Accepted Manuscript

Title: Policy Uncertainty, Investment, and the Cost of Capital

Authors: Wolfgang Drobetz, Sadok El Ghoul, Omrane

Guedhami, Malte Janzen

PII: S1572-3089(17)30777-5
DOI: https://doi.org/10.1016/j.jfs.2018.08.005
Reference: JFS 643

To appear in: Journal of Financial Stability

Received date: 15-11-2017

Revised date: 1-7-2018
Accepted date: 27-8-2018

Please cite this article as: Drobetz W, El Ghoul S, Guedhami O, Janzen M, Policy
Uncertainty, Investment, and the Cost of Capital, Journal of Financial Stability (2018),
https://doi.org/10.1016/j.jfs.2018.08.005

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 Policy Uncertainty, Investment,
and the Cost of Capital
Wolfgang Drobetza, Sadok El Ghoulb, Omrane Guedhamic, and Malte Janzend,e

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Highlights

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 Policy uncertainty weakens the sensitivity of investment to the cost of capital.
 Effect is stronger for firms that are more opaque.
 Effect is stronger for firms with high government dependency.
 Policy uncertainty distorts the fundamental investment-cost of capital relationship.

Abstract U
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We examine the effect of economic policy uncertainty on the relation between investment and the cost
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of capital. Using the news-based index developed by Baker, Bloom, and Davis (2016) for twenty-one
countries, we find that the strength of the negative relation between investment and the cost of capital
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decreases during times of high economic policy uncertainty. An increase in policy uncertainty reduces
the sensitivity of investment to the cost of capital most for firms operating in industries that depend
strongly on government subsidies and government consumption as well as in countries with high state
ownership. Consistent with the price informativeness channel, we find that an increase in policy
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uncertainty reduces the investment-cost of capital sensitivity for firms from more opaque countries,
firms with low analyst coverage, firms with no credit rating, and small firms. We conclude that
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economic policy uncertainty distorts the fundamental relation between investment and the cost of
capital.
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a
University of Hamburg, Hamburg Business School, Moorweidenstrasse 18, 20148 Hamburg, Germany.
Email: wolfgang.drobetz@uni-hamburg.de.
b
University of Alberta, 8406, Rue Marie-Anne-Gaboury (91 Street), Edmonton, AB, T6C 4G9, Canada.
Email: elghoul@ualberta.ca.
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c
Corresponding author. University of South Carolina, 1014 Greene Street, Columbia, SC 29208, USA.
Email: omrane.guedhami@moore.sc.edu.
d
University of Hamburg, Hamburg Business School, Moorweidenstrasse 18, 20148 Hamburg, Germany.
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Email: malte.janzen@uni-hamburg.de.
e
We thank two anonymous referees, Iftekhar Hasan (Editor), Narjess Boubakri, Joseph Clougherty, Ettore Croci,
Simon Döring, Ralf Elsas, Michael Halling, Florian Heider, Emanuel Moench, Peyman Momtaz, Per Östberg,
Tatjana Puhan, Christoph Schneider, Henning Schröder, and participants at the 2017 Paris Financial Management
Conference, the 2018 Eastern Finance Association Conference, the 2018 Swiss Finance Association Conference,
and the 2018 Financial Management (Europe) Conference for helpful comments. We appreciate the generous
financial support from Canada’s Social Sciences and Humanities Research Council.
Keywords: Economic uncertainty, policy uncertainty, investment, cost of capital
JEL Classification Codes: P16, G32

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1. Introduction

The relation between a firm’s cost of capital and its level of investment appears

unambiguous. Standard corporate finance theory dictates that capital budgeting decisions be

made using the net present value (NPV) approach. Under this approach, the decision of whether

to invest in a project is based on a forecast of the project’s discounted cash flows, where the

firm’s cost of capital is the discount rate. An increase in the firm’s weighted average cost of

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capital (WACC) leads to lower investment rates. In practice, this method is widely used by

financial decision makers (Graham and Harvey, 2001). However, despite the theoretical

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importance of the relation between WACC and investment and the widespread use of the NPV

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criterion, empirical evidence on this relation is scarce.

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Frank and Shen (2016) address this gap by building on the theoretical model of Abel
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and Blanchard (1986) to relate a firm’s investments to its cash flow and cost of capital. They
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take the model to the data, and find that the inverse relation between corporate investment and
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the cost of capital holds when the cost of equity capital is constructed using the implied cost of

capital approach. However, it becomes positive when they use cost of equity capital estimates
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based on expected returns from factor-based asset pricing models. The evidence in Frank and
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Shen (2016) thus suggests that the relation between investment and the cost of capital depends
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on the form of the cost of capital measure.

In this paper, we extend Frank and Shen’s (2016) model by using Baker et al.’s (2016)
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index of policy uncertainty to examine how economic policy uncertainty affects the relation

between corporate investment and the cost of capital. Our analysis builds on a strand of
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literature showing that uncertainty affects economic outcomes. Uncertainty affects economic

growth (Baker and Bloom, 2013), bank liquidity hoarding (Berger et al., 2018), business cycles

(Basu and Bundick, 2012; Bidder and Smith, 2012; Christiano, Motto, and Rostagno, 2014;

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Bianchi, Ilut, and Schneider, 2014; Bloom et al., 2012), investment dynamics (Bachmann and

Bayer, 2014), and equity prices and premiums (Pástor and Veronesi, 2012, 2013; Brogaard and

Detzel, 2015; Da, Engelberg, and Gao, 2015).

Complementing this aggregate-level evidence, other studies find that uncertainty

impacts various firm-level outcomes, such as capital expenditures (Pindyck, 1993; Dixit and

Pindyck, 1994; Bloom, 2009; Julio and Yook, 2012; Gulen and Ion, 2016), R&D expenditures

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and hiring (Stein and Stone, 2014), mergers and acquisitions (Bonaime, Gulen, and Ion, 2018;

Nguyen and Phan, 2017), leverage and the speed of leverage adjustment (Cao, Duan, and

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Uysal, 2013; Colak, Gungoraydinoglu, and Öztekin, 2018), equity issuance (Colak, Durnev,

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and Qian, 2017; Jens, 2017), firm risk-taking (Akey and Lewellen, 2017), the costs of corporate

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debt and equity (Francis, Hasan, and Zhu, 2014; Waisman, Ye, and Zhu, 2015; Colak et al.,
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2017), investment in accruals (Arif, Marshall, and Yohn, 2016), and earnings management
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(Stein and Wang, 2016). Overall, abundant empirical evidence suggests that uncertainty
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amplifies business cycles by affecting corporate decisions.

