CG and CoC-An International Study

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International Review of Finance, 14:3, 2014: pp. 393429

DOI: 10.1111/irfi.12034
Corporate Governance and the Cost

of Capital: An International Study*
FEIFEI ZHU
College of Business Administration, Hawaii Pacific University, Honolulu, HI, USA
ABSTRACT
This study shows that firms with good corporate governance are consistently
associated with both lower cost of equity and cost of debt capital in an
international setting. The association between corporate governance and the
cost of equity is more pronounced in countries with strong legal systems,
extensive disclosure practices, and good government quality. However, the
relation between corporate governance and the cost of debt is stronger in
countries characterized by weak legal protection, low transparency, and poor
government quality. The differential relations can be attributed to asymmet-
ric payoffs received by creditors and shareholders.
I. INTRODUCTION
In this study, I investigate the relation between a firms internal governance

practice and its costs of external financing, i.e., the cost of equity and cost of
debt capital, particularly focusing on how the relation is influenced by various
aspects of the institutional environment. This paper attempts to shed light on
whether firm-level governance complements or substitutes for country-level
governance in protecting the benefits of both shareholders and creditors.
Corporate governance could reduce the agency problem and protect minor-
ity shareholders against expropriation by managers and controlling sharehold-
ers. Therefore, it has been widely recognized that firms with better corporate
governance are associated with higher firm value and accounting profitability.1
Strong governance practice can also lower investors required rate of return by
enhancing financial reporting quality and reducing the monitoring costs.
However, existing literature that examined the relation between corporate gov-
ernance and the cost of capital either limits their sample to US firms or, if
international companies are examined, concentrates only on one aspect of a
* I thank Lilian Ng, Valeriy Sibilkov, Keshab Shrestha, Sudipto Dasgupta, an anonymous referee,
and seminar participants at the University of Wisconsin Milwaukee, 2009 Financial Manage-
ment Association meeting and 2009 Southern Finance Association meeting for many helpful
comments and suggestions. All mistakes remain mine.
1 See Gompers et al. (2003) for US evidence and Aggarwal et al. (2009) for international
evidence.
2014 International Review of Finance Ltd. 2014

International Review of Finance
firms financing costs.2 Furthermore, in an international setting, governance

depends on both firm-level and country-level mechanisms. The interactive
effects between firm-level and country-level governance are far from clear.
Previous work that is valuation-oriented documents a substitution effect
between corporate governance and legal environments (Klapper and Love 2004;
Durnev and Kim, 2005). Chen et al. (2009) find similar results and show that
corporate governance effect on the cost of equity is more pronounced in
countries that provide relatively poor legal protection. Conversely, Ge et al.
(2012) demonstrate that the favorable effect of firm-level governance on loan
contracting terms is stronger in countries with strong legal institutions.
This study is particularly interested in understanding the interactive relations
between firm- and country-level governance in affecting external financing
costs. As suggested by La Porta et al. (1998), how the firm-level and country-
level governance interplay affects the costs of equity and debt capital may
probably depend upon the various rights the securities bring to their owners.
The equity gives its owners upside potential of their investments, i.e., contin-
gent payments to be determined in the future, but it gives managers strong
residual control rights. Shareholders can only indirectly participate in gover-
nance by voting for the directors of companies, which assume the fiduciary
responsibilities to constrain opportunistic behavior and expropriation. As in
Shleifer and Vishny (1997), this corporate governance mechanism is far from
perfection in preventing insiders absconding with the money. Because of these,
shareholders (especially minority shareholders) may need to rely upon external
forces to protect their interests and ensure the creditability of the internal
governance mechanism.
On the other hand, creditors receive a contractual obligation of fixed pay-
ments. They are more concerned with a firms downside risk when the company
failed to make promised payments, which is higher in countries unable to
protect the accuracy of disclosed information and the intactness of firms assets
(Ge et al. 2012). Furthermore, as discussed by John et al. (2008), given the
prevalent pyramid ownership structure in poorly protected countries, a domi-
nant insider may take risks in units where his cash flow rights are low and
siphon out earnings to high cash flow right units. This excessive risk-taking
would be detrimental to creditors as consequent earnings volatility may nega-
tively affect firms ability to make committed payments to debtholders. There-
fore, high quality internal governance mechanism may become especially
valuable to creditors in countries with weak institutions, where the above-
mentioned problems are more prominent.
In a sample comprising a total of 11,521 firm-years across 23 countries from
2002 to 2005, I find that firms with better governance are associated with both
2 See Chen et al. (2009), Hail and Leuz (2006) for the association between governance practice
and equity financing; see Klock et al. (2005), Ashbaugh et al. (2006) for the association
between governance practice and debt financing. A notable exception is Francis et al. (2005),
who investigate how accounting disclosures impact a firms costs of equity and debt
financing.
394 2014 International Review of Finance Ltd. 2014

Corporate Governance and the Cost of Capital: An International Study
lower cost of equity and cost of debt capital. The evidence is consistent with the
idea that good corporate governance reduces the risks faced by both sharehold-
ers and creditors, lowering the costs at which they are willing to offer capital.
The relation between corporate governance and the cost of capital is further
examined under a multitude of country characteristics that pertain to legal
institutions, information disclosure, and government quality. These country
factors have been widely documented to affect the costs and benefits of adopt-
ing certain governance attributes. Law and quality determine the security
holders rights and how well these rights are protected (La Porta et al. 1998).
Credible disclosures could reduce information asymmetry between a firm and
its investors as well as among investors. The quality of political institution is
related to the control of corruption and government efficiency, which affects
the protection of investors benefits (La Porta et al. 1999; Qi et al. 2010).
Results show that the association between the governance practice and the
cost of equity is more pronounced in countries characterized by strong legal
protection, strict information rules, and high government quality. Firm-level
and country-level governance are complements to each other in reducing the
cost of equity. Results further support the argument in Doidge et al. (2007). The
adoption of good internal governance is prohibitively expensive in weakly
protected countries. Even if firms successfully commit to higher standards, the
benefits of doing so, i.e., access to capital markets on better terms, are limited
because weakly protected countries are often associated with less financial
development. On the contrary, the association between internal governance
and the cost of debt capital is stronger in countries with weak legal institutions,
poor disclosure practice, and low government quality. Firm-level governance
substitutes for country-level governance in reducing the cost of debt capital.
When country-level institutions are strong to protect the interests of creditors,
the association between firm-level governance and the cost of debt becomes less
pronounced.
There are two issues that plague the empirical work on governance (Hermalin
and Weisbach, 2003; Adams et al. 2010). One is that governance and other
variables are endogenous and two, some unknown factors may simultaneously
affect the choice of corporate governance and the cost of capital. To address
these two issues, I use the matching technique from Aggarwal et al. (2009). Each
foreign firm is matched to a US firm based on industry and closest propensity
scores.3 The governance index of a matched US counterpart is used as a regressor
rather than the governance index of the firm whose costs of equity and debt
capital are dependent variables. I find consistent evidence that internal gover-
nance and country-level protection serve as complements in reducing the cost
of equity capital while they serve as substitutes in reducing the cost of debt
capital. A further examination of differences in governance between a foreign
firm and a matched US firm reveals that a governance gap (positive or negative)
is significantly associated with the cost of equity in strongly protected countries
3 I thank an anonymous referee for suggesting this part of tests.
2014 International Review of Finance Ltd. 2014 395

while it is significantly associated with the cost of debt in poorly protected

countries. Even the matching technique provides robust evidence, a caveat
follows that this research only shows the association between internal gover-
nance and external financing costs. No causal relationship should be inferred
from the results.
This study makes a number of contributions to existing literature. First, this
work improves the understanding of the mechanism by which internal corpo-
rate governance affects firms valuation (Ammann et al. 2011). The valuation
effect may reflect a higher level of investment opportunities (the cash flow
effect), a lower risk premium demanded by investors (the cost of capital effect),
or both. I provide a thorough examination on the cost of capital, which suggests
that at least part of the valuation benefits from good corporate governance are
derived from the reduced cost of capital. Second, the results from previous
studies cannot be directly compared with each other partly because of the
different governance ratings they adopt. For instance, Ge et al. (2012) uses
governance attributes from Institutional Shareholders Services (ISS), while Chen
et al. (2009 employs the survey-based governance scores provided by the Credit
Lyonnais Securities Asia (CLSA).4 This study overcomes this problem by adopt-
ing the same governance rating system (ISS) and allows a comparison of the
relations between governance and both equity and debt financing costs.
Third, this study is closely related to Chen et al. (2009) and Ge et al. (2012)
yet complements them as the inclusion of disclosure practice and government
quality in the analysis and adds new evidence to the previous studies that focus
on legal institutions only. Fourth, I attempt to add evidence to the growing
body of literature on the firm-level and country-level governance interplay.
Doidge et al. (2007) argues that investor protection and firm-level governance
are complements for some low level of investor protection provided by the
state; but they become substitutes when the country-level protection is beyond
a certain point. Bruno and Claessens (2010) further substantiates this argument
and find that companies with good governance practices operating in stringent
legal environments show a valuation discount relative to similar companies
operating in flexible legal environments. Results in this study are of value
because I show that firm-level and country-level governance could serve as
either complements or substitutes depending on a firms external financing
methods.
The paper is organized as follows. Section II describes the data and sample
construction. Empirical results are contained and discussed in Section III and IV.
The final section concludes the paper.
II. DATA AND SAMPLE
The sample for this study comes from different data sources. This study employs
a detailed and comprehensive collection of governance provisions provided by
4 See Khanna et al. (2006) for an evaluation of the quality of CLSA dataset.

ISS for the period from 2003 to 2006 that is readily available. This period covers
firms corporate governance practice from 2002 to 2005. Constrained by the
availability of the ISS data, this study focuses on firms that are both included in
ISS database and Worldscope financial and accounting information for this
period. I include US firms that are in any of the following indexes: the Standard
and Poors 500 index, the Standard and Poors SmallCap 600 index, and the
Russell 3000 index.5 The final data set is 11,521 firm-year observations for 23
developed countries from 2002 to 2005. The cost of equity is calculated based
on analyst forecast records from I/B/E/S, while the cost of debt and other
accounting variables are calculated using financial statement data from
Worldscope. Monthly returns of both stocks and of Morgan Stanley Capital
International (MSCI) country indexes are from Datastream. A multitude of
country-specific variables are drawn from various sources, such as International
Financial Statistics (IFS), World Bank, and existing literature on investor pro-
tections. Firms from regulated industries, namely, utilities, banks, transporta-
tion, telecommunication services, energy, and insurance are excluded from the
sample. All variables used in this research are summarized and presented in
Appendix A.
A. Corporate governance ratings

The ISS database tracks 55 different governance attributes of firms from 22
developed countries excluding the US, and provides 61 governance attributes of
firms from the US. The wide spectrum of governance attributes allows the
construction of an overall governance rating as well as several subratings for
different aspects of a firms corporate governance practice. Similar to earlier
studies (Aggarwal et al. 2009), an additive approach is adopted to measure the
level of corporate governance of a firm. A binary value of one is assigned if a
firm meets the minimum acceptable governance standards and a zero other-
wise. For each firm, the rating in the governance index is determined by the
number of criteria met by the company for the attributes in question as a
percentage of the total number of nonmissing attributes in the same index.
Following Aggarwal et al. (2009), only 44 important governance attributes
are considered. An overall governance index (Gov) is determined by calculating
the percentage of governance attributes a firm actually satisfies. Appendix B
describes the 44 governance attributes in detail. Gov captures the key aspects of
a firms governance mechanism, including board quality, anti-takeover provi-
sions, audit practice, and executive compensation and ownership plan. The
second column of Table 1 presents, by country, the median values of corporate
governance rating, with the highest in Canada (0.636) and lowest in Portugal,
Belgium, and Greece (0.295).
5 This coverage is comparable with Aggarwal et al. (2009). The Russell 3000 index captures 98%
of the market capitalization of the US market.

