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Simultaneous Determination of Insider Ownership, Debt, and Dividend PoliciesAuthor(s): Gerald R. Jensen, Donald P. Solberg and Thomas S. ZornSource: The Journal of Financial and Quantitative Analysis, Vol. 27, No. 2 (Jun., 1992), pp.247-263Published by: University of Washington School of Business Administration

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JOURNAL FFINANCIALNDQUANTITATIVENALYSIS VOL27, NO 2, JUNE1992

Simultaneous Determination of Insider Ownership,

Debt, and Dividend Policies

Gerald R. Jensen, Donald R Solberg, and Thomas S. Zorn*

Abstract

We examine the determinants of cross-sectional differences in insider ownership, debt,and dividend policies. These policies are related not only directly, but also indirectly,through their relationship with operating characteristics of firms. To distinguish these

effects, we examine the determinants of the three policy choices within a system of equa?tions. Our empirical results support the hypothesis that levels of insider ownership differ

systematically across firms. Further, high insider ownership firms choose lower levelsof both debt and dividends. Finally, the effects of profitability, growth, and investment

spending on debt and dividend policy support a modified "pecking order" hypothesis.

I. Introduction

In this paper, we investigate the determinants of insider ownership, debt,

and dividend policies within a common empirical framework. Our analysisbuilds on research in each of these areas to study dependence among the three

policies. Previous studies have invoked information costs and agency problemsto explain each policy independently. However, agency and signalling theory

suggest that a firm's debt, dividend, and insider ownership levels are related

not only to similar firm-specific attributes, but directly to each other. In lightof the direct and indirect relationships among these policies, the motivation

for simultaneous study is clear. Careful analysis is required to distinguish anydirect effects from indirect effects resulting from the firm's operating choices.

A simultaneous equations framework is the natural tool to identify the effects

ofinterdependent

decisions.

In previous studies, insider ownership has been assumed to be an exogenous

firm-specific attribute hypothesized to affect dividend or debt policy. Despite this

common assumption, there is strong reason to believe that insider ownership is

*Jensen, College of Business Administration,Northern Illinois University,Dekalb, IL 60115;

Solberg, School of Business, Universityof Wisconsin-Milwaukee,P.O. Box 742, Milwaukee, WI53201, but currentlyon leave at the Federal Home Loan MortgageCorporation; ndZorn, Collegeof Business Administration,Universityof Nebraska-Lincoln,NE 68588. The authors hankDavid F.Scott, VahanJanjigian,JamesSchmidt,GeorgeMcCabe,GordonKarels,RichardDeFusco, Richard

DeMong, ArtHogan,and Robert Miller for theirhelpfulcomments. They are also gratefulto JFQAreferee WilburLewellen for providingextensive comments. The usualdisclaimerapplies.

247








248 Journal of Financial and Quantitative Analysis

itself determined by many of the same firm-specific features that affect dividend

and debt policy. Demsetz and Lehn (1985) make a persuasive case that insider

ownership choices are endogenous outcomes of value-maximizing behavior. If

insider ownership is itself endogenous, previous evidence that insider ownership

affects debt and dividend policy might be misleading. Estimation within a

system helps to avoid any false attribution of causality among these three policy

choices that actually stems from spurious correlations.

Insider ownership, debt, and dividend policies might be related directly

through agency and signalling theories. Three stakeholder groups are most rele-

vant: firm managers, external shareholders, and creditors. Jensen and Meckling

(1976) provide an analysis of the effects of agency conflicts among the three

groups. Their analysis suggests that the proportion of equity controlled by in?siders should influence the firm's policies. Leland and Pyle (1977) and Ross

(1977) present hypotheses that insider ownership and financial policies help

resolve informational asymmetry between managers and external investors.

The paper proceeds as follows. Section II reviews the relevant issues

in the analysis of debt, dividend, and insider ownership policies, and discusses

empirical studies of insider ownership. Section III describes the empirical model

and methodology used in this study. Section IV reports findings from our

empirical analysis. Summary and conclusions are presented in Section V.

