FinancialThe

EFA
Eastern
Finance
Association Review
The Financial Review 34 (1999) 119-136

Managerial Ownership and Agency

Conflicts: A Nonlinear Simultaneous
Equation Analysis of Managerial
Ownership, Risk Taking, Debt Policy, and
Dividend Policy
Carl R. Chen*
Thomas L. Steiner
University of Dayton

Abstract

This paper uses a nonlinear simultaneous equation methodology to examine how

manage-rial ownership relates to risk taking, debt policy, and dividend policy. The results
have implications for our understanding of agency costs. We find risk to be a significant and
positive determinant of the level of managerial ownership while managerial ownership is
also a significant and positive determinant of the level of risk. The result supports the
argument that managerial ownership helps to resolve the agency conflicts between external
stockholders and managers but at the expense of exacerbating the agency conflict between
stockholders and bondholders. We further observe evidence of substitution-monitoring
effects between managerial ownership and debt policy, between managerial ownership and
dividend policy, and between managerial ownership and institutional ownership.

Keywords: agency theory, managerial ownership, risk, debt policy, dividend policy
JEL classifications: G30lG32

*Corresponding author: Department of Economics and Finance, University of Dayton, 300 College
Park, Dayton, OH 45469-2240;Phone: (937) 229-2418, Fax: (937) 229-2477,E-mail: chen@udayton.edu.
We acknowledge the beneficial comments of an anonymous referee in addition to the efforts of Stephen
P. Fems, the editor. This paper was presented at the 1998 Financial Management Association meetings.

119
120 C.R. Chen, T.L. Steiner/The Financial Review 34 (1999) 119-136

1. Introduction
This paper uses a nonlinear simultaneous equation estimation procedure to
investigate the relation of managerial ownership to risk-taking, debt policy, and
dividend policy. Managerial ownership is an important internal monitoring force which
has been argued to be a function of risk as well as a determinant of risk. For example,
the arguments of Demsetz and Lehn (1985) have been used to explain a positive causal
relation from risk to managerial ownership due to the increased value of this internal
monitoring tool for resolving the agency conflicts between external stockholders and
managers. However, the empirical relation supporting this contention by Crutchley and
Hansen (1989) may be a spurious relation if, indeed, a causality from managerial
ownership to risk exists. For example, the theoretical arguments of Galai and Masulis
(1976) and the empirical results of Saunders, Strock, and Travlos (1990) suggest higher
ownership by managers may exacerbate the agency conflicts between stockholders and
bondholders to the extent it inspires higher risk while Amihud and Lev (1981) and May
(1995) find evidence of an inverse causal relation from managerial ownership to risk.
The relation between managerial ownership and risk, therefore, remains a vital topic for
empirical research.
Additionally, risk is a central theme in financial economics which ties
manage-rial ownership to corporate debt and dividend policies. For example,
while manage-rial ownership has been argued to inspire a higher levels of risk,
higher risk has been argued by Ravid (1988) to cause a lower level of debt and
has been argued by Venkatesh (1989) to cause a reduction in a firm's
willingness to discharge cash through dividend payments. Indeed, Jensen,
Solberg, and Zorn (1992) make arguments that managerial ownership, debt, and
dividends are jointly related although their method produces relatively weak
statistical significance on the parameter estimates in the managerial ownership
equation.' We extend this area of research by considering an empirical model in
which managerial ownership, risk-taking, debt policy, and dividend policy are
each treated as endogenous, jointly determined variables. The specification is
supported by the fact that managerial ownership, risk-taking, debt policy, and
dividend policy are integral parts of corporate decision making in the agency
framework. Institutional ownership along with other control variables is
external to the firm and, therefore, they are not corporate decision variables.
Our paper offers several contributions. First, we model a four-equation system
which explicitly ties managerial ownership and other potential corporate monitoring
forces to corporate risk-takmg, as such, this approach has not been previously
attempted. Second, our model allows us to more powerfully understand how manage-

' Jensen, Solberg, and Zorn proxy managerial ownership with insider ownership which differs from our
measure of officer and director ownership by the inclusion of certain large beneficial owners. The
simultaneous equations methodology has also been employed by a number of other studies including
research by Peterson and Benesh (1983). Dhrymes and Kurz (1967). McCabe (1979), Jalilvand and
Harris (1984), and Bathala, Moon, and Rao (1994).
 C.R. Chen, T.L. SteinedThe Financial Review 34 (1999) 119-136 121