Focusing largely on “real options,” the theoretical literature on the effects of economic
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uncertainty predicts a negative relation between uncertainty and investment: The option value
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of a delay in investment is high when uncertainty is high, and thus firms prefer to wait to avoid
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making costly mistakes (Bernanke, 1983; Brennan and Schwartz, 1985; McDonald and Siegel,

1986; Ingersoll and Ross, 1992; Dixit and Pindyck, 1994; Schwartz and Trigeorgis, 2004;
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Grenadier and Malenko, 2010). Empirical evidence supports the prediction that investment

decisions contain an option-to-wait component. For example, using Baker et al.’s (2016) PU
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index, Gulen and Ion (2016) examine the effect of policy uncertainty on the level of investment.

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They report that high uncertainty leads to lower investment rates.1 The negative effect is

observed for up to five quarters, after which investment starts to increase and eventually makes

up for the delayed investment caused by the elevated level of policy uncertainty.

Similarly, Julio and Yook (2012) analyze investment behavior in the presence of

politically induced uncertainty in a global context. In contrast to Baker et al.’s (2016)

continuous PU index used in Gulen and Ion (2016), Julio and Yook (2012) capture uncertainty

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using a binary measure of national elections that changes only once each election cycle.2 They

document that firms around the world hoard cash and reduce corporate investments during

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election years relative to non-election years. They conclude that political uncertainty appears

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to be an important channel through which the political process can affect real economic

outcomes.
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Julio and Yook (2012) and Gulen and Ion (2016) study the effects of political
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uncertainty and policy-induced economic uncertainty, respectively, on the level of investment.
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In contrast, we focus on the effects of policy uncertainty on the sensitivity of investment to

changes in the cost of capital. Bloom (2014) highlights a sensitivity effect that is consistent
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with the real option argument, but which so far has received little attention in the extant
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literature. Uncertainty not only reduces the level of economic outcomes, such as investment or
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consumption, but it also makes economic agents less sensitive to changes in business

conditions. For example, when uncertainty is high, the sensitivity of investment to changes in
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interest rates will be lower, and thus a policy intervention in the form of lower interest rates
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1
For earlier empirical evidence on the negative relation between uncertainty and investment, see Pindyck and
Solimano (1993), Leahy and Whited (1996), Guiso and Parigi (1999), Bond and Cummins (2004), Eisdorfer
(2008), and Badertscher, Shroff, and White (2013).
2
Consider the 2000 U.S. elections and the attacks of 9/11/2001. Under the Julio and Yook (2012) approach, the
year 2000 is an “uncertain” year, but 2001 is not. However, the Baker et al. (2016) textual analysis of newspaper
articles approach reveals that economic policy uncertainty was actually 1.5 times higher in 2001 than in 2000.
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will be less effective.3 This sensitivity effect dampens the productivity-enhancing reallocation

of resources across firms and reduces economic growth.

We test this sensitivity effect by examining the degree to which economic policy

uncertainty distorts the relation between investment and the cost of capital. We expect an

increase in policy uncertainty to reduce the sensitivity of investment to changes in the cost of

capital. This prediction is rooted in recent literature that emphasizes the role of the information

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content of stock prices in managerial decisions.

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According to Bond, Edmans, and Goldstein (2012), the value of secondary markets

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depends on the amount of information that managers obtain from prices, i.e., the amount of

information that the firm’s financial decision maker does not already possess. Speculators

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produce and trade on private information, implying that their information is reflected in stock
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prices. Despite the fact that managers are better informed than outsiders, they receive
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information about their company from the stock price that would not otherwise be available to
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them, and they exploit this information in their investment decisions (Dow and Gorton, 1997;

Chen, Goldstein, and Jiang, 2007; Bakke and Whited, 2010; Edmans, Goldstein, and Jiang,
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2012). “Real efficiency” implies that the stock price reveals information that is necessary for
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managers to pursue value-maximizing actions. Bond et al. (2012) refer to the extent to which
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prices reveal the information necessary for real efficiency as “revelatory price efficiency” (as

opposed to traditional “forecasting price efficiency”).

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Because both the volatility of individual stocks and the correlations between stocks

increase during times of higher policy uncertainty (Pástor and Veronesi, 2012, 2013), stock
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prices are more likely to deviate from revelatory price efficiency. In other words, they will

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Eickmeier, Metiu, and Prieto (2016) find that monetary policy is more effective at stimulating economic activity
during periods of lower volatility. A comparable effect is observed for the sensitivity of private consumption of
durable goods to demand and price signals (Foote, Hurst, and Leahy, 2000; Bertola, Guiso, and Pistaferri, 2005).
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include less private information from which managers can obtain information they can use in

making investment decisions. This price informativeness channel attenuates the negative link

between investment and the cost of capital during times of elevated uncertainty, because

managers can no longer use the stock price as a signal of the firm’s investment opportunities.

Therefore, we hypothesize that the sensitivity of investment to the cost of capital becomes

lower when policy uncertainty is higher.

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Our dataset comprises 65,486 observations for 11,518 firms from 21 countries over the

1989-2012 period. Given evidence in Frank and Shen (2016), we focus on the ex-ante cost of

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capital. We use the implied cost of equity capital (ICC) measures from Claus and Thomas

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(2001), Ohlson and Juettner-Nauroth (2005), Easton (2004), and Gebhardt, Lee, and

Swaminathan (2001) to construct a firm’s WACC.

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Our cross-country evidence corroborates earlier results based on U.S. data. In particular,
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we find that 1) an increase in policy uncertainty leads to lower investment, in line with Gulen
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and Ion (2016), and 2) an increase in the cost of capital decreases investment, in line with Frank

and Shen (2016). More importantly, we show that the link between the cost of capital and
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investment is distorted by policy uncertainty: The sensitivity of investment to WACC is

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significantly lower when economic policy uncertainty is higher. Thus, during high policy
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uncertainty years, the negative relation between investment and the cost of capital becomes

less pronounced. When we decompose WACC into its debt and equity components, we find
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that the direct (level) effects of the cost of debt on investment are comparable to those of the

cost of equity. The sensitivity effects for the cost of debt and the cost of equity are also similar
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in magnitude. Our main results are robust to several robustness tests, including placebo tests

that address endogeneity concerns.

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 Our international dataset gives us an important advantage over empirical tests that rely

only on U.S. data. International cross-sectional comparisons that exploit variations across both

firm and country characteristics can yield more insights into potential explanations behind the

observed sensitivity effect. For example, we consider the effect of government dependence on

the investment-cost of capital sensitivity, classifying firms based on measures of government

subsidies, government dependence, and state ownership. The moderating effect of policy

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uncertainty on the link between investment and the cost of capital is stronger for firms operating

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in industries that depend more on government subsidies and direct government consumption,

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as well as for firms from countries with higher state ownership.