Table 1 Median values of key firm characteristics and control variables by country
398
Country Nobs Gov COE COD Size Beta BM Fbias Lev ROA gS Own Infl rL
Australia 279 0.477 0.078 0.125 14.32 0.87 0.53 0.00 0.26 0.07 0.09 0.36 0.025 0.089
Austria 40 0.341 0.101 0.107 14.28 0.87 0.68 0.06 0.25 0.06 0.07 0.49 0.024 0.043
Belgium 68 0.295 0.097 0.110 14.98 0.83 0.71 0.09 0.24 0.05 0.03 0.40 0.027 0.067
Canada 413 0.636 0.085 0.132 14.11 0.62 0.52 0.03 0.24 0.05 0.08 0.17 0.019 0.044
Denmark 50 0.341 0.073 0.129 14.03 0.84 0.39 0.23 0.20 0.08 0.06 0.31 0.012 0.062
Finland 83 0.409 0.097 0.105 14.47 0.17 0.66 0.01 0.23 0.05 0.02 0.21 0.023 0.039
France 254 0.432 0.091 0.086 15.81 0.84 0.52 0.09 0.25 0.04 0.02 0.41 0.023 0.039
Germany 264 0.398 0.089 0.149 15.25 0.86 0.58 0.01 0.18 0.04 0.01 0.37 0.006 0.091
Greece 105 0.295 0.096 0.101 13.08 1.10 0.52 0.01 0.26 0.06 0.11 0.54 0.023 0.059
Hong Kong 203 0.386 0.095 0.072 14.62 0.97 0.78 0.01 0.19 0.06 0.12 0.57 0.000 0.050
Ireland 35 0.409 0.091 0.137 14.28 0.76 0.48 0.02 0.35 0.06 0.01 0.29 0.022 0.047
Italy 137 0.364 0.089 0.092 15.02 1.06 0.62 0.01 0.31 0.03 0.03 0.50 0.024 0.055
Japan 1,663 0.364 0.070 0.034 14.90 0.96 0.73 0.26 0.21 0.02 0.03 0.30 0.006 0.014
Netherlands 158 0.398 0.104 0.116 14.91 0.73 0.53 0.05 0.26 0.05 0.00 0.18 0.023 0.030
New Zealand 40 0.409 0.086 0.133 13.46 0.41 0.62 0.01 0.32 0.08 0.06 0.55 0.005 0.104
Norway 48 0.318 0.095 0.108 13.12 0.61 0.49 0.12 0.18 0.04 0.01 0.24 0.024 0.042
Portugal 25 0.295 0.086 0.089 14.81 0.84 0.43 0.02 0.42 0.04 0.01 0.64 0.025 0.048
Singapore 170 0.386 0.089 0.064 14.16 0.85 0.80 0.01 0.24 0.05 0.06 0.60 0.013 0.053
Spain 126 0.341 0.091 0.113 14.35 0.71 0.44 0.02 0.28 0.06 0.07 0.54 0.030 0.058
Sweden 134 0.364 0.080 0.115 14.93 0.64 0.44 0.24 0.06 0.03 0.21 0.020 0.048
0.09
Switzerland 186 0.432 0.087 0.097 14.50 0.92 0.42 0.14 0.23 0.05 0.02 0.22 0.006 0.033
UK 1,050 0.523 0.086 0.127 13.96 0.93 0.42 0.52 0.22 0.06 0.05 0.14 0.028 0.045
US 5,990 0.614 0.085 0.121 13.42 1.10 0.41 0.11 0.19 0.06 0.10 0.18 0.024 0.062
Total 11,521 0.523 0.084 0.106 14.07 0.98 0.48 0.07 0.21 0.05 0.07 0.24 0.024 0.043
This table presents country medians for the key firm characteristics and control variables. Nobs is the total number of firm-year observations.
Gov is corporate governance index detailed in Appendix B. COE is the average of implied cost of equity capital of rCT, rOJ, rGLS, and rPEG. COD is
the cost of debt capital. Size is total assets in US$ thousands. Beta is market beta in the June of year t. BM is book-to-market equity ratio. Fbias
is the analyst forecast bias. Lev is defined as total debt scaled by total assets. ROA is the return on assets. gS is annual sales growth from year t 1
to year t. Own is the % of closely held number of shares by insiders. Infl is the median of the current years annualized monthly inflation rates.
rL is the bank rate that meets the short- and medium-term financing needs of the private sector. The sample period is from 2002 to 2005.

B. The cost of capital and firm characteristics

The ex ante implied cost of capital is used as a proxy for the expected cost of
equity. Following Hail and Leuz (2006), the test employs the average of four
different implied cost of capital (ICOC) estimates as a proxy for a firms cost of
equity capital. The four models are (i) Gebhardt et al.s (2001, GLS) residual
income valuation model; (ii) Claus and Thomass (2001, CT) residual income
valuation model; (iii) Ohlson and Juettner-Nauroths (2005, OJ) abnormal earn-
ings growth valuation model; and finally (iv) Eastons (2004) PEG ratio (Price-
to-Earnings ratios divided by Growth rate) model, a special case of (iii). The
basic premise of these models is that the ICOC is the internal rate of return that
equates current stock price to the present value of expected future sequence of
residual incomes or abnormal earnings. Hail and Leuz (2006) offers detailed
comparisons of the four models and show how they vary in the use of analyst
forecast data, the short-term and long-term growth assumptions, the forecast
horizon, and whether and how inflation is incorporated into the steady-state
terminal value. Estimation of these models strictly follows their method and
data requirements. The specifications of the four ICOC models are provided in
Appendix C, which also briefly discusses the data requirements and estimation
procedures. For each firm in a given year, four ex ante ICOC are estimated based
on the four different models, and then an average of the four estimates is taken.
This firm-year average ICOC is labeled as COE.
The cost of debt (COD) is defined as the interest rate on a firms debt, equal
to the interest expense for the year divided by the average of short- and
long-term debts during the year (see Francis et al. 2005). The COD estimate
reflects a historic pre-tax interest rate based on cumulative debt financing
decisions of each firm.6 Both COE and COD are leading one period ahead (t + 1)
of all independent variables including Gov. Table 1 presents cross-country
median values of COE and COD that vary substantially across countries. Among
all countries, Japan has the lowest median value of the cost of debt and cost of
equity, with 7.0% and 3.4%, respectively. On the other hand, Netherlands has
the highest cost of equity of 10.4%.
Drawn from existing literature, firm-specific variables that have been shown
to explain the cost of capital are defined and controlled in this research (Francis
et al. 2005; Hail and Leuz, 2006). Size is log of total assets in thousands of US
dollars. Beta is defined as the covariance of MSCI country index monthly returns
with monthly firm returns divided by MSCI country index monthly return
variance over the past 60 months till June of year t. In Table 1, there is a
substantial international variation in Beta, ranging from 0.17 in Finland to 1.10
in Greece. BM is the book-to-market ratio. Fbias is the 1-year-ahead consensus
6 Prior research on US markets defines the cost of debt as the yield to maturity of outstanding
bonds. However, the trading data for international corporate bonds is largely unavailable.
Instead, I use this accounting-based cost of debt measure. The precision of the cost of debt
estimate may also be affected by different reporting rules across countries. However, Francis
et al. (2005) suggests that this cost of debt proxy is closely related to a firms disclosure practice
despite the possible measurement error.

forecast minus the actual earnings reported in I/B/E/S. The cost of equity
estimates rely on analyst forecasts, and any differences in the forecast behavior
could mechanically change the results. An optimistic forecast would reflect as
a positive forecast bias. If market participants understand this bias and adjust
prices accordingly, an upwardly biased cost of equity estimate would be
observed, thereby a positive coefficient on Fbias. From Table 1, the median
value for forecast bias is negative in most countries, indicating a pessimistic
prediction from the market. Profitability is measured by return on assets (ROA).
Leverage (Lev) is the ratio of short- and long-term debt to total assets. Empirical
evidence manifests that firms with higher leverage are subject to heavy debt
obligations and have high default risks. Therefore, the coefficient on leverage in
the cost of debt regression is expected to be positive. On the other hand, high
leverage may reflect the cumulative effect of a lower cost of debt. Firms that
have a historically low cost of debt may keep borrowing at a lower rate.
Therefore, a regression of the cost of debt on leverage may capture the trend
that lower borrowing rates are leading to higher leverage rather than greater
distress possibilities induced by the higher leverage.
C. Country characteristics
The inflation rate (Infl) and lending rate (rL) are used to control for time-varying
macroeconomic conditions. Infl is defined as the median of the current years
annualized monthly inflation rates for each country based on consumer price
indices provided by IFS. Analyst forecasts are expressed in nominal terms and
hence, the resulting estimates for COE reflect the countries expected inflation
rates. The coefficient of Infl is expected to be positive and smaller than one. For
the cost of debt, country-specific lending interest rate (rL) is employed as a
benchmark interest rate relative to which all other borrowers pay a default risk
premium. The higher the benchmark rate, the larger is the cost of borrowing.
This measure is obtained from Datastream and the coefficient on rL is expected
to be positive. In each regression, the year-fixed effects are controlled to capture
the time-series variation in the risk-free rate.
In this study, I employ the fixed summary scores of legal, transparency, and
government quality for each country and also use time-variant proxies to reflect
changes in country institutional environments. The first legal variable is a
dummy (LOrg), which is equal to one if a country is from a common-law origin
and zero if it is from a civil-law origin. La Porta et al. (1998) and Djankov et al.
(2008) show that countries with the common-law legal origin have better
protection of minority shareholders than do countries with the civil-law legal
origin. The second variable is legal enforcement (LEnf). Prior studies suggest that
a countrys legal enforcement institutions could substitute or even dominate
the formal set of company laws that govern investor protection. Following Leuz
et al. (2003), I define legal enforcement as the mean scores across three legal
variables from La Porta et al. (1998): (i) the efficiency of the judicial system, (ii)
an assessment of rule of law, and (iii) the corruption index. All three variables

range from 0 to 10. The third variable is the law and order index (LICR) from
International Country Risk Guide (ICR), scale from zero to one. To assess the
law element, the strength and impartiality of the legal system are considered,
while the order element is an assessment of popular observance of the law. The
last measure is a time-variant rule of law index from Worldwide Governance
Indicators (WGI), ranging from 2.5 (weak) to 2.5 (strong). It captures percep-
tions of the extent to which agents have confidence in and abide by the rules of
society, and in particular the quality of contract enforcement, property rights,
the police, and the courts, as well as the likelihood of crime and violence
(Kaufmann et al. 2009).
The first disclosure index is from the Center for International Financial
Analysis and Research data base (Cifar). Cifar represents both mandated and
voluntary disclosure practices. Prior literature shows that countries with weak
investor protection environments have lower quality auditing and accounting
standards, thereby probably making the disclosure unreliable and ineffective
(see La Porta et al. 1998). Thus, it can be assumed that the voluntary disclosure
is more common in a well-protected market, and this measure reflects the
overall transparency of the market. The second measure proxies for disclosure
regulation (Dreg) that mandates disclosures on prospectus requirements, direc-
tor compensation, ownership structure, and party-related transactions and con-
tracts (La Porta et al. 2006). The third measure is based on survey results about
the level and availability of financial disclosure score index (DGCR) in the
annual Global Competitiveness Report issued by the World Economic Forum.
The DGCR is calculated as average scores for 1999 and 2000 divided by 10 such
that the score falls in the 0 to 1 range (Gelos and Wei 2005). The last variable is
a time-varying index of internet users per 100 people (NetPc) from World Bank,
which is a broad index for media coverage and news transmission.
I consider three aspects of political risks and government quality, i.e., gov-
ernment efficiency, government effectiveness, and control of corruption. The
first aspect of government efficiency relates to bureaucratic delays (BDL from La
Porta et al. 1999). With a scale from zero to 10, a higher rating indicates a lower
level of obstructive official routine or procedure in the bureaucracy of the
country. The second aspect of government efficiency assesses the level of tax
compliance (TaxC) with a scale from zero to six, where higher scores indicate
higher tax compliance and hence more efficient government. The following
two time-varying measures capture the government effectiveness (GE) and
control of corruption (CCP). GE captures perceptions of the quality of public
and civil service, and the degree of its independence from political pressures,
the quality of policy formulation and implementation, and the credibility of the
governments commitment to such policies. CCP assesses perceptions of the
extent to which public power is exercised for private gain. Both measures are
from WGI.
Median values of country legal institutions, transparency, and government
quality measures are reported in Table 2. The lowest scores on governance
standards mainly concentrate on three countries, namely, Greece, Italy, and

Table 2 Legal institutions, transparency, and government quality measures

Country LOrg LEnf LICR LWGI Cifar Dreq DGCR NetPc BDL TaxC GE CCP
Australia 1 9.51 1 1.79 80 0.75 6.3 61.43 6.33 4.58 1.93 1.93
Austria 0 9.36 1 1.79 62 0.25 6 41.11 6.00 3.6 1.82 2.03
Belgium 0 9.44 0.83 1.39 68 0.42 5.9 53.55 6.24 2.27 1.82 1.42
Canada 1 9.75 1 1.78 75 0.92 6.3 63.92 6.55 3.77 2.08 1.89
Denmark 0 10 1 1.95 75 0.58 6.2 70.95 6.54 3.7 2.25 2.30
Finland 0 10 1 1.92 83 0.5 6.5 65.92 5.75 3.53 2.21 2.41
France 0 8.68 0.78 1.38 78 0.75 5.9 36.18 5.16 3.86 1.65 1.43
Germany 0 9.05 0.83 1.66 67 0.42 6 53.54 7.07 3.41 1.57 1.88
Greece 0 6.82 0.5 0.82 61 0.33 16.25 4.69 2.36 0.83 0.51
Hong Kong 1 8.91 0.75 1.50 73 0.92 5.8 56.95 4.56 1.61 1.70
Ireland 1 8.36 1 1.56 81 0.67 5.6 33.80 5.91 3.55 1.68 1.57
Italy 0 7.07 0.67 0.50 66 0.67 31.43 4.22 1.77 0.66 0.33
Japan 0 9.17 0.83 1.29 71 0.75 5.6 62.21 6.16 4.41 1.31 1.23
Netherlands 0 10 1 1.71 74 0.5 6.1 64.10 6.78 3.4 2.07 2.07
New Zealand 1 10 1 1.87 80 0.67 6 61.49 5 1.91 2.34
Norway 0 10 1 1.98 75 0.58 5.8 74.95 6.52 3.96 2.13 2.00
Portugal 0 7.19 0.83 1.19 56 0.42 5.1 25.60 4.23 2.18 1.08 1.19
Singapore 1 8.93 0.83 1.76 79 1 5.9 61.85 7.49 5.05 2.23 2.19
Spain 0 7.14 0.80 1.07 72 0.5 5.6 40.17 4.79 1.91 1.41 1.31
Sweden 0 10 1 1.88 83 0.58 6.3 76.94 6.53 3.39 2.12 2.20
Switzerland 0 10 0.83 1.94 80 0.67 5.7 64.00 7.78 4.49 2.20 2.15
UK 1 9.22 0.97 1.70 85 0.83 6.3 62.78 6.19 4.67 1.82 1.88
US 1 9.54 0.83 1.54 76 1 66.26 6.99 4.47 1.66 1.54
Total 1 9.54 0.83 1.54 76 1 5.9 63.10 6.99 4.47 1.72 1.70
This table presents country-level proxies for legal institutions, transparency, and government
quality. LOrg is legal origin indicator (equal 1 for a common-law origin and 0 for a civil-law
origin). LEnf is the legal enforcement measure in La Porta et al. (1998). LICR is the law and order
index from ICR. LWGI is the time-variant rule of law index from WGI. Cifar measures the level of
accounting disclosure practice. Dreq is the disclosure requirement index from Hail and Leuz
(2006). DGCR is a survey-based financial disclosure index from Gelos and Wei (2005). NetPc is
internet users per 100 people from World Bank. BDL is bureaucratic delay index from La Porta
et al. (1999). TaxC is tax compliance index from La Porta et al. (1999). GE is the government
effectiveness index from WGI. CCP is the control of corruption index from WGI.
Portugal. For example, Greece has the lowest scores on legal enforcement and
law and order, while Italy has the lowest scores on all government quality
measures. On the other hand, highest scores on governance standards scatter
among countries, such as Finland, Norway, Singapore, Sweden, Switzerland,
and UK. From Table 3, Gov is positively correlated with all country governance
standards, suggesting that good governance practice is more prevalent in coun-
tries with stringent regulations and extensive disclosure practice. All country
governance standards are positively correlated with each other. The correlation
coefficients range from as high as 0.89 between GE and CCP to 0.03 between
LICR and Dreq. A country with strong legal institutions is very likely to have
good disclosure practices and government quality, and vice versa. However,
these different institutional aspects are not completely overlapped with each
other.