II. Insider Ownership, Debt, and Dividends

A. Simultaneous Determination of Policy Choices

A simple framework suggests that firms can minimize the costs created

by informational asymmetry and misaligned incentives by optimizing jointly

over debt, dividend, and insider ownership policies. If firms were identical in

their real operations, empirical analysis of these policies would then be verysimple. We could simply examine debt, dividend, and insider ownership levels

to identify systematic tradeoffs in these policies.

Casual observation suggests that the world is not so simple. Not only do

firms differ with respect to factors such as firm size, growth, and profitability,

but these firm attributes have also been related empirically to debt and dividend

policies, and insider ownership. For this reason, empirical work must be struc?

tured to avoid incorrect inferences of causality among these policy choices that

may be attributable to a common relationship with real operating choices. A

system of equations provides a useful tool in disentangling these effects.

Our analysis applies three stage least squares (3SLS) to a system of equa?

tions that includes one equation for each of the three policy choices. Our de-

velopment of this system follows the classical form for estimation of structural

equations. We begin with the debt, dividend, and insider ownership variables

that are the focus of this analysis. To these, we add a vector of explanatory vari?

ables that capture the real attributes of firms, and estimate a system of structural

equations.

These variables could also be used to estimate reduced form equationsin which each exogenous variable appears in all three equations. For example,








Jensen, Solberg, and Zorn 249

Crutchley and Hansen (1989) estimated independent equations for debt, dividend

policy, and insider ownership. Their work can be viewed as the reduced form

analog of the structural equations studied in this paper. Such studies hypothesize

no direct relationships among the three policies?any correlation among policy

choices is assumed to be created indirectly by each policy's relationship to

operating choices.

B. Review of the Determinants of Policy Choices

The empirical estimation that follows examines the interaction of financial

policy and insider ownership while controlling for the economic character of

firms. The real character of the firm includes both operating choices (e.g., firmsize or fixed asset utilization) and external economic factors affecting the prof-

itability and risk of operating cash flows. In the following section, we will

first review some of the relevant hypotheses that have linked real attributes to

each of the three policy areas, then discuss the motivation for study of their

interdependence.

1. Insider Ownership

Ourempirical

work considers four "real" determinants of insiderownership:business risk, firm size, the number of operating divisions of the firm, and

research and development expenditures. These variables capture various real

attributes that help to determine the benefits and costs of insider ownership.

Demsetz and Lehn (1985) present several arguments for the hypothesis that

insider ownership should vary predictably across firms. Generally, benefits from

insider ownership are linked to gains in control potential from managers taking

a large stake in the firm. The costs of insider ownership are borne by insiders

who must allocate a large portion of their wealth to the firm, and necessarily

hold a maldiversified portfolio (Beck and Zorn (1982)).

Control of a firm provides the greatest incremental value when informa?

tional asymmetry between insiders and outsiders is greatest. If outsiders know

as much about both the corporation and managerial effort as insiders, there is

little incremental value to insider ownership. Demsetz and Lehn argue that high

firm-specific risk increases the value of insider ownership because the contri?

bution of managers to firm performance is difficult to measure due to the noise

created by external factors. Firms with high research expenditures or a large

number of divisions will also be morecostly

for external investors to monitor.

Benefits of insider ownership will be partially or wholly offset by costs of

inducing managers to maldiversify their wealth. Managerial risk aversion and

constraints on managerial wealth limit the willingness or ability of managers

to become owners and so limit the supply of insider ownership. Risk-averse

managers are willing to take a larger position in any firm only at higher expected

rates of return that compensate them for additional risk. Limits on managerial

wealth make it more costly for managers to take controlling interests in large

firms. Therefore, insider ownership should be inversely related to the size of

the firm.









2. Debt Policy

Debt policy can be affected by firm-specific real characteristics that affect

the supply curve of debt offered to the firm, or the firm's demand for debt. We

use business risk, profitability, research and development expenditures, and fixed

asset levels to characterize the likelihood of a firm employing debt. Generally,

creditors are "external" investors who face the same informational disadvantage

as external stockholders. Therefore, features that increase the costs of monitor-

ing the firm's activities should decrease the supply of debt to the firm.

