Financing Constraints and the Cost of Capital: Evidence from the Funding of Corporate Pension Plans
Review of Financial Studies, Vol. 25, No. 3, pp. 868-912
Posted: 22 Aug 2011 Last revised: 4 Mar 2012
Date Written: August 21, 2011
We investigate the relation between firms' weighted average cost of capital and internal financial resources, using mandatory pension contributions as a proxy for internal financial resources. Rauh (2006) documents a negative association between mandatory pension contributions and capital expenditures. We find that an increase in mandatory pension contributions increases the cost of capital, but only for firms facing greater external financing constraints. Our results suggest that firms’ cost of capital is an intervening variable that can explain Rauh’s finding that mandatory pension contributions (i.e. internal financing constraints) result in foregone investment. We also find that, consistent with their view that mandatory pension contributions are a credit neutral event, Moody’s does not incorporate mandatory pension contributions into their credit ratings. Our evidence suggests this view is appropriate for firms that are not financially constrained but is inappropriate for firms that are more financially constrained. Overall, we provide evidence consistent with recent studies (Rauh 2006; Almeida and Campello 2007) that conclude that financial market frictions affect real economic activity, and in particular, corporate investment.
Keywords: financing constraints, investment, cost of capital, defined benefit pension plans
JEL Classification: G23, G30, G31, G32
Suggested Citation: Suggested Citation