Table 3 Pearson pairwise correlation coefficients

Gov COE COD Size Beta BM Fbias Lev ROA gS Own Infl
COE 0.05
COD 0.03 0.04
Size 0.04 0.12 0.16
Beta 0.13 0.10 0.05 0.13
BM 0.28 0.14 0.06 0.14 0.11
Fbias 0.02 0.02 0.01 0.02 0.00 0.01
Lev 0.02 0.17 0.16 0.31 0.10 0.03 0.03
ROA 0.08 0.27 0.03 0.11 0.17 0.11 0.02 0.08
gS 0.01 0.01 0.00 0.01 0.00 0.01 0.00 0.00 0.00
Own 0.36 0.03 0.00 0.09 0.08 0.10 0.01 0.01 0.00 0.03
Infl 0.58 0.05 0.09 0.20 0.17 0.29 0.03 0.01 0.05 0.00 0.20
rL 0.44 0.11 0.10 0.16 0.12 0.21 0.03 0.02 0.07 0.00 0.04 0.43
LOrg 0.66 0.05 0.08 0.31 0.11 0.21 0.03 0.02 0.02 0.01 0.21 0.55
LEnf 0.40 0.01 0.01 0.11 0.01 0.10 0.01 0.03 0.02 0.01 0.24 0.13
LICR 0.03 0.05 0.03 0.04 0.16 0.03 0.01 0.01 0.02 0.01 0.15 0.07
LWGI 0.24 0.10 0.06 0.09 0.07 0.08 0.03 0.03 0.02 0.02 0.14 0.14
Cifar 0.29 0.04 0.06 0.13 0.01 0.13 0.03 0.01 0.03 0.01 0.21 0.31
Dreq 0.63 0.05 0.02 0.24 0.15 0.17 0.01 0.02 0.02 0.00 0.19 0.37
DGCR 0.58 0.16 0.15 0.24 0.07 0.21 0.04 0.03 0.08 0.01 0.27 0.58
NetPc 0.55 0.06 0.04 0.14 0.09 0.18 0.01 0.05 0.03 0.01 0.24 0.31
BD 0.49 0.02 0.05 0.19 0.09 0.13 0.01 0.04 0.03 0.02 0.16 0.19
TaxC 0.31 0.10 0.01 0.12 0.09 0.04 0.00 0.03 0.01 0.00 0.15 0.03
GE 0.29 0.12 0.06 0.13 0.08 0.09 0.03 0.02 0.01 0.01 0.14 0.28
CCP 0.07 0.14 0.06 0.07 0.12 0.03 0.03 0.01 0.00 0.01 0.08 0.15
rL LOrg LEnf LICR LWGI Cifar Dreq DGCR NetPc BDL TaxC GE
LOrg 0.47
LEnf 0.06 0.39
LICR 0.08 0.26 0.55
LWGI 0.27 0.35 0.73 0.72
Cifar 0.12 0.53 0.42 0.57 0.61
Dreq 0.16 0.82 0.44 0.03 0.10 0.34
DGCR 0.54 0.69 0.43 0.79 0.75 0.72 0.16
NetPc 0.24 0.45 0.79 0.38 0.61 0.44 0.46 0.43
BD 0.28 0.56 0.78 0.21 0.57 0.23 0.60 0.15 0.69
TaxC 0.08 0.53 0.61 0.27 0.38 0.50 0.65 0.05 0.53 0.61
GE 0.18 0.46 0.68 0.65 0.89 0.61 0.26 0.70 0.55 0.59 0.33
CCP 0.05 0.30 0.55 0.73 0.86 0.62 0.02 0.78 0.40 0.42 0.28 0.89
This table presents the Pearson correlation coefficients for the key firm characteristics and country
governance measures. Gov is corporate governance index detailed in Appendix B. COE is the average of
implied cost of equity capital of rCT, rOJ, rGLS, and rPEG. COD is the cost of debt capital. Size is total assets
in US$ thousands. Beta is market beta in the June of year t. BM is book-to-market equity ratio. Fbias is
the analyst forecast bias. Lev is defined as total debt scaled by total assets. ROA is the return on assets.
gS is annual sales growth from year t 1 to year t. Own is the % of closely held number of shares by
insiders. Infl is the median of the current years annualized monthly inflation rates. rL is the bank rate
that meets the short- and medium-term financing needs of the private sector. LOrg is legal origin
indicator (equal 1 for a common-law origin and 0 for a civil-law origin). LEnf is the legal enforcement
measure in La Porta et al. (1998). LICR is the law and order index from ICR. LWGI is the time-variant rule
of law index from WGI. Cifar measures the level of accounting disclosure practice. Dreq is the disclosure
requirement index from Hail and Leuz (2006). DGCR is a survey-based financial disclosure index from
Gelos and Wei (2005). NetPc is internet users per 100 people from World Bank. BDL is bureaucratic delay
index from La Porta et al. (1999). TaxC is tax compliance index from La Porta et al. (1999). GE is the
government effectiveness index from WGI. CCP is the control of corruption index from WGI.

III. CORPORATE GOVERNANCE, GOVERNANCE COMPONENTS,

AND THE COST OF CAPITAL
A. Corporate governance and the cost of capital
In this section, I examine the relation between corporate governance and the
cost of capital. Good governance could positively affect firm value through two
channels. One channel is through the increased expected cash flows as good
corporate governance may align the objectives of management with sharehold-
ers and increase future growth opportunities. The other channel is through the
reduced cost of capital as good corporate governance may reduce insider expro-
priation and information risk, and therefore lead to lower costs of external
financing. To test the latter, I regress the cost of capital on a firms governance
proxy and an extensive collection of risk and control variables which are
demonstrated to affect a firms cost of capital. The regression results are pre-
sented in Table 4. All regressions account for the fact that the same firm enters
the sample multiple times by clustering standard errors at the firm-level while
controlling for year-, industry-, and country-fixed effects.
Panel A of Table 4 shows the association between governance and the cost of
equity capital with different combinations of control variables. Gov is negatively
associated with the cost of equity. The coefficient is 0.025 in Model 1 and is
statistically and economically significant, indicating that an improvement of
corporate governance quality from the 25th (Gov = 0.41) to 75th (Gov = 0.64)
percentiles would translate into an average reduction in the cost of equity of
0.58% (0.025 (0.64 0.41)). This result suggests that improving corporate
governance quality could reduce the possible equity risks associated with an
individual firm and hence, decrease the firms equity financing costs. The cost
reduction associated with good corporate governance remains strongly signifi-
cant and robust to a variety of risk proxies and country control variables. Model
3 serves as the baseline model for following tests on the cost of equity.
Effects of the control variables on the cost of equity are consistent with those
reported by prior studies (Hail and Leuz 2006; Chen et al. 2009). The coefficient
of Infl is positive and statistically significant. In addition, results show that
conventional risk proxies, such as Size, BM, and Beta, yield signs consistent with
those of existing evidence and are all statistically significant at the 1% level (see,
for example, Fama and French 1992). A positive coefficient on Fbias indicates
that the market understands that an optimistic forecast would lead to an
upward bias, and it adjusts to this forecast bias properly. I also measure the
impacts of other relevant variables on the cost-governance association in
Models 4 and 5. The coefficient of sales growth is negative and significant,
suggesting firms with great growth potential have lower cost of equity. Owner-
ship concentration measured by closely held ownership is negatively associated
with the cost of equity.
Panel B of Table 4 shows evidence of association between governance and the
cost of debt. Similar to Panel A, the improvement in corporate governance is

Table 4 Corporate governance, governance components, and the cost of capital

Panel A: Dependent variable = COE
1 2 3 4 5 6 7 8 9 10
Gov 0.025 0.026 0.008 0.008 0.007

(6.02) (6.19) (1.88) (2.02) (1.70)
Board 0.006 0.001
(1.85) (0.31)
AT 0.001 0.001
(0.37) (0.41)
Aud 0.005 0.004
(3.16) (2.65)
Comp 0.007 0.006
(2.73) (2.26)
Size 0.002 0.002 0.002 0.002 0.002 0.002 0.002 0.002
(8.10) (7.98) (8.04) (8.56) (9.06) (8.89) (8.41) (8.30)
Beta 0.006 0.006 0.006 0.006 0.006 0.006 0.006 0.006
(9.74) (9.61) (9.61) (9.72) (9.72) (9.74) (9.70) (9.72)
BM 0.014 0.014 0.015 0.015 0.015 0.014 0.014 0.014
(9.92) (9.83) (9.98) (10.07) (10.24) (10.11) (10.02) (9.93)
Fbias 0.005 0.005 0.005 0.005 0.005 0.005 0.005 0.005
(2.16) (2.15) (2.16) (2.16) (2.15) (2.16) (2.15) (2.15)
gS 0.001
(2.02)
Own 0.019
(0.10)
Infl 0.173 0.174 0.174 0.160 0.172 0.170 0.170 0.172 0.171
(4.81) (4.68) (4.67) (4.24) (4.63) (4.56) (4.55) (4.60) (4.57)
Constant 0.103 0.099 0.099 0.099 0.100 0.098 0.095 0.100 0.099 0.102
(32.87) (29.96) (22.48) (22.46) (22.07) (22.95) (23.34) (23.39) (23.31) (21.65)
Nobs 9,441 9,441 9,196 9,173 8,907 9,196 9,196 9,196 9,196 9,196
R2 13.90% 14.10% 19.57% 19.56% 19.73% 19.57% 19.52% 19.67% 19.65% 19.71%
Panel B: Dependent variable = COD
11 12 13 14 15 16 17 18 19 20
Gov 0.299 0.306 0.132 0.125 0.133

(4.63) (4.79) (2.07) (1.97) (1.98)
Board 0.119 0.083
(2.12) (1.74)
AT 0.004 0.020
(0.09) (0.42)
Aud 0.029 0.009
(1.21) (0.36)
Comp 0.071 0.047
(2.27) (1.71)
Size 0.028 0.027 0.028 0.028 0.030 0.030 0.029 0.028
(6.44) (6.40) (6.22) (6.54) (7.11) (7.07) (6.79) (6.45)
Lev 0.336 0.342 0.335 0.335 0.334 0.334 0.335 0.335
(8.51) (8.65) (8.39) (8.47) (8.46) (8.45) (8.50) (8.47)
ROA 0.002 0.002 0.002 0.002 0.002 0.002 0.002 0.002
(1.72) (1.47) (1.30) (1.74) (1.67) (1.70) (1.72) (1.74)
gS 0.005
(0.33)
Own 0.005
(0.15)
rL 0.351 0.185 0.162 0.122 0.036 0.033 0.022 0.138 0.103
(0.67) (0.36) (0.32) (0.23) (0.07) (0.06) (0.04) (0.27) (0.20)
Constant 0.442 0.425 0.760 0.751 0.767 0.766 0.723 0.742 0.744 0.789
(8.34) (6.84) (9.36) (9.27) (8.93) (9.35) (8.87) (9.33) (9.53) (8.97)
Nobs 9,041 9,041 8,996 8,977 8,684 8,996 8,996 8,996 8,996 8,996
R2 3.41% 3.40% 6.04% 6.11% 5.90% 6.06% 5.99% 6.01% 6.04% 6.04%
This table shows regressions of a firms corporate governance practice on its cost of equity capital (Panel A) and cost of debt (Panel B).
Gov is corporate governance index detailed in Appendix B. Board is the sub-index of Gov for board independence. AT is the sub-index
of Gov for anti-takeover provisions. Aud is the sub-index of Gov for audit quality. Comp is the sub-index of Gov for executive
compensations. COE is the average of implied cost of equity capital of rCT, rOJ, rGLS, and rPEG. COD is the cost of debt capital. Size is total
assets in US$ thousands. Beta is market beta in the June of year t. BM is book-to-market equity ratio. Fbias is the analyst forecast bias.
The coefficients of Fbias are multiplied by 100. Lev is defined as total debt scaled by total assets. ROA is the return on assets. gS is annual
sales growth from year t 1 to year t. Own is the % of closely held number of shares by insiders. The coefficients of gS and Own are
multiplied by 100. Infl is the median of the current years annualized monthly inflation rates. rL is the bank rate that meets the short-
and medium-term financing needs of the private sector. t-statistics are computed based on clustered standard errors at the firm level,
displayed in parentheses under coefficients. Statistically significant coefficients at the 10% level are displayed in bold. Nobs is number
of observations. R 2 is the adjusted R2. Year, industry, and country-fixed effects are included. Sample period is from 2002 to 2005.

