Shareholder Rights and the Cost of Equity Capital

Abstract

This paper investigates the effects of firm-level shareholder rights on the cost of equity capital. Theory suggests that investors discount cash flows at a higher cost of equity capital for firms with higher agency costs, and that strong shareholder rights can potentially reduce agency costs. However, the empirical evidence is mixed on whether stronger firm-level shareholder rights actually lead to lower agency costs. Using the Gompers, Iishii and Metrick (2003) data from 1992 through 2002 in both levels and changes models of the cost of equity capital, we find that weak (strong) firm-specific shareholder rights levels are associated with higher (lower) costs of equity capital. Moreover, the market responds to changes in firm-level shareholder rights levels by adjusting the required rate of return accordingly. Further tests reveal that the effect is driven by the Protection and State shareholder rights sub-indices. Finally, we reconcile our results with those of Gompers et al. (2003) by showing that the strength of shareholder rights impacts both the ex-ante cost of equity capital and the subsequent abnormal returns.