An Integrated Framework of Corporate Governance and Firm Valuation

European Financial Management, Vol. 12, No.
2, 2006, 249–283
An Integrated Framework of Corporate

Governance and Firm Valuation
Stefan Beiner, Wolfgang Drobetz, Markus M. Schmid and
Heinz Zimmermann
Department of Finance, Wirtschaftswissenschaftliches Zentrum (WWZ), University of Basel,
Petersgraben 51, 4003 Basel, Switzerland
e-mail: stefan.beiner@unibas.ch, wolfgang.drobetz@unibas.ch, markus-max.schmid@unibas.ch,
heinz.zimmermann@unibas.ch
Abstract
Recent empirical research shows evidence of a positive relationship between
the quality of firm-specific corporate governance and firm valuation. Instead of
looking at one single corporate governance mechanism in isolation, we con-
struct a broad corporate governance index and apply five additional variables
related to ownership structure, board characteristics, and leverage to provide a
comprehensive description of firm-level corporate governance for a representa-
tive sample of Swiss firms. To control for potential endogeneity of these six
governance mechanisms, we develop a system of simultaneous equations and
apply three-stage least squares (3SLS). Our results support the widespread
hypothesis of a positive relationship between corporate governance and firm
valuation.
Keywords: corporate governance; principal-agent problems; ownership structure;

firm valuation; endogeneity.
JEL classification: G12, G32, G34, G38
We thank Yakov Amihud, Manuel Berger, Wolfgang Bessler, John Doukas (the editor), Filippo
Ippolito, Colin Mayer, Tarun Ramadorai, Regina Riphan, Frank Schmid, Nico Waldmeier,
Gabrielle Wanzenried, David Yermack, and an anonymous referee as well as participants in
seminars at the University of Oxford, the University of St. Gallen, and the University of
Frankfurt for helpful comments. We also thank Max Schmid for his large contribution to the
collection of compensation and shareholding data from the annual reports. Financial support
from the National Center of Competence in Research ‘Financial Valuation and Risk
Management’ (NCCR FINRISK) is gratefully acknowledged. The NCCR FINRISK is a
research programme supported by the Swiss National Science Foundation. Parts of this
research were undertaken while Beiner was a visiting scholar at the Saı̈d Business School at
the University of Oxford; he acknowledges financial support from the Swiss National Science
Foundation (SNF). All remaining errors are our own.
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Journal compilation # 2006 Blackwell Publishing Ltd, 9600 Garsington Road, Oxford OX4 2DQ, UK and 350 Main Street, Malden, MA
02148, USA.
250 Stefan Beiner, Wolfgang Drobetz, Markus M. Schmid and Heinz Zimmermann
1. Introduction
Is the quality of firm-level corporate governance priced in stock markets? Does ‘good’
corporate governance cause higher stock market valuations? Or are firms with higher
market values more likely to choose better governance structures, for example, because
they have better investment opportunities and rely more heavily on external financing?
If there was a causal relationship between corporate governance and firm valuation, is
the effect economically significant for corporate decision makers and fund managers to
pay attention? Given that a firm can choose from a menu of corporate governance
mechanisms, are there possible substitution effects? Specifically, is the greater use of one
specific governance mechanism positively related to firm value, or do different combi-
nations of mechanisms lead to equal firm valuations? Finally, do the newly adopted
codes of best practice help to construct a reliable corporate governance index? These
issues are addressed in this paper using a comprehensive sample of Swiss firms.
From a theoretical point of view, agency problems may affect the value of firms
through the expected cash flows accruing to investors and/or the cost of capital. First,
agency problems make investors pessimistic about future cash flows. La Porta et al.
(2002) argue that investors bid up stock prices, because ‘with better legal protection,
more of the firm’s profits would come back to them as interest or dividends as
opposed to being expropriated by the entrepreneur who controls the firm’.1 Second,
good corporate governance decreases the cost of capital to the extent that it reduces
shareholders’ monitoring and auditing costs (e.g., Lombardo and Pagano, 2002).
Recent empirical studies support this proposition. La Porta et al. (2002) document
higher valuation of firms in countries with better protection of minority shareholders.
Durnev and Kim (2005) and Klapper and Love (2004) use data on firm-level
corporate governance rankings and find that companies with better governance and
better disclosure standards exhibit higher Tobin’s Qs.2 Drobetz et al. (2004) construct
a broad corporate governance rating related to the German Corporate Governance
Code and document a positive relationship between governance practices and firm
valuation for German public firms. Similarly, Bauer et al. (2004) use Deminor
Corporate Governance Ratings for companies included in the FTSE Eurotop 300
index and find that higher ratings lead to higher common stock returns and enhance
firm value. Gompers et al. (2003) construct a governance index based on takeover
defences for a sample of US firms. They report that firms with better governance receive
higher market valuations and have better operating performance and lower capital
expenditures. However, most studies do not appropriately address the issue of endo-
geneity, i.e., the results can only be interpreted as partial correlations without indication
of causality. An exception is the study by Black et al. (2003), who also find a positive
relation between their governance index and Tobin’s Q for a sample of Korean compa-
nies. They apply a three-stage least squares (3SLS) approach and show that a 10-point
increase (out of 100) in the governance index leads to a 19.4% increase in Tobin’s Q.
1
See La Porta et al. (2002), p. 1147. See also Shleifer and Wolfenzon (2002) and Durnev and
Kim (2005) for theoretical models.
2
Both papers document a stronger relationship between governance practices and firm valua-
tion in less investor friendly countries. This result may explain why previous studies based on
US data show mixed results (e.g., Demsetz and Lehn, 1985), because the US provides one of the
strongest legal frameworks.
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Journal compilation # Blackwell Publishing Ltd. 2006
An Integrated Framework of Corporate Governance and Firm Valuation 251
The Swiss corporate governance regime is particularly interesting to analyse. The

institutionalisation of shareholdings has had a strong effect on the structural changes
of the equity market after pension plans became mandatory in the mid-eighties and
emerged as the major domestic investment force. Moreover, with globalising equity
markets many restrictions protecting the management and/or owner families of Swiss
firms were abandoned, for example, restrictions on the transferability of shares or
multiple share classes with limited or unequal voting rights. For example, Kunz (2002)
reports that in 1989 only 13% of all Swiss companies had unitary shares, but this
number rose to 71% by 2001.3 Finally, although the market for corporate control
developed only slowly during the 1990s (e.g., Loderer and Zgraggen, 1999), there have
been serious attempts by many firms to adopt internationally recognised governance
principles in recent years. These structural changes make it interesting to investigate
the role of specific governance mechanisms and their interdependence in more detail.
This paper has two major contributions. First, we construct a firm-specific corporate
governance index (CGI) for Switzerland. Many European countries have adopted codes
of best practice only recently to establish guidelines for listed companies and to improve
the overall quality of corporate governance. In Switzerland, for example, the ‘Directive
on Information Relating to Corporate Governance’ and the ‘Swiss Code of Best
Practice’ have become effective as of 1 July 2002. This new set of rules enables the
construction of a broad firm-specific CGI. Our index is based on a survey among all
listed companies on the Swiss stock exchange, and virtually all survey questions relate
to the recommendations in the Swiss Code of Best Practice. Reflecting soft governance
attributes, which are not (yet) legally required, the index is not directly related to other
governance mechanisms.
The second major contribution of our paper is that we present an integrated empirical
framework to measure the valuation effects of different corporate governance mechanisms.
In contrast to most previous research, we control for endogeneity and account for possible
substitution effects between different corporate governance mechanisms. Endogeneity is a
problem that plagues virtually all empirical studies in corporate governance (e.g., Börsch-
Supan and Köke, 2002).4 The key question is whether good corporate governance causes
higher firm valuations. Alternatively, firms with higher market values could be more likely
to choose better governance structures. For example, firm insiders may believe that better
governance structures will further raise firm value. In this case, there is a causal relationship,
but ordinary least squares coefficients overstate the actual connection. Alternatively, firms
may adopt good corporate governance to signal that firm insiders behave well, but
governance is only a proxy for an omitted variable (for example, management quality)
that simultaneously determines corporate governance and performance. Accordingly, the
resulting correlation between corporate governance and firm valuation is spurious. Finally,
Klapper and Love (2004) and Durnev and Kim (2005) argue that firms with better
investment opportunities and larger needs for outside financing have more incentives to
adopt better governance practices. Growth opportunities are reflected in the market
valuation of the firm, implying a positive correlation between governance and Tobin’s Q.
There is a causal connection between corporate governance and firm valuation, but
ordinary least squares coefficients will again overstate the actual connection.
3
Faccio and Lang (2002) report that 48% of Swiss firms have a family as the controlling
shareholder.
4
See also Himmelberg et al. (1999).
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In addition, given a broad menu of alternative corporate governance mechanisms

firms’ decision makers can choose from, one may suspect that there are substitution
effects. Agrawal and Knoeber (1996) argue that the greater use of one mechanism
need not be positively related to firm performance, and where one mechanism is used
less, others may be used more, resulting in equally good performance. The existence of
alternative governance mechanisms and their likely interdependence make ordinary
least squares regressions that relate the use of any single governance mechanism to
firm performance difficult to interpret. Our methodology avoids a potential missing
variables bias and controls for possible interrelationships between the different
corporate governance mechanisms and Tobin’s Q. In addition to the CGI, we include
additional mechanisms that are not contained in the index, for example, ownership
and board characteristics. To avoid spurious results, we follow Agrawal and Knoeber
(1996) and develop a system of simultaneous equations to capture the interdepen-
dence between the corporate governance mechanisms and Tobin’s Q and apply three-
stage least squares (3SLS).
Our results support the hypothesis of a positive relationship between corporate
governance and firm value, i.e., firms with better corporate governance standards
receive higher market valuations. We are hesitant to exactly quantify the valuation
impact of improved governance standards. For the median firm, a one standard
deviation increase in the corporate governance index causes an increase of the market
capitalisation by at least 12% of a company’s book asset value. Our results further
reveal that board size is positively related to firm value, but neither the presence of a
controlling shareholder nor large (outside) blockholders have a significant valuation
impact. Firms with a controlling shareholder tend to have larger boards and a smaller
fraction of outside directors, indicating private benefits from sitting on the board.
The remainder of the paper is organised as follows. Section 2 presents the methodo-
logical approach and gives a motivation for the use of each of the corporate
governance mechanisms employed in this paper. Section 3 defines the variables and
describes the data. The empirical results are presented in Section 4. Finally, section 5
concludes.
2. Methodological Approach
Most previous studies that estimate the valuation impact of corporate governance
concentrate on specific aspects of corporate governance in isolation, for example,
takeover defences (Gompers et al., 2003), executive compensation (Loderer and
Martin, 1997), blockholdings (Demsetz and Lehn, 1985; Densetz and Villalonga,
2001), board size (Yermack, 1996; Eisenberg et al., 1998) or board composition
(Hermalin and Weisbach, 1991; Bhagat and Black, 2002). However, the existence of
alternative corporate governance mechanisms may lead to a missing variables bias
and spurious correlations. In addition to our broad corporate governance index, we
therefore use an extensive set of governance mechanisms simultaneously: (1) share-
holdings of the largest shareholder, (2) shareholdings by large outside blockholders,
(3) board size, (4) leverage, and (5) outsider representation on the board. Following
Agrawal and Knoeber (1996), we allow for interdependence between these corporate
governance mechanisms by specifying a system of simultaneous equations, where each
governance mechanism is the dependent variable in one of the equations. The choice
of any of the corporate governance mechanisms may depend upon choices of all other
mechanisms as well as other (exogenous) factors. To investigate the valuation impact
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of corporate governance, we add an additional equation with Tobin’s Q as the