rial ownership relates to risk-taking and, therefore, the conflict between external
shareholders and management as well as the conflict between shareholders and
bondholders. Third, our model allows us to examine how different monitoring
forces (managerial ownership, debt, and dividends) relate to one another in
lowering agency costs. Fourth, the use of ordinary least squares (OLS) regression
analysis to model jointly determined variables generates parameter estimates which
are both biased and inconsistent (Johnston, 1984), drawing into question the results
reported in prior research relative to the pair-wise relations between managerial
ownership, risk, debt, and dividends. The OLS methodology assumes that all
exogeneous variables are uncorrelated with the residual terms. In the case that the
regressors are endogenous, this basic assumption of the OLS estimator is violated
and the resulting estimates are biased and inconsistent. Finally, we introduce a
nonlinear simultaneous equations approach, seldom utilized in financial research,
which allows us to model risk as a nonlinear determinant of managerial ownership
with both risk and managerial owner-ship treated endogenously.
The empirical results of our paper offer several interesting conclusions. First,
the level of risk causes the level of managerial ownership through a nonlinear
relation which is supportive of a positive managerial monitoring hypothesis over
low levels of risk (i.e., managerial ownership is beneficial in reducing the conflict
between external equityholders and management), yet managerial risk aversion
limits the equity contribution of managers over higher levels of risk. Second, the
level of managerial ownership positively causes risk-taking. This result suggests
that while managerial ownership reduces the conflict between management and
external equi-tyholders, it exacerbates the conflict between stockholders and
bondholders. Third, the limitations on managerial ownership, due to wealth
constraints and risk aversion, are mitigated by the substitution-monitoring effects
that are evident between manage-rial ownership and debt and between managerial
ownership and dividends. We find a similar effect between managerial ownership
and institutional ownership. The rest of the paper is organized as follows: Section 2
discusses previous literature on managerial ownership, risk, debt, and dividends.
Section 3 reviews the data, hypothe-ses, and methodology. Empirical results are
reported in Section 4. Section 5 offers concluding remarks.

2. Literature review and the relationships between

the endogenous variables
In this section, we describe research which has attempted to explain the
determi-nants of managerial ownership, risk-taking, debt policy, and dividend
policy sepa-rately, and we motivate the joint relations among these variables.
The determinants of managerial ownership have been argued by previous
researchers to include risk, debt, and dividends, in addition to total equity value and
research and development. Other research also allows us to infer a causal relationship
from institutional ownership (and 5% blockholders) to managerial own-
122 C.R. Chen, T.L. Steiner/The Financial Review 34 ( I 999) I 19-136

ership. Demsetz (1983) and Demsetz and Lehn (1985) argue that firms which operate in
risky markets are more difficult to monitor externally. Based upon this reasoning, higher
risk increases the value of managerial ownership as an internal monitoring mechanism.
However, as Demsetz and Lehn (1985) further argue, at sufficiently high levels of risk,
an aversion to risk may dominate which suggests a negative causal relation from risk to
managerial ownership. Crutchley and Hansen (1989) and Jensen, Solberg, and Zorn
(1992) make these arguments in modeling officer and director ownership and insider
ownership, respectively. Both studies find positive parameter estimates relating risk to
their measures of managerial ownership, although neither study allows for a nonlinear
modeling of the relation and only Crutchley and Hansen (1989) produce significant
parameter estimates. Jensen and Meckling (1976) argue that the use of debt capital
lessens the need for external equity, and thus raises the proportion of managerial
ownership in the firm. However, while Friend and Lang (1988) investigate the causal
relation from managerial ownership to debt, they hypothesize an inverse causality may
also proceed from debt to managerial ownership. One can easily argue that excessive
use of debt increases bankruptcy risk, which in turn, increases the non-diversifiable risk
to the managers thus discouraging managerial ownership. Moreover, the causal relation
from dividends to managerial ownership can be motivated through Jensen’s (1986) free
cash flow hypothesis which argues that dividends reduce agency costs associated with
free cash flow. If dividends and managerial ownership serve as substitutes in controlling
agency problems of free cash flow, we may expect a negative causal relation from
dividends to managerial ownership. A similar explanation can support the causal
relation from debt to managerial ownership as Jensen (1986) argues that debt may also
serve to reduce agency costs associated with free cash flow.
Other variables that can be argued to effect managerial ownership include firm
size, research and development, institutional ownership, and 5% blockholder
ownership. Simple reasoning suggests an inverse relation between total equity value
and managerial ownership. Essentially, financial constraints prevent managers from
owning a high percentage of equity as the total value of equity increases. Demsetz
(1983) and Demsetz and Lehn (1985) make arguments consistent with this
reasoning. Crutchley and Hansen (1989) and Jensen, Solberg, and Zorn (1992) have
modeled managerial ownership as a function of research and development
expenditures and report negative parameter estimates. Crutchley and Hansen (1989)
reason that re-search and development expense registers the presence of
discretionary investment opportunities which serve as a proxy for greater debt
agency costs. Consequently, firms should increase managerial ownership with
higher research and development expense. Alternatively, they suggest that firms
which devote more to research and development impose greater diversification
costs on their managers. Therefore, research and development is an uncertain and
intangible investment inspiring a negative relation to managerial ownership.
Furthermore, the percentage of institutional ownership is hypothesized to be
an inverse determinant of the percentage of managerial ownership based upon
earlier
 C.R. Chen, T.L. Steiner/The Financial Review 34 (1999) 119-136 123