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Furthermore, split-sample tests, in which we categorize firms based on opacity, analyst

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coverage, rating, and size, lend support to the price informativeness channel. The distorting
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effect of policy uncertainty on the relation between investment and the cost of capital is
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stronger in firms incorporated in more opaque and less transparent countries, as well as in firms
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that have lower analyst coverage, firms without credit ratings, and smaller firms. In these firms,

managers receive little additional information about their companies from firms’ security prices
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on secondary markets.
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Our paper contributes to the growing literature on the relation between economic policy
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uncertainty and investment behavior in three key ways. First, we extend the work of Frank and

Shen (2016) and Gulen and Ion (2016) to a cross-country setting. We show that the inverse
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relation between the cost of capital and investment, as well as the negative link between policy

uncertainty and investment, hold for our international sample of twenty-one countries. Second,
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we confirm Bloom’s (2014) prediction that policy uncertainty affects not only the level of

investment but also the (negative) sensitivity of investment to the cost of capital. Third, we

provide evidence consistent with revelatory price efficiency. The effect of policy uncertainty

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on the relation between investment and the cost of capital is stronger in firms where managers

receive little additional information about their companies from firms’ security prices. These

managers cannot use stock prices as a signal of firms’ investment opportunities, which leads to

a lower investment-cost of capital sensitivity during high policy uncertainty periods.

The remainder of the paper is structured as follows. Section 2 develops our main

hypotheses, while section 3 describes the variables used in our analysis, the sample, and our

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research design. Section 4 presents our main results, and section 5 presents the results of

robustness tests. Section 6 concludes and discusses policy implications.

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2. Motivation and hypotheses

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At the macro level, uncertainty is strongly countercyclical. Bloom (2009) links the
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majority of high uncertainty periods to negative political, social, and economic shocks. Bloom
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(2014) and Baker et al. (2016) show that uncertainty about future stock prices, as measured by
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implied volatility, is negatively related to stock market returns. Bachmann, Elstner, and Sims

(2013), Bloom (2014), Jurado, Ludvigson, and Ng (2015), and Scotti (2016) document that
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macroeconomic forecasts are noisier, forecasters are less confident about their forecasts, and
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the forecasts are more optimistic than actual outcomes during recessionary periods.

Similar patterns can be seen at the micro level. For example, during recessions, volatility
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in industry- and firm-level stock returns increases (Campbell et al., 2001), and output growth
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dispersion across industries widens (Bloom, 2014). Vavra (2014) uses consumer product prices

from the Bureau of Labor Statistics to calculate the Consumer Price Index. He finds that the
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volatility of price changes across products increases significantly during recessions.

The above evidence suggests a causal link, rather than mere correlation, between

uncertainty and the state of the economy. Prior literature suggests that recessions can increase

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uncertainty in several ways. One argument is based on the idea that firms’ production, hiring,

and investment activities transmit information to markets. Since these activities slow during

recessions, less new information reaches the markets, which in turn increases uncertainty

(Fajgelbaum, Schaal, and Taschereau-Dumouchel, 2014). Another argument holds that

uncertainty rises during recessions because they are rarely observed economic states. The

infrequency hinders forecasters’ ability to generate accurate forecasts during such periods,

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which contributes to greater uncertainty (Orlik and Veldkamp, 2014). A third argument

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suggests that policy makers prefer to maintain the status quo during good economic periods,

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but they have incentives to make policy changes during poorer-performing periods. This results

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in higher (policy) uncertainty (Pástor and Veronesi, 2012).

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However, there may be a causal link between uncertainty and economic activity that
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runs in the other direction. Bloom (2009) develops a model in which high uncertainty reduces
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economic growth by inducing firms to optimally postpone investment and hiring. Bloom
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(2014) shows that uncertainty may further depress economic growth by decreasing optimal

resource allocation across firms. Baker and Bloom (2013) provide empirical evidence for a
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causal relation in which uncertainty drives the state of the economy.

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We focus on a specific type of uncertainty here, namely, economic policy uncertainty.

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Politicians and regulatory institutions frequently make decisions that change the environment

in which firms operate. Policy uncertainty is the part of overall economic uncertainty that is
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attributable to the political and regulatory system. For example, Gulen and Ion (2016) find that

an increase in economic policy uncertainty has a negative effect on the level of investment. In
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response to high policy uncertainty, firms tend to reduce investment for up to five quarters,

after which investment generally begins to make up for the delay.

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 This result relates to a broader strand of literature that links uncertainty and investment

via real options. Real options theory predicts a negative relation between uncertainty and

investment, where firms facing high uncertainty optimally delay investment so they can “wait

and see” to avoid costly mistakes (Bernanke, 1983; Brennan and Schwartz, 1985; McDonald

and Siegel, 1986). Bloom (2014) argues that the real options channel affects not only the level

of investment, but also the sensitivity to the factors that drive investment behavior. We test the

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latter theoretical prediction for a particularly important relation: the sensitivity of corporate

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investment to the cost of capital.

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Abel and Blanchard (1986) develop a model in which investment is a function of

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marginal q, the expected present value of the investment’s profit. Since marginal q cannot be

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observed directly, they construct a measure that relies on marginal profit and a discount factor,
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the ex-ante cost of capital. They show that variations in their measure of marginal q are due
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mainly to the discount factor. Given the proposed relation between investment and marginal q,
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they predict a negative relation between the cost of capital – the denominator in their measure

of marginal q – and investment. Frank and Shen (2016) test this model using a sample of U.S.
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firms. When they estimate the cost of equity capital using the ICC measures, the expected
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negative investment sensitivity is observed for both components of the cost of capital.
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We build on Frank and Shen (2016) to examine the effect of policy uncertainty on the

negative relation between investment and the cost of capital. Based on Bloom’s (2014)
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argument that uncertainty not only reduces the level of economic outcomes but also makes

investors less sensitive to changes in business conditions, the strength of the relation should
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decrease in policy uncertainty. This prediction is consistent with the strand of literature that

emphasizes the role of stock markets in transmitting incremental information to managers who

do not have perfect information about every decision-relevant factor.

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 Dow and Gorton (1997) study a model in which managers learn from prices. Speculators

produce and trade on private information, so their information is incorporated into firm stock

prices. While better informed than corporate outsiders, managers receive investors’ private

information about the company from the stock price, and exploit it when making their

investment decisions. As a result, financial markets have a real effect because of this

transmission of information. Recent studies provide empirical evidence for such a feedback

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effect that emanates from prices that are “revelatory efficient” in the spirit of Bond et al.