dependent variable. Tobin’s Q is also included as an explanatory variable in all
other equations to allow for a possible interdependence. In order to control for
reverse causality in the relationship between the corporate governance mechanisms
and Tobin’s Q, we estimate the system of equations using 3SLS.
Corporate Governance Index (CGI): We use a survey-based CGI as the dependent
variable in the first equation of our system of equations. A detailed description is
postponed until section 3.1, but we emphasise that the index refers to the recommen-
dations contained in the Swiss Code of Best Practice and is not directly related to the
other corporate governance mechanisms. The index depends on choices of the other
corporate governance mechanisms and on exogenous control variables. Because
larger firms face more severe agency problems and may voluntarily choose stricter
governance rules (e.g., Jensen, 1986), the first exogenous variable is firm size,
Lnassets, measured by the natural logarithm of total assets.5 A measure of growth
opportunities is used as the second explanatory variable. Firms with growth oppor-
tunities need to raise external financing and may find it optimal to improve their
governance standards to reduce their cost of capital.6 We follow Klapper and Love
(2004) and use the average annual sales growth over the past three years (2000–2002),
labeled as Growth.7 To capture a possible interrelation between operating perfor-
mance and firm-specific corporate governance, we include the return on assets,
ROA. This variable is defined as the operating profit in 2002 divided by the average
of the 2002 starting and ending values of total assets. Furthermore, the composition
of a firm’s assets will likely affect its contracting environment. It is easier to monitor
and harder to steal fixed assets than soft capital and, hence, a firm operating with a
higher proportion of intangible assets may adopt stricter governance standards to
prevent misuse. Therefore, the relationship between CGI and the proportion of
intangible to total assets, denoted as Intang, should be positive.
Finally, we include several dummy variables: (i) SMI, a dummy variable that is
equal to one if a firm is included in the Swiss Market Index, or zero otherwise, and (ii)
Industry, which relates to dummy variables in 12 industries according to the classifica-
tion of Swiss Exchange (SWX). Assuming that all relations are linear and labelling the
other five corporate governance mechanisms as CGMij and Tobin’s Q simply as Qi,
the first equation of our system is:8
X
5
CGIi ¼ a0 þ aj CGM ij þ a6 Qi þ a7 Lnassetsi þ a8 Growthi þ a9 ROAi
j¼1
X
12
þ a10 Intangi þ a11 SMIi þ a11þj Industryij þ ei ð1Þ
j¼1
5
See Klapper and Love (2004) and Drobetz et al. (2004) for empirical evidence.
6
See Lombardo and Pagano (2000) and Himmelberg et al. (2001).
7
For banks and insurance companies sales growth is not a useful measure. Therefore, we use the
average annual growth in gross premiums for financial services firms.
8
We assume linear relations to avoid econometric problems, which may occur in simultaneous
equation systems with nonlinear (endogenous) variables (e.g., Davidson and MacKinnon,
1993).
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Incentive alignment and control structure: Jensen and Meckling (1976) argue that
higher managerial ownership aligns managers’ incentives with those of other
shareholders (convergence-of-interest hypothesis).9 In contrast, managers may want
to hold equity in highly profitable firms because this increases their wealth (Leland
and Pyle, 1977). The empirical evidence is rather mixed. Morck et al. (1988) find that,
at least when the fraction of shares held by the board is small, greater board
shareholdings improve firm performance.10 Loderer and Martin (1997) employ a
system of simultaneous equations and find no evidence that larger managerial
stockholdings lead to better firm performance, but that performance affects how
much stock executives want to hold.11
A typical US- or UK-centric model of corporate governance may have managerial
shareholdings as the dependent variable in the second equation of our system.
However, while the Berle and Means (1932) model of widely dispersed corporate
ownership is dominant in the USA and the UK, large shareholders control a sig-
nificant number of firms in most European countries (e.g., La Porta et al., 1999;
Faccio and Lang, 2002; Becht and Roëll, 1999). When companies have a controlling
shareholder, the controlling party can appropriate private benefits not shared by
other shareholders (e.g., Barclay and Holderness, 1989; Dyck and Zingales, 2004;
Edwards and Weichenrieder, 2004). Most importantly, with a controlling shareholder
the shareholdings of the management are not as important as in a widely held firm. In
fact, the management is usually hired and fired by the controlling shareholder, and
often the two parties coincide. To capture this peculiarity of corporate Switzerland,
we construct the variable Lshare that captures the shareholding of the largest share-
holder of the firm. It is used as a dependent variable in our second equation.12
We expect Lshare to be lower when the costs of holding an underdiversified
portfolio are higher (e.g., Dyck and Zingales, 2004). We use the standard devia-
tion of stock returns over a 60-month time window, Vola, and firm size, Lnassets,
as indicators of these costs. In contrast, Growth is included as an indicator of
growth opportunities, which increase the attractiveness of holding shares. We also
include the natural logarithm of the number of years since inception of the firm,
Lnage. Intuitively, Lshare should be higher both in growth firms and younger
firms. In addition, voting restrictions may allow a shareholder to dominate the
firm even if he owns less than 50% of the firm’s stock. We expect a positive
relationship between Lshare and Scat, a dummy variable which is equal to one if
the firm has different share categories with different voting rights, and zero
otherwise.13 Finally, we include a dummy variable, labelled as Founder, which is
equal to one if the CEO or the president of the board is also the founder of the
9
In a related strand of literature, Diamond and Verrechia (1982) and Holmstrom and Tirole
(1993) propose models that are based on the interaction of capital markets and contingent
compensation.
10
See also McConnell and Servaes (1990).
11
See Chung and Pruitt (1996) and Schmid (2004) for further results.
12
In ordinary least squares regressions we also apply the percentage of managerial ownership,
Stocksod, as a dependent variable and demonstrate non-linearities in relation with firm valua-
tion (see section 4.1).
13
Schmid (2004) shows that different share categories may also aggravate a possible entrench-
ment effect.
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firm, and zero otherwise. Hence, the second equation of our system is:
X
5
Lsharei ¼ a0 þ aj CGM ij þ a6 Qi þ a7 Volai þ a8 Lnassetsi þ a9 Growthi
j¼1
X
12
þ a10 Lnagei þ a11 Scati þ a12 Founderi þ a12þj Industryij þ ei ð2Þ
j¼1
Outside blockholding: Stiglitz (1985) argues that one of the most important ways
to ensure that managers pursue value maximising strategies is through
concentrated ownership. Shleifer and Vishny (1986) present a model in which a
blockholder effectively monitors management by virtue of representing a credible
takeover threat.14 The empirical evidence is mixed at best even for samples of US
firms. Denis et al. (1997) show that top executive turnover is more sensitive to
poor performance in firms with outside blockholders. Similarly, McConnell and
Servaes (1990) find a positive relationship between institutional ownership and
Tobin’s Q. In contrast, Demsetz and Lehn (1985), Agrawal and Knoeber (1996)
and Demsetz and Villalonga (2001) find no relationship between concentrated
shareholdings and firm performance.
The dependent variable in the third equation of our system is outside block-
holding, denoted as Blockout, which is the percentage of cumulated voting rights
exercised by non-group listed companies, mutual funds, and pension funds owning
5% or more of a firm’s equity. Because we eventually want to capture the
monitoring function associated with concentrated ownership, controlling share-
holders who run the firm through professional managers or pyramidal structures
are not included in Blockout. We expect Blockout to be negatively related to the
costs of outside blockholding and again use Vola and Lnassets as indicators of
these costs. Because it is more attractive to hold stock in a firm with higher
growth opportunities, we assume Blockout to be positively related to Growth.
Furthermore, large investors will recognise that firms with higher R&D intensity
and a more diffuse information structure are more difficult to monitor.15
Accordingly, Blockout should be negatively related to Intang. In contrast, we
expect a positive relationship between Blockout and Scat, the latter being a
dummy variable for the existence of more than one share category. Finally, the
number of outside blockholders, Blockonr, is included as a control variable in the
third equation of our system:
X
5
Blockouti ¼a0 þ aj CGMij þ a6 Qi þ a7 Volai þ a8 Lnassetsi þ a9 Growthi
j¼1
X
12
þ a10 Intangi þ a11 Scati þ a12 Blockonri þ a12þj Industryij þ ei ð3Þ
j¼1
14
See also Admati et al. (1994).
15
See Zeckhauser and Pound (1990).
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Board size: The role of the board of directors is to monitor and discipline a firm’s
management, thereby ensuring that managers pursue the interests of shareholders.
Lipton and Lorsch (1992) and Jensen (1993) were the first to hypothesise that board
size is an independent governance mechanism. Because of increasing coordination and
communication problems, large boards may be less effective than small boards. Using
a sample of large US public corporations, Yermack (1996) reports an inverse
relationship between board size and firm value, as measured by Tobin’s Q. His
results also show that causality runs from board size to Tobin’s Q, and there is no
evidence that firms change board size as a reaction to past performance.16
The fourth equation in our system has the number of directors on the board,
labelled as Bsize, as the dependent variable. The first exogenous control variable is
firm size, Lnassets, and we expect large firms to have larger boards of directors. We
include a dummy variable Sown, which is one if the state owns more than 5% of the
firm’s equity, and zero otherwise. This variable accounts for the possibility that
political influences lead to presumably larger boards with a disproportionate number
of government representatives. As hypothesised by Yermack (1996), small boards
could increase firm performance, or depending on the direction of causality, firms
may adjust board size in response to past performance. Therefore, the return on
assets, ROA, is included in the fourth equation of our system:
X 5
Bsizei ¼ a0 þ aj CGMij þ a6 Qi þ a7 Lnassetsi þ a8 Divi þ a9 ROAi
j¼1
X
12
þ a9þ1 Industryij þ ei ð4Þ
j¼1
Leverage: Jensen (1986, 1993), Stulz (1990), and Hart and Moore (1995), among
others, suggest that debt helps to discourage overinvestment of free cash flow by
self-serving managers. Debt can also create value by giving the management an
opportunity to signal its willingness to distribute cash flows and to be monitored by
lenders.17 Empirically, McConnell and Servaes (1995) find that book leverage is
positively correlated with firm value when investment opportunities are scarce,
which is consistent with the hypothesis that debt alleviates the overinvestment
problem. However, Agrawal and Knoeber (1996) and Beiner et al. (2004) find no
relationship between leverage and firm performance and argue that leverage is
employed optimally in conjunction with other governance mechanisms.
The dependent variable in the fifth equation of our system is leverage (LV), as
measured by the ratio of total (non-equity) liabilities to total assets (see Rajan and
Zingales, 1995). Following Jensen (1986), mature firms with stable cash flows should
use more debt in order to discipline managers. We use two different variables to proxy
for the maturity of a firm: firm size, denoted as Lnassets, and firm age, referred to as
Lnage. In addition, we include a dummy variable, denoted as Div, which is one if the
firm paid dividends in 2003 (based on the earnings of 2002), and zero otherwise.
Because the availability of internal funds provides an alternative to debt financing,
16
See also Eisenberg et al. (1998) and Beiner et al. (2004).
17
However, the argument that debt can ensure good corporate governance is significantly
weakened by the fact that retained earnings are the most important source of financing for
corporations (e.g., see Hellwig, 1998).
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there should be a negative relationship between Div and LV. However, for firms with
substantial growth opportunities their debt servicing requirements can limit manage-
ment’s ability to pursue positive net present value projects, leading to Myers’ (1977)
underinvestment problem. Hence, we expect a negative relationship between Growth
and LV.18 Finally, to capture a possible relationship between operating performance
and leverage, we include the return on assets, ROA, in the fifth equation of our system:
X
5
LVi ¼ a0 þ aj CGMij þ a6 Qi þ a7 Lnassetsi þ a8 Lnagei þ a9 Divi
j¼1
X
12
þ a10 Growthi þ a11 ROAi þ a11þj Industryij þ ei ð5Þ
j¼1
Outsider representation on the board: The model in Hermalin and Weisbach (1998)
predicts that CEO turnover is more sensitive to performance when the board is
more independent and that the probability of independent directors being added
to the board rises following poor firm performance. Inside directors’ careers are
tied to the CEO’s, hence, they are often unwilling to remove incumbent CEOs. In
addition, outside directors will avoid becoming associated with failing firms to
maintain their reputation. Rosenstein and Wyatt (1990) document a positive stock
price reaction upon announcement of the appointment of an outside director.
Weisbach (1988) finds that firms with outsider-dominated boards are more likely
to remove the CEO after bad performance than firms with insider-dominated
boards. In contrast, Yermack (1996) and Beiner et al. (2004) find no association
between the fraction of outside directors and firm performance for US and Swiss
data, respectively.
The percentage of outside directors on the board, Outsider, is the dependent
variable in the sixth equation of our system. The first control variable is Ceop, a
dummy variable which is equal to one if the CEO is the president of the board at the
same time, and zero otherwise. While this dual capacity alleviates coordination and
communication problems between the CEO and the board of directors, it may lead to
a concentration of power and the election of less independent board members.19 We
also include the Founder dummy variable, because founding CEOs and presidents of
the board may withdraw from their positions but retain their stock holdings of the
firm, still having enough power to influence the composition of the board. To control
for the effect of government ownership on board composition, we include the dummy
variable Sown. Finally, to capture a possible relationship between board composition,
growth opportunities and operating performance, we use Growth and ROA, respect-
ively, as exogenous explanatory variable in the sixth equation of our system:
X
5
Outsideri ¼ a0 þ aj CGMij þ a6 Qi þ a7 Ceopi þ a8 Sowni þ a9 Founderi
j¼1
X
12
þ a10 Growthi þ a11 ROAi þ a11þj Industryij þ ei ð6Þ
j¼1
18
See Drobetz and Fix (2005).
19
See Shivdasani and Yermack (1999).
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Firm value: To examine the relationship between the governance mechanisms and
firm value, the dependent variable in the last equation of our system is Tobin’s Q.
Following Yermack (1996), we include two variables to control for growth
opportunities: Lnassets and Growth. We expect a positive relationship between
Growth and Q and a negative influence of Lnassets on Q. Based on simple valuation
models, Q may depend on ROA and Beta. Beta is the market beta estimated by
regressing a firm’s monthly stock returns over the past 60 months on the returns of the
Swiss Performance Index (SPI). Therefore, the final equation in our system is:
X
6
Q i ¼ a0 þ aj CGMij þ a7 Lnassetsi þ a8 Growthi þ a9 ROAi þ a10 Betai
j¼1
X
12
þ a10þj Industryij þ ei ð7Þ
j¼1
3. Data Description
3.1. Definition of variables

