Shareholder Protection and the Cost of Capital

Abstract

Do shareholder protection laws affect the corporate cost of capital? To identify the causal impact of shareholder protection laws on firms’ implied cost of capital, we exploit the staggered adoption across 23 U.S. states of universal demand (UD) laws, which place significant obstacles to derivative lawsuits and thus undermine shareholder litigation rights. Using a sample of public U.S. firms between 1985 and 2013, we find that weakened shareholder litigation rights materially increase firms’ implied cost of capital. We further show that the curtailing of shareholder rights leads to a deterioration in information quality, increased risk-taking, and more severe insider expropriation, all of which contribute to the heightened financing costs. Overall, our findings indicate that weakened shareholders’ litigation rights lead shareholders to face greater agency conflicts and higher market risk, which ultimately translates into higher required returns.

Keywords: Shareholder protection, Universal demand (UD) laws, Implied cost of capital (ICOC)

JEL Classification: G32, G38, K22, M41