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(2012).4

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Policy uncertainty increases investor uncertainty with respect to firms’ expected future

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cash flows, thereby decreasing the quality of information contained in stock prices. It makes

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investors less informed, and leads to stock prices containing less private information. As a
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result, managers will be less willing to base their investment decisions on the information
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contained in stock prices during times of high policy uncertainty. Stock prices also become
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noisier, and managers become more informed relative to outside shareholders. We therefore

expect the sensitivity of investment to stock prices to be lower during periods of high policy
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uncertainty.
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Another argument that relates to the price informativeness channel is that policy
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uncertainty increases the volatility of individual stocks and the correlations between stocks

(Pástor and Veronesi, 2013). Morck, Yeung, and Yu (2000) show that, if a firm’s stock returns
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For example, Chen et al. (2007) show that the sensitivity of investment to price is stronger when more private
information is incorporated into the price through the trading process. Bakke and Whited (2010) find that
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information, not mispricing, guides corporate investment. By exploiting a shock to price informativeness arising
from changes in insider trading laws, Edmans, Jayaraman, and Schneemeier (2017) show that the sensitivity of
investment to Tobin’s q is increasing in the amount of information in prices that the manager does not possess.
This indicates that the manager uses the stock price as a signal of the firm’s investment opportunities. Edmans et
al. (2012) also provide evidence on the real effects of secondary financial markets that stem from the informational
role of market prices. They demonstrate the effect of stock price informativeness on firms’ takeover activity. Boot
and Thakor (1997) and Subrahmanyam and Titman (1999) use the feedback effect of security prices to explain a
firm’s choice to issue publicly traded securities in the primary markets rather than to raise private financing (e.g.,
bank loans).
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are highly correlated with market returns, then its price is likely to contain less firm-specific

information. In contrast, if a firm’s stock returns move asynchronously with market returns,

more firm-specific information will be incorporated into the price. Therefore, when stocks

move in the same direction during periods of high policy uncertainty, individual stock prices

will contain less private information that managers can exploit in making their investment

decisions. This leads to a reduction in investment-price sensitivity.

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Durnev (2011) finds that the decrease in investment-price sensitivity during U.S.

election years (which are associated with higher political uncertainty) is due to stock prices

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becoming noisier signals for managers. During election years, managers appear to pay less

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attention to stock prices, not because they are more informed than outside investors, but rather

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because stocks become less informative (as captured by Morck et al.’s (2000) stock return
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synchronicity measure).
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Finally, in an accounting context, Stein and Wang (2016) show that firms facing
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relatively higher levels of economic uncertainty report more negative discretionary accruals.

Market prices are less (more) sensitive to earnings surprises during times of higher (lower)
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economic uncertainty.5 An implication may be that managers do not pay attention to stock
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prices (or firm fundamentals) in their investment decisions during periods of high policy
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uncertainty. This may be attributable to the fact that the market believes fundamentals are based

on luck and will not persist. In contrast, during times of low policy uncertainty, firm
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fundamentals are believed to be based on managerial skill and to be more persistent.

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The economic mechanism is as follows. A firm with uncertain prospects manages earnings downward because
markets are more likely to attribute good performance to luck, or to expect performance at such times to be
transient. In contrast, when a firm’s value is more certain, it manages earnings upward, because markets are more
likely to attribute good performance to skill, or to expect performance to be persistent.
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 In summary, the above discussion leads to three testable hypotheses. Based on the real

options argument, we expect a negative link between policy uncertainty and investment. We

also expect an inverse relation between investment and the cost of capital, as proposed in Abel

and Blanchard’s (1986) theoretical model. This leads to our first and second hypotheses:

Hypothesis 1: The relation between policy uncertainty and firm investment is negative.

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Hypothesis 2: The relation between a firm’s cost of capital and investment is negative.

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Frank and Shen (2016) and Gulen and Ion (2016) have documented these level effects

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for U.S. firms. We extend their results to a large cross-section of countries. More importantly,

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motivated by Bloom (2014), we expect uncertainty to affect not only the level but also the

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sensitivity of investment to changes in the cost of capital. Therefore, our third hypothesis is as
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follows:
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Hypothesis 3: Policy uncertainty weakens the negative relation between a firm’s cost of capital
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and investment.
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3. Research design
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3.1. Economic policy uncertainty

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Uncertainty is difficult to measure due to its qualitative nature. Studies typically rely on

second moments of firm-level outcomes (e.g., stock returns, profits, and forecasts) to capture
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economic uncertainty (Jurado et al., 2015). However, because such measures are based on firm-

level data, they are not necessarily good proxies for (aggregate) policy uncertainty.
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In our study, we use a more direct measure of economic policy uncertainty, the time-

varying news-based index of economic policy uncertainty proposed by Baker et al. (2016).6

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The data are available at www.policyuncertainty.com.
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The PU index is based on the frequency of articles in a country’s major newspapers that focus

on uncertainty about future economic policy. For the U.S., Baker et al. (2016) count articles in

the top ten newspapers in the U.S. that include keywords in three categories: economy, policy-

related, and uncertainty. After adjusting the raw article counts to reflect the total number of

articles in each newspaper, they aggregate the article counts across the ten newspapers and then

normalize the counts. They obtain a mean of 100 for each month over the 1985-2009 period.

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Baker et al. (2016) repeat this procedure for twenty additional countries for which text-

based analysis can be conducted for the country’s most relevant newspapers. They find that the

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PU index rises ahead of elections and during times of war and economic crisis, and it falls when

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macroeconomic indicators such as industrial production and employment are low. They also

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show that it captures economic policy uncertainty rather than more general economic and
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political effects.7
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Focusing on the U.S., Baker et al. (2016) also create three alternative economic policy
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uncertainty indices that are not derived from textual analysis. The first is based on the degree

of disagreement about future purchases by the federal, state, or local government, where the
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government purchase forecasts come from a quarterly survey of macroeconomic forecasts

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published by the Federal Reserve Bank of Philadelphia. The second uses forecast dispersion
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about expected CPI, which comes from the same survey. The third index is the present dollar

value of expiring tax provisions over the next ten years.

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In addition to these three alternative indices, Baker et al. (2016) construct an aggregate

index that is given as the weighted average of the three alternative indices and the news-based
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Baker et al. (2016) show that the PU index is correlated with established measures of economic and political
uncertainty, and that it is not biased by the political views of any of the newspapers included in the index. When
they control for the quality of their text search algorithm via a manual audit of a subsample of articles, the results
are highly correlated. Any deviation is independent of macroeconomic states or the level of the PU index.
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PU index. In robustness tests, we examine whether our results using the news-based index

continue to hold using these alternative indices.

