External Governance and the Cost of Equity Financing Abstract

Transcription

1 External Governance and the Cost of Equity Financing Abstract This paper examines how the competitive pressure in the product market affects the implied cost of equity capital. Using a large panel of US listed firms during the period , we show that an intensification of product market competition results in lower equity financing costs. We interpret our findings as supportive of the monitoring power of product market competition which alleviates a firm s agency problems, reducing thus the cost of equity capital. This result was subject to a battery of robustness tests, including the use of alternative proxies of product market competition and cost of equity estimates, alternative specifications of the cost of equity models, robustness to noise in analyst forecasts, and robustness to endogeneity. In additional analyses, we find the negative relation between competition and the cost of equity is more pronounced for firms with weak governance structures. Overall, the results lend strong support to the prediction that firms benefit from the external governance pressure provided by the product market, which is manifested in lower cost of equity. 1

2 1. Introduction Over the last several decades, antitrust laws have significantly influenced the state of product market competition in the United States. Beginning with the Sherman Antitrust Act of 1890, these laws were designed to prohibit the creation of a monopoly power that is likely to harm consumers benefits. Senator John Sherman notably stated If we will not endure a king as political power, we should not endure a king over the production, transportation and sale of any of the necessaries of life. Along with the antitrust enforcement policies, import competition and deregulatory initiatives in many sectors contributed to the intensification of competition in the product market landscapes. For example, a considerable literature has emerged on the substantial rise in foreign competition following the gradual removal of trade barriers (e.g., Harrison, 1994; Tybout, 2004; Bernard et al., 2006). This basic change in the competitive environment has remarkably shifted research attention towards the channels through which competition affects firm performance and shareholder value in different contexts. Unfortunately, the literature on this issue remains inconclusive. On the one hand, the disciplinary effect of competition (e.g., Hart, 1983; Nickell et al., 1997; Schmidt, 1997) and its productivity-enhancing effect (e.g., Nickell, 1996) suggest that a more intense competition translates into a better corporate performance. On the other hand, the possible predatory threats of rivals, which are likely to erode profit margins (e.g., Beiner et al., 2011) and to increase uncertainty about firms future performance (e.g., Gaspar and Massa, 2006), suggest that competition is negatively related to corporate performance. In an attempt to further explore the implications of the competitive pressure, our study looks at investors perception of product market competition which is reflected in the required rate of return. More precisely, our objective is to examine whether the intensity of product market competition influences the cost of raising equity capital. In addition to the paucity of previous research on the relation between product market competition and the cost of equity, our study is also motivated by the importance of cost of equity as a direct yardstick to assess investment, financing and capital structure decisions. In fact, it is the required rate of return that reflects an investor s perception of firms riskiness. Since stiffer competition is likely to lead to rapidly changing environments and thus increasing firm risk (e.g., Haushalter et al, 2007; Hoberg et al., 2014; Su and Shi, 2015), we would expect equity 2

3 financing costs to change significantly according to the intensity of competition in firms product markets. Moreover, the cost of equity has been shown to depend on the quality of corporate governance (e.g., Attig et al., 2008; Chen et al., 2009; Chen et al., 2011). Hence, product market competition should influence the cost of equity financing through its impact on firms agency problems. Understanding the association between product market competition and the cost of equity capital would, therefore, have important implications for managers to adjust their investment and financing decisions in response to the changing product market conditions. The existing literature offers two different views regarding the impact of product market competition on the cost of equity capital. First, there is both anecdotal and academic evidence documenting that the intensity of competition could increase investors perception of a firm s risk. For instance, Warren Buffett stresses that barriers to entry matter most when investing in a company. 1 The investor stated in his Fortune article: The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors. In support of such anecdotal evidence on the impact of competition on firms riskiness, a growing number of empirical studies show that firms operating in more competitive markets are riskier since they have a lower ability to transfer market shocks to their customers and, thus, face a lower probability of maintaining their profit margins. Indeed, under rivals predatory threats (Haushalter et al., 2007; Hoberg and Philips, 2014), firms are characterized by a higher stock return volatility (Gaspar and Massa, 2006) and a lower cash flow stability (Irvine and Pontiff, 2009). From this perspective, investors would be more concerned with the uncertainty surrounding firms operating in competitive industries, implying thus an increase in the cost of raising equity. Consequently, we expect a positive relation between product market competition and the cost of equity capital. Second, there is an alternative view that draws on the monitoring role of product market competition, arguing that the competitive pressure improves firms corporate governance, by directly influencing managerial behavior (e.g., Hart, 1983; Schmidt, 1997; Shleifer and Vishny, 1997). The idea is premised on the view that stiffer competition exposes firms to severe 1 See How to invest like Warren Buffett by Jonathany (ft.com Feb 28, 2014). 3

