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International Journal of Arts & Sciences,

CD-ROM. ISSN: 1944-6934 :: 4(26):147155 (2011)


c 2011 by InternationalJournal.org
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CEO POWER: THE EFFECT ON CAPITAL STRUCTURE AND FIRM


PERFORMANCE
Melek ACAR BOYACIOLU
Selcuk University, Turkey
The present study investigates the effect of CEO power on capital structure and firm
performance. CEO power has an influence on critical corporate decisions such as selection of
capital structure. Powerful CEOs may affect decisions concerning leverage use and make
decisions on capital structure by giving priority to their own interests rather than shareholders
interests. According to the agency theory, CEO power increases agency costs, causes nonoptimal leverage and as a result firm performance decreases. In this study, regression analysis
and structural equation modelling were used on the basis of the data of the firms on the
Istanbul Stock Exchange (ISE) National 100 Index. According to the findings obtained as a
result of the study, in firms where the CEO is powerful, a change in the capital structure in
favour of leverage has a negative effect on firm performance. This result indicates, as foreseen
by the agency theory, that powerful CEO increases agency costs and affects firm performance
negatively.
Keywords: CEO power, CEO duality, Capital structure, Agency Theory, Firm performance, Leverage,
Regression analysis, Structural equation modeling.

INTRODUCTION
Chief Executive Officer (CEO) and other top executives play a significant role in carrying out
firms activities. While CEO is responsible for making strategic decisions and putting them into
practice, board of directors approve and control the decisions made by CEO. The powerful CEO
concept is the indication of how much of the decision making power is owned by CEO (Liu and
Jiraporn, 2010). In fact, the concept of power here is multidirectional and cannot be observed
easily. Finkelstein (1992) mentions four types of power: Structural power, ownership power,
expert power and prestige power. The one that is frequently used in the literature is structural
power and it is based on formal organizational structure and hierarchical authority. Ownership
power emerges from the right to vote. Expert power emerges from the capability of contributing
to organizational success by having an impact on certain strategic decisions. Prestige power
represents influence by using personal prestige, self-esteem, personal relations and
characteristics. Following the literature, the focus of this study is structural power, especially the
power of CEO on top executive team.
There are two theoretical approaches that explain the advantages and costs of CEO duality
which is the indication of powerful CEO. The first of these is the agency theory of Jensen and
Meckling (1976). According to agency theory, when ownership and control are separated in the

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firm, the capital structure results in an increase in agency costs. If CEO and chairman of the
board are the same person, this upsets the balance of power among top executives of the
company. Internal inspection and control role of the board of directors weakens and the benefits
of shareholders are sacrificed for the good of top executives. This may happen through paying
them higher salaries, poison pills1, golden parachute2, and greenmail3 (Kholeif, 2008). Therefore,
this theory asserts that there is a need for effective management that protects the interests of
shareholders. Benefits of shareholders are protected only when CEO and chairman of the board
positions are occupied by two different people.
The other is stewardship theory of Donaldson and Davis (1991). According to this theory,
when CEO is the chair of board of directors, he/she is equipped with structural and psychological
authority and thus, CEO can serve the firm and shareholders better. CEO duality eliminates both
internal and external uncertainties regarding the responsibilities related to the firm and the
performance of the firm is positively affected by this.
The findings obtained from empirical studies that explored how CEOs also acting as the
chairman of the board affects the firms performance vary (Kholeif, 2008). While some mention
a positive correlation between firm performance and chairman of the board who does not take
part in management (Berg and Smith, 1978; Rechner and Dalton, 1991; Daily and Dalton, 1994),
some others have reached the conclusion that the chairman of the board who takes part in
management boosts firm performance (Donaldson and Davis, 1991; Finkelstein and DAveni,
1994; Lin, 2005). Still some other studies have reported that there is not a significant relationship
between firm performance and the chairman of the board taking or not taking part in
management (Chaganti et al., 1985; Molz, 1988; Baliga et al., 1996; Abdullah, 2004).
According to the agency theory, powerful CEO has significant effects on the firm. Dominant
CEOs adopt a strict managerial approach, aggregate agency conflict and thus harm the firms
value. In agency conflict, executives may not always take advantage of leverage effect to
maximize shareholder value. On the contrary, they may opt for leverage level that increases their
personal benefits. According to this theory, agency cost may lead to taking leverage decisions
that deviate from the optimal level for the shareholders. It is not clear whether the effect of
deviation from the optimal leverage is positive or negative and if agency cost results in much or
very little leverage. For example, on the one hand, executives can avoid debt. Interest payments
of loans reduce existent free cash flow that the executives will use (Grossman and Hart, 1982).
Therefore, they prefer less leverage to decrease the risk, to avoid the pressure of interest loads
and to be safe from the danger of losing their jobs in case of bankruptcy. On the other hand,
executives may increase the amount of leverage to strengthen their right to vote (Stulz, 1988).
Zwiebel (1996) developed a theoretical model that supports the view that executives keep the
level of debt high to increase their privileges in the firm.
In this study, the existence of the relationship between the power of CEO and capital
structure and firm performance can be tested on the firms on the ISE National 100 Index.
Moreover, in this relationship, the purpose is to identify the mediation effect of leverage level.
The study consists of six sections. In the second section, the literature is reviewed; in the
third, information about data set is given; in the fourth, information about the model which is
developed, hypotheses and method is provided. In the fifth section, research findings are
interpreted. The last section includes results and discussions.
1