This section provides a description of the variables used in the empirical analysis.
Most important, our CGI is based on responses to a detailed questionnaire, which
refers to the recommendations in the Swiss Code of Best Practice. The survey was sent
out to all Swiss firms quoted at Swiss Exchange (SWX) with the exception of invest-
ment companies and was completed between May and July 2003. When necessary, the
data was supplemented and verified consulting annual reports and web pages. The
survey consisted of 38 questions/attributes in five categories: (1) corporate governance
commitment, (2) shareholders’ rights, (3) transparency, (4) board of directors and
executive management, and (5) auditing and reporting. To qualify for inclusion, an
attribute must refer to a governance element that is not (yet) legally required. All
attributes can be initiated and implemented by a firm’s decision makers. The full list
of questions is provided in the Appendix.
The construction of the index is straightforward: First, firms were asked to indicate
their acceptance level by assigning a value between 1 (minimum) and 5 (maximum) to
each question. One point is added for each subsequent acceptance level on this five-
scale answering range. A higher acceptance level is interpreted as an (earlier) active
move by the firm’s decision makers to improve its corporate governance system.
Second, we compute the simple sum over all 38 questions. While such a simple
weighting scheme makes no attempt to accurately reflect the relative importance of
the individual governance attributes, it has the advantage of being transparent and
easy to interpret. Finally, the index is normalised to have a value between 0 and 100,
with better-governed firms having higher index levels.
The other corporate governance mechanisms are defined as follows: Lshare denotes
the percentage of voting rights exercised by the largest shareholder.20 Blockout is the
20
Alternatively, we use 10% and 20% thresholds in the definition of controlling shareholders.
However, our results do not qualitatively change because the average shareholding of the
largest investor is already as high as 28% (see Table 2).
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percentage of cumulated voting rights exercised by true outside blockholders, i.e.,

non-group listed companies, mutual funds, and pension funds with voting rights
exceeding 5%. Bsize is the number of directors on the firm’s board. Outsider refers
to outside membership on the board, measured by the percentage of board seats held
by directors without any executive function. LV denotes firm leverage and is calcu-
lated as the ratio of total (non-equity) liabilities to total assets. In addition, 14
exogenous control variables are included in our system of equations. They have
been introduced in section 2, and Table 1 gives a summary of all variables employed.
Finally, our measure of firm valuation is Tobin’s Q, or simply Q. Following Chung
and Pruitt (1994), Perfect and Wiles (1994), Agrawal and Knoeber (1996), Kang and
Stulz (1996), and Loderer and Peyer (2002), among others, Tobin’s Q is computed as
the ratio of the market value of equity plus the book value of debt to the book value
of total assets. To avoid that fluctuations in the market value of firms’ equity
influence our results, we take the market value of equity as the mean of weekly
observations during 2002. For some firms weekly stock price data are not available
for all share categories on Datastream, and we replaced them by the mean of the 2001
and 2002 year end values of total market capitalisation obtained from Worldscope.
3.2. Sample description

We target all 275 firms quoted at SWX by the end of 2002. The exclusion of
investment companies leaves us with a sample of 235 firms receiving our question-
naire. Overall, 120 firms returned the questionnaire, which implies a response rate of
51.06%. Another nine (smaller) firms must be dropped due to insufficient data.
Finally, the exclusion of two obvious outliers concerning their value of Tobin’s Q
and return on assets leaves us with a sample of 109 firms for our cross-sectional
regression analysis.
Data have been collected from different sources besides the questionnaire and
generally refer to the reporting period from January 2002 to December 2002. Data
for the variables Lshare, Blockout, Bsize, Blockonr, Ceop, Lnage, Scat, and Sown are
from the website of ‘Finanz & Wirtschaft’ and the ‘Swiss Stock Guide 2002/2003’.
Stocksod has been collected from annual reports. The necessary data to compute Q,
LV, Beta, Div, Growth, Intang, Lnassets, ROA, and Vola are obtained from
Datastream and Worldscope. However, for most variables data are not available
for all firms in our sample. Missing values were obtained directly from the companies’
annual reports. SMI constituents are spotted from the website of the SWX. Finally,
the variables CGI, Industry, Founder, and Outsider are based on questionnaire
answers and were double-checked using publicly available information.
Table 2 shows descriptive statistics of all variables included in our analysis. To save
space, we do not provide a detailed discussion, and rather concentrate on the CGI.
The distribution of the index is displayed in Figure 1. The mean of CGI is 58.46 and
the median 59.21, indicating a relatively symmetric distribution. As expected, SMI
firms have significantly higher values of CGI than the other firms in our sample.
Additionally, Figure 1 reveals that there are substantial differences in firm-level
corporate governance between the 109 firms in our sample: the minimum value is
25.00, and the maximum value is 90.13. This suggests that our corporate governance
proxies are adequately selected to reach a sufficiently wide distribution, which miti-
gates possible sample selection biases. To further explore this potential problem, we
follow Moore and Reichert (1983) and Graham and Harvey (2001) and compare the
# 2006 The Authors
Table 1
Summary of variables
Endogenous variables
Q Ratio of market value to book value of assets (market value of assets is

computed as market value of equity plus book value of assets minus
book value of equity)
CGI Corporate governance index (takes into account 38 different aspects of the
corporate governance structure of a company; scaled to a value between 0 and 100)
Lshare Percentage of voting rights exercised by the largest shareholder
Stocksod Percentage of equity owned by officers and directors (if Scat ¼ 1, nominal
values of different share categories are used for weighting)
Blockout Percentage of cumulated voting rights exercised by large outside investors
(non-group listed companies, mutual funds, and pension funds) with >5%
of voting rights
Bsize Number of directors on the board of the company
LV Leverage, measured as the ratio of total (non-equity) liabilities to total assets
Outsider Outsider membership on the board, measured by the percentage of board
seats held by non-officers without relationship to the founding family (if any)
Exogenous variables
Beta Beta estimated from monthly stock returns (1998–2002)