4 predatory threats from rivals, thus raising managerial career concerns (Schmidt, 1997). This particular situation provides managers with less opportunity for slack and more incentives to work harder so as to avoid being driven out of the market. In this vein, previous empirical studies point to the conclusion that product market competition acts as an external disciplinary mechanism, by reducing agency problems (e.g., Jagannathan and Srinivasan, 1999; Leventis et al., 2011), inducing managers to make optimal decisions with regard to the best interests of shareholders (e.g., Grullon and Michaely, 2007; Balakrishnan and Cohen, 2013), and enhancing firm efficiency (e.g., Nickell, 1996, Nickell, 1997; Bozec, 2005). In light of the monitoring role of product market competition, investors expectations about future prospects are expected to be improved in more competitive industries, which in turn leads to a lower required rate of return. Indeed, prior empirical evidence shows that equity financing costs fall in the presence of effective governance mechanisms (e.g., Durnev and Kim, 2005; Chen et al., 2011; Attig et al., 2013). Consequently, we expect a negative relation between product market competition and cost of equity capital. Our empirical investigation provides evidence that there is a negative relation between product market competition and cost of equity capital. Using a large panel of US listed firms over the period, we document that the cost of equity financing is significantly lower for firms facing stiffer competition. This finding is consistent with the notion that the competitive threats from rivals are likely to discipline managerial behavior, thus decreasing the cost of equity capital. We also conduct numerous robustness tests to further test the soundness of our findings. For instance, we examine the sensitivity of our previous results to the use of alternative proxies of competition using market concentration, competitive pressure measures as well as cost of equity estimates. Additionally, we address endogeneity concerns using an instrumental variable approach and GMM estimation technique. We substantiate our hypothesis by further examining the cross-sectional variations in the effect of product market competition on the cost of equity. More specifically, we check whether the monitoring effect of product market competition differs among firms with different governance qualities. Prior studies on the interactive effect between competition and corporate governance point to the conclusion that there is a substitution effect between the disciplinary power of 4

5 competition and the effectiveness of governance mechanisms in reducing agency problems (e.g., Giroud and Mueller, 2010; Giroud and Mueller, 2011; Tian and Twite, 2011). Consistent with this view, our results show that the negative relation between competition and the cost of equity is more pronounced in firms with lower governance quality. Our study makes several contributions. First, with respect to the literature on product market competition, it complements the emerging research documenting that there is a link between industrial organization and financial markets. A large amount of the existing literature delves into how the competitive landscape has important implications for the firms capital structure (e.g., Xu, 2012), debt pricing (e.g., Valta, 2012; Waisman, 2013), value of cash holdings (e.g., Alimov, 2014), stock liquidity (e.g., Kale and Loon, 2011), volatility of firms stock returns (e.g., Gaspar and Massa, 2006; Irvine and Pontiff, 2009), among others. In this paper, we focus on the association between the intensity of product market competition and the cost of equity capital. Our study is similar in spirit to Hou and Robinson (2006) and Hoberg and Philips (2010) in that it sheds lights on the effect of the competitive pressure on the required rate of return. However, Hou and Robinson (2006) and Hoberg and Philips (2010) use the ex post stock returns as a proxy for the risk premium. In his presidential address, Elton (1999) argues that ex post stock returns are likely to be noisy proxies for the expected returns and the cost of equity capital since they capture external shocks to firms growth opportunities. In the current study, we rely on an alternative proxy of the risk premium that has been widely used in the recent accounting and finance literature (e.g., Hail and Leuz, 2006; Attig et al., 2008; Chen et al., 2009; El Ghoul et al., 2012; Boubakri et al., 2012; Attig et al., 2013). We use the ex ante approach to measure the cost of equity implied in stock prices and analyst forecasts that reflect investors expectations about future cash flows. As far as we know, our paper is the first to address the important but hitherto unexplored question of whether product market competition matters in explaining cost of equity. Second, with respect to the literature on firms equity financing costs, we show that product market competition is a material determinant of cost of equity. Specifically, our study expands the scope of research focusing on firm-level factors of cost of equity capital, such as information disclosure (e.g., Botosan and Plumlee, 2002; Francis et al., 2005), ownership structure (e.g., Attig et al., 2008; Boubakri et al., 2010), firm geographic location (e.g., El Ghoul et al., 2013; Boubakri et al., 2016), corporate diversification (e.g., Hann et al., 2013), corporate social responsibility (El 5

