Introduction of Study

The debt financing or external financing is one of the most important way of financing the business and its operations. The cost associated with it is the interest cost and when the firm becomes unable to pay it, it leads to default. The fundamental or Ratio analysis of a business is used to assess the default risk (inability to pay debt) of a concern in Pakistan. But in this study we will use the corporate Governance disclosure in order to assess the default risk of a corporate. Creditors are most important users of corporate reports. So it is essential to know, whether these annual reports are helpful for assessing the default risk or not .Our study will investigate whether the corporate disclosures are inversely related to its default risk or not. Chapter: 01 Review of Literature 1.1 Corporate Governance Disclosures and Cost of Debt:

There are many researches conducted to find the relationship between the corporate disclosure and other factors which are very much closely linked to it. Few of previous researches found that there is a negative relationship between the firm disclosure quality and cost of debt [( Sengupta,1998; Zhao.et.al.2008; Aksu .et.al. 2005; F Yua 2005; Nikolaev.et.al.2005; De Alencar.et.al.1997; Bhojraj Sanjeev,1998; Fisher, 1959; Cohen, 1962; Horrigan, 1966,;West, 1970; Kaplan and Urwitz, 1979;Weinstein, 1981)] . The study which is inconsistent to it [(Gao Piyang, 2008)]. 1.2 Corporate Governance Disclosures and Information Asymmetry:

In Few of previous studies a link is developed between corporate disclosure and information asymmetry and found, there is a negative association between a firms voluntary disclosure quality and the level of information asymmetry between investors. And this negative relationship also reduces the cost of capital. Moreover, this high disclosure quality can either reduce the relative amount of informed trading or decreases the frequency of obtaining the private information by the investors [(Brown.et.al.2003 ;Diamond,1985;Verrecchia 2001; Easley et. al, 2002; Botosan and Plumlee, 2002; Langand Lundholm,1996; Maddala, 1983;Fishman et. al 1989; Merton,1987; Callahan et. al.1997, ;Neal and O'Hara, 1998; Lee et. al, 1994; Hasbrouck's, 1991; Jensen and Meckling, 1976 ;Ajinkya, et. al, 1999)]. The few researches conducted previously also found that, Higher disclosure quality reduces the incentives to search for private information by reducing the expected benefits obtaining

from private information. [(Diamond, 1985;Hakansson 1977;Verrecchia, 1982;Grossman and Stiglitz, 1980; Bhojraj Sanjeev, 1998)]. Similarly in the literature of the corporate governance there is a study on the corporate governance and equity liquidity in which the writer tried to examine the effect of S&P Transparency and Disclosure Ranking on the equity liquidity of the corporate. This study is done to test the hypothesis that with the improved Disclosure given by the S&P(2000) the liquidity position of the corporate equity increases. The reason behind it is the reduction in the agency cost, because the level of information for the security dealer will be almost certain they will not increase their spread by increasing the equity prices, due to which the market liquidity will be increased of the corporate equity. In this study on corporate governance and equity liquidity the transparency disclosures are taken as a proxy variable for corporate governance like cheng et.al, 2003. According to this study as the the firm ranking of financial transparency increases the corporate governance is assumed to be increased. The transparency disclosure are divided into three segments to find the corporate governance ranking. a) Ownership structure and investor right b) Financial Transparency and information disclosure c) Board Management structure and process. The first hypothesis of the study is, that the firm with the good corporate governance has the good market liquidity and to test this hypothesis this study followed the previous study lin et al. 1995 and used the effective spread as a proxy for the market liquidity. To test the relationship between corporate governance and market liquidity of corporate equity the data of 341 corporates were collected on number of trade, volume of trade and closing ending price of each stock on daily basis and used it as a determinant of market liquidity of equity like stoll(2005) while for information asymmetry intraday transactions are recorded. The other variable used by this study is financial leverage like [( welker,1995; Ho and Wong,2001; chow and Won Boren,1987; Hossain et.al1994)] and profitability and type of industry as a control variable in this study like (Meek.et.al,1995). This study which is done by Liao.et.al seems superior to all previous studies conducted in the regard of corporate governance and equity prices, because it used 3SLS, General Moment Model and simultaneous equation to explain the relationship of the proxy variable (Ownership structure, financial transparency Disclosure and Board Management) of corporate governance and other variable number of trade, volume of trade and closing ending price of each stock on daily basis as a proxy for the market liquidity of equity and concluded that the firm which dont have good disclosure practices will result in increased spread by the market dealer, because of information asymmetry and so the market liquidity for equity of the corporate stock will reduce 1.3 Corporate Governance Disclosures Quality, Amount of Uniformed trading and Investment:

