Outside board effect on firm value

The Effects of Outside Board on Firm Value
in the Emerging Market from the
Perspective of Information Transaction
Costs*
Sung Wook Joh
College of Business Administration, Seoul National University
Jin-Young Jung**
Johnson Graduate School of Management, Cornell University
Received 31 August 2011; Accepted 11 January 2012
Abstract
This paper examines whether the problem of high information asymmetry lowers the positive
impact of board independence on firm value. Independent directors are outside directors
who have never had business and professional ties with the firm. We adopt various proxies
for information transaction costs from the market microstructure literature and traditional
measures, such as firm size, firm age, number of analyst reports, governance scores, credit
ratings, and institutional ownership, to see how they interact. Using data on publicly listed
firms and their directors between 1999 and 2006 in Korea, we find that independent directors
are correlated with higher corporate value when the firm has lower information transaction
costs. The results suggest that the monitoring role of independent directors is limited when
transferring firm-specific information is costly.
Keywords Information asymmetry; Outside directors; Market microstructure; Firm value;
Board independence
JEL Classification: G14, G32, G34, G38, K22
*Acknowledgments: We are grateful to Editor Jun-Koo Kang and three anonymous referees.
We are also grateful to the Institute of Banking and Finance, Hyuk Choe, and Cheol-Won
Yang for providing us with the data. We appreciate research grants from the Management
Research Center and Institute of Banking and Finance at Seoul National University. Any
remaining errors are entirely those of the authors.
**Corresponding author: Jin-Young Jung, Visiting Scholar of Finance, Research Associate of
Emerging Markets Institute, Johnson Graduate School of Management, Cornell University,
248 Sage Hall, Ithaca, NY 14853-6201, USA. Tel: +1-607-527-0612, Fax: +1-607-254-4590,
email: jj396@cornell.edu.
Asia-Pacific Journal of Financial Studies (2012) 41, 175–193 doi:10.1111/j.2041-6156.2012.01069.x
Ó 2012 Korean Securities Association 175

1. Introduction
While outside directors are there to monitor and supervise the management of the
firm to increase firm value and protect shareholder interests, there is no consistent
empirical relationship between outside directors and corporate performance. For
example, in the US, a higher share of outside directors improves monitoring of cor-
porate affairs (Hermalin and Weisbach, 2003), but it might lower firm performance
depending on the roles of the directors (Klein, 1998). With a few exceptions, most
analyses using data outside the US show a positive correlation between outside
directors and firm performance. There are positive effects of outside directors on
firm value in New Zealand (Hossain et al., 2001) and Korea (Choi et al., 2007;
Kim, 2007), while Vafeas and Theodorou (1998) do not find a significantly positive
relationship between the two for UK firms.
In this study, we argue that differences in the effects of outside directors on
firm value come from two sources: independence of outside directors and infor-
mation asymmetry within firms. While outside directors, unlike inside directors,
are understood as non-executive directors, some of them might engage in busi-
ness or professional activities associated with the firm. Outside directors with a
business or professional relationship with the firm might find it difficult to
maintain their independence. Classifying outside directors as independent or gray
directors, we examine whether the higher share of independent directors
increases firm value as the directors would engage in monitoring and supervising
a firm’s management.
We also argue that firm characteristics, such as the degree of information asym-
metry, matters to the effectiveness of outside directors. As Duchin et al. (2010)
argue, when information acquisition cost is high, outside directors are less effective
at monitoring than when it is low. To explore this foundational hypothesis in an
emerging market, we construct firm-specific proxies for information costs and esti-
mate how information costs affect the relationship between performance and board
independence. Using market microstructure-based information measures, our paper
mitigates the problems associated with various proxies that are correlated with firm
size, which is an important contribution to the stream of research on information
asymmetry and firm value.
As noted by Denis and McConnell (2003), board independence depends on sys-
tems and regulations specific to a given country, as well as firm characteristics and
financial conditions (Kaplan and Minton, 1994). We argue that firms with high
information asymmetry would bring in fewer independent directors and solicit less
monitoring from them because transferring firm-specific information to outsiders is
costly (Maug, 1997). Therefore, board independence increases when information
asymmetry costs are low because the costs and benefits of the board’s monitoring
roles are correlated with information asymmetry (Linck et al., 2008).
The purpose of this paper is to examine whether the effects of board indepen-
dence on firm value are different across various information environments in the
S. W. Joh and J.-Y. Jung
176 Ó 2012 Korean Securities Association

