The effect of shareholder rights on firm value is a field of growing interest as corporate governance issues grow in importance. The theory states that strong shareholder rights should lower the cost of capital and mitigate over-investment, but the evidence to date has been inconclusive. Now, a new study suggests this may in fact be what is happening.

Kevin C.W. Chen, Zhihong Chen (formal doctoral student at HKUST), and K.C. John Wei looked at shareholder rights and implied cost of equity capital in 13,148 firm-year observations in the US for 1990-2004. They found stronger shareholder rights reduced the cost of equity by a significant amount - in one scenario, by 34 basis points.

They used specific measures for both variables. Shareholder rights was measured by the Governance Index, which reflects the number of anti-takeover provisions and restrictions on shareholder rights in the firm. A higher G-index means the balance of power is more favourable to management, and shareholder rights are weaker.

Implied cost of equity was examined with reference to current stock prices and analyst earnings forecasts, and with special attention given to free cash flows which show how much freedom managers have to make investment decisions. When there is limited cash flow, managers have to look outside for additional funds, which subjects them to external monitoring. If cash flows are higher, they can fund the projects internally, but this risks potential damage from overinvestment to existing shareholders.

Shareholder rights and free cash flows intersect to influence the cost of capital if there are "agency problems" in which managers overinvest at the expense of shareholders.

"If you have both information asymmetry and agency problems, where managers have private information and dishonest managers can hide that information, weak governance will increase a firm's exposure to systematic risk and increase the cost of equity," the authors say.

"The shift in balance of power to managers decreases the effectiveness of the takeover market in disciplining them. Therefore the presence of more anti-takeover provisions will induce greater expropriations by managers in various forms."

Shareholder rights counterbalances that, and the data from the US firms supported their benefits. When anti-takeover provisions were reduced by 10 points on the Governance Index (of 1-17 points), the cost of equity decreased by 34 basis points. This implied an economic enhancement of more than 6.8 per cent, which translated into $92 million for the median sized firms.

A key strength in the findings is that they look at voluntary corporate action rather than relying solely on mandatory regulations. Voluntary action is susceptible to self-selection issues but the authors did extensive robustness tests and found the same results.

"We identify that shareholder rights matter most in reducing the cost of equity when agency problems from free cash flows are most severe. The results provide further empirical evidence to support the presence of a causal link between corporate governance, agency problems, and the cost of equity, as predicted by theory," they say.