Tax avoidance and ex ante cost of capital

This study examines the association between tax avoidance and ex ante cost of equity capital. Based on prior research, we develop two proxies for investors’ expectations of tax avoidance and explore whether deviations from those expectations result in higher ex ante cost of equity capital. We find that the ex ante cost of equity capital increases with tax avoidance that is either below or above investor expectations and that the increase is larger for tax avoidance that exceeds investors’ expectations. We then examine whether firms that alter their future tax avoidance exhibit a lowering of their ex ante cost of equity capital and find that tax avoidance decreases (increases) from the prior year for firms that were above (below) investors’ expectations in the prior year. These results are consistent with the trade‐off suggested by the Scholes and Wolfson framework and reinforce the notion that balancing tax benefits and non‐tax costs is an important feature of firms’ tax planning.     

Quality of Corporate Social Responsibility Disclosure and Cost of Equity Capital: Lessons from China

This article explores the relationship between the quality of corporate social responsibility (CSR) disclosure and the cost of equity capital by analyzing the financial data and CSR reports of A-share listed firms in China from 2008 to 2014. The quality of the CSR disclosure is shown to be negatively related to the cost of equity capital of the listed firms. This negative correlation proves to be more prominent among firms of environmentally sensitive industries. Taking the ownership of the listed firms into consideration, it is further confirmed that the negative relationship between the CSR disclosure and the cost of equity capital is of higher significance for state-owned enterprises. Our findings also empirically demonstrate that the quality of CSR disclosure is more negatively related to the cost of equity capital among the large listed firms than the smaller ones.     

The value of Big 4 audits in Australia

Research suggests that equity markets value Big N audits over non‐Big N audits. Explanations include the information quality hypothesis, whereby Big N auditors increase information quality, and the insurance hypothesis, whereby investors value the deeper pockets of Big N auditors. Using client firms’ex ante cost of capital as the dependent variable, we investigate whether capital market participants differentially value Big 4 versus non‐Big 4 audits in Australia and whether the value of Big 4 audits in Australia changed as a result of the audit failures of 2001–2002. We find that Big 4 audits reduce the ex ante cost of equity capital until 2001, but not after 2001. We cannot dismiss the insurance hypothesis for the persistence of the loss beyond 2003 because of the establishment of liability caps, but the demise of the Big 4 audit value for 2001–2003 is consistent with the information quality hypothesis and does not support the insurance hypothesis.     

The Cost of Capital of Cross‐listed Firms

This paper analyses the cost of capital of firms with foreign equity listings. Our purpose is to shed light on the question whether international and domestic asset pricing models yield a different estimate of the cost of capital for cross‐listed stocks. We distinguish between (i) the multifactor ICAPM of Solnik (1979) and Sercu (1980) including both the global market portfolio and exchange rate risk premia and (ii) the single factor domestic CAPM. We test for the significance of the cost of capital differential in a sample of 336 cross‐listed stocks from nine countries in the period 1980–99. Our hypothesis is that the cost of capital differential is substantial for firms with international listings, as these are often large multinationals with a strong international orientation. We find that the asset pricing models yield a significantly different estimate of the cost of capital for only 12% of the cross‐listed companies. The size of the cost of capital differential is around 50 basis points for the US, 80 basis points for the UK and 100 basis points for France.     

CEO Risk‐Taking Incentives and the Cost of Equity Capital

In this paper, we show that the sensitivities of an executive's wealth to changes in stock prices (deltas) decrease the implied cost of equity capital while the sensitivities of an executive's wealth to changes in stock volatility (vegas) increase the implied cost of equity capital. Our findings demonstrate that shareholders understand the risks of firms’ future projects as embedded in executive compensation and price these risks into the cost of equity capital accordingly. The findings have strong implications for optimal executive compensation contract design, project evaluation and cost of capital estimation.     

Property crime,earnings variability,and the cost of capital

We show that firms located in states where property crime is more prevalent have more uncertain earnings and higher financing costs. Specifically, firms located in states with higher property crime rates have more volatile and less persistent earnings as well as lower quality analysts' earnings forecasts. Firms located in states with higher property crime rates also have a higher cost of equity and debt capital. These results are robust to accounting for econometric and endogeneity concerns in various ways. Overall, our results suggest that a potentially large and overlooked cost of crime is a higher cost of capital.     

The speed of adjustment in working capital requirement

This paper analyzes the determinants of working capital requirement (WCR) and examines the speed with which firms adjust toward their target WCR. The findings indicate that firms adjust relatively quickly, which supports the hypothesis that current balance sheet items are easier to manipulate and could be changed quite easily, even in the short run. Moreover, we find that the speed of adjustment is not equal across all firms and varies according to their external finance constraints and their bargaining power. Firms with better access to external capital markets and greater bargaining power adjust faster due to their lower costs of adjustment.     