emerging markets by using more refined independence and information asymmetry
measures.
In our empirical analyses, independent outside directors are those who appear
to have no current or past ties with the firm at either a professional or business
level. In other words, independent outside directors are defined as those who have
not accepted any consulting fees from the firm as a lawyer or accountant, for exam-
ple, and have not been employed by the firm or by any subsidiary thereof.
We test how firms with high information transaction costs affect the impact of
board independence on firm value. We construct information transaction cost mea-
sures from several sources. One source is the market microstructure literature based
on the Glosten and Harris (1988) model, and the other is based on the Hasbrouck
(1991), Foster and Viswanathan (1993) (HFV) model. Conceptually, these measures
share the spirit of the Glosten and Milgrom (1985), under which information trans-
action costs widens bid-ask spread. In addition, we also examine how other tradi-
tional proxies for information transaction costs, such as firm size, firm age, the
number of analyst reports, governance scores, credit ratings, and institutional own-
ership, interact with board independence and affect the valuation effect of board
independence.
Our work has hand-collected information on outside directors appointed by all
listed non-financial firms in Korea between 1999 and 2006. We choose Korean firms
and their board directors for our test for a couple of reasons. First, Korean financial
markets are a good example to test for the effect of information transaction costs
on firm value as a representative emerging market vis-a`-vis other developed mar-
kets. Hubbard and Palia (1999) choose the 1960s in the US to test for the motive
of internal capital market, arguing that the capital markets during the 1960s were
under-developed and the costs and benefits of information asymmetry risk were
more important. Second, Korean society places great emphasis on the effect of con-
nections in terms of firm activities (Jeon and Ahn, 2001; Kim, 2005; Siegel, 2007;
Johnson et al., 2009), making it possible to better examine the role of board inde-
pendence. Third, The Korean market has had a regulatory requirement regarding
the ratio of outside directors on boards as a key part of governance reform in 1997,
and information transaction costs have become even more important in the after-
math of the Asian financial crisis.
Some of the findings in the study are as follows. First, outside directors affect
firm value positively and significantly. Since board structure is endogenously deter-
mined by firm performance, we deal with this problem using two-stage least squares
(2SLS) regressions and fixed effect models. Our results are robust when endogeneity
issues are controlled for. We also find that independent outside directors who have
no professional or business ties with the firm generally increase firm value, while
gray outside directors who appear to have or have had professional or business ties
with the firm do not. This suggests that the valuation effect of board of directors
changes with board independence. Finally, we recognize that the valuation effects of
independent outside directors are more evident when information asymmetry is not

so grave at the firm. Taken together, board independence and information transac-
tion costs are important factors that decide the valuation effect of boards.
The rest of the paper is organized as follows. In Section 2, we present a litera-
ture review and develop our hypotheses. We describe our data and the sample in
Section 3. In Section 4, we show the empirical design and the test results of our
hypotheses regarding the valuation effect of board independence. We provide con-
cluding remarks in Section 5.
2. Board Independence and Information Asymmetry
A board of directors is believed to serve as an internal watchdog for governance,
representing and protecting shareholders’ interests from management who may pur-
sue their own interests in modern corporations where ownership and management
are separated (Jensen and Meckling, 1976). It is also argued that independent
outside directors are crucial in determining the effectiveness of monitoring and
disciplining management (Choi et al., 2007).
Board independence alone, however, does not guarantee effective monitoring.
Maug (1997) argues that it is an optimal choice to give full control to management
when information is too costly for outside directors to acquire. On the other hand,
when information is not difficult to acquire, boards can intervene in the management
of the firm. Furthermore, Raheja (2005) argues that outside directors provide better
independent monitoring than insiders but are less informed about the firm. Thus, as
the benefits of monitoring increase, boards will do more monitoring leading to more
outsiders, while as the costs of monitoring increase, boards will do less monitoring
leading to fewer outsiders. Linck et al. (2008) shows that outside directors incur infor-
mation acquisition and processing costs in utilizing their expertise for the specific firm
for which they serve. As a proxy for information acquisition and processing costs,
Linck et al. use market-to-book (MTB) ratio, R&D expenditures, and the standard
deviation of monthly returns. The result suggests that board independence decreases if
information asymmetry is high. The aforementioned literature mentions that the ben-
efit of monitoring and the advisory role played by outside directors decreases with the
higher cost of acquiring and processing information.
Thus, based on the aforementioned theoretical and empirical works, we can
make a prediction that the valuation effect of board independence will decrease with
higher information transaction costs. To capture the information acquisition and
processing costs, we use two measures. One has grown out of the Glosten and Har-
ris (1988) model, and the other is based on the Hasbrouck (1991), Foster and
Viswanathan (1993) model in the market microstructure literature. These measures
are based on the price impact costs generated by private information and reflect the
spirit that information asymmetry widens the bid-ask spread (Glosten and Milgrom,
1985). We test to see how information transaction costs are related to the valuation
effect of board independence. Additionally, we examine whether firm characteristics,
such as firm size, firm age, analyst reports, institutional ownership, governance,

credit ratings, which all proxy for information acquisition and processing costs, are
linked to the valuation effect. We expect the low information transaction costs
encompassing all these characteristics to be positively related to the valuation
impact of board independence.
3. Sample Selection and Data
Our sample consists of all Korean firms listed between 1999 and 2006. From this
population, we select all non-financial firms that have data available on board com-
position and information transaction costs calculated using the GH and HFV mar-
ket microstructure models. Omitting financial and utility companies, we then
combine the information with annual financial data and monthly stock returns
from the FnDataguide.
Figure 1 presents the time series of the board composition of the sample. The
sample includes 3,927 firm-years from 1999 to 2006. Figure 1 shows that the ratio
of outside directors was only about 15% in 1999, when the Korean government
introduced the system of outside directors, and it surged thereafter, exceeding 30%
in 2006. We include all the sample data on the number of outside directors, while
we only include in the sample those independent or gray outside directors whose
personal background data is available. The ratio of independent outside directors is
the number of outside directors who do not participate in the management of the
firm at present or in the past, or who have no business or professional ties with a
firm, divided by the total board size.
Table 1 presents each sample firm’s descriptive statistics regarding key firm char-
acteristics, board, and information asymmetry variables. We use Tobin’s Q as a mea-
sure of corporate value, following earlier studies on corporate governance and
0
5
10
15
20
25
30
35
1999 2000 2001 2002 2003 2004 2005 2006
Ratio(%)
Year
Outside directors
Indep outside directors
Figure 1 Board Structure Trends: 1999–2006.
The sample includes 584 unique firms covering 3,927 firm-years over the period 1999–2006. Figure reports
the percentage of outside directors and independent outside directors. Outside directors is the ratio of
legally registered outside directors to board size. Independent outside directors (Indep outside directors) is
the ratio of outside directors who have no business or professional ties to a firm to board size.