Some researches conducted to find the relationship between the corporate disclosure and amount of uniformed trading and concluded that there is a positive relationship between the high disclosure quality and amount of uniformed trading and investment. [(Diamond and Verrecchia, 1991; Grossman and Stiglitz, 1980; Merton, 1987; Fishman and Hagerty ,1989; AICPA, 1994; FASB, 2001; Levitt, 1998 ;Kyle, 1985; French and Roll, 1986 ;Barclay et. al, 1990; Hasbrouck 1991)]. 1.4 Corporate Governance Disclosures and Macro Economic Factor: Few previous researches also shows there is a relationship between the corporate disclosure and macro economic factors within the country and across the countries. [( Minyue Dong Minyue)]. 1.5 Corporate Governance, Shareholders Rights and Firms value:

In few previous studies a relationship between the corporate governance as a proxy for shareholders right and earnings built and found that the firm with strong share holder right had more firm value as compare to the firms with the weak shareholder rights. [(Gompers et. al, 2003)]. Existing researches also indicated that sustained increase in the disclosures also result in the more institutional ownership. [( Healy et. al. 1999)]. 1.6 Corporate Governance, Board Outsiders and Chances of Fraud Similarly there is an existing study in which the relationship between the board outsider and chances of fraud is discussed and ultimately it is found there is a negative association between these two factors. It means as no. of outsiders increases in the Board of a corporate the chances of fraud in that corporate decreases [(Beasley,1996)]. Similarly in an existing research a relationship is developed between the characteristics of corporate governance and likelihood of financial distress and found that The other study on the corporate governace and BOD composition is based on the hypothesis that the corporation have the more outsi (Kesner et.al 1986) 1.7 Corporate Governance Rating and Corporate Bond Yield: In few previous studies a relation is built between the Corporate Governance rating and bond yield, institutional ownership and bond yield and it is concluded that there is a negative relationship between the Corporate Governance rating and bond yield and institutional ownership and bond yield, while there is a positive association between the corporate rating and institutional ownership [( Bhojraj and Partha, 2003; Ajinkya, et. al. 1999; Healy et. al.1999)].

1.8 Corporate Governance, Institutional Ownership and Shareholders Rights: in some recent researches a link is developed between institutional ownership and shareholders right and found that they are positively associated with each other [( Jarell and Poulsen,1987; Brickley, et. al. 1988; Agrawal and Mandelker, 1990; McConnell and Servaes, 1990). The studies which are inconsistent to it (Black 1990, Admati et. al., 1994, Karpoff, et. al. 1996)]. 1.9 Corporate Governance, Blockholders and Bond Yield:

