Shareholder Rights and The Cost of Equity

CHEN, Zhihong | CHEN, Kevin C W | WEI, Kuo-chiang John

Shareholder rights are, in theory, supposed to lower the cost of equity because they enable shareholders to keep manager excesses in check, such as over-investment. But the evidence for this has been mixed and has even called into question the effect of shareholder rights.

Now, scholars approaching the problem from a new angle have been able to construct a clearer picture and found that there is indeed a basis for the hunch behind the theory: stronger shareholder rights do reduce the cost of equity.

Kevin CW Chen, Zhihong Chen and KC John Wei came to that conclusion after focusing on the cost of equity implied in stock prices and analysts’ earnings forecasts which, unlike other approaches, is less likely to be confounded by other factors. “This type of model explicitly attempts to separate the effect of the cost of equity from firm valuations and controls for cash flow and growth effects,” they said.

With this setting, they were able to hone in more precisely on the relationship of the implied cost of equity with shareholder rights, which were measured by the number of anti-takeover provisions in corporate charters and bylaws (the G-index). These provisions strengthen managers’ hands at warding off hostile takeovers and therefore cement managers’ standing, so a higher number of provisions means shareholder rights are weaker.

The authors applied their measures to 2,161 US firms from 1990-2004 and found confirmation for the idea that a decrease in the G-index reading, and thus an increase in shareholder rights, reduced the implied cost of equity.

A 10-point decrease in the G-index (their sample ranged from 1-17) reduced the cost of equity on average by 34 basis points – which translated into an implied value enhancement of more than 6.8 per cent (or $92 million for a firm with the median size of $1.35 billion in their sample).

Taking that finding further, they looked at whether the effect of shareholder rights on the implied cost of equity was stronger among firms with more severe agency problems due to free cash flows. “Free cash flows are a proxy for looking at agency problems because they indicate the potential damage caused by overinvestment. When there his little free cash flow, managers have fewer economic resources to squander.”

“On the other hand, managers of firms with high free cash flows can finance investments by internal funds and therefore avoid extra monitoring from the capital market. In this case, the potential damage from overinvestment to existing shareholders would be higher.”

Their tests confirmed that firms with high free cash flows and poor investment opportunities showed a stronger relationship between shareholder rights and the implied cost of equity than did firms with low free cash flows and good investment opportunities.

Apart from contributing evidence on the effect of shareholder rights on the cost of equity, the authors also provided a new perspective on the association between corporate governance and the cost of equity. Previous studies have been at the country level and looked at how legal institutions affect all firms equally within a single jurisdiction. This study, by contrast, addressed how firm-specific corporate governance, such as shareholder rights, affected the firm-level cost of equity capital.

CHEN, Zhihong

Associate Professor

CHEN, Kevin C W

Chair Professor