A Study On The Impact Of Internal Control Quality On Cost Of Equity Capital

The capital market is the basic direct financial channel of firms and the chain that combines firms with investors. A lot of firms gain the fund supporting for operation and development from the capital market. Investors also obtain investment earnings and maximize their wealth from the capital market. Cost of equity capital plays a key role in organizing the resource allocation and guiding the high efficient flow of fund on the capital market. It is the direct reflection of the capital market’s finance and investment efficiency. But because of low quality internal control and low level of risk management, some firms can not realize the scheduled operation objective and strategic development goal, and are even stuck in bankrupt. Investors also suffer enormous losses due to these firms’false financial information and operation failure. This significantly beats the investors’confidence of the capital market, and also seriously damages the finance and investment efficiency of the capital market. Therefore, the deep analysis of the Mechanism of the effect of internal control on cost of equity capital and the exploration of internal control’s role in the process of the capital asset pricing has an important theoretical and practical significance.From the theoretical significance, on the one hand it helps the deep understanding of the action mechanism of the effect of internal control on cost of equity capital and enriches the research literatures on the economic consequences of internal control. On the other hand, it expands the influencing factors of cost of equity capital and enriches the stock pricing theory. From the practical significance, on the one hand the study on this problem helps to enhance the listed companies’awareness of internal control construction for reducing cost of their cost of equity capital. On the other hand it helps investors to analyze the influencing factors of cost of equity capital from internal control perspective and more accurately estimate their investment cost and the prices of stocks. So investors’ interest protection is enhanced, and the capital market develops healthily.This paper is the theoretic analysis and the empirical test of the effect of internal control quality on cost of equity capital and the specific action paths. The main conclusions are as follows: 1. Internal control quality acts on cost of equity capital by affecting investors’ information risk and a firm’s operating risk. On the one hand, as an institutional arrangement of the control of the information production process, internal control helps to enhance the reliability of the financial reports and the other relative information released to the outside. With the improvement of internal control quality investors can make the more accurate judgment of the firm’s current operation and the precise prediction of its future earnings. Therefore, investors ask for the lower information risk compensation, and cost of equity capital declines. On the other hand, internal control is an important tool in which a business organization strengthens risk management. A firm is organized by a series of hierarchies. Besides the first agency relationship between management and investors and the second agency relationship between the control shareholders and small ones, a series of agency relationship exist in different level managers and between management and staff. Because each hierarchy has its own different interest objective function, each hierarchy will have an opportunistic behavior for its own interest which will corrode the firm’s benefit.Internal control enhances the supervision and counterbalance of different hierarchies by a series of system design and control activities. The aims and behaviors of different hierarchies are unified into the aim for the whole firm’s interest The probability and degree of corroding the firm’s interest declines. The firm will have a higher probability of realizing the future operation target. Therefore the risk compensation the investors require decreases and cost of equity capital declines.2. In the environment that investors hold portfolios, this paper embeds internal control in the classic CAPM model and finds internal control also affects cost of equity capital by affecting systematic risk. Specifically, internal control quality affects the investors’estimation of the covariance of a firm’s flow with the market flow. The higher internal control quality is, the smaller estimation error is. As a result cost of equity capital declines. Secondly, internal control quality affects the ratio of the expectation of a firm’s future flow and the covariance of the firm’s future flow with the market flow. The higher internal control quality is, the smaller this ratio is. As a result cost of equity capital declines.3. The empirical test result shows internal control may significantly affect cost of equity capital by information risk, operating risk and systematic risk. Ignoring these indirect action paths may lead to underestimate the effect of internal control on cost of equity capital. The empirical result also shows internal control more largely affects cost of equity capital through information risk. It illustrates the current internal control of Chinese listed companies is mainly related with financial reports. The non-financial-reports objectives have less effect on cost of equity capital.This paper is divided into seven chapters. The main content of each chapter is as follows:Chapter1is introduction. It introduces the topic selection backgrounds research significance, research thread, research method, the main content, the academic contribution and innovation.Chapter2is the definition of the concepts and the review of the literatures. It firstly defines the two core concepts in this paper-internal control quality and c^st of equity capital. And then, it makes a review and comment of the relative literatures in this field, and postulates the problems in the current research.Chapter3is the theoretical analysis of the action mechanism of internal control on cost of equity capital and the specific action paths. Firstly this chapter introduces the theoretical basis of the analysis which includes efficient market theory,information asymmetry theory and principal-agent theory. Then this chapter specifically analyzes how internal control affects cost of equity capital through information risk, operating risk and systematic riskChapter4introduces the measurement method of internal control quality this paper chooses. After reviewing the current measure methods of internal control quality, this paper decides to construct a internal control index to measure firms’internal control quality comprehensively and systematically. Then this chapter specifically introduces the internal control index’s construction rules, the construction method, the selection and dimensionless method of the indicators and the calculation method of the weight. The last part of this chapter tests the reliability of the internal control index using the data of Chinese listed companies.Chapter5is the research on the estimation methods of cost of equity capital. Firstly this chapter has a review and comment of the main estimation methods of cost of equity capital. These estimation methods are categorized into two categories:the direct estimation method based on the risk premium and the indirect estimation method based on the future earning discount. The former includes CAPM model, APT model and Fama-French three factor model. The latter includes there classes:the dividend discount models, the residual income models and the abnormal earnings growth models. The last part of this paper tests the reliability of the various specific estimation models using the data of Chinese listed companies. The empirical result shows OJ model, MPEG model and PEG model have the higher reliability. Therefore chapter6will choose these three models to estimate cost of equity capital.Chapter6is the empirical test of the effect of internal control quality on cost of equity capital and the specific action paths under the theoretical analysis of chapter3. The relative effect of each action path on cost of equity capital is compared in the empirical test.Chapter7concludes the research, puts forwards the policy proposals and reveals the limitations of the research as well as the potential direction in the future studies.