Chapter 13: The construction and valuation effect of corporate governance indices
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There are two different channels through which corporate governance may help to overcome agency problems and thereby increase firm value. On the one hand, high corporate goverance standards may result in higher stock price multiples as investors anticipate that less cash flows will be diverted. Hence, a higher fraction of the firms’ profits will come back to them as interest or dividend payments (Jensen and Meckling, 1976; La Porta et al., 2002). On the other hand, good corporate governance may reduce the expected return on equity as it reduces shareholders’ monitoring and auditing costs resulting in lower costs of capital (Shleifer and Vishny, 1997). However, the implementation of a stronger corporate governance structure within firms is associated with costs and therefore it is not clear ex ante whether the benefits outweigh the costs of a strong firm-level corporate governance (e.g., Gillan et al., 2003; Chhaochharia and Grinstein, 2007; Bruno and Claessens, 2010). The majority of prior research investigating the relationship between firm-level corporate governance and firm valuation finds better corporate governance to be associated with higher firm values (Yermack, 1996; Gompers et al., 2003; Cremers and Nair, 2005; Core et al., 2006; Bebchuck et al., 2009).

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