Table 1 Descriptive statistics for sample firms 1999–2006
The sample is drawn from FnDataguide. Data related to board of director characteristics are taken from
Korea Listed Companies Association and KISLINE, a database maintained by Korea Investors Service,
Inc. (KIS) as well as database of people of JoongAng Ilbo. Data related to GH (HFV) are taken from
Trade and Quote (TAQ) database provided by the Institute of Banking and Finance at Seoul National
University (IFB ⁄ KSE database) from 1999 to 2004. Tobin’s Q is the ratio of the sum of the market value
of common equity, the book value of preferred equity, and the book value of long-term debt to the book
value of assets. Outside directors is the ratio of directors who are not employees of the company and
have no operational responsibilities within the company to board size. Independent outside directors
(Indep outside directors) is the ratio of outside directors who have no business or professional ties to a
firm to board size. GH or HFV is information transaction costs estimated by the Glosten and Harris
(1988) or Hasbrouck (1991)–Foster and Viswanathan (1993) models. Board size is the total number of
directors. Director age is the age of boards as of the year end. Largest ownership is the percentage share-
holding of the largest shareholder. CAPEX ⁄ assets is the ratio of capital expenditures to total assets.
Leverage is the ratio of total debt to total assets. Firm size is the natural logarithm of (total
assets ⁄ 1 000 000). Operating profitability is the ratio of earnings before interest and taxes (EBIT) to
beginning total assets. Chaebol dummy is a dummy variable to indicate whether a firm belongs to one of
the 50 largest chaebols. The Korea Fair Trade Commission updates the list of the 50 largest chaebols
annually. Market risk (beta) is the estimate from market model in which the firm’s monthly returns over
the last year are regressed on the KOSPI monthly returns. Analyst report is the natural logarithm of total
number of analyst reports in the year. Credit rating dummy for companies with credit ratings for CPs or
corporate bonds is set as ‘‘1’’, and for companies without credit ratings for CPs or corporate bonds is set
as ‘‘0’’. Firm age is the natural logarithm of the firm’s age. Institutional ownership is the fraction of
shares owned by institutions. Governance is the natural logarithm of total Korean corporate governance
index (KCGI) which consists of four sub-indices: Shareholder Rights, Disclosure, Audit Committees, and
Ownership Parity (excluding Board structure index) between 2002 and 2006.
Variable
First
quartile Mean Median
Third
quartile
Standard
deviation
Sample
size
Tobin’s Q 0.321 0.601 0.469 0.702 0.515 3,927
Outside directors 0.020 0.241 0.222 0.300 0.154 3,927
Indep outside directors 0.000 0.186 0.204 0.250 0.152 3,927
GH 0.001 0.016 0.005 0.018 0.343 2,719
HFV 0.001 0.025 0.005 0.018 0.229 2,719
Board size 5.000 8.282 7.000 9.000 7.063 3,927
Director age 51.91 54.44 54.89 57.76 5.379 3,927
Largest ownership 0.199 0.324 0.309 0.442 0.176 3,927
CAPEX ⁄ assets 0.007 0.042 0.026 0.063 0.314 3,927
Leverage 0.354 0.519 0.499 0.645 0.255 3,927
Firm size 4.463 5.503 5.276 6.302 1.481 3,927
Operating profitability 0.007 0.023 0.034 0.068 0.141 3,927
Chaebol dummy 0.000 0.188 0.000 0.000 0.391 3,927
Market risk (beta) 0.438 0.709 0.720 1.004 0.371 3,927
Analyst report 0.000 2.901 0.000 2.000 5.588 3,927
Credit rating dummy 0.000 0.243 0.000 0.000 0.434 3,927
Firm age 3.099 3.324 3.399 3.670 0.567 3,927
Institutional ownership 0.082 0.258 0.199 0.383 0.215 2,860
Governance 4.575 4.704 4.691 4.804 0.209 2,218