Market imperfections have motivated tests of the effects of fixed asset

ratios, profitability, risk, and research and development expenditures on debt

policy. Ravid (1988) discusses these relationships in an interesting review of

the debt policy literature. High business risk or research and development

expenditures should reduce the quantity of debt supplied to the firm at any

given interest rate. Conversely, a firm's level of fixed assets should be related

positively to debt levels.1

Myers and Majluf (1984) relate profitability to debt policy through a mod-

ified "pecking order" hypothesis, which suggests that more profitable firms willdecrease their demand for debt, since more internal funds will be available to

finance investment.2 Profitable firms have more earnings available for retention

or investment and, therefore, would tend to build their equity relative to their

debt.

R&D expense proxies for the level of agency costs if external stakehold-

ers bear greater monitoring costs when a significant amount of investment is

allocated to intangibles (see Long and Malitz (1985)).3 R&D expense also has

been used as aproxy

for futuregrowth opportunities

andimplicit

claims of the

firm's stakeholders. In this sense, R&D reflects the level of potential indirect

bankruptcy costs, which suggest a negative relationship with debt.4

!See Scott (1977) for a discussion of the secured debt hypothesis, which predicts a positiverelationshipbetween debt and fixed assets. A "Tax Shield"hypothesisadvancedby DeAngelo andMasulis (1980) predictsthe opposite relationshipbetween debt and fixed assets.

2The "peckingordertheory"was firstproposedby Donaldson(1961) as a theoryto explain theobserved financialbehavior of firms. A modifiedversion of the pecking ordertheorywas proposedby Myers (1984) and Myers and Majluf (1984). These analyses revised the pecking ordertheoryby suggesting that informationalasymmetriesand bankruptcycosts also influence a firm'scapital

structurechoice.3Long and Malitz (1985) argue that firms devoting a large proportionof funds to intangible

investmentswould experiencehigher agency costs of debt caused by the under-investment nd thewealth transferproblems outlined by Barnea, Haugen, and Senbet (1985). In contrast,Bradley,Jarrell,and Kim (1984) claim thatR&D expense representsan investmentthat can be deductedinthe currentperiod. Therefore,R&D expense can be treatedas a tax shield, which would lead to a

negative relationshipwith debt ratios.4Thebankruptcy ost literature see Altman(1984), Baxter(1967), Gordon and Malkiel (1981),

and Lintner(1982)) argues that financiallydistressedfirms tend to lose employees, suppliers,andtheir financialflexibility. The costs of such losses are likely to be higherfor firms with largeR&D

programs,as such firms rely on the ability to quickly develop new discoveries. High R&D firms

are also likely to experiencelarger osses if forced to liquidate,given the specializednatureof theirassets. For a discussion of indirectbankruptcy financial distress) costs createdby the actions of

stakeholders,see Cornell and Shapiro(1987).









3. Dividend Policy

The financial literature has related dividends to the firm's future profitabil?

ity.Current

profitability,investment,

growth,and business risk are used as indi-

cators of future profitability. Bhattacharya (1979) and Miller and Rock (1985)

explain optimal dividend payments as signals of future profitability. Rozeff

(1982) argues that higher dividend payments reduce agency conflicts between

managers and shareholders and finds evidence of relationships among growth,

profitability, and dividends. Greater business risk makes the expected direct re?

lationship between current and expected future profitability less certain. There?

fore, we hypothesize that greater business risk will be associated with lower

dividend payments.

A positive relationship between profitability and dividends seems plausible,all else constant. Moreover, the documented empirical relationship between div?

idends and profitability suggests that we must include profitability to help capture"real" differences among firms. Investment and growth opportunities faced bya firm should also affect dividend policy. Myers and Majluf (1984) argue that

profitable firms with good investment opportunities may be forced to choose be?

tween dividend payments and capital expenditures when capital market frictions

are important. Frictions in capital markets lead to a sort of competition between

dividends and investmentprojects

aspotential

uses ofprofits.

