Internal Versus External Equity Funding Sources and Earnings Response Coefficients
34 Pages Posted: 23 Jul 1997
Date Written: June 1997
Under the assumption that capital markets are imperfect due to transactions costs and investor-manager information asymmetries, internally generated funds should be less costly than funds raised by issuing shares (Myers and Majluf 1984). This suggests that the mix of firms' sources of shareholders equity should affect the discount rates the market applies to unexpected earnings. In particular, the discount rate should be lower for firms using a higher proportion of internal funds relative to externally obtained equity, and, accordingly, such firms should have larger earnings response coefficients. Furthermore, this effect should be magnified for high growth firms where the disparity between inside information and publicly available information is greatest (i.e., high growth firms have a larger portfolio of positive NPV projects to fund and can reduce their cost of equity capital at a greater rate by using internally generated funds). We test these predictions using a sample of 14,955 firm-year observations. The results of pooled regressions and annual cross-sectional regressions support both predictions after controlling for other determinants of earnings response coefficients.
JEL Classification: G31, G32
Suggested Citation: Suggested Citation