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INTERDISCIPLINARY JOURNAL OF CONTEMPORARY RESEARCH IN BUSINESS
COPY RIGHT © 2012 Institute of Interdisciplinary Business Research 489
NOVEMBER 2012
VOL 4, NO 7
The Relationship between Corporate Governance and Finance Patterns of the
Listed Companies
Corresponding Author: Mahmoud Moeinaddin Ph.D.27
Mohsen Karimianrad28
Abstract
The present study intends to examine the relationship of corporate governance and selection of
the finance patterns. Financing the company and application of potential investment
opportunities is chiefly regarded by the managers. Appropriate and timely applications of the
company‟s capacity can have a considerable influence on the future profitability. There are
various methods for financing the firms with different consequences. Management structure and
ownership can impact the decisions made for this selection. Management ownership and non-
executive members of the board that impact the management structure are utilized as the
corporate governance mechanisms in addition to the institutional shareholders and ownership
concentration which play a monitoring role on the board of directors. Finance patterns include
financing through self-financing through retained earnings, incremental debt and issuing stocks.
The required data include the information of 53 listed companies in Iran in a five year period
including 2006-2010. The findings indicate that there is a significant relationship between
corporate governance mechanisms and finance patterns. Actually, considering specific corporate
governance regime can lead to the selection of a particular finance pattern.
Keywords: Corporate Governance, Institutional Shareholders, Non-executive Members of the
Board, Ownership Concentration, Finance
1. Introduction
Organization of Economic Cooperation and Development (OECD, 2004) defined corporate
governance as the relationship of managers, board of directors, shareholders and stakeholders.
Corporate governance is an indispensable factor of the organizations. It is not only the required
clause for the appropriate growth of the firm in the market, but also the most precious item for
the shareholders for the purpose of keeping up with the impartiality, accountability, disclosure
and transparency of the different elements and parameters (Base, 2009).
Corporate governance provides a structure by which the objectives of the firm are defined.
Additionally, this structure determines how to monitor the performance of the managers (Al-
Najjar ,2010).
There are some issues confronted by the managers to manage and control the company that
include institutional shareholders and penetration of them in making the decisions related to their
finance needs. Today, it seems that internal sources of the companies are not essential. It is
especially expected that those companies that use the instruments and finance patterns in a
desirable and timely manner in the inflation situation, experience a considerable growth. It is
therefore interpreted that the decisions made by corporate governance for the purpose of
selecting a finance method is one of the main factors in improving the economic efficiency. In
27
Assistant Professor, Islamic Azad University Yazd Branch, Islamic Republic of Iran, 09133546008 28
M.A. in accounting, Islamic Azad University Yazd Branch, Islamic Republic of Iran
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doing so, diverse ways such as receiving loans and issuing stocks are performed by the managers
and it might lead to the different behavior of them by considering the effect of the size and
institutional shareholders on the managers.
2. Theoretical Background
Agency theory is one of the well-known theories about corporate governance. Agency problem
was first introduced by Ross in 1973 followed by Jensen and Mcling. They considered the
managers as the agents and the shareholders as the owners of the firms. There is no monitoring
and control probability in the firms with the dispersion shareholders and that‟s why the managers
look forward their own interests.
If the large institutional shareholders play the role of the monitoring agencies and dividends are
paid to reduce the agency costs, then there should be an alternative relationship between
dividend policy and institutional ownership. This relationship requires the positive association
between the percentage of shares owned by the institutional ownerships and earnings
accumulation (Stouraitis and Wu, 2004).
Regular payments of dividends can reduce the agency conflicts among the interests of the
managers and shareholders. Therefore, the range of possible abuse from the resources is reduced
by the managers. According to this assumption and considering the retained earnings as an
internal finance resource, dividend payment requires companies to rely on the external markets
to finance themselves. There was a great deal of opposition to the management tendency toward
retaining more earnings by the institutional owners. They can also require managers to pay the
dividends according to their voting and penetration power (Bichara, 2008). On the other hand, it
is expected that the agency costs are declined by increasing the ownership concentration and
reducing retained earnings (Harada, and Nguyen, 2006).