6 Ghoul et al., 2011; Dhaliwal et al., 2014), among others. Although these studies go deeply into the understanding of cost of equity determinants, they shrug off the cushioning role of industry characteristics in shaping investors expectations about future prospects. Other studies highlight the existence of significant cross-industry differences in the cost of equity estimates. For instance, Gebhardt et al. (2001) and Gode and Mohanram (2003) control for industry membership based on Fama and French (1997) industry classification and find that investors require a higher rate of return on firms belonging to certain industries. Nonetheless, they leave unexplored the question of what specific industry characteristics explain the inter-industry differences of cost of capital. In our paper, we attempt to look beyond the well-established factors identified in the extant literature by viewing the variations of firms cost of capital within the context of industry competition. The remainder of this paper is organized as follows. The second section deals with the literature review and the development of our main hypothesis. Section 3 provides details on the sample and the main variables used in our study. Section 4 presents the results pertaining to the relation between product market competition and the cost of equity capital. In section 5 and 6, we test the soundness of our results through a number of robustness checks and additional analyses. Finally, section 7 concludes the paper. 2. Literature review and hypothesis development There are a number of reasons to believe that the degree of competition in the product markets influences the cost of equity capital. One reason is that firms facing more competitive pressures are exposed to a higher level of risk. If competition increases investors perception of firms riskiness, one would expect equity financing costs to be greater in more competitive industries. Anecdotal evidence suggests that a firm s ability to fend off competitive threats is considered as an important factor in evaluating a business. Prior academic research suggests that firms operating in more concentrated industries have a stronger market power than firms in less concentrated industries, which allows them to maintain high profits even in the face of a cyclical risk (e.g., Subrahmanyam and Thomadakis, 1980; Moyer and Chatfield, 1983; Bernier, 1987). However, firms in competitive markets are more exposed to exogenous cost shocks since they are not endowed with the ability to pass on such shocks to their customers. Gaspar and Massa (2006) examine the effect of product market competition on firm idiosyncratic risk using 6

7 stock return volatility as a proxy for firm risk. The authors argue that firms facing stiffer competition are not able to maintain their profit margins, which translates into a higher level of stock return variability. More recently, Datta et al. (2011) suggest that profit variability of firms operating in more competitive industries results in a higher complexity of analyst forecasting process, as proxied by analyst accuracy. Hoberg et al. (2014) shed lights on the threats of a competitive product market environment. In support of Bolton and Scharfstein (1990) s argument, they provide evidence that firms combat such threats by increasing cash holdings and share repurchase and decreasing dividend payouts. Overall, those findings imply that product market competition results in an upward shift of profits uncertainty in the whole industry, and thus a higher distress risk. The existing literature suggests that investors require a premium for accepting to bear that risk. Chava and Purnanandam (2010), for instance, find that the probability of bankruptcy and default risk are significantly positively related to the expected stock returns measured as the implied cost of capital. Consequently, we argue that the intensity of competition increases risk that cannot be diversified away through investors portfolio diversification. In light of the above discussion, one would expect that product market competition and cost of equity capital are positively related: competition. H 1a: Cost of equity capital increases with the intensification of product market However, there are several counter-arguments for why the intensification of product market competition may have the opposite effect on the cost of equity capital. These arguments advocate that the disciplinary power of competition provides valuable monitoring of managerial behavior. The idea is premised on the principal-agent problem highlighted in corporate governance literature. Hart (1983) explains that competitive pressure helps to discipline managers by inducing them to work more efficiently since it hampers the realization of high profits. Hence, competition is effective in mitigating conflicts of interest between managers and shareholders. The idea that competition acts as an external governance mechanism spawned an important stream of research that points to a substitution effect between competitive threats and monitoring mechanisms (e.g., Giroud and Mueller, 2010; Giroud and Mueller, 2011; Chou et al., 2011). More specifically, if a firm competes with a large number of peers in the same industry, it shares an important proportion of its profits with rivals. Therefore, firms are subject to a higher liquidation risk that raises greater managerial career concerns (Schmidt, 1997). In this 7

