Financing constraints and the cost of equity: Evidence on the moral hazard of the controlling shareholder

This study examines the financial consequences of the moral hazard of the controlling shareholder. Using a sample of Chinese listed companies during the 2003–2009 period, we find that companies characterized by a wider divergence between the controlling shareholder's control and cash flow rights have a significantly higher cash flow sensitivity of cash. This result is consistent with the argument that the agency problem between the controlling shareholder and minority shareholders induces financing constraints. We also find that the divergence of the control and cash flow rights increases the cost of equity, suggesting that minority shareholders take into account the moral hazard of the controlling shareholder and demand higher risk premium. Our results imply that the moral hazard of the controlling shareholder prevents a firm from funding all its desired investments and that minority shareholders discount the terms at which they are willing to provide financing.