Controlling shareholder share pledging and the cost of equity capital: Evidence from China

We propose and test the incentive view—that the margin call pressure and ownership-control discrepancy associated with insider share pledging increase investors’ perceived risk, and thus also the cost of equity capital, in an emerging market. Using a controlling shareholder share pledging sample for Chinese listed firms, we find that firms with share pledging have a cost of equity capital that is 23.7 basis points higher than firms without share pledging. Further, share pledging increases the cost of equity capital through the information risks and agency conflicts channels. Cross-sectional analyses show that share pledging has a stronger effect on the cost of equity capital in non-state-owned enterprises, firms without monitoring of multiple large shareholders, firms with controlling shareholders assuming the position of chairperson, and firms with a weak institutional environment. In addition, using the global financial crisis and the outbreak of the coronavirus (COVID-19) as quasi-natural experiments, we disentangle the potential confounding effect of firm fundamentals and show that share pledging is positively associated with the cost of equity capital. Overall, the results are consistent with our incentive view that share pledging increases the cost of equity capital in an emerging market.     

Policy and oversight of corporate political activities and the cost of equity capital

This paper investigates the effect of voluntary adoption and disclosure of policies/oversight of corporate political activities/spending on the cost of equity capital for S&P 500 firms over the period 2015–2018. Using the CPA-Zicklin Index to measure the level of policies, oversight, and disclosure of corporate political activities, we find that firms with a greater level of policies and oversight enjoy a lower cost of equity capital. We also document that a higher index is associated with higher stock liquidity. The negative relation is more pronounced among firms with higher exposure to political risk and firms with higher dependence on government spending. We also find that a firm’s information environment plays an important role in moderating the relation between policies and oversight of corporate political activities and the cost of equity capital. Our findings suggest that voluntary adoption and disclosure of policies and oversight mitigates risks and uncertainties related to firms’ political activities, thereby reducing information asymmetry and the cost of equity capital.     

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.     

Disclosure Interactions and the Cost of Equity Capital: Evidence From the Spanish Continuous Market

Abstract:  The purpose of this paper is to provide some new evidence on the relationship between disclosure and the cost of equity capital. We propose a new specification for the empirical test based on the idea that in the previous models one crucial variable was missing: accounting policy choice. We test our theoretical hypothesis using a sample of Spanish firms quoted on the Spanish continuous market from 1999 to 2002. We adopt the ex-ante approach to measure the cost of equity capital, taking analysts predictions as a proxy for expected earnings. As an explanatory variable we use an index measuring annual report disclosure quality. This measure of disclosure is combined with a proxy for the accounting policy choice of the firm. We measure firms' conservatism using the modified Jones model of Dechow et al. (1995) to estimate discretionary accruals. Our results confirm that the relationship between disclosure and cost of capital is affected by the choice of accounting policy.     

Compliance with goodwill-related mandatory disclosure requirements and the cost of equity capital

Theory suggests that increased levels of corporate disclosure lead to a decrease in cost of equity via the reduction of estimation risk. We examine compliance levels with International Financial Reporting Standard 3 Business Combinations and International Accounting Standard 36 Impairments of Assets mandated goodwill-related disclosure and their association with firms’ implied cost of equity capital (ICC). Using a sample of European firms for the period 2008–2011, we find a median compliance level of about 83% and significant differences in compliance levels across firms and time. Non-compliance relates mostly to proprietary information and information that reveals managers’ judgement and expectations. Overall, we find a statistically significant negative relationship between the ICC and compliance with mandated goodwill-related disclosure. Further, we split the sample between firms meeting (or not) market expectations about the recognition of a goodwill impairment loss in a given year to study whether variation in compliance levels mainly plays a confirmatory or a mediatory role. We find the latter: higher compliance levels matter only for the sub-sample of firms that do not meet market expectations regarding goodwill impairment. Finally, our results hold only in countries where enforcement is strong.     

Labor cost voluntary disclosures and firm equity values: Is human capital information value-relevant?

This study examines the market value relevance of labor cost voluntary disclosures using a valuation model relating firm market values to book values of equity and to disclosed human capital information, such as labor costs, net pension liabilities (NPLs), and estimated average and marginal labor productivity and efficiency indicators. Results indicate that labor cost disclosing companies command higher equity market values in general, and that labor productivity and efficiency measures appear to be undervalued. Both findings suggest that there might be market opportunities for firms with valuable human capital to differentiate themselves from their industry peers, which might encourage further human capital disclosure in the future. More refined measures of human capital assets and investments are needed to assess firms’ human resource management decisions and performance impacts in the capital markets more adequately.     

Information and the Cost of Capital in a Mean‐Variance Efficient Market

Before information ? arrives, market observers must be uncertain whether the stock price conditioned on ? will be higher or lower than the current price. Otherwise there is an obvious arbitrage opportunity. By assuming this minimal condition of efficient markets, it is shown under the mean‐variance CAPM that information that leaves the future value of a firm more certain, in the sense that its perceived covariance with the market is reduced towards zero, can lead to a higher expected return on that asset. A further result is that it is theoretically possible that the required return on the stock will necessarily fall after observing signal ?, or (in other circumstances) that it will necessarily rise. In general, information that allows better discrimination between firms leads some firms to have higher costs of capital and other firms to have lower costs of capital. Less obviously, better discrimination between firms can induce a higher average cost of capital across the market.     

