Corruption, Firm Governance, and the Cost of Capital

45 Pages Posted: 5 Jan 2005  

Mark J. Garmaise

University of California, Los Angeles (UCLA) - Anderson School of Management

Jun Liu

University of California, San Diego (UCSD) - Rady School of Management

Abstract

We develop a model of a firm owned by shareholders and administered by managers who may be either honest or dishonest. When managers have an informational advantage but shareholders retain control, dishonest managers can make false reports that distort investment and thereby reduce firm cash flows. When dishonest managers have privileged access to both information and control, firm value is further reduced and profits are diminished especially in the worst states of the world. Ineffective corporate governance combined with corruption (dishonesty) thus increases firms' exposure to systematic risk. In a cross-country empirical test of the model, we find that corruption substantially increases firm betas, particularly in countries with weak shareholder rights. Moving from the level of corruption in Canada to that in South Korea raises industry-adjusted betas by 0.35.

Suggested Citation

Garmaise, Mark J. and Liu, Jun, Corruption, Firm Governance, and the Cost of Capital. AFA 2005 Philadelphia Meetings Paper. Available at SSRN: https://ssrn.com/abstract=644017 or http://dx.doi.org/10.2139/ssrn.644017

Mark J. Garmaise (Contact Author)

University of California, Los Angeles (UCLA) - Anderson School of Management ( email )

110 Westwood Plaza
Los Angeles, CA 90095-1481
United States

Jun Liu

University of California, San Diego (UCSD) - Rady School of Management ( email )

9500 Gilman Drive
Rady School of Management
La Jolla, CA 92093
United States
858.534.2022 (Phone)
5858.534.0745 (Fax)

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