International Research Journal of Finance and Economics ISSN 1450-2887 Issue 61 (2011) EuroJournals Publishing, Inc. 2011 http://www.eurojournals.com/finance.

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Impact of Corporate Governance on Firm Performance Evidence from the Tobacco Industry of Pakistan
Khurram Khan Assistant Professor, Riphah International University, Islamabad, Pakistan E-mail: khurram.khan@Riphah.edu.pk Tel: +92-321-5375887 Ali Raza Nemati Riphah International University, Islamabad, Pakistan E-mail: alirazanemati@gmail.com Tel: +92-345-5905581 Moazzam Iftikhar Assistant Professor, Riphah International University, Islamabad, Pakistan E-mail: miftikhar786@gmail.com Abstract This paper examines the affect of corporate governance on a firms performance. The research has been carried out on the Tobacco industry of Pakistan which is a major contributor to Pakistans Exports. There are several aspects and dimensions of corporate governance, which may influence a firms performance but this study focused on three aspects namely ownership concentration, CEO duality and Boards Independence. Firms performance has been measured through Return on Equity (ROE) & Return on Assets (ROA). Strong and positive impact of corporate governance on firms performance has been seen.

Keywords: Corporate Governance, Firms Performance, ROE, Independence, CEO Duality and Ownership Concentration

ROA,

Board

Introduction
The aim of this research paper is to investigate the importance of corporate governance in firms performance. This study examines that how and in which direction corporate governance can affect firms performance. Corporate governance provides a structure that works for the benefit of the firm and can help in increasing firms performance .Shleifer and Vishny (1997) states that, Corporate governance deals with the ways in which suppliers of finance to corporations assure them of getting a return on their investment The factors that determine corporate governance can be internal factors defined by the officers, stockholders or the rules of a company, as well as the external forces such as consumer groups and government regulations. The internal factors affecting corporate governance are, Separation of ownership and control, ownership concentration, boards independence whereas & ROA have been used as measures of performance.

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The tobacco industry of Pakistan has been selected for this study due to its size and importance to Pakistans economy. Tobacco crop in Pakistan, which provides yield well above the world average, contributes 4.4 %, or over Rs. 27.5 billion, to the national Gross Domestic Product (GDP). It is the single biggest contributor of excise duty, six times than that from cotton. Over 5 per cent of all taxes collected in the country come from the tobacco industry. It employs over one million people directly or indirectly. Further, the industry is a fair mix of multinational and national companies, which makes it a good sample for subsequent generalization of the findings of this study over the entire industrial sector in Pakistan.

Literature Review
Governance as described by J. Wolfensohn, president of the World Bank, is about promoting corporate fairness, transparency and accountability" (Financial Times, June 21, 1999). Mahmood Osman Imam and Mahfuja Malik (2007) state that the need for corporate governance arises from the potential conflicts of interest among participants (stakeholders) in the corporate structure .These conflicts of interest often arise from two main reasons. First, different participants have different goals and preferences. Second, the participants have imperfect information as to each others actions, knowledge, and preferences. Tosi and Gomez-Mejia (1989) state that the challenge of corporate governance is to set up supervisory and incentive alignment mechanisms that alter the risk and effort orientation of agents to align them with the interests of principals. Renato Giovannini (2009) suggests that corporate governance and board ownership as mechanisms to manage and monitor the firm without missing opportunities that stem from shareholder base enlargement, rather than pursuing exploitation of outsider director skills. According to Tricker (1994), corporate governance is an umbrella term that includes specific issues from interactions among senior management, shareholders, board of directors, and other corporate stakeholders. Blair (1995) argues that corporate governance implicates, the whole set of legal, cultural, and institutional arrangements that determine what publicly traded corporations can do, who controls them, how that control is exercised, and how the risks and returns from the activities they undertake are allocated. Shleifer & Vishny, (1997) defines corporate governance that it deals with the ways in which suppliers of finance to corporations assure themselves of getting a return on their investment. Jensen and Meckling (1976) addressed these conflicts by examining the separation of corporate ownership from corporate management. They noted that this separation, with the absence of other corporate governance mechanisms, provides executives with the ability to act in their own self-interest rather than in the interests of shareholders. A large proportion of the regulatory changes have focused on boards of directors .In order to define a board of directors or a system of governance. Caselli, S, & Gatti, S. (2007) say that two elements must be taken into consideration with respect to board of directors: actors and context, by actors they meant not only directors, but the entire range of stakeholders representing interests and power within the firm. Their presence guarantees, on the one hand, the creation of value and the distribution of the value created; on the other, it determines contextual factors, beginning with governance mechanisms. By context, they meant geographical, cultural, sectoral, and firm specific differences and variations. Among these are the degree of dispersion in and the nature of firm ownership, differences in size, lifecycle variations, including crises and the configuration of firm resources, and CEO tenure and its features and background. Institutional investor also plays a vital role in the governance of the firm moving from good to great. Institutional investors are organizations which pool large sums of money and invest those sums in companies. Institutional investors can be banks, mutual funds, insurance companies and etc. They can direct the board to protect the rights of the shareholders and improves and can impact the running governance of the company. If the institutions can more easily select directors, at least for a minority of board seats, they can hire directors to watch companies on their behalf and be accountable to them.