associated with a lower cost of debt. The coefficient of Gov is 0.299 in

Model 1. When a firm improves its corporate governance quality from the
bottom 25% to the top 25%, its cost of debt is decreased by 6.88% (0.299 (0.64
0.41)). The negative governance and the cost of debt relationship continues to
hold when I control for lending rate, size, leverage, and ROA in Model 13, which
serves as the baseline model for the following tests of a relation between
internal governance and the cost of debt. Firm size and growth rate are nega-
tively associated with the cost of debt. I interpret the negative coefficient of
leverage as a cumulative effect of low cost of debt, rather than the default risk
of a firm.
In summary, governance improvement is associated with lower costs of both
equity and debt, which supports the prediction that good governance would
enhance management monitoring and reduce insiders expropriation. Consis-
tent with prior studies, industry, and country-fixed effects are jointly significant
for all models. The baseline models could explain about 20% of international
variations of firms cost of equity and 6% of variations of firms cost of debt,
which are broadly comparable with other studies (Francis et al. 2005; Hail and
Leuz, 2006).
B. The role of governance components

The interactions between governance mechanisms determine the effectiveness
of a firms total governance structure (Shleifer and Vishny, 1997). Different
mechanisms may serve as complements or substitutes for one another. For
example, Cremers and Nair (2005) finds that the market for corporate control
is important only in the presence of an active body of shareholders when
investigating the equity prices. Gillan et al. (2006), however, shows that board
independence serves as a substitute for the market for corporate control. A
summary governance index may contaminate the real effects of individual
attributes if they are substitutes. In this section, I break Gov into four different
subcategories, namely board (Board), anti-takeover (AT), audit (Aud), and com-
pensation and ownership (Comp) to determine the association between each
subcategory and both cost of equity and cost of debt.
In Table 4, Gov is replaced with one of its subcomponents in Model 6 to 9
and Model 16 to 19 for the cost of equity and cost of debt, respectively. All
subcomponents are included in Model 10 and Model 20. In Panel A, Board
coefficient under the cost of equity is 0.006, and is significant at the 10%
level. The responsibilities of a board of directors are to provide independent
oversight of management and to hold management accountable to sharehold-
ers for its actions. The quality of the board directly affects the terms at which
firms could access outside capital (Coles et al. 2008). Another aspect of cor-
porate governance, Aud, has a highly significant coefficient of 0.005 in
Model 8. Audit practice influences the integrity of accounting process and
ensures soundness and quality of internal control process. Hence, the audit
quality determines the accuracy of the information to outside investors and is

negatively related to the cost of equity. Model 9 shows that Comp is 0.007,
significant at the 1% level. Compensation and ownership relates to how
executive remuneration promotes management monitoring and enhances the
long-term success of a firm. This suggests that shareholders may view the
appropriate use of options and other equity awards as leading to increased
monitoring and lower risks. In Panel B with the cost of debt, Board continues
to stay negative and, is statistically significance at the 5% level, which is
consistent with the findings in Anderson et al. (2004). In Model 19, the coef-
ficient of Comp is 0.071, indicating that a reasonable compensation structure
may lower the risks faced by creditors.
AT provisions are probably most controversial in the corporate governance
literature. Shareholders perceive takeover-facilitating provisions as beneficial
because their rights become stronger when they are able to replace management
if necessary. On the contrary, creditors prefer entrenched management as credi-
tors could easily be a victim of wealth transfer and asset substitution in the
event of a takeover. In studies of US firms, a takeover defense adversely affects
firm value, yet it leads to lower borrowing costs (Gompers et al. 2003; Klock
et al. 2005). However, in this study, AT does not significantly affect either the
cost of equity or the cost of debt, possibly because of the fact that a takeover
event is not as important for international firms as it is for US firms. All
subcomponents of governance are included for the cost of equity in Model 10,
and for the cost of debt in Model 20. Comp and Aud appear to dominate other
aspects of governance in reducing the cost of equity, while Board and Comp
seem to matter the most to creditors.
IV. INVESTOR PROTECTIONS, CORPORATE GOVERNANCE, AND

THE COST OF CAPITAL
It has been shown that good corporate governance is associated with lower cost
of equity and cost of debt capital across the world. However, it is still largely
unclear whether and how the associations between internal governance and the
external financing costs vary under different levels of country legal institutions,
disclosures practices, and political environments. Previous literature proposes
two hypotheses regarding the relation between firm-level and country-level
governance. One, they serve as complements to each other. Doidge et al. (2007)
argue that better governance reduces a firms cost of funds only to the extent
that the firm commits itself credibly to higher quality governance. Strong
country institutions reduce the costs for firms to adopt higher standards and
increase the credibility of good governance practice (Aggarwal et al. 2009).
Alternatively, they serve as substitutes to each other. Firm-level governance
practice may be more valuable in countries with weak institutions, i.e., where it
is scarce (Durnev and Kim 2005).
To examine how country-level and firm-level governance interact in affecting
the costs of equity and debt, I divide the sample into highlow groups based on

yearly median values of country proxies for legal institutions, disclosure prac-
tices, and government quality. The relation between corporate governance and
the cost of capital is evaluated in each subsample. The benefit of using highlow
groups rather than interaction terms is that the regression coefficients are
allowed to behave differently in two subsamples.
A. Legal institutions, corporate governance, and the cost of capital

Table 5 shows the estimates of regressions of firms external financing costs on
the internal governance practice in highlow groups of legal institutions. Panel
A exhibits results with respect to the cost of equity. First, Govs coefficient is
0.018 and significant at the 1% level in common-law countries, while its
coefficient is 0.011 and insignificant in civil-law countries. Second, I examine
the role of internal governance given the highlow levels of legal enforcement,
as legal enforcement may determine the effectiveness of a set of formal rules
that govern investor protection. The association between governance practice
and the cost of equity is still negative and statistically significant in countries
with strong enforcement. Next, I investigate the governance cost of equity
association in a dichotomy based on time-varying indices, LICR and LWGI,
respectively. The coefficient of Gov is very significant at the 1% level in countries
with high levels of LICR and LWGI.
It is very likely that the selected four proxies for legal institutions incorporate
aspects of country governance and regulation other than legal institutions. To
enhance the efficiency and efficacy of these proxies in capturing the underlying
country governance characteristic, I perform the principal component analysis
based on the correlation matrix within the four proxies for legal institutions.
The first principal component explains 63% of the variations among legal
institution measures. I divide the sample into high and low groups based on the
first principal components for legal institutions (PCA). The results remain vir-
tually unchanged.
I further evaluate and compare the magnitude of Govs coefficients in high
low groups of legal institutions. First, the standardized coefficients of the
governance index in strong legal institutions are larger in magnitude than those
in weak legal institutions. Second, I use a one-tailed t-test to examine whether
the documented relation is statistically stronger in countries with strong legal
regime than in countries with weak legal regime.7 Supporting evidence is found
in divisions based on LICR, LWGI, and PCA, where p-values are below the 1%
significance level.
Shareholders receive contingent payments of future profits and rely upon the
board of directors to detect the wrongs. Therefore, they are especially concerned
with the quality of firm-level governance to constrain opportunistic behavior
and agency problems. Strong legal institutions associated with independent
7 The null hypothesis is {H0: Govhigh,COE Govlow,COE}, where Govhigh,COE and Govlow,COE represent
Govs coefficients for COE regressions in strong and weak institutions, respectively.

Table 5 Legal institutions, corporate governance, and the cost of capital

LOrg LEnf LICR LWGI PCA
High Low High Low High Low High Low High Low
Gov 0.018 0.011 0.014 0.025 0.040 0.001 0.036 0.001 0.037 0.0003
(2.78) (1.09) (2.19) (2.51) (4.09) (0.11) (3.24) (0.23) (3.91) (0.07)
Size 0.002 0.002 0.002 0.002 0.003 0.002 0.004 0.002 0.003 0.002
(3.94) (3.12) (3.32) (4.11) (4.21) (7.09) (4.46) (7.11) (4.64) (6.83)
Beta 0.010 0.012 0.008 0.013 0.011 0.006 0.010 0.006 0.010 0.006
(7.79) (6.83) (5.42) (8.73) (5.76) (8.09) (3.64) (9.26) (5.67) (8.15)
BM 0.016 0.023 0.030 0.013 0.021 0.014 0.029 0.012 0.022 0.014
(6.70) (8.27) (9.43) (5.47) (5.94) (8.78) (7.68) (8.04) (6.35) (8.68)
Fbias 0.037 0.004 0.032 0.004 0.040 0.004 0.005 0.005 0.035 0.004
(1.83) (3.46) (2.04) (2.21) (1.91) (2.61) (0.86) (2.16) (1.75) (2.62)
Infl 0.079 0.381 0.233 0.170 0.194 0.129 0.260 0.136 0.263 0.131
(1.99) (5.67) (4.22) (2.50) (2.35) (2.37) (3.00) (3.04) (3.69) (2.37)
Constant 0.105 0.101 0.090 0.108 0.128 0.095 0.136 0.094 0.124 0.095
(11.79) (8.06) (9.61) (9.77) (10.43) (20.04) (8.85) (21.28) (10.91) (19.81)
Nobs 6,450 2,746 6,005 3,191 1,769 7,427 1,550 7,646 1,952 7,244
R2 16.31% 31.17% 19.77% 24.06% 25.10% 20.36% 28.33% 19.91% 24.79% 20.57%
Govstd 0.084 0.027 0.069 0.077 0.141 0.003 0.124 0.006 0.131 0.002
Pvalue 0.27 0.17 0.00 0.00 0.00
Gov 0.030 0.245 0.018 0.378 0.021 0.074 0.025 0.248 0.046 0.294
(0.40) (1.66) (0.22) (2.76) (0.18) (0.94) (0.18) (2.75) (0.47) (2.61)
Size 0.031 0.019 0.031 0.026 0.033 0.028 0.033 0.024 0.032 0.024
(5.70) (2.54) (5.36) (3.47) (3.85) (5.26) (4.83) (4.66) (5.35) (3.80)
Lev 0.330 0.353 0.320 0.356 0.410 0.307 0.480 0.236 0.368 0.234
(6.71) (5.72) (6.36) (5.81) (4.12) (7.55) (4.71) (5.63) (4.70) (5.56)
ROA 0.106 0.107 0.092 0.140 0.328 0.045 0.444 0.111 0.215 0.077
(1.68) (0.44) (1.41) (0.86) (2.35) (0.69) (3.09) (0.79) (1.84) (0.41)
rL 0.129 3.894 1.339 2.755 2.503 0.774 2.777 0.792 2.847 0.624
(0.15) (2.67) (2.02) (1.39) (1.62) (1.35) (2.37) (1.49) (2.38) (0.97)
Constant 0.753 0.583 0.593 0.819 0.725 0.665 0.764 0.730 0.673 0.785
(6.83) (2.33) (6.13) (4.50) (4.95) (7.20) (5.47) (5.92) (5.73) (4.85)
Nobs 6,133 2,863 5,481 3,515 2,013 6,983 1,676 7,320 2,175 6,821
R2 4.27% 14.85% 4.21% 12.52% 10.49% 6.46% 14.80% 6.11% 9.94% 6.45%
Govstd 0.007 0.054 0.005 0.091 0.006 0.024 0.008 0.077 0.013 0.095
Pvalue 0.10 0.01 0.25 0.09 0.05
This table provides the differential relations between corporate governance and the cost of capital under different levels
of legal institutions. Gov is corporate governance index detailed in Appendix B. COE is the average of implied cost of
equity capital of rCT, rOJ, rGLS, and rPEG. COD is the cost of debt capital. Size is total assets in US$ thousands. Beta is market
beta in the June of year t. BM is book-to-market equity ratio. Fbias is the analyst forecast bias. The coefficients of Fbias
are multiplied by 100. Lev is defined as total debt scaled by total assets. ROA is the return on assets. Infl is the median
of the current years annualized monthly inflation rates. rL is the bank rate that meets the short- and medium-term
financing needs of the private sector. LOrg is legal origin indicator (equal 1 for a common-law origin and 0 for a civil-law
origin). LEnf is the legal enforcement measure in La Porta et al. (1998). LICR is the law and order index from ICR. LWGI
is the time-variant rule of law index from WGI. PCA is the first principal component calculated from the coefficient
matrix of LOrg, LEnf, LICR, and LWGI. High LOrg indicates countries from the common-law origin, and Low from the
civil-law origin. Countries with above median LEnf, LICR, LWGI, and PCA are classified as High; otherwise, they are
Low. t-statistics are computed based on clustered standard errors at the firm level, displayed in parentheses under
coefficients. Statistically significant coefficients at the 10% level are displayed in bold. Nobs is number of observations.
R 2 is the adjusted R2. Standardized coefficient of Gov (Govstd) is presented at the bottom. Pvalue is for the one-tailed t-test
comparing the magnitude of Govs coefficients between high and low groups of country-level institutions. Year,
industry, and country-fixed effects are included. Sample period is from 2002 to 2005.

judicial systems and broader standards (including fiduciary duties) would make
it optimal to invest more in internal governance and also increase its creditability
(La Porta et al. 2008; Aggarwal et al. 2009). On the other hand, weak country-
level investor protection makes it more costly to improve internal governance.
Even firms find ways to commit to higher governance standards, they may still
have difficulty accessing to capital market on better terms as countries with poor
investor protection are often associated with less financial development.
Panel B presents the results with respect to the cost of debt. On the whole, the
relation between internal governance and the cost of debt is more pronounced
in countries with weak legal institutions than in countries with strong legal
institutions. For example, the coefficient of Gov is 0.245 and significant at the
10% level in civil-law countries, compared with an insignificant coefficient of
0.030 in common-law countries. The similar results also appear when the legal
enforcement index, time-varying rule of law index, as well as the first principal
component are used. Furthermore, The standardized coefficients and a one-
tailed t-test are employed to compare Govs coefficient in weak institutions with
that in strong institutions.8 Results show an economically and statistically larger
coefficient of Gov in countries with weak legal institutions than that in strong
legal institutions.
Creditors receive contractual fixed payments. The value of good internal
governance practices may not be prominent in countries with strong legal
institutions, but can be more appreciated by creditors when the external legal
protection is weak. Moreover, in countries with poor legal institutions, domi-
nant shareholders are prevalent and can easily exchange low-risk assets for
high-risk investment, which could expose debtholders to the risk of asset
substitution (John et al. 2008). Strong firm-level governance mechanisms can
restrict the insider expropriation and thus protect creditors.
The findings are different from what have been documented in Chen et al.
(2009) and Ge et al. (2012). It is noteworthy that the sample of Chen et al.
(2009) mostly covers Asian countries and emerging economies while the focus
of this study is the developed economies. It is very likely that good internal
governance practice may signal the superior quality of the firm when the overall
investor protection is limited and financial markets are relatively small, which
can lead to a different conclusion than the one made here. Ge et al. (2012) find
that the favorable effect of internal governance on bank loan contracting terms
is stronger in countries with strong legal institutions than in countries with
weak legal institutions. However, their finding is only limited to nonprice
loan terms, i.e., loan size and maturity, which cannot be directly compared
with the results in this study where the cost of debt capital (a price term) is
examined.
8 The null hypothesis is {H0: Govlow,COD Govhigh,COD}, where Govlow,COD and Govhigh,COD represent
Govs coefficients for COD regressions in weak and strong institutions, respectively. The
p-values are below 10% and the null hypothesis is rejected when LEnf, LWGI, and PCA are used
to construct highlow groups.