Thiscompetitioncan explain why high growth firms with strong investment opportunities often

pay low dividends.

C. The Relationship among Debt, Dividends, and Insider Ownership

The interaction between financial policies and insider ownership can be

linked to informational asymmetries between insiders (managers) and external

investors. This informational advantage includes information about the firm's

prospects, the manager's level of effort, and perquisite consumption. Debtand dividend policies and insider ownership may have redundant benefits in

reducing agency or informational asymmetry problems. At the same time, there

are costs associated with using each of these tools. Insider ownership is costlyto managers who become maldiversified. Debt reduces free cash flow only by

creating new conflicts between creditors and owners. Similarly, dividend policyreduces informational asymmetry only if dividend changes are a costly signal.

Studies of insider ownership and financial policy assume that any causality

amongthese choices runs from insider

ownershipto financial

policy.Insider

ownership is typically viewed as exogenous and its determinants are not sub-

jected to economic analysis. For example, Friend and Lang (1988) study the

effects of insider ownership on debt ratios. The authors note that a potential

shortcoming in their analysis is precisely the assumption that insider ownership"causes" changes in debt levels. A more plausible explanation is that these

variables are determined simultaneously. In particular, debt policy may also

affect insider ownership choices, or both may be independent of each other,

but related to similar firm-specific attributes. However, their single-equation

technique permits no analysis of simultaneity.









Leland and Pyle (1977) and Kim and Sorenson (1986) predict a positive

relationship between insider ownership and debt. Friend and Hasbrouck (1987)

and Friend and Lang (1988) hypothesize that bankruptcy costs lead to a negative

relationship between debt and insider ownership.5 Empirical evidence on the

relationship between dividends and insider ownership is rare. Rozeff (1982)

found a negative relationship between insider ownership and dividend payments

among firms.

III. Model and Methodology

A system of equations is the natural technique to address the questions

we have posed. Although single equation estimation has been the techniqueof choice in empirical analyses of financial policies, the use of a system of

equations is not unprecedented. Peterson and Benesh (1983), Dhrymes and

Kurz (1967), McCabe (1979), Jalilvand and Harris (1984), and Jensen and Zorn

(1989) each examine firm policy decisions within such a system.

The structural equations to be estimated are:

DEBT = DE(INSIDER, DIVIDEND, BUSINESS RISK,

PROFITABILITY, R&D, FIXED ASSETS),

DIVIDEND = DI(INSIDER, DEBT, BUSINESS RISK, PROFITABILITY,

GROWTH, INVESTMENT),

INSIDER = IN(DEBT, DIVIDEND, BUSINESS RISK, SIZE,

DIVISIONS, R&D).

The exogenous variables include R&D expense, Business Risk, Profitability,

Fixed Assets, Growth, Investment, Size, and Number of Divisions. Of course,

neither real nor financial attributes of the firm are completely exogenous. Weassume that each firm makes "long-run" choices for real operations. Given these

real decisions, financial policy is used to minimize agency costs, exploit the tax

code, or pursue other objectives.

We analyze cross-sectional firm data at two points in time?1982 and 1987.

Each firm included in the analysis had the requisite financial data on the Com?

pustat date file, and its level of insider ownership listed in the Value Line

Investment Survey. The number of divisions for each firm was taken from

the Value Line data base. There were 565 firms that satisfied these conditions

5Leland and Pyle (1977) propose a positive relationshipbased on signalling arguments. Kimand Sorenson (1986) provide both demand and supply hypotheses. The demand hypothesis isthat closely held firms demand more debt because insiders can maintain effective control if their

ownership is not diluted with more equity. On the supply side, they argue that insider-controlledfirms have lower agency costs of debt, increasingthe supplyof debt financingavailableto the firm.

