Legal protection of investors, corporate governance, and the cost of equity capital

Legal protection of investors,corporate governance,and the cost of equity capital ☆
Kevin C.W.Chen a ,Zhihong Chen b ,K.C.John Wei a,⁎
a School of Business Management,Hong Kong University of Science and Technology,Clearwater Bay,Kowloon,Hong Kong b
Department of Accountancy,City University of Hong Kong,83Tat Chee Avenue,Kowloon,Hong Kong
a r t i c l e i n f o a
b s t r a
c t
Article history:
Received 21October 2006
Received in revised form 2January 2009Accepted 7January 2009
Available online 12January 2009This study examines the effect of firm-level corporate governance on the cost of equity capital in emerging markets and how the effect is in fluenced by country-level legal protection of investors.We find that firm-level corporate governance has a signi ficantly negative effect on the cost of equity capital in these markets.In addition,this corporate governance effect is more pronounced in countries that provide relatively poor legal protection.Thus,in emerging markets,firm-level corporate governance and country-level shareholder protection seem to be substitutes for each other in reducing the cost of equity.Our results are consistent with the finding from McKinsey's surveys that institutional investors are willing to pay a higher premium for shares in firms with good corporate governance,especially when the firms are in countries where the legal protection of investors is weak.
©2009Elsevier B.V.All rights reserved.
JEL classi fication:F30G30G34
Keywords:
Corporate governance Cost of equity
Legal protection of investors
1.Introduction
In this study,we explore two issues related to corporate governance that are highly relevant to firms and investors in emerging markets.1The first issue is whether the quality of corporate governance can reduce the cost of equity in those markets in which the legal protection of investors is relatively poor.Jensen and Meckling's (1976)agency theory suggests that there are con flicts of interest between managers and shareholders.An important function of corporate governance is to protect shareholders against expropriation by managers or controlling shareholders.That is,corporate governance is a mechanism that is used to reduce agency
Journal of Corporate Finance 15(2009)273–289
☆The authors appreciate helpful comments from Bruce Behn,Bernie Black,Robert Bushman,Dosung Choi,Florencio Lopez-de-Silanes,Randall Morck,Jay Ritter,James Shinn,RenéStulz,Shyam Sunder,and seminar participants at the Hong Kong University of Science and Technology,National Cheng Kung University,National Chengchi University,National Taiwan University,Peking University,Singapore Management University,the 2004American Accounting Association Annual Meetings,the 2004Asian Finance Association/FMA Annual Meetings,the third Asian Corporate Governance Conference held at Korea University,the 2004HKUST Accounting Summer Research Symposium,the second International Symposium of Corporate Governance held at Nankai University,China,and the 2008Chinese Annual Conference in Finance,Beijing,China,where the paper was the winner of one of the best paper awards.The authors also wish to thank Jeffry ter (the editor)and an anonymous associate editor for insightful comments and suggestions and Dr.Virginia Unkefer for editorial assistance.We acknowledge financial support from the Research Grants Council of the Hong Kong Special Administration Region,China (HKUST6134/02H).⁎Corresponding author.Tel.:+852********;fax:+852********.
E-mail addresses:acchen@ust.hk (K.C.W.Chen),chenzhh@.hk (Z.Chen),johnwei@ust.hk (K.C.J.Wei).1
We adopt the de finition of emerging markets used by Credit Lyonnais Securities Asia (CLSA).There is no standard de finition of emerging markets.For example,the MSCI's Emerging Market Index does not include Hong Kong,Singapore,Greece,or Turkey.However,these countries,except for Greece,were included in the CLSA emerging market survey and by other services like ISI Emerging Markets ( ).Kvint (2008)speci fically points out that IMF even adopts inconsistent de finitions of emerging markets in its statistics compilation.In the emerging market literature,Bekaert and Harvey (2000)include Greece and Turkey,while Lesmond (2005)includes Greece,Singapore,and
Turkey.