research. Brickley, Lease, and Smith (1988), Pound (1988), and McConnell and
Servaes (1990) each report evidence supporting a positive monitoring role for
institutional investors. Consequently, the presence of institutional investors would
be expected to diminish the need for managerial ownership. Finally, 5% or
blockholder ownership can be hypothesized to influence managerial ownership.
Shleifer and Vishny (1986) develop a model which predicts a positive relation
between the presence of a blockholder and the market value of the firm. However,
Holderness and Sheehan (1988) report empirical evidence that blockholders do not
influence firm value, and McConnell and Servaes (1990) find mostly insignificant
and negative relations across various models. If blockholders serve to reduce
monitoring costs, we expect an inverse relation to managerial ownership. However,
if blockholders impede firm valuation, possibly due to their presence in lowering
the probability of a firm being exposed to the market for corporate control, then we
might expect a non-negative relation to managerial ownership due to a greater
monitoring value for managerial ownership. To summarize, although literature
investigating the deter-minants of managerial ownership is abundant, the results are
less concrete. The employment of our nonlinear simultaneous equation
methodology offers additional insight into this topic.
Existing research has also attempted to explain the determinants of risk. The
determinants include managerial ownership, debt, and dividends, in addition to research
and development, operating leverage, and firm diversification. An under-standing of
agency theory facilitates an appreciation for the causal relation from managerial
ownership to risk. Black and Scholes (1973) and Galai and Masulis (1976) observe that
equity can be regarded as a call option on the firm value with the exercise price equal to
the level of debt in the firm. While the price of this option increases with the firm value,
the option price is bounded from below by zero. Importantly, the value of this call
option (equity position) will increase with the variance or risk of the firm. The causal
relation from managerial ownership to risk can be understood through this analysis.
Because the value of this call option increases with risk, managers who are more
aligned with shareholders through a higher level of equity ownership will undertake
decisions which increase the risk of the firm. In effect, this is a wealth transfer
hypothesis since as risk increases, wealth is transferred from bondholders to
stockholders. Saunders, Strock, and Travlos (1990) have found empirical evidence
consistent with this hypothesis. A second explanation for how managerial ownership
may affect risk-takmg is due to risk aversion concerns of managers.Because managers
have a personal portfolio which is undiversified after their commitments of human and
financial capital, we may expect management’s risk aversion to result in efforts to
reduce firm risk. Treynor and Black (1976) make arguments supportive of this
hypothesis and Amihud and Lev (198 l), May (1999, and Chen, Steiner, and Whyte
(1998) have found empirical evidence consistent with this hypothesis. Additionally,
Venkatesh (1989) has empiri-cally observed a negative causal relation from dividend
policy to risk, while simple financial analysis can demonstrate a positive relation
between financial leverage
124 C.R. Chen, T.L. Steiner/The Financial Review 34 (1999) 119-136

and risk. Moreover, operating leverage increases risk which is well documented
in the finance literature, while firm diversification is expected to reduce risk
through a portfolio effect. Furthermore, the larger the size of the firm, as
measured by the logarithm of the total assets, the lower the firm’s risk. Finally,
Crutchley and Hansen (1989) argue that research and development is an
uncertain, intangible asset which increases firm risk.
Debt policy has been a dominant research topic in financial economics. The
determinants of debt have included risk, managerial ownership, and dividends, in
addition to fixed assets, profitability, and research and development. Ravid (1988)
discusses how higher risk is expected to reduce the enthusiasm of the firm for debt.
Friend and Lang (1988) investigate the effect of managerial self-interest on debt
policy. They concluded that managerial ownership has an inverse causal relation to
debt. On the other hand, both Leland and Pyle (1977) and Kim and Sorenson (1986)
argue for a positive relation whereby managerial ownership causes debt choices.
Jensen, Solberg, and Zorn (1992) have reported a negative causal relation from
dividends to debt policy. They contend firms trade off dividend payments with fixed
financial charges. Moreover, Jensen’s (1986) free cash flow hypothesis also
suggests an inverse relation. For other determinants of debt policy, Scott (1976)
presents a secured debt hypothesis in which debt and fixed assets are positively
related, and Myers and Majluf (1984) make arguments for a negative relation
between profitabil-ity and debt as more profitable firms will decrease their debt
because more internal funds will be available to finance their investments. Finally,
Bradley, Jarrell, and Kim (1984) reason that research and development expense can
be viewed as a tax shield which would result in a negative relation between
research and development and debt.
Dividend policy has also been extensively studied within the financial
literature. The determinants have included risk, managerial ownership, and debt, in
addition to profitability, investment, and growth. Kale and Noe (1990) develop a
model in which higher risk results in a lower dividend payout. Rozeff (1982) has
found a higher level of managerial ownership to cause a lower level of dividend
payments. Furthermore, Jensen, Solberg, and Zorn (1992) report a negative causal
relation from debt levels to dividend payments. They also reason that higher
profitability can be expected to result in higher dividends. Myers and Majluf (1984)
contend that firms may have to choose between dividend payments and capital
expenditures (investments). Finally, Rozeff (1982) argues that greater growth will
be associated with lower dividend payments.
Through this brief survey of previous research, it is evident that the four
endogenous variables - managerial ownership, risk, debt, and dividends - have a
relation to one another. Figure 1 offers a simplified presentation of these various
causal relations by referencing selected theories or empirical findings. It is clear
from this figure that causality may proceed in either of two directions between
each pair of variables which justifies the value of the simultaneous equation
methodology to model the variables. For example, while the arguments of
Demsetz and Lehn
 C.R. Chen, T.L. Steiner/The Financial Review 34 (1999) 119-136 125

Management
Ownership

4 W
Jensen (1986), Jensen, Solberg, & Zom (1992)

Figure 1

Summary of relationships
This figure offers a summary representation of the relationships between management ownership, risk-
taking, debt policy, and dividend policy. Selected empirical and theoretical research supporting each
causal relationship is presented.

