Internal versus external equity funding sources and earnings response coefficients

Abstract

Because of transactions costs and investor/manager information asymmetries, internally generated funds should be less costly than funds raised by issuing common shares. This suggests that as firms use more internal funds relative to external equity, their costs of equity capital will fall and the rate the market uses to discount unexpected earnings of such firms will be lower. We hypothesize that (1) firms having a higher proportion of internal to external equity will have larger earnings response coefficients, and (2) this effect will be magnified for high growth firms since the disparity between inside information and publicly available information about high growth firms' investment opportunities is greatest. We find support for both hypotheses using pooled and annual cross-sectional regressions after controlling for other determinants of ERCs. The results are also generally robust to alternative measures of the mix of equity funding sources and of unexpected earnings and to consideration of other factors affecting the mix of equity capital. © 2001 Kluwer Academic Publishers.