The securities that are announced to seem less valuable in the eyes of the firm that is trying to acquire the potential target firm.
Particular rights given to top executives by the firm in the form of compensatory payments.
3
Greenmail is the practice of purchasing the shares of a firm from the potential purchaser firm or person by paying a certain
premium to avoid a takeover.
2

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149

LITERATURE REVIEW
There are quite few studies that explore the effect of powerful CEO on capital structure and firm
performance. In the empirical studies that have been carried out lately, it is reported that
powerful CEO increases agency cost, results in higher loan costs and it has a negative impact on
firm performance and decreases market value, profitability and credit rating. Among the most
prominent of these studies is the one by Bebchuk et al. (2008). In their study, Bebchuk et al.
(2008) concluded that powerful CEO decreases the firm value calculated by Tobins Q and it
diminishes accounting profitability. In addition, they stressed that dominant CEO may make
acquisition decisions which give harm to firm value. In their study in 2009, the authors pointed
out that powerful CEO behaves in a way to protect his own benefits rather than those of the
shareholders, and this further aggregates the agency conflict between the shareholders and
executives.
Liu and Jiraporn (2008) investigated the agency conflict between shareholders and
bondholders. According to the findings of their study, bondholders view CEO as a critical factor
that determines the cost of debt. Especially in those firms in which CEO claims a dominant role,
cost of debt is higher and credit rating is lower as well. If CEO is powerful in a firm,
informational asymmetry increases and this in turn makes it difficult for bondholders to control
activities of executives. Powerful CEO encourages a stable managerial structure and strengthens
asset substitution problem and decreases reporting transparency. As a result, bondholders
demand more return from the firms in which CEO is powerful. Liu and Jiraporn (2010) obtained
similar results in their latest study in which they researched the effect of CEOs power on bond
rating and return. The firms in which CEO is powerful work in an environment with more
transparent information and this in turn decreases transparency. Thus, it becomes difficult for
bondholders to observe the executives, and as a result they expect higher return.
Adams et al. (2005) researched how CEO power affected performance change. As a result of
the study, it was found that firms performance change increased in connection with the level of
CEO effect. This is because when CEO is powerful, it is more probable that extreme decisions
are taken. Powerful CEOs are less willing to reconcile, and thus, they are able to make more
extreme decisions. The direction of the positive correlation between powerful CEO and firm
performance is from power to performance. Daily and Johnson (1997) reached the conclusion
that powerful CEO and firm performance are related to each other and performance is the result
of the power of CEO.
In accordance with agency theory, Kholief (2008) researched the existence of negative
correlation between powerful CEO and firm performance by using the data of the firms traded in
Egyptian stock market in 2006. This study found that in the firms with large boards and low top
management ownership, firm performance is affected negatively by powerful CEO and
positively by institutional ownership.
In their study, Kim and Lu (2008) stated that the negative correlation between ownership
power, structural and firm performance is statistically significant only when external managerial
mechanisms that limit the power of CEO are weak. In the opposite case, the correlation between
positive performance and power is statistically significant when external management
mechanisms are powerful. In this study, external management mechanisms are represented by
institutional ownership density and accepting Sarbanes-Oxley Act.
In a study in which Boyd (1995) used the financial data belonging to the year 1980 of 192
American firms from 12 different industrial groups, the researcher reached the finding that both
agency and stewardship theories failed to predict the impact of powerful CEO on the firm. Body

