Corporate governance, the cross section of returns, and financing choices: theory and empirical evidence

Thesis (Ph. D.)--University of Rochester. William E. Simon Graduate School of Business Administration, 2008.The first part of this thesis develops an investment-based asset pricing model with costly equity and debt financing and agency conflicts between shareholders and managers. In the model, managers seek private benefits proportional to the sizes of their firms and hence tend to overinvest. Corporate governance serves as a mechanism for shareholders to discipline managers. Consistent with recent empirical findings, the model predicts: (1) firms with stronger governance outperform firms with weaker governance in booms and underperform these firms in recessions; (2) firms with stronger governance have higher costs of debt financing and rely more on equity financing than firms with weaker governance. The second part of this thesis provides two empirical tests on the predictions of the model about the cross section of returns. Both tests are conducted using two measures of the strength of corporate governance: governance index (G-index) and entrenchment index (E-index). First, I identify booms and recessions from September 1990 to December 2005 based on the expected market risk premium. The results show that controlling for market, size, value, and momentum factors, strongly governed firms on average earn higher returns than weakly governed firms during booms and lower returns during recessions. Second, I construct two investment factors to proxy for the effect of overinvestment on stock returns. Based on these investment factors, data seems to suggest that overinvestment can explain the return differences between strongly and weakly governed firms only when the economy is in good states