In few previous studies a relationship is linked between blockholders and bond yield and found that in the perspective of shared benefits hypothesis there is a negative relationship between these two variables and in perspective of private benefits hypothesis there is a negative association between these variables.[( Demsetz 1983; Shleifer and Vishny, 1986; Jarrell and Poulsen, 1987; Lease et al., 1983; Barclay et al., 1993; Barclay et al. 1989; Barclay et al, 1992; Agrawal and Madelker, 1990; Agrawal and Knoeber, 1996; Mikkelson and Regassa, 1991; Zwiebel, 1995. See also Jensen and Warner, 1988. See Barclay and Holderness 1992, Huddart; 1993; Maug, 1998)]. In recent studies a relationship is also constructed between the outside directors and firm performance and showed the shareholders wealth increases with the the increase of outside directors [(Borokhovich, et. al., 1996. Rosenstein and Watt, 1990; Cotter, et. al. 1997)]. The study which is inconsistent to it is (Yermack, 1996; Bhagat and Black ,1997 ;Coombes and Watson ,2000). In few recent studies an association is built between the 1.10 Corporate Governance and Bankruptcy Among the researches conducted previously on the corporate governace a study has already been conducted on the Bankruptcy and Corporate Governance: The impact of Board Composition and Strucure . this study is based on three hypothesises. The first hypothesis is the bank rupt firms have the joint CEO-board chairperson structure; and to test this hypothesis in this study data of 100 firms were collected 1972-1982. these 100 firms were included the Major Bankrupt 57 corporation from 1972-1982 and 57survivor firms from 1972-1982. to check the first hypothesis of the study the data of corporate structure i.e the firms with one person as a CEO- and boardchairman which is called duality and the firm with separate CEO and Chairperson was taken and regressed against the financial variables like profitability, leverage etc using the logistic regression model and found that the firms with duality had the more chances of Bankrupt as compare to the firms with separate CEO and Boardchairman. Similarly the second hypothesis of this study is Bankrupt firms will have more proportion of affiliated directors than the suvivor firms; and to test this hypothesis the proportion of affilitation director is regressed against the financial variable used in this study like profitability, leverage etc using the logistic regression and found that as the proportion of affiliated directors in the composition of BOD increases the bankruptcy increases. The third hypothesis of the study is about the duality of structure and proportion it is basically the combination of the first two hypothesis which is also checked using the same data and found that, as the 4

propotion of affiliated directors duality in the Board structure increases a distinguish is created between the Bankrupt Firm and Survivor. Moreover, in this study it is also concluded that the Corporation with the good qualification of BOD has strong financial indicators an thus does not lead to the bankruptcy.[( Daily and Dalton,1994.)]. Similarly another study conducted in past on corporate governance and financial distress to test the relationship of corporate governance and financial distress this study is conducted on the two types of compnies from 1994-1995 a) 46 financially distressed companies of canada b) 46 financially healthy companies of Canada The objective of this study was to prove that the coporates which are financially distress not only because of the their financial indicators but because ownership structure and outside directors affect the likelihood of financial distress. The hypothesis of this study includes a) The proportion of outside directors is positively related with financial distress b) The financially distressed firms have joint CEO and Board structure To test this hypothesis the scholar used the variables like Audit Committee, Boss, Blockholders, leverage, liquidity as a control variable and for Dependent variable coded the financially Distressed firm as 1 and Healthy firms as 0, moreover the scholar used the logit regression analysis to find the validity of his hypothesis at the end the researcher found financial distress is not only because of financial indicators but the corporate governance also vital role in bringing the financial distress.[( Fathi and Jean 2001)]. Many previous studies as discussed above are limited to the following variables to study the effectiveness of Corporate Governance Disclosures. For example, Bhojraj and Sengupta (2003) investigated board independence and institutional ownership, while Anderson et al. (2004) examined board characteristics and the cost of debt for S & P 500 firms in the United States and found cost of debt to be inversely related to board size and independence and also with audit committee independence, size and meeting frequency. In this study we will take a thorough approach to the measurement of Governance Disclosures and develop a comprehensive corporate Disclosure index like Christina James and Julie Cotter (2007) and S&P 2002. Our index will be centered on corporate governance disclosures according to the International Principles of Good Corporate Governance and Best Practice Recommendations. This index will be based on the Code of Corporate Governance issued by the various regulatory bodies in the world. This approach will help us to test whether these recommended disclosures are useful while assessing default risk. One important factor that encourages a company to disclose its information is to reduce the risk involved to make the investment in the company and also to decrease the external cost of financing. So, Incomplete and weak disclosure can mar a firms financial position and its ability to repay its debts and ultimately the firm may lead to default. Moreover, along with the construction of disclosure index, the credit rating given by the rating companies like PACR (Pakistan credit rating agency), S&P etc. will also help us to

assess the default risk, the corporate with the good disclosure quality are given more marks due to which trust on its ability to pay back loan increases in the mind of lenders and underwriters.

