In search of the corporate governance risk premium embedded into the cost of capital

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Abstract

The paper proposes to intend the firm as a “nexus of stakeholders”, each bearing return-to-risk expectations about the sharing of the corporate performance. All the stakeholders must achieve their own satisfaction through the bargaining of contracts that must be sustainable, i.e., keep both the firm and its stakeholders-network alive in the long term. Governance is intended as the mechanism that gives a solution to the above puzzle. When both market and contracts are complete, an optimal solution can be easily found. But when incompleteness emerges, governance solutions can misallocate the firm performance among the stakeholders. This is the case when incomplete governance emerges. In fact, in incomplete contests, the stakeholders will negotiate the visible-only arguments of their contracts, this way binding also the invisible ones, i.e., those impacting anyway on their ex-post performance. This being the case, a governance risk premium (GRP) emerges in the medium-long run, impacting equity investors’ return-to-risk performance, thus incentivizing a governance repackage. Such a GRP depends both on the actual grade of market completeness and the one of contracts as per the risk allocation made through time. The proposed methodology to detect GRP is then applied to the Italian case to test its strength. Results show that GRP inflates 39bp the cost of equity capital with the following break-down: 123bp as basic-GRP from operations which is increased +98bp for the GRP-informative component and reduced -191bp by GRP-managerial component; a GRP-behavioural component +90bp would lead GRP from operations up-to 120bp while sharing 81bp with debt capital leads the final figure down to 39bp (i.e., 123 + 98 – 191 + 90 – 81).

Keywords: Corporate Governance, Corporate Risk, Incomplete Markets, Incomplete Contracts

Authors’ individual contribution: Conceptualisation — G.B. and G.M.M.; Methodology — G.M.M.; Validation — G.B.; Formal Analysis — G.B. and G.M.M.; Investigation — G.B. and G.M.M.; Resources — G.M.M.; Data Curation — G.M.M.; Writing — Originality Draft — G.M.M.; Writing — Review & Editing — G.B.; Visualization — G.B. and G.M.M.; Supervision — G.B.; Project Administration — G.B. and G.M.M.

Declaration of conflicting interests: The Authors declare that there is no conflict of interest.

JEL Classification: G34, G35, M10, M21, M51

Received: 05.10.2022
Accepted: 12.05.2023
Published online: 16.05.2023

How to cite this paper: Bertinetti, G., & Mantovani, G. M. (2023). In search of the corporate governance risk premium embedded into the cost of capital. Corporate Ownership & Control, 20(3), 112–129. https://doi.org/10.22495/cocv20i3art8