3.2. The cost of capital

To compute a firm’s cost of capital, or WACC, we follow convention, and estimate:

𝑊𝐴𝐶𝐶 = 𝐿𝐸𝑉 × 𝐾𝐷𝑒𝑏𝑡 × (1 − 𝑇𝐴𝑋) + (1 − 𝐿𝐸𝑉) × 𝐾𝐸𝑞𝑢𝑖𝑡𝑦 , (1)

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where LEV is the firm’s leverage, which is equal to total debt as a fraction of total assets; KDebt

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is the firm’s average cost of debt, which is equal to interest expenses divided by total debt; TAX

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is the firm’s corporate tax rate, which is equal to income tax expenses divided by net income;

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and KEquity is our main measure of the firm’s ex-ante cost of equity capital, which we estimate

following the ICC approach.8

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More specifically, following prior literature (Hail and Leuz, 2006; Chen, Chen, and
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Wei, 2011; Hou, van Dijk, and Zhang, 2012; Barth, Konchitchki, and Landsman, 2013), we
M

calculate KEquity as the arithmetic average of the ICC measures of Claus and Thomas (2001;

KCT), Ohlson and Juettner-Nauroth (2005; KOJN), Easton (2004; KMPEG), and Gebhardt et al.
D

(2001; KGLS).9 To mitigate concerns that our results are biased by the availability of any
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individual ICC measure, we also estimate our main specification below using the four

individual measures. We refer to the left term on the right-hand side of Equation (1) as a firm’s
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cost of debt, COD, and the right term as its cost of equity, COE.
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A

8
Pástor, Sinha, and Swaminathan (2008) show that this approach is well suited to explaining time variations in
expected returns. It entails using analyst forecast data and stock price data to compute the internal rate of return
at which the market price of equity equals future residual income or abnormal earnings.
9
See El Ghoul, Guedhami, Kim, and Park (2018) for a detailed description of the four individual ICC measures,
including the assumptions with respect to forecast horizon and growth rates.
14
3.3. Sample

Our initial sample is comprised of firms in the merged Compustat–I/B/E/S datasets. We

first restrict the sample to country-years for which Baker et al.’s (2016) PU index is available.

Following Frank and Shen (2016), we then exclude firms with negative average cash flow over

the sample period.10 We also require non-missing data on investment, cash flows, and WACC.

Finally, we exclude utilities and financial firms. Our final sample consists of 65,486

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observations representing 11,518 firms from 21 countries over the 1989-2012 period. All

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variables are winsorized at the 1st and 99th percentiles.

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Table 1 gives summary statistics for our full sample by country. The table reports the

number of firm-year observations, the number of distinct firms, the sample period, and the

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means of the key variables used in our empirical tests. The number of observations and the
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number of distinct firms vary by country, depending on the availability of accounting and stock
A
market data in Compustat and the PU index of Baker et al. (2016). Note that the U.S. accounts
M

for almost half of both the number of observations and the number of firms. We compute

investment, INV, as capital expenditures net of asset sales divided by beginning-of-year fixed
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assets, and cash flow, CF, as operating income before depreciation deflated by beginning-of-
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year fixed assets.

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Insert Table 1 here

The mean investment ratio is 27%, with higher rates in Brazil, France, Germany, and
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India, and lower rates in Mexico, Chile, Japan, and Ireland. Mean cash flow ranges from 34%
A

in Chile to 171% in Sweden, with a sample mean of 106% of fixed assets. The sample mean

WACC is 10.9%. Japanese firms have the lowest mean WACC (7.8%), and Russian firms have

10
Frank and Shen (2016) impose this restriction given the expected signs for marginal q and WACC derived from
Abel and Blanchard’s (1986) model of optimal investment.
15
the highest mean WACC (15.7%). The average cost of equity (KEquity) is 13.1%, and the average

cost of debt (KDebt) is 9.8%. Japanese firms enjoy the lowest costs of equity and debt, Russian

firms have the highest cost of equity (19.5%), and Brazilian firms have the highest cost of debt

(19%).11 The average leverage ratio in our sample is 24%.

Table 2 reports detailed descriptive statistics for the main model variables based on the

full sample of firms. The means are identical to those in the last row of Table 1. The median is

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smaller than the mean for all variables of interest. The difference is most pronounced for cash

flow (0.513 vs. 1.064) and total assets (792 million USD vs. 4,783 million USD). The median

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investment ratio is 0.19, compared to a mean of 0.27; these numbers are close to those reported

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by Frank and Shen (2016) for their U.S. sample.

Insert Table 2 here

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3.4. Empirical specification
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Our main empirical specification builds on Abel and Blanchard (1986) and Frank and

Shen (2016), who model investment as a function of cash flow and the cost of capital. We are
D

interested in how policy uncertainty affects the relation between the cost of capital and
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corporate investment. Therefore, we include the natural logarithm of the twelve-month average

(over the fiscal year) of Baker et al.’s (2016) country-level PU index, as well as the interaction
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between the cost of capital measures and the PU index.

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Because the PU index is a time-varying country-level variable, it may capture

differences in the level and sensitivity of investment to the cost of capital between countries
A

and over time. Following Edmans et al. (2017), we include country (Country) and year (Year)

11
All cost of capital estimates exhibit low correlations with the PU index, thus mitigating potential concerns about
multicollinearity. Table IA.1 in the Internet Appendix presents the matrix of correlations between the PU index
and the cost of capital measures.
16
fixed effects, which control for the base level of investment in a given country and for time

trends in investment, respectively. We also include interactions between the cost of capital and

country (WACC×Country) and year (WACC×Year) fixed effects to control for differences in

the sensitivity of investment to the cost of capital across countries and over time. Including

country fixed effects is essential in our research design because Baker et al.’s (2016) PU index

is normalized at the country level. The inclusion of country fixed effects absorbs the

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normalizing constant from the policy uncertainty index. Finally, we include (two-digit SIC)

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industry (Industry) fixed effects to control for differences in investment across industries. Our

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main specification is given by:

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𝐼𝑁𝑉𝑖,𝑐,𝑘,𝑡 = 𝛽1 𝐶𝑜𝑢𝑛𝑡𝑟𝑦𝑐 + 𝛽2 𝐼𝑛𝑑𝑢𝑠𝑡𝑟𝑦𝑘 + 𝛽3 𝑌𝑒𝑎𝑟𝑡 + 𝛽4 𝑃𝑈𝑐,𝑡 + 𝛽5 𝐶𝐹𝑖,𝑐,𝑘,𝑡 (2)
+𝛽6 𝑊𝐴𝐶𝐶𝑖,𝑐,𝑘,𝑡 +𝛽7 𝑊𝐴𝐶𝐶𝑖,𝑐,𝑘,𝑡 × 𝑃𝑈𝑐,𝑡 + 𝛽8 𝑊𝐴𝐶𝐶𝑖,𝑐,𝑘,𝑡 × 𝐶𝑜𝑢𝑛𝑡𝑟𝑦𝑐 +
𝛽9 𝑊𝐴𝐶𝐶𝑖,𝑐,𝑘,𝑡 × 𝑌𝑒𝑎𝑟𝑡 + 𝜀𝑖,𝑐,𝑘,𝑡 ,
U
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where i indexes firms, c indexes countries, k indexes industries, and t indexes years. We cluster
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standard errors by country.12
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Firm fixed effects are perfectly correlated with both country and industry fixed effects
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to the extent that firms do not change their country of origin or their industry. We use country
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rather than firm fixed effects in Equation (2) because policy uncertainty varies at the country

level, but not at the firm level. Nevertheless, we also test a specification that includes firm
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(Firm) and year (Year) fixed effects to control for the base level of investment in a given firm

in addition to time trends in investment. As explained above, our identification also contains
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interaction terms between the cost of capital and firm (WACC×Firm) fixed effects, as well as
A