Objectives of Study:
The Objectives of our Study are: To find the relationship between the corporate rating and default risk of a corporate. To find the relationship between the corporate Governance disclosure and its default risk.

Hypothesis of Study:
We will use the following hypothesis to test the relationship between corporate governance disclosures found in annual reports and assessed default risk. H0: Credit ratings are positively related to the default risk H0: Corporate Governance Disclosures are positively related to default risk

METHODOLOGY
This chapter on the research methodology has been divided into the followings segments. a) Data and Data sources b) Construction of the corporate governance index c) Method of analysis d) Variables and their explanation e) Model of Study a) Data and Data sources For the detailed analysis of the proposed hypothesis the researcher considered initially 67 companies which were rated by PACRA in year 2009 on the basis of performance in year 2008 and are listed Karachi stock exchange and on Lahore stock exchange, but then to keep the homogeneity in data and to get the satisfied results used only 42 companies, and so removed 25 companies because of difference in operations and non availability of data on the variables researchers used in this study. Thus, at the end, the 6

sample of the study is comprised of 42 companies, from the operations like manufacturing and production etc. For the assessment of default risk we used the numeric value given by PACRA against the corporate rating Scale to each corporate and to test that this default risk is because of corporate governance we used the different indicators (liquidity, leverage, performance, growth, size, stock price variations) of Default of a corporate given in its annual reports of 2008. While to get the data on quality of corporate governance a corporate has employed we used the score given by PACRA (unlike the previous studies done on corporate governance) to each corporate for its corporate governance. To give the touch of primary data to research and check the validity of the score given by PACRA like the previous studies (James and cotter,2008) we also constructed the corporate Governance index. Whose explanation is provided in the forthcoming segment Construction of Corporate Governance Index A corporate governance index based on annual report disclosures was also designed to rate each companys corporate governance disclosure quality. Construction of the index is based on the corporate governance indicators suggested by prior research like Corporate Governance Disclosure and the Assessment of Default Risk by James and Julie,2008. And indicators of corporate governance disclosures given by S&P 2002. The indicators used in the previous study like James and Julie,2008; Nelson 2003;.Weber,2006; Daily and Dalton 1994; Bhojraj and Sengupta,2003 Elloumi and Jean,2001;were limited to BOD, independence, CEO characteristics, CEO a same person as a chairperson, BOD composition, Audit Committee size etc. though the researcher also used all these indicators in this study as well, but tried to see the collective effect of all these variable in the firm performance rather than depending only on the few factors of corporate governance as used in these previous studies, due to which this study seems to be a contribution in the existing literature available on the corporate governance. Moreover, the index used in our study also carry the marks for financial transparency information disclosure which was missing in the previous study like James and Julie,2008; Nelson 2003;.Weber,2006; Daily and Dalton 1994; Bhojraj and Sengupta,2003 Elloumi and Jean,2001. But the indicators of financial transparency Information disclosures are used in the rating methodology of S&P issued on October, 2002 The maximum possible score for corporate Governance disclosure was 64. Division of the score of Corporate Governance Disclosures in the index is given below a. Maximum possible sore for general Disclosure is 04 b. Maximum possible sore for Disclosure of BOD is 14 c. Maximum possible sore for Disclosure Ownership is 04 d. Maximum possible sore for Disclosure of Independence is 26 e. Maximum possible sore for Disclosure of r External Audit is 03 f. Maximum possible sore for Disclosure of Procedures is 02 7