8 case, managers are less inclined to pursue private benefits at the expense of outside investors. The reduction of such agency problems through improved governance has been documented to be valuable to investors (e.g., LaPorta et al, 2002; Gompers et al, 2003; Durnev and Kim, 2005). For example, Durnev and Kim (2005) provide evidence that firms with better corporate governance have higher market valuations. The authors argue that managers are more willing to tunnel out resources when investment opportunities are extremely scarce. Since firms investment opportunities, and hence managers opportunistic behavior, depend on market-wide swings, the required rate of return is significantly affected by the level of agency costs. Consequently, one may argue that the cost of equity capital decreases with the improved quality of corporate governance. A large number of studies lends support for this contention using different governance mechanisms, such as the presence of multiple large shareholders (Attig et al., 2008), audit quality (Chen et al., 2011; Choi and Lee, 2014), long-term institutional investment (Attig et al., 2013), among others. Accordingly, we posit that the monitoring power of product market competition is negatively associated with cost of equity capital. The aforementioned arguments thus lead to our second hypothesis: competition. H 1b: Cost of equity capital decreases with the intensification of product market Given the foregoing discussion, we argue that the relation between competition and cost of equity is an empirical issue. On the one hand, the perceived firm riskiness is higher in more competitive industries. Hence product market competition increases equity financing costs. On the other hand, the disciplinary power of competition reduces agency costs, which in turn results in a lower cost of equity. 3. Data and cost of equity estimation 3.1. Sample Our sample starts with all firms that belong to the COMPUSTAT and CRSP databases during the period. We merge our initial sample with I/B/E/S database where we collect data on analyst forecasts that are necessary for the calculation of cost of equity estimates. These estimates require each firm to be followed by at least 2 analysts; to have positive 1- and 2-year ahead forecasted earnings per share, a long-term growth rate of earnings forecasts (if not available, a 3-year ahead earnings forecast), a positive book-value per share, and a stock price 8

9 corresponding to the period in which forecasts have been recorded. We also collect data on product market competition and industry classification from Hoberg-Philips Data Library starting in We restrict our sample to firms with non-missing and non-zero observations of firm total sales or assets Product market competition measures Following previous literature on product market competition (e.g., Alimov, 2014; Chi and Su, 2015; Li and Zhan, 2016), we use two different proxies to capture the intensity of competition in product markets, namely FLUIDITY and TNIC3HHI. FLUIDITY is a text-based measure developed by Hoberg and Philips (2014) based on product descriptions found in firms 10-K filings and captures the degree to which a firm s products are changing due to the evolution of rivals products. More specifically, it is defined as the similarity between a firm s vocabulary and the change in the overall use of vocabulary by rivals in a given industry. A greater similarity in the business descriptions between rivals implies that a firm faces higher competitive threats and thus a higher intensity of product market competition. The use of FLUIDITY as a measure of competition is interesting in that it is highly representative of the competitive pressure imposed by the threat of existing rivals, which is likely to either increase uncertainty or discipline insiders, and therefore may influence the cost of equity capital. Recently, a number of empirical studies have used FLUIDITY as a proxy for the competitive threats that a firm faces. For instance, Hoberg et al. (2014) show that firms with higher fluidity tend to decrease dividend payouts and increase cash holdings as a way of managing the predation risk arising from rivals predatory behavior. Alimov (2014) employs fluidity as an additional measure of firms product market dynamics and report that competition increases the value of cash holding. Therefore, FLUIDITY is an ideal proxy for the level of competitive pressure in a product market. To alleviate the concern that the relation between product market competition and cost of equity could be only driven by the predatory threats of rivals, we use as a second measure TNIC3HHI which is calculated as the sum of the squared market shares using firm sales based on the TNIC industry classification of Hoberg and Philips (2016). This measure captures a different dimension of competition, namely industry concentration. Based on textual analysis of firms product descriptions, Hoberg and Phillips (2016) use a clustering algorithm to create the Text- 2 We download the data from 9

10 based Network Industry Classification (TNIC). Unlike traditional industry classifications such as SIC and NAICS, the TNIC is better able to capture industry changing dynamics since TNIC industry groups may change over time with the change of similarity scores between a firm and its industry peers. Additionally, the use of HHI based on the TNIC industry classification is motivated by the fact that this measure captures forward-looking competition, which is likely to be more informative in determining investors expectations about future firm performance. Consequently, we expect this variable to be significantly related to the cost of equity capital Cost of equity estimates To gauge the effect of product market competition on the cost of equity capital, we calculate the ex ante cost of equity estimates rather than ex post stock returns. According to Bekaert and Harvey (2000) and Hail and Leuz (2006), ex post stock returns are likely to capture external shocks to the growth opportunities of companies. Therefore, we estimate the ex ante cost of equity implied in current stock prices and forecasted earnings per share, and which is intended to explicitly control for the cash flow and growth effects. Our cost of equity estimates are derived from four different models developed by Claus and Thomas (2001); Gebhardt, Lee and Swaminathan (2001); Easton (2004) and Ohlson and Juettner-Nauroth (2005), labeled k CT, k GLS, k CT and k OJN, respectively. All four models consist of valuation equations that are based on the idea that analyst forecasts represent investors expectations. However, each model relies on its own set of assumptions regarding the explicit forecast horizon and growth expectations. To avoid spurious results that might be driven by a specific cost of equity measure, we calculate the arithmetic average of the four different estimates, denoted r avg, following the recent empirical literature (Hail and Leuz, 2006; Attig et al., 2008; Chen et al., 2009; El Ghoul et al., 2012; Boubakri et al., 2012; Attig et al., 2013) Model and variables To test the impact of product market competition on the cost of equity capital, we estimate several specifications of the following regression model using panel data: K AVG= α 0+ a 1 PMC+ CONTROLS+ FIXED EFFECTS+ ε. (1) where r avg is the average implied cost of equity capital estimated using the four models, PMC is one of the competition related variables FLUIDITY and TNIC3HHI. Following previous 10