Nonoptimalinvestmentagency cost (Myers (1977)), and wealth transferagency costs (Jensenand

Meckling (1976)), could be smaller because bondholdersbelieve negotiation with insiders couldalleviate these costs. Kim and Sorenson find a positive empirical relationshipbetween insider

ownershipand debt ratios, while Friendand Hasbrouck 1987) and Friend and Lang (1988) find a

negative relationship.









for 1982 and 632 firms for 1987.6 Definitions of the variables are as follows:7

Debt: ratio of long-term debt to the book value of total assets;8

Dividend: ratio of dividends to operating income;9

Insider: percentage of shares held by insiders;10

Business Risk: standard deviation of the first difference in operating income

divided by total assets;11

Profitability: ratio of operating income to total assets;

R&D: ratio of research and development expense to total assets;12

Fixed assets: ratio of fixed assets to total assets;

Growth: five-year growth rate in sales;13

Investment: expenditure for plant, equipment, and R&D as a percentage of

total assets;Size: log of total assets; and

Divisions: number of divisions operated by the firm.

6Consistentwith the study by Friend and Lang (1988), we excluded financialorganizationsand

public utilities from the sample.7The following variables were calculated as averages over a three-year period, 1980 through

1982 and 1985 through 1987: Debt, Profitability,R&D, Fixed Assets, Investment,and Size. The

purposeof averagingthe variableswas to alleviate measurementproblemsencounteredwhen a firm

reportsunusualfinancial data in one year. Five yearsof data were utilized in derivingthe dividend

payoutvariable. Rozeff (1982) cites several

problemswith

stabilityin the dividend

payoutvariable.

To alleviate these problems,we calculateddividendpayoutsfor five years, eliminatedthe high andlow value, and averagedthe remainingthreepayouts. Firmswith negative payoutswere eliminatedfrom the sample. In the majorityof cases, data were availablefor the variables identifiedabove forall threeyears. However,where the full threeyears were not available,the figurewas derivedfromthe datareported.

8Ouranalysis focuses on results derived with a debt ratio calculated from the book value of

equity. The book value debt ratio results are emphasized, despite their imperfections, for tworeasons. First, as indicatedby Baskin (1989), the book debt ratio more accurately indicates the

financingmix managershave actuallyobtained from outside sources. Second, a marketvalue debtratiocreatesthe potentialfor spuriousrelationships.If firmsadjustto theirtargetcapital structures

only gradually,as observed by Jalilvandand Harris(1984), then a spurious relationship may be

producedbetween the debt ratio and the firm's real characteristics.9We measure dividend yield as a percentageof operatingincome, primarilyto assure a more

consistent denominatoracross firms. Some firms pay dividends even when their net income is

negative. This creates a discontinuityin the dividendyield measure at zero dollars of net income.A corporationwith $1 of net income would appearto have a very high payoutratio while, if netincome was ?$1, the payout ratio is negative. Our choice, therefore,allows us to preservemoresensible observationsof dividendyield.

10The evel of insiderownershipis obtainedfrom the Value Line Index. Value Line defines aninsider to be a corporateofricer,director,or any individualwho is actively involved in the decisionsof the firm. In addition, firms that had 25 percentor more of their stock owned by other groups(anotherfirm,a noninsider ndividual or family, an investmentcompany,etc.) were excluded from

the sample.nTen years of annual data were used in derivingthis measure. The first difference was used to

detrendoperating ncome.12TheR&D variable was missing for approximately200 firms in each of the periods. For firms

with missing R&D expense, the averageR&D variablefor the industry (four-digitSIC code) wassubstituted.It is worthnotingthat the firms that fail to reportR&D are usuallyfromindustrieswithlow levels of R&D, hence, eliminatingfirms with missing R&D may bias the sample. Our resultsdiffer very little whether we exclude firms with missing R&D or substitutethe industrymean. The

majorchange is that the R&D and investmentreach a higher level of statisticalsignificancewhenthe smallersample is employed. These results are availablefrom the authors.

13Growthwas calculated as one plus the arithmeticaverageof growthin sales over the previous

five-yearperiod.









