Analysts’ estimates of the cost of equity capital

We explore a large sample of analysts' estimates of the cost of equity capital (CoE) to evaluate their usefulness as expected return proxies (ERP). We find that the CoE estimates are significantly related to a firm's beta, size, book-to-market ratio, leverage, and idiosyncratic volatility but not other risk proxies. Even after controlling for the popular return predictors, the CoE estimates incrementally predict future stock returns. This predictive ability is better explained as the CoE estimates containing ERP information rather than reflecting stock mispricing. When evaluated against traditional ERPs, including the implied costs of capital, the CoE estimates are found to be the least noisy. Finally, we document CoE responses around earnings announcements, demonstrating their usefulness to study discount-rate reactions of market participants. We conclude that analysts' CoE estimates are meaningful ERPs that can be fruitfully employed in a variety of asset pricing contexts.     

Does capital market drive corporate investment efficiency? Evidence from equity lending supply

The increased equity lending supply (ELS) in the equity loan market, available for short sellers to borrow, exposes a firm to greater short selling threats. Considering short sellers' strong incentives to uncover firm-specific information and monitor managers, we hypothesize that short selling threats, proxied by ELS, enhance corporate investment efficiency. We find that ELS significantly reduces managerial tendencies to underinvest (overinvest) especially for firms prone to underinvest (overinvest). The effect of ELS on investment efficiency is stronger for firms with higher information asymmetry and weaker corporate governance, confirming short sellers' role in mitigating information and agency costs. However, short selling risk weakens the effect of ELS. Our evidence is robust to endogeneity checks and suggests that corporate investment can be driven by a particular capital market condition: the amount of lendable shares in the equity loan market.     

Does bank loan supply affect the supply of equity capital? Evidence from new share issuance and withdrawal

We examine the hypothesis that fluctuations in the aggregate supply of bank loans influence the supply of new equity capital. Using residual lending standards as a clean measure of aggregate loan supply and a VAR framework to aid identification, we find that a one-standard-deviation shock to lending standards results in 15% fewer IPOs. Shocks elicit strong responses from IPO-firms that are highly dependent on external capital and increase the number of withdrawals, strengthening the interpretation that the above is driven by changes in the supply of equity. Our results suggest that credit conditions are important to a well-functioning IPO market.     

Investors’ perception of CEO overconfidence: evidence from the cost of equity capital

Prior literature documents that CEO overconfidence plays an important role in corporate financial reporting and accounting decisions. However, an unexplored issue is how investors perceive the risks associated with CEO overconfidence. This study examines the effect of CEO overconfidence on the cost of equity capital. We find that the association between CEO overconfidence and the cost of equity is nonlinear: a moderate level of CEO overconfidence results in the lowest cost of equity capital after controlling for other known determinants of the cost of equity. We also find an inverted nonlinear relation between CEO overconfidence and equity issuance, which corroborates our main conclusion of the nonlinear effect of CEO overconfidence on the cost of equity. Our results are robust to alternative overconfidence measures, cost of equity measures, and change analysis.     

Does corporate social responsibility affect the cost of capital?

We examine the effect of corporate social responsibility (CSR) on the cost of equity capital for a large sample of US firms. Using several approaches to estimate firms’ ex ante cost of equity, we find that firms with better CSR scores exhibit cheaper equity financing. In particular, our findings suggest that investment in improving responsible employee relations, environmental policies, and product strategies contributes substantially to reducing firms’ cost of equity. Our results also show that participation in two “sin” industries, namely, tobacco and nuclear power, increases firms’ cost of equity. These findings support arguments in the literature that firms with socially responsible practices have higher valuation and lower risk.     

Do anti-bribery laws reduce the cost of equity? Evidence from the UK Bribery Act 2010

We examine the impact of the UK Bribery Act 2010 on the implied cost of equity. We find a significant reduction in the cost of equity amongst UK firms with high bribery exposure after the passage of the Bribery Act. We further show that the Bribery Act improves internal control systems and increases stock liquidity of firms with high bribery exposure. Our results suggest that more stringent anti-bribery regulations are not always bad for the firm.     

Does information risk affect the implied cost of equity capital? An analysis of PIN and adjusted PIN

Using a unique dataset of Korean listed companies for which trade initiators are correctly identifiable, we estimate bias-free PIN (probability of informed trading) that is no longer subject to the trade misspecification problem and test whether it is related to expected returns. Unlike prior studies, we find that bias-free AdjPIN, the adjusted PIN purged of a liquidity component, is positively related to implied cost of equity. Our findings suggest that the errors in PIN variables hamper a proper identification of PIN pricing in prior studies.     

