EXTERNAL GOVERNANCE AND THE COST OF EQUITY FINANCING

• Author: Lamia Chourou,Syrine Sassi,Samir Saadi,Sabri Boubaker
• Date: 01 December 2019
• Published date: 01 December 2019
• DOI: http://doi.org/10.1111/jfir.12197

The Journal of Financial Research Vol. 42, No. 4 Pages 817–865 Winter 2019

DOI: 10.1111/jfir.12197

EXTERNAL GOVERNANCE AND THE COST OF EQUITY FINANCING

Syrine Sassi

South Champagne Business School

Samir Saadi

University of Ottawa and IPAG Business School

Sabri Boubaker

EM Normandie Business School and IRG, Université Paris Est Créteil

Lamia Chourou

University of Ottawa

Abstract

We examine whether and how competitive pressure in the product market influences

the cost of equity capital. Using a large panel of U.S. public firms, we find that

intensification of product market competition results in lower equity financing costs.

Our results are statistically significant and economically sizable. In line with the

view of the disciplinary role of product market competition, we show that corporate

governance, payout policy, and investment policy are channels through which

competitive pressure influences the cost of equity capital.

JEL Classification: G18, G32

“If we will not endure a king as political power, we should not endure a king over the production, transportation and

sale of any of the necessaries of life.”

Senator John Sherman, author of the Antitrust Act of 1890

I. Introduction

For over a century, antitrust laws have significantly influenced the state of product

market competition in the United States. Beginning with the Sherman Antitrust Act of

We acknowledge helpful comments from John Bai, Hyungjin Cho, Ramesh Rao, Alfred Davis, William Rentz,

Imed Chkir, Devinder Gandhi, Yang Ni, Dimitrios Gounopoulos, Jocelyn Grira, Ligang Zhong, and Meziane Lasfer.

Our paper has also benefited from feedback from participants at the 2016 Paris Financial Management Association

(Paris, France), 2016 International Research Meeting in Business and Management (Nice, France), 2016 Vietnam

Symposium in Banking and Finance (Hanoi, Vietnam), 2016 International Conference on Decision Aid Sciences and

Applications (Hammamet, Tunisia), and from seminar participants at the Telfer School of Management of the

University of Ottawa, Institut de Recherche en Gestion (University of Paris Est, France), Portsmouth University,

South Champagne Business School, and Vietnam National University (Hanoi, Vietnam). Samir Saadi acknowledges

financial support from the Social Sciences and Humanities Research Council of Canada, Telfer School of

Management and Champagne‐Ardenne region (France). All errors are our own responsibility. Part of this research

was conducted while Samir Saadi was visiting Stern School of Business, New York University.

817

© 2019 The Southern Finance Association and the Southwestern Finance Association

1890, these laws are designed to prohibit monopoly power that is likely to harm

consumers. Along with antitrust enforcement policies, import competition and

deregulatory initiatives in many sectors have contributed to intensification of

competition in product markets.

1

This basic change in the competitive environment

has shifted research attention toward the channels through which competition affects

firm performance and shareholder value. The literature on this issue remains

inconclusive, however. On the one hand, the possible predatory threats of competitors,

which tend to erode profit margins (e.g., Akdoğu and MacKay 2012) and increase

uncertainty about firms’future prospects (e.g., Gaspar and Massa 2006), suggest that

competition is negatively related to firm performance. On the other hand, the

disciplinary effect of competition (e.g., Hart 1983; Schmidt 1997) suggests that more

intense competition translates into better firm performance. To further explore the

implications of competitive pressure, we provide reliable evidence on the association

between product market competition and the cost of equity capital.

2

The cost of equity

capital is an important tool to gauge firms’investment, financing, and capital structure

decisions. Accordingly, understanding the association between product market

competition and cost of equity capital would have important implications for managers

adjusting their investment and financing decisions in response to changing product

market conditions.

There are two conflicting predictions regarding the nature of the association

between product market competition and the cost of equity capital. The first view is

based on evidence that the intensity of competition could increase investor perception

of a firm’s overall risk. For instance, in an interview for Fortune magazine, Warren

Buffett stated, “The key to investing is not assessing how much an industry is going to

affect society, or how much it will grow, but rather determining the competitive

advantage of any given company and, above all, the durability of that advantage. The

products or services that have wide, sustainable moats around them are the ones that

deliver rewards to investors.”