g. Maximum possible sore for Financial Transparency and Information Disclosure is 11 Total Score 64 Each companys total corporate governance score was calculate out of the total corporate governance score 64. the first component of the index is a) General Disclosures: The total marks for the general disclosure are 04. The division of these 04 marks was as follow I. If the annual report consists of statement describing the corporate governance 1 mark is awarded otherwise 0. II. If the reference is made to the code of corporate governance of Pakistan in the annual report of the company 1 score is awarded to the company otherwise 0. III. If the annual report consist of statement of compliance with the code of corporate governance applicable in Pakistan 1 score is awarded otherwise 0, while in case of detailed Description of code of compliance with the code of corporate governance 02 score is awarded. b) Disclosures of BOD: The total marks for the disclosures are 14 The division of these 14 marks is given as follow: I. 1 score is given if list of BOD, list of BOD committee, Details of remuneration of BOD, experience of BOD, qualification of BOD, attendance of BOD at meeting , Direcors are classified as executive or outsiders, Board size, Job of BOD, and no. of independent directors were disclosed by the company in annual report. Other wise 0 score is awarded.. II. While 02 scores are given in case detailed description of Directors remuneration, Directors Qualification and Directors job related experience is provided in the annual report of the company. c) Disclosures of Ownership: The total marks for the ownership disclosure are 04 The division of these 04 marks is given as follow. I. 1 score is given if no. of shares hold and their shareholding pattern is disclosed by the company in its annual report, Other wise 0 score is awarded to the company. II. While 02 scores are given to the company in case top 05 shareholders are disclosed by the company in its annual report. 8

d) Disclosures of Independence: The total marks for ownership disclosures were: 25 The independence Disclosures were further categorized into BOD Independence Audit Committee Independence Remuneration committee independence Nomination Committee independence Under the BOD independence the corporate where the CEO is not the same person as chairperson, the corporate where the proportion of non executive members of BOD to total members of BOD is 30 %, the corporate where the proportion of the independent members of BOD is 30 % are given the score 1 otherwise 0. While where the proportion of non executive members of BOD to total members of BOD is above 30% and where the proportion of independent members of BOD to total members of BOD is above 30% that corporate will be given 2 scores. Similarly in the Disclosure of audit committee where the audit committee is comprised of 6 members, the proportion of non executive member to total member of audit committee is 30%, the proportion of independent member to total member of audit committee is 30%, the frequency of meeting of audit committee during the year is 6 the corporate is given 01 score otherwise 0, while if the size of the audit committee is above 06, the proportion of non executive members to total members of audit committee is above 30%, the proportion of independent members of audit committee to total members of audit committee, the frequency of audit committee meeting during the period of research is above 06 that corporate is given 02 scores. Similarly in the Disclosure of Remuneration committee where the Remuneration committee is comprised of 6 members, the proportion of non executive member to total member of Remuneration committee is 30%, the proportion of independent member to total member of Remuneration committee is 30%, the corporate is given 01 score otherwise 0, while if the size of the Remuneration committee is above 06, the proportion of non executive members to total members of a Remuneration committee is above 30%, the proportion of independent members of a Remuneration committee to total members of Remuneration committee is above 30%, that corporate is given 02 scores. Similarly in the Disclosure of Nomination committee where the Nomination committee is comprised of 6 members, the proportion of non executive member to total member of Nomination committee is 30%, the proportion of independent member to total member of Nomination committee is 30%, the chairperson of the Nomination Committee is independent the corporate is given 01 score otherwise 0, while if the size of the

