Firm‐level political risk and implied cost of equity capital

• Published date: 01 September 2023
• Author: Dev R. Mishra
• Date: 01 September 2023
• DOI: http://doi.org/10.1111/irfi.12411

ORIGINAL ARTICLE

Firm-level political risk and implied cost of

equity capital

Dev R. Mishra

Edwards School of Business, University of

Saskatchewan, Saskatoon, Saskatchewan,

Canada

Correspondence

Dev R. Mishra, Edwards School of Business,

University of Saskatchewan, Saskatoon,

Saskatchewan, Canada.

Email: mishra@edwards.usask.ca

Abstract

I find a strong positive association between firms' implied

cost of equity capital and firm-level political risk. This effect

is above and beyond the firm-level cost of equity implica-

tions of economywide political risk. Firm-level political risk

contributes to elevating stock illiquidity, increases disper-

sion of analyst forecasts and dampens analyst coverage and

these attributes, in turn, have positive cost of equity capital

implications. Overall, the findings of this study suggest firm-

level political risk has a non-trivial effect on increasing

equity market illiquidity, increasing dispersion of earnings

forecasts and decreasing analyst coverage thus increasing

financing costs.

KEYWORDS

CEO attributes, earnings conference calls, firm-level political risk,

implied cost of equity, institutional ownership

JEL CLASSIFICATION

G3, G32, M12

1|INTRODUCTION

Both popular press and academic literature has significant evidence on inseparability of politics and finance.

From January 1, 2019, to December 31, 2020, “Wall Street banks and financial services interests reported spending

$2.9 billion to influence decision-making in Washington”, provides an example of the importance of politics for finance

I acknowledge the generous support of N. Murray Edwards through the Edwards Enhancement Chair in Business program. I thank Tarek A. Hassan,

Stephan Hollander, Laurence van Lent, Ahmed Tahoun for making political risk dataset available - https://www.firmlevelrisk.com/. This research also

benefits from the comments by Thomas J. O'Brien, Shantaram Hedge, George Tannous, Dragon Yongjun Tang (editor), an anonymous reviewer and

associate editor.

Received: 11 May 2022 Revised: 12 November 2022 Accepted: 14 January 2023

DOI: 10.1111/irfi.12411

© 2023 International Review of Finance Ltd.

International Review of Finance. 2023;23:615–644. wileyonlinelibrary.com/journal/irfi 615

and thus of political risk.

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To this end, academic literature, such as Pástor and Veronesi (2013) show that

economywide political risk is priced and involves a nontrivial risk premium. It is unique and orthogonal to

economywide fundamental risk; thus, it is not captured simply by the traditional market risk premium. Similarly,

empirical evidence shows significant firm-level outcomes of economywide policy uncertainty and political risk

(Bordo et al., 2016; Francis et al., 2014; Pham, 2019; Wang et al., 2019). However, until recently, most empirical

literature has limited its examination of political risk to firm-level consequences of economywide partisan politics or

economywide policy uncertainty. Baker et al.'s (2016) policy uncertainty index has been one of the common

measures of policy risk used in the literature.

This literature generally assumes that political risk is synonymous with other macro factors that result in largely

similar economywide shocks to which every firm in the economy bears similar exposure. However, it ignores the fact

that the significance of political risk is asymmetric across sectors and industries (e.g., see Gad et al., 2021), and within

the same sector or industry, it is asymmetric across firms by virtue of firms' unique characteristics, such as the head-

quarters location, firm size, business, geographic segments and the variation among firms in their effort to hedge

such risks (such as, political lobbying). The lack of validated firm-level political risk databases largely limits firm-level

implications of political risk to those of global, national or state-level political risk proxies. Recently, Hassan et al.

(2019) developed a measure of firm-level political risk based on political risk-related conversations during corporate

earnings conference calls. Hassan et al. validated this measure and demonstrated that it reflects risk that is political

in nature. More specifically, Hassan et al. (2019, p. 2135) find “the vast majority of the variation in …[the measure of

political risk]…is at the firm level rather than at the aggregate or sector level …The dispersion of this firm-level political

risk increases significantly at times with high aggregate political risk”. This finding suggests that political risk shows sig-

nificant heterogeneity across firms irrespective of industry or sector. Furthermore, top scoring transcripts on political

risk “identify conversations that center on risks associated with politics, including, for example, concerns about regulation,

ballot initiatives, and government funding”, and the measure of political risk elevates substantially “around federal elec-

tions”and varies positively with Baker et al.'s (2016) index of “aggregate economic policy uncertainty”(see Hassan

et al., 2019, p. 2137). Hassan et al. demonstrate that an increase in this measure is associated with a subsequent

increase in the volatility of firms' stock returns, a decline in investments, capital budgets and additions to firms' work-

force, and an increase in political donations, all of which are expected outcomes of firm-level political risk. Therefore,

this measure is the first powerful proxy of firm-level political risk.

In this paper, within the theoretical and empirical insights of Pástor and Veronesi (2012,2013), Kogan and

Papanikolaou (2013,2014), Dittmar and Lundblad (2017), Francis et al. (2014) and Islam et al. (2022), I argue that

firm-level political risk, as a unique risk characteristics of a firm, inches a firm closer to default,

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increases stock illi-

quidity, deteriorates quality of analyst forecasts and analyst coverage, and thus incentivizes investors to require

higher returns in their investment in the firm's securities. To support these arguments, I exploit the firm-level mea-

sure of political risk and examine its effect on firms' implied cost of equity, thus effectively departing from prior stud-

ies that examine firm-level outcomes of aggregate economywide political risk. Using panel tests, I find that implied

cost of equity increases with the extent of firm-level political risk, suggesting that firm-level political risk is an impor-

tant risk characteristic with nontrivial cost of equity implications. Overall, a one standard deviation change in political

risk is associated with an approximately 8 to 10 basis point corresponding change in a firm's implied cost of equity

capital. These findings account for potential endogeneity issues, namely, in panel tests, by controlling for a battery of

observable CEO, firm, analyst, and policy uncertainty attributes and unobservable joint time-industry shocks and

time-invariant firm- and industry-specific heterogeneity. In the similar panel tests the firm-level political risk has non-

trivial effect on elevating stock illiquidity and reducing analyst coverage and increasing dispersion of earnings fore-

casts thus deteriorating information environment, consequently contributing to higher equity financing costs.

The findings of this study help demonstrate Hassan et al.'s assertion that firms implying elevated firm-level polit-

ical risk reduce hiring and investment, and Gad et al.'s findings that lenders adjust lending rates in response to the bor-

rower's firm-level political risk. Namely, the present study implies that a plausible explanation for a decrease in

investments and hiring for firms with heightened firm-level political risk could be their inability to raise funds at a

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