Derwall and Verwijmeren (2007)

Derwall, Jeroen and Patrick Verwijmeren. "Corporate Governance and the Cost of Equity Capital: Evidence from GMI's Governance Rating." ECCE Research Note 06-01, European Centre for Corporate Engagement, version 2.0, January 2007.

This brief but important study investigates the impact of corporate governance practices on equity cost of capital for 1168 publicly traded U.S. corporations. The governance database is from Governance Metrics International, while financial data are drawn from CRSP and Compustat.

The implied cost of capital is estimated for each firm using a technique from Easton (2004) - independent variables are market value of equity (after log transformation), beta, debt/assets ratio (using book, not market values), the price/book ratio, year fixed effects, and the corporate governance index. Two versions of the model are used to separate financial from non-financial companies, and to control for industry effects using Fama & French's 48 industry classifications. Both models show a reduction in cost of capital for well-governed companies, which is statistically significant at the 10% level.

A second analysis uses multiple models to estimate beta and idiosyncratic risk using independent variables similar to those above. In all models, well-governed companies had lower estimated risk, and the governance score was statistically significant at the 1% or 5% level.

The authors conclude that "we find evidence that better governance is associated with with lower firm-specific risk, lower systematic risk, and a lower implied cost of equity capital." If true - and see Barber (2006) for more on this, the implications for theoretical finance are potentially important. As the authors note, "since the CAPM rests on the assumption of perfect capital markets it is reasonable to state that a separate corporate governance risk factor is needed in cost of equity models."