3

In support of such a statement, a growing number of

empirical studies show that firms operating in more competitive markets are riskier, as

they have less of an ability to transfer market shocks to their customers and, thus, face a

lower probability of maintaining their profit margins. Indeed, firms that face higher

competitive threats from their rivals are characterized by higher stock return volatility

(Gaspar and Massa 2006) and lower cash‐flow stability (Irvine and Pontiff 2009). From

this perspective, investors would be more concerned about the uncertainty surrounding

firms operating in competitive industries, thus implying an increase in the cost of

raising equity. Consequently, according to the first view, there is a positive relation

between product market competition and the cost of equity capital.

1

There is, for instance, evidence of a substantial rise in foreign competition following the gradual removal

of trade barriers (Bernard, Jensen, and Schott 2006).

2

Throughout our article, we use the terms cost of equity capital and required rate of return interchangeably.

3

Warren Buffett and Carol Loomis, “Mr. Buffett on the Stock Market,”Fortune Magazine, as reported on

CNN Money (November 22, 1999), https://money.cnn.com/magazines/fortune/fortune_archive/1999/11/22/

269071/.

818 The Journal of Financial Research

The alternative view draws on the disciplinary role of product market competition

given that competitive pressure curbs managerial misbehavior (e.g., Hart 1983;

Scharfstein 1988; Hermalin 1992; Schmidt 1997). Schmidt (1997), for instance, argues

that intense competition exposes firms to severe predatory threats from rivals, thus raising

managerial career concerns. This situation provides managers with fewer opportunities to

extract private benefits of control and more incentives to work harder to avoid being driven

out of the market. In this vein, previous empirical studies point to the conclusion that

product market competition acts as an external disciplinary mechanism by reducing agency

problems (e.g., Tian and Twite 2011), inducing managers to make optimal decisions (e.g.,

Grullon and Michaely 2014), and enhancing firm efficiency (e.g., Nickell 1996). In light of

this disciplinary role of product market competition, investors are likely to form better

expectations about future prospects in more competitive industries, which in turn leads to a

lower cost of equity capital. Indeed, prior empirical evidence shows that cost of equity

decreases in the presence of effective governance mechanisms, such as ownership

concentration (Durnev and Kim 2005), multiple large shareholders (Attig, Guedhami, and

Mishra 2008), audit quality (Chen et al. 2011), and the presence of institutional investors

(Attig et al. 2013), among others. Thus, and contrary to the first view, the cost of equity

capital is expected to be negatively affected by product market competition. Accordingly,

the nature of the relation between product market competition and cost of equity capital is

an empirical question that we seek to answer.

Using a large panel of U.S. public firms, we document a negative relation

between product market competition and cost of equity capital. Stated otherwise, we

find that equity financing costs are significantly lower for firms facing intense

competition. The market competition effect is not only statistically significant but also

economically important. For instance, an increase of one standard deviation in the level

of competition in a particular firm’s industry is associated with a decrease of 16 to 23

basis points in equity financing costs. Our findings are consistent with the notion that

product market competitive pressure is likely to discipline managerial behavior, thus

improving investor beliefs and decreasing the required rate of return.

We conduct numerous robustness tests to examine the reliability of our

findings. For instance, we provide further support for the causal interpretation of the

negative impact of competitive pressure on the cost of equity capital by addressing

endogeneity concerns using a quasi‐natural experiment involving an exogenous shock

to the intensity of product market competition,

4

as well as a placebo test and an

instrumental variable approach. To further reinforce the reliability of our findings and

conclusions, we repeat our analyses using various proxies of product market

competition and alternative model estimation procedures. In addition, though we

employ a widely used approach of measuring the cost of equity capital, we conduct a

battery of robustness checks that addresses potential concerns associated with our main

4

According to the international trade literature, a fall in entry barriers following large tariff rate reductions

is likely to attract foreign competitors, which in turn invites more imports to the domestic product market,

resulting in a significant increase in competitive pressure (Bernard, Jensen, and Schott 2006). Several empirical

studies take advantage of this unique setting to document how firms’decisions respond to product market

competition (e.g., Xu 2012; Valta 2012).

819External Governance