Corporate Governance and the Cost of Debt

Abstract

This paper examines the relation between the quality of corporate governance and the cost of debt. This study is based on the idea that debt holders take a firm's corporate governance into account when estimating its default risk. A higher quality would imply a lower cost of debt. The methodology of our study is comparable to Sengupta (1998). We use the Deminor Rating for the year 2000 as a proxy for the quality of corporate governance performance of the 300 largest European firms (FTSE Eurotop 300). Deminor Rating bases its score on approximately 300 criteria, which can be subdivided into four corporate governance categories: rights and duties of shareholders; range of takeover defences; disclosure on corporate governance; and board structure and functioning. As a proxy for the cost of debt we use the yield of 77 bonds issued in the year 2001. After adjusting for issuer characteristics, issue characteristics and market characteristics, we find that corporate governance performance is negatively related to the cost of debt. It shows that firms with strong corporate governance have lower cost of debt financing while firms with a relatively weak corporate governance performance are associated with higher cost of debt financing, with a difference of about 1.4%. The findings support the idea that debt holders use the quality of corporate governance in their assessment of risk profiles of firms. Our results imply - given the in general found positive correlation between corporate governance and equity related measures - good corporate governance pays off for both equity and debt holders.