Modeling Governance as a Reward for Risk
As illustrated by Jensen and Meckling (1976), Corporate Governance mechanisms, while being costly themselves, reduce the prevailing agency problems and induced agency costs and increase firm value. While there are a number of studies which analyze the relationship between Corporate Governance and firm value, the link between Governance mechanisms and the required rate of return is largely unexplored. Lombardo and Pagano (2002) argue that this is because most microeconomic models of corporate financing generally take the opportunity cost of funds as exogenously given. In an all-equity financed firm, the cost of capital equals the cost of equity capital which is also referred to as the expected rate of return on equity. The required rate of return is the opportunity cost to the investor of investing scarce resources elsewhere in business opportunities with equivalent risk. Hence, risky projects need to earn at least the required return238 in order to be acceptable to shareholders. Assuming the risk of an additional new project equals the risk of the firm, the expected return can be estimated using the CAPM239.
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