We examine whether good corporate governance plays a role in influencing a firm’s financing policy. Specifically, we hypothesize that firms with strong governance tend to prefer stocks over long-term debt. We argue that this is because strong governance reduces information asymmetry between providers of capital (equity investors) and users of capital (managers). While the reduction of information asymmetry has positive connotations for both equity and debt financing, we argue that there is a more significant effect on equity financing. Our test results are consistent with this prediction. We find that equity is preferred to debt financing in firms with high quality governance. This finding contradicts an alternative theory, the pecking order hypothesis, which suggests that firms will issue equity as their last resort. Our results suggest, instead, that strong governance can lower agency costs to a level where equity becomes more attractive to debt as a method of long-term financing.
Keywords: corporate governance; equity finance; agency theory
JEL Classification: G3
