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

Published online by Cambridge University Press:  17 September 2010

Kevin C. W. Chen ,
Zhihong Chen  and
K. C. John Wei
Kevin C. W. Chen
Affiliation:
School of Business and Management, Hong Kong University of Science and Technology, Clear Water Bay, Kowloon, Hong Kong. acchen@ust.hk
Zhihong Chen
Affiliation:
College of Business, City University of Hong Kong, Tat Chee Ave., Kowloon, Hong Kong. chenzhh@cityu.edu.hk
K. C. John Wei
Affiliation:
School of Business and Management, Hong Kong University of Science and Technology, Clear Water Bay, Kowloon, Hong Kong. johnwei@ust.hk
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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.

Type
Research Articles
Information
Journal of Financial and Quantitative Analysis , Volume 46 , Issue 1 , February 2011 , pp. 171 - 207
Copyright
Copyright © Michael G. Foster School of Business, University of Washington 2011

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