performance issues by Morck et al. (1988). Tobin’s Q is the ratio of the sum of the
market value of common equity, the book value of preferred equity, and the book
value of long-term debt to the book value of assets.1
The mean value of Tobin’s Q is
0.601. The average ratio of outside directors is 0.241, which includes 0.186 for the ratio
of independent directors. GH and HFV measures are proxies for information transac-
tion costs. We use the Trade and Quote (TAQ) database compiled by the Korea Stock
Exchange and prepared by the Institute of Banking and Finance at Seoul National
University (IFB⁄KSE database) to measure GH and HFV variables. We confine the
data sample for GH and HFV to that of the year 2004 due to data availability. The
mean values of the information transaction costs for the sample firms are 0.016 for
GH and 0.025 for HFV. A high value of GH or HFV variable implies that directors
have to incur a high cost when acquiring information on the firm.
Table 2 shows the results of the correlation analysis among the information
asymmetry variables, Tobin’s Q, and board independence.
The results of this analysis suggest the possibility that multicollinearity may
affect the results of regression analyses since variables, or proxies for information
asymmetry, such as credit ratings, analyst reports, institutional ownership, and firm
age, are highly correlated with firm size. To segregate these effects, we include two
commonly used benchmarks for information transaction costs (GH and HFV mea-
sures) in the market microstructure literature which are unrelated to firm size. Choe
and Yang (2006) argue for the effectiveness of GH and HFV measures by regressing
each information asymmetry measure on various firm characteristic variables that
are likely to be related to the information asymmetry risk of a firm, i.e., firm size,
BE⁄ME, turnover, residual volatility, and analyst coverage.
4. Empirical Design and Results
To analyze how information transaction costs impact the valuation effect of board
independence, we first examine whether board independence affects firm value.
Then we carry out regression analyses using the interaction terms between board
independence and the information transaction costs derived from market micro-
structure models. We then interact board independence with other firm characteris-
tics related to firms’ information transaction costs for a robustness check.
4.1. Measuring the Degree of Information Transaction Costs
To determine how information environments influence the valuation effect of board
independence, we use several measures of information transaction costs. Traditional
measures, such as firm size, firm age, number of analyst reports, governance scores,
credit ratings, and institutional ownership, are obtained from financial and non-
1
Additionally, we measured Tobin’s Q using a different method, which Chung and Pruitt
(1994) presented, and the results are consistent with the results of our study.

Table2Correlationanalysisamongthevariables
ThistablepresentstheSpearmancorrelationsamongthemainvariablesofsamplefirms.ThesevariablesincludeTobin’sQ,Independentoutsidedirectors,GH,HFV,
Firmsize,Institutionalownership,Analystreport,Creditratingdummy,andFirmage.Tobin’sQistheratioofthesumofthemarketvalueofcommonequity,the
bookvalueofpreferredequity,andthebookvalueoflong-termdebttothebookvalueofassets.Independentoutsidedirectors(Indepoutsidedirectors)istheratio
ofoutsidedirectorswhohavenobusinessorprofessionaltiestoafirmtoboardsize.GHorHFVisinformationtransactioncostsestimatedbytheGlostenandHarris
(1988)orHasbrouck(1991)–FosterandViswanathan(1993)models.Firmsizeisthenaturallogarithmof(totalassets⁄1000000).Institutionalownershipisthefrac-
tionofsharesownedbyinstitutions.Analystreportisthenaturallogarithmoftotalnumberofanalystreportsintheyear.Creditratingdummyforcompanieswith
creditratingsforCPsorcorporatebondsissetas‘‘1’’,andforcompanieswithoutcreditratingsforCPsorcorporatebondsissetas‘‘0’’.Firmageisthenaturalloga-
rithmofthefirm’sage.Thesampleconsistsof3,927firm-yearsbetween1999and2006(GHorHFVvariableincludesdatafrom1999to2004).***,**,and*denote
statisticalsignificanceatthe1%,5%,and10%levels,respectively.
Indep
outside
directorsGHHFVFirmsize
Institutional
ownership
Analyst
report
Credit
ratingFirmage
Tobin’sQ0.097***0.0120.023)0.054***0.0140.156***)0.071***)0.178***
Indepoutsidedirectors)0.016)0.0120.217***0.0200.251***0.087***)0.049***
GH0.885***)0.002)0.009)0.001)0.0210.007
HFV)0.005)0.005)0.008)0.0120.017
Firmsize0.246***0.658***0.456***0.130***
Institutional
ownership
0.197***0.126***)0.008
Analystreport0.287***)0.036***
Creditrating
dummy
0.098***

financial corporate characteristics. Market microstructure variables are based on the
GH and HFV models. Using information on price, quote, and spread, Glosten and
Harris (1988) empirically divide the bid-ask spread into permanent components
related to information asymmetry cost and temporary components related to order
processing cost, inventory cost, etc. We follow the method of Chae et al. (2011).
This method can be explained as follows:
mt ¼ mtÀ1 þ k1Vt þ et
Pt ¼ mt þ w1Qt
DPt ¼ k1Vt þ w1ðQt À QtÀ1Þ þ et,
ð1Þ
where:
mt = expected value of a stock under information of time t
k1 = information transaction costs with permanent effect
Vt = signed trading volume at time t indicated as trade direction (+ if it is a
buyer initiated trading, ) if it is a seller-initiated trading)
k1Vt = price impact by private information
et = a signal of public information
Pt = trade price of a stock at time t
w1 = temporary component of information transaction costs reflecting order
processing cost, etc.
Qt = an indicator variable as trade direction (+ if it is a buyer initiated
trading, ) if it is a seller-initiated trading).
Hasbrouck (1991) and Foster and Viswanathan (1993) consider the effects over
time. Their variable has been modified by Brennan and Subrahmanyam (1996).
Hasbrouck (1991) uses a vector autoregression (VAR) model to estimate the unpre-
dictable component of order flows, which is considered to be a portion of private
information as follows.
Vt ¼ aq þ
X5
i¼1
biDPtÀi þ
X5
i¼1
ciVtÀi þ st
DPt ¼ ap þ w2DQt þ k2st þ et
ð2Þ
where:
Vt = signed trading volume at time t indicated as trade direction (+ if it is a
buyer initiated trading, ) if it is a seller-initiated trading)
DPt = change in trade price
st = a proxy for private information
w2 = temporary component of information transaction costs reflecting order
processing cost, etc.
DQt = change in an indicator variable as trade direction (+ if it is buyer initi-
ated trading, ) if it is seller-initiated trading)
k2 = information transaction costs with permanent effect.