12
As a robustness check, we re-estimate our baseline regression with standard errors two-way clustered on country
and year dimensions. The t-statistics (not reported) are close to those based on one-way clustering in Table 3. The
test statistics decrease for the coefficient on WACC, but increase for those on WACC×PU, which is the main
coefficient of interest in our framework. In our main analysis, therefore, we take the conservative approach, and
use one-way clustering by country. This choice is also motivated by examples in Petersen (2009), who shows that
clustering coefficients by time may not be necessary after including time dummies.
17
year (WACC×Year) fixed effects to control for differences in the sensitivity of investment to

the cost of capital across firms and over time. Industry fixed effects are omitted due to perfect

correlation with firm fixed effects.

In addition, we examine whether the effect of the PU index varies across the cost of

debt and cost of equity components of the cost of capital. We therefore estimate a model in

which we include these two components instead of WACC, together with their respective

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interaction terms with PU:

𝐼𝑁𝑉𝑖,𝑐,𝑘,𝑡 = 𝛾1 𝐶𝑜𝑢𝑛𝑡𝑟𝑦𝑐 + 𝛾2 𝐼𝑛𝑑𝑢𝑠𝑡𝑟𝑦𝑘 + 𝛾3 𝑌𝑒𝑎𝑟𝑡 + 𝛾4 𝑃𝑈𝑐,𝑡 + 𝛾5 𝐶𝐹𝑖,𝑐,𝑘,𝑡

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(3)
+ 𝛾6 𝐶𝑂𝐷𝑖,𝑐,𝑘,𝑡 +𝛾7 𝐶𝑂𝐷𝑖,𝑐,𝑘,𝑡 × 𝑃𝑈𝑐,𝑡 + 𝛾8 𝐶𝑂𝐸𝑖,𝑐,𝑘,𝑡 + 𝛾9 𝐶𝑂𝐸𝑖,𝑐,𝑘,𝑡

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× 𝑃𝑈𝑐,𝑡 + 𝛾10 𝐶𝑂𝐷𝑖,𝑐,𝑘,𝑡 × 𝐶𝑜𝑢𝑛𝑡𝑟𝑦𝑐 + 𝛾11 𝐶𝑂𝐷𝑖,𝑐,𝑘,𝑡 × 𝑌𝑒𝑎𝑟𝑡
+ 𝛾12 𝐶𝑂𝐸𝑖,𝑐,𝑘,𝑡 × 𝐶𝑜𝑢𝑛𝑡𝑟𝑦𝑐 + 𝛾13 𝐶𝑂𝐸𝑖,𝑐,𝑘,𝑡 × 𝑌𝑒𝑎𝑟𝑡 + 𝜀𝑖,𝑐,𝑘,𝑡 .

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While Baker et al. (2016) mitigate concerns that their PU index merely reflects
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macroeconomic conditions, it may nevertheless capture some macroeconomic information
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related to investment opportunities. We thus estimate Equations (2) and (3) after adding a set
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of country-level economic indicators that may influence investment decisions. These controls

comprise annual gross domestic product in current USD (GDP), annual percentage change in
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GDP (GDP growth), annual inflation rate (Inflation), and exports plus imports scaled by GDP
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(Trade). For robustness, we also include proxies for expected future investment opportunities,

such as GDP forecasts, a consumer confidence index, and a composite leading indicator.
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4. Results
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In this section, we examine the effect of policy uncertainty on the link between the cost
A

of capital and corporate investment. We first examine the effect of the news-based PU index

for the full cross-country sample. We then analyze whether our main results vary across firms,

industries, or countries.

18
4.1. Main analysis

Table 3 gives estimation results for Equations (2) and (3), with and without the set of

country-level economic indicators discussed above. In column 1, the coefficients of interest are

those on PU, WACC, and the interaction term WACC×PU. Consistent with Hypothesis 1, we

find a significantly negative coefficient on PU, implying that an increase in economic policy

uncertainty is associated with lower investment even after controlling for the cost of capital.

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This result extends Gulen and Ion’s (2016) finding that policy uncertainty distorts investment

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to a cross-country dataset.

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SC
Consistent with Hypothesis 2, there is a negative relation between investment and the

cost of capital. The estimate implies that a one-standard deviation decrease in WACC increases

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investment by 0.86%, which is equivalent to 3.23% of the mean investment ratio. Although
N
this effect is less pronounced than that in Frank and Shen’s (2016) U.S. data, it is economically
A
relevant given that we control for country, year, and industry fixed effects.13
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Finally, consistent with Hypothesis 3, we find that the coefficient on the interaction term

between WACC and PU is significantly positive. Confirming Bloom’s (2014) sensitivity effect
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argument, an increase in policy uncertainty reduces the effect of the cost of capital on
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investment. When PU is set to its first quartile, the effect of a one-standard deviation decrease
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in WACC results in a 1.56% increase in the investment ratio. The increase is only 0.13% when

we set PU to its third quartile.14 The resulting difference of 1.43% is equal to 5.33% of the
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mean investment ratio.

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13
In Frank and Shen (2016), the increase in investment is equivalent to 7.6% of the mean investment ratio using
the one-period Gordon growth model.
14
A one-standard deviation decrease in WACC is equal to -0.048. The average coefficients on the statistically
significant interaction terms WACC×Country (𝛽8 ) and WACC×Year (𝛽9 ) are -0.255 and -0.127, respectively. The
economic impact of a one-standard deviation change in WACC on investment is then calculated as follows:
[(−2.726 + (0.636 × 𝑃𝑈) − 0.255 − 0.127] × 0.048, which is equal to -1.56% when PU is set to its first
quartile (4.378), and -0.13% when PU is set to its third quartile (4.844).
19
 Investment is positively linked to changes in cash flow. This result is not surprising,

given that investment-cash flow sensitivities are well documented (Fazzari, Hubbard, and

Petersen, 1988; Kaplan and Zingales, 1997; Chen and Chen, 2012; Lewellen and Lewellen,

2016). Cash flow may capture part of marginal q in the absence of other control variables and

corrections for measurement errors in marginal q (Erickson and Whited, 2000, 2012).15

In column 2, we decompose WACC into its components, COD and COE. We find they

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have significantly negative effects on investment that are comparable in magnitude. The

estimated sensitivity effects for both cost of capital components are also similar in magnitude.