B. Disclosure, corporate governance, and the cost of capital

In this section, I specifically address the issues of informational risk and
disclosure practices. The quality of information is of great importance to
shareholders because they are most adversely affected by informational asym-
metries (Myers and Majluf 1984). Creditors also value information disclosures
as they make creditors better able to monitor potential violations in their debt
agreements. In this section, I examine how the informational environment
interacts with corporate governance in affecting the costs of equity and debt
capital.
Panel A of Table 6 presents the results on the association between governance
practice and the cost of equity. I first examine this association with a country-
level accounting transparency index, Cifar, which includes both mandatory and
voluntary disclosures. The coefficient of Gov is 0.017 and significant at the 1%
level in countries with the high level of accounting transparency, but is 0.010
and insignificant in countries with the low level of accounting transparency.
Compared with Cifar that assesses extensive accounting standards, Dreq mea-
sures the institutional disclosure requirements (Hail and Leuz 2006). Govs
coefficient is 0.008 in countries with stringent disclosure requirements, at a
significance level of 10%. A similar pattern also appears when a survey index on
the level and availability of financial disclosure (DGCR) is employed. Lastly, a
time-variant transparency index is adopted to measure internet usage per 100
people (NetPc), which evaluates the speed of obtaining new information. The
relation between corporate governance and the cost of equity is more pro-
nounced in countries with more internet usage than in countries with less
internet usage.
Previous findings are further corroborated when the principal component
analysis, standardized coefficients and a one-tailed t-test of Govs coefficients are
employed. Firm-level disclosures reduce information asymmetries between the
firm and its investors, but only if they are credible and not self-serving (e.g.,
Verrecchia 2001). Shareholders are particularly concerned with information
asymmetries, as their stock valuation is tied to the quality of firms disclosures.
Good country-level informational environments complement internal gover-
nance in reducing information asymmetries, and thus decreasing the cost of
equity.
On the contrary, Panel B shows that the relation between internal
governance and the cost of debt is more pronounced in less transparent
environments. In particular, Gov carries a significant coefficient in countries
with less accounting transparency, lower disclosure requirements, and less
internet usage, while its coefficient is insignificant in countries with higher
levels of accounting disclosures, disclosure requirements, and internet
usage. The same results also emerge when I use the first principal com-
ponent based on four transparency measures. Furthermore, Govs coefficient
is economically and statistically larger in countries with opaque infor-
mational environments than in countries with transparent informational

Table 6 Transparency, corporate governance, and the cost of capital

Cifar Dreq DGCR NetPc PCA
Gov 0.017 0.010 0.008 0.009 0.034 0.010 0.019 0.012 0.036 0.011
(2.73) (0.82) (1.93) (0.57) (3.38) (0.68) (3.32) (0.88) (3.89) (0.68)
Size 0.002 0.002 0.002 0.006 0.004 0.001 0.002 0.002 0.003 0.003
(5.58) (2.52) (6.91) (4.67) (5.08) (1.74) (5.00) (2.97) (4.79) (3.18)
Beta 0.010 0.011 0.006 0.013 0.013 0.007 0.010 0.011 0.011 0.012
(8.05) (5.58) (8.95) (3.26) (7.00) (4.00) (8.53) (5.64) (5.75) (5.26)
BM 0.023 0.015 0.011 0.042 0.025 0.013 0.018 0.021 0.021 0.016
(9.26) (5.49) (8.23) (7.28) (6.58) (4.32) (8.19) (6.68) (6.25) (4.77)
Fbias 0.038 0.004 0.004 0.124 0.057 0.003 0.010 0.004 0.035 0.004
(2.23) (3.09) (2.26) (10.44) (3.07) (3.69) (1.45) (2.74) (1.77) (3.22)
Infl 0.129 0.417 0.068 0.100 0.172 0.390 0.213 0.233 0.197 0.319
(3.28) (4.72) (1.79) (0.70) (2.09) (2.95) (5.13) (2.15) (2.79) (2.85)
Constant 0.108 0.090 0.099 0.137 0.130 0.104 0.104 0.091 0.127 0.120
(12.73) (6.54) (22.94) (7.45) (10.82) (7.63) (12.69) (6.47) (10.94) (7.40)
Nobs 6,940 2,256 8,283 913 1,876 2,266 7,459 1,737 1,862 2,280
R2 17.43% 29.61% 18.00% 39.88% 28.06% 25.69% 19.09% 27.22% 23.21% 29.38%
Govstd 0.078 0.022 0.044 0.023 0.113 0.025 0.095 0.028 0.129 0.024
Pvalue 0.32 0.15 0.09 0.02 0.08
Gov 0.016 0.519 0.057 0.420 0.090 0.175 0.032 0.522 0.061 0.453
(0.22) (2.69) (0.83) (1.90) (0.73) (0.80) (0.44) (3.11) (0.40) (2.62)
Size 0.031 0.020 0.026 0.044 0.039 0.008 0.029 0.026 0.033 0.020
(5.91) (2.25) (5.74) (2.50) (4.37) (1.14) (5.91) (2.53) (4.01) (2.42)
Lev 0.342 0.322 0.292 0.905 0.486 0.228 0.331 0.348 0.429 0.309
(7.07) (5.20) (7.49) (4.66) (4.59) (3.76) (7.44) (4.90) (4.17) (4.96)
ROA 0.100 0.166 0.091 0.292 0.360 0.241 0.100 0.147 0.274 0.165
(1.62) (0.56) (1.54) (0.83) (2.38) (0.83) (1.63) (0.51) (1.87) (0.55)
rL 0.665 3.204 0.341 5.359 0.771 3.163 0.821 3.822 0.553 2.016
(1.05) (1.62) (0.60) (2.77) (0.42) (1.81) (1.26) (1.90) (0.30) (1.06)
Constant 0.688 0.756 0.663 1.017 0.852 0.471 0.656 0.827 0.821 0.686
(7.27) (2.97) (7.74) (2.47) (5.21) (1.79) (7.27) (3.16) (4.19) (2.98)
Nobs 6,552 2,444 8,109 887 2,093 2,464 7,114 1,882 2,094 2,463
R2 4.54% 14.88% 5.47% 22.05% 13.92% 10.23% 5.30% 15.10% 10.14% 15.13%
Govstd 0.004 0.100 0.018 0.078 0.023 0.041 0.009 0.112 0.016 0.090
Pvalue 0.01 0.06 0.37 0.00 0.01
of transparency measures. Gov is corporate governance index detailed in Appendix B. COE is the average of implied cost
of equity capital of rCT, rOJ, rGLS, and rPEG. COD is the cost of debt capital. Size is total assets in US$ thousands. Beta is
market beta in the June of year t. BM is book-to-market equity ratio. Fbias is the analyst forecast bias. The coefficients
of Fbias are multiplied by 100. Lev is defined as total debt scaled by total assets. ROA is the return on assets. Infl is the
median of the current years annualized monthly inflation rates. rL is the bank rate that meets the short- and
medium-term financing needs of the private sector. Cifar measures the level of accounting disclosure practice. Dreq is
the disclosure requirement index from Hail and Leuz (2006). DGCR is a survey-based financial disclosure index from
Gelos and Wei (2005). NetPc is internet users per 100 people from World Bank. PCA is the first principal component
calculated from the coefficient matrix of Cifar, Dreq, DGCR, and NetPc. Countries with above median Cifar, Dreq, DGCR,
NetPc, and PCA are classified as High; otherwise, they are Low. t-statistics are computed based on clustered standard
errors at the firm level, displayed in parentheses under coefficients. Statistically significant coefficients at the 10% level
are displayed in bold. Nobs is number of observations. R 2 is the adjusted R2. Standardized coefficient of Gov (Govstd) is
presented at the bottom. Pvalue is for the one-tailed t-test comparing the magnitude of Govs coefficients between high
and low groups of country-level institutions. Year, industry, and country-fixed effects are included. Sample period is
from 2002 to 2005.

environments.9 Creditors are less adversely affected by information asymme-

tries. In countries that offer limited access to information, accounting
numbers revealed by a well-disciplined company could assist creditors to
accurately assess risks of their investment. However, in countries with high
informational transparency, firm-level governance becomes less important in
reducing information risks for creditors.
C. Government quality, corporate governance, and the cost of capital

Government quality is another important factor that greatly affects sharehold-
ers and creditors. Political institutions are directly related to countrys overall
macroeconomic stability, which in turn affects firms future profitability and
payoffs to shareholders (Roe 2006). The quality of government also influences
the constancy of legal institutions, and thus whether the terms in a given debt
contract remain valid. In this section, I examine how government quality
interacts with corporate governance in affecting the costs of equity and debt
capital.
Panel A of Table 7 shows the relation between corporate governance and the
cost of equity in countries with different levels of government quality. Consis-
tent with the previous arguments, high government quality complements the
internal governance practice in decreasing the cost of equity. Supporting evi-
dence is found with all four measures of government quality and political risk.
For example, the coefficient of Gov is 0.030 in countries with more bureau-
cratic delay, which is statistically significant at the 5% level. Govs coefficient is
0.002 and insignificant in countries with less bureaucratic delay. Furthermore,
the complementary relation is statistically stronger in countries with good
government quality than in countries with poor government quality. Results
show that good internal governance is associated with lower cost of equity in
countries with strong political institutions. In countries with high political
risks, good corporate governance alone is insufficient to ensure the protection of
shareholders benefits as well as the upside potential of their investments.
Panel B reports the estimates of regressions of the cost of debt on internal
governance given highlow levels of political institutions. The coefficient of Gov
is negative and statistically significant at the 5% level in countries with
low levels of government efficiency and effectiveness. However, the internal
governance is not significantly associated with the cost of debt when country-
level control of corruption is weak. Greater corruptions divert away the assets
that firms use to support debt payments, which cannot be restored with any
firm-level self-discipline (Qi et al. 2010). In short, evidence suggests that politi-
cal stability and government quality affect the interplay between the corporate
9 The standardized coefficients of Gov from the low groups are greater than the ones from the
high groups across all four transparency measures. P-values from one-tailed t-tests of Govs
coefficients are less than 10% in high and low groups of Cifar, Dreq, and NetPc.