Does it pay to be socially connected with wall street brokerages? Evidence from cost of equity

We show that social connections between a firm's executives and directors and brokerages that follow the firm decrease the firm's cost of equity. We use quasi-natural experiments to address endogeneity concerns and find that the uncovered effect of firm-brokerage social connections on cost of equity is likely causal. The effect is found to be more pronounced for firms with more soft information, opaque information environments, tight financial constraints, weak corporate monitoring, or high executive equity ownership. Further, consistent with the evidence on cost of equity, we find that firm-brokerage social connections reduce SEO underpricing, decrease information asymmetry in stock markets, and improve the firm's equity valuation.     

Does equity market timing have a persistent impact on capital structure? Evidence from China

This paper uses the change in individual securities accounts as a measure of equity funding supply to examine whether the persistent timing effect on capital structure exists for the Chinese equity market. This new equity timing measure avoids previous criticisms over a timing measure not being independent of a firm's characteristics of capital structure. Our empirical results show that this new measure is an effective market timing variable for issuing equity in the Chinese equity market, and that a persistent effect of equity market timing on firm capital structure exists for more than 7 years. This paper offers evidence that the market conditions of equity funding supply play an important role in corporate financing decisions in China.     

Multiple corporate governance attributes and the cost of capital – Evidence from Germany

This paper investigates the extent to which corporate governance affects the cost of debt and equity capital of German exchange-listed companies. I examine corporate governance along three dimensions: financial information quality, ownership structure and board structure. The results suggest that firms with high levels of financial transparency and bonus compensations face lower cost of equity. In addition, block ownership is negatively related to firms' cost of equity when the blockholders are other firms, managers or founding-family members. Consistent with the conjecture that agency costs increase with firm size, I find significant cost of debt effects only in the largest German companies. Here, the creditors demand lower cost of debt from firms with block ownerships held by corporations or banks. My findings demonstrate that a uniform set of governance attributes is unlikely to satisfy suppliers of debt and equity capital equally.     

Who benefits from capital account liberalization? Evidence from firm-level credit ratings data

Using a novel panel data set on corporate foreign-currency credit ratings and capital account restrictions in advanced and emerging economies during 1995–2004, we find a strong positive effect of capital account liberalization on firms' credit risk, as measured by corporate credit ratings. As an identification strategy, we exploit within-country variation in firms' ability to obtain foreign currency and, thus, their ability to repay foreign currency debt. We find that liberalizing the capital account benefits significantly more those firms with more limited foreign currency access, namely, those producing nontradables. Our findings demonstrate a novel channel through which capital account restrictions affect economic outcomes, and they are robust to a broad range of alternative specifications.     

Do conventional financial disclosures matter in alternative financing? Evidence from equity crowdfunding

As a novel form of external financing, equity crowdfunding enables small and early stage firms to raise capital from the public through an online platform. There has been criticism of the benefits and costs of mandating financial statements to promote this alternative form of financing. Using a setting where disclosure of financial statements is optional, this study provides evidence that financial statements influence investors’ decisions and facilitate borderless capital formation. The provision of financial statements appears to enhance how investors view other aspects of disclosure, suggesting a positive reporting externality. These market-wide benefits provide important insights on the role of financial disclosures for market participants, policymakers, and academics.     

Does social trust restrain firm financing violations? Evidence from China

We use a sample of Chinese firms to examine the impact of social trust, as an informal institution, on firm financing violations. Our findings suggest that when a firm is located in a region with high social trust, it commits fewer financing violations than those committed by firms in a region of low social trust. The results are robust for alternative measures of financing violations (fraudulent activities when issuing new shares, changing the use of new funds to uses other than the stipulated purposes, or illegally using third‐party loan guarantees), social trust, and after using instrumental variables estimation to account for endogeneity. Additional analysis suggests that the impact of social trust on restraining financing violations is more pronounced for firms having lower interest costs, facing low industry competition, located in high marketisation regions, and having good internal control. The findings show that the impact of social trust on financing violations is moderated by the economic reality of the firm (interest costs and competition), the formal institutional environment (level of marketisation), and the internal governance of a firm (internal control).     

Does geopolitical uncertainty affect corporate financing? Evidence from MIDAS regression

This paper investigates the effect of geopolitical uncertainty on (market) leverage ratio, debt maturity, and choice of debt source. Using a new monthly index of geopolitical uncertainty and annual data for corporate financing variables, we find that under geopolitical uncertainty firms tend to reduce debt and increase market leverage. We argue that this increase is driven by asymmetrical reductions in the numerator (total debt) and the denominator (total debt and equity) of the leverage ratio. Under geopolitical uncertainty, firms tend to shorten their debt maturity structure and—especially those firms with lower credit quality—to substitute bank debt for public debt.     

