Shareholder rights theoretically should lower the cost of capital by reducing overinvestment as well as investors' out-of-pocket monitoring costs and idiosyncratic risk. But evidence of these effects as so far has been mixed and somewhat surprising, suggesting that the predictions may not hold.

One of the problems, say Kevin C.W. Chen, Zhihong Chen and K.C. John Wei in a study of the issue, is that researchers may have been looking at the wrong measure - actual returns as opposed to the expected future cost of equity as implied by stock prices and analysts' earnings forecasts. The authors apply this measure to 13,140 firm-year observations for 2,161 firms in the US from 1990-2004 and find compelling evidence of a strong effect from shareholder rights on the cost of equity.

These rights are based on the "G-index", which is the number of anti-takeover provisions and restrictions of shareholder rights stipulated in a firm's charter and bylaws or by state law (hostile takeovers are seen as an important mechanism to monitor and discipline managers so restricting them reduces this function). A higher number is considered to have lower shareholder rights and therefore higher cost of equity.

The authors combine the G-index score with a measure of the cost of equity based on free cash flows from operations and investment opportunities. These cash flows are more likely to give rise to potential agency problems in firms that hold a lot of cash but do not have good investment opportunities, because they enable managers to fund investments internally without needing to seek external funding and be monitored by capital markets. If governance is weak, such a situation can create opportunities for managers.

"In the presence of information asymmetry, when managers have private information about the quality of an investment project, and agency problems, in which dishonest managers can hide private information, weak governance can increase a firm's exposure to systematic risk and increase the cost of equity," the authors say.

The results of their tests show that there is indeed a link between shareholder rights and the implied cost of equity. The firms in their sample span 17 points on the G-index and lowering a score by 10 points is associated with a decrease in the cost of equity of 34 basis points, which translates into US$92 million for a firm with the sample median size of US$1.35 billion.

"Firms holding a lot of cash flow but who do not have good investment opportunities are more likely to face potential agency problems from free cash flows," they say. The coefficient on the G-index is highest for firms with high free cash flow/low investment opportunities, and lowest for those with low free cash flow/high investment opportunities.

"We have identified a channel through which shareholder rights improve firm value. While other studies show that weaker shareholder rights are associated with lower expected cash flows, our study suggests they are also associated with higher discount rates."

"More importantly," add the authors, "we show that shareholder rights matter most in reducing the cost of equity when agency problems from free cash flows are more severe. The results provide further empirical evidence that supports the presence of a causal link between corporate governance, agency problems and the cost of equity."