Stakeholders‟ theory, interest convergence hypothesis and the stability assumption of the
management position are all derived from accepting the agency theory. This was introduced by
Demsetz in 1983 and was more nalyzed by the other researchers. According to this hypothesis,
the competitiveness in the labor market of the managers and the incentive of keeping the position
and achieving higher and better positions leads managers protect their interests. If the manager
owns a major part of the stocks, there might be no motivation for using their maximum efforts.
Hierarchy theory of finance is the most significant theory about financing the companies.
According to Myers & Majluf (1984), the firms prefer financing through the internal resources
than the external finance sensitive to the information. The theory is based on this assumption that
the internal individuals are more knowledgeable than the shareholders. Therefore, the investment
resources are initially financed from the retained earnings followed by the debts with low risk
and high risk and finally by issuing stocks. This arrangement intends to reduce information
asymmetry and other finance costs.
Some specific studies in industrialized and developing countries demonstrate the different
behavior of them in selecting finance patterns. Singh and Hamid (1992) and Singh (1995)
examined the finance patterns in fifty developed and developing countries. The main findings
revealed that the developing countries apply more external resources to finance and issuing new
stocks to increase their net assets. In a similar study, Corbett & Jenkinson (1994) found that the
most important finance pattern is the internal resources; while issuing securities holds a small
share in their finance.
According to the above statements, it can be concluded that considering the corporate
governance mechanisms can affect management efficiency. Four measures are selected in this
study to investigate the hypotheses. Institutional shareholders‟ ownership is one of the measures
used because of the adequate experience, expertise and facilities they possess. Ownership
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concentration is the other measure which is regarded because of the considerable influence on
the firm and the board of directors. On the other hand, board ownership and the ratio of non-
executive members of the board are applied because of the executive power in the firm and the
monitoring effect over the board member, respectively. The main hypothesis of the study is
described as follows:
There is a significant relationship between corporate governance mechanisms and
finance patterns.
Financing through retained earnings, borrowing and issuing stocks are selected among the
finance patterns and two measures are regarded for each one. Therefore, the main hypothesis of
this study is examined through three sub hypotheses.
3. Research Background
Jensen et al (1992), Farinha (2003) and Harada, and Nguyen (2006) found the negative
relationship between ownership concentration and dividend. In other words, these studies
confirm the direct relationship between ownership concentration and retained earnings.
Abdelsalam and colleagues (2008) found that board composition is not significantly related to
dividend policy, but increasing institutional ownership leads to reducing the retained earnings.
They conducted the study among the Egypt companies. Guo and Ni (2009) confirmed the
negative relationship between institutional ownership and retained earnings. However, Kumar
(2003) found the positive relationship between institutional ownerships and retained earnings in
Indian companies.
Anderson (2004) covered the information of 500 companies in a time period including 1993-
1998 and found that finance costs are inversely dependent upon the non-executive members and
board size. Kouki and Guizani(2009) analyzed the effect of ownership structure on dividend
policy of Tunisian companies. Their findings showed that there is a negative relationship
between ownership concentration and retained earnings.
Al-Najar (2010) conducted a study in Japan and documented that there is no significant
relationship between dividend policy and institutional investment. Chalevas & Tzovas (2010)
examined the effect of corporate governance rule before and after the implementation and found
that its accomplishment will reduce the capital cost and increase the financial leverage. Lin
(2010) asserted that finance costs through borrowing have a significant relationship in those
firms with a high divergence between owners controlling right and factors affecting it.
4. Methodology
This is an applied study with the post event orientation and is classified as a correlation
study. We have used the previous studies to provide the literature review. Additionally, the
required information was collected from what has been documented in the financial statements
of the listed companies on Tehran Stock Exchange. The correlation and multivariate regressions
were used to test the relationship between the variables; while the significance of the model was
confirmed by F-statistics. Other tests related to the data are presented in different tables. The
Pearson correlation coefficient is applied to investigate the correlation of independent variables
in a pair-wise form. The significant level of 95 and 99 percent were considered along with t-
statistics.
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5.Statistical Population and Sampling
Tehran listed companies are selected as the sample for a five year period covering 2006 to 2010.