11 literature, we include a set of control variables (CONTROLS) that have been shown to be germane in explaining the variation of cost of equity estimates. These variables are presented as follows: Beta (β) Sharpe s (1964) seminal model on asset pricing implies that investors are compensated for holding a systematic risk defined as market beta. Therefore, we control for market beta that we obtain by regressing monthly excess stock returns on the market excess return based on the CRSP index over the previous 60 months. We expect market beta to load positively on the cost of capital. Book-to-market ratio (BTM) A higher book-to-market ratio might signal lower firms growth opportunities, and hence a higher risk premium. Indeed, Fama and French (1992) show that book-to-market equity accounts for the cross-sectional variation of average stock returns. Following previous studies on cost of equity capital (e.g., Gode and Mohanram, 2003; Hail and Leuz, 2006), we include the ratio of book value to market value of equity (BTM) as a control variable. We expect BTM to be positively associated with the implied cost of equity estimates. Size Firm size is likely to mirror firm visibility and information availability to market participants. Disclosure literature shows that investors revise downward the required rate of return on firms with expanded disclosure (e.g., Botosan, 1997). More recently, Attig et al. (2008) control for analyst coverage as a proxy for firm size since larger firms are more heavily followed by information intermediaries and report a negative association between firm size and cost of equity capital. In our regression model, we control for firm size defined as the natural logarithm of firm total assets. We expect a negative association between firm size and cost of capital. Long term growth (LTG) The effect of earnings growth on the cost of capital remains unclear. On the one hand, Gebhardt et al. (2001) find that the forecasted long-term growth rate is positively associated with the implied cost of equity capital. The underlying premise is that high growth firms are riskier because of potential errors in growth rate forecasts. On the other hand, La Porta (1996) provide evidence that firms with a higher long-term growth rate have lower stock returns since they 11

12 enjoy better growth prospects. In our study, we include as a control variable the long-term growth rate of the forecasted earnings per share obtained from I/B/E/S database. Leverage (LEV) The risk premium has been theoretically (Modigliani and Miller, 1958) and empirically (Fama and French, 1992; Botosan and Plumlee, 2002) shown to increase with firm leverage. Consequently, we control for firm leverage in our regression model using the ratio of long-term debt to total assets. Analyst forecast dispersion (DISP) Rountree et al. (2008) provide empirical evidence that firms with a lower level of future expected earnings volatility have higher valuations since investors prefer less risky stocks. Following prior studies on cost of equity capital (e.g., Gebhardt et al., 2001; Gode and Mohanram, 2003; El Ghoul et al., 2013), we capture future earnings variability using the dispersion of analyst forecasts. In our study, DISP is measured as the standard deviation of one-year-ahead analyst earnings forecasts divided by their arithmetic mean. Forecast Bias (FBIAS) Easton and Sommers (2007) argue that analyst forecast optimism may generate an upward bias in the estimates of the implied cost of equity capital, which are based on analysts earnings forecasts. We therefore control for the possible effect of analyst forecasting behavior on cost of equity estimates using analyst forecast bias (FBIAS). We calculate the forecast bias as the difference between the one-year-ahead analyst earnings forecasts and the current realized earnings deflated by beginning of period assets per share. Positive values of the forecast bias (FBIAS) reflect the optimism in analyst forecasts. Consequently, we expect a positive relation between the cost of equity capital and analyst forecast bias. FIXED EFFECTS: time and industry dummies included to control for the leftover variation in equity financing costs caused by industry and time differences; and ε an error term. 4. Main analysis: The effect of product market competition on the cost of equity 4.1. Summary statistics Table 1 reports the descriptive statistics for our key variables. Our competition variables of interest, FLUIDITY and TNIC3HHI, have mean values of 7.16 and 0.19, respectively. These 12