(1985) can be used to reason how risk positively impacts management ownership,
Saunders, Strock, and Travlos (1990) contend that management ownership positively
impacts risk. Similar difficulties with causality exist between managerial ownership and
debt policy. As Figure 1 shows, Friend and Lang (1988) find a relation by which
managerial ownership causes debt; however, Jensen and Meckling (1976) argue the use
of debt capital raises the proportion of managerial equity ownership in the firm.
Comparable arguments can be applied to the two-way relation between debt and risk.
Conventional wisdom postulates that debt policy effects firm risk due to financial
leverage, yet Ravid (1988) suggests that firm risk affects debt policy. Additionally,
Jensen, Solberg, and Zorn (1992) find debt and dividends to be jointly determined and
inversely related. Moreover, while Kale and Noe (1990) contend risk causes dividend
policy, Venkatesh (1989) finds that dividend policy influences
126 C.R. Chen, T.L. Steiner/The Financial Review 34 (1999) 119-136

risk. Finally, while Rozeff ( 1 982) reasons that managerial ownership causes
dividend policy, Jensen’s free cash flow hypothesis can explain how dividend
policy may cause managerial ownership.

3. Data, testable hypotheses, and methodology

Based upon our literature review and our arguments of the endogeneity of
the firm’s managerial ownership, risk-taking, debt policy, and dividend policy,
we develop a simultaneous equation model defined by Equations 1-4.
(1) LOWN = f (LRISK, LRISK’, LDEBT, LDIV, LVAL, R&D, FIVE, INST);
(2) LRISK = f (LOWN, LDEBT, LDIV, LSIZE, R&D, OL, DINDEX);
(3) LDEBT = f (LRISK, LOWN, LDIV, FIXED, ROA, R&D);
(4) LDIV = f (LRISK, LOWN, LDEBT, INV, ROA, GRTH).
The following notation is used to define the variables in the empirical model:
LOWN = the natural log of the ratio of officer and director ownership to total shares
outstanding;
LRISK = the natural log of the standard deviation of the market returns on the companies
common stock, a proxy for total risk;
LDEBT = the natural log of long term debt to the market value of equity;
L D N = the natural log of the ratio of dividends divided by operating income plus one;
INST = the percentage of the firm owned by institutional investors;
FIVE = the percentage of the firm owned by 5% blockholders;
O L = operating leverage defined as the ratio of depreciation expense to the total
assets; R&D =the ratio of research and development expenditures to the total assets;
ROA = net income as a percentage of the book value of total assets;
GRTH = average sales growth rate over the previous four years;
DINDEX = a measure of the level of firm diversification, i.e., the concentric diversifica-tion
index;
FIXED = a measure of the level of fixed assets defined as the ratio of property, plant, and
equipment to total assets;
IN V = the level of capital expenditure;
LSIZE = the natural log of the total assets in the firm;
LVAL =the natural log of the total value of the equity of the firm.

The financial data used to estimate Equations 1-4 generated from a sample
of firms which are listed on the New York Stock Exchange and which have
complete financial data on the primary Compustat tapes, the Analysts Consensus
Estimates (ACE) tapes, the CRSP tapes, and the Business Information Compustat
tapes for the year of 1994. Additionally, each firm must have complete managerial
ownership data as reported on proxy statements and the Compact Disclosure
database, complete institutional ownership as reported by Spectrum on the Compact
Disclosure database, and complete 5% ownership as reported by Spectrum on the
Compact Disclosure database. The final sample numbers 785 firms.
 C.R. Chen, T.L. Steiner/The Financial Review 34 (1999) 119-136 127

The endogenous, or jointly determined variables, are managerial ownership

( L O W ) , total risk (LRISK), debt policy (LDEBT), and dividend policy
(LDIV).2 To formulate the variable L O W , we use officer and director
ownership taken from proxy statements and reported in the Compact Disclosure
database. The variable LRISK is generated by using daily stock returns taken
from the CRSP tape over the period 1991 to year-end 1993. Both LDEBT and
LDIV are calculated from information taken from the primary Compustut tape.
The exogenous variables in the system include institutional ownership
(INST), 5% ownership (FIVE) operating leverage (OL), research and development
(R&D), return on assets (ROA), growth (GRTH), firm diversification (DINDEX),
fixed assets (FIXED), capital expenditures (INV), firm size (LSIZE), and equity
value (LVAL). The percentage of institutional ownership (INST) and the
percentage of 5% (FIVE) ownership are taken from the Compact Disclosure
database which reports Spectrum information. A number of the exogenous financial
measures use data from the Compustut database. This includes: OL, R&D, ROA,
FIXED, MV, LSIZE, and LVAL.3 DINDEX is a measure of firm diversification
which is defined using the Business Information Compustut tape. Following
Wernerfelt and Montgomery (1988), this measure is the concentric diversification
index (CI) which is defined as follows:

Note, i represents the firm, j and 1 represent industries within the firm,
wijrepresents the fraction of firm i's assets that are in industry j , and dj,lis a weight
whose value depends on the relations between j and 1 in the standard industrial
classification (SIC) system. d = 0 if j and 1 have the same three-digit SIC code; d =
1 if j and 1 have a different three-digit code but identical two-digit codes; d = 2 if j
and 1 have different two-digit codes. The index captures the relatedness between
industries in a firm. It will equal zero for a perfectly focused firm. It will equal 0.5
if the firm has 50% of its assets in one industry and 50% of its assets in a second
industry with different three-digit SIC codes but identical two-digit SIC codes.4

