External Financing Needs, Corporate Governance, and Firm Value

• Author: Huimin Chung,Wei‐Peng Chen,Tsui‐Ling Hsu,Soushan Wu
• DOI: http://doi.org/10.1111/j.1467-8683.2010.00801.x
• Published date: 01 May 2010
• Date: 01 May 2010

External Financing Needs, Corporate

Governance, and Firm Value

Wei-Peng Chen*, Huimin Chung, Tsui-Ling Hsu, and Soushan Wu

ABSTRACT

Manuscript Type: Empirical

Research Question/Issue: We set out in this study to explore the overall impact of external f‌inancing needs on corporate

governance and f‌irm value, arguing that external f‌inancing needs have extremely important impacts on corporate gover-

nance, essentially because external f‌inancing can proveto be very costly, largelyas a result of asymmetric information. Thus,

we suggest that improvements in corporate governance of f‌irms with external f‌inancing needs could help to reduce costs of

outside equity f‌inancing.

Research Findings/Insights: Our results reveal that it is in fact f‌irm valuation that has an effect on governance practices, as

opposed to the reverse, and that external f‌inancing needs appear to strengthen the inf‌luence of the quality of corporate

governance practices on f‌irm value.

Theoretical/Academic Implications: The external forces considered in this study are product market competition,

investment opportunities, and external f‌inancing needs, with particular emphasis being placed upon the impact of

external f‌inancing needs, since this relates directly to outside shareholders. Given that poor corporate governance practices

signal higher asymmetric information costs, and thus, lead to an increase in the costs of raising external capital, it is

important to gain a comprehensive understanding of the impact of external f‌inancing needs on f‌irm value and corporate

governance.

Practitioner/Policy Implications: Our results demonstrate the important implications that corporate governance

practices have for those f‌irms with a particularly strong need for external equity, and the fact that external f‌inancing needs

provide incentives for f‌irms to seek out ways of making improvements to the overall quality of their corporate governance

practices.

Keywords: Corporate Governance, Firm Value, Governance-Value Relationship, External Financing Needs

INTRODUCTION

We set out in this study to explore the impactof external

f‌inancing needs on f‌irm value and corporate gover-

nance, arguing that such a need for external f‌inancing has

extremely important impacts on corporate governance,

essentially because external f‌inancing can prove to be very

costly, largely as a result of asymmetric information. The

results suggest that the need for outside equity could

provide incentives for f‌irms to seek out improvements in

their overall corporate governance practices.

An examination is undertaken in many of the prior

empirical studies of the functional relationship that exists

between f‌irm performance and corporate governance,

namely, the market for corporate control.1Such studies note

that higher f‌irm value and/or stronger shareholder rights

are readily discernible in those f‌irms with better governance

practices (where such f‌irms are wide open to market control

measures) than in those f‌irms with relatively poor gover-

nance practices.

Masulis, Wang, and Xie (2007) and Dittmar and Mahrt-

Smith (2007) argue that in cases where corporate governance

practices are qualitatively weaker, this can ultimately lead to

the destruction of shareholder value,essentially as a result of

the ineff‌icient investment decisions taken by managers, or

the devaluation of cash resources through wastage. In other

words, it is suggested that f‌irms which consistently pursue

good corporate governance practices will be more capable

of mitigating the conf‌licts of interests that arise between

shareholders and managers, and thereby, of alleviating

shareholder-manager agency costs. However, while the

direct correlation between better corporate governance

*Address for correspondence: Department of Finance, Shih Hsin University, no. 111,

Mu-Cha Road, Sec. 1, Taipei 11645, Taiwan.Tel: +886-2-2236-8225 ext.63443; Fax: +886

22236 2265; E-mail: wpchen@cc.shu.edu.tw

234

Corporate Governance: An International Review, 2010, 18(3): 234–249

© 2010 Blackwell Publishing Ltd

doi:10.1111/j.1467-8683.2010.00801.x

practices and f‌irm value has already been well documented,

there has seldom been any discussion of the external driving

forces leading to the adoption of such governance practices

by f‌irms.

We extend the current understanding of this issue by

linking governance value with external forces; these forces

include the competitiveness of the product market, invest-

ment opportunities and external f‌inancing needs. The major

focus in the present study is placed upon the ways in which

governance practices change in response to the needs for

external f‌inancing and the inf‌luence on f‌irm value arising

from the interactions between corporate governance and

external f‌inancing needs. The particular emphasis that is

placed upon the impact of external f‌inancing needs in the

present study is essentially based upon the direct relation-

ship that such needs have with outside shareholders.