Table 7 Government quality, corporate governance, and the cost of capital

BD TaxC GE CCP PCA
Gov 0.030 0.002 0.008 0.004 0.032 0.001 0.032 0.003 0.019 0.005
(2.38) (0.35) (1.78) (0.25) (3.61) (0.16) (3.38) (0.66) (3.01) (0.43)
Size 0.001 0.002 0.002 0.005 0.003 0.002 0.004 0.002 0.003 0.001
(2.35) (7.98) (7.09) (4.41) (4.25) (7.10) (5.71) (6.53) (6.56) (1.16)
Beta 0.012 0.005 0.006 0.012 0.009 0.006 0.011 0.005 0.011 0.011
(7.53) (7.53) (8.93) (3.41) (5.21) (8.27) (6.01) (8.24) (7.17) (7.06)
BM 0.011 0.017 0.012 0.040 0.023 0.013 0.022 0.014 0.024 0.017
(4.07) (9.24) (8.19) (7.40) (6.65) (8.61) (6.78) (8.92) (9.11) (6.15)
Fbias 0.004 0.100 0.004 0.138 0.038 0.004 0.035 0.004 0.034 0.004
(2.59) (2.93) (2.26) (18.70) (1.86) (2.70) (1.75) (2.65) (1.89) (3.09)
Infl 0.250 0.143 0.088 0.046 0.276 0.135 0.246 0.150 0.280 0.330
(2.79) (2.59) (2.24) (0.35) (4.00) (2.28) (3.00) (2.57) (6.18) (3.40)
Constant 0.100 0.097 0.099 0.134 0.118 0.096 0.129 0.093 0.109 0.062
(8.53) (20.17) (22.93) (7.33) (10.98) (19.86) (11.13) (19.85) (12.01) (4.50)
Nobs 6,232 2,774 8,234 962 1,908 7,288 1,973 7,223 5,473 3,533
R2 25.31% 19.90% 17.93% 39.14% 25.60% 20.57% 25.29% 20.67% 19.30% 23.64%
Govstd 0.147 0.005 0.040 0.011 0.119 0.004 0.107 0.017 0.082 0.029
Pvalue 0.02 0.43 0.00 0.00 0.03
Gov 0.007 0.244 0.056 0.475 0.075 0.210 0.038 0.063 0.035 0.351
(0.09) (1.97) (0.81) (2.26) (0.61) (2.20) (0.25) (0.84) (0.44) (2.87)
Size 0.035 0.017 0.026 0.035 0.032 0.025 0.038 0.026 0.035 0.016
(5.85) (2.28) (5.79) (2.10) (4.97) (4.23) (4.40) (5.07) (6.05) (2.59)
Lev 0.346 0.319 0.299 0.802 0.352 0.243 0.500 0.293 0.379 0.287
(6.79) (5.15) (7.54) (4.69) (4.19) (5.90) (4.82) (7.29) (7.29) (6.43)
ROA 0.115 0.001 0.093 0.315 0.171 0.146 0.316 0.048 0.076 0.159
(1.73) (0.01) (1.58) (0.85) (1.20) (1.00) (1.97) (0.75) (1.09) (1.33)
rL 0.839 4.829 0.473 4.810 2.105 0.950 2.806 0.687 2.704 4.298
(1.27) (2.16) (0.84) (2.46) (1.99) (1.67) (1.66) (1.22) (2.63) (1.93)
Constant 0.712 0.473 0.667 0.885 0.743 0.733 0.833 0.631 0.638 0.381
(6.80) (2.95) (7.86) (2.81) (6.36) (5.03) (4.62) (6.96) (6.01) (1.64)
Nobs 5,738 3,041 8,039 957 2,135 6,861 2,144 6,852 5,430 3,349
R2 5.16% 11.44% 5.57% 21.18% 9.53% 6.46% 11.31% 6.00% 4.99% 10.16%
Govstd 0.002 0.065 0.017 0.093 0.021 0.067 0.009 0.021 0.008 0.148
Pvalue 0.04 0.03 0.20 0.44 0.00
of government quality measures. Gov is corporate governance index detailed in Appendix B. COE is the average of
implied cost of equity capital of rCT, rOJ, rGLS, and rPEG. COD is the cost of debt capital. Size is total assets in US$ thousands.
Beta is market beta in the June of year t. BM is book-to-market equity ratio. Fbias is the analyst forecast bias. The
coefficients of Fbias are multiplied by 100. Lev is defined as total debt scaled by total assets. ROA is the return on assets.
Infl is the median of the current years annualized monthly inflation rates. rL is the bank rate that meets the short- and
medium-term financing needs of the private sector. BDL is bureaucratic delay index from La Porta et al. (1999). TaxC is
tax compliance index from La Porta et al. (1999). GE is the government effectiveness index from WGI. CCP is the control
of corruption index from WGI. PCA is the first principal component calculated from the coefficient matrix of BDL, TaxC,
GE, and CCP. Countries with above median BDL, TaxC, GE, CCP, and PCA are classified as High; otherwise, they are
Low. t-statistics are computed based on clustered standard errors at the firm level, displayed in parentheses under
coefficients. Statistically significant coefficients at the 10% level are displayed in bold. Nobs is number of observations.
R 2 is the adjusted R2. Standardized coefficient of Gov (Govstd) is presented at the bottom. Pvalue is for the one-tailed t-test
comparing the magnitude of Govs coefficients between high and low groups of country-level institutions. Year,
industry, and country-fixed effects are included. Sample period is from 2002 to 2005.

governance and the cost of debt. When government is not efficient to ensure
the protection of creditors, good corporate governance allows creditors to better
monitor and control potential violations in their debt agreements. However,
when government corruptions imperil the intactness of firms assets, firm-level
governance protection appears to be insignificant in reducing the cost of debt
capital.
D. Comparing governance between non-US and

US firms using matched pairs
One major issue with previous findings is the endogeneity problem. It is pos-
sible that some unobserved factors affect both corporate governance and the
cost of capital in various country environments. To address these issues, I adopt
a method suggested by Aggarwal et al. (2009) to match each foreign firm to a
comparable US firm using industry and propensity scores. The propensity score
is equal to the probability that a firm with given characteristics is a foreign firm
in a probit regression. A total of 5605 foreign firms are matched with US
counterparts based on industry and propensity scores. Approximately 83% of
the firms that invest more in governance than their matching US firm are
located in two countries, Canada and UK. The results of this experiment are not
subject to the endogeneity issue as the regressor becomes the governance index
of a different US firm than the governance index of the foreign firm whose costs
of external financing are measured. Table 8 presents the estimates of regressions
of foreign firms costs of external financing on the internal governance of US
counterparts. The coefficient of internal governance on the cost of equity is
negative and statistically significant at the 1% level in countries with high levels
of legal institutions, disclosure practice, and government quality, while the
coefficient of governance on the cost of debt is negative and statistically sig-
nificant only in countries with low levels of legal institutions, disclosure prac-
tice, and government quality. Results suggest that the country-level institutions
complement the internal governance in reducing the cost of equity while strong
internal governance substitutes for the weak institutions in reducing the cost of
debt.
The US is recognized for its strong financial development and superior
investor protection, hence, the internal governance of firms in the US can come
very close to the optimal level of corporate governance that a foreign firm
would have if it were not constrained by weaker institutions and lower devel-
opment compared with the US (Aggarwal et al. 2009). I further examine
whether a governance gap of a foreign firm from the US counterpart would
affect the costs of equity and debt capital. In Panel A of Table 8, GovGap has a
negative and statistically significant coefficient for the cost of equity capital in
countries with strong governance mechanisms. In Panel B of Table 8, GovGap has
a negative and statistically significant coefficient with the cost of debt capital in
countries with weak governance mechanisms. The coefficient of GovUS
stays negative and significant when GovGap is included. This finding provides

Table 8 Matching foreign firms to U.S. firms with propensity scores
Legal institutions Transparency Govm. quality
GovUS Gov Gap +/Gap GovUS Gov Gap +/Gap GovUS Gov Gap +/Gap
416
High Low High Low High Low High Low High Low High Low High Low High Low High Low
GovUS 0.023 0.007 0.053 0.019 0.054 0.021 0.024 0.002 0.046 0.024 0.047 0.026 0.026 0.006 0.045 0.038 0.046 0.041
(3.16) (1.00) (3.58) (1.11) (3.63) (1.26) (3.39) (0.29) (3.22) (1.37) (3.25) (1.45) (3.74) (0.85) (3.20) (2.04) (3.24) (2.20)
GGap 0.038 0.010 0.038 0.012 0.035 0.026
(3.82) (0.67) (3.99) (0.72) (3.73) (1.52)
NGap 0.032 0.013 0.033 0.015 0.030 0.029
(3.08) (0.85) (3.42) (0.91) (3.12) (1.73)
PGap 0.080 0.219 0.071 0.236 0.072 0.209
(3.69) (1.26) (3.25) (1.30) (3.31) (1.22)
Size 0.003 0.003 0.003 0.002 0.003 0.002 0.003 0.003 0.003 0.003 0.003 0.003 0.003 0.002 0.003 0.002 0.003 0.002
(4.76) (3.29) (4.38) (3.07) (4.47) (3.09) (4.82) (3.40) (4.61) (3.05) (4.69) (3.10) (4.84) (2.49) (4.66) (2.11) (4.75) (2.13)
Beta 0.010 0.011 0.009 0.011 0.009 0.011 0.010 0.010 0.009 0.011 0.009 0.011 0.009 0.013 0.009 0.013 0.009 0.013
(4.49) (5.36) (5.16) (5.55) (5.14) (5.57) (4.49) (4.57) (5.00) (5.03) (4.99) (5.06) (4.11) (5.76) (4.94) (5.87) (4.92) (5.90)
BM 0.024 0.017 0.022 0.017 0.023 0.017 0.023 0.018 0.022 0.018 0.022 0.017 0.025 0.018 0.023 0.018 0.024 0.018
(6.52) (4.95) (5.98) (5.03) (6.07) (5.03) (6.28) (4.82) (5.90) (4.83) (5.99) (4.82) (6.77) (4.87) (6.38) (5.05) (6.47) (5.05)
Fbias 0.043 0.004 0.037 0.004 0.037 0.004 0.040 0.004 0.035 0.004 0.035 0.004 0.040 0.004 0.035 0.004 0.035 0.004
(2.24) (3.11) (1.81) (3.07) (1.80) (3.07) (2.10) (3.20) (1.75) (3.23) (1.74) (3.23) (2.10) (3.05) (1.74) (3.20) (1.72) (3.20)
Infl 0.159 0.282 0.205 0.288 0.198 0.298 0.148 0.325 0.184 0.314 0.182 0.330 0.212 0.277 0.242 0.255 0.240 0.264
(1.97) (2.60) (2.59) (2.61) (2.46) (2.66) (2.06) (2.85) (2.62) (2.74) (2.59) (2.82) (2.94) (2.43) (3.45) (2.19) (3.40) (2.24)
Constant 0.135 0.132 0.135 0.115 0.138 0.116 0.137 0.132 0.133 0.127 0.136 0.128 0.139 0.120 0.131 0.110 0.134 0.111
(11.41) (10.78) (9.83) (7.61) (9.82) (7.69) (11.55) (8.82) (9.40) (7.33) (9.37) (7.39) (11.77) (9.26) (9.45) (6.87) (9.44) (6.97)
Nobs 1,795 2,353 1,795 2,353 1,795 2,353 1,806 2,152 1,806 2,152 1,806 2,152 1,870 2,095 1,870 2,095 1,870 2,095
R2 21.24% 0.2578 23.76% 26.79% 23.91% 26.90% 19.24% 0.2821 21.76% 29.10% 21.86% 29.21% 21.15% 0.2657 24.09% 27.67% 24.21% 27.81%

GovUS 0.075 0.185 0.040 0.650 0.022 0.626 0.062 0.144 0.023 0.581 0.090 0.559 0.046 0.189 0.009 0.599 0.075 0.569
(0.75) (2.97) (0.27) (2.93) (0.15) (2.78) (0.66) (2.23) (0.15) (2.65) (0.57) (2.48) (0.50) (2.82) (0.06) (2.62) (0.48) (2.43)
GGap 0.090 0.454 0.062 0.425 0.042 0.393
(0.67) (2.36) (0.43) (2.26) (0.29) (1.99)
NGap 0.044 0.437 0.026 0.413 0.004 0.373
(0.31) (2.26) (0.17) (2.17) (0.03) (1.86)
PGap 0.323 1.951 0.249 1.739 0.302 2.020
(1.13) (2.08) (0.88) (1.52) (1.03) (1.98)
Size 0.031 0.019 0.033 0.016 0.032 0.016 0.032 0.019 0.032 0.017 0.031 0.017 0.032 0.017 0.033 0.015 0.032 0.015
(4.09) (2.26) (4.02) (2.02) (4.00) (2.01) (4.14) (2.24) (4.01) (2.00) (4.00) (2.00) (4.27) (1.92) (4.14) (1.67) (4.13) (1.67)
Lev 0.417 0.318 0.419 0.318 0.420 0.318 0.417 0.317 0.417 0.316 0.419 0.317 0.427 0.328 0.427 0.329 0.429 0.329
(4.10) (5.15) (4.09) (5.17) (4.14) (5.16) (4.08) (4.98) (4.07) (4.99) (4.11) (4.99) (4.18) (5.13) (4.16) (5.15) (4.20) (5.14)
ROA 0.275 0.215 0.275 0.221 0.270 0.223 0.281 0.177 0.289 0.183 0.285 0.185 0.302 0.213 0.305 0.220 0.301 0.222
(1.85) (0.81) (1.86) (0.84) (1.82) (0.85) (1.87) (0.57) (1.95) (0.59) (1.91) (0.60) (2.00) (0.71) (2.05) (0.74) (2.02) (0.74)
rL 2.869 2.423 2.865 2.773 2.943 2.662 0.132 1.193 0.156 1.606 0.198 1.557 2.422 3.404 2.472 3.696 2.549 3.568
(1.76) (1.12) (1.75) (1.29) (1.77) (1.24) (0.07) (0.59) (0.08) (0.79) (0.11) (0.77) (1.45) (1.42) (1.46) (1.56) (1.49) (1.50)
Constant 0.711 0.753 0.658 0.893 0.680 0.888 0.882 0.614 0.869 0.755 0.898 0.745 0.786 0.615 0.769 0.738 0.793 0.732
(4.49) (3.12) (4.55) (3.33) (4.44) (3.29) (4.53) (2.66) (4.34) (3.05) (4.36) (2.99) (4.48) (2.52) (4.28) (2.78) (4.27) (2.73)
Nobs 1,991 2,557 1,991 2,557 1,991 2,557 2,034 2,324 2,034 2,324 2,034 2,324 2,080 2,261 2,080 2,261 2,080 2,261
R2 9.50% 13.91% 9.53% 14.24% 9.62% 14.22% 9.55% 14.91% 9.57% 15.20% 9.66% 15.19% 9.48% 15.66% 9.48% 15.90% 9.58% 15.88%
This table shows estimates of regressions of the costs of equity and debt capital on differences in governance between a foreign firm and a matched US firm based on industry and propensity scores obtained
from a probit analysis. GovUS is corporate governance index from a matched US firm. GGap is the governance gap between a foreign firm and its matched US firm. NGap and PGap are the governance gap
of a firm from its matching US counterpart if negative and if positive, respectively. COE is the average of implied cost of equity capital of rCT, rOJ, rGLS, and rPEG. COD is the cost of debt capital. Size is total

assets in US$ thousands. Beta is market beta in the June of year t. BM is book-to-market equity ratio. Fbias is the analyst forecast bias. The coefficients of Fbias are multiplied by 100. Lev is defined as total
debt scaled by total assets. ROA is the return on assets. Infl is the median of the current years annualized monthly inflation rates. rL is the bank rate that meets the short- and medium-term financing needs
of the private sector. Legal institutions is the first principal component of LOrg, LEnf, LICR, and LWGI. Transparency is the first principal component of Cifar, Dreq, DGCR, and NetPc. Govm. quality is
the first principal component of BDL, TaxC, GE, and CCP. t-statistics are computed based on clustered standard errors at the firm level, displayed in parentheses under coefficients. Statistically significant
coefficients at the 10% level are displayed in bold. Nobs is number of observations. R 2 is the adjusted R2.
consistent evidence that firm-level and country-level serve as complements in