'Following the empirical study of Demsetz and Lehn (1985), we use a log transfornation on the endogenous
ownership variable. Furthermore, because both theoretical arguments suggest the possibility of nonlinear
relationships between the endogenous variables and because the correlation coefficients between level forms
are weaker than between log forms, we employ log transformations on all four of the endogenous variables. To
facilitate the log transformation of the dividend measure we add one to the dividend ratio. In a recent study,
Chung and Jo (1996) also employ log transformation on a few dependent variables because they increased
explanatory power and thus offer a better model specification.
' Following the approach used by Jensen, Solberg, and Zorn (1992), we substituted the industry average
R&D ratio when data is missing. We use two-digit SIC codes to define these industry averages.
' We calculated the debt ratio, the dividend ratio, the operating leverage ratio, research and devlopment,
return on assets, fixed assets, capital expenditures, total assets, and total equity value as the average over
the prior three years. This approach is also used by Jensen, Solberg, and Zorn (1992).
128 C.R. Chen, T.L. Steiner/The Financial Review 34 (1999) 119-136

We use a nonlinear two-stage least squares methodology to estimate the

parame-ters in the model defined by Equations 1 4 . The approach is appropriate
when the endogenous variables are nonlinearly related. In our model, risk is a
nonlinear determinant of managerial ownership consistent with the arguments of
Demsetz and Lehn (1985). The nonlinear estimation technique is discussed in
Green (1997). The two-stage nonlinear simultaneous equation method is estimated
by including all squared exogenous variables and their cross products as
instruments (Kelejian, 1971; Rice and Smith, 1977). The four equations are
estimated simultaneously. We discuss each equation below and develop five
primary hypotheses which relate managerial ownership to risk-taking, debt policy,
and dividend policy. The endogenous and exogenous variables included in each
equation are supported by our literature review in Section 2 of the paper.

3.1. Ownership equation

In Equation 1, the LOWN equation, we include the endogenous variables LRISK,
LDEBT, and LDIV and the exogenous variables LVAL, R&D, FIVE, INST. We expect
managerial ownership to be a positive function of risk due to the value of managerial
ownership in resolving the conflicts between external equityholders and management.
We expect the relationship to be negative if management risk aversion becomes
dominant at sufficiently high levels of risk. To examine these two effects, we model
managerial ownership as a nonlinear function of risk through a variable transformation
(LRISK and LRISK’). This leads to Hypothesis 1:
Hypothesis 1: Risk is a nonlinear determinant of managerial
ownership. At low levels of risk, a positive relation is expected in
support of a reduction in the conflicts between external equityholders
and management. At higher levels of risk, managerial risk aversion
considerations are ex-pected to limit managerial ownership.
We hypothesize higher levels of debt (LDEBT) and dividend payouts (LDIV)
serve to reduce problems with free cash flow (Jensen, 1986) and, consequently,
the value of managerial ownership is expected to decline over higher levels of
debt and dividend payouts. This leads to Hypothesis 2:
Hypothesis 2: Debt and dividends serve as substitute-monitoring
forces for managerial ownership leading to an inverse causal relation
from both debt and dividends to managerial ownership.
Several control variables are included in the model of LOWN based upon arguments
made in previous research. Consistent with the contention of Demsetz and Lehn (1983,
we expect LVAL to be negatively related to managerial ownership. Following the
reasoning of Crutchley and Hansen (1989) and Jensen, Solberg, and Zorn (1992), we
expect R&D to be negatively related to managerial ownership. Furthermore, the
percentage of institutional ownership (INST) is expected to be inversely related to
 C.R. Chen, T.L. SteinedThe Financial Review 34 (1999) 119-136 129

the percentage of managerial ownership (LOWN). This is consistent with the

positive monitoring effect for institutional ownership identified by Brickley, Lease,
and Smith (1988), Pound (1988), and McConnell and Servaes (1990). The model
further controls for the percentage of 5% or blockholder ownership (FIVE). If
blockholders serve to reduce monitoring costs (Shleifer and Vishny, 1986), we
expect an inverse relation to managerial ownership. However, if blockholders are
ineffective monitors and impede firm valuation (Holdemess and Sheehan, 1988;
McConnell and Servaes, 1990) then we might expect a non-negative relation to
managerial ownership due to a greater monitoring value for managerial ownership.

3.2. Risk equation

Equation 2, the LRISK equation, includes the endogenous variables LOWN,
LDEBT, and LDIV and the exogenous variables LSIZE, R&D, OL, and DINDEX.
LOWN allows us to examine whether managerial ownership leads to higher risk
thus exacerbating the conflict between stockholders and bondholders through a
wealth transfer effect. Hypothesis 3 follows from this contention:
Hypothesis 3: Managerial ownership is a positive determinant of the
level of risk in support of a wealth transfer hypothesis (Galai and
Masulis, 1976; Saunders, Strock, and Travlos, 1990).
As an alternative to Hypothesis 3, Amihud and Lev (1981) and May (1995) argue
that the risk aversion hypothesis supports a negative causal relation from
managerial ownership to risk. The endogenous variable LDEBT tests the effect of
financial leverage on risk. Consistent with Venkatesh (1989), we anticipate
dividend policy (LDIV) to have a negative impact on risk. Moreover, higher
growth firms are expected to cause higher risk, while operating leverage (OL) is
expected to increase risk. Research and development (R&D) is expected to be
positively associated with firm risk (Crutchley and Hanses, 1989). Finally, we
anticipate the size of the firm (LSIZE) to be negatively correlated with risk, and we
also anticipate firm diversification to have a negative impact on risk.