0929-1199/$–see front matter ©2009Elsevier B.V.All rights reserved.doi:10.1016/j.jcorp fi
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274K.C.W.Chen et al./Journal of Corporate Finance15(2009)273–289
costs;firms with better corporate governance should therefore have higher valuation.Recent empirical evidence seems to support this theory in terms offirm valuation.2
However,as argued by Hail and Leuz(2006a),the mechanisms by whichfirm-level corporate governance or country-level legal protection of investors affectfirms'valuations are still unclear.It is possible that the valuation effect primarily reflects different levels of expropriation and/or different investment opportunities(the cashflow effect).But effective corporate governance or legal protection may also reduce the risk premium demanded by investors and,therefore,reduce the cost of capital(the discount rate effect).However,the existence of the link between corporate governance or legal protection and the cost of capital is not obvious.It depends on the extent to which differences in corporate governance or legal protection lead to measurable differences in nondiversifiable risk acrossfirms or countries.
The second issue that we investigate is how the relation betweenfirm-level corporate governance and the cost of equity is influenced by the country-level legal protection of investors.Specifically,we examine whetherfirm-level corporate governance is more or less useful in reducing afirm's cost of equity capital in countries where legal protection is weak.So far,no empirical study has examined this interactive effect.McKinsey's surveys(Coombes&Watson,2000)have concluded that institutional investors are willing to pay a higher premium for shares infirms with good corporate governance,especially when thefirms are in countries with weak legal protection of investors.So far,there has been no empirical evidence offered to support thisfinding.
Previous studies typically focus on the association between corporate governance and ex post returns or other measures of returns on equity,such as dividend yields or earnings-to-price ratios.However,it is still debatable whether ex post returns or other measures are proxies for afirm's cost of capital.As argued by Stulz(1999),these proxies not only capture differences in afirm's cost of capital but they may also reflect shocks to afirm's growth opportunities,differences in expected growth rates(Bekaert&Harvey, 2000;Hail&Leuz,2006a,b),and/or changes in investors'risk aversion.In contrast,the estimate of the ex ante cost of equity makes an explicit attempt to control for the cashflow and growth effects(Hail&Leuz,2006a).Thus,instead of focusing on ex post returns, we explore the relation between corporate governance and the cost of capital implied in stock prices and analysts'earnings forecasts.
We examine the association between corporate governance and the cost of equity capital using data from559firm-year observations across the17emerging markets that were covered in two corporate governance surveys by Credit Lyonnais Securities Asia (CLSA).The internationalfirm-level data allow us to test the interactive effect between country-level shareholder protection andfirm-level corporate governance.We measure the cost of equity capital using four models that have been developed in recent research. These models are based on the earnings forecasts of analysts and different versions of the residual income model.Wefind a significantly negative relation between afirm's corporate governance and its cost of equity capital after controlling for risk factors, especially amongfirms in countries with relatively weak shareholder protection.This result suggests that country-level legal protection andfirm-level corporate governance are substitutes for one another.Ourfindings are consistent with thefindings from McKinsey's surveys that institutional investors from around the world are willing to pay a premium of more than20%for shares in companies with good corporate governance and that the premium is higher in countries with weak legal protection of investors.
Our study is complementary to voluminous studies that explore the effects of corporate governance onfirm value and its two components:accounting profitability(i.e.,the numerator of the valuation model)and the cost of capital(i.e.,the denominator of the model).Using U.S.data,Gompers,Ishii,and Metrick(2003)show that the number of anti-takeover provisions in corporate charters and bylaws(denoted as the“G-index”),a measure of shareholder rights or external corporate governance mechanisms,is related tofirm value.More specifically,the market gives higher valuations tofirms with strong shareholder rights.Core,Guay and Rusticus(2006)also show thatfirms with strong shareholder rights have better accounting performance,as measured by operating returns on assets(ROA).Further,Chen,Chen and Wei(2008)show that,in the U.S.,corporate governance lowers the cost of capital through the mitigation of agency problems.More specifically,the negative relation between corporate governance and the cost of capital is stronger forfirms with more severe agency problems from free cashflows.3
Our study also contributes to the research on corporate governance in emerging markets.Durnev and Kim(2005)use CLSA's corporate governance survey data to show that the quality of afirm's corporate governance and its disclosure practices is positively related tofirm valuation.In addition,the positive relation is stronger in weaker legal regimes.4Klapper and Love(2002)use the same dataset to demonstrate that better corporate governance is associated with betterfirm performance as measured by ROA,and this association is higher in countries with weak legal environments.Thus,in emerging markets,the relation between corporate governance andfirm value or accounting profitability has already been established.What is not yet clear is the association between corporate governance and the cost of capital.Our study attempts tofill this gap in the literature.