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Currently, directors are often more loyal to corporate officers than to the shareholders whom the directors nominally serve Separation of ownership and control can also play an important role .Moshe Pinto (2006) states that the separation of ownership and control creates an agency problem .The managers may run the firm in their own, rather than the shareholders' interest, choosing the maximization of their own utility over the maximization of shareholder value. Shleifer and Vishny (1988) show, in the context of managerial ownership, that high managerial ownership may entrench managers, as they are increasingly less subject to governance by board of directors and to discipline by the market for corporate control. Mace (1971) reports case-study evidence that suggests that nonexecutive directors will oppose exceedingly poor performance or obviously bad proposals. Weisbach (1988) finds that non-executive dominated boards are significantly more likely to respond to poor performance by dismissing the CEO. Koke (2001) finds that German firms under concentrated ownership have higher productivity growth Mazumdar (2006) found family owned business, lack of loyalty, misconception about delegation of authority, and missing internal audit function to be the reasons behind poor corporate governance in Bangladesh. Vishny (1997) have observed that strong legal protection of investors and some form of concentrated ownership are essential elements of a good corporate governance system.

Theoretical Framework
Figure 1:

CEO Duality

ROE
Return on Equity

Ownership Concentration

Corporate Governance

Firm Performance

Board Independence

ROA
Return on Asset

This model shows the relationship of variables with one another this model assumes that corporate governance is affected by CEO duality i.e. the holding of both the top offices of the chairman and the CEO by the same person can affect corporate governance which would have impact on to firms performance. The relationship between the ownership concentration and corporate governance has also been shown. There is ample evidence in the literature, that the more the ownership concentration the less would be the effective corporate governance. The impact on another variable that would be seen on corporate governance is board independence. The literature also supports the proposition that presence of more independent directors on the board leads to better corporate governance, which in turn would positively impact the firms performance .It has been shown in the model that firms performance would be measured through ROA and ROE. H1: Better the corporate governance of the firm the better would be firms performance.

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Sample and Data Collection

For the purposes of this study, data from three listed companies of the Tobacco industry, namely Pakistan Tobacco, Lakson Tobacco and Khyber Tobacco has been used. The required data has been extracted from the annual reports, of the above named companies, of five years- 2004-2008

Methodology
There are a number of factors that may affect corporate governance and a firms performance. This study, however, is confined to the relationship of five factors (variable). These are briefly described below: Independent Variables a. CEO Duality: It is whether a firm has different persons appointed as CEO & Chairman or the same person assumes both the positions. b. Ownership Concentration: It is the shareholding pattern of the firm. Whether fewer people have larger number of shares or shares are diversified to larger number of people. c. Boards Independence: It is the presence of non executive directors in the board. The presence of more independent directors on the board will make the board more independent. An independent board will be better placed to make independent decisions and hence safe guard the interests of all the stake holders, particularly the rights of minority shareholders. Intervening Variable a. Corporate Governance Dependent Variable a. Firms Performance Firms performance has been measured by: a. ROA (Return on Asset): It is the net income divided by the total assets of the firm. b. ROE (Return on Equity): It is the net income divided by shareholders equity of the firm.

