The Impact of Financial Development on the Cost of Capital: Evidence from Pakistan

Abstract

This study adds to the body of knowledge by empirically examining how financial development affects the level of cost of capital of the firms listed on the Pakistan Stock Exchange. This paper applies pooled regression model to the panel data of 150 non-financial firms listed on the Pakistan stock exchange from 2005 to 2017. The aggregate index of financial development and the two sub-indices namely financial market development and financial institutional development are used as measures of financial development; however, the weighted average cost of capital (WACC) is used as a measure of the cost of capital. We found that the cost of capital is likewise inversely correlated with financial development. Our study confirmed that financial market and institutional development are also very negatively correlated with the weighted average cost of capital. These results imply that the level of financial development in the country lowers the average cost of financing as financial development improves governance mechanism, reduces information asymmetry, and risk diversification, mitigates economic uncertainty, and promotes liquidity provisions through stock market development. The empirical evidence of this research is potentially helpful to corporate managers, financial analysts, investors, and policymakers