Agency Costs of Free Cash Flow and the Effect of Shareholder Rights on the Implied Cost of Equity Capital

Abstract

In this paper, we examine the effect of shareholder rights on reducing the cost of equity and the impact of agency problems from free cash flow (FCF) on this effect. We find that firms with strong shareholder rights have a significantly lower implied cost of equity after controlling for risk factors, price momentum, analysts' forecast biases, and industry and year effects than do firms with weak shareholder rights. Further analysis shows that the effect of shareholder rights on reducing the cost of equity is significantly stronger for firms with more severe agency problems from FCFs.

Executive Pay Disparity and the Cost of Equity Capital

“…*, **, and *** indicate significance at the 10%, 5%, and 1% levels, respectively. The previous finding is consistent with that of Chen et al (2011) that shareholders charge a higher risk premium for firms with weak shareholder rights when the agency problem of free cash flow is more severe. The evidence is also consistent with that of Bebchuk et al (2011), that firms with a large CPS make less profitable acquisitions.…”

“…That is, does a higher cost of equity in the previous period drive a larger CPS? To address this concern, we follow Chen et al (2011) to include the lagged dependent variable in our regression. Reverse causality can be ruled out to some extent if the coefficient on CPS remains positive.…”

“…To test Hypothesis 3, we follow Chen et al (2011) and measure the agency problem of free cash flow using operating cash flow and investment opportunities. Operating cash flow (CF) is defined as net cash flow from operating activities, and investment opportunities are defined as Tobin's Q. Definitions of variables are detailed in the Appendix.…”

“…The results (unreported) are similar. To alleviate the concern that the results may be driven by the endogenous relation between CPS and the free cash flow problem, we regress Q or CF on CPS, and we use residual Q (denoted as RQ) or residual CF (denoted as RCF) to partition our sample (Chen et al (2011)). …”

A Flexible Valuation Model Incorporating Declining Growth Rates

“…Ho, Lee, Lin, and Yu (2017) empirically compare three common valuation models: (1) A multi-stage formulation of the traditional constant growth model as demonstrated by Chen, Chen, andWei (2011) andHou, van Dijk, andZhang (2012), (2) A multistage formulation of the RIM approach as demonstrated by Claus and Thomas (2001) and Gebhardt, Lee, and Swaminathan (2001), and (3) The Ohlson-Juettner (2005) earnings capitalization model. They find that the Ohlson-Juettner model provides more reliable results.…”