Analysis
Figure 2:
Tobacco Industry of Pakistan (Corporate Governance) Ownership CEO Duality Concentration N N 2004 N N 2005 N N 2006 N N 2007 N N 2008 Y Y 2004 Y Y 2005 Y Y 2006 Y Y 2007 Y Y 2008 N N 2004 N N 2005 N N 2006 N N 2007 N N 2008

Variables

Pakistan Tobacco

Lakson Tobacco

Khyber Tobacco

Board Independence Y Y Y Y Y Y Y Y Y Y N N N N N

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Figure 3a:

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Years Net income Total assets Return On assets

2004 1,277.744 5,022.410 25.44 %

Pakistan Tobacco Return On Asset (ROA) 2005 2006 1,321.919 1,904.988 7,968.453 8,734.400 16.59 % 21.81 %

2007 1,300.517 9,826.232 13.24 %

2008 1,361.422 10,395.041 13.10 %

Figure 3b:
Pakistan Tobacco Return On Equity (ROE) 2004 2005 2006 665.227 1,321.919 1,904.988 3,262.823 3,639.414 4,139.187 20.39 % 36.32 % 46.02 %

Years Net income Share Holders Equity Return On assets

2007 1,300.517 4,022.857 32.33 %

2008 1,361.422 3,608.331 37.73 %

Figure 4a:
Lakson Tobacco Return On Asset (ROA) 2004 2005 2006 1,277.744 2,571.950 1,554.885 5,022.410 5,692.861 5,981.003 25.44 % 45.18 % 26.00 %

Years Net income Total assets Return On assets

2007 1,737.633 6,593.209 26.355 %

2008 1,105.400 9,439.784 11.71 %

Figure 4b:
Lakson Tobacco Return On Equity (ROE) 2004 2005 2006 1,277.744 2,571.950 1,554.885 2,554.806 4,145.491 4,956.281 50.01 % 62.04 % 31.37 %

Years Net income Shareholders Equity Return On assets

2007 1,737.633 5,566.993 31.21 %

2008 1,105.400 5,993.961 18.44 %

Figure 5a:
Khyber Tobacco Return On Assets (ROA) 2005 2006 1.935 1.856 9.127 5.093 21.20 % 36.44 %

Years Net income Total Assets Return On assets

2004 0.635 26.086 02.43 %

2007 9.940 9.709 102.44 %

2008 5.760 35.317 16.31 %

Figure 5b:
Khyber Tobacco Return On Equity (ROE) 2005 2006 1.935 1.856 (42.685) (41.423) -04.53 % -04.48 % Lakson Tobacco ROA-% ROA-% 25.4 50.0 45.1 62.0 26.0 31.4 26.4 31.2 11.7 18.4

Years Net income Shareholder's Equity Return On assets Year 2004 2005 2006 2007 2008

2004 0.635 (60.029) -01.06 %

2007 9.944 (31.480) -31.59 %

2008 5.760 (25.720) -22.39 %

Pakistan Tobacco ROA-% ROA-% 25.4 20.4 16.6 36.3 21.8 46.0 13.2 32.3 13.1 37.7

Khyber tobacco ROA-% ROA-% 02.43 -01.0 21.20 -04.5 36.4 -04.5 102.4 -31.6 16.3 -22.4