The remainder of this paper is organized as follows.Section2develops the hypotheses.Section3describes the sample selection process and the measurement of the variables.Section4provides the empirical results of the relationship betweenfirm-level corporate governance and the cost of equity capital.Section5reports the results of the effect of country-level shareholder protection on the relationship betweenfirm-level corporate governance and the cost of equity capital.Section6concludes the paper.
2For example,La Porta et al.(2002)find that stock markets in economies with better corporate governance have higher valuations(at the country level). Gompers et al.(2003)find thatfirms in the U.S.with better corporate governance have higher valuations(at thefirm level).
3Cheng,Collins and Huang(2006)also document a negative relation between shareholder rights and the cost of capital.Ashbaugh-Skaife,Collins and LaFond (2006)explore the effects of various corporate governance measures,fromfinancial information quality,ownership structures,and stakeholder rights to board structures,on the cost of capital as measured by the average of Value Line's high and low annualized expected returns over a three-tofive-year horizon.
4Hail and Leuz(2006a)examine if differences in countries'securities regulation explain differences in the average cost of equity capital at the country level. Their study incorporates data from both developed and emerging markets.
2.Hypotheses development
2.1.Firm-level corporate governance and the cost of equity capital
La Porta,Lopez-de-Silanes,Shleifer and Vishny (2000)de fine corporate governance as a set of mechanisms through which outside investors can protect themselves against expropriation by insiders.These mechanisms can reduce a firm's cost of equity in several ways.First,corporate governance can reduce the non-diversi fiable risk of expropriation by corporate insiders.The literature suggests that the degree of expropriation by corporate insiders depends on the investment opportunity and the cost of expropriation,among other factors.A firm's investment opportunity has a non-diversi fiable component that depends on macroeconomic conditions.Consequently,expropriation by insiders also has a component that is related to the market condition that is not diversi fiable.Speci fically,insiders are expected to expropriate more when the market is experiencing a downturn and less when the market is booming (Johnson,Boone,Breach &Friedman,2000;Durnev &Kim,2005).This negative relation between expropriation and market conditions can magnify the systematic risk of a firm,which must be compensated by a higher required rate of return.Through the imposition of a higher cost for expropriation,better corporate governance reduces the negative relation between the degree of expropriation and market conditions.
Second,better corporate governance lowers the cost of equity by reducing the cost of external monitoring by outside investors.Lombardo and Pagano (2002)postulate that investors have to incur external monitoring costs to ensure a given payoff from a firm's management.This monitoring cost is compensated by a higher required rate of return.5Thus,outside investors demand a higher required rate of return from firms with poorer corporate governance because they need to spend more time and resources on monitoring those firms'managers.
Third,corporate governance also reduces the cost of equity by limiting opportunistic insider trading and thus reducing information asymmetry.6Hung and Trezevant (2003)find that,in Southeast Asia,better corporate governance is associated with less insider trading.In firms that have weak corporate governance,and especially those that are controlled by rich families,insiders trade aggressively on their proprietary knowledge.Bhattacharya and Daouk (2002)find that the cost of equity in a country decreases signi ficantly after the first prosecution under insider trading laws.
All these arguments predict that better corporate governance is associated with a lower cost of capital.However,the empirical magnitude of these effects is still an open issue.As suggested by Hail and Leuz (2006a),it is possible that these effects may only lead to minor differences in nondiversi fiable risk or that they can be largely captured by traditional proxies for risks,such as book-to-market equity,size,and market beta.Our first hypothesis is stated as follows:
H1.Firm-level corporate governance is negatively associated with the cost of equity in emerging markets.2.2.Country-level legal protection,firm-level corporate governance,and the cost of equity capital
Legal protection of minority shareholders includes both the rights prescribed by laws and regulations and the effectiveness of Porta,Lopez-de-Silanes,Shleifer and Vishny (1997,1998,2002)document that countries with strong legal protection of investors have more developed stock markets,better corporate governance,and higher firm valuation than do countries with weak legal protection of Porta,Lopez-de-Silanes and Shleifer (2006)examine how securities laws affect capital market development and find that the enforcements of securities laws do matter,especially in countries that mandate disclosure and facilitate private enforcement through liability rules.Hail and Leuz (2006a)have further documented that firms from countries with more extensive disclosure requirements,stronger securities regulations,and stricter enforcement mechanisms tend to enjoy a signi ficantly lower country-level cost of capital.Daouk,Lee and Ng (2006)find that improvements in the capital market governance (CMG)index are associated with reductions in the country-level cost of equity capital (as measured by the implied cost of equity or realized returns).