Why do managers avoid EPS dilution? Evidence from debt–equity choice

Survey evidence reveals that managers prefer to avoid dilution of earnings per share (EPS), though financial theory suggests it is irrelevant in firm valuation. We explore contracting and behavioral explanations for this apparent paradox using a large sample of debt–equity issuers. We first provide evidence that firms with greater agency conflicts between managers and shareholders are more likely to use EPS as a performance measure in bonus contracts. After controlling for possible endogeneity related to compensation contract design, we find that managers are more likely to avoid earnings dilution when their bonus compensation explicitly depends upon EPS performance. This effect is increasing in the magnitude of bonus compensation for this subset of firms; we document no such associations for the firms that do not use EPS in setting bonus pay. Additional tests of firms’ speed of adjustment to target leverage ratios and firms’ debt conservatism levels indicate that explicitly rewarding executives on EPS performance helps to resolve underleveraging problems. We also find that clientele effects are associated with managers’ aversion to earnings dilution. Our findings provide a deeper understanding of the factors that underlie the use of accounting performance in compensation contracts and new evidence on the implications of the contracting role of accounting in firm decision-making.     

Are there monitoring benefits to institutional ownership? Evidence from seasoned equity offerings

We provide new evidence on the monitoring benefits from institutional ownership by analyzing the impact of institutional ownership on stock price and operating performance following seasoned equity offerings, a setting where the effects of monitoring are likely to be especially important. We find that announcement returns are positively and significantly related to total and active institutional ownership levels and concentration. Post-issue stock returns are positively and significantly related to the contemporaneous post-issue changes in total and active institutional ownership and the concentration of their shareholdings. Operating performance improvements are also related to institutional monitoring in the one, two, and three years following the equity issue. Our results continue to hold even after accounting for the possibility that institutional investors have an informational advantage that enables them to identify and invest in subsequently better performing firms. We also empirically eliminate the possibility that our findings are driven by institutions buying past winners and selling past losers as a way to window-dress their portfolio holdings.     

Does the law of one price hold in international financial markets? Evidence from tick data

This paper investigates the validity of the law of one price (LOP) in international financial markets by examining the frequency, size and duration of inter-market price differentials for borrowing and lending services (‘one-way arbitrage’). Using a unique data set for three major capital and foreign exchange markets that covers a period of more than seven months at tick frequency, we find that the LOP holds on average, but numerous economically significant violations of the LOP arise. The duration of these violations is high enough to make it worthwhile searching for one-way arbitrage opportunities in order to minimize borrowing costs and/or maximize earnings on given funds. We also document that such opportunities decline with the pace of the market and increase with market volatility.     

Does stock market development always improve firm-level financing? Evidence from Tunisia

The question of whether or not increased stock market size allows for improved financing conditions for firms in emerging markets is an important one for policy-making. This paper seeks to investigate this issue by analyzing whether increases in market-level liquidity have indeed trickled down to individual firms over the last decade of stock market development in Tunisia, a fast-growing Mediterranean emerging market. We develop time varying liquidity scores for all firms listed in the Tunisian market over the 1997–2009 period and analyze the extent to which market development, firm-level characteristics and risk exposure affect the magnitude and the distribution of liquidity using a set of fixed effect panel regressions. Our results suggest that massive increases in value traded have created market congestion, thereby increasing the costs of trading, in a context of persistently low efficiency and increased international integration. The main implications of this process are (i) market-level development and international integration are not sufficient conditions to ease access to finance for local firms, (ii) further reforms in the Tunisian market should focus on diversifying corporate ownership and improving the disclosure of information, and (iii) international investors seeking diversification in Tunisia should be aware of a significant illiquidity risk.     

Does venture capital investment enhance corporate innovation? Evidence from Korea

We examine whether venture capital (VC) investment enhances corporate innovation in Korea. Using a matched sample of 802 firms from 1998 to 2012, we find that after the first round of VC investment, VC-backed firms are more innovative than non-VC-backed firms. Our results suggest that the positive influence of VC investment largely comes from the ability of VC firms to reduce information asymmetry between investors and ventures: VC funds managed by independent venture capitalists significantly enhance corporate innovation, whereas those managed by governmental venture capitalists do not. Furthermore, this positive influence becomes more pronounced where there is greater information asymmetry. Finally, we show that funds with profit-based compensation structures are more likely to encourage corporate innovation than those with fee-based compensation structures.     

Who benefits more from international diversification?

This paper investigates the relative magnitude of the international diversification benefits for the domestic investors in various countries. The constraints of short-sales, over-weighting investments, and investing region are considered. The empirical results suggest that local investors in the less developed countries, particularly in East Asia and Latin America, comparatively benefit more from both regional and global diversification. This finding holds even though the international market has become more integrated so that the diversification benefits have decreased over the past two decades. The results are useful for asset management professionals to determine target markets to promote the business of national/international funds.