National culture and international differences in the cost of equity capital.

Author:Gray, Sidney John


* Prior literature suggests that national culture influences many facets of business operations including corporate governance, capital structure, managerial compensation, foreign direct investment behavior and accounting systems.

* Extending this line of literature, we examine whether key aspects of national culture are also related to international differences in the cost of equity capital.

* In a cross-country sample of 32 countries during 1992-2006, we find that the cost of equity capital tends to be higher in more individualistic and less uncertainty avoiding societies consistent with their greater risk-taking orientation.

* This finding contributes to the international business and financial literature by identifying national culture as an important institutional variable influencing firms' cost of equity capital around the world.

Keywords: National culture * Cost of equity capital * Individualism * Uncertainty avoidance * Risk-taking


It has become increasingly recognized that institutional factors are critical determinants of values and behavior in a nation and ultimately economic performance (Scott 1995; North 1990, 1994, 2005). North defines institutions at the national level as formal rules, including constitutions, laws and regulations, and informal constraints such as behavioral norms and culture that establish the 'rules of the game' which organizations tend to follow. Both elements should be taken into account in order to understand the institutional system of a nation. In this paper, we focus on the impact of informal institutional factors, i.e., national culture, on firms' cost of equity capital across 32 countries from 1992-2006. While prior research has investigated the influence of formal institutional factors such as legal systems and securities regulation (e.g., Hail and Leuz 2006), there has been no study to date that assesses the influence of national culture on the cost of equity capital i.e., capital providers' assessments of company risk. Specifically we investigate whether national culture dimensions are systematically related to firms' cost of equity capital internationally beyond formal institutional factors as well as firm- and country-specific risk factors.

Previous studies have shown that national culture influences various aspects of business operations including financial systems, firms' financing decisions, managerial compensation, reward preferences, foreign direct investment behavior, life insurance consumption, and accounting choices (e.g., Schuler and Rogovsky 1998; Chui et al. 2002; Stultz and Williamson 2003; Doupnik and Tsakumis 2004; Tosi and Greckhamer 2004; Kwok and Tadesse 2006; Radebaugh et al. 2006; Chiang and Birtch 2006; Bhardwaj et al. 2007; Chui and Kwok 2008; Han et al. 2010). However, there appear to be no studies linking national culture to firms' cost of equity capital which is a key variable in managerial performance evaluation and firm valuation. (1)

Identifying determinants of the cost of equity capital across countries is important for several reasons. Cost of equity capital is a key measure in making capital budgeting decisions. As Damodaran (2006) notes, every business needs to assess where to invest its funds and to regularly re-evaluate the quality of its existing investments. The cost of equity capital is a critical benchmark in making such evaluations. Hence, our investigation sheds some light on how national culture is related to capital providers' assessments of company risk. As capital markets around the world globalize, it is becoming increasingly important to understand the effects of national culture on the cost of equity capital around the world. Identifying additional determinants of the cost of equity capital would enable researchers/practitioners to improve its estimation, leading to more accurate evaluations of investments and more accurate valuations of equity.

Our definition of culture follows previous research (e.g., Hofstede 1980, 2001; Hofstede and Hofstede 2005; Guiso et al. 2006). Hofstede (1980, p. 9) defines culture as "the collective programming of the mind that distinguishes the members of one group or category of people from another." Similarly, Guiso et al. (2006, p. 23) define culture as "those customary beliefs and values that ethnic, religious, and social groups transmit fairly unchanged from generation to generation."