Nomination committee is above 06, the proportion of non executive members to total members of a Nomination committee is above 30%, the proportion of independent members of a Nomination committee to total members of Nomination committee is above 30%, that corporate is given 02 scores. Similarly in the Disclosure of External audit if the corporate disclosed the name of audit firm, audit fee is more than the minimum audit fee according to criterion issued in the circular by ICAP ( The Institute of Chartered Accountants of Pakistan) on 13 August 2008, Audit of the corporate is conducted by Big four audit firms in Pakistan which are A.F. Furgoson and Company, KPMG Taseer Hadi & Co, Delight and Fortrhodes. The corporate is given 01 score otherwise 0. Similarly in the Disclosure of Procedure, if the Job of the BOD is Disclosed, code of conduct for the employees has been mentioned in the annual report of the company, the corporate is given 01 score otherwise 0. Similarly in the Financial Transparency Information Disclosures if, the company has provided an overview of the trend in its industry, company provided the detail of its product, company provided the detail of its market share, company reported its earning forecast for upcoming years, company repoted its output in the annual report in physical terms, company reported the efficiency indicators in the annual report like ( Return on Assets and Return on Equity etc), Company provided the investment plan in the coming years in its annual report. Company provided the comparison of its performance with rest of the companies operating in the same industry is given 01 score otherwise 0.

h.

Table 1 at the end shows the index. The division of the total marks is as follow: (7 disclosure, 14 independence, 2 external audit, 2 procedures). Each companys corporate governance score (CGSCORE) will be calculated by dividing their total score by this maximum possible score. Unlike the previous research like Christina James and Julie Cotter (2007) and Mahmoud Abou(2006) we also used the marks assigned by the PACRA in case of Pakistan to each corporate against its corporate Disclosure quality and Corporate Rating. So, this study on Corporate Governance seems to be first study in this regard in which both the secondary and primary data is used. The other data on coporate operating and financial performance was collected from the annual reports published by those companies, and to get the annual report we used the Website of lahore stock exchange and Karachi Stock Exchange, while to calculate the STSP we got the daily stock prices from the 10

website of Karchi stock exchange. Moreover, the researcher persoanlly collected all data. b) Method of analysis The aim of this study is to assess the default risk through corporate ratings, if the corporate rating is not good it means assessed default risk is high, then to prove, it may be because of not good Corporate Governance and if the default risk is low i.e corporate rating is high, then to prove, it may be because of Good level of Corporate Governance Score, and these scores are given on the basis of Corporate Governance Disclosure available in the annual report of the corporate, it means Corporate Governance Disclosure Quality basically indicates how effectively the Corporate policies are designed and corporate affairs are managed and controlled and its impact could be seen from different types of ratios which are indicators of default risk a which a corporate is suffering from. To conduct this study we divided the default risk into a) Short term Default risk b) Long term Default risk a) Short Term Default Risk: And to measure the short term default risk of measured the liquidity position, EBITDA etc. like the Christina James and Julie Cotter (2007), but he did not divide the firm Default risk into short term default risk and long term default risk as we did b) Long Term Default Risk while for the measurement of long term default risk we used the following indicators like Leverage, Growth, log of book value of fixed assets and Standard Deviation of the Stock prices of the firm c) Variables: Assessment of Corporate Governance Disclosure is made by the numeric value of crediting rating assigned by the rating companies to each corporate. And in this study we will consider this proxy variable as our dependent variables. This rating score is obtained from the rating company in Pakistan Pakistan Credit Rating Agency PACRA. Similarly annual reports of the companies are also used to measure the quality of corporate governance Disclosure through the index as well. The index was developed on the basis of Corporate Governance Disclosure indicators given by the S&P in 2002. The list of dependent and independent variable is provided in the table below Variables Definition Variables of Previous studies Expected used this Relationship Reason of using variable

11

variable Dependent variables

PCRATEt+1

of variable

the

PCGSCOREt+1

CGSCOREIndt+1

Corporate rating score assigned by PACRA in year 2009 on the basis of the performance performed by PACRA in year 2008 Corporate Governance Score assigned by PACRA in 2009 on the basis of corporate Governance performance in year 2008 and meeting the criterion set for corporate Governance Score obtained by a corporate for corporate Governance out of the total score given in index