Thus, we use the information transaction costs with the permanent effect, k1
(GH) and k2 (HFV), as proxies for information asymmetry risk. Thus, a high value
of GH or HFV measure indicates a high risk of information asymmetry.
4.2. Measuring the Degree of Board Independence
We limit the sample of directors to those who are legally registered and divide them
into insiders and outsiders based on their legal positions. Weisbach (1988) defines
independent directors as those who may be independent of current management
because of no extensive business dealings with the company or family relationships
with management. Choi et al. (2007) define independent outside directors as those
with no current or potential business ties with the firms in question. They define
gray outside directors as those who appear to have business ties with the firms by
virtue of their professions, e.g., lawyers, accountants, consultants, or bank execu-
tives. For our study, we take the definition of independent outside directors one
step further from that of Choi et al. We consider both professional and business ties
with top managers (e.g. CEOs) or owners (controlling shareholders) as well as work
experience in the firm or the firm’s affiliates. In other words, in line with the defini-
tion of independence in the Sarbanes Oxley (SOX) Act (2002), we define indepen-
dent outside directors as those who have neither past nor current professional and
business ties (i.e. employees, consultants, lawyers, accountants) with the firm or its
affiliates. Nor will they have worked at the same job with the top manager (e.g.
CEO) or controlling shareholders of the firms.
We arrange independent outside directors using the hand-collected data avail-
able on individual work experience. We then use as a proxy for board independence
the ratio of the number of independent outside directors on the total number of
boards.
4.3. Valuation Effect of Board Independence
This section reports the results of the tests for our hypotheses on the valuation
effect of board independence. Our specifications are as follows:
Tobin0s Q ¼ a þ b1 (Board independence) þ b2 (Board size)
þ b3 (Boards average ageÞ þ b4 (Largest ownership)
þ b5 (CAPEX/assets) þ b6 (Leverage) þ b7 (Firm size)
þ b8 (Operating profitability) þ b9 (Chaebol dummy)
þ b10 (Market risk) þ b11 (Industry dummy) þ b12 (Year dummy)
ð3Þ
Panel A in Table 3 presents the annual trend of information transaction costs
based on the market microstructure model. The trend tells us that GH and HFV
variables were virtually constant within the range of 0.02 and 0.04 during the

sample period of 1999–2004. Panel B in Table 3 reports the empirical relationship
between information transaction costs derived from the market microstructure
model and traditional informational measures, such as firm size, governance scores,
and credit ratings, in our 1999–2004 sample based on univariate tests. Panel B
shows how GH and HFV variables are related to the traditional measures. To show
that, we divide the entire sample into a large group and a small group, with median
being the basis, for firm size, governance, and credit ratings, and then calculated the
means of GH and HFV variables, and finally the t-values for the differences.
According to the results of the univariate analysis, GH and HFV variables did not
show significant differences between the group with bigger firm sizes and higher
Table 3 Characteristics of information transaction costs from market microstructure model
This table presents annual trends of information transaction costs from the market microstructure model
and the univariate analysis of information transaction costs between 1999 and 2004. GH or HFV is infor-
mation transaction costs estimated by the Glosten and Harris (1988) or Hasbrouck (1991)–Foster and
Viswanathan (1993) models. Panel A shows the annual trend of GH and HFV variables in the sample
period. Panel B presents the relations between GH and HFV variables and traditional informational mea-
sures, such as firm size, governance score, and credit ratings, based on univariate tests. The t-statistic of
differences between large group and small group of each traditional variable are reported in the table.
Firm size is the natural logarithm of (total assets ⁄ 1 000 000). Governance score is the natural logarithm
of total Korean corporate governance index (KCGI) which consists of four sub-indices: Shareholder
Rights, Disclosure, Audit Committees, and Ownership Parity (excluding Board structure index) between
2002 and 2004. Credit rating score is the credit ratings given to CPs or corporate bonds. Level of signifi-
cance is indicated by ** for 5%.
Panel A: Annual trend of information transaction costs
0.00
0.01
0.02
0.03
0.04
0.05
0.06
0.07
0.08
1999 2000 2001 2002 2003 2004
GH,HFV
Year
GH
HFV
Panel B: Univariate analysis of relationship with traditional measures
Firm size Governance score Credit rating score
Large Small t-value High Low t-value High Low t-value
GH 0.022 0.033 )1.252 0.029 0.035 )0.326 0.007 0.049 )2.486**
HFV 0.023 0.032 )1.368 0.029 0.037 )0.436 0.007 0.047 )2.468**