IV. Results

A. Summary Statistics

Tables 1 and 2 present summary statistics for the endogenous variables

grouped according to two-digit SIC codes. The data show that large inter-

industry differences exist between insider ownership, debt ratio, and dividend

payout. The dispersion in insider ownership across industries suggests that

insider ownership is not simply exogenous, but like dividend and debt policy,

requires some explanation.

a Data are reported only for those industries represented by five or more firms. The statisticsat the bottom of the table were calculated over all firms. The three endogenous variablesare reported as percentages.









a Data are reported only forthose industries represented by five or more firms. The statistics

reported at the bottom of the table were calculated over all firms. The three endogenousvariables are reported as percentages.

B. Relationship among the Endogenous Variables

1. Debt Equation

Results of the three-stage least squares (3SLS) estimation are presented in

Tables 3A, 3B, and 3C. The debt equation results indicate that insider ownership

leads to less debt. The negative coefficient on insider ownership is consistent

with two complementary explanations. The result conforms to the claim of

Friend and Lang (1988) and Friend and Hasbrouck (1987) that insiders with

a majorstake

areless

diversified,and have more incentive to reduce financial

risk. A second argument is that firms with higher insider ownership should









have lower agency costs of equity and higher agency costs of debt because the

incentives of managers would be more closely aligned with owners than with

creditors.

The negative sign on the dividend ratio (t = ?6.22 and t = ?5.33) suggests

that firms with high dividend payouts find debt financing less attractive than

equity financing. This is consistent with the explanation that firms with high

fixed financial costs are unwilling to commit simultaneously to higher dividend

payouts.

* Significant at the 5-percent level

System Weighted R-Square for 1982 = 0.30.

System Weighted fi-Square for 1987 = 0 27

Debt Equation f?-Square for 1982 = 0.42.Debt Equation f?-Square for 1987 = 0.27.

Equation f?-Squares are calculated as the square of the correlation between the predictedand actual values of the endogenous variables.

2. Dividend Equation

The negative sign and statistical significance of the coefficient on insider

ownership in the dividend equation (t = -4.95 and t = -3.14) in Table 3B

indicate that insider ownership is an important determinant of a firm's divi?

dend policy. This observation supports Rozeff's proposition that the benefits

of dividends in reducing agency costs are smaller for firms with higher in?

sider ownership. Closely held firms might also select dividend levels that allow

shareholders to realize the tax benefits of capital gains.

The coefficient on the debt variable in the dividend equation is negative inboth periods, but significant only in 1987 (t = -0.63 and t = -6.65). Generally,









TABLE3B

3SLS Results

Structural Equation 2Dependent Variable = Dividend Payout

Independent

*Significant at the 5-percent level.

Insider Ownership Equation /^-Square for 1982 = 0.16.

Insider Ownership Equation R-Square for 1987 = 0.03.









these results confirm that firms trade off dividend payments with fixed financial

charges.

3. Insider Ownership Equation

Both debt and dividend payout are insignificant in the insider ownership

equation (t = -0.99 and 1.32 for debt and t = -0.62 and t = 1.20 for divi?

dend payout). Thus, there is no evidence that financial policy is an important

determinant of the stake insiders will have in a firm. More specifically, after

controlling for "real" firm-specific attributes affecting insider ownership, nei-

ther dividend policy nor debt policy provides any information about the level

of insider ownership a firm will take. Taken with the results of the debt and

dividend equations, the evidence is consistent with the view that more insider

ownership permits managers to control the financial policies of the firm. Con-

versely, however, there is no reason to believe that insiders are attracted to or

repelled by any particular financial policy.

C. Effects of Firm-Specific "Real" Attributes

As noted in Section III, simultaneous equation estimation with 3SLS has

two primary advantages over ordinary least squares. First, 3SLS permits an

analysis of interdependence among endogenous variables that are related to

common exogenous variables. Second, the coefficient parameter estimates of

the exogenous variables will be unbiased and consistent estimators. In the latter

context, it is useful to compare the 3SLS estimates presented in Tables 3A, 3B,

and 3C to those estimated in previous studies.