Independent variables:
Liquidityt

It shows the Fathi proportion of Jean,2001 short term assets available

and The expected Relationship of the liquidity with

The reason of using this variable is this variables

12

to meet the meet the short term obligations and liabilities. And it is calculated by dividing the short term assets with short term liabilities. Grater the liquidity position lower will be the default risk in short term and vice versa

SIZEt

It shows the size of the corporate and size of the corporate is calculated by taking the log of book value of all fixed assets. Higher the log of book value of all fixed assets lower will be its default risk

Fama and Jensen 1993; Dehaene et al 2001; Pearce and Zahra 1992; Mangel and Singh 1993

dependent basically variable is measures the positive short term default risk on to meet the short term obligations of the firm so we are using this variable as measurement of short term financial performance, and we are assuming if short term default risk is high which means the firm liquidity position is not good so according to hypothesis of our study it may be because of bad Corporate Governance. Expected sign We used this of Size with variable to the dependent measure the long variable is term default risk positive the firm with less size have more long term default risk because it has less size in terms of fixed assets and this may be because of not good corporate governance. 13

PERt

This variable indicates the performance of the firm and it is calculated by dividing earning before interest, tax, depreciation and amortization by Total assets

Expected sign of the control variable with the dependent variable is positive

Because risk does not exist solely, it may be because of poor operations and poor financial performance which may also be due to the not good corporate governance, so this poor operations ad financial performance of the corporate may result in the less size of the corporate, due to which its default risk may be more. The reason of using this variable is if the firms earning are less from the assets employed by the company it means the firms default risk is high because it is getting less reward out of its assets, and this less reward out of the assets employed by the company shows that the firm may 14

LEVt

This variables shows the level of leverage, and leverage is calculated by dividing the total long term loans and advances by total equity. The level of leverage shows the proportion of total long term borrowings to total equity lower is the ratio better is the performance considered of a corporate or firm. The impact of leverage on the performance of the corporate is on one side the corporate has to pay the interest on long term borrowing

Belkaoui et al. 1978; Wallace et al. 1991; Malone et al. 1993; Fathi and Jean,2001

Expected Relationship of the variable with the dependent variable is negative.

not governed properly, due to which its performance is not good and this low performance may ultimately lead to default. .The corporate with more leverage has the incentive to improve its corporate Governance, because more is the debt more interest will be paid by the company and this more interest will increase the interest cost and reduce the profitability and similarly if firm fails in making the payment its default risk will also increase we are assuming the firm if the firm is properly governed then its leverage may be low and hence the firm the firms long term default risk may decline. So, we can say the firm 15

and advances due to which its expenses increases of the operating period which results in the lower profit, and because of this low profit the firm have to pay the low tax. So, it means this leverage may effect the operations of the business while on the other hand leverage increases the default risk, because it is possible the firm may be unable to pay debt or interest on debt. Though this variable has the impact on the operating performance, but iam considering it as a variable related with the financial performance,

may be properly governed. Or we can say due to proper governance the firm is utilizing its equity more properly rather than borrowing from the external sources, due to which its default risk may decline.

16

GROWt

because of its ultimate impact on the financing performance of the corporate and measurement for default risk. This variable indicates the growth of a corporate and it is calculated as proportion of Tangible assets to total assets

Sengupta, 1998; Bhojraj and Sengupta, 2003; Anderson et al,2004; Balatbat et al,2004

Expected sign of this variable with the dependent variable is positive.

Expected sign of this variable with the dependent variable is positive. The reason of using this variable is the firm which is properly governed it means the firm is not stagnant but it is growing as a result of the better operating and financing performance. And this better operating and financing performance of the corporate may be because of better corporate performance which we still have to prove empirically. Though this variable is also used in the 17

STDSt

Standard Deviation of Stock return. It is calculated by taking the square of deviation of daily stock prices during the year 2008 from average stock price of a stock during the year 2008 and then dividing it by

Sengupta,1998; Brown et. al,2003;Diamond 1985; Verrecchia, 2001.

