An Econometric Model and Empirical Analysis of Interrelationships Between Debt,Dividends,and the Cost of Capital

Abstract

In this paper we argue that dividends, debt leverage, and the firm's cost of capital are endogenously related. In order to correctly account for the interdependence between those variables, we develop an econometric model in a system of simultaneous equations. Specifically, we estimate three multiple regression equations with three endogenous variables as the dependent variables using 2SLS and 3SLS methods. Our findings from the 3SLS method show that the three endogenous variables are negatively related to each other. The evidence suggests that use of debt leverage and dividend payout can lower the firm's cost of capital. High beta stocks tend to have higher cost of capital and firms with higher cash flows have a lower cost of capital. The larger the firm size, the lower is the cost of capital. Firms in the financial sector, technology, and utilities have higher costs of capital than those in the excluded set. The findings provide important implications for financial and investment policies of firms.