Corporate Governance and Costs of Equity : Theory and Evidence

We propose and test an alternative explanation for the existence of the positive governance-return relation in the 1990s and its disappearance in the 2000s: The governance-return relation is procyclical. Corporate governance mitigates investment distortions so that firms with strong governance have more valuable investment options during booms and more valuable divestiture options during busts than the ones with weak governance. Because investment options are riskier and divestiture options are less risky than assets-in-place, the expected returns of strongly governed firms are higher during booms but lower during busts than the weakly governed ones. Empirical evidence strongly supports the procyclical governance-return relation