The statistical sample is chosen among the firms of the specified industries according to a
filtering criterion. The specified firms are selected among the others:
1. Those firms that are listed on Tehran Stock Exchange before 2006.
2. The firms that their end of the fiscal year is consistent with the calendar year.
3. Those firms that experience no variation in the fiscal year during the period.
4. Those firms with no transaction cease for more than six months.
5. The firms should not be classified as financial intermediaries or banks.
6. The required data about those firms should be available.
7. There should be no loss reported in their financial statements.
8. Those firms that have borrowed at least once in a time period covering 2006-2010.
6.Variables
Independent Variables
Managerial share ownership (MANOWN)
This variable is calculated by dividing the shares held by executive and non-executive members
to the total issued stocks.
Institutional Investor Ownership( INSOWN)
Bushee (1998) defined the institutional investors as the large investors such as banks, insurance
companies, investment firms and pension institutes. In the present study, this variable is
calculated by summing the shares held by the institutional investors and total issued stocks.
Non-Executive Directors of the board (NED)
Non-executive directors are the part time members who are not of executive responsibility. This
ratio is calculated by dividing the non-executive directors to the total directors.
Ownership Concentration
Herfindal-Hirschman index is the proxy used to calculate the ownership concentration. This
index is an economic proxy for measuring the exclusivity level of the market. Hence, the share
percentage of any shareholder is squared and summed together. The result is between 0 and 1
and the closer number of 1 is more concentrated:
OWNCON= ∑ (of ownership percentage)2
Dependent Variables
Financing through retained earnings is measured through the two following measures:
Self- Financing Ratio- Fixed Assets (SFRF): It is measured by dividing retained earnings
to the book value of the fixed assets.
Self-Financing Ratio- Total Assets (SFRT): It is calculated by dividing the retained
earnings to the total assets.
Financing through borrowing is measured through the two following measures:
Incremental Debt Financing Ratio (IDFR): This is the result of dividing total debts to the
total assets.
Debt on Equity (DOE): This variable is computed by dividing the total debts to the total
owner’s equity.
Financing through issuing stocks is measured through the two following measures:
New Equity Financing Ratio (NEFR): It is measured by dividing the owner’s equity
except for retained earnings to the total assets of the firm.
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Incremental Equity Financing Ratio (IEFR): It is calculated by dividing the total owner’s
equity to the total assets at the end of the period.
Control Variables
Firm Size: This variable is the natural logarithm of the total assets.
Book Value of property, plant and equipment to total Assets (PPE): This is the ratio
calculated by dividing the book value of the tangible fixed assets to the total assets. The
summary findings are presented in table 1. Table1. Summary of the Variables
Variable Title The Position in the
Model Ind. Source
The ownership percentage of the Board Independent MANOWN Valenti et al (2011) The ownership percentage of the Institutional
Shareholders Independent INSOWN Pushner (1993), Chalevas and Tzovas
(2010) Non-Executive Directors Independent NED Valenti et al (2011), Lin et al (2010) Ownership Concentration Independent OWNCON Lee (2008), Garcia (2011) Self-Financing Ratio- Total Assets Dependent SFRT Chung & Wang (2000), G. Saldana
(1999) and Abdul Samad (2002) Self- Financing Ratio- Fixed Assets Dependent SFRF G. Saldana (1999), Chung & Wang
(2000)and Abdul Samad (2002) Incremental Debt Financing Ratio Dependent IDFR G. Saldana (1999), Chung & Wang
(2000)and Abdul Samad (2002) Debt on Equity Dependent DOE Renneboog (2000), Duc Pham &
Carlin (2009) and Barbuţa (2010) New Equity Financing Ratio Dependent NEFR G. Saldana (1999), Chung & Wang
(2000)and Abdul Samad (2002) Incremental Equity Financing Ratio Dependent IEFR G. Saldana (1999), Chung & Wang
(2000)and Abdul Samad (2002) Firm Size Control Size Gonenc (2005), Alnajjar (2010) Book Value of the property, plant and
equipment total Assets Control PPE M. Bowen et al (2008), Chalevas and
Tzovas (2010)
7. Data Analysis
The descriptive and inferential statistics are used to analyze the collected data. The findings are
summarized in table 2.