governance scores and the group with smaller firm sizes and lower governance
scores. However, when it comes to credit ratings, the values of GH and HFV vari-
ables were higher for the firms with lower credit ratings.
Table 3 reports the results from the estimation of equation (3), showing
evidence that board independence (measured by the ratio of outside directors)
positively impacts firm performance (measured by Tobin’s Q). Hermalin and Weis-
bach (1991) suggest that board structure and firm performance are likely to be
endogenously determined. Our research design uses several approaches to address
this concern, as presented in Table 3.
4.4. 2SLS Models Controlling for Endogeneity Issues
To mitigate the endogeneity problem, we examine the robustness of our results after
including lagged values of our dependent variables (outside directors) and estimate
our models in a simultaneous equations framework, following the method
employed by Linck et al. (2008). In the regressions presented in Table 4, the coeffi-
cients of outside directors are all positive and significant, which does not alter their
valuation effect.
Regression (5) in Table 4 shows the results when we define board independence
more precisely with past career paths taken into account, and examine whether
there is a difference in positive impact. According to regression (5) in Table 4, this
positive impact is significant when outside directors are independent. Therefore, we
suggest that independent outside directors who have neither business nor profes-
sional ties with a firm have a strong valuation effect, proving that the independence
of outside directors is important in the emerging market, as emphasized by the
SOX Act of 2002.
4.5. Influence of Information Transaction Costs on the Valuation Effect of Board
Independence
Recently, there have been a few articles examining the tendency of firms with a high
information asymmetry risk to decrease board independence (Linck et al., 2008).
They argue that outside directors incur information acquisition and processing costs
while tailoring their general expertise for the specific firm they serve. They suggest
that board independence decreases with the cost of information acquisition and
processing. They use the MTB ratio, the level of R&D spending, and the standard
deviation of stock returns as the costs of information acquisition and processing,
following the method of Fama and Jensen (1983), and Gaver and Gaver (1993).
Since Linck et al. (2008) show that information asymmetry is negatively related to
board independence, we expect the valuation effect of board independence to be
negatively related to information asymmetry risk.
We use, as proxies for information transaction costs, two market micro-struc-
tural variables (GH, HFV) as well as the other firm characteristics used in existing
studies, i.e., firm size, firm age, analyst reports, institutional ownership, governance,
and credit ratings.

Table4Effectsof(independent)outsidedirectorsonfirmvalue
Thistablepresentslinearordinaryleast-squaresregressionanalysesofeffectsof(independent)outsidedirectorsonfirmvaluebetween1999and2006.Thedependent
variableisTobin’sQ,whichistheratioofthesumofthemarketvalueofcommonequity,thebookvalueofpreferredequity,andthebookvalueoflong-termdebt
tothebookvalueofassets.Outsidedirectorsistheratiooflegallyregistereddirectorswhoarenotemployeesofthecompanyandhavenooperationalresponsibilities
withinthecompanytoboardsize.Independentoutsidedirectors(Indepoutsidedirectors)istheratioofoutsidedirectorswhohavenobusinessorprofessionaltiesto
afirmtoboardsize,whenconsideringtheirpastcareerpaths.Boardsizeisthenaturallogarithmoftotalnumberofdirectors.Directorageisthenaturallogarithmof
theageasoftheyearend.Largestownershipisthepercentageshareholdingofthelargestshareholder.CAPEX⁄assetsistheratioofcapitalexpenditurestototalassets.
Leverageistheratiooftotaldebttototalassets.Firmsizeisthenaturallogarithmof(totalassets⁄1000000).Operatingprofitabilityistheratioofearningsbefore
interestandtaxes(EBIT)tobeginningtotalassets.Chaeboldummyisadummyvariabletoindicatewhetherafirmbelongstooneofthe50largestchaebols.Market
risk(beta)istheestimatefrommarketmodelinwhichthefirm’smonthlyreturnsoverthelastyearareregressedontheKOSPImonthlyreturns.Regression(1)shows
theresultsofbasicregressionandregressions(2)and(3)showfixedeffectregressionsoffirmperformanceandoutsidedirectors.Regressions(4)and(5)showsimul-
taneousequationanalysisoffirmvalueandtheratioof(independent)outsidedirectors,usingthetwo-stageleastsquaresmethod.Instrumentsincludelagged(inde-
pendent)outsidedirectorvariable.Standarderrorsareshowninparenthesesunderparameterestimates.Levelsofsignificanceareindicatedby***,**,and*for1%,
5%,and10%,respectively.
Variable(1)(2)(3)(4)(5)
Outsidedirectors0.245***(0.060)0.092*(0.056)0.141***(0.052)0.400***(0.108)
Indepoutsidedirectors0.364***(0.099)
Boardsize)0.009(0.022))0.001(0.024))0.009(0.022)0.028(0.022)0.026(0.022)
Directorage)1.194***(0.092))0.781***(0.130))1.200***(0.092))1.151***(0.094))1.191***(0.092)
Largestownership)0.001(0.044)0.019(0.058))0.005(0.044)0.009(0.045)0.004(0.044)
CAPEX⁄assets0.001(0.023))0.003(0.021)0.001(0.023)0.024(0.025))0.001(0.023)
Leverage)0.069(0.036)0.078*(0.046))0.063*(0.036))0.090**(0.038))0.074**(0.036)
Firmsize0.028***(0.008)0.019(0.016)0.032***(0.008)0.024***(0.009)0.032***(0.008)
Operatingprofitability0.053(0.057)0.158***(0.055)0.051(0.058))0.008(0.060)0.050(0.058)
Chaeboldummy0.042*(0.022)0.102(0.065)0.042*(0.022)0.039(0.023)0.043*(0.022)
Marketrisk(beta)0.040*(0.022))0.017(0.022)0.040**(0.023)0.066***(0.024)0.041*(0.023)
IndustrydummyYesYesYesYes
YeardummyYesYesYesYes
IndustryfixedeffectsYes
YearfixedeffectsYes
Numberoffirms3,9273,9273,9273,2933,927
Adj.R2
0.2390.5780.2440.2490.247