The above discussion and the discussion from Section 2.1also point to the possible interaction between country-level shareholder protection and firm-level corporate governance in reducing the cost of capital.Although better legal protection helps some firm-level corporate governance mechanisms to take effect,not all firm-level corporate governance mechanisms,such as ownership structure,board independence,and the choice of auditors with good reputations,are implemented completely through legal protection.For example,the dissipation of control among several large minority investors could be a credible method to limit expropriation when legal protection is weak (Bennedsen &Wolfenzon,2000).Therefore,better firm-level and self-disciplined corporate governance should be more valuable in countries with weak legal protection of minority shareholders,as investors cannot rely on legal systems alone to prevent expropriation by corporate insiders.Thus,the effectiveness of firm-level corporate governance in the reduction of the cost of equity may be greater in countries with weak legal protection of investors.This can be tested using the following hypothesis:
H2.The association between firm-level corporate governance and the cost of equity is stronger in markets that have weak legal protection of investors than in market that have strong legal protection of investors.
5See Stulz (1999)for a similar argument.
6
Easley and O'Hara (2004)show that information asymmetry positively affects a firm's cost of capital.
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3.Sample selection and measurement of variables
3.1.Sample construction and country-level legal protection of investors
In response to the growing demand by investors for independent assessments of corporate governance,Credit Lyonnais Securities Asia(CLSA)Emerging Markets,which is a provider of brokerage and investment banking services in the emerging markets of Asia,Latin America,and Europe,released a comprehensive report on corporate governance in April2001entitled “Saints&Sinners:Who's Got Religion?”7and an updated survey in February2002entitled“Make me Holy…But Not Yet!”In these reports,corporate governance is assessed based on seven key criteria.8The reports also show thatfirms with good corporate governance are associated with strong performance on several dimensions,including share price levels,past stock returns,and past accounting profitability.
Our sample selection begins with the CLSA corporate governance surveys that were published in2001and2002,which cover 491and498firms,respectively,in25emerging markets.Wefirst match thesefirms with I/B/E/S to obtain the analysts'earnings forecasts and with Datastream for stock prices,market values,book values of equity,and payout ratios.We then excludefirms that have missing cost of equity estimates and control variables(to be discussed later).This process leaves us with results for afinal sample of276firms in2001and283firms in2002.9Table1shows the distribution of the559firm-year observations across17 economies.
Table1also reports several measures of country-level legal protection of investors and extra-legal institutional factors.Since legal protection of shareholders includes not only the rights prescribed by regulations and laws,but also the effectiveness of enforcement,our measures of legal protection include investor protection(INPR),private enforcement(PREN),public enforcement(PBEN),law enforcement(LWEN),and anti-self-dealing(ASDI).INPR is the investor protection index,which is the principal component of indices of disclosure requirements,liabilities standards,and anti-director rights,from La Porta et al. (2006).This index is probably the most representative and integrated measure of legal protection of shareholders.PREN and PBEN are,respectively,the private enforcement and the public enforcement indices also from La Porta et al.(2006).LWEN is the law enforcement index,which is the average of scores on rule of law,judicial efficiency,corruption,risk of expropriation,and the contract repudiation indexes,from La Porta et al.(1998).ASDI is the anti-self-dealing index from Djankov,La Porta,Lopez-de-Silanes and Shleifer(2008).Djankov et al.(2008)construct this new index of shareholder protection against expropriation by corporate insiders.The index focuses on private enforcement,is better grounded in theory and works better empirically than the index of anti-director rights(ADRI)constructed by La Porta et al.(1997,1998)and the revised anti-director rights index(ADRR)in Djankov et al.(2008).For each of these indices,a higher value indicates better protection of investors.
