Illiquidity and the cost of equity capital: Evidence from actual estimates of capital cost for U.S. data

Abstract

Illiquidity measures appear to be related to monthly realized returns but do they impact long-run costs of capital (CoC) for firms? Using U.S. data, we find cross-sectional evidence that, controlling for market capitalization, the Amihud (2002, Journal of Financial Markets, 5, 31) measure of illiquidity is negatively related to CoC estimates. A difference-in-differences analysis around exogenous brokerage closures reveals that Amihud illiquidity increases without an impact on CoC. Nonetheless, other illiquidity measures, such as those based on serial covariances, zero returns, and price impact, do show a strong positive relation with CoC. However, we do not find evidence that liquidity risk and the probability of informed trade influence CoC. Overall, our results advance our understanding of precisely which illiquidity measures influence required firm returns.