Effect of Earnings Volatility on Cost of Debt: The case of Swedish Limited Companies

University essay from Högskolan Dalarna/Företagsekonomi

Abstract:

The paper empirically tests the relationship between earnings volatility and cost of

debt with a sample of more than 77,000 Swedish limited companies over the period 2006 to

2013 observing more than 677,000 firm years. As called upon by many researchers recently

that there is very limited evidence of the association between earnings volatility and cost of

debt this paper contributes greatly to the existing literature of earnings quality and debt

contracts, especially on the consequence of earnings quality in the debt market. Earnings

volatility is a proxy used for earnings quality while cost of debt is a component of debt

contract.

After controlling for firms’ profitability, liquidity, solvency, cashflow volatility,

accruals volatility, sales volatility, business risk, financial risk and size this paper studies the

effect of earnings volatility measured by standard deviation of Earnings Before Interest,

Taxes, Depreciation and Amortization (EBITDA) on Cost of Debt.

Overall finding suggests that lenders in Sweden does take earnings volatility into

consideration while determining cost of debt for borrowers. But a deeper analysis of various

industries suggest earnings volatility is not consistently used by lenders across all the

industries. Lenders in Sweden are rather more sensitive to borrowers’ financial risk across all

the industries. It may also be stated that larger borrowers tend to secure loans at a lower

interest rate, the results are consistent with majority of the industries. Swedish debt market

appears to be well prepared for financial crises as the debt crisis seems to have no or little

adverse effect borrowers’ cost of capital.

This study is the only empirical evidence to study the association between earnings

volatility and cost of debt. Prior indirect research suggests earnings volatility has a negative

effect on cost debt (i.e. an increase in earnings volatility will increase firm’s cost of debt).

Our direct evidence from the Swedish debt market is consistent for some industries including

media, real estate activities, transportation & warehousing, and other consumer services.

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