Effective corporate governance and the cost of capital and financial performance: An empirical investigation into the peculiar link in Saudi stock market listed firms

Abstract

Recent decades have experienced a trend in companies implementing scrupulous structures of corporate governance in response to various infamous commercial failings. It is vital that such structures are in place that would enable companies to operate openly and without the danger of being accused of inefficient management. This will help encourage foreign investors in addition to ensuring a healthy and efficient business environment. The aim of this study is to examine the effects of ensuring effective corporate governance mechanisms on the cost of capital and financial performance, focusing on non-financial companies registered with the Saudi Arabia Stock Exchange. Saudi Arabia is a developing market in the Gulf region where block-holding ownership dominates the business world. With this peculiar ownership structure, Saudi Arabia was relatively unaffected by the Global Financial Crisis (GFC) a quality that allows local companies, with limited influences from the external business world, to be subjected to a deeper analyses with regard to their corporate governance mechanisms and their impact on the cost of capital and financial performance. The agency theory was the primary model used in the development of the conceptual framework for this study with some borrowings from resource dependence and stewardship theories. The outcomes of existing studies in this field are largely inconclusive, with no ongoing research on the relationship between the cost of capital and corporate governance in Saudi Arabia and the limited number of studies examining this relationship between corporate governance and financial performance in the Kingdom. Thus, there is a gap in the research, which this study has aimed to fill. The findings of the current study, in addition to filling the void in the literature, are expected to influence policy-makers, practitioners, and those looking to invest in Saudi Arabian companies by equipping investors with more awareness about the information and security protection provided by the structure of corporate governance in Saudi Arabia. The current study used 84 non-finance companies registered in Saudi Arabia between 2006 and 2014. Two prominent issues have been examined in this study: the relationship between corporate governance mechanisms and the cost of capital, and the relationship between corporate governance mechanisms and firm performance. This study employed three regression techniques examine the relationship between corporate governance variables (measured as board structure, audit committees structure, ownership structure) and the cost of capital measured as weighted average cost of capital (WACC) in Saudi Arabia Stock Exchange listed non-finance firms. The three methods of regression included: First the, hypotheses being investigated using a pooled ordinary least squares (OLS) regression. This was followed by panel data models, both random and fixed effects, to control for any unnoticed heterogeneity. Lastly, a generalised least square (GLS) is used to investigate the hypotheses further, this time focusing on the peculiar problems of causality and endogeneity. The results showed that corporate governance mechanisms, such as board size and block ownership, have a significant positive effect on the cost of capital. Nevertheless, board independence has a significant negative effect on the cost of capital, which indicates that these findings align closely with the theoretical underpinnings of agency theory. The financial performance of a company is expressed in this study via return on assets (ROA) and Tobin's Q. The same three aforementioned methods of regression are adopted here to examine the relationship between the implementation of corporate governance mechanisms and firms’ performance. Results indicated that the governance mechanisms, including foreign ownership, government ownership, board meeting, and audit committee independence have significant positive effects on firm performance. On the other hand, board size, audit committee size and audit committee meetings have a significant negative effect on firm performance. The current study’s findings showed, as suggested by the agency theory, that corporate governance mechanisms and firm performance are clearly interlinked in the context of the emerging market of Saudi Arabia. The findings of the current study are largely aligned with the theoretical underpinnings of agency theory and with the findings of the existing literature in varying world contexts. These findings, due to their close touch with the practical world and relevance to the country’s current business scenario, are expected to be relevant and beneficial for managers, investors, policy-makers and other stakeholders considering involvement with Saudi Arabian companies.