3.3. Debt policy equation

Equation 3, the LDEBT equation, includes the endogenous variables
LOWN, LDIV, and LRISK and the exogenous variables FIXED, ROA, and
R&D. If the level of managerial ownership and the level of debt serve as
substitute-monitoring forces, we may expect a negative causal relation from
managerial ownership to debt policy. This leads to Hypothesis 4:
Hypothesis 4: Managerial ownership causes a lower level of debt due to
a substitution-monitoring effect (Jensen, 1986; Friend and Lang, 1982;
Jensen, Solberg, and Zom, 1992).
130 C.R. Chen, T.L. Steiner/The Financial Review 34 (1999) 119-136

As an alternative to Hypothesis 4, Leland and Pyle (1977) and Kim and Sorenson
(1986) argue for a positive causal relationship from managerial ownership to debt. The
firm risk (LRISK) variable is anticipated to negatively cause debt policy (LDEBT)
consistent with prior empirical results reported by Ravid (1988). Moreover, Jensen
(1986) has argued that both dividends and debt can work to control the agency costs of
free cash flow. Consequently, the larger the dividend payout (LDIV), the less need there
is for debt (LDEBT) to control such agency costs. This expectation is consistent with
the empirical findings of Jensen, Solberg, and Zorn (1992).
Several control variables are included in the model of LDEBT. We
anticipate FIXED to positively cause LDEBT consistent with the prior research
of Scott (1977). Following the arguments of Myers and Majluf (1984), we
expect a negative relation between ROA and debt. Research and development
(R&D) is expected to be nega-tively related to debt utilization based upon the
arguments of Bradley, Jarrell, and Kim (1984).

3.4. Dividend policy equation

Equation 4, the LDIV equation, includes the endogenous variables of
LOWN, LDEBT, and LRISK and the exogenous variables of INV, ROA, and
GRTH. We anticipate the level of managerial ownership (LOWN) to inversely
impact the divi-dend payout (LDIV). This leads to Hypothesis 5 :
Hypothesis 5: Because dividends are part of the firm’s monitoringhonding
package and serve to reduce agency cost, firms will establish higher dividend
payouts when managers hold a lower fraction of the equity.
Several control variables are included in the dividend equation. Myers and Majluf
(1984) make arguments which predict an inverse relation between investment
(INV) and dividends (LDIV). Rozeff (1982) predicts high growth firms (GRTH)
will choose to pay a lower dividend (LDIV), and Jensen, Solberg, and Zorn (1992)
report a positive relation between profitability (ROA) and dividend payout (LDIV).

4. Empirical results
We report empirical findings in this section of the paper. Table 1 reports
descriptive statistics for all the variables defined in Section 3 of this paper.
Table 2 presents the nonlinear two-stage least squares parameter estimates of
Equations 1 4
In Table 1, the average percentage of managerial ownership (OWN) is 8.39
with a standard deviation of 11.86. The risk measure (RISK) has an average of
1.84%. The average debt to equity ratio (DEBT) is 48.78%. The dividend measure
(DIV) has a mean value of 14.06% of the average operating income, with a
standard deviation of 13.24%. The percentage of institutional ownership (INST) is
52.37% for the average firm and the standard deviation is 19.59%. The average
percentage
 C.R. Chen, T.L . SteinedThe Financial Review 34 (1999) 1 19-136 13 1

Table 1
Descriptive statistics
LOWN is the natural log of managerial ownership; LRISK is the natural log of the standard deviation of
stock returns in percentage form; LDEBT is the natural log of the debt to equity ratio; LDIV is the log
of the ratio of dividends to operating income plus 1; INST is the percentage of institutional ownership:
FIVE is the percentage of 5% ownership; OL is a measure of operating leverage; GRTH is the growth
rate; R&D is research and development expenditures; ROA is return on assets; FIXED is the ratio of
property, plant, and equipment to total assets; INV is the ratio of capital expenditures to total assets:
LSIZE is the natural log of the firm’s total assets measured in millions of dollars; LVAL is the log of the
market value of equity; DINDEX is the concentric diversification index.
~ ~ ~

Standard
Variable N Mean Deviation Minimum Maximum
OWN 785 8.3945% 11.8673% 0.0087% 69.8245%
LOWN 785 1.0694 1.6848 -4.7493 4.2460
RISK 785 1.8376% 0.7929% 0.5627% 11.0890%
LRISK 785 0.5310 0.3901 -0.575 1 2.4060
DEBT 785 48.7836% 93.0914% 0.0214% 1,928.68%
LDEBT 785 3.0483 1.5436 -3.8466 7.5646
DIV 785 14.0586% 13.2389% 0.0000% 142.1776%
LDIV 785 0.1257 0.1052 0.0000 0.8845
INST 785 52.3675% 19.5899% 0.0100% 93.4700%
FIVE 785 23.2793% 21.5921% 0.0000% 99.9900%
OL 785 4.5707% 2.3915% 0.0004% 18.9531%
GRTH 785 7.3743% 12.9247% -30.1786% 134.7721%
R&D 785 1.6344% 3.3744% 0.0000% 40.9214%
ROA 785 4.1036% 4.7570% -17.7593% 46.5148%
FIXED 785 42.0650% 24.6672% 0.2616% 91.9322%
INV 785 8.9404% 6.5562% 0.0000% 44.1523%
SIZE 785 5,056.76 15,662.17 379.9343 204,213.67
LSUE 185 7.2657 1.5138 3.6359 12.2269
VAL 785 3,381.90 7,870.37 21.7237 76,641.28
LVAL 785 6.9666 1.4816 3.0784 11.2469
DINDEX 785 0.4106 0.4839 0.0000 1.6303