Table 2. Descriptive Statistics of the Research Variables Kurtosis Skewness Std.
Deviation
Median Mean Number Variable
6/82 2/82 19/16 0 6/99 265 MANOWN
2/48 -1/7 2/11 80 74/63 265 INSOWN
57/02 7/59 1/05 60 61/52 265 NED
0/321 0/845 21/17 29/8 31/62 265 OWNCON
1/75 0/843 1/87 34/88 36/23 265 DOE
5/51 1/69 1/087 13/3 15/51 265 IEFR
10/97 2/83 1/54 1/56 1/9 265 IDFR
-0/343 0/361 0/14 39 40 265 NEFR
-0/34 -0/361 0/14 61 59 265 SFRT
0/611 0/567 0/09 21 21/9 265 SFRF
1/83 2/1 1/7 21/68 24/43 265 PPE
0/94 0/50 1/24 13/44 13/43 265 SIZE
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The descriptive proxies (central tendency and dispersion) are summarized in table 2. According
to the table above, all the variables are significantly different from the normal distribution except
for the IDFR, IEFR and SIZE.
The variables are normalized before the research. This is because it is assumed that the research
variables are normally distributed in estimating the parameters of the model.
Hypotheses Testing
Table 3 and 4 shows the findings of the regression model for the first hypothesis.
Table 3. The Summary Findings of Examining the Effect of Corporate Governance on SFRF
Estimation Period: 2006-2010
SFRFit = b0+ b1INSOWN it+ b2 MANOWN it+ b3 NED it+ b4OWNCON it+ b5Sizeit+ b6 PPEit+εit
Cross-section fixed (dummy variables)
R2
0.93 F 53.14
Adj. R2
0.91 (Prob) 0
Durbin-Watson 1.743
Explanatory Variable Coefficient t-statistics Prob. Sig.
Intercept 91/15 44/11 0 %99
OWNCON 817/0 003/2 046/0 %95
MANOWN 32/0- 484/0- 628/0 -
INSOWN 005/0- 328/2- 02/0 %95
NED 34/1- 235/5- 0 %99
SIZE 77/0- 92/7- 0 %99
PPE 79/3- 54/15- 0 %99
Table4. The Summary Findings of Examining the Effect of Corporate Governance on SFRT
It is asserted that the regression model is significant at 99 percent. The findings related to the
Durbin-Watson statistics demonstrate that the data are proportionately independent. R2 of the
model indicates the relevancy level of the model and SFRT and SFRF. This coefficient is equal
to 0.90 and 0.91 for the two above models. It means that 90 and 91 percent of the variations in
the SFRT and SFRF are predictable through the mentioned patterns. It is finally concluded that:
Institutional shareholders and retained earnings are inversely related. In other words,
Institutional shareholders results in less aggregation of earnings and more dividends.
SFRTit = b0+ b1INSOWN it+ b2 MANOWN it+ b3 NED it+ b4OWNCON it+ b5Sizeit+ b6 PPEit+εit
Cross-section fixed (dummy variables)
R2 Adj. R
2 Durbin-Watson
Statistics F Prob
0/92 0/90 6791/1 46/53 0
Explanatory Variable Coefficient t-statistics Prob. Sig.
Intercept 566/0 048/6 0 %99
OWNCON 0562/0 058/1 291/0 -
MANOWN 040/0- 436/0- 662/0 -
INSOWN 001/0- 793/5- 0 %99
NED 005/0 3087/0 757/0 -
SIZE 017/0- 327/2- 020/0 %95
PPE
1/0- 651/4- 0 %99
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A direct relationship is found between ownership concentration and SFRT. That is, the
ownership concentration leads to fewer dividends and more application of retained
earnings in finance.
The non-executive members of the board and SFRF are inversely associated. It means
that increasing the number of non-executive members of the board to the total members
will decrease SFRF. This decline is the same as less application of the firm’s earnings in
obtaining the capital assets. Generally, those firms with a higher ratio of non-executive
members use another method but the earnings accumulation.
There was no significant relationship found between Managerial share ownership and
retained earnings. Therefore it can be concluded that the ownership level of the board
has no influence on self financing. This is inconsistent with the hierarchy theory of
finance. This is because the theory expects self financing to be one of the initial priorities
of the managers.