Blockonr Number of outside shareholders with an equity stake >5%
Ceop 1, if the CEO is also the president of the board; 0 otherwise
Div 1, if the company paid out dividends in 2002; 0 otherwise
Founder 1, if the CEO or the president of the board founded the company; 0 otherwise
Growth Average annual growth of sales (or gross premiums for banks and insurance
companies) over the past three years (2000–2002)
Industry 12 industry dummy variables according to the classification of Swiss Exchange
(SWX)
Intang Ratio of intangible assets to total assets
Lnage Natural log of firm age
Lnassets Firm size, measured by the natural logarithm of book value of total assets
ROA Ratio of operating income to total assets (return on assets)
Scat 1, if the firm has different share categories with different voting rights
attached; 0 otherwise
SMI 1, if the company belongs to the Swiss Market Index; 0 otherwise
Sown 1, if state owns >5% of the firm’s equity; 0 otherwise
Vola Standard deviation of stock returns estimated from monthly stock returns
(1998–2002)
characteristics of the 109 responding firms to the characteristics of the complete

sample of 170 Swiss firms with data available for all variables (except CGI). If the
characteristics between the two groups match, our sample is representative for the
underlying population. Specifically, we test the equality in means and medians of
Tobin’s Q, the additional governance mechanisms (Lshare, Stocksod, Blockout, Bsize,
LV, and Outsider), Lnassets, Beta, Growth, and ROA between our sample of 109 firms
and the complete sample of 170 firms. Results not shown here indicate that sample
firms are significantly larger. With respect to all other variables, however, we cannot
# 2006 The Authors

Table 2
Descriptive statistics
The table includes descriptive statistics of all variables included in the empirical analysis. The
sample consists of 109 firms quoted at Swiss Exchange (SWX).
Variable Mean Median Standard deviation Maximum/Minimum
Q 1.3390 1.0606 0.7618 5.6637/0.6004

CGI 58.4561 59.2105 14.3384 90.1316/25.0000
Lshare 0.2862 0.2200 0.2614 0.9400/0.0000
Stocksod 0.1201 0.0059 0.1899 0.7878/0.0000
Blockout 0.1262 0.0605 0.1836 0.8500/0.0000
Bsize 7.3486 7.0000 2.7161 16.0000/3.0000
LV 0.6234 0.6266 0.2183 0.9855/0.0890
Outsider 0.8927 1.0000 0.1333 1.0000/0.4000
Beta 0.7933 0.6261 0.5826 2.2455/0.0843
Blockonr 1.7064 2.0000 1.3492 5.0000/0.0000
Ceop 0.1468 0.0000 0.3555 1.0000/0.0000
Div 0.7339 1.0000 0.4439 1.0000/0.0000
Founder 0.1009 0.0000 0.3026 1.0000/0.0000
Growth 0.1277 0.0597 0.4188 3.9722/0.6080
Intang 0.0756 0.0261 0.0968 0.3727/0.0000
Lnage 3.6513 3.8067 1.2397 6.2766/0.6931
Lnassets 14.2414 13.9571 2.1072 20.8897/9.1714
ROA 0.0215 0.0365 0.0908 0.1861/0.6002
Scat 0.2202 0.0000 0.4163 1.0000/0.0000
SMI 0.1835 0.0000 0.3889 1.0000/0.0000
Sown 0.1193 0.0000 0.3256 1.0000/0.0000
Vola 0.1004 0.0927 0.0515 0.2589/0.0061
find statistically different mean or median values. We interpret this observation as

suggesting that our sample matches the underlying population and that our results are
unlikely to be affected by a non-response bias.
Table 3 shows the correlation coefficients between Tobin’s Q and the six govern-
ance mechanisms we use in our system estimations. Of special interest, and consistent
with our general notion, is the positive and statistically significant correlation coeffi-
cient of 0.24 between our corporate governance index, CGI, and Tobin’s Q. Blockout
and Bsize are also positively correlated with Tobin’s Q. In contrast, Lshare, LV, and
Outsider are all negatively correlated with Q. Finally, it is important to note that CGI
is based on the recommendations and suggestions of the Swiss Code of Best Practice
and incorporates a broad range of soft corporate governance issues. Hence, the index
is not directly related to the additional governance mechanisms. Nevertheless, there
are minor overlaps that cannot be avoided. For example, one question in the survey
refers to the one share-one vote principle (see question 6 in the appendix), which
affects Lshare as well as Blockout and is also captured by the dummy variable Scat.
After experimenting with the construction of the index and the specification of the
system of equations, we are confident that these overlaps do not cause major pro-
blems. First, we estimate the system of equations excluding Scat, and the results
remain unchanged (see section 4.4). Second, in results not reported here we extend
# 2006 The Authors
14
12
10
Number of Firms 8
0
20 30 40 50 60 70 80 90 100
Corporate Governance Index
SMI Firms All Firms
Fig. 1. Empirical distribution of the corporate governance index (CGI)

The figure shows the distribution of the survey-based CGI for 109 Swiss firms listed at SWX.
The index represents an unweighted sum of the basis points (on a five-scale answering range) for
all corporate governance proxies in the five categories (1) corporate governance commitment,
(2) shareholders’ rights, (3) transparency, (4) management and supervisory board matters, and
(5) auditing. CGI is normalized to have a value between 0 and 100, with better-governed firms
having higher index scores. Dark grey represents firms included in the Swiss Market Index
(SMI).
Table 3
Correlation matrix between corporate governance mechanisms and Tobin’s Q
The table reports the Pearson correlation coefficients between Tobin’s Q and the corporate
governance mechanisms. The sample consists of 109 firms quoted at Swiss Exchange (SWX).
p-values are in parentheses. ***/**/ * denotes statistical significance at the 1%/5%/10% level.
CGI Lshare Blockout Bsize LV Outsider
Q 0.2417** 0.1268 0.0067 0.0296 0.2457** 0.1247

(0.0113) (0.1887) (0.9450) (0.7598) (0.0100) (0.1963)
CGI 0.2476*** 0.0606 0.0725 0.0171 0.0116
(0.0094) (0.5317) (0.4537) (0.8598) (0.9043)
Lshare 0.1890** 0.1386 0.2865*** 0.1444
(0.0490) (0.1561) (0.0025) (0.1337)
Blockout 0.1208 0.0008 0.1556
(0.2110) (0.9931) (0.1062)
Bsize 0.2454** 0.3062***
(0.0101) (0.0012)
LV 0.3472***
(0.0002)
# 2006 The Authors

CGI by including outsider ownership and removing equation (6) from the system, but
the coefficients in the Q-equation (7) do not change qualitatively.21 And third, the
correlation coefficients between CGI and the other variables are low, with Lshare
(0.25) being the exception. However, the relationship between CGI and Lshare is
estimated insignificantly in our regression results in section 4.
4. Empirical Results
Our empirical analysis proceeds in three steps: First, we estimate ordinary least
squares regressions where firm value depends only on a single corporate governance
mechanism. Similar estimations have been standard in the literature, but they ignore
the influence of alternative mechanisms on firm performance and possible endogene-
ities. Second, we estimate equation (7) using OLS to examine the effects of all
governance mechanisms simultaneously. And third, to avoid incorrect inferences
due to possible endogenous relationships between the different governance mechan-
isms themselves as well as between the governance mechanisms and Tobin’s Q, we
estimate equation (7) along with equations (1)–(6) in a system of simultaneous
equations using 3SLS. This procedure treats Q as endogenous along with the six
governance mechanisms, allowing each of the mechanisms to affect Q, but also
allowing Q to affect the choice of each mechanism. A comparison of the 3SLS
estimates with the OLS estimates of equation (7) allows a direct inspection of the
differences that arise from any possible endogeneities.
Our system of equations includes 14 exogenous and seven endogenous variables.
The order-condition for identification states that the number of predetermined vari-
ables excluded from the equation must be greater than or equal to the number of
included endogenous variables minus one. The list of included endogenous variables
contains variables on the left-hand side and the right-hand side of the equation.
Therefore, at least six of the exogenous variables must be excluded from any single
equation to identify the system. However, the development of equations (1)–(7) is
motivated independently of the requirement that these identification restrictions are
to be met. All equations in our system are overidentified and at least three variables
could be included to any equation without jeopardising its identification.
4.1. Ordinary least squares results
Table 4 presents the results from OLS regressions of Q on individual governance

mechanisms along with the exogenous control variables included in equation (7) of
our system. Column (1) shows that CGI has a statistically significant positive effect on
firm valuation. This supports our hypothesis that firms with higher governance stan-
dards receive higher market valuations. The only other governance mechanism that
exhibits a significant coefficient is Bsize in column (4). Notably, the relationship
between board size and firm value is positive, which contradicts previous results by
Yermack (1996). It is particularly interesting to observe that both variables related to
21
In an additional survey question not included in the construction of the original governance
index we asked firms whether the majority of their non-executive board members were
independent. We use the same construction principles for this extended index as explained in
section 3.1.
# 2006 The Authors

Table 4
Results from OLS regressions
The table reports the results from OLS regressions of Tobin’s Q on individual corporate governance mechanisms as well as all mechanisms together
# 2006 The Authors

along with the exogenous control variables included in equation (7) of the system of equations. The sample consists of 109 firms quoted at SWX. Wald
tests are performed for the simultaneous significance of all coefficients (except the constant and the industry dummies). The numbers in parentheses are
probability values for two-sided tests. ***/**/* denotes statistical significance at the 1%/5%/10% level.
Dependent variable ¼ Q
Independent
variable (1) (2) (3) (4) (5) (6) (7) (8) (9)

Constant 1.4660 1.6777* 1.5932* 1.6890* 1.5301* 1.7865* 0.9234 2.0944** 1.0948
(0.1070) (0.0731) (0.0887) (0.0692) (0.0930) (0.0820) (0.2761) (0.0463) (0.2726)
CGI 0.0083** 0.0087** 0.0103**
(0.0305) (0.0174) (0.0121)
Lshare 0.2591 0.1757
(0.3220) (0.5089)
Blockout 0.2321 0.0335 0.0719
(0.2947) (0.8854) (0.7451)
Bsize 0.0450* 0.0538** 0.0466**
(0.0673) (0.0315) (0.0420)
LV 0.4858 0.2959 0.4432
(0.1833) (0.4017) (0.2083)
Outsider 0.3733 0.4124 0.0456
(0.3468) (0.2857) (0.9061)
Stocksod 2.9953** 3.1241***
(0.0113) (0.0068)
Stocksod^ 2 4.6499** 5.1943***
(0.0215) (0.0093)
Lnassets 0.0781 0.0537 0.0496 0.0838 0.0296 0.0448 0.0193 0.1121 0.0774
(0.2316) (0.4107) (0.4487) (0.2330) (0.6506) (0.4905) (0.7532) (0.1279) (0.2414)
# 2006 The Authors
ROA 2.3093*** 2.1392*** 2.1289*** 2.4367*** 2.0899*** 2.1766*** 2.0549*** 2.5319*** 2.3779***

