Over-investment and the cost of debt

Abstract

In this paper, we examine the association between over-investment and the cost of debt. Using bond yield spreads as a proxy for the cost of debt, we find that over-investment is positively associated with bond yield spreads. This suggests that when firms engage in over-investment, the quality of their financial reporting is lower and business risk is higher. Therefore, investors demand higher risk premiums because of their inability to evaluate firms’ financial position and future operating performance efficiently. We also find that the positive association between over-investment and bond yield spreads is weaker for firms in which managers and foreign shareholders own a high percentage of shares. This same association is stronger for firms in which the largest shareholders own a large proportion of the company. These results imply variation in the effect of over-investment on bond yield spreads according to the ownership structure. Our findings provide empirical evidence that over-investment brings about negative consequences for firms by increasing their external financing costs. This paper contributes to extant literature by using bond yield spreads as a proxy for the cost of debt rather than using credit ratings and interest expenses. Bond yield spreads can be regarded as a more effective measure for the cost of debt because this measure reflects more timely and direct information about decision-making processes of financial market participants when corporate bonds are issued.