Another finding provides evidence about the inverse relationship between self financing
and firm size index and PPE.
Testing the Second Hypothesis
The results of examining the second hypothesis are summarized in tables 5 and 6.
Table 5. The Summary Findings of Examining the Effect of Corporate Governance on IDFR
IDFRit = b0+ b1INSOWN it+ b2 MANOWN it+ b3 NED it+ b4OWNCON it+ b5Sizeit+ b6 PPEit+εit
Cross-section fixed (dummy variables)
R2 Adj. R
2
Durbin-Watson
Statistics F Prob
0/96 0/94 1/7320 86/87 0
Explanatory Variable Coefficient t-statistics Prob. Sig.
Intercept -1/01 -13/61 0 %99
OWNCON 0/134 2/411 0/0168 %95
MANOWN 0/011 0/0831 0/933 -
INSOWN 0/0003 0/763 0/445 -
NED -0/019 -0/897 0/370 -
SIZE 0/114 17/4 0 %99
PPE 0/078 3/31 0/0011 %99
Table 6. The Summary Findings of Examining the Effect of Corporate Governance on DOE
According to the F-statistics and its probability, it can be concluded that the regression model is
significant at 99 percent for both models. R2 of the model explains that how the model and IDFR
DOEit = b0+ b1INSOWN it+ b2 MANOWN it+ b3 NED it+ b4OWNCON it+ b5Sizeit+ b6 PPEit+εit
Cross-section fixed (dummy variables)
R2
Adj. R
2
Durbin-Watson
Statistics F Prob
0/95 0/94 1/76422 75/25 0
Explanatory Variable Coefficient t-statistics Prob. Sig.
Intercept -6/742 -21/77 0 %99
OWNCON 1/149 4/982 0 %99
MANOWN -0/215 -0/187 0/85 -
INSOWN 0/003 1/640 0/102 -
NED 0/07 0/532 0/59 -
SIZE 0/588 24/51 0 %99
PPE
0/336 2/092 0/037 %95
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in table 5 are related. This is 0.94 and it means that 94 percent of the variations in IDFR are
predictable from this pattern. Additionally, this finding holds the same for DOE.
The conclusions of the second hypotheses are summarized as follows:
There is a significant relationship between ownership concentration and incremental
debt financing. While, the other corporate governance mechanisms are not related to the
incremental debt financing. It means that more concentration on ownership will lead to
more borrowing in finance.
There was no significant association found between institutional shareholders,
managerial ownership and non-executive members with the incremental debt financing.
This issue is not appropriate until the essential ratios like liquidity and solvency ratios are
in a satisfactory level.
The findings also reveal that there is a direct association between financing through
borrowing and firm size and SFRT.
Testing the Third Hypothesis
The summary findings of the third regression model (significant relationship between corporate
governance mechanism and financing through issuing stocks) are provided according to the two
measures of NEFR and IEFR in tables 7 and 8.
Table 7. The Summary Findings of Examining the Effect of Corporate Governance on NEFR
NEFRit = b0+ b1INSOWN it+ b2 MANOWN it+ b3 NED it+ b4OWNCON it+ b5Sizeit+ b6 PPEit+εit
Cross-section fixed (dummy variables)
R2
Adj. R
2
Durbin-Watson
Statistics F Prob
0/9718 0/9639 1/72208 122.630 0
Explanatory Variable Coefficient t-statistics Prob. Sig.
Intercept 1/539 23/125 0 99%
OWNCON -0/099 -1/946 0/053 -
MANOWN -0/050 -0/607 0/544 -
INSOWN 0/001 2/556 0/011 %95
NED -0/003 -0/524 0/60 -
SIZE -0/10 -22/73 0 %99
PPE
-0/001 -0/19 0/84 -
Table 8. The Summary Findings of Examining the Effect of Corporate Governance on IEFR
IEFRit = b0+ b1INSOWN it+ b2 MANOWN it+ b3 NED it+ b4OWNCON it+ b5Sizeit+ b6 PPEit+εit
Cross-section fixed (dummy variables)
R2
Adj. R
2
Durbin-Watson
Statistics F Prob
0/9607 0/9496 1/7320 86/877 0
Explanatory Variable Coefficient t-statistics Prob. Sig.