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(1995) claimed that powerful CEO had a positive effect under certain industrial conditions and
apart from these it had a negative effect. In a study in which Kiel and Nicholson (2003)
researched the correlation between integration of board of directors of 348 large firms traded in
Australian stock market and firm performance, findings similar to those of Boyd (1995) were
found. They stated that each of agency, representation, and resource dependence theories (Pfeffer
and Salancik, 1978)4 alone was not able to explain the relationship between firm management
and performance, but each theory can be applied under different conditions. Moreover, in this
study, it was concluded that there was not a correlation between powerful CEO and firm
performance except for market performance criteria (Tobins Q).
DATA SET
The scope of the study is composed of 2007 data from companies on the ISE National 100 Index.
Data on the financial performances of the companies and leverage levels were obtained from the
ISE and FINNET Electronic Publishing Data Communication Industry Trade Inc. websites
(http://www.imkb.gov.tr), (http://www.finnet.com.tr) and from Matriks Information
Dissemination Delivery Services Inc. Information about the criteria used in measuring CEO
power was obtained from annual reports companies published on their own websites.
As it is difficult to observe CEOs power directly, there is a need for a variable to measure
this power. In the literature, various criteria have been used to measure CEO power. Bebchuk et
al. (2008) and Bebchuk et al. (2010) considered CEOs pay slice (CPS). If the pay is high, CEO
is accepted to be very dominant and powerful. Particularly in recent studies, this measurement
criteria was predominantly employed (Fung et al. 2003; Liu and Jiraporn, 2008; Henderson et al.
2008; Grinstein et al. 2008; Fracassi and Tate, 2009; Keys et al. 2009; Liu and Jiraporn, 2010).
In the literature, there are also studies which consider CEO duality as a criterion to measure CEO
power. CEO duality means that CEO and chairman of the board are the same person. Boyd,
1995; Kiel and Nicholson, 2003; Adams et al. 2009; Davidson et al. 2004; Baliga et al. 1996;
Brickley et al. 1997; Daily and Dalton, 1997; Dalton et al. 1998; Kholief 2008; Kim et al 2009
are among the leading ones. Besides, the formal titles that CEO holds were employed to measure
CEO power. Other than CEO position, s/he can hold titles like chairman of the board, president
and Chief Operating Officer (COO). It is accepted that the more the number of titles is, the more
powerful CEO is. Finkelstein (1992) and Harrison et al (1988) used this criterion to measure
CEO power. Adams et al. (2005) employed the criteria of CEOs being the company founder,
only insider on the board of directors and the chairman of the board altogether measuring CEO
power. Ashbaugh-Skaife et al. (2006) measured CEO power with the number of committees of
which s/he is a member. They argued that the more committees the CEO belongs, the more
his/her decision making power increases.
In this study, to measure CEO power, which was taken as independent variable, CEOs
being the chairman or member of the board criterion was used. If the CEO was the member or
chairman of the board, it was encoded as 1, if not it was encoded as 0. Leverage level was taken
as moderating variable. Following the literature, leverage variable in this study was calculated
4

Resource dependence theory studies the relationships between organizations own structures and behaviours and other
organizations in order to sustain themselves. According to this theory, the changes that take place around the organization also
change the organizations relations with its environment. Organizations in this respect are active in their relations with the
environment.

CEO Power: The Effect on Capital Structure and Firm Performance

151

using Total Dept/Total Equity ratio. Financial performance, which was the dependent variable,
was measured using return on asset-ROA (Net Profit/Total Asset).
RESEARCH METHOD
Within the scope of the study, the influence of powerful CEO on capital structure and firm
performance was investigated. The developed model is seen in Figure 1. According to the model,
leverage level functions as a moderating variable between powerful CEO and firm performance.
Powerful CEO

Firm Performance

Moderating Variable
(Leverage Level)

Figure 1. Research Model.

The hypotheses of the study were determined as follows:


H1: As CEO power increases, firm performance decreases.
H2: As CEO power increases, leverage level increases.
H3: As leverage level increases, firm performance decreases.
H4: Increasing CEO power and leverage level decreases firm performance.
The relations between variables were tested by using regression analysis and structural equation
modeling. The relations were examined firstly by pair wise comparisons, and then the integrated
effect of CEO power and leverage level on firm performance was examined. For pair wise
relation, linear regression was used and for integrated effect multiple regression analysis was
used to calculate. Structural equitation model was applied to determine the mediation effect of
leverage level on the relation between powerful CEO and firm performance.
EXPERIMENTAL RESULTS
Data in Table 1 indicate that the positive relationship between powerful CEO and leverage ratio
and the negative relationship between powerful CEO and ROA are significant at 5 %, and the
negative relationship between leverage ratio and ROA is significant at 1 %. The results seem to
verify the first three research hypotheses.