Adler (1997) argues that culture influences people's values, attitudes, and behavior. Homer and Kahle (1988) provide empirical evidence consistent with this view. Gray (1988) hypothesizes that culture also influences the development of firms' accounting systems and practices internationally. Stultz and Williamson (2003) find that differences in culture, especially religion, explain cross-country variations in investor protection such as creditor rights. Chui et al. (2002) argue that national culture affects corporate capital structures. (2) Kwok and Tadesse (2006) conclude that culture impacts the extent to which countries are more likely to have a bank-based financial system. Hart et al. (2010) find that managers' tendency to mask firm performance using accrual-based earnings management is systematically related to national culture. In particular, their findings indicate that earnings management is higher (lower) for firms in more individualistic (uncertainty avoidant) societies. Kanagaretnam et al. (2011) document the effects of national culture on the earnings quality of banks indicating that banks in higher risk-taking cultures experience more bank problems in terms of larger losses or larger loan loss provisions. Mihet (2012) finds that firms in countries with low uncertainty avoidance, low tolerance for hierarchical relationships and high individualism take more risks.

Our evidence shows that the cost of equity capital is significantly higher (lower) in more individualistic (uncertainty avoidant) societies, consistent with the view that risk-taking is greater in more individualistic and less uncertainty avoidant cultures with consequent impacts on capital providers assessments of company risk. These findings are also consistent with recent evidence by Han et al. (2010) and Kangaretnam et al. (2011) which demonstrate the impact of higher risk-taking cultures on earnings quality.

By evidencing these associations, our study contributes to the extant literature in international business as well as the culture, management, finance, legal, and accounting literatures by extending the literature on firms' cost of equity capital in an international setting (e.g., Hail and Leuz 2006; Aggarwal and Goodell 2008). Most importantly, national culture is identified as a significant determinant of the cost of equity capital. In the next section, we develop hypotheses. In Sect. 3, we describe our research design and sample selection. In Sect. 4, we discuss the main results and robustness tests. We conclude in Sect. 5.


Hofstede (1980) reports significant differences in work related values. He identifies four cultural dimensions. First, uncertainty avoidance concerns a society's tolerance for uncertainty and ambiguity and may lead to a preference for rules and conformity as opposed to a more flexible and relaxed approach. Second, individualism concerns the extent of integration among members of a society and suggests a preference for a more loosely knit social approach where individuals care more for themselves and are more competitively oriented. Third, power distance concerns the extent to which members of a society accept that power in organizations is distributed unequally. Finally, masculinity/ femininity concerns the way in which society allocates social roles.

Gray's (1988) model, as extended by Doupnik and Tsakumis (2004), (3) defines several accounting values which are linked to Hofstede's (1980) cultural values. (4) In the model, Gray (1988) notes that the value systems of attitudes of accountants may be expected to be related to and derived from cultural values with special reference to work related values. Gray's (1988) model starts by defining four accounting values which are linked to Hofstede's (1980) "Societal Values". These "Accounting Values" are Professionalism, Uniformity, Conservatism, and Secrecy. According to Gray (1988, p. 8), professionalism refers to "a preference for the exercise of individual professional judgment and the maintenance of professional self-regulation". Uniformity refers to "a preference for the enforcement of uniform accounting practices between companies and for the consistent use of such practices over time as opposed to flexibility in accordance with the perceived circumstances of individual companies". Conservatism refers to "a preference for a cautious approach to measurement so as to cope with the uncertainty of future events as opposed to a more optimistic, laissez-faire, risk-taking approach". Finally, secrecy refers to "a preference for confidentiality and the restriction of disclosure of information about the business only to those who are closely involved with its management and financing as opposed to a more transparent, open, and publicly accountable approach". Gray (1988) notes that individualism and uncertainty avoidance likely serve as the key proxies for them. Similarly, Hope (2003) indicates that the individualism and uncertainty avoidance dimensions of the Hofstede culture dimensions are likely to have the most important implications for managers' behavior in making accounting choices.

Under Gray's (1988) model, countries which are more uncertainty avoidant tend to require more uniformity from accountants with many rules and relatively low self-governance in the regulation of the accounting profession and what provided in financial reports. In more uncertainty avoiding countries, rules tend to support a more conservative approach to risk-taking and would be manifested in lower earnings management. Han et...

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