For robustness checks,we also include other shareholder protection variables that have been shown to be associated with legal protection of investors(La Porta et al.,1997,1998,2006;Djankov et al.,2008).They include original anti-director rights(ADRI), revised anti-director rights(ADRR),accounting standards(ACST),stock market development(MKDV),and law origin(LO).ADRR is the revised anti-director rights index,which relies on the same basic dimensions of corporate law as ADRI,but defines them with more precision(see,Djankov et al.,2008,page453).ACST is the accounting standards rating by CIFAR and is from La Porta et al. (1998).MKDV is a market development measure,which is a dummy variable that equals one if a market is in the MSCI developed market index,and zero otherwise.LO is a binary variable that is equal to one if the law system of a country originates from the U.K., and zero otherwise.A higher value of these indices indicates better protection of shareholders.
In addition,firms'financial decisions may be affected by societal and cultural factors.Dyck and Zingales(2004)refer to these institutional variables as“extra-legal”institutions.As argued by Dyck(2000),these“extra-legal”institutions may play an important role in curtailing private benefits of control.These extra-legal institutional variables may capture the influences on the cost of equity capital not measured by the legal variables only.10We therefore include competition law(CPLW)and newspaper circulation(NWPC)as additional robustness checks.CPLW is the competition laws index and NWPC is the newspaper circulation scaled by population.Both extra-legal indices are from Dyck and Zingales(2004).Dyck and Zingales(2004)argue andfind that product market competition(CPLW)represents a natural constraint to the diversion of private benefits,while public opinion pressure(NWPC)might limit controlling shareholders'efforts to extractfirm resources because of their reputational cost.It can be 7Earlier in October2000,CLSA issued a much smaller-scale corporate governance report entitled“The Tide is Out:Who's Swimming Naked?”Because this report covers only115firms and uses a much less rigorous set of criteria than the later reports,it is not used in this study.
8Thefirms that are selected are larger,or receive greater investor interest in each market.Thus,although a relatively small number offirms was covered by the CLSA surveys(2001,2002),thesefirms account for a significant percentage in terms of market capitalization in the corresponding markets.For example,in9out of the25countries that are covered by the CLSA surveys(2001,2002),thefirm value of coveredfirms accounts for over50%of the market value of the country's firms covered by DataStream,and in several markets,such as Hong Kong and India,thefigure exceeds80%.Even if we consider the markets in which relatively fewfirms are covered,the total market value of thefirms that are covered by CLSA accounts for about53%of the total market value of thefirms covered by DataStream in the24markets.Furthermore,we do not expect that CLSA deliberately includedfirms that have a cost of equity that is heavily affected by corporate governance in their surveys.Even if they did,the fact that thesefirms receive much investor attention indicates that the institutional investors have paid premiums forfirms with good corporate governance.
9The includedfirms have significantly higher overall corporate governance ratings(CG)than the deletedfirms have.To investigate how the sample selection process would affect our results,we use the availablefirms to examine how the effects of CG on the cost of equity vary as CG increases.Wefind that the negative association between CG and the cost of equity weakens as CG increases.This suggests that the CG effect would be even stronger if we could retain all of thefirms in the CLSA survey in ourfinal sample.
10The authors thank an anonymous associate editor for the suggestion to include these extra-legal variables in our analysis.
seen from Table 1that countries with a higher INPR index also have higher values in other legal protection indices and extra-legal institutional indices.
3.2.Measures of firm-level corporate governance
The CLSA surveys include 57criteria that are grouped into seven major categories:(1)transparency (TRAN),(2)management discipline (DSPL),(3)independence (INDP),(4)accountability (ACCT),(5)responsibility (RESP),(6)fairness (FAIR),and (7)social awareness (SOCL).The meanings of these categories are as follows.“Transparency ”refers to the ability of outsiders to assess the true position of the company.“Discipline ”refers to the management's commitment to shareholder value and financial discipline.“Independence ”refers to the board of director's independence from controlling shareholders and senior management.“Accountability ”refers to the accountability of the management to the board of directors.“Responsibility ”refers to the effectiveness of the board in taking necessary measures in case of mismanagement.“Fairness ”refers to the treatment that minority shareholders receive from majority shareholders and management.The last category,“social awareness,”refers to the company's emphasis on ethical and socially responsible behavior.Each category includes between six and ten criteria.Each of the criteria is stated in a questionnaire,and CLSA asked its analysts who cover the company to give a zero/one answer to each question.The answers to the questions in each category are summed to form a score and are then scaled by the total number of questions in the corresponding category to convert it into a percentage.The 57rating criteria are reproduced in Appendix A.
