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How Does a Firm’s Environmental Profile Impact Its Cost of Equity and Debt Capital?

Author

Sudheer Chava, Georgia Institute of Technology

Research Questions Addressed

How do a firm’s environmental strengths and concerns influence the interest rate it receives when borrowing money from financial institutions?

How does a firm’s environmental footprint (its environmental strengths and concerns) affect the return required by investors? Is a firm’s environmental profile simply a substitute for unaccounted default risk?

Do environmental concerns influence the number of institutional investors a firm has or the number of banks from which they borrow money?

Primary Findings

Investors require significantly higher expected stock market returns when firms have environmental concerns—resulting in a higher cost of equity for these firms. Investors demand higher returns to offset the increased risk that arises from potential future regulation, compliance costs, or litigation.

Lending institutions charge significantly higher interest rates to firms that have more environmental concerns than strengths. Higher interest rates increase the cost of debt to the firm and offset the perceived risk to the environment and reputation incurred by the lender.

The presence of environmental concerns neither increases nor decreases a firm’s risk of bankruptcy or a credit rating downgrade—highlighting that a firm’s environmental profile is not simply proxying for unaccounted default risk.

Firms with environmental concerns have significantly fewer institutional investors than firms without such concerns. Institutional investors, such as banks or pension funds, are likely to screen out stocks based on environmental concerns. Similarly, firms with environmental concerns borrow money from a smaller number of lenders.

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