In Table 5, we examine the relationship between the valuation effect of board
independence and information transaction costs derived from the market micro-
structure model. Our regressions include interaction terms between the outside
director ratio and the GH (HFV) measure. In regressions (1) and (2), the
Table 5 Valuation effect of board independence and information transaction costs
This table reports results from regressing firm value on board independence and various firm characteris-
tics from 1999 to 2004. The dependent variable is Tobin’s Q, which is the ratio of the sum of the market
value of common equity, the book value of preferred equity, and the book value of long-term debt to
the book value of assets. Outside directors is the ratio of directors who are not employees of the com-
pany and have no operational responsibilities within the company to board size. Independent outside
directors (Indep outside directors) is the ratio of outside directors who have no business or professional
ties to a firm to board size, when considering their past career paths. GH or HFV is information transac-
tion costs estimated by the Glosten and Harris (1988) or Hasbrouck (1991)–Foster and Viswanathan
(1993) models. See Table 4 for exact definitions of the variables. Industry dummies and Year dummies
are employed to control for industry compensation practices and economy-wide shocks. Standard errors
are shown in parentheses under parameter estimates. Levels of significance are indicated by ***, **, and
* for 1%, 5%, and 10%, respectively.
Variable (1) (2) (3) (4)
Outside directors 0.284*** (0.056) 0.286*** (0.055)
Indep outside
directors
0.233*** (0.053) 0.236*** (0.052)
Board size )0.014 (0.020) )0.014 (0.020) )0.015 (0.020) )0.015 (0.020)
Director age )0.897*** (0.093) )0.895*** (0.092) )0.892*** (0.093) )0.889*** (0.092)
Largest ownership )0.024 (0.043) )0.019 (0.043) )0.024 (0.043) )0.019 (0.043)
CAPEX ⁄ assets 0.009 (0.023) 0.008 (0.023) 0.009 (0.023) 0.008 (0.023)
Leverage )0.126*** (0.040) )0.130*** (0.039) )0.120*** (0.040) )0.124*** (0.039)
Firm size 0.029*** (0.007) 0.030*** (0.007) 0.032*** (0.007) 0.033*** (0.007)
Operating
profitability
0.300*** (0.067) 0.300*** (0.065) 0.302*** (0.067) 0.302*** (0.066)
Chaebol dummy 0.001 (0.021) )0.002 (0.021) 0.002 (0.022) 0.001 (0.021)
Market risk (beta) 0.054** (0.023) 0.054** (0.023) 0.058** (0.023) 0.058** (0.023)
GH 0.142*** (0.052) 0.151*** (0.051)
HFV 0.162*** (0.055) 0.179*** (0.055)
Outside
director · GH
)0.367 (0.223)
Outside
director · HFV
)0.444* (0.234)
Indep outside
director · GH
)0.556** (0.286)
Indep outside
director · HFV
)0.688*** (0.288)
Industry dummy Yes Yes Yes Yes
Year dummy Yes Yes Yes Yes
Number of firms 2,719 2,719 2,719 2,719
Adj. R2
0.238 0.236 0.236 0.235

coefficients of the interaction terms are not significant for the GH measure and
marginally significant for the HFV measure. However, if we change the variable
from an outside director to independent outside directors, the results turn more
significant. Regressions (3) and (4) in Table 5 show the analysis results using the
interaction term between the GH (HFV) measure and board independence, using
our refined board independence measure (refer to 4.2.), which takes professional-
or business-level independence into consideration.
In columns (3) and (4), independent outside directors have a more positive val-
uation effect with low information transaction costs. This is consistent with our
hypotheses, according to which board independence is less effective for monitoring
when it is costly for independent outsiders to acquire information on the firm.
Therefore, we can predict that the valuation effects of independent boards with no
professional or business relationships with a firm, its affiliates, CEO, or controlling
shareholders may vary with a firm’s information transaction costs.
Consequently, the valuation effect of independent outside directors, i.e., an
increase in firm value, decreases under high information asymmetry because the
costs of tailoring information are high, while the valuation effect increases under
low information asymmetry because of increased benefits of tailoring information.
Using traditional measures of information transaction costs, Table 6 presents
the results of regressions using other conditions under which the firms’ information
environments change. The results on the effects of independent directors on firm
value are consistent with the results presented in Table 5. In other words, a large
firm with a long corporate history, more analyst reports, high credit ratings, large
institutional ownership, and good governance has more positive valuation effect of
board independence because it incurs lower information transaction costs, which
decreases the costs of monitoring and advisory activities. Therefore, our estimation
from Table 6 indicates that the association between the valuation effect of board
independence and information transaction costs is definite.
5. Conclusion
This paper examines the effects of independent outside directors on firm value from
the perspective of information transaction costs in Korea, one of the most promi-
nent emerging markets.
Our empirical results indicate that independent outside directors have a signifi-
cant and positive effect on firm value. We also find that the valuation effect of inde-
pendent outside directors varies with the degree of information asymmetry at a
firm. The higher a firm’s information asymmetry risk, the weaker the valuation
effect of board independence; the lower the information asymmetry risk, the stron-
ger the valuation effect.
We test for our hypothesis using information transaction cost measures from
various sources, including traditional measures and measures estimated by the mar-
ket microstructure model. We find that firms with low information transaction