Intercept 2/019 15/56 0 99%
OWNCON -0/13 -1/85 0/064 -
MANOWN -0/011 -1/088 0/92 -
INSOWN -0/000 -0/710 0/47 -
NED 0/019 1/068 0/28 -
SIZE -0/11 -11/61 0 %99
PPE -0/07 -2/69 0/007 %99
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These regression models are both significant at 99 percent. As shown in table 7, R2 of the model
shows the relevancy of the model and NEFR which is 0.94. Additionally, this holds for the next
model (table8) as 0.96. This means that 94 and 96 percent of the variations in NEFR and IEFR
are predicted through the specified patterns, respectively.
The conclusions show that there is a direct relationship between institutional shareholders and
NEFR. However, none of the corporate governance mechanism don‟t significantly relate to
IEFR. It is interpreted that the institutional shareholders tend to finance through issuing stocks.
The results also indicate an inverse relationship between issuing stocks financing and firm size
and SFRT.
Conclusion and Discussion
Corporate governance is today highly debated in scientific journals and most of the studies
concentrate on the monitoring role of the board of directors for the purpose of protection
interests of the shareholders in making organizational decisions (Weisbach, 1988). This study
seeks to find the relationship of corporate governance mechanisms with some financing patterns
of the firms performing in emerging and evolutional markets and economies like Iran.
The findings provide evidence that the presence of the institutional shareholders will encourage
the financing through issuing stocks and will reduce the self financing through retained earnings.
It can be therefore concluded that institutional shareholders have more tendency to dividends and
pay less attention to retained earnings. This is inconsistent with the hierarchy theory of financing.
This result is supported by Abdelsalam et al (2008), Guo and Ni (2009) and Zhang and Keasay
(2002). This is however completely different from the findings of Kumar (2003). Al-najar (2010)
confirmed that there is no relationship between institutional shareholders and retained earnings.
The positive relationship between ownership concentration and financing through retained
earnings and borrowing is also another conclusion of the study. This is consistent with the results
of Jensen et al (1992), Farinha (2003) and Harada and Nguyen (2006). However, there is no
consistency with the findings of Kouki and Guizani (2009). This means that more ownership
concentration will lead to more borrowing in finance. When a more percentage of the stocks are
held by fewer owners, then they tend to finance through incremental debt in order to maintain
their position, control over the firm and earn more profit. This subject might lead to some
relationships with the managers which are not in line with the interests of the minority
shareholders.
The inverse relationship between non-executive managers and financing through retained
earnings is another conclusion of this study. This was also found by Anderson (2004). However,
the findings of Chalevas and Tzovas (2010) were completely inconsistent with the conclusions.
Finally, corporate governance mechanisms influence on the finance patterns of the companies.
Investors, shareholders and creditors can pay more attention to the corporate governance
mechanisms which are aimed to follow the objectives. Lower tax and keeping the sensitive
information of the market, consistency in dividing the expected profit, penetration probability of
some investors in the firm and the need to equipments, experiences and expertise should be
essentially considered in finance. Therefore, applying a specific finance pattern with a special
corporate governance mechanism can‟t be prescribed for all companies. Generally, it is
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suggested to increase the institutional shareholders because of their experience and expertise and
also to increase the non-executive managers because of the fact that they have no executive role.
Applicable Suggestions
Financing through retained earnings is a very important finance pattern for the shareholders and
they are suggested to pay more attention to increasing the non-executive managers of the board,
lowering ownership concentration and increasing the ownership of the institutional shareholders
in order to use less self-financing. This will finally lead to declining the expected risk and
enhancing the firm‟s value.
The investors are offered to consider the ratio of non-executive managers as a positive factor
when making investment decisions. The further subjects can be defined as follows:
Corporate governance has very extensive subjects and they provide a lot of research
opportunities. There are also some other methods to determine the finance patterns of the firms.
Additionally, there are some other patterns like property lease which can be investigated.
Eventually, we offer to separately study and examine the roles of the corporate governance
mechanisms.
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