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Discussion
The performances of the organizations included in this study have been measured by Return on Assets and Return on Equity. Table 6 shows that Khyber Tobacco has shown negative Return on Equity for all the five years under study. This has been resulted from the huge losses accumulated over the years. The accumulated losses in 2008 had grown to Rs. 41,050,782, creating negative equity. There could be number of factors which have caused these losses. However, if the picture is looked at from the Corporate Governance, the Annual Reports of the company for the year 2008-09 reveal serious lapses in, or lack of Corporate Governance. Khyber Tobacco: The external auditors of the company, in their audit report pertaining to the financial 2008-09, have noted Without qualifying our opinion, we draw your attention to the matter that Karachi and Lahore Stock Exchanges have put the name of the company on Defaulting Companies List due to non-registration with Central Depository Company. The auditors have further noted that, The company has adopted a depreciation policy which is not in compliance with the requirements of IAS-16, Property, Plant, and Equipment, IAS-36, Impairment of Assets read with TR-II (reformatted 2004). The auditors, in their review report, have also highlighted the following two significant points: i. All directors are not tax payers ii. No internal audit report was available as the internal audit did not find any discrepancy to report. The company has also been fined by the Security and Exchange Commission of Pakistan, the corporate watch dog for violating the provisions of the Companies Ordinance- 1984, by not holding the Annual General Meeting of the company with the prescribed period. Though the above referred financial report states that five directors, out of total seven directors of the board, are independent and non-executive directors, but some of the independent directors (number not provided) are non-tax payers. This only goes to reflect that such non-taxing paying directors could be insignificant personalities from whatever professions they may belong to. They could hardly be expected to forcefully pursue the independent stance at the board meetings. It finds further credence from the auditors note that no internal audit report was available with the company, proving thereby that either the Audit Committee is either nonexistent or remained ineffective during the year.
Share Capital General Reserves Total Accumulated Losses Equity 12,018,410 3,312,465 15,330,875 (41,050,782) (25,719,907)

Pakistan Tobacco has consistently outperformed its competitors during the entire period covered by this study (i.e. five years from 2004 to 2008) on both performance measures. When we look at the corporate governance parameters, we find that, here again, Pakistan Tobacco presents strong indicators of good corporate governance. Table 2 above provides comparative positions of the corporate governance parameters.

CEO Duality
Pakistan Tobacco has different persons as the CEO and the Chairman (No CEO duality) Lakson Tobacco has the same person as the CEO and the Chairman (CEO duality)

Ownership Concentration & Board of Directors Pakistan Tobaccos ownership is divided among British American Tobacco (Investment) Company Ltd. (BAT) which holds 94.7% of the equity while the balance equity is held by

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International Research Journal of Finance and Economics - Issue 61 (2011) individuals. BAT being an institutional investor, which represents the interests of its own wide spectrum of shareholders, is not considered as one owner for measuring the ownership concentration. Therefore, this study has not taken Pakistan Tobacco as an organization whose ownership is concentrated in one or few hands of related shareholders (e.g. family ownership). Pakistan Tobacco- the Board, consisting of 12 directors, has four (4) executive directors and eight (8) independent directors. The independent directors account for one highly respected legal practitioner, two well reputed high ranking bureaucrats, retired from Government of Pakistan Service, one retired general (retired) turned industrialist and four successful businessmen of Pakistan. The Audit Committee of the board is well defined with detailed terms of reference and is chaired by an independent director. Six other independent directors are also members of the committee whereas CEO and the Chief Financial Officers are invited to the meetings of the committee as non-members, having no voting rights. Similarly, the Technical Committee and Human Resource Committee, having adequate number of independent directors as members, are also functioning in accordance with their respective Terms of Reference. Lakson Tobacco has ownership concentration within their shareholding pattern however they have independent board of directors so there is never a conflict between agent and principle this problem arises it has always been solved resulted in the optimum performance of the organization because of good corporate governance.

Limitations
The study, based on the data of Tobacco Industry of Pakistan, has proved the hypothesis that, Better the corporate governance of the firm the better would be firms performance. However, the study is based on a simplistic model of corporate governance that has taken into account only three aspects, namely, ownership concentration, CEO duality and Boards Independence. There are other factors, internal as well as external that also may affect state of corporate governance in an organization. A further study may be carried out including more factors in the model and by expanding its scope to other industries for better understanding and generalizing of the findings. Further, an organizations performance has been measured through Return on Equity (ROE) & Return on Assets (ROA). Other Key Performance Indicators (KPI) may also be introduced in the model for more authentic measurement of a firms all round performance.

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References
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