When confronted with potentially prof‌itable opportuni-

ties for growth, f‌irms will often f‌ind themselves faced with

the choice of either using their internal resources to f‌inance

any proposed ventures, or seeking to raise such funds from

external resources. Almeida and Wolfenzon (2005) argue

that where there are certain def‌iciencies in f‌irm perfor-

mance, essentially as a result of the ineff‌icient use of internal

resources, the use of external f‌inancing has obvious benef‌its;

thus, the suggestion is that external f‌inancing needs can be

seen as a mechanism affecting the eff‌icient allocation of

capital.

We argue that when dealing with issues of governance

and external f‌inancing, there are two important aspects that

should be considered, as follows. Firstly, good corporate

governance provides a signal to investors that f‌irms are

likely to have fewer potential problems of information asym-

metry, reduced conf‌lict of interest between managers and

shareholders, and thus, greater shareholder wealth.2There is

therefore a greater likelihood of investors being willing to

invest in those f‌irms whose governance practices are quali-

tatively better; as a result, f‌irms with better governance

practices which are presented with good investment oppor-

tunities, and which therefore have external f‌inancing needs,

will f‌ind that they can more easily raise capital from the

various fund providers.

Secondly, the equities of f‌irms with better corporate gov-

ernance are likely to have relatively better market liquidity;3

as such, the cost of capital for these f‌irms will be lower.

External f‌inancing will invariably prove to be costly where a

f‌irm is associated with asymmetric information (Myers &

Majluf, 1984); thus, in those cases where such f‌irms do have

a need for external f‌inancing, this can provide them with

incentives to improve the quality of their corporate gover-

nance. This may well, in turn, lower the costs of such exter-

nal f‌inancing. According to traditional f‌inancial theory, the

predetermined components of f‌irm valuation are expected

cash f‌lows and the cost of capital; we hypothesize that where

the need for external f‌inancing is strong, by pursuing

improvements in the quality of their corporate governance

practices, such f‌irms can enhance their overall value.

In the majority of the prior studies investigating the rela-

tionship between the quality of corporate governance and

f‌irm performance, it is assumed that corporate governance is

exogenous, and therefore, not determined by other gover-

nance mechanisms or f‌irm characteristics;4however, it is

clear that while f‌irms have only a passive role to play in the

governance-value relationship, they will, nevertheless, seek

to actively improve their governance practices in order to

raise the valuation of the f‌irm. Therefore, the premise in the

prior literature, that the inf‌luence of governance on corpo-

rate performance is exogenous, may well have led to incon-

sistent or biased results.

In order to ensure that we undertake appropriate exami-

nation of the issue of reverse causality between corporate

governance and f‌irm value, and to ensure that the potential

problem of endogeneity is also taken into consideration, we

estimate a system of simultaneous equations using “three-

stage least squares” (3SLS) and “generalized method of

moments” (GMM) methods, both of which, while allowing

corporate governance to affect f‌irm value, will nevertheless

provide appropriate controls for these effects.

After providing appropriate controls for both f‌irm charac-

teristics and the instrumental variables, our results reveal

that it is in fact f‌irm valuation which has an effect on gover-

nance practices, as opposed to the reverse scenario; thus, we

argue that the corporate governance practices of f‌irms are

affected by the external forces identif‌ied in this study (i.e.,

product market competition, investment opportunities and

external f‌inancing needs). Furthermore, we f‌ind that exter-

nal f‌inancing needs appear to strengthen the effect of the

quality of corporate governance practices on f‌irm value.

The results reported here are consistent with our hypoth-

esis of the existence of an association between better corpo-

rate governancequality and the higher valuation of a f‌irm, as

well as our suggestion that external f‌inancing needs provide

appropriate incentives for f‌irms to pursue improvements in

the overall quality of their corporate governance practices.

The f‌indings of the present study – through our much more

detailed examination of the relationship between f‌irm per-

formance and corporate governance – also provide support

for the results reported in Lehn, Patro, and Zhao (2007).

The remainder of this paper is organized as follows. A

review of the related literature is presented in the next

section, along with the development of our empirical

hypotheses. The subsequent section presents the data and

methodology, including a description of the variables, the

econometric models and the data sample. The empirical

results are reported in the penultimate section, followed by

presentation of the conclusions drawn from this study in the

f‌inal section.

LITERATURE REVIEW AND

HYPOTHESIS DEVELOPMENT

Governance and Firm Value

The relationship between f‌irm performance and corporate

governance has already been dealt with in considerable

numbers of studies within the extant literature. The present

study considers the important index of corporate gover-

nance proposed by Gompers, Ishii, and Metrick (2003). In

order to investigate the relationship between corporate gov-

ernance and corporate performance, they constructed their

“GIM index” using 24 different provisions as a proxy for the

balance of power between shareholders and managers;

EXTERNAL FINANCING NEEDS, CORPORATE GOVERNANCE, AND FIRM VALUE 235

Volume 18 Number 3 May 2010© 2010 Blackwell Publishing Ltd