Review of Quantitative Finance and Accounting, 16, 33–52, 2001
2001 Kluwer Academic Publishers. Manufactured in The Netherlands.
Internal versus External Equity Funding Sources and
Earnings Response Coefﬁcients
CHUL W. PARK
Assistant Professor of Accounting, School of Business and Management, Hong Kong University of Science and
Technology, Clearwater Bay, Kowloon, Hong Kong
Associate Professor of Accounting, Tippie College of Business, The University of Iowa, 108 PBAB, Iowa City,
IA 52242-1000, U.S.A.
Abstract. Because of transactions costs and investor/manager information asymmetries, internally generated
funds should be less costly than funds raised by issuing common shares. This suggests that as ﬁrms use more
internal funds relative to external equity, their costs of equity capital will fall and the rate the market uses to discount
unexpected earnings of such ﬁrms will be lower. We hypothesize that (1) ﬁrms having a higher proportion of inter-
nal to external equity will have larger earnings response coefﬁcients, and (2) this effect will be magniﬁed for
high growth ﬁrms since the disparity between inside information and publicly available information about high
growth ﬁrms’ investment opportunities is greatest. We ﬁnd support for both hypotheses using pooled and annual
cross-sectional regressions after controlling for other determinants of ERCs. The results are also generally robust
to alternative measures of the mix of equity funding sources and of unexpected earnings and to consideration of
other factors affecting the mix of equity capital.
Key words: earnings response coefﬁcients, information asymmetries, internal and external sources of equity
JEL Classiﬁcation: M4, G32, G1
1. Introduction and theoretical development
Research examining the relation between earnings and share prices often focuses on the
earnings response coefﬁcient since the ERC captures the sensitivity of security returns to
unexpected earnings. Accounting researchers have identiﬁed a number of determinants of
ERCs, including earnings persistence, growth opportunities, riskiness of earnings, auditor
quality, and ﬁrm size (e.g., Kormendi and Lipe (1987), Collins and Kothari (1989), Easton
and Zmijewski (1989), Teoh and Wong (1993)). In this paper, we hypothesize and provide
support for another determinant of ERCs; namely, the mix of internally and externally
generated common equity capital.
The ﬁnance literature documents that ﬁrms exhibit a clear preference for internal funds
(i.e., retained earnings) over external sources of ﬁnancing such as debt or issuing shares