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Illiquidity and the Cost of Equity Capital: Evidence from Actual Estimates of Capital Cost for U.S. Data

Author

Listed:
  • Amit Goyal

    (University of Lausanne; Swiss Finance Institute)

  • Avanidhar Subrahmanyam

    (University of California, Los Angeles (UCLA) - Finance Area; Institute of Global Finance, UNSW Business School; Financial Research Network (FIRN))

  • Bhaskaran Swaminathan

    (LSV Asset Management)

Abstract

Illiquidity measures appear to be related to monthly realized returns but do they actually impact the long-run costs of capital for firms? We make progress on this issue by analyzing the relation between the well-known Amihud (2002) liquidity measure and actual cost-of-capital (CoC) estimates, which rely on imputing the internal rate of returns on firms’ equity cash flows. Using U.S. data, after controlling for well-known determinants of CoC, we find that illiquidity is strongly and negatively related to CoC estimates. This result obtains even as we confirm that illiquidity is positively related to monthly realized returns. Liquidity risk and the probability of informed trading bear no relation to CoC. While our results do not rule out that short horizon investors demand compensation for illiquidity, our results run contrary to the notion that corporations should care about illiquidity, liquidity risk, or information risk, while setting discount rates for long-term projects.

Suggested Citation

  • Amit Goyal & Avanidhar Subrahmanyam & Bhaskaran Swaminathan, 2021. "Illiquidity and the Cost of Equity Capital: Evidence from Actual Estimates of Capital Cost for U.S. Data," Swiss Finance Institute Research Paper Series 21-87, Swiss Finance Institute.
    • Handle: RePEc:chf:rpseri:rp2187
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    Keywords

    Trading Costs; Determinants of Equity Returns; Liquidity Premia;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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