Ebook International Differences in the Cost of Equity Capital: Do Legal Institutions and Securities Regulation Matter?
In this paper, we examine international cost of equity capital differences across 40 countries. Recent research suggests that countries’ legal institutions are a key determinant of financial market development, capital and ownership structures, dividend policies, and firms’ equity valuations (e.g., La Porta et al, 1997, 2000a and 2002). Based on this evidence, we investigate whether the effectiveness of a country’s legal institutions has a systematic influence on its firms’ cost of equity capital, over and above traditional risk and country factors.
Well-functioning legal systems protect investors; they confer rights on investors, e.g., to receive information, and enforce financial contracts. As a result, effective legal institutions reduce monitoring and enforcement costs to investors, which may in turn reduce the expected rate of return that investors demand for their capital. Prior studies suggest that effective legal institutions increase firms’ equity valuations (e.g., La Porta et al., 2002). However, these results may reflect the effects of legal systems on firms’ cash flows, for instance, by reducing expropriation or expanding growth opportunities, rather than the effects on the risk premium demanded by investors. Thus, it is still an open question whether the quality of legal institutions manifests in systematic differences in firms’ cost of capital. Moreover, as capital markets around the world become more integrated, country specific factors may lose their importance for firms’ cost of capital (e.g., Harvey, 1991; Bekaert and Harvey, 1995). To explore these issues and to shed some light on the mechanism through which legal institutions affect valuations, we examine whether differences in countries’ securities regulation, i.e., disclosure rules and enforcement, explain international differences in cost of capital.
We focus on securities regulation requiring disclosures because it is often justified with the argument that it reduces firms’ cost of capital (e.g., Levitt, 1998). Economic theory suggests that a firm’s commitment to disclosure reduces information asymmetries between the firm and its investors and among investors (see Verrecchia, 2001, for a survey). However, it is unclear whether the reduction in information asymmetry also lowers the firm’s cost of capital. An effect on the cost of capital requires that differences in disclosure lead to differences in non diversifiable risk. A recent paper by Easley and O’Hara (2002) provides support for this notion.
Empirical evidence at the firm level also suggests that firms providing more disclosures have a lower cost of capital (e.g., Botosan, 1997; Hail, 2002). However, tests of this relation within one country rely on voluntary disclosures, which may not constitute a commitment to disclosure, and are prone to selection bias (Leuz and Verrecchia, 2000). In contrast, securities regulation mandates disclosures at the country (or exchange) level, resulting in a commitment if it is properly enforced. Thus, cross-country settings provide a promising way to explore the link between securities regulation and the cost of capital.
Our analysis is based on the cost of equity capital implied in share prices and analyst forecasts. We use four different models suggested in the literature to compute the implied cost of capital from 1992 to 2001 for firms from 40 countries. We find significant differences in the cost of equity capital across countries. Traditional risk factors, i.e., size, volatility and the book-to-market ratio explain a substantial portion of the cross-sectional variation. We also find that country factors capturing differences in inflation rates and macroeconomic variability are significantly related to international cost of capital differences. Together, these factors explain more than 60% of the country-level variation in the cost of equity capital around the world.
Next, we introduce proxies for the effectiveness of a country’s legal institutions into the analysis. We find that securities regulation and legal institutions explain variation in the cost of equity capital, even after controlling for risk and country factors. Firms in countries with strong securities regulation, i.e., extensive disclosure rules and strong legal enforcement, display significantly lower cost of capital. The findings suggest that the effects are strongest for institutions mandating the disclosure of information and enabling investors to privately enforce their contracts. We perform numerous sensitivity analyses mitigating concerns that these results are driven by correlated omitted variables or endogeneity of the institutional variables.
We further investigate to what extent the effect of legal institutions and disclosure regulation differs by capital market integration. If investors can invest freely around the world, the quality of securities regulation of any particular country may become less important. Using several proxies, we find that the effects are strongest for markets that are least integrated. Among countries with integrated capital markets, extensive disclosure requirements continue to be negatively associated with the cost of capital, but the effect is smaller in magnitude. However, the enforcement variables are generally insignificant. These findings are consistent with the notion that, in integrated markets, risk is priced globally and that there are local factors under segmentation (e.g., Bekaert and Harvey, 1995; Harvey, 1995; Karolyi and Stulz, 2002).
Our study builds on recent advances in the finance literature on the role of legal institutions in financial market development and firm valuations (see La Porta et al., 2000b, for a survey). We extend this literature by presenting evidence that the effectiveness of securities regulation and supporting legal institutions is systematically related to international differences in the implied cost of equity capital. Our paper complements the studies by La Porta et al. (2003) showing that securities regulation explains cross-sectional variation in financial development, Bhattacharya and Daouk (2002)demonstrating that enforcement of insider trading regulations lowers firms’ cost of capital, Frost et al. (2001) suggesting that disclosure requirements by stock exchanges increase market liquidity, and Lee and Ng (2002) demonstrating that firms in corrupt countries trade at lower multiples. Our study also relates to recent work on the institutional determinants of corporate transparency (e.g., Bushman et al., 2003; Leuz et al., 2003).
Our paper is most closely related to a study by Lombardo and Pagano (2000b). They document that proxies broadly capturing the quality of the legal framework are positively associated with returns on equity using realized stock returns, dividend yields, and price-earnings ratios. However, the latter proxies are likely to also capture differences in firms’ profitability and growth opportunities, i.e., cash-flow effects, which could explain the difference to our findings. In this paper, we employ valuation models and forecast data to compute ex ante estimates for the cost of capital, which are less likely to reflect cash-flow effects.
Our work also contributes to the international finance literature. This study is one of the first to systematically analyze international cost of capital differences using analyst forecasts for a large set of countries around the world. Prior studies are generally based on realized stock returns and find that the explanatory power of the international CAPM is fairly low. This result is often attributed to market segmentation (e.g., Harvey, 1995). The issue can be addressed by jointly estimating the ex ante cost of capital and the degree of market integration (Bekaert and Harvey, 1995). However, standard techniques to obtain unbiased estimates of expected returns from realized stock returns require fairly long time-series because economic events often have opposite effects on the expected and the realized return (e.g., Stulz, 1999). An alternative approach is to use country credit-risk ratings (Erb et al., 1996), which are available for a broad cross-section of countries but based on survey data.
In contrast, our study builds on models that estimate the ex ante rate of return required by investors based on market data and analyst forecasts. Aside from being novel at the descriptive level, our evidence complements prior return-based studies in providing further evidence on the cross-sectional determinants of international cost of capital differences and on the mitigating role of market integration.
Finally, we document that implied cost of capital models produce estimates that are highly associated with traditional risk and country factors. This finding for a cross-section of 40 developed and developing countries complements recent work validating implied cost of capital estimates based on US data (e.g., Botosan and Plumlee, 2002; Guay et al., 2003) and for the G7 countries (Lee et al., 2003).
The paper is organized as follows. Section 2 describes the sample and the construction of the implied cost of capital estimates. In Section 3, we present our base results relating traditional risk and country factors to firms’ cost of capital. In Sections 4 and 5, we present the empirical tests for the legal factors and the mitigating effect of market integration, respectively. Section 6 concludes the study.
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