reducing the cost of equity yet serve as substitutes in reducing the cost of debt.
I further divide a governance gap into a negative and a positive governance
gap from its matching US counterpart, if negative and positive respectively. As
shown in Table 8, in well-governed countries, a further improvement beyond
the governance level of a US firm (PGap) is associated with a reduction in the
risk premiums demanded by shareholders (lower cost of equity), and a shortfall
of governance relative to the level of US counterpart (NGap) is associated with
an increase in equity risk premiums. Consistent with previous findings, the
coefficient of a positive governance gap or of a negative governance gap is not
significantly related to a firms cost of equity capital in poorly protected coun-
tries, indicating that strong country-level institutions play a critical regulatory
role in affecting the relation between internal governance and the cost of
equity.
On the contrary, in poorly protected countries, a positive governance gap is
significantly associated with a reduction in the cost of debt capital, and a
negative governance gap is associated with an increase in risk premiums
demanded by debtholders (higher cost of debt). When country-level institu-
tions are weak, internal governance is especially important to creditors and so
are the governance gaps. When institutional environment is strong and effec-
tive, a further improvement or shortfall in governance practice becomes insig-
nificantly related to the the cost of debt capital.
Moreover, the coefficient of a positive gap is economically larger than that of
a negative governance gap for both COE and COD. In particular, meeting one
more governance attribute than its US counterpart is associated with a 0.18%
(4.43%) reduction in COE (COD), while a shortfall of one governance attribute
compared with its US counterpart is associated with an increase of 0.07%
(0.99%) in COE (COD).10 It is possible that shareholders and creditors reward an
improvement in governance (decrease in risk premiums) more than they punish
a governance shortfall (increase in risk premiums). However, whether a gover-
nance shortfall or an improvement is significantly associated with external
financing costs largely depends on the country-level institutional environ-
ments. This is in line with the previously documented differential relations.
In the matched sample, UK and Canada account for over 80% of the firms
with a positive governance gap and Canada alone accounts for over 50%. In
addition, Japanese firms account for a large proportion in the original sample.
It is necessary to verify the robustness of the results in a sample that excludes
firms from these countries. The untabulated results show that exclusion of firms
from UK hardly changes the results. On the other hand, excluding firms from
Canada or Japan has changed some of the results, especially the ones on the
positive governance gap. For example, when Canadian firms are excluded, the
coefficient of PGap in the COE regression remains negative in countries with
good institutional environments, but is only statistically significant in the high
10 Calculations are based on the division of the legal institution.

group of legal institutions. This change is not surprising as removing over 50%
of observations with positive governance gaps would possibly reduce the sta-
tistical significance of PGaps coefficient. However, GovUS and NGap still remain
statistically and economically significant.
E. Other issues
In this section, I perform two robustness tests to address the issues concerning
cross-listed firms and the investment risk. Previous literature suggests that
cross-listed firms could enhance governance ratings by committing to higher
standards of governance requirements, i.e., the bonding hypothesis (Karolyi
2006). Therefore, cross-listed firms that have access to higher governance stan-
dards may not subject their choice of governance standards to home countrys
institutional environments as much as the other firms that are not cross-listed,
which may potentially contaminate the results. I then confine my sample to
only noncross-listed firms and present the results under Ex. cross-listed firms
in Table 9. Previously observed results are largely preserved. Firm-level gover-
nance and country-level investor protection serve as complements to each
other in affecting the cost of equity. Shareholders value the quality of corporate
governance only when such governance mechanism is secured by strong insti-
tutional environment. Weak external protections may render corporate gover-
nance ineffective in reducing equity risks. On the contrary, good firm-level
governance is related to lower cost of debt in countries with weak institutions,
while this relation is not significant in countries with strong legal systems,
extensive disclosure practices, and superior government quality.
The cost of capital is closely related to the risks of a firm. Some risks may
adversely affect both shareholders and creditors, i.e., the agency risk, informa-
tion risk, and default risk. Some risks may adversely affect creditors but benefit
shareholders, i.e., the investment risk. For instance, John et al. (2008) show that
good investor protection leads firms to take riskier but more value-enhancing
projects, which ultimately create more upside potential for equity investments.
However, a high level of corporate risk-taking may potentially harm the credi-
tors as riskier investments and consequent earnings volatility may negatively
affect firms ability to make committed payments to debtholders. Given that
riskier corporate operations have more volatile returns to capital, I use the
volatility of corporate earnings as the proxy for investment risk (John et al.
2008).
In Table 9, I include the level of investment risk as a control variable into
regressions of the cost of equity and the cost of debt, respectively. Results show
that high investment risk is associated with high cost of equity in countries with
strong legal institutions, extensive disclosure practice, and stable political envi-
ronment. In addition, the positive relation between investment risk and the
cost of equity also appears in countries with weak disclosures and poor govern-
ment quality. On the contrary, firms that undertake riskier projects have high
cost of debt capital in poorly protected countries. In these countries, firms are

Table 9 Cross-listings and investment risk
Ex. cross-listed firms Investment risk
Legal institutions Transparency Govm. quality Legal institutions Transparency Govm. quality
High Low High Low High Low High Low High Low High Low
Gov 0.040 0.0005 0.038 0.023 0.012 0.004 0.040 0.001 0.040 0.010 0.021 0.008
(3.92) (0.11) (3.78) (1.36) (2.31) (0.50) (3.97) (0.15) (3.96) (0.64) (2.97) (0.65)
Size 0.003 0.002 0.003 0.003 0.002 0.002 0.004 0.002 0.004 0.002 0.004 0.000
(4.07) (6.91) (4.12) (3.23) (7.67) (3.27) (4.71) (7.20) (4.95) (2.16) (6.52) (0.52)

Beta 0.011 0.006 0.011 0.012 0.007 0.007 0.009 0.006 0.010 0.010 0.012 0.012
(5.56) (7.96) (5.65) (5.11) (8.04) (5.74) (4.31) (8.04) (4.47) (4.32) (6.92) (7.00)
BM 0.023 0.014 0.023 0.016 0.015 0.014 0.022 0.013 0.022 0.015 0.024 0.015
(6.06) (8.58) (6.09) (4.49) (8.39) (5.28) (6.19) (8.19) (6.10) (4.62) (8.48) (5.13)
Fbias 0.043 0.004 0.043 0.004 0.051 0.004 0.040 0.004 0.040 0.004 0.042 0.004
(2.15) (2.54) (2.18) (3.21) (2.85) (2.94) (2.00) (2.60) (2.00) (3.26) (2.26) (2.99)
InvR 0.028 0.000 0.026 0.071 0.008 0.028
(2.25) (0.20) (2.07) (3.05) (1.98) (1.88)
Infl 0.223 0.125 0.166 0.308 0.227 0.400 0.245 0.126 0.167 0.318 0.292 0.346
(2.82) (2.12) (2.14) (2.55) (4.08) (2.93) (3.11) (1.94) (2.17) (2.69) (5.41) (2.94)
Constant 0.131 0.095 0.132 0.130 0.095 0.087 0.129 0.096 0.133 0.100 0.098 0.011
(9.83) (19.91) (9.77) (7.51) (17.32) (11.36) (10.45) (17.98) (10.70) (6.13) (6.77) (0.33)
Nobs 1,704 7,060 1,629 2,094 5,215 3,364 1,728 6,937 1,648 2,193 5,089 3,391
R2 25.75% 20.44% 24.59% 29.16% 19.20% 23.65% 26.4% 20.8% 24.9% 30.2% 20.2% 23.6%
419
420
Table 9 (continued )
Ex. cross-listed firms Investment risk
Gov 0.012 0.074 0.013 0.435 0.053 0.306 0.028 0.299 0.103 0.403 0.033 0.349
(0.08) (0.97) (0.07) (2.42) (0.71) (2.49) (0.24) (2.46) (0.59) (2.38) (0.40) (2.80)
Size 0.031 0.030 0.030 0.028 0.033 0.022 0.025 0.021 0.026 0.015 0.033 0.014
(3.03) (5.61) (2.93) (3.50) (5.48) (3.52) (3.63) (3.03) (2.78) (1.74) (5.51) (2.17)
Lev 0.453 0.294 0.454 0.246 0.385 0.262 0.387 0.245 0.468 0.314 0.394 0.288
(4.06) (7.16) (3.91) (4.64) (7.24) (6.21) (4.46) (5.28) (3.95) (4.99) (7.08) (6.27)
ROA 0.151 0.026 0.146 0.144 0.033 0.078 0.289 0.129 0.387 0.149 0.107 0.180
(0.91) (0.40) (0.85) (0.42) (0.46) (0.70) (2.28) (0.67) (2.45) (0.48) (1.47) (1.48)
InvR 0.101 0.196 0.111 0.557 0.018 0.198
(0.75) (3.24) (0.85) (2.18) (1.44) (1.80)
rL 3.421 0.852 1.199 1.733 1.735 3.818 2.322 3.233 0.323 0.473 2.494 3.661
(1.97) (1.48) (0.60) (0.93) (1.50) (1.71) (1.71) (2.76) (0.16) (0.24) (2.24) (1.57)
Constant 0.701 0.674 0.815 0.761 0.746 0.438 0.011 0.155 0.692 0.589 0.670 0.218
(3.65) (7.26) (3.40) (3.17) (6.85) (1.87) (0.04) (0.63) (3.14) (2.43) (6.30) (0.59)
Nobs 1,831 6,617 1,760 2,259 5,078 3,161 1,914 6,636 1,846 2,377 5,104 3,238
R2 9.34% 6.35% 9.58% 15.22% 4.76% 10.11% 11.2% 6.4% 11.2% 15.6% 5.0% 9.9%
This table provides the estimates of regressions of the costs of equity and debt capital in a sample where cross-listed firms are removed and when
the investment risk is controlled as a regressor. Gov is the corporate governance ratings detailed in Appendix B. COE is the average of implied
cost of equity capital of rCT, rOJ, rGLS, and rPEG. COD is the cost of debt capital. Size is total assets in US$ thousands. Beta is market beta in the June
of year t. BM is book-to-market equity ratio. Fbias is the analyst forecast bias. The coefficients of Fbias are multiplied by 100. Lev is defined as total
debt scaled by total assets. ROA is the return on assets. InvR is the investment risk. Infl is the median of the current years annualized monthly
inflation rates. rL is the bank rate that meets the short-and medium-term financing needs of the private sector. Legal institutions is the first
principal component of LOrg, LEnf, LICR, and LWGI. Transparency is the first principal component of Cifar, Dreq, DGCR, and NetPc. Govm.
quality is the first principal component of BDL, TaxC, GE, and CCP. t-statistics are computed based on clustered standard errors at the firm level,
displayed in parentheses under coefficients. Statistically significant coefficients at the 10% level are displayed in bold. Nobs is number of
observations. R 2 is the adjusted R2. Year, industry, and country-fixed effects are included. Sample period is from 2002 to 2005.

more likely to have dominant shareholders which can tunnel the cash flow
away from creditors. Excess risk-taking may further exacerbate this problem and
increase the risks facing the creditors in countries with weak institutions. The
relations between internal governance and the costs of equity and debt capital
remain unchanged.
V. CONCLUSION
In this paper, I examine the differential relations between corporate governance

and external financing costs given different levels of country governance stan-
dards. I first show that firms with good corporate governance are associated with
lower cost of equity and cost of debt capital across 23 countries. Furthermore,
the association between internal governance and the cost of equity is consis-
tently stronger in countries with strong legal systems, high transparency, and
strong political institutions. On the contrary, the association between gover-
nance practice and the cost of debt is stronger in countries with weak legal
systems, low transparency, and poor government quality. This study addresses
the endogeneity issue by instrumenting the governance index of a foreign firm
with that of a matched US firm (Aggarwal et al. 2009). However, one should
refrain from making any causal inference from the matching results about the
relation between corporate governance and the costs of equity and debt capital.
The results are also robust when cross-listed firms are excluded and when the
investment risk is controlled for as an independent variable.
Shareholders are interested in the upside potential of their equity investment
and hence, rely on the fiduciary responsibilities of management. Therefore,
firms self-discipline provided by internal governance may not necessarily
reduce the equity risks without a stringent legal regime, a transparent informa-
tion environment, and a stable and efficient government. However, creditors
are more concerned of the downside risk of their investments and hence, value
firms ability to fulfill their contractual obligations. Countries with weak insti-
tutional environments are unable to provide sufficient protections for creditors,
i.e., strong legal enforcement to deter misbehavior, accuracy of disclosed infor-
mation, and efficient governments. Therefore, the relation between internal
governance practice and the cost of debt is more pronounced in countries with
weak legal regime, low transparency, and poor political institutions (except for
government corruption).
Feifei Zhu
College of Business Administration
Hawaii Pacific University
1132 Bishop Street FH 504
Honolulu, HI 96813
USA
fzhu@hpu.edu

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APPENDIX A. VARIABLE DEFINITION
Variables Acronym Description

(i) Firm characteristics
Governance index Gov The percentage of governance attributes a firm
actually satisfies out of 44 governance provisions
from ISS.
Board independence Board Sub-index of Gov for board independence.
Anti-takeover AT Sub-index of Gov for anti-takeover provisions.
Audit Aud Sub-index of Gov for audit.
Compensation Comp Sub-index of Gov for executive compensation and
ownership.
Cost of equity COE Average of four implied cost of capital estimates,
rCT, rGLS, rPEG, and rOJ as detailed in Appendix C.
Cost of debt COD The cost of debt capital, calculated as the interest
expense scaled by the average of short-term and
long-term debt during the year.
Size Size Log of total assets in thousands of US dollars.
Beta Beta The covariance of MSCI country index monthly
return with monthly firm return divided by MSCI
country index monthly return variance over the
past 60 months till June of year t.
Book-to-market ratio BM Total assets over total assets minus book equity plus
market capitalization.
Forecasting bias Fbias One-year-ahead consensus forecast minus the actual
earnings reported in I/B/E/S.
Leverage Lev Book leverage, equal to total debt over total book
assets.
Return on assets ROA Net income over total assets.
Investment risk InvR For each firm with available earnings and total
assets for at least 5 years in past 10 years, I
compute the deviation of the firms
EBITDA/Assets from the country average (for the
corresponding year) and then calculate the
standard deviation of this measure for each firm.
Sales growth gS Total sales growth from previous year.
Ownership Own Closely held ownership.
concentration
(ii) Country-level characteristics
Inflation Infl The median of the current years annualized
monthly inflation rate for each country based on
consumer price indices provided by IFS.
Lending rate rL The bank rate that meets the short-and
medium-term financing needs of the private
sector obtained from International Financial
Statistics.
(a) Legal Institutions
Legal origin LOrg An indicator variable, which equals 1 if a country is
from the common-law origin and 0 if it is from
the civil-law origin.