13 values are largely comparable to the statistics reported in the previous studies on product market competition (e.g., Morellec et al., 2013; Li et al., 2014; Chi and Su, 2015). Moreover, the mean (median) value of firm size, as measured by natural logarithm of total assets, is 7.11 (6.99) indicating that our sample covers relatively large firms. Table 2 presents the correlation matrix for the variables used in our main regression and highlights a couple of interesting points. First, the pairwise correlation coefficients between the independent and control variables are relatively small. We can therefore surmise with some assurance that that multicollinearity does not seem to be a serious problem in our study. Second, table 2 shows that FLUIDITY is negatively and significantly correlated with TNIC3HHI, though the correlation coefficient is not very large (-0.282). This suggests that, although these proxies are designed to measure the intensity of competition faced by firms, they capture different dimensions of the product market competitive threats. [Insert Tables 1 and 2 about here] 4.2. Empirical Results Table 3 tabulates the multivariate regression results from estimating Equation (1). The results from all the model specifications (Columns (1)-(10)) strongly support our prediction that the FLUIDITY (TNIC3HHI) is negatively (positively) associated with firms cost of equity capital after controlling not only for firm-specific determinants but also for industry and time-fixed effects. In Columns (1) and (2), we estimate Equation (1) with robust standard errors clustered by firms and report that the coefficient on variable FLUIDITY (TNIC3HHI) is negative (positive) and statically significant. In Columns (3) (10) of Table 3, we report the results using alternate estimation approaches. In Columns (3) and (4), we compute the standard errors in our baseline model using the Fama and MacBeth (1973) procedure to mitigate concerns about crosssectional dependence. The results suggest that the impact product market competition, proxied by FLUIDITY (TNIC3HHI), on the cost of equity capital is negative (positive) and statistically significant. Our evidence regarding the role of product market competition continues to hold when we account for serial correlation of standard errors under the Newey-West specification in Columns (5) and (6), and the Prais-Winsten specification in Columns (7) and (8). Our results also hold 13

14 when we run weighted least squares regression where the weight is the inverse of the number of firm-year observations per industry (Columns (9) and (10)). In terms of economic magnitude, depending on the specification that we consider, an increase of one standard deviation in FLUIDITY (TNIC3HHI) is associated with an average decrease (increase) of 5 (7) to 8 (11) basis points in equity financing costs. To put these numbers in context, an increase of one standard deviation in firm beta is associated with an average decrease of 9 to 22 basis points in the cost of equity capital. In all the specifications, the control variables enter significantly into the main specification with their expected signs. [Insert Table 3 about here] 5. Robustness Checks 5.1. Alternative market competition variables This test aims to check the sensitivity of our results to the use of alternative measures of product market competition. First, we replicate our baseline regression model using the Fitted Herfindahl-Hirschman Index (fithhi) which is a measure of industry concentration at the threedigit SIC level. The advantage of using the Fitted HHI is that this measure takes into account both public and private firms by combining data from Compustat as well as data from the US Census Bureau and Bureau of Labor Statistics (Hoberg and Philips, 2010). Moreover, we use additional market concentration measures based on traditional industry classifications. More specifically, we use the sales-based HHI using two-digit, and three-digit SIC (HHI, HHI3) industries, and the asset-based HHI using two-digit and three-digit SIC industries (HHIa, HHIa3). In addition to industry concentration measures, we also use other competition proxies which capture the level of competitive pressure from existing rivals. We use the Hoberg and Phillips (2016) similarity index (TNIC_TSIMM), which measures the product descriptions closeness between a given firm and its peers. Intuitively, a higher similarity index implies a stronger competitive pressure. Additionally, we use the pctcomp measure as suggested by Li et al. (2013). pctcomp is a text-based measure that captures managerial perception of rivals competitive behavior. It is calculated by Li et al. (2013) as the number of occurrences of competition words per 1000 words in each firm s 10-K filings. Table 4 presents the results of our 14

15 multivariate regression model using alternative competition-related proxies. In columns (1) through (5), we include measures of industry concentration. In columns (6) and (7), we include competition measures that reflect rivals competitive pressure. Overall, the results show that the conclusions drawn previously are robust to alternative proxies of competition. [Insert Table 4 about here] 5.2. Individual cost of equity estimates, alternative specifications of the cost of equity estimates, and alternative specifications of the cost of equity models We examine whether our main evidence is robust to using the individual cost of equity capital estimates (i.e. K GLS, K CT, K OJN, and K MEG) as the dependent variable and this for our two main product market competition proxies (FLUIDITY and TNIC3HHI). The results, reported in Table 5, show that our main results are not driven by particular model(s) among the four models used to construct K AVG. Furthermore, to ensure that our main results are driven by the choice of cost of equity estimates, we re-examine our hypothesis using three alternative cost of equity capital estimates. The results are reported in Table 6. Precisely, in column 1 we measure the cost of equity using the forward earnings-to-price (EP) ratio, which is defined as FEPSt+ divided by Pt (Easton, 2004), in column 2 we use the price-earnings-growth (PEG) model, which assumes no dividend payments to estimate the equity premium using short-term earnings forecasts, and in column 3 we apply the trailing earnings yield (TEYD), which is defined as current EPS divided by Pt. In each of these specifications, we find that the significant negative relation between product market competition and equity financing costs. Finally, instead of the average of the four individual cost of equity model (i.e. K AVG) we use the median and the first principal component approach. In doing so, we seek to examine the robustness of our main findings to alternative specifications for the cost of equity estimates. The results, presented in Table 7, show that FLUIDITY (TNIC3HHI) is (negatively) positively associated with firms cost of equity capital. In other words, negative relation between product market competition and equity financing costs continues to hold. [Insert Tables 5, 6 and 7 about here] 15