1. Debt Equation

Results in Table 3A are generally consistent with previous evidence on the

determinants of debt policy. The negative coefficients on the R&D variable

(t = -4.39 and -3.98) and the profitability variable (t = -5.04 and -2.18) are

consistent with previous findings, as are the observed positive coefficients on

the fixed assets variable (t = 6.34 and 1.94).14

The business risk variable has been included as an explanatory variable in

numerous capital structure studies and the observed relationships have varied

considerably. The relationship has been positive and significant, negative and

significant, and insignificant.15 Our results provide evidence supporting a neg?

ative relationship, as both coefficients are negative, however, only the latter is

14Negativerelationshipsbetween debt and profitabilityhave been observedby Long and Malitz

(1985), Friendand Lang (1988), Carletonand Silberman(1977), Toy, Stonehill, Remmers,Wright,and Beekhuisen (1974), Hurdle(1974), Nakamuraand Nakamura(1982), Titman(1982), Baskin

(1989), and Titmanand Wessels (1988). Bradley,Jarrell,and Kim (1984) and Long and Malitz

observe a negative relationshipbetween debt and R&D. Several studies have identifieda positive

relationshipbetween debt and fixed assets (Long and Malitz,Ferri and Jones (1979), Marsh(1982),and Friend and Lang).

l5Studies by Baxter (1967), Long and Malitz (1985), and Friend and Lang (1988) suggest a

negative relationshipbetween debt and business risk. Kim and Sorensen (1986) find a positive

relationship,while Flath and Knoeber

(1980),Ferri and Jones

(1979),and Kester

(1986)find an

insignificantrelationship.Baskin (1989) claims that the relationship s not robust andthe significant

relationshipsreported n previousstudies are due to model misspecifications.









significant (t = -1.41 and -4.62). The negative coefficient is consistent with

the hypothesis that firms substitute financial and business risk to keep total risk

at a manageable level. The observed negative relationship between debt and

business risk is also consistent with the static tradeoff theory.16

2. Dividend Equation

The results for the dividend equation, reported in Table 3B, are generallyconsistent with the findings of Rozeff (1982).17 Investment and growth are

related negatively to dividends, while profitability is related positively to divi?

dends. Significant negative coefficients on the growth (t = ?4.03 and t = ?2.64)

and investment (t = ?3,00 and t = ?3.82) variables indicate that greater invest?

ment and growth opportunities reduce dividends. The coefficient on profitabilityis significantly positive in both periods (t = 3.45 and t = 2.11), suggesting that

firms generating more earnings pay higher dividends. The coefficient on the

business risk variable is negative in both periods, but is significant only in 1987

(t = ?0.53 and t = ?5.76). The negative coefficient on the business risk variable

supports the view that firms avoid the commitment to higher dividends when

uncertainty about earnings is high.

3. Insider Ownership Equation

An analysis of Table 3C indicates that only size has a consistently sig?

nificant effect on the level of insider ownership (t = ?5.45 and t = ?2.44).

Research and development and business risk are insignificant in both periods,

while the number of divisions is negative in both periods, but significant only

in the latter (t = ?0.97 and t -?2.73). The negative coefficient on size and

number of divisions is consistent with the hypothesis that insiders take larger

positions in firms where they can exercise the most control. Smaller firms with

fewer divisions typically have more focused operations, which might give in?

siders greater control of the operations. In addition, the negative coefficient on

the size variable exists at least partially because far less wealth is required to

own a given percentage of a small firm.

D. Overview of Empirical Results

The results of the analysis support the proposition that financial decisions

and insider ownership are interdependent. Specifically, insider ownership has a

negativeinfluence on a firm's debt and dividend levels. An F-test was

performedto test the null hypothesis that the three endogenous variables, when included as

explanatory variables in an equation, are equal to zero. In each period, the null

hypothesis was rejected at the 0.0001 level. An F-test was also performed on

the null hypothesis that the level of insider ownership in the debt and dividend

16Thestatic tradeoff theory (bankruptcycost/tax shelter theory) suggests that firms select an

optimal capital structureby adding debt until expected bankruptcycosts equal the tax advantage.See Krausand Litzenberger 1973), Kim (1978), Turnbull 1979), and Scott (1976) for studies thathave developed static tradeoff models.

l7Rozeff(1982)

finds evidence that dividendpolicy

is relatednegatively to expected futureinvestment(as proxiedby currentandprospectivefuturegrowth),firmrisk, and the level of insider

ownership.









equations is equal to zero. In each period, the null hypothesis could not be

rejected at the 0.10 level. Together, these results suggest that interdependence

exists between the three policy decisions. Further, any causality appears to run

from insider ownership to financial decisions and not vice versa.