(0.0008) (0.0010) (0.0011) (0.0006) (0.0016) (0.0008) (0.0015) (0.0004) (0.0016)
Growth 0.8855*** 0.8670*** 0.8895*** 0.9061*** 0.8850*** 0.8800*** 0.8064*** 0.8661*** 0.7915***
(0.0000) (0.0000) (0.0000) (0.0000) (0.0000) (0.0000) (0.0000) (0.0000) (0.0000)
Beta 0.3335*** 0.3791*** 0.3380*** 0.3856*** 0.3441*** 0.3570*** 0.3061*** 0.3768*** 0.2998***
(0.0040) (0.0010) (0.0033) (0.0009) (0.0025) (0.0020) (0.0038) (0.0004) (0.0030)
Industry Included Included Included Included Included Included Included Included Included
Wald test 13.3475 12.0805 12.8459 17.6207 14.4505 13.2121 13.8053 9.0978 9.0213
(0.0000) (0.0000) (0.0000) (0.0000) (0.0000) (0.0000) (0.0000) (0.0000) (0.0000)
Adjusted R2 0.4224 0.4088 0.4093 0.4193 0.4134 0.4071 0.4506 0.4261 0.4708
An Integrated Framework of Corporate Governance and Firm Valuation
265
ownership structure do not have any significant impact on Tobin’s Q. A higher share-
holding of the largest shareholder, Lshare, is not associated with a lower firm value.22
This observation is consistent with Dyck and Zingales (2004), who argue that private
benefits of control are not necessarily inefficient.23 Likewise, a stronger monitoring
function of outside blockholders, Blockout, does not entail a higher firm valuation.
To replicate previous results by McConnell and Servaes (1990), Peasnell et al. (2003)
and Schmid (2004), we explore the relationship between managerial ownership and
firm valuation. Specifically, we include an additional variable, denoted as Stocksod,
which is defined as the sum of all shares owned by officers and executive as well as non-
executive members of the board (firm insiders) divided by the total number of shares
outstanding.24 To explore a possible nonlinear relationship, we also include a squared
term, labelled as Stocksod^ 2. The results in columns (7) and (9) of Table 4 reveal a
curvilinear relationship between shareholdings of officers and directors and firm
valuation, i.e., higher managerial shareholdings are associated with higher firm valua-
tion up to some point (even in the presence of alternative corporate governance
mechanisms).25 The negative effect on firm value for levels of Stocksod beyond this
point might be explained by managerial entrenchment (for example, managers con-
trolling a substantial fraction of the firm’s equity may have enough voting power and/
or influence to guarantee their employment and attractive salaries). However, given the
prevailing ownership structure in Switzerland, Stocksod includes some owners who are
also the CEO and/or a director of the board. Private benefits of control may therefore
be a more suitable explanation rather than managerial entrenchment.26 Therefore, we
only use the shareholding of the largest shareholder, Lshare, instead of Stocksod in our
system estimations to capture this distinctive feature of corporate Switzerland.
To summarise, neglecting the interdependence of different governance mechanisms,
our corporate governance index, board size, and shareholdings of officers and direc-
tors have a statistically significant influence on firm valuation. The coefficients on the
exogenous variables in the lower part of Table 4 generally exhibit the expected signs,
and a Wald test for the significance of all coefficients (except the constant and the
industry dummies) always rejects the null hypothesis that they are jointly zero. The
adjusted R-squares are between 0.41 and 0.45.
Our results may be misleading because they ignore the existence of other govern-
ance mechanisms and their likely interdependence. To explore this possibility, column
22
We also tested a curvilinear relationship between Lshare and Tobin’s Q by adding a squared
term Lshare^ 2, but the corresponding coefficient is insignificant.
23
See also Grossman and Hart (1980).
24
For companies with more than one share category, which applies to about 22% of our sample,
the ownership of different share categories is weighted by their respective nominal values.
25
In contrast, Morck et al. (1988) find a positive relationship between share ownership of the
board of directors and Q in the 0% to 5% ownership range, a negative and less pronounced
relationship in the 5% to 25% range, and a further positive relationship beyond 25%.
26
In fact, compared to the US figures in Loderer and Martin (1997) and Anderson et al. (2000),
there are more firms in Switzerland with substantial managerial shareholdings. Unfortunately,
individualised data for shareholdings of officers and directors is not available for Swiss firms.
Hence, it is impossible to figure out the exact distribution of ownership within the group of officers
and directors and to discriminate between owners who are also CEOs and/or directors on the
board.
# 2006 The Authors

(8) in Table 4 presents the results for an OLS regression of Tobin’s Q on all govern-
ance mechanisms simultaneously. This regression allows for the adoption of different
governance mechanisms at the same time, but it does not account for interdepen-
dence. A comparison with the regression results reported in column (1) reveals that
the coefficient on CGI remains statistically significant at the 5% level. Even the
magnitude of the coefficient remains virtually unchanged. The coefficient on Bsize is
also similar in magnitude and remains significant. Finally, in column (9) we confirm
that the curvilinear relationship between managerial shareholdings and firm valuation
is robust to an inclusion of other governance mechanisms. Overall, we find that
allowing for the availability of alternative governance mechanisms does not qualita-
tively change the results obtained from looking at the effect of each corporate
governance mechanism on firm valuation in isolation.
4.2. Results from estimating a system of simultaneous equations
To account for a possible interdependence between the corporate governance mechan-

isms and Tobin’s Q, we estimate the simultaneous equations framework developed in
equations (1)–(7) using 3SLS. In a first step, however, to make sure that 3SLS is an
appropriate methodology, we test for the endogeneity of the corporate governance
mechanisms and Tobin’s Q using a Durbin-Wu-Hausman test (e.g., Hausman,
1978).27 Applied to the Q-equation, the Durbin-Wu-Hausman test rejects the null
hypothesis of no endogeneity at the 10% level. We conclude that OLS may lead to
biased and inconsistent estimates in our sample.28
Table 5 reports the results obtained from estimating simultaneously all seven
equations of our system using 3SLS. The system treats firm valuation as well as the
six corporate governance mechanisms as endogenous, and it allows each of them to
affect all the others in order to capture possible substitution effects. Most import-
antly, the coefficient on CGI in column (7) is positive and statistically significant at the
1% level. We interpret this result as evidence for a causal relationship between the
quality of firm-specific corporate governance and firm valuation rather than a signal-
ling explanation. Nevertheless, it should be noted that the coefficient increases in
magnitude roughly by a factor of 6 compared to the OLS results in Table 4, and it is
hard to find persuasive arguments. In fact, most related papers also struggle with high
coefficients on governance indices in instrumental variable regressions. Albeit smaller
27
The Durbin-Wu-Hausman test involves a two-stage procedure. In the first stage, each depen-
dent variable is regressed on all exogenous variables in the system. The predicted values for the
dependent variables are calculated using the estimated coefficients from these first-stage regres-
sions. In the second stage, each dependent variable is regressed on the exogenous variables in
the respective equation, the right-hand-side dependent variables, and the predicted values of the
right-hand-side dependent variables. The significance of each predicted right-hand-side depen-
dent variable is tested using a t-test (F-Test) with the null hypothesis of no endogeneity. If a
predicted dependent variable has significant explanatory power, the dependent variable is
presumed to be endogenous. For example, in our Q-equation the predicted dependent variables
of the six governance mechanisms are jointly significant at the 10% level, indicating that at least
one of the mechanisms is endogenous.
28
However, we noticed that the Durbin-Wu-Hausman test is sensitive to changes in the speci-
fication of the system (for a discussion see Johnston and DiNardo, 1997; Cohen and Walsh,
2000).
# 2006 The Authors

Table 5
Results from 3SLS system estimation
The table reports the results from a three-stage least squares (3SLS) estimation of equations (1)–(7) of the system of simultaneous equations. The sample
consists of 109 firms quoted at Swiss Exchange (SWX). Wald tests are performed for the simultaneous significance of all coefficients (except the constant
# 2006 The Authors

and industry dummies). The numbers in parentheses are probability values for two-sided tests. ***/**/* denotes statistical significance at the 1%/5%/
10% level.
Dependent variable
Independent CGI Lshare Blockout Bsize LV Outsider Q

variable (1) (2) (3) (4) (5) (6) (7)
Constant 12.5235 0.6666 0.3107 9.0484** 0.2289 1.0558*** 3.2614**

(0.5887) (0.1293) (0.4150) (0.0126) (0.5631) (0.0000) (0.0220)
CGI 0.0101 0.0032 0.0839 0.0200*** 0.0056* 0.0555***
(0.2019) (0.7245) (0.1617) (0.0062) (0.0783) (0.0061)
Lshare 10.4368 0.4625 3.7206* 0.2410 0.3815** 0.3548
(0.3122) (0.3565) (0.1000) (0.2171) (0.0445) (0.6484)
Blockout 6.8572 0.1156 3.8926** 0.1787 0.1135 0.4734
(0.5226) (0.5912) (0.0216) (0.3871) (0.3651) (0.4589)
Bsize 2.3669** 0.0054 0.0108 0.0502** 0.0484** 0.2073***
(0.0404) (0.8437) (0.6554) (0.0422) (0.0014) (0.0045)
LV 46.8248*** 1.2362 0.0771 6.7593** 0.2237 1.8089*
(0.0000) (0.0054) (0.8532) (0.0340) (0.2980) (0.0634)
Outsider 8.6977 0.1107 0.0701 5.0183 0.1597 1.5571
(0.6577) (0.7892) (0.8372) (0.1405) (0.6465) (0.2032)
Q 9.0740*** 0.1368** 0.0262 0.7754* 0.1505*** 0.0375
(0.0032) (0.0304) (0.7209) (0.0648) (0.0086) (0.3888)
SMI 2.0387
(0.4880)
Intang 0.9245 0.0392
(0.9091) (0.8864)
Lnassets 7.0568*** 0.0669 0.0183 1.3207*** 0.1501*** 0.4669***
(0.0000) (0.1099) (0.6683) (0.0000) (0.0005) (0.0002)
ROA 57.9683*** 7.1858** 1.1225*** 0.1613 4.1592***
(0.0002) (0.0104) (0.0010) (0.3853) (0.0001)

