; Renewable Energy;β008. 1303 relocating a project should be associated to a corresponding increase or decrease in the price of the site, whereas sites lying over the same isoprofit should have similar prices. Of course such market will often be influenced by the multiple use of land, in which the implementation of a renewable energy project is just one of the possible uses explaining demand. Same isoprofit should have similar prices. Of course such market will often be influenced by the multiple use nature of land, in which the implementation of a renewable energy project is just one of the possible uses explaining demand. Technologies, especially wind energy, but also small-scale hydro power, energy from biomass, and solar thermal applications, are economically viable and competitive. The others, especially photovoltaic, depend only on increasing demand and thus production volume to achieve the economy of scale necessary for competitiveness with central generation. This should be seen against the rapidly improving fiscal and economic environment being created in the EU both by European legislation itself swinging into full implementation and the εember States‘ own programmes and support measures, which despite the short-term macro-economic background, are accelerating rapidly at the time of publication. In this context, the generation of energy from renewable sources is beginning to gather strength throughout the world, motivating leaders to implement policies aimed at increasing the number of projects according to this line of thinking. Source: Zulunga, Dyner; Incentives for renewable energy in reformed Latin-American electricity markets: the Colombian case; Journal of Cleaner Production; 2006 Although the reduction of poverty is perhaps the most important concern in the developing countries, there is significant environmental interest associated with the use of new energy sources which will help to reduce the environmental impacts that have been caused by traditional forms of energy based on the combustion of fossil fuels. From simulations carried out for the Colombia market, it is less efficient to promote renewable energies through fiscal policies such as income tax exemption, while other kinds of policies such as direct subsidies have a major effect as far as accelerating the process of technology diffusion. Therefore, it remains for the government to set the appropriate incentives in order to efficiently exploit renewable energy resources. Although in the process of Turkish market, renewable energy did not occupy a prominent place, there now seems to be a new international trend to develop these resources, which will begin to