The economic benefits of FASB's recommended disclosures: Evidence from the pharmaceutical industry

Prior research has documented an association between disclosure quality and various economic benefits, most notably between the cost of equity capital and market liquidity. We extend this literature by investigating whether pharmaceutical firms that comply with recommended voluntary disclosures of the Financial Accounting Standards Board (FASB) exhibit lower bid-ask spreads, greater market depth, and lower cost of equity capital. Cross-sectional analysis using pharmaceutical firms reveals a negative association between disclosure quality and bid-ask spreads (both the total spread and its adverse-selection component), but no association between disclosure quality and either market depth or the ex ante cost of equity capital. Overall, our findings provide some evidence of benefits accruing to pharmaceutical firms that comply with the FASB's recommended voluntary disclosures under the assumption that lower bid-ask spreads reduce the cost of capital and strong evidence that complying with FASB's recommended disclosures provide a direct benefit to small investors, those who bear the entire weight of bid-ask spreads.     

Economic Benefits of Adopting IFRS or US‐GAAP – Have the Expected Cost of Equity Capital Really Decreased?

Abstract:   The question of whether the adoption of International Financial Reporting Standards (IFRS) results in measurable economic benefits is of special interest, particularly in light of the European Union's adoption of IFRS for listed companies. In this paper, I investigate the common conjecture that internationally recognised financial reporting standards (IAS/IFRS or US‐GAAP) reduce the cost of capital for adopting firms. Building on Leuz and Verrecchia (2000) , I use a set of German firms that have adopted such standards and investigate the potential economic benefits of this reporting strategy by analysing their cost of equity capital through the use and customisation of available implied estimation methods. Evidence from the 1993–2002 period fails to document lower expected cost of equity capital for firms applying IAS/IFRS or US‐GAAP. During the transition period I analyse, the expected cost of equity capital in fact appear to have rather increased under non‐local accounting standards.     

Managing Earnings with Intercorporate Investments

Abstract:  We explore to what extent firms deliberately manage their financial reports by exploiting the flexibility of generally accepted accounting principles. Using a sample of Oslo Stock Exchange-listed firms with 20–50% equity holdings in other firms, we find that firms with high financial leverage tend to maximize reported earnings from these investments through their choice between the cost method and the equity method, possibly in an attempt to reduce debt renegotiation costs or to avoid regulatory attention. In contrast, managers do not systematically bias reported earnings to extract private benefits or to signal revised expectations about future cash flows. Firms use different earnings management tools in a consistent way, as the earnings effect of the cost/equity choice is not offset by discretionary accruals.     

Accruals Quality, Information Risk and Cost of Capital: Evidence from Australia

Abstract:  Recent theoretical work argues that information risk is a non-diversifiable risk factor that is priced in the capital market. Using accruals quality to proxy for information risk, Francis et al. (2005) provide empirical support for this argument using a sample of US firms. This paper re-examines the interplay of accruals quality, information risk and cost of capital in Australia, where a number of important institutional and regulatory differences are hypothesized to affect the relation between accruals quality and cost of capital. The results suggest that, while accruals quality impacts on the cost of capital for Australian firms, some salient differences exist. In contrast to findings for US firms, the costs of debt and equity for Australian firms are largely influenced by accruals quality arising from economic fundamentals (i.e., innate accrual quality) but not discretionary reporting choices (i.e., discretionary accrual quality). This finding is consistent with our predictions based on the Australian institutional and regulatory environment. In addition, using both the asset pricing tests in Francis et al. (2005) and Core et al. (2008) , we provide evidence consistent with accruals quality being a priced risk factor.     

To be or not to be all-equity for firms that eliminate long-term debt

Despite the advantages of debt, a significant number of firms that have an established leverage policy deliberately become all-equity. These firms eliminate a substantial amount of long-term debt as the average firm’s leverage ratio is approximately 30 percent at the year-end prior to debt elimination. Firm-level “shocks” such as CEO turnover and changes in credit ratings cannot explain the dramatic recapitalization decision. Consistent with the tradeoff theory, firms that eliminate debt have lower benefits (less tax shield benefits, agency costs) and higher costs (probability of financial distress, access to capital markets, etc.) of leverage in the three prior years compared to a matched sample. We also find that the factors influencing the decision to eliminate all debt is different from those to significantly reduce leverage or to have very low debt levels. Firms primarily finance the approximately $70 million of average long-term debt eliminated using proceeds from sales of relatively unproductive assets and from equity issues. Interestingly, over half of these firms issue significant amount of new debt within three years of becoming all-equity. Firms with lower liquidity and non-debt tax shields, higher potential overinvestment agency costs, and those that issue equity at the debt elimination year are more likely to relever quickly.