16 5.3. Robustness to noise in analyst forecasts Similar to other proxies for cost of equity capital proposed in the literature, our measure suffers from limitations resulting from potential measurement errors. If the measurement errors are correlated with the independent variables (i.e., non-random measurement errors) then our empirical results would be biased and lead to spurious inferences. The literature identifies three main sources of measurement errors. The first is model misspecification, which arises from the implicit assumption that expected returns are constant when they are actually stochastic. As discussed above, to alleviate this concern we follow the previous literature and control for leverage, expected earnings growth and forecast dispersion in all our multivariate analyses. The second source of measurement errors arises from analysts forecast bias. Recent research documents an upward bias in analysts forecasts for growth firms, which translates into systematically higher implied costs of equity capital estimates for growth firms than for value firms (e.g., Easton and Sommers, 2007). In Table 8, we use several techniques to mitigate this concern. In an initial approach at addressing this issue, we exclude the top 5, 10, 25, and 50% of firm-year observations with extremely optimistic earnings forecasts. Panel A of Table 8 shows that, despite the major sacrifice in power in these smaller samples, we continue to observe that FLUIDITY loads highly negatively. We repeat this exercise for the long-term growth forecast (LTG) by discarding firm-year observations with extreme values in Models (5) to (8) and still find that FLUIDITY exhibits a negative and statistically significant association with the cost of equity capital. The third main source of measurement errors identified in the literature is the sluggishness of analyst forecasts; in other words, analysts tend to react gradually to publicly available information (e.g., Ali, Klein, and Rosenfeld, 1992). We address this concern in three ways. First, in line with Hail and Leuz (2006), we control for analyst accuracy by running weighted least squares regressions where the weight equals the inverse of the forecast error (absolute value of one-year-ahead earnings minus realized earnings deflated by assets per share). This approach assigns less weight to less precise forecasts and more weight to more precise forecasts (Column 9). Second, we re-estimate the implied cost for equity capital using end-of-january instead of endof-june prices to allow analysts to incorporate recent price movements into their forecasts (Hail 16

17 and Leuz, 2009; Guay, Kothari, and Shu, 2011). The results are reported in Column 10. Third, we follow Chen, Chen, and Wei (2009) and Guay, Kothari, and Shu (2011) and control for price momentum estimated as compounded stock returns over the past six months (see Column 11). In all the three specifications (Columns 9-11), we continue to obtain a negative and statistically significant coefficient on FLUIDITY, suggesting that firms equity financing costs are negatively correlated with product market competition. Similar conclusion holds when we use TNIC3HHI as a proxy for product market competition instead of FLUIDITY. In fact, results reported in Panel B show that in all the specifications (Columns 1-11) the coefficient on TNIC3HHI is positive and statistically significant suggesting that cost equity capital is negatively associated with product market competition. [Insert Table 8 about here] 5.4. Robustness to endogeneity So far in the analyses, we used FLUIDITY as a proxy for product market threats, which pertains to the movements of firms rivals and, therefore, is exogenous to firms characteristics (Hoberg and Phillips, 2014). Although the use of FLUIDITY is likely to mitigate endogeneity concerns, we further pin down the causal relation between product market competition and the cost of equity using two approaches. First, we employ an instrumental variable (IV) approach using import tariff rates as an instrument for our competition-related variables (e.g., Xu, 2012; Li and Zhan, 2016). The international trade literature offers arguments consistent with the idea that trade liberalization causes major changes in the domestic market structure. Indeed, import tariff rates are considered as a trade barrier that protects domestic producers. Therefore, a reduction in import tariff rates is likely to encourage foreign entries, and hence results in a tremendous increase in foreign competitive pressure (Bernard et al., 2006). Using the trade data available at the Schott s International Economics Resource Page (Schott, 2010) 3, we follow previous studies in calculating the industry-level import tariff rates (Frésard, 2010; Xu, 2012; Waisman, 2013; Li and Zhan, 2016). For each industry, we calculate the ad valorem tariff rate as the duties charged on all exporting countries to that industry divided by the free-on-board value of general imports. We 3 The information on import data are assembled by Feenstra (1996), Feenstra, Romalis and Schott (2002) and Schott (2010) at the Harmonized Sytem (HS) level, and then converted to Standard Industry Classification (SIC) level using the concordances provided by Pierce and Schott (2009). 17