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Table 1. Descriptive Statistics.

Standard
Deviation

Powerful
CEO

,76

,429

2,27

2,64

,207*

,068

,092

-,195*

-,368**

Mean
Powerful
CEO
Leverage
Ratio
ROA

Leverage
Ratio

ROA

* significant at 5 % level.
** significant at 1 % level.

However, the relationships between variables were examined using regression analysis to be able
to make a more robust interpretation. The results of linear regression analysis are summarized in
Table 2. Linear regression analysis results also suggest that the relationship between powerful
CEO and leverage ratio and ROA is significant at 5 % and the relationship between leverage
ratio and ROA is significant at 1 %. These results verify the first three hypotheses of the study.
Table 2. Linear Regression Analysis.

Independent
Variable

Dependent
Variable

Powerful CEO

ROA

- ,195

- 1,96

,049

,19

Powerful CEO

Leverage Ratio

,207

2,09

,038

,21

Leverage Ratio

ROA

- ,368

- 3,91

,000

,37

To measure the moderating effect of leverage ratio on the relationship, powerful CEO and ROA,
leverage ratio and powerful CEO variables were entered into the equation together and the
relationship between powerful CEO and ROA was expected to weaken or lose its significance
level.
It is understood from significance level in Table 3 that the relationship between powerful
CEO and ROA lost its significance. These results verify the fourth hypothesis of the study.
Table 3. Multiple Regression Analysis.

Independent
Variable

Dependent
Variable

Powerful CEO

- ,124

- 1,29

,198
,39

ROA
Leverage Ratio

-,342

-3,57

,000

CEO Power: The Effect on Capital Structure and Firm Performance

153

Data were entered into structural equation modeling to test results as whole and alternative
models. In the comparison of structural equation model and alternative models, RMSEA (Root
Mean Square Error Approximation), GFI (Goodness of Fit Index), AGFI (Adjusted Goodness of
Fit Index), CFI (Comparative Fit Index) and NFI ( Normed Fit Index) indexes were used.
Analysis results are given in Table 4.
Table 4. Confirmatory Factor Analysis Results.

Model

RMSEA

GFI

AGFI

CFI

CEO->ROA>LEV

.25

.96

.73

.75

LEV->ROA>CEO

.31

.93

.61

.59

CEO->LEV>ROA

.07

.99

.94

.98

Ideal Values

< .10

> .95

> .90

> .95

NFI
.74
.60
.94
> .95

In Table 4, it was determined that only the relationship between powerful CEO, leverage ratio
and ROA meets goodness of fit criteria. Alternative models do not meet these criteria. This result
reveals that the projected model is confirmed by the data obtained in the study.
According to the result of analysis, there is a positive relationship between powerful CEO
and leverage ratio and a negative relationship between powerful CEO and ROA. In firms with
powerful CEO, more leverage was used. This result supports the argument that powerful CEOs
can rise debt level to increase their concessions in the company and vote power. Dominant CEOs
prefer sub-optimal leverage, which increases agency conflict. This situation negatively
influences firm performance.
CONCLUSION
In this study, the effect of powerful CEO on capital structure decisions and firm performance
was investigated. According to empirical findings obtained as a result of regression analysis and
structural equation modeling carried out using data from the companies on the ISE National 100
Index, there is a positive relationship between powerful CEO and leverage level. Companies in
which CEOs play a dominant role use more leverage. Thus, they increase their concessions and
vote power in their companies. Above-optimal leverage use affects firm performance negatively.
If CEO is also the chairman or member of the board of directors, the observation and supervision
of board of directors weakens and the interests of shareholders are sacrificed in favor of
executives. This leads to agency conflict and increases agency cost. Therefore, firm performance
decreases.
The limitation of this study is that cross sectional analysis is conducted using only 2007 data
of the ISE National 100 Index and ROA variable was used as an indicator for firm performance.
In further studies, analysis can be repeated by increasing the number of years and using market
performance indicators or accounting and market performance indicators together.

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