Table6Variousfirmcharacteristicsandvaluationeffectofboardindependence
Thistablereportsresultsfromregressingfirmvalueonboardindependenceandvariousfirmcharacteristics.ThedependentvariableisTobin’sQ,whichistheratioof
thesumofthemarketvalueofcommonequity,thebookvalueofpreferredequity,andthebookvalueoflong-termdebttothebookvalueofassets.Independent
outsidedirectors(Indepoutsidedirectors)istheratioofoutsidedirectorswhohavenobusinessorprofessionaltiestoafirmtoboardsize.Intheregression(1),Firm
sizeisadummyvariablethatequals1iffirmsizeislargerthanthemedianofallsamplefirms.Firmageisthenaturallogarithmofthefirm’sage.Analystreportis
thenaturallogarithmoftotalnumberofanalystreportsintheyear.CreditratingdummyforcompanieswithcreditratingsforCPsorcorporatebondsissetas‘‘1’’,
andforcompanieswithoutcreditratingsforCPsorcorporatebondsissetas‘‘0’’.Institutionalownershipisthefractionofsharesownedbyinstitutions.Governance
isthenaturallogarithmoftotalKoreancorporategovernanceindex(KCGI)whichconsistsoffoursub-indices:ShareholderRights,Disclosure,AuditCommittees,and
OwnershipParity(excludingBoardstructureindex)between2002and2006.SeeTable4forexactdefinitionsofthevariables.IndustrydummiesandYeardummies
areemployedtocontrolforindustrycompensationpracticesandeconomy-wideshocks.Standarderrorsareshowninparenthesesunderparameterestimates.Levelsof
significanceareindicatedby***,**,and*for1%,5%,and10%,respectively.
Variable(1)(2)(3)(4)(5)(6)
Indepoutsidedirectors)0.140(0.095)0.069(0.078)0.002(0.064)0.040(0.070)0.058(0.089)0.033(0.118)
Boardsize0.021(0.020)0.002(0.022))0.002(0.021))0.001(0.022))0.006(0.022)0.083**(0.033)
Directorage)1.166***(0.091))1.153***(0.092))1.038***(0.091))1.188***(0.092))0.946***(0.101))1.260***(0.123)
Largestownership)0.015(0.044))0.021(0.044)0.043(0.043))0.011(0.044))0.092*(0.049)0.061(0.059)
CAPEX⁄assets0.004(0.023))0.007(0.023)0.002(0.022)0.003(0.023)0.004(0.033))0.019(0.026)
Leverage)0.064*(0.035))0.068*(0.035))0.038(0.035))0.058(0.036)0.042(0.036))0.417***(0.058)
Firmsize)0.035(0.026)0.035***(0.008))0.038***(0.009)0.040***(0.008)0.009(0.008)0.039***(0.011)
Operatingprofitability0.065(0.057)0.034(0.057)0.039(0.056)0.032(0.057)0.098*(0.059))0.409***(0.085)
Chaeboldummy0.067***(0.021)0.043(0.022)0.007(0.022)0.054**(0.022)0.018(0.024)0.087***(0.030)
Marketrisk(beta)0.054**(0.022)0.031(0.023)0.024(0.023)0.050**(0.023)0.018(0.024)0.115***(0.033)
Firmage)0.120***(0.024)
Analystreport0.025***(0.003)
Creditratingdummy)0.129***(0.026)
Institutionalownership0.164***(0.057)
Governance0.021(0.036)

Table6(Continued)
Variable(1)(2)(3)(4)(5)(6)
Indepoutsidedirector·
Firmsizedummy
0.480***(0.109)
Indepoutside
director·Firmage
0.149*(0.091)
Analystreport
0.011**(0.006)
Creditratingdummy
0.249***(0.089)
Institutionalownership
0.375*(0.231)
Indepoutside
director·Governance
0.232*(0.142)
Industry(Year)dummyYesYesYesYesYesYes
Numberofﬁrms3,9273,9273,9273,9272,8602,218
Adj.R2
0.2390.2450.2750.2770.2740.291

costs show a more positive impact of board independence, while firms with high
information asymmetry show a lower or negative impact of board independence.
Our empirical results are generally consistent with the hypothesis that the valua-
tion effect of board independence varies with the cost of information transactions.
In a broader sense, the effects of monitoring can increase when a firm has low
information transaction costs. Firms with high information transaction costs
generally have a lower valuation effect of independent boards, while large firms,
well-governed firms, and firms with good credit ratings tend to have a higher valua-
tion effect of independent boards.
Overall, our results caution against regulatory frameworks imposing one-size-
fits-all requirements on board structure. Further, our results suggest that policy
makers and researchers should pay special attention to the effect of mandated
reforms on small, poorly governed firms with high information transaction costs.
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