18 define tariffrate3 as the tariff rate calculated at the 3-digit SIC level, and tariffrate4 as the tariff rate calculated at the 4-digit SIC level. The second approach of accounting for endogeneity is the use of the generalized method of moments (GMM) (Arellano and Bond, 1991; Blundell and Bond, 1998). The GMM estimation technique allows for the use of internal instruments, which are based on the lagged values (and differences) of the instrumented variables. We report the results of the IV and GMM approaches in table 9, using the FLUIDITY measure in Panel A and the TNIC3HHI in Panel B. In support of our previous finding, we show that the intensity of product market competition significantly reduces the cost of equity capital. [Insert Table 9 about here] 5.5. Factors affecting the link between product market competition and cost of equity In this section, we aim to identify the mechanism through which product market competition affects cost of equity capital. According to the monitoring channel, the disciplinary power of competition plays a cushioning role in mitigating agency conflicts, which, in turn, translates into lower equity financing costs. If a firm is characterized by severe agency problems and weak monitoring mechanisms, it would benefit more from the governance pressure of the external product market. Therefore, we should observe that the cost of equity of weak-governed firms responds more negatively to the intensification of product market competition. In contrast, if a firm is already characterized by a strong governance structure, its cost of equity would be less influenced by product market competition. To evaluate the reliability of this channel, we define two proxies for the quality of firm governance. First, we use the passage of the Sarbanes Oxley Act of 2002 as a source of an exogenous variation in firms governance environments. We define SOX as a dummy variable that takes 1 for firm-year observations after 2002, and 0 otherwise. We rerun our baseline regression model by adding an interaction term between each of our competition-related variables and governance proxies. Second, we conduct our analysis using the entrenchment index (E-index) proposed by Bebchuk et al. (2009) and based on governance data from Institutional Shareholder services (ISS). The e-index is comprised of six anti-takeover provisions, namely classified boards, limits to shareholder bylaw amendments, supermajority requirements for mergers, supermajority requirements for charter amendments, poison pills and golden parachutes. 18

19 Table 10 presents the results of the role of governance in influencing the relation between product market competition and cost of equity. The coefficient of Prodmktfluid x SOX (Prodmktfluid x E-Index) is positive (negative) and statistically significant suggesting that the negative relation between FLUIDITY and the cost of equity is weaker after the passage of the Sarbanes-Oxley Act, and stronger for firms with higher values of E-index. Similar conclusions are reached using the TNIC3HHI as another proxy for product market competition. Overall, the results find support to the monitoring channel through which the external competitive pressure influences the cost of equity capital. [Insert Table 10 about here] 6. Conclusion Extant literature on product market competition provides evidence that the impact of the competitive threats on firms is twofold. On the one hand, stiffer competition is likely to reduce profit margins, and thus exposing incumbent firms to higher liquidation risk. On the other hand, such liquidation risk arising from intense competition raises greater managerial career concerns, which in turn leads to less managerial slack and better performance. In this paper, we investigate an implication of the external competitive pressure in the product market. Specifically, we examine whether and how the intensity of competition affects the cost of equity capital. Using a large panel of US listed firms over the period spanning from 1998 to 2013, we find that product market competition plays a key role in shaping the perceptions of a particular firm in the eyes of external investors. In particular, we show that firms operating in more competitive industries have lower equity financing costs. We interpret these findings as consistent with the notion that the disciplinary power of competition improves investors expectations about firms future prospects, which in turn results in a lower cost of equity capital. This result stands up to a battery of robustness checks including the use of alternative proxies of product market competition and cost of equity estimates, alternative specifications of the cost of equity models, and robustness to noise in analyst forecasts. We further address endogeneity issues using the instrumental variable (IV) approach and the generalized method of moments (GMM) estimation technique. More importantly, our findings show that the negative impact of the product market 19

20 competitive threats on the cost of equity is more pronounced for firms with weaker governance structures, supporting the effectiveness of the monitoring role of product market competition. This study contributes to the literature debating the consequences of the intensification of product market competition, by furthering our understanding of the valuation effects of the competitive pressure of the product market. Additionally, it digs deeper into the determinants of the cost of equity capital, by focusing on product market competition, which is one of the major industry-level determinants that have been largely overlooked in the extant literature. 20

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