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The differences in the increase in investment in response to a one-standard deviation decrease

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in COD and CEO when PU moves from the first to the third quartile are 1.0% and 1.3%,

U
respectively. Again, this difference constitutes a substantial fraction of firms’ mean investment
N
ratio (3.5% for COD and 4.6% for COE).
A
This result is consistent with prior findings that stock and bond markets are similar in
M

terms of informational efficiency once institutional trade dominance and other specific bond

trading features are accounted for (Downing, Underwood, and Xing, 2009; Ronen and Zhou,
D

2013; Tsai, 2014). Related evidence shows that macroeconomic announcements have a
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significant impact on the returns of both stock and bond markets (Balduzzi, Elton, and Green,
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2001; Flannery and Protopapadakis, 2002), which indicates that the feedback effect from

private information is similarly important for equity and debt markets.

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15
In an amended version of the baseline model in Equation (2), we test the linearity of the effect of policy
A

uncertainty on the investment-cost of capital sensitivity. We replace the continuous PU index with two dummy
variables that indicate periods of high and low policy uncertainty. A firm’s fiscal year is classified as a high (low)
policy uncertainty year if its PU index value is in the top (bottom) tercile of policy uncertainty in the distribution
of the respective country. The signs on the estimates of the two interaction terms (not reported), WACCPU_LOW
and WACCPU_HIGH, indicate that the investment-cost of capital sensitivity increases when policy uncertainty
is low, and decreases when policy uncertainty is high. These patterns suggest a linear relation in the effect of
policy uncertainty on the sensitivity of investment to the cost of capital. We do not find evidence for non-linearity,
because high uncertainty weakens the sensitivity of investment to the cost of capital but low uncertainty does not
strengthen the relationship.
20
 In columns 3 and 4, we repeat our baseline regressions using firm fixed effects instead

of country and industry fixed effects. Albeit less pronounced, the results remain qualitatively

similar. Given that Baker et al.’s (2016) PU index is normalized at the country level, and that

the inclusion of country fixed effects absorbs the normalizing constant from the index, we use

the baseline specification in Equation (1) in all tests below that use our full international

sample.

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Insert Table 3 here

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In columns 5 and 6, we add the four country-level economic indicators as control

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variables to mitigate concerns that our policy uncertainty measure is capturing other economic

variables that affect firm investment behavior. The effect of policy uncertainty on the level of

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investment does not change when we add these controls. More importantly, while the estimates
N
for WACC and WACC×PU decrease slightly in magnitude, they remain statistically significant.
A

Similarly, the estimates for COD and COE are either nearly unchanged or only slightly smaller,
M

but they again remain statistically significant.

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Finally, in columns 7 and 8, we keep the country-level economic indicators in the

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models, but replace the country fixed effects with firm and year fixed effects. The results

continue to remain qualitatively similar.

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4.2. Government dependence

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Next, as in Gulen and Ion (2016), we test whether the effect of policy uncertainty on the

relation between investment and the cost of capital varies with industry and country
A

characteristics that are related to government dependence. To analyze heterogeneous effects,

we split our sample into subsamples based on 1) industry-level sensitivity to government

subsidies, 2) industry-level government consumption, and 3) country-level state ownership. A

21
given level of policy uncertainty should result in a higher level of demand uncertainty for firms

that are more dependent on government subsidies or direct government consumption and for

firms in countries with higher state ownership. We expect the effect of policy uncertainty on

the relation between investment and cost of capital to be stronger for these firms.

We construct the sensitivity to government subsidies at the industry level. For each firm,

we calculate the correlation between the firm’s sales and government subsidies as a fraction of

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total government spending.16 We then aggregate these correlations at the two-digit SIC level,

and categorize industries into high (above-median) and low (below-median) sensitivity groups.

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SC
Our second measure, industry-level government consumption, is more direct. Using the

2005 OECD Structural Analysis Input-Output tables, which provide data on purchases of an

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industry’s production by other industries, households, and the government, we estimate the
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government’s share of an industry’s production. For each country, we first calculate an
A
industry’s total production as the sum of all purchases from that industry. Next, we calculate
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the mean fraction of this production that is consumed by the government across countries.17

We then categorize industries into high or low government dependence groups based on the
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median across all industries.18

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Our third measure, country-level state ownership, allows us to test whether the effect
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that we document differs for firms with high and low state ownership. To construct this
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16
We use the GC.XPN.TRFT.ZS time series from the World Bank database (http://data.worldbank.org). This
variable includes “all unrequited, non-repayable transfers on current account to private and public enterprises;
grants to foreign governments, international organizations, and other government units; and social security, social
A

assistance benefits, and employer social benefits in cash and in kind.”

17
The output category is general government final consumption (GGFC), which is defined by the World Bank as
“all government current expenditures for purchases of goods and services (including compensation of employees).
It also includes most expenditures on national defense and security, but excludes government military
expenditures that are part of government capital formation.”
18
Industries in the Input-Output tables are categorized by the UN’s International Standard Industrial Classification
of All Economic Activities (ISIC Rev. 3). We use the ISIC Rev. 3 to SIC concordance tables to match industries
to Compustat.
22
measure, we use data from the Fraser Institute’s Economic Freedom report to categorize

countries according to the “government enterprises and investment” sub-index.19

Table 4 gives the results. Columns 1-4 show results for the government subsidy

subsamples. For firms from industries that are highly sensitive to government subsidies, the

estimate for WACC×PU is statistically higher than that for firms from industries with low

sensitivity to government subsidies. Using COD and COE rather than WACC, the coefficient

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on COE×PU is again significantly larger for the high subsidy sensitivity subsample, while the

coefficient on COD×PU is of equal magnitude across the two subsamples.

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Insert Table 4 here

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Columns 5-8 show the results for the government dependence subsamples. Again, the
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moderating effect of PU on the link between investment and the cost of capital is driven by
A
firms from industries that strongly depend on government consumption. The effects of WACC
M

and WACC×PU are statistically significant only for the subsample of government-dependent

industries. When we decompose WACC into its components, we find that the coefficients on
D

both components, that is, COD and COD×PU as well as COE and COE×PU, are again
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statistically significant only for industries that rely on a high level of government consumption.
EP

Finally, columns 9-12 report the results for firms from countries with high versus low

state ownership. Except for the coefficient on COD×PU, the effect of policy uncertainty on
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investment-to-cost of capital sensitivity is observed only in countries with high state ownership

(and arguably high government dependence).

A

19
This index “[…] measures the extent to which countries use private investment and enterprises rather than
government investment and firms to direct resources” (Fraser Institute website: https://www.fraserinstitute.org/
economic-freedom/approach). A country is assigned to the high state ownership category if its index value is
above or equal to the median in our sample.
23
 Overall, the evidence in Table 4 shows that the sensitivity of investment to the cost of

capital is not homogeneous across industries. The effect is stronger for firms in industries that

are more government-dependent.

