The Conditional Nature of the Value of Corporate Governance
Journal of Banking and Finance, Vol. 34, No. 2, pp. 350-361, February 2010
42 Pages Posted: 28 Nov 2008 Last revised: 27 Jul 2010
Date Written: July 27, 2009
Agency theory suggests that governance matters more among firms with greater potential agency costs. Rational investors are unlikely to value safeguards against unlikely events. Yet, few studies of the relation between governance and firm value control for investor perceptions of the likelihood of agency conflicts. Shleifer and Vishny (1997) identify investment-related agency conflicts as the more severe type of agency conflicts in the U.S. We measure the perceived likelihood of this type of agency conflict using free cash flow (Jensen, 1986). We find that firm value is an increasing function of improved governance quality among firms with high free cash flow. In contrast, governance benefits are lower or insignificant among firms with low free cash flow. We show that not controlling for this conditional relation between governance and firm value could lead to erroneous conclusions that governance and firm value are unrelated.
Keywords: governance, agency, overinvestment, free cash flow, conditional
JEL Classification: C23, G34
Suggested Citation: Suggested Citation