Corporate Governance and the Cost of Equity Capital
bustopHollis Ashbaugh
University of Wisconsin – Madisonanimals英语怎么读
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hashbaugh@bus.wisc.edu旅鸫
Daniel W. Collins *
University of Iowa
daniel-collins@uiowa.edu
Ryan LaFond
University of Wisconsin – Madison
rzlafond@wisc.edu
October 2004
* Corresponding author
Corporate Governance and the Cost of Equity Capital
I. Introduction
Separation of ownership and control in corporate organizations creates information asymmetry problems between shareholders and managers that expo shareholders to agency costs. Agency costs ari when managers have incentives to pursue their own interests at shareholder expen, i.e., information asymmetry creates a moral hazard problem. Self-interested managerial behavior can take veral forms including shirking, consumption of perquisites, over compensation, and empire building that result in shareholder loss (Jenn and Meckling [1976]). Agency costs also ari when investors cannot discern the true economic value of the firm that is partially a function of the indistinguishable quality of management, i.e., information asymmetry creates an adver lection problem. The lack of transparent financial information results in greater information risk being impod on the shareholder. Without adequate controls, effective monitoring, and transparent financial information, rational investors will price-protect against expected agency costs, effectively raising the firm’s cost of equity capital. Corporate governance encompass a broad spectrum of m
echanisms intended to mitigate agency problems by increasing the monitoring of managements’ actions, limiting managers’ opportunistic behavior, and reducing the information risk borne by shareholders. This paper investigates the extent to which governance attributes that are intended to mitigate agency problems affect firms’ cost of equity capital.
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We structure our analysis of the effects of governance on the cost of equity bad on prior literature that identifies and links specific elements of governance to a reduction in agency costs (e Bushman and Smith [2001] and Shleifer and Vishny [1997] for an overview). Specifically, we examine governance attributes that relate to (1) financial information quality, (2) ownership structure, (3) shareholder rights, and (4) board structure. We u the magnitude of abnormal accruals, the timeliness and relevance of earnings, and the independence of the audit committee to
proxy for the quality of firms’ financial information. The level of institutional ownership, the number of blockholders and the ownership stake of insiders are ud to capture firms’ ownership structure. The elements of governance are relevant to asssing the external monitoring of management, the propensity for rent extraction by significant equity stakeholders and incentive alignment between management and shareholders. We employ the shareholder rights governance score of Gompers, Ishii and Metrick (2003) to proxy for how easy or difficult it is for shareholders to make changes in m
anagement or changes in ownership that potentially affect shareholder value. The independence of the board and the percentage of directors that own stock are ud to capture the board structure. This dimension of governance is relevant to asssing the degree of objectivity and attentiveness the board exercis in providing oversight of management performance and the degree to which they hold management accountable to stakeholders for its actions. To the extent a governance attribute attenuates the problems of adver lection and moral hazard, we predict it will be negatively related to firms’ cost of equity. If, on the other hand, a governance attribute exacerbates agency problems between shareholders and managers or increas the likelihood that lected shareholders can extract rents from other shareholders, we expect it to be positively related to firms’ cost of equity.
Our analysis yields veral key findings. First, we document a significant association between a number of governance attributes and firms’ cost of equity capital. Specifically, we find that firms reporting larger abnormal accruals and less transparent earnings have a higher cost of equity, whereas firms with more independent audit committees have a lower cost of equity. Consistent with potential rent extraction, we find that concentrated ownership in the form of the percentage of shares held by institutions and the number of five-percent blockholders are positively related to the c
ost of equity. In addition, we find a negative relation between the cost of equity and the independence of the board, the percentage of the board that owns stock, and managerial power, as proxied by the shareholder rights score. Collectively, the governance
attributes we examine explain roughly 8% of the cross-ctional variation in firms’ cost of capital.
Second, we document that our t of governance attributes have a significant incremental explanatory power for firms’ cost of equity after controlling for well-known risk proxies, namely beta, size, and market-to-book. The results of benchmark regressions indicate that beta, size, and market-to-book in isolation explain 12, six, and five percent of firms’ cost of equity, respectively. The three risk measures combined with our t of governance factors explain 16 percent of the cross-ctional variation in the cost of equity. Interestingly, while the t of governance attributes adds explanatory power relative to the conventional risk measures, we find that only the variables that capture the quality of firms’ financial information, in the form of more transparent earnings information and the audit committee’s oversight over the financial reporting process, continue to be negatively related to the cost of equity after controlling for the effects of beta, size and market-to-book. Our finding that firms with higher earnings transparency and greater integrity of the audit process, as proxied by the audit committee’s oversight of the financial reporting process, have lower
costs of equity capital adds to the extant literature on the financial information characteristics that are valued by the market. In addition, the consistent documentation of a positive relation between the number of blockholders and firms’ cost of equity suggests that concentrated owners do not rve to monitor management and reduce agency costs. Rather the positive association between the number of blockholders and the cost of equity is consistent with potential rent extraction by significant shareholders, e.g., blockholders can extract rents via targeted share repurchas or greenmail.
Our results also provide insights into how governance is priced in that we document that many of the governance attributes we examine are significant determinants of firms’ beta. We find that the magnitude of abnormal accruals and degree of financial transparency as proxied by the timeliness and value relevance of earnings are highly significant explanatory factors for beta. We also find that the percentage of shares held by institutional investors is positively related to
kite是什么意思beta, which is consistent with institutional investors having preferences for investing in firms with higher risk and expected returns. The results indicate a negative relation between the stakeholder rights score and beta, which suggests that firms with greater managerial power have lower betas. This result is consistent with more entrenched management eking to avoid loss by taking on les大量的英文
s risky projects (i.e., lowering firms’ operating risk). Finally, we find that the independence of the board and the percentage of directors that own stock are negatively associated with beta. Collectively, the governance attributes explain 17 percent of the variation in beta. The findings lend support to Garmai and Liu (2004) who model firms’ exposure to market risk as a function of the quality of firms’ governance. More importantly, our findings provide evidence largely overlooked in the prior literature that governance affects firms’ cost of equity capital both directly and indirectly via beta.
To provide some economic interpretation of our findings, we construct a composite governance score and incorporate the governance score in rank regressions along with beta, size and market-to-book. The results indicate that firms with better governance have a lower cost of equity. Better governed firms, on average, have a cost of equity that is 80 basis points lower than firms with weaker governance. Furthermore, when we add a governance factor, defined as the difference in returns between firms in the bottom quintile versus the top quintile of the composite governance scores, to the Fama-French (1993) three-factor ast pricing model, we find a highly significant positive coefficient on the governance factor. This finding suggests that governance is another risk factor in addition to beta, size and market-to-book that affects firms’ cost of equity.
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To provide further evidence that governance matters for firms’ cost of equity and to address endogeneity concerns we conduct a change analysis. We document that firms that improve their governance structure over our sample period from 1996 to 2002 benefit by lowering their cost of equity. Demonstrating an association between changes in governance and changes in the cost of equity is important in that it mitigates concerns that the results from the cross-ctional analys are driven by some correlated omitted variable(s).