The expected sign of this variable with the dependent variable is negative.

studies conducted but our hypothesize relation is inconsistent to them, as we are trying to prove that the firm who want to grow is in need to improve its corporate Governance. And so when the firm grows it default risk is low because now the firms proportion of tangible assets increased and it may be because of corporate governance the firm is growing and not stagnant. The reason of using this variable, we believe the firms operating and fianacial performance also result in the default risk and this operating and financial performance is signaled by the stock price of that particular company, if the 18

no. of days stock exchange remained active in the year 2008

firms operating and financing performance is better its share prices may not be so much varying from day to day prices but if the corporates performance is not consistent then its stock price variation may be more, which is an indication of more default risk

It is the error term. d) Model of study

The following model will be used to test the hypothesis that a firms credit rating is Positively related to its default risk and this default risk may be because of not good corporate governance.
PCRATEt+1 = + 1 PCGSCOREt+1 + 2Liquidityt + 3SIZEt + 4PERt + 5LEVt +6GROWt + 7STDSt +t(I) PCGSCOREt+1 = + 1Liquidityt+ 2SIZEt +3PERt + 4LEVt +5GROWt + 6STDSt+ t

(II)
(III)

CGSCOREIndt+1= + 1Liquidityt + 2SIZEt +3PERt + 4LEVt +5GROWt + 6STDSt+ t

19

And the marks obtained by an individual firm out of the total marks (X/25) will be used to measure the quality of its disclosure, so it will be our dependent variable and we will relate this variable with the other independent variable, which are our proxy variable as Firm size, Firm performance, Firm growth and firm stock price variation in the secondary market, which was missing in the study of Christina James and Julie Cotter (2007) and was used in the study of (Sengupta 1998,Brown Stephen, and H. A. Stephen.2003, Diamond 1985 Verrecchia 2001) to measure the default risk. The rating companies like S&P and Pacra consider both the qualitative aspects(policy matters, timeliness of reporting, concentration of ownership, shareholders right etc) and quantitative aspects 20

like (industry risk, operating risk, credit risk and liquidity risk) to assign the grade to a firm, this grade contain some numeric value which is not a available to public, we will get total marks assigned to each corporate against its rating, then we will regress them against the proxy variables we are using for the measurement of default risk. Similarly out of the total marks assigned to a corporate against its rating we will also regress the marks assigned to a corporate for qualitative aspects or for its disclosures against proxy variable which are a measurement for default risk. The previous study (Christina James and Julie Cotter 2007) is limited only to the corporate rating and they did not collect separate data for corporate disclosures. Our study will be focused on the industrial sector only because of the different nature of business, financial sector will be ignored. In our control variables we will include Firm size. For Firm size in this study we will use the proxy variable, the natural log of book value of assets as a firm size (1SIZEt). (Balat at et al. 2004). It is hypothesized that, there is a positive relationship between the corporate rating and its firm size. Our other control variables include the Firm Performance and to measure the Firm performance (2PERt) we will use proxy variable the ratio of (EBITDA) to total assets, where EBITDA is earnings before interest, tax, depreciation and amortization. The other dependent variable of our study is level of leverage of Firm. And to find the level of leverage(3LEVt) of the firm we will use the Book value long term debt/market value common equity as a proxy variable. Similarly another independent variable of our study will be the Growth of firm ( 4GROWt) and to calculate the Growth we will use the proportion of tangible assets to total assets. The Previous studies shows high leverage and growth firms are associated with higher risk and therefore a higher cost of debt and a lower credit it means their default risk increases (Sengupta 1998; Bhojraj and Sengupta 2003; Anderson et al. 2004; Balatbat et al. 2004). The last variable which will check the validity of another hypothesis that high corporate disclosure or high rating will increase the information asymmetry, which is another indicator of risk for investor. And to measure the information asymmetry we, will use the Stock price variation (5STDSt) of the firms share in the secondary market as a proxy variable.

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