Economic policy uncertainty and the cost of capital

This paper examines the impact of economic policy uncertainty (EPU) on the cost of capital in China. We find that an increase in EPU results in a significantly higher cost of capital and this impact is mainly through increasing the cost of equity instead of the cost of debt. There is no significant difference between the impact of EPU on state-owned enterprises (SOEs) and the one on private firms, but a stronger impact on large firms than on small firms is found. Further analysis suggests that the stronger impact on large firms occurs only in private firms instead of SOEs. We provide and test several channels through which EPU might affect the cost of capital. Our results suggest that EPU influences the cost of capital through increasing information asymmetry and reducing the quality of internal controls.