As the aim of this paper is to study the importance of corporate governance mechanisms in general,we combine the first six categories into one corporate governance variable.The arithmetic mean of these six categories is used as the measure of the strength of corporate governance and is denoted as CG .We do not include social awareness in this study because the cost of equity capital is not expected to depend on a firm's social responsibility.11
Some items in the CLSA survey depend on the results of subjective assessments that are based on the experience of the analysts covering the companies.This approach has the advantage of measuring the essence,instead of the form,of corporate governance,but it is also susceptible to bias (Brooker,2001).To alleviate the potential bias,CLSA designed 70%of the questions to be based on facts,such as whether the board meets at least four times a year.In addition,when a subjective assessment has to be made,analysts have to provide a de finite yes/no answer to reduce the degree of subjectivity.The CLSA scores have been widely used in academic research.For example,Doidge,Karolyi and Stulz (2004)examine the determinants of corporate governance in countries in different development stages using data from CLSA and Standard &Poor's.In addition,the validity of the CLSA scores has been examined by other studies.For instance,Khanna,Kogan and Palepu (2002)construct a “scandal index,”which is based on the media-reported incidences of expropriation,tax evasion,and price fixing,for a group of Indian firms that are covered by CLSA.They
11
In addition,we do not find a signi ficantly negative association between social awareness and the cost of equity.
Table 1
Sample selection process and distribution of sample across 17economies.Economy
2001
2002
Economy-level institutional factors INPR
PREN PREN LWEN ASDI ADRI ADRR ACST MKDV LO CPLW NWPC Brazil 10120.4420.290.29 6.460.29355400 4.90.4Chile
10120.6100.460.46 6.770.63545200 5.4 1.0Columbia 100.3550.260.26 5.660.58335000 4.710.5Greece 200.3190.390.39 6.840.23225510n/a n/a Hong Kong 36510.8510.790.798.770.96556911 5.858.0India
34310.7690.790.79 6.120.55555701n/a n/a Indonesia 15140.5070.580.58 4.380.6824n/a 00 4.420.2South Korea 14190.3580.710.71 6.710.462 3.56200 4.9 3.9Malaysia 38390.7290.790.797.710.95457601 4.84 1.6Mexico 370.0980.350.35 5.990.18136000 4.93 1.0Pakistan 400.6250.510.51 4.300.4154n/a 01n/a n/a Philippines 1590.8120.920.92 4.080.24336500 4.610.8Singapore 27330.7700.830.838.99 1.00457811 5.21 3.2South Africa 26150.5990.750.75 6.700.81557001 4.890.34Taiwan 22240.5470.710.718.080.56336500 5.56 2.7Thailand 10130.3730.630.63 5.930.85246401 4.770.6Turkey
9
4
0.338
0.36
0.36
5.46
0.43
2
2
51
5.14
1.1
This table presents the sample selection process and the distribution of the sample across 17economies and two years.Firms in the CLSA surveys (2001,2002)are first matched with those in I/B/E/S and Datastream.We then exclude the observations that are missing cost of equity estimates or control variables of beta,size,book-to-market,momentum,and analyst forecast error.This selection process results in a final sample of 276firms for June 2001and 283firms for June 2002,respectively.INPR is the investor protection index,which is the principal component of indices of disclosure requirements,liabilities standards,and anti-director rights,from La Porta et al.(2006).PREN and PBEN are,respectively,the private enforcement and the public enforcement indices from La Porta et al.(2006).LWEN is the law enforcement index,which is the average of rule of law,judicial ef ficiency,corruption,risk of expropriation,and the contract repudiation indexes,from La Porta et al.(1998).ASDI is the anti-self-dealing index from Djankov et al.(2008).ADRI is the anti-director rights index from La Porta et al.(1998).ADRR is the revised anti-director rights index from Djankov et al.(2008).ACST is the accounting standard rating by CIFAR and is from La Porta et al.(1998).MKDV is a dummy variable that equals one if a market is in the MSCI developed market index (integrated),and zero otherwise (segmented).LO is a binary variable that is equal to one if the law system of a country originates from the U.K.,and zero otherwise.CPLW is the competition laws index from Dyck and Zingales (2004).NWPC is the newspaper circulation scaled by population from Dyck and Zingales (2004).
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