The results also provide support for a modified version of the pecking

order theory. In particular, the results from the dividend equation indicate that

firms set dividend levels that permit managers to finance expected investments

internally. If dividend policy corresponds to managerial projections of future

investment opportunities, firms can maintain stable dividends and obtain needed

equity financing internally. Obviously, this policy is most plausible if the costs of

external equity are large. Evidence in the debt equation indicates that profitable

firms use less debt. These observations suggest that firms set their debt anddividend policies to take advantage of retained earnings.

The other significant variables in the debt and dividend equations, however,

would indicate that the pecking order theory is not a complete explanation for

a firm's financial decisions. The significant coefficients on fixed assets, R&D,

insider ownership, and business risk imply that bankruptcy and agency costs

also play a role in financial policy. The evidence is also consistent with the

theory that insiders take major positions in firms where the potential for control

is high.

Overall, the equation system displays a comparatively high degree of ex?

planatory power for cross-sectional regressions of firm policy. The system-

weighted ^-squares were R2 = 0.30 and R2 = 0.27 in 1982 and 1987, respec?

tively. In addition, the results are consistent across the two time periods, which

suggests the specification is fairly robust. In previous studies, outliers in some

of the variables have reduced explanatory power and led to inconsistent re?

sults. Our 3SLS analysis was performed on "winzerized" data to determine the

effect of outliers on the explanatory power of the system and the coefficient

estimates.18 The results are quite similar, indicating that outliers were not a

major problem in these data.

18Thewinzerizationprocedure s a methodfor correcting problemscreatedby outliers (BarnettandLewis (1984)). Forexamplesof applicationsof the techniqueto financialdata,see Pinches and

Mingo (1973) and Wilson (1986). The procedure n this study involved adjustingvalues that were

more than two standarddeviationsgreater(less) than the mean to exactly two standarddeviations

greater (less) than the mean. This adjustmentwas applied to all the variables included in the

analysis.Performing he analysison winzerizeddata resulted n a small increase n theexplanatorypower

of the system as a whole and in most of the equations. The system weighted /?-square ncreased

from0.30 to 0.32 in 1982 and from 0.27 to 0.29 in 1987. The largest ncreasesin equation l-squareoccurredfor the insider ownership equationfor 1982 (/?-square ncreasedfrom 0.03 to 0.10) andthe dividendequationfor 1982 (/?-square ncreasedfrom 0.21 to 0.25).

The significance level of several variables increasedwhen the adjusteddata were employed.However,only two coefficients changedfrom being insignificantto being significant.The business

risk variable became significantin 1982 (f-statistic increasedfrom ?1.41 to -2.28) and the fixed

assets variable became significant n 1987 (f-statistic ncreasedfrom 1.94 to 2.62). The resultsfrom

the winzerizeddataare available from the authorsupon request.









V. Summary and Conclusions

Despite strong theoretical arguments and empirical evidence that insider

ownership and firm financial decisions are interdependent, studies of these vari?ables have overwhelmingly employed single equation estimation techniques.

The results have been inconsistent. The analysis here utilizes three stage least

squares (3SLS) in examining the relationship between a firm's debt, dividend,

and insider ownership decisions. The 3SLS approach allows for the interdepen-

dence of firm decisions, while controlling for effects that other firm character?

istics may have on these decisions.

The results support the proposition that financial decisions and the level

of insider ownership are interdependent. Specifically, the level of insider own?

ership has a negative influence on a firm's debt and dividend levels. Insider

ownership itself is related to variables that proxy for the wealth gains from the

control potential of the firm. The results also provide strong support for a mod-

ified version of the pecking order theory, which suggests that agency costs and

bankruptcy costs also affect a firm's financing decisions.

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