# 2006 The Authors
Growth 8.3572** 0.0327 0.0034 0.1495* 0.0922* 0.7593***
(0.0411) (0.6432) (0.9477) (0.0421) (0.0503) (0.0000)
Beta 0.2467*
(0.0843)
Lnage 0.0052 0.00051
(0.8006) (0.7359)
Scat 0.1320* 0.0921
(0.0954) (0.4063)
Founder 0.1013 0.0517

(0.2577) (0.3540)
Sown 2.5130*** 0.1607*
(0.0096) (0.0685)
Blocklnr 0.1431***
(0.0000)
Ceop 0.1280***
(0.0006)
Div 0.0042
(0.9111)
Vola 2.3230*** 0.1849
(0.0001) (0.8647)
Industry Included Included Included Included Included Included Included
Wald test 87.7153 33.6226 60.4433 72.5954 31.5437 27.8577 51.0618
(0.0000) (0.0008) (0.0000) (0.0000) (0.0009) (0.0034) (0.0000)
Sargan 2.5456 0.8569 1.0805 4.7699 5.4805 0.7197 11.1408
Chi2 (10%) 6.250 (3) 4.605 (2) 4.6050 (2) 9.2360 (5) 6.2500 (3) 6.2500 (3) 7.7790 (4)
Hausman 12.653 5.5932 2.5233 7.2039 8.1512 5.4169 6.4775
Chi2 (10%) 27.205 (19) 28.412 (20) 28.412 (20) 24.769 (17) 27.204 (19) 27.204 (19) 25.989 (18)
An Integrated Framework of Corporate Governance and Firm Valuation
269
than that reported here, the respective coefficient in Durnev and Kim (2005) is very
large even for emerging stock markets.29 The problem is less pronounced in Black
et al. (2003), but they include an extensive discussion that provides interesting
insights. They argue that any interpretations about the coefficient and its significance
relate only to the instrumented part of CGI.
One theoretical possibility would be to conduct an event study of the stock price
reaction upon announcement of an improvement in the corporate governance of the
firm. Unfortunately, such evidence is not available for most governance attributes
related to the Swiss Code of Best Practice, since disclosure is only required in the
annual financial statements. However, one question in the survey refers to the one
share-one vote principle. In this respect it is interesting to observe that many Swiss
firms simplified their equity capital structure only recently. Nestlé was the first Swiss
firm to allow foreign investors to hold registered shares in 1988.30 In a clinical study,
Loderer and Jacobs (1995) examine the announcement effect of the different cate-
gories of common stock. While the price of registered shares sharply increased and
that of voting bearer shares dropped, from back-of-the-envelope calculations we
conjecture that aggregate equity value increased by 3.2% during the announcement
window.31 Kunz (2002) also studies the announcement effect of simplifications of the
equity capital structure. Using a sample of 46 Swiss firms, he finds significant
cumulated abnormal returns in conjunction with increased liquidity (as proxied by a
reduced bid-ask spread).
In spite of this evidence, we are hesitant to exactly quantify the valuation impact of
improved corporate governance standards. Therefore, we interpret the (biased) OLS
coefficient on CGI in column (8) of Table 4 (0.0087) as a lower limit. Looking at the
median firm, a one standard deviation increase in the CGI causes an increase of the
market capitalisation by at least 12% of a company’s book asset value. Theoretically,
it is easy to show that in our sample the 2SLS or 3SLS estimates should be higher than
the respective OLS estimates. First, in the second stage of the Durbin-Wu-Hausman
test each dependent variable is regressed on the exogenous variables in the respective
equation, the right-hand-side dependent variables (including CGI), and the predicted
values of the right-hand side dependent variables (including the instrumented part of
CGI). In results not reported here, we find that in the Q-equation all coefficients on
the predicted values of the dependent variables are positive, indicating that the OLS
coefficients on CGI and the other governance mechanisms are downward biased (e.g.,
Wooldridge, 2002). Second, following Black et al. (2003), we regress CGI on all
exogenous variables in the system and decompose it into a predicted portion (i.e.,
the instrumented part of CGI) and an orthogonal portion. To test whether the
instrumented portion of CGI predicts larger changes in firm value than the orthogonal
portion, we run a regression of Tobin’s Q on the respective instruments and the
predicted and orthogonal components of CGI. In results not reported here, we
estimate that the coefficient on the predicted part of CGI is highly significant
29
See Durnev and Kim (2005) Table 5.
30
Many Swiss firms have long been legally able to exclude certain groups from effective owner-
ship of their registered shares.
31
See Loderer and Jacobs (1995), Tables 2 and 3. They argue that the different price behaviour
of individual share categories is best explained by a downward-sloping demand curve rather
than agency or signalling theories.
# 2006 The Authors

(t-value ¼ 2.87), while the orthogonal part of CGI is insignificant (t-value ¼ 1.56).
Following Black et al. (2003), we interpret this result as follows: Assuming instrument
validity, the statistical inference from a significant t-test in 2SLS or 3SLS is accurate,
but the coefficient on the instrumented part of CGI is an upward biased estimate of
the power of CGI as a whole (or the orthogonal part) to predict Tobin’s Q.32 In other
words, the instrumented part of CGI predicts firm value more strongly than the
uninstrumented CGI. Intuitively, this result is consistent with the results from the
second-stage regression of the Durbin-Wu-Hausman test, where the predicted values
of the corporate governance mechanisms are significant even in the presence of their
uninstrumented values. Third, one may suspect that the dependent variables cannot
be measured accurately. Most importantly, even though our survey-based CGI is
related to best practice standards, measurement errors may likely affect our results.
Similarly, accounting data taken from databases or even annual financial statements
may suffer from misreporting. Verbeek (2000) shows that the OLS estimator tends to
underestimate the effect of an independent variable if it is subject to (systematic)
measurement errors that are unrelated to the true level.33 Finally, it should be noted
that all results rest on the assumption that the instruments are valid and exogenous.
Bound et al. (1995) show that the inconsistency of 2SLS or 3SLS estimates relative to
OLS estimates depends (i) on the correlation between the instruments and the endo-
genous variables and (ii) on the correlation between instruments and the unobserved
mechanism.34 If the correlation between the instrument and the endogenous explana-
tory variables is weak, then even a small correlation between the instruments and the
error can produce a larger inconsistency in the 2SLS or 3SLS estimate than in the
OLS estimate. While the R-square of a regression of CGI on all exogenous variables is
reasonably high (0.44), we cannot ultimately be certain that our instruments are
purely exogenous, which would lead to upward biased 3SLS estimates. However, we
address this issue and conduct tests of instrument validity and system specification
(see section 4.3) and exclude two control variables that are potentially endogenous
(see section 4.4).
Our 3SLS results in Table 5 further indicate that the coefficient on Bsize remains
significantly positive (even at the 1% level), which again contradicts previous results
by Yermack (1996). The results also confirm our OLS findings that neither the
presence of a controlling shareholder nor large (outside) blockholders have a signifi-
cant valuation impact. In contrast, higher leverage, as measured by LV, is estimated
to have a significantly positive effect on firm valuation, which is consistent with both
a trade-off theory of the capital structure as well as Jensen’s (1986) free cash-flow
theory.
As discussed above, estimating a system of simultaneous equations allows us to
investigate the interdependence between the corporate governance mechanisms and
Tobin’s Q. In fact, the coefficient estimates in the line labelled Q (where Q is the
independent variable) in Table 5 reveal that higher values of CGI not only lead to
higher firm valuation, but that there is also reverse causality, i.e., firms with higher
32
See Black et al., 2003, p. 41.
33
See Verbeek (2000, p. 122). He also shows that the bias is larger if the variance of the
measurement error (noise) is large in relation to the variance of the true values (signal).
34
Note that the second condition relates to the standard textbook requirement that the instru-
ments are exogenous.
# 2006 The Authors

values of Tobin’s Q adopt better corporate governance practices. High Q firms seem
to be precursors in implementing the recommendations of the Swiss Code of Best
Practice, as shown by the significant coefficient on Q in column (1). In addition, it is
supposedly harder and more costly to gain a controlling stake in more valuable firms.
Therefore, in firms with higher Qs the shareholdings of the largest shareholder tends
to be smaller. Firms with higher Qs also choose more leverage, as indicated by the
significant coefficient in column (5). Controlling for growth, higher leverage may
discipline management by forcing it to pay out cash flows as interest payments
(Jensen, 1986). Finally, while our results provide evidence that larger board size
leads to higher firm valuation, the significantly positive coefficient in column (4)
also provides evidence for reverse causality – it is presumably more attractive for
potential board members to join successful companies.
The significantly negative relationship between Lshare and Outsider in column (6) is
likely to be explained by resistance of the controlling shareholder to call outside
directors into the board; at least, they tend to limit the number of outside directors
in their boards in an attempt to protect their private benefits of control. In addition,
firms with a controlling shareholder tend to have larger boards, as shown by the
significant coefficient on Lshare in column (4). Both observations are evidence for
potential private benefits from sitting on the board of directors.35 In sharp contrast,
firms with large outside blockholders have smaller boards, as shown by the signifi-
cantly negative coefficient on Blockout in column (4). These results are also consistent
with the negative (albeit insignificant) coefficients on Blockout and Lshare in columns
(2) and (3), respectively, which hint to possible conflicts of interest between these two
shareholder groups, as discussed in Dyck and Zingales (2004). The positive and
statistically significant coefficient on Bsize in column (6) indicates that there are
more non-executive directors on larger boards. Finally, there may be a substitution
effect between CGI and Outsider, as indicated by the negative coefficient on CGI in
column (6). Overall, our results reveal interesting interdependencies between the
different corporate governance mechanisms, which strongly underscore the advantage
of a simultaneous equations framework to investigate their influence on firm
valuation.
The coefficients on the exogenous variables generally have the predicted signs, but
they are often statistically insignificant. For example, CGI is higher for large firms. In
contrast, the coefficients on Growth and ROA are both negative and statistically
significant at the 1% level. This result is somewhat surprising, and we do not have
any persuasive ad hoc explanation. One possibility may be that these firms have
higher capital requirements because of their poor past performance and low profit-
ability. However, to obtain any external financing, they are forced to improve their
corporate governance.
Finally, we provide interesting results for the other corporate governance mechan-
isms as well. For example, the existence of more than one share category, Scat,
allowing some shareholders to practically dominate a firm even if they own signifi-
cantly less than 50% of the firm’s stock, is positively related to Lshare. With respect to
Blockout, only Blockonr is statistically significant at the 1% level, which should come
as no surprise. Looking at Bsize, all exogenous variables exhibit the predicted signs
35
The negative relation between Lshare and LV may be explained by hedging motives (Smith
and Stulz, 1985).
# 2006 The Authors