of 5% ownership (FIVE) is 23.28% with a standard deviation of 21.59%. Operating

leverage (OL) and growth (GRTH) have mean values of 4.57% and 7.37%, respec-
tively. Research and development (R&D) and profitability (ROA) have mean values of
1.63% and 4.10%, respectively. The measure of fixed assets (FIXED) defined as the
ratio of property, plant and equipment divided by total assets has a mean value of
42.07%. Capital expenditures (INV) as a percentage of total assets is 8.94%. The
average total assets (SIZE) is $5.056 billion. Finally, the average market value of equity
(VALUE) is $3.382 billion, and the average diversificationindex is 0.4106.
Table 2 presents the parameter estimates from using the nonlinear two-stage least
squares method to jointly estimate Equations 1 4 . Column 1 of Table 2 shows results
for the managerial ownership (LOWN) equation. Of the endogenous variables, each is
significant. Consistent with Hypothesis 1, the relationship between risk
132 C.R. Chen, T.L. Steiner/The Financial Review 34 (1999) 119-136

Table 2
Nonlinear two-stage least squares simultaneous equation regressions
LOWN is the log of the percentage of managerial ownership; LRISK is the log of the standard deviation of
stock returns; LDEBT is the log of the debt to equity ratio; LDIV is the measure of dividend payout; LVAL is
the log of the market value of equity; FIXED is the ratio of property, plant, and equipment to total assets; INV
is the ratio of capital expenditures to total assets; LSIZE is the log of the total assets; INST is the percentage of
institutional ownership; FIVE is the percentage of 5% ownership; RDA is research and development
expenditures; ROA is return on assets; GRTH is the growth in sales revenue over the past four years; OL is a
measure of operating leverage; DINDEX is the concentric diversification index.

VARIABLE 1: LOWN 2: LRISK 3: LDEBT 4: LDIV

Intercept 4.5390 0.7013 5.3150 0.2959
(9.27)*** (5.87)*** (23.15)*** (14.22)***
LOWN 0.0846 -0.0802 -0.0086
(5.34)*** (1.76)* (2.71)***
LDEBT -0.3288 0.0122 -0.0203
(6.92)*** (1.07) (5.10)** *
LDIV -2.2276 -1.9017 -5.3374
(2.06)** (8.66)*** (6.54)***
LRISK 4.1143 -1.6443 -0.1369
(7.74)*** (7.27)*** (8.45)***
LRISK2 -2.6099
(7.02)***
LVAL -0.4248
LSIZE (10.45)*** -0.0045

(0.38)
FXXED 0.0075
INV (3.71)*** -0.0007

INST -0.0077 (1.33)

(2.32)**
FIVE 0.0100
R&D (3.72)*** 0.0103 -0.1069
-0.0637
(3.83)*** (2.55)*** (8.02)***
ROA -0.1867 -0.0019
(19.62)*** (1.69)
GRTH -0.0017
OL 0.0109 (6.24)***

(2.11)**
DINDEX -0.0521
Adjusted R2 (1.98)**
43.19% 36.14% 50.01% 31.95%

* Indicates statistical significance at the 0.01 level

* Indicates statistical significance at the 0.05 level
* Indicates statistical significance at the 0.10 level
 C.R. Chen, T.L. Steiner/The Financial Review 34 (1999) 119-136 133

