Abstract
This paper provides empirical evidence that firms in more competitive industries have lower cost of equity capital than those in concentrated industries. The association between product market competition and the cost of equity capital is more pronounced with lower analyst coverage, lower forecast accuracy, higher forecast dispersion, and higher bid-ask spread. Using import tariff rate reductions as a quasi-natural experiment, we find that tariff reductions intensify domestic product market competition, which in turn reduces firms’ cost of equity capital. When the tariff rate reduction is larger, the more intensified competition reduces the cost of equity capital to a greater extent. Tariff rate reductions also influence firms’ financing policy, cash flow from operations, and growth rate.
1. Introduction
In this paper, we examine the impact of product market competition on the cost of equity capital. The cost of equity capital is important to a firm given that it directly influences the financing cost of the firm and thus the capital structure and financing strategies. Theoretically, it is unclear whether competition at the industry level affects a firm’s cost of equity capital. Theoretical work suggests that under certain circumstances, there exists an equilibrium with more disclosures in industries where competitions are more intense (Wagenhofer, 1990; Darrough, 1993; Corona & Nan, 2013; Suijs & Wielhouwer, 2019). Empirical studies echo this finding and document that firms in concentrated industries tend to disclose less (Bamber & Cheon, 1998; Botosan & Stanford, 2005; Ali, Klasa, & Yeung, 2014), suggesting a negative association between industry concentration and corporate disclosure. Theories on disclosure and the cost of capital have not reached a consensus. Some theoretical papers suggest there is no effect of disclosure on the cost of capital (Hughes, Liu, & Liu, 2007; Christensen, de la Rosa, & Feltham, 2010; Bertomeu, 2015; Caskey, Hughes, & Liu, 2015), while others find that information affects the cost of capital (Bertomeu, Beyer, & Dye, 2011; Cheynel, 2013; Bertomeu & Cheynel, 2016; Dye & Hughes, 2018). Given the above, whether product market competition increases or decreases the cost of equity capital remains an empirical question.