and are statistically significant. For example, large firms have larger boards of
directors, and firms with significant government ownership also have larger boards.
On average, state ownership leads to 2.51 additional board members, all else equal.
The statistically significant and negative coefficient on ROA indicates that firms with
lower operating performance have larger boards of directors. As hypothesised, LV is
significantly higher for larger firms (albeit not for older firms). The availability of
internal funds, as measured by the dummy variable Div, which provides an alternative
to debt financing, is negatively related to LV (but not statistically significant). Finally,
the coefficients on Growth and ROA are both negative and statistically significant at
the 1% and 5% level, respectively. Hence, firms with favourable growth opportunities
have lower leverage ratios, supporting the pecking order theory. Finally, with respect
to board composition, the fraction of outside board members seems to be negatively
related to state ownership and past growth rates. Most importantly, consistent with
Shivdasani and Yermack (1999), the negative and statistically significant coefficient
on Ceop suggests that the concentration of power associated with a CEO being at the
same time president of the board leads to the election of less independent board
members.
4.3. Tests of instrument validity and system specification
Because the advantages of 3SLS depend on instrument validity and the correct
specification of the system of equations, we further investigate these statistical pre-
requisites by employing two different tests. First, instruments are only valid, and
3SLS estimates are only consistent, if they are orthogonal to the error term of the
respective equation. Therefore, we implement a Sargan misspecification test (e.g., see
Sargan, 1964; Davidson and McKinnon, 1993).36 If the Sargan test statistic is sig-
nificantly larger than predicted under the null hypothesis, one should be extremely
cautious in interpreting our estimates, because it is likely that either the model is
incorrectly specified and/or some of the instruments are invalid. However, the results
at the bottom of Table 5 reveal that the Sargan test cannot be rejected at the 10% level
for all seven equations, indicating that the instruments of our system are orthogonal
to the error terms of the respective equations.37
Second, to test for the correct specification of the entire system of simultaneous
equations, we apply a Hausman specification test (e.g., see Hausman, 1978; Hausman,
1983). This test statistic is based on a comparison of 2SLS and 3SLS estimates. Under
the null hypothesis of no misspecification, the 3SLS results are consistent and effi-
cient, while the 2SLS results are consistent but inefficient. The Hausman test investi-
gates for each equation whether the 3SLS results are inconsistent due to a
misspecification in one of the other equations. Under 3SLS, the misspecification of
36
The Sargan statistic for each equation in our system is calculated as N (sample size) times the
R-square from a regression of the residuals of a 2SLS estimation on all instruments included in
the system. It is asymptotically distributed as chi-squared with degrees of freedom equal the
number of overidentifying restrictions (the number of instruments included in the system less
the number of regressors in the respective equation).
37
The only exception is equation (7), where the Sargan test rejects at the 10% level, but it cannot
reject at the 1% level. However, note that the Hausman specification test for the correct
specification of the entire system of equations cannot reject for all equations at the 10% level.
# 2006 The Authors

any single equation is transmitted to all equations by the use of an inconsistently

estimated covariance matrix in the third stage. In contrast, under 2SLS only the
particular equation that is misspecified is affected. Accordingly, the crucial assump-
tion of the Hausman test is that at least one equation is correctly specified.38 If the
null is rejected, there is a misspecification somewhere in the system, but the test
remains silent about what changes are necessary for the system to be correctly
specified.39 As shown in Table 5, the Hausman test statistic cannot reject at the
10% level for all seven equations of our system. Hence, under the assumption that
at least one of the equations of our system is correctly specified, the specification of
the entire system cannot be rejected and the most efficient estimates are obtained by
applying 3SLS.
4.4. Robustness tests

In this section we conduct several potentially important robustness tests. First, we
employ an alternative measure of firm valuation. Following Loderer and Peyer
(2002), La Porta et al. (2002), Gompers et al. (2003), and others, we define an
industry-adjusted Tobin’s Q as Tobin’s Q minus the median Q of the corresponding
industry. Accordingly, we exclude the industry dummies from the regression equa-
tions. In contrast to our earlier findings, the results of an OLS regression of the
industry-adjusted Tobin’s Q (labelled Adjusted Q) on the six governance mechanisms
and a set of control variables reveals that the coefficients on CGI and Bsize are no
longer statistically significant. The results are reported in column (2) of Table 6.
However, re-estimating our full system of equations with Q replaced by adjusted Q,
we again uncover a positive and statistically significant coefficient on CGI, as shown
in column (2) of Table 7. All other coefficients are robust to the use of an industry-
adjusted Tobin’s Q as well. In addition, we use the market-to-book ratio, defined as
the market value of common stock divided by the book value of common stock, as
another alternative measure of firm value. As column (3) of Table 6 reveals, the
coefficient on CGI remains positive and statistically significant at the 5% level. The
results are robust when we re-estimate the full system of equations with Q replaced by
the market-to-book-ratio in column (3) of Table 7. Overall, these results confirm the
conclusion that our corporate governance index is a major determinant of firm value
because the underlying relationship is robust to the choice of alternative measures.
Second, we investigate whether our results depend on the weighting of the five
categories of our index. As described in section 3.1, our index consists of 38 govern-
ance attributes divided into five categories. Since the 38 attributes are all equally
weighted in our index, but the number of attributes differs across the five categories,
this simple weighting scheme leads to different weights assigned to each category: (1)
corporate governance commitment (13.16%), (2) shareholders’ rights (18.42%), (3)
transparency (13.16%), (4) management and supervisory board matters (39.47%), (5)
38
If this is not the case, 2SLS and 3SLS results are inconsistent and the Hausman test is not
meaningful.
39
The Hausman test statistic is distributed chi-square with degrees of freedom equal to min
[ki, p–pi], where ki denotes the number of all variables contained in equation i, pi is the number
of additional exogenous variables that could be included into equation i to be exactly identified,
and p is the sum of all pi’s for all equations.
# 2006 The Authors

Table 6
Robustness checks: OLS results
The table reports robustness checks of the OLS results. For eased comparison, column (1)
shows the results from the Q-equation of the standard specification in column (8) of Table 4.
Columns (2) and (3) report results from OLS regressions of an industry-adjusted Tobin’s Q
(Adjusted Q) and the market-to-book ratio (MTB-Ratio), respectively, on all five corporate
governance mechanisms together along with the exogenous control variables included in
equation (7) of the system of equations. Column (4) shows the estimates of an OLS regression
of Q on an alternatively weighted corporate governance index (CGI_12345), the other five
corporate governance mechanisms and the set of control variables. The sample consists of 109
firms quoted at SWX. Wald tests are performed for the simultaneous significance of all
coefficients (except the constant and the industry dummies). The numbers in parentheses are
p-values for two-sided tests. ***/**/* denotes statistical significance at the 1%/5%/10% level.
Dependent variable
Q Adjusted Q MTB-Ratio Q
Variable (1) (2) (3) (4)
Constant 2.0944** 0.8528 0.3761 2.0715*

(0.0463) (0.2538) (0.8502) (0.0508)
CGI 0.0087** 0.0031 0.0302**
(0.0174) (0.3488) (0.0144)
CGI_12345 0.0072**
(0.0400)
Lshare 0.1757 0.2388 0.9735 0.1854
(0.5089) (0.2054) (0.3516) (0.4952)
Blockout 0.0335 0.1234 0.9428 0.0399
(0.8854) (0.5284) (0.2108) (0.8846)
Bsize 0.0538** 0.0339 0.0784 0.0512**
(0.0315) (0.1260) (0.2225) (0.0378)
LV 0.2959 0.0437 2.8378 0.3040
(0.4017) (0.8761) (0.1348) (0.3977)
Outsider 0.4124 0.4014 1.9622* 0.4002
(0.2857) (0.2540) (0.0611) (0.3099)
Lnassets 0.1121 0.0741 0.1643 0.1047
(0.1279) (0.1975) (0.3345) (0.1527)
ROA 2.5319*** 1.8013*** 2.7725 2.4891***
(0.0004) (0.0007) (0.2495) (0.0005)
Growth 0.8661*** 0.7542*** 1.2573*** 0.8660***
(0.0000) (0.0000) (0.0000) (0.0000)
Beta 0.3768*** 0.3196*** 0.8962*** 0.3863***
(0.0004) (0.0036) (0.0020) (0.0011)
Industry Included Excluded Included Included
Wald test 9.0978 10.3902 5.2659 8.7907
(0.0000) (0.0000) (0.0000) (0.0000)
Adjusted R2 0.4261 0.2853 0.2545 0.4203
auditing (15.79%). To check whether our results are robust to an equal weighting of
the five categories, we construct an alternative index, labelled CGI_12345, which
attributes a weight of 20% to each of the five categories. The results of an OLS
# 2006 The Authors

Table 7
Robustness checks: 3SLS results
The table reports robustness checks of the 3SLS results. To save space, only the results from the
Q-equation are reported. For eased comparison, column (1) shows the results from the
Q-equation (equation (7)) of the system of simultaneous equations in column (7) of Table 5.
Columns (2) and (3) show the results obtained by replacing Q by an industry-adjusted Tobin’s
Q (Adjusted Q) and the market-to-book ratio (MTB-Ratio), respectively. Column (4) reports the
estimates when an alternatively weighted governance index (CGI_12345) is applied. The sample
consists of 109 firms quoted at SWX. Wald tests are performed for the simultaneous signifi-
cance of all coefficients (except the constant and the industry dummies). The numbers in
parentheses are probability values for two-sided tests. ***/**/* denotes statistical significance
at the 1%/5%/10% level.
Dependent variable
Q Adjusted Q MTB-Ratio Q
Independent variable (1) (2) (3) (4)
Constant 3.2614** 1.0136 3.0800 2.0047

(0.0322) (0.5155) (0.4092) (0.1930)
CGI 0.0555*** 0.0396*** 0.1676***
(0.0061) (0.0046) (0.0000)
CGI_12345 0.0598***
(0.0022)
Lshare 0.3548 0.2453 2.1017 0.0951
(0.6484) (0.7321) (0.2715) (0.9065)
Blockout 0.4734 0.4284 0.7779 0.3124
(0.4589) (0.4993) (0.6676) (0.6261)
Bsize 0.2073*** 0.2343*** 0.1451 0.1469**
(0.0045) (0.0023) (0.4698) (0.0387)
LV 1.8089* 1.5338 7.3145*** 2.0959**
(0.0634) (0.1298) (0.0022) (0.0424)
Outsider 1.5571 1.1288 0.6809 0.8138
(0.2032) (0.4069) (0.8394) (0.5235)
Lnassets 0.4669*** 0.3717*** 0.8440*** 0.4427***
(0.0002) (0.0005) (0.0024) (0.0001)
ROA 4.1592*** 0.6545*** 5.5151** 4.0835***
(0.0001) (0.0000) (0.0334) (0.0001)
Growth 0.7693*** 0.8980*** 1.4133*** 0.8492***
(0.0000) (0.0000) (0.0054) (0.0000)
Beta 0.2467 0.2102* 0.1076 0.2089
(0.0843) (0.0816) (0.6878) (0.1321)
Industry Included Excluded Included Included
Wald test 51.0618 53.2155 35.6943 52.8354
(0.0000) (0.0000) (0.0001) (0.0000)
regression (reported in column (4) of Table 6) and a 3SLS estimation of our complete
system (reported in column (4) of Table 7) reveal that our general notion of a
relationship between CGI and firm valuation is robust to this alternative weighting
scheme.
# 2006 The Authors