APPENDIX A. (continued )
Variables Acronym Description

Law enforcement LEnf Mean scores across three legal variables from La
Porta et al. (1998): the efficiency of judicial
system, rule of law, and corruption index (Leuz
et al. 2003).
Law and order LICR Law and order index which measures the strength
and impartiality of the legal system and popular
observance of the law, produced by International
Country Risk (ICR).
Rule of law LWGI Rule of law index from Worldwide Governance
Indicators (Kaufmann et al. 2009).
(b) Transparency
Accounting Cifar A measure for the level of accounting disclosure
standards practice from Center for International Financial
Analysis and Research.
Disclosure Dreq Disclosure requirement index from Hail and Leuz
requirement (2006).
Financial disclosure DGCR It is based on survey results about the level and
availability of financial disclosure score index in
the annual Global Competitiveness Report issued
by the World Economic Forum. Average scores for
1999 and 2000 divided by 10 such that the score
falls in the 0 to 1 range (Gelos and Wei 2005).
Network usage NetPc Internet users per 100 people from World Bank.
(c) Political environment
Bureaucratic delays BDL An indicator of bureaucratic delays, scale from 0 to
10 [La Porta et al. 1999, Business Environmental
Risk Intelligences (BERI) operation risk index].
Tax compliance TaxC Assessment of the level of tax compliance, scale
from 0 to 6 (La Porta et al. 1999; World
Economic Forum, various years).
Government GE Capturing perceptions of the quality of public
effectiveness services, the quality of the civil service and the
degree of its independence from political
pressures, the quality of policy formulation and
implementation, and the credibility of the
governments commitment to such policies from
Worldwide Governance Indicators.
Control of CCP Capturing perceptions of the extent to which
corruption public power is exercised for private gain,
including both petty and grand forms of
corruption, as well as capture of the state by
elites and private interests from Worldwide
Governance Indicators.

APPENDIX B. CORPORATE GOVERNANCE ATTRIBUTES
Minimally acceptable corporate governance standard
Board
1. All directors attended 75% of the board meetings or had a valid excuse 94.6%
2. CEO serves on the boards of two or fewer public companies 93.9%
3. Board is controlled by more than 50% independent outside directors 59.5%
4. Board size is at greater than six but less than 15 89.2%
5. CEO is not listed as having a related party transaction 84.5%
6. No former CEO on the board 75.7%
7. Compensation committee comprised of solely of independent outsiders 58.2%
8. Chairman and CEO are separated or there is a lead director 68.2%
9. Nominating committee comprised solely of independent directors 45.3%
10. Governance committee exists and met in the past years 42.0%
11. Shareholders vote on directors selected to fill vacancies 63.5%
12. Governance guidelines are publicly disclosed 54.8%
13. Annually elected board (no staggered board) 39.0%
14. Policy exists on outside directorships (four or fewer boards is the limit) 10.6%
15. Shareholders have cumulative voting rights 3.9%
16. Shareholder approval is required to increase/decrease board size 35.1%
17. Majority vote requirement to amend charter/bylaws (not supermajority) 56.8%
18. Board has the express authority to hire its own advisors 69.1%
19. Performance of the board is reviewed regularly 61.0%
20. Board approved succession plan in place for the CEO 44.2%
21. Outside directors meet without CEO and disclose number of times met 34.2%
22. Directors are required to submit resignation upon a change in job 21.9%
23. Board cannot amend bylaws without shareholder approval or can only do so under 47.0%
limited circumstances
24. Does not ignore shareholder proposal 99.4%
25. Qualifies for proxy contest defenses combination points 2.7%
Audit
26. Consulting fees paid to auditors are less than audit fees paid to auditors 80.7%
27. Audit committee comprised solely of independent outsiders 63.6%
28. Auditors ratified at most recent annual meeting 63.6%
Anti-takeover
29. Single class, common 91.4%
30. Majority vote requirement to approve mergers (not supermajority) 58.5%
31. Shareholders may call special meetings 70.1%
32. Shareholder may act by written consent 20.2%
33. Company either has no poison pill or a pill that was shareholder approved 75.4%
34. Company is not authorized to issue blank check preferred 47.5%
Compensation and ownership
35. Directors are subject to stock ownership requirements 22.2%
36. Executives are subject to stock ownership guidelines 22.4%
37. No interlocks among compensation committee members 99.7%
38. Directors receive all or a portion of their fees in stock 72.5%
39. All stock-incentive plans adopted with shareholder approval 86.5%
40. Options grants align with company performance and reasonable burn rate 55.1%
41. Company expenses stock options 22.0%
42. All directors with more than one year of service own stock 75.4%
43. Officers and directors stock ownership is at least 1% but not over 30% total shares 60.2%
outstanding
44. Repricing is prohibited 61.5%

This table presents the composition of the overall corporate governance

index (Gov), which consists of four broad categories, namely board, audit,
takeover, and compensation and ownership. For each attribute, I report the
percentage of firms meeting the minimally acceptable standard over the total
number of nonmissing observations for each attribute. The full sample includes
11,521 firm-year observations across 23 developed countries for the period
20032006.
APPENDIX C. IMPLIED COST OF CAPITAL MODELS
I follow Hail and Leuz (2006) by employing the average of four different ICOCs
as a proxy for each firms yearly cost of capital. For consistency and for com-
parison of results with those of Hail and Leuz, I closely adopt the two authors
specifications and assumptions of the four models, as described below, when
estimating the ex ante cost of capital as implied by each model.
1 Gebhardt et al.s (2001) residual income valuation model is given by
Pt = bvt +
T
(eps
t + rGLS bvt + 1 ) (eps
+
t +T +1 rGLS bvt +T )
, (1)
=1 (1 + rGLS ) rGLS (1 + rGLS )T
where Pt is the market price of a firms stock at time t, pst+ is the expected future
earnings per share for period (t + 1, t + ), and bvt+1 is the book value per
share at time t + 1. The model obtains the initial 3 years of expected future
residual income from actual book values per share and forecasted earnings per
share up to 3 years ahead. Assuming clean surplus, future book values are
imputed from current book values, forecasted earnings, and dividends; the same
assumption is also adopted by Claus and Thomas (2001) below. For each year,
dividends are set equal to the average of the past 3 years of payout ratios.
Dividends are defined in the same way for the following three models. Beyond
the initial 3 years, the stream of residual incomes is derived by linearly decreas-
ing the forecasted accounting return on equity over the next 9 years to the
firms specific sectors median return on equity determined over the past 3
years. Following Hail and Leuz (2006), I classify firms into industrial, service,
and financial sectors. If a specific sectors median is negative, then I replace it by
the country-year median. Residual income is assumed to remain constant
beyond 12 years.
2 Claus and Thomass (2001) residual income valuation model is given

by
Pt = bvt +
T
(eps
t + rCT bvt + 1 ) (eps
+
t +T rCT bvt +T 1 ) (1 + g )
. (2)
=1 (1 + rCT ) (rCT g ) (1 + rCT )T
The model obtains the stream of expected future residual income from actual
book values per share and forecasted earnings per share up to 5 years ahead.

Beyond year five, nominal residual income is assumed to grow at the rate g
equal to the expected inflation (as proxied by the annualized median of a
countrys 1-year ahead realized monthly inflation rates).
3 Eastons (2004) PEG model is given by
Pt =
(eps
t +2 + rPEG dt +1 eps
t +1 ). (3)
2
rPEG
The model derives a measure of abnormal earnings growth by using 1-year and
2-year ahead earnings per share forecasts as well as expected dividends per share
in period t + 1. It assumes perpetual growth in abnormal earnings after the
initial period.
4 Ohlson and Juettner-Nauroths (2005) abnormal earnings growth

valuation model is specified as follows
d
g st + rOJ t +1 g lt
t +1
eps t +1
eps (4)
Pt = .
rOJ (rOJ g lt )
The model uses 1-year-ahead forecasted earnings and dividends per share as well
as forecasts of short-term and long-term abnormal earnings growths. The short-
term growth rate gst is equal to the average of the forecasted percentage change
in the first 2 years of earnings and the 5-year growth forecast provided by
financial analysts on I/B/E/S. The long-term earnings growth rate glt is set equal
to the annualized country-specific median of 1-year-ahead realized monthly
inflation rates.
I obtain financial information from the Worldscope database and analyst
earnings forecasts (proxies for future earnings) and stock price information
from the I/B/E/S database. All information is denominated in local currency.
The sample includes firms that have current stock price Pt, earnings forecasts
of one and two periods ahead (pst+1 and pst+2), and either pst+3 through pst+5
or a long-term earnings growth forecast. Only positive earnings forecasts are
employed. All analyst earnings forecasts are mean analyst consensus forecasts
in I/B/E/S and this information is updated every third Thursday of each
month.
Analyst earnings forecasts and stock prices are measured as of month +10
subsequent to the fiscal year-end. Using information that is released 10 months
after the fiscal year-end ensures that financial information, such as earnings and
book values of equity, is already released to the public and gets reflected in the
stock price I use to estimate the ICOC. As such, a firms one-period-ahead
earnings forecast pst+1 is 2 months prior to its fiscal year-end. Accordingly, the
current stock price, Pt in all the four ICOC models corresponds to Pt+10, where t
refers to the firms previous fiscal year-end.

In all estimations, I use an iterative algorithm to back out the value of each
ICOC from the model, and the ICOC is constrained to be positive or missing
otherwise. The iterative procedure stops when the imputed price is within a
0.001 difference of its actual price.

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International Review of Finance, 14:3, 2014: pp. 393429

Corporate Governance and the Cost

In this study, I investigate the relation between a firms internal governance

2014 International Review of Finance Ltd. 2014

firms financing costs.2 Furthermore, in an international setting, governance

394 2014 International Review of Finance Ltd. 2014

3 I thank an anonymous referee for suggesting this part of tests.

2014 International Review of Finance Ltd. 2014 395

while it is significantly associated with the cost of debt in poorly protected

II. DATA AND SAMPLE

396 2014 International Review of Finance Ltd. 2014

A. Corporate governance ratings

2014 International Review of Finance Ltd. 2014 397

2014 International Review of Finance Ltd. 2014

B. The cost of capital and firm characteristics

2014 International Review of Finance Ltd. 2014 399

400 2014 International Review of Finance Ltd. 2014

2014 International Review of Finance Ltd. 2014 401

Table 2 Legal institutions, transparency, and government quality measures

402 2014 International Review of Finance Ltd. 2014

Table 3 Pearson pairwise correlation coefficients

2014 International Review of Finance Ltd. 2014 403

III. CORPORATE GOVERNANCE, GOVERNANCE COMPONENTS,

A. Corporate governance and the cost of capital

404 2014 International Review of Finance Ltd. 2014

Table 4 Corporate governance, governance components, and the cost of capital

Gov 0.025 0.026 0.008 0.008 0.007

Panel B: Dependent variable = COD

Gov 0.299 0.306 0.132 0.125 0.133

2014 International Review of Finance Ltd. 2014 405

associated with a lower cost of debt. The coefficient of Gov is 0.299 in

B. The role of governance components

406 2014 International Review of Finance Ltd. 2014

IV. INVESTOR PROTECTIONS, CORPORATE GOVERNANCE, AND

2014 International Review of Finance Ltd. 2014 407

A. Legal institutions, corporate governance, and the cost of capital

408 2014 International Review of Finance Ltd. 2014

Table 5 Legal institutions, corporate governance, and the cost of capital

Panel A: Dependent variable = COE

Panel B: Dependent variable = COD

2014 International Review of Finance Ltd. 2014 409

410 2014 International Review of Finance Ltd. 2014

B. Disclosure, corporate governance, and the cost of capital

2014 International Review of Finance Ltd. 2014 411

Table 6 Transparency, corporate governance, and the cost of capital

Panel A: Dependent variable = COE

Panel B: Dependent variable = COD

412 2014 International Review of Finance Ltd. 2014

environments.9 Creditors are less adversely affected by information asymme-

C. Government quality, corporate governance, and the cost of capital

2014 International Review of Finance Ltd. 2014 413

Table 7 Government quality, corporate governance, and the cost of capital

Panel A: Dependent variable = COE

Panel B: Dependent variable = COD

414 2014 International Review of Finance Ltd. 2014

D. Comparing governance between non-US and

2014 International Review of Finance Ltd. 2014 415

Panel B: Dependent variable = COD

2014 International Review of Finance Ltd. 2014

consistent evidence that firm-level and country-level serve as complements in

10 Calculations are based on the division of the legal institution.

2014 International Review of Finance Ltd. 2014 417

418 2014 International Review of Finance Ltd. 2014