Corporate Governance, Cost of Capital and Value Creation: Evidence from Indian Firms

Abstract

In this paper, we investigate the impact of corporate governance on firm performance and valuation in India. Our study is the first to use a composite measure of corporate governance to examine the impact of corporate governance on Indian firms' performance and valuation. Because agency theory suggests that companies with better corporate governance standards perform better, we propose that better governed Indian firms should have greater performance lower cost of capital and thus, higher valuation. To achieve this objective, we use WaCC, Cost of Equity, Cost of Debt, Tobin Q, Return on Capital Employed, Return on equity, Sales growth, as the key variables that defined the cost of capital and performance of the firm respectively. On the other hand, for the measure of corporate governance, we use Board Independence, Board size, CEO Duality and ownership pattern in the company. Most importantly, we find that our composite measure of corporate governance is positively and significantly associated with firm performance and valuation. In addition, our results show that ownership concentration and board independence have a positive impact on firm performance and valuation. We use a sample of large firms over 10 years in a unique governance setting, India, to analyze the role that the variation in firm-level corporate governance mechanisms play in explaining a firm's cost of capital. We find that greater insider ownership, the presence of institutional blockholders and independent boards all serve to reduce the perceived risk of a firm, thereby leading investors to demand lower rates of return on capital provided. This highlights the important role that corporate governance plays in creating value for shareholders by reducing the cost of external financing. Given the inconclusiveness of existing literature that uses Q to measure firm value, this research suggests an alternative and potentially more suitable way to investigate the impact of corporate governance on firm value. Finally we design a predictive model using discriminant analysis, which we name as Singhal's V-score Model, that can help a potential investor predict whether a firm will dampen or add higher value (spread) to his shareholdings, given the state of governance mechanisms that the management of firm employs. The V-score greater than 1.168 suggests that the firm will diminish the value of investor's investment and a V-score less than -0.888 suggests that the firm will add higher value to the investments either by earning superior returns & performance or bearing lower cost of funds invested. These findings have implications for policy makers, researchers, managers, and investors in general and those in emerging markets in particular.