Third and finally, we exclude two potentially problematic variables from our system
of equations. The first is Div, which is included as an exogenous control variable in the
leverage equation. For example, one may argue that Div is dependent on leverage. A
similar argument applies for Scat. Most important, the decision to issue different
share categories presumably depends on ownership structure. Due to data and speci-
fication reasons, we do not treat Div and Scat as endogenous and include additional
equations into our system. To circumvent a possible endogeneity problem, we exclude
the variables and again re-estimate the system using 3SLS. However, the exclusion of
Div from equation (5) as well as Scat from equations (2) and (3) does not alter our
results qualitatively. To save space, we do not report the results here.
5. Conclusion
In this paper we address the question whether ‘good’ corporate governance has a
positive impact on firm valuation. While most previous studies used US or emerging
markets data, we investigate this relationship using a broad sample of listed Swiss
firms. The Swiss corporate governance regime is interesting to analyse, since the
country has only recently taken important steps to improve its transparency standards
in the corporate sector. For example, the ‘Directive on Information Relating to
Corporate Governance’ and the ‘Swiss Code of Best Practice’ have become effective
in 2002. Observing the intense public discussion since then, these new rules have
undoubtedly increased the general consciousness for the importance of internationally
recognised governance practices.
Our most important result supports the widespread hypothesis of a positive rela-
tionship between firm-specific corporate governance and Tobin’s Q. Specifically, we
construct a corporate governance index based on the recommendations and sugges-
tions of the Swiss Code of Best Practice. Looking at the median firm, a one standard
deviation increase in the corporate governance index causes an increase of the market
capitalisation by at least 12% of a company’s book asset value. This result is robust to
possible endogeneity, i.e., our analysis confirms that causation runs from corporate
governance to firm value, but we also find evidence of reverse causality, with higher
valued firms adopting better corporate governance practices.
Our results also emphasise the importance to control for a possible interrelationship
among different governance mechanisms and Tobin’s Q. To provide a comprehensive
analysis of corporate governance, we use a broad corporate governance index and five
additional governance mechanisms: shareholdings of the largest shareholder, outside
blockholdings, leverage, board size, and the fraction of outside directors on the board.
One may suspect that important substitution effects between these six governance
mechanisms exist, i.e., where one mechanism is used less, others may be used more,
resulting in the same valuation effects. Therefore, to avoid spurious results and
capture the possibly complex interrelationships between the different governance
mechanisms, we develop a comprehensive system of seven simultaneous equations
and apply three-stage least squares (3SLS). This setup allows each of the governance
mechanisms to affect Tobin’s Q, while at the same time Tobin’s Q is also allowed to
affect the choice of each mechanism. Our results also reveal that board size is
positively related to firm value, but neither the presence of a controlling shareholders
nor large (outside) blockholders have a significant impact on valuation. Firms with a
controlling shareholder tend to have larger boards and a smaller fraction of outside
directors, indicating potential private benefits from sitting on the board. In contrast,
# 2006 The Authors
firms with large outside blockholders have smaller boards. We also confirm the
quadratic relationship between managerial shareholdings and firm value previously
found in the empirical literature.
Our results also have an important policy implication. It is widely agreed that
investor protection and prosecution capabilities form the basis for good corporate
governance. Although the task of reforming investor protection laws and improving
judicial quality is a lengthy process that requires the support of many interest groups,
it seems like a worthwhile objective in the public interest. However, once adequate
disclosure and transparency standards are in place, our empirical results suggest that
it is ultimately the capital market that rewards good governance practices and pun-
ishes bad ones. In other words, corporate governance should be understood as a
chance rather than an obligation from the perspective of a firm’s decision makers.
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Appendix: Full list of survey questions

Corporate governance commitment
1. Does the value-oriented management and control of the firm also follow corpo-
rate governance principles?
2. Does the annual financial statement explicitly refer to the company-specific
corporate governance practices?
3. Are there company-specific corporate governance guidelines in written form?
4. Are these corporate governance guidelines (if available) easily accessible for all
stakeholders (for example, via Internet)?
5. Is there a corporate governance compliance officer who reports regularly to the
board of directors?
Shareholders’ rights
6. Does the firm strictly follow the one share-one vote principle (for example, are no
preferential shares and participation certificates outstanding)?
7. Does the company disclose a detailed analysis of any deviations from previously
announced sales and earnings targets?
8. Are there measures in place that facilitate the personal exercising of shareholder
voting rights (for example, via Internet) and assist shareholders in the use of proxies?
9. Does the company make it possible for shareholders to follow parts of the general
shareholders’ meeting using modern communication media (for example, via
Internet)?
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10. When registered shares are acquired through custodian banks, is the party acquir-
ing the shares invited to apply for registration into the company’s register of
shareholders?
11. Do the articles of association lower to an appropriate degree the statutory thresh-
old for shareholders to place items on the agenda?
12. Do the articles of association lower to an appropriate degree the statutory thresh-
old for shareholders to convene an extraordinary general shareholder’s meeting?
Transparency
13. Are there analyst and investor meetings on a regular basis?
14. Does the company respect the principle of equal treatment in the dissemination of
information to investors and financial analysts (including information that is not
subject to ad-hoc disclosure requirements)?
15. Are the annual financial statement, the agenda of the general shareholders’ meet-
ing, and the detailed minutes of the meeting available in electronic?
16. Does the company disclose information about shareholdings in non-group com-
panies even if the percentage of shares held is below the statutory threshold (5%)?
17. Does the company provide investors and analysts with a schedule of the major
recurrent announcements (for example, annual reports, quarterly reports) suffi-
ciently in advance?
Board of directors and executive management

18. Are there company-specific rules in writing that deal with possible conflicts and
own account trading of members of the board of directors and the executive board?
19. Are there company-specific principles in writing for the remuneration of members
of the board of directors and the executive management (including a relative
performance benchmark, for example, an adequate sector index)?
20. Does the company disclose the content of clauses on changes of control in
agreements and plans benefiting members of the board of directors and/or the
executive board and/or other members of the cadre (for example, golden
parachutes)?
21. Does the company disclose the total of all compensation for acting members of
governing bodies separated into fixed and variable components in the notes to the
annual financial statement?
22. Does the company disclose the stock ownership (including stock options) of
acting members of governing bodies in individualised form in the notes to the
annual financial statement?
23. Are there company-specific criteria in writing to select members of the board of
directors who represent the shareholders (for example, as regards to knowledge,
expert experience, potential conflicts of interest, age)?
24. Is there a sufficient number of committees of the board of directors to deal with
complex matters and perform defined tasks (for example, audit, compensation,
strategy)?
25. Are there company-specific rules ensuring that members of the board of directors
and the executive management do not accept more than a total of five mandates
in the board of directors in non-group listed companies?
26. Does the board of directors evaluate the performance of the executive manage-
ment using a proprietary catalog of criteria on a regular basis?
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27. Does the ordinary term of office for members of the board of directors not exceed
three years?
28. Are there staggered terms of offices for members of the board of directors?
29. Does the board of directors meet at least four times a year according to the
requirements of the company?
30. Are all independent members of the board of directors Swiss nationals?
31. Does the audit committee meet, at least two times a year according to the
requirements of the company?
32. Does the audit committee meet with the head of the external audit before
disclosure of the annual financial statement?
Reporting and auditing

33. Does the company publish quarterly reports?
34. Are the annual and interim (if available) financial statements in accordance with
internationally recognised accounting principles (i.e., IFRS/IAS or US-GAAP)?
35. Does the annual financial statement specifically discuss the firm’s risk manage-
ment system?
36. Are the annual financial statements published within 90 days of the end of the
financial year?
37. Are the interim reports published within 45 days of the end of the reporting
period?
38. Are there company-specific rules to ensure that the auditor does not perform
other services for the company (for example, consulting work)?
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An Integrated Framework of Corporate Governance and Firm Valuation

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European Financial Management, Vol. 12, No.

An Integrated Framework of Corporate

Keywords: corporate governance; principal-agent problems; ownership structure;

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The Swiss corporate governance regime is particularly interesting to analyse. The

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In addition, given a broad menu of alternative corporate governance mechanisms

of corporate governance, we add an additional equation with Tobin’s Q as the

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3.1. Definition of variables

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percentage of cumulated voting rights exercised by true outside blockholders, i.e.,

3.2. Sample description

Q Ratio of market value to book value of assets (market value of assets is

Beta Beta estimated from monthly stock returns (1998–2002)

characteristics of the 109 responding firms to the characteristics of the complete

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Variable Mean Median Standard deviation Maximum/Minimum

Q 1.3390 1.0606 0.7618 5.6637/0.6004

find statistically different mean or median values. We interpret this observation as

SMI Firms All Firms

Fig. 1. Empirical distribution of the corporate governance index (CGI)

CGI Lshare Blockout Bsize LV Outsider

Q 0.2417** 0.1268 0.0067 0.0296 0.2457** 0.1247

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4.1. Ordinary least squares results

Table 4 presents the results from OLS regressions of Q on individual governance

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Journal compilation # Blackwell Publishing Ltd. 2006

Journal compilation # Blackwell Publishing Ltd. 2006

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4.2. Results from estimating a system of simultaneous equations

To account for a possible interdependence between the corporate governance mechan-

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Independent CGI Lshare Blockout Bsize LV Outsider Q

Journal compilation # Blackwell Publishing Ltd. 2006

(0.0002) (0.0104) (0.0010) (0.3853) (0.0001)

Journal compilation # Blackwell Publishing Ltd. 2006

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4.3. Tests of instrument validity and system specification

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any single equation is transmitted to all equations by the use of an inconsistently

4.4. Robustness tests

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Constant 2.0944** 0.8528 0.3761 2.0715*

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Constant 3.2614** 1.0136 3.0800 2.0047

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Appendix: Full list of survey questions

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Board of directors and executive management

Q 0.2417 0.1268 0.0067 0.0296 0.2457 0.1247