Does financial fraud affect implied cost of equity?

Abstract

Abstract The paper examines the relationship between financial fraud and a firm's implied equity cost. Using a U.S. sample of 15,552 firm‐year observations, we find a positive relationship between a firm's financial fraud and implied equity cost. Consistent with the monitoring channel, financial fraud increases a firm's equity cost in the presence of higher external and internal monitoring in terms of higher analyst coverage and institutional ownership. Our results are robust to alternate specifications and tests, including alternate definitions of equity cost, financial fraud, and other endogeneity concerns. The findings negate the business case of financial fraud by showing that financial fraud tends to enhance equity cost, thereby lowering the firm's value.

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