(LRISK) and managerial ownership (LOWN) is nonlinear. The positive and signifi-
cant parameter estimate for LRISK suggests that over low levels of risk, as risk
increases, the level of managerial ownership increases to reduce the conflict
between stockholders and managers. This result is supportive of the monitoring
value of managerial ownership for controlling the conflict between external owners
and managers (Demsetz and Lehn, 1985). The negative and significant sign on
LRISK2 suggests that at high levels of risk, risk aversion becomes important to
managers and managerial ownership is reduced. The limitations on managers’
financial contri-butions due to risk aversion as well as wealth constraints is,
however, tempered by substitution-monitoring effects between managerial
ownership and debt and between managerial ownership and dividends. Debt policy
(LDEBT) is statistically significant at the 0.01 level with a negative parameter
estimate in this equation. The dividend policy variable (LDIV) is also negative and
significant with a t-statistic of 2.06. These results on the debt and dividend variables
are supportive of Hypothesis 2. These results are consistent with firms trading-off
various monitoring forces in an effort to reduce agency costs.
Of the exogenous variables in the managerial ownership equation, the market
value of equity (LVAL), institutional ownership (INST), 5% blockholders (FIVE),
and research and development (R&D) are each significant. The negative parameter
estimate on LVAL is consistent with the financial constraints managers feel as the
market value of the firm’s equity increases. The negative parameter estimate on
INST is consistent with a substitution hypothesis in which a higher level of
monitoring by institutional investors reduces the value of managerial ownership.
The positive parameter estimate on FIVE is consistent with blockholders helping to
reduce the probability of the firm being exposed to the discipline associated with
the market for corporate control. The negative parameter estimate on R&D clarifies
and rein-forces earlier arguments by Crutchley and Hansen (1989) and Jensen,
Solberg, and Zorn (1992).
In the risk (LRISK) equation, managerial ownership (LOWN) is positive and
significant at the 0.01 level with a t-statistic of 5.34, which is supportive of Hypothe-sis
3. As managerial ownership increases, managers have an incentive to increase the
firm’s risk to maximize the value of their call option on the firm value (i.e., equity
ownership). The result supports the wealth transfer arguments of Saunders, Strock, and
Travlos (1 990) but the result is inconsistent with the findings of Amihud and Lev
(1981) and May (1995). Although we found support in the LOWN equation for the
argument that managerial ownership serves to reduce the conflicts between external
stockholders and managers, the wealth transfer effect found in the risk equation
suggests that managerial ownership also serves to exacerbate the conflict between
stockholders and bondholders. Moreover, this result together with the results from the
managerial ownership (LOWN) equation offers evidence that managerial ownership
and risk are jointly determined. Debt policy (LDEBT), although it carries a positive
sign, is not statistically significant. This may be because high debt firms are more
exposed to debt market monitoring which yields lower-risk decision making
134 C.R. Chert, T.L. SteinedThe Financial Review 34 (1999) 119-136

which, in turn, partially offsets the effects of financial leverage. Among the three
exogenous variables, operating leverage (OL) is positive and significant at the 0.05
level; firm diversification (DINDEX) is negative and significant at the 0.05 level;
firm size (LSIZE) is negative but insignificant; and research and development (R&
D) is positive and significant at the 0.01 level of significance, which is
supportive of Crutchley and Hansen (1989).
In the debt policy (LDEBT) equation, the endogenous variables are each signifi-
cant. In support of Hypothesis 4, managerial ownership (LOWN) is negative and
significant at the 0.10 level which is more consistent with the findings of Friend and
Lang (1988) than the results of Leland and Pyle (1977) and Kim and Sorenson (1986).
LRISK is a significant (with a t-statistic of 7.27) and negative determinant of the
amount of long-term debt employed by the firm which is consistent with work reported
in Ravid (1988). Dividend policy (LDIV) is negative and significant at the 0.01 level
with a t-statistic of 6.54. This result is consistent with the arguments of Jensen (1986)
and Jensen, Solberg, and Zorn (1992). The exogenous variables in the debt equation are
each significant at the 0.01 level. The positive relation between FIXED and LDEBT is
supportive of the arguments by Scott (1977). The negative relation between R&D and
LDEBT are consistent with the arguments of Bradley, Jarrell, and Kim (1984).
Furthermore, the negative relation between ROA and LDEBT is supportive of the
conclusions of Myers and Majluf (1984).
In the dividend (LDIV) equation, we find managerial ownership (LOWN) to
have a strong negative impact on dividend policy (LDIV) in support of Hypothesis
5 and the arguments of Rozeff (1982). We also find debt policy (LDEBT) to have a
negative impact on dividend policy (LDIV). This result is supportive of the evidence
reported by Jensen, Solberg, and Zorn (1992). Furthermore, we find risk (LRISK) to
negatively cause dividend policy (LDIV) consistent with the arguments of Kale and
Noe (1990). Of the exogenous variables included in the dividend equation, the growth
variable (GRTH) is negative and highly significant yet neither profitability (ROA) nor
investment (INV) are significant.

5. Conclusion
Our paper builds on several veins of research. By simultaneously
modeling the relations between managerial ownership, risk-taking, debt policy,
and dividend policy, we extend the literature which has more commonly
modeled these financial variables individually. The value and justification of
employing a simultaneous equation system is enhanced by the fact that
although the literature supporting two-way causality between each pair of the
decision variables is abundant, the interrelations among these decision
variables have rarely been examined within a system of equations.
Our paper focuses on how managerial ownership relates to risk-taking, debt
policy, and dividend policy. Therefore, the analysis facilitates a greater
understanding of agency relationships. We find risk, at low levels, to be a positive
determinant of
 C.R. Chen, T.L. SteinedThe Financial Review 34 (1999) 119-136 135

managerial ownership consistent with managerial ownership resolving the conflict

between external equityholders and managers. At higher levels of risk, we find
managerial risk aversion to be a significant effect. We also observe managerial
ownership to positively cause risk-taking, which is consistent with the contention that
managerial ownership serves to exacerbate the conflict between stockholders and
bondholders. Although many studies have argued for a one-way causal relation-ship
from managerial ownership to risk or from risk to managerial ownership, our results
clearly demonstrate a joint determination between these variables. Finally, we
document a substitution-monitoring effect between managerial ownership and debt
policy and between managerial ownership and dividend policy. This effect is also
evident in the relation between managerial ownership and institutional owner-ship.
These results are consistent with firms choosing to trade-off alternative monitor-ing
forces in an effort to lower agency costs.

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