4.3. Price informativeness

A possible explanation for our findings is that investment sensitivity to the cost of

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capital is greater when managers are more likely to learn from prices in the secondary market,

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i.e., when outside information is reflected in stock prices. Following Edmans et al. (2017), we

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conduct cross-sectional test to examine the relevance of the price informativeness channel for

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our results. Using an international sample, Edmans et al. (2017) show that enforcement of

insider trading laws increases information acquisition by outsiders, and thus revelatory price

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efficiency and investment-Tobin’s q sensitivity. This is particularly true if outsider information
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is important for investment decisions.20
A

We test the relevance of the revelatory price efficiency channel using four measures of
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price informativeness: country opacity, analyst coverage, availability of credit rating, and firm
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size. Table 5 presents the results of split sample tests.

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First, we measure price informativeness using the opacity index of Kurtzman, Yago,

and Phumiwasana (2004). This index is based on five factors: corruption, legal system
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efficiency, accounting standards, regulatory effectiveness, and economic as well as

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enforcement policies. For each factor, a higher opacity score indicates a poorly functioning

government, which increases the cost and the risk of doing business. We separate countries
A

20
In a similar vein, Morck et al. (2000) document that informed arbitrage is impeded in low-income economies,
countries with poor protection of private property rights, and countries with poor corporate governance. This
implies that firm-specific information is not incorporated into stock prices.
24
into high and low opacity subsamples using the median across countries in our sample.21 In

line with the price informativeness explanation, Table 5 (columns 1-4) shows that the

sensitivity effect (as captured by WACCPU) observed for the full sample is present only in

more opaque institutional environments (see columns 2 and 4).

Second, we split the sample using firm-level analyst coverage. Analysts collect and

process inside as well as outside information about firms. Thus, analyst coverage serves as a

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proxy for stock price informativeness. Analyst coverage is defined as the number of analysts

covering a firm. A firm has high (low) coverage if the number of analysts covering it is above

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(below) the median in the respective country. Again in line with expectations, we find that our

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results are driven by the subsample of firms with low analyst coverage and low revelatory price

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efficiency (columns 5-8); managers of these companies therefore cannot learn much from the
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stock price of their firms.
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Insert Table 5 here

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Third, similar to analysts, rating agencies also process information about firms and can
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increase price informativeness. If a firm does not have a credit rating, managers may receive
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little incremental information about their firms beyond what is conveyed by the firm’s stock

price. Therefore, in our next test, we consider whether the sensitivity effect that we document
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differs for firms with and without credit ratings.22 We again confirm the price informativeness
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channel. Our main result, the significant effect of WACCPU (columns 9 to 12), shows up only

in the sample of firms without credit ratings.

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21
In this analysis, we omit firms from the U.S. because they would dominate their respective subsample. Thus,
any inference drawn from a country-level comparison including the U.S. would be severely biased.
22
We merge ratings data from Capital IQ with our dataset. Roughly 40% of the firms in our international sample
have a rating. As expected, summary statistics (not shown) confirm that firms with a rating have a lower cost of
capital for all three measures of capital (𝐾𝐷𝑒𝑏𝑡 , 𝐾𝐸𝑞𝑢𝑖𝑡𝑦 , and 𝑊𝐴𝐶𝐶).
25
 Finally, we split our sample according to firm size. The size of a firm is a determinant

of the speed with which a stock price adjusts to new information, possibly because larger firms

have greater visibility (Merton, 1987). Firm size also captures the degree to which a firm is

financially constrained (Erickson and Whited, 2000). We expect that the effect of policy

uncertainty on the link between investment and the cost of capital will be stronger for

financially constrained firms. Their corporate policies, particularly investment decisions, are

T
likely more sensitive to market conditions (Campello, Graham, and Harvey, 2010; Drobetz et

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al., 2017). We classify a firm as small (large) if the mean total assets over the sample period is

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in the bottom (top) tercile of the distribution of all firms within a country. As expected, the

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coefficient on our interaction term of interest (columns 13-16) is significant only in the

subsample of small firms.

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N
Overall, the results of our cross-sectional analyses in Table 5 support the price
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informativeness channel. The effect of policy uncertainty on the relation between investment
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and the cost of capital is stronger in firms incorporated in more opaque countries, as well as

those that have low analyst coverage, do not have a credit rating, or are small. In these firms,
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managers receive little incremental information from the company’s stock price. Due to low
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revelatory price efficiency, they are less likely to use the stock price as a signal of investment

opportunities.
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Robustness23
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5.

In the following subsections, we perform numerous tests to check the robustness of our
A

main results. First, we run placebo tests to address potential endogeneity. Second, we use Baker

et al.’s (2016) alternative uncertainty indices for the sample of U.S. firms. Third, we use

23
We thank anonymous reviewers for suggesting these robustness checks.
26
individual ICC measures rather than their mean. Fourth, we test cross-regional effects. Fifth,

we control for potentially omitted variables that drive investment or the relation between

investment and the cost of capital. Sixth, we summarize results from a battery of other

robustness tests. Finally, the Internet Appendix reports results from other model specifications

that use alternative investment measures (Table IA.2), alternative implied cost of capital

estimates (Table IA.3), and weighted least squares regressions (Table IA.4).

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5.1. Placebo tests

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Although we include an extensive set of control variables in our main analysis, a bias

SC
may still be present due to omitted explanatory variables. For example, indicators of general

economic uncertainty, other than those for which we control, could drive both policy

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uncertainty and investment activity. Similarly, a large decrease in investment activity could
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raise questions among regulators and politicians about how to respond and could increase
A
policy uncertainty.
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We address reverse causality concerns using a placebo test. Specifically, we replace the
D

̃ , which is randomly drawn from the sample distribution of 𝑃𝑈 within

true 𝑃𝑈 measure with 𝑃𝑈
TE

a country. Randomly reassigning the 𝑃𝑈 values within a country results in the same distribution

of the PU index, but the correlation between the two measures is close to zero. We draw from
EP

the sample distribution of the PU index within a country, and estimate the baseline regression

̃ and on the interactions between 𝑃𝑈

model, 100 times. We report the average coefficient on 𝑃𝑈 ̃
CC

and the cost of capital measures.

A

Table 6 gives our results. We find that our main results survive the placebo test. As

̃ , nor the interaction terms between 𝑃𝑈

expected, neither 𝑃𝑈 ̃ and WACC, COD, or COE, are

statistically significantly related to investment activity.

27
 Insert Table 6 here

5.2. Alternative measures of policy uncertainty

In our main analysis, we use Baker et al.’s (2016) news-based PU index for a sample of

twenty-one countries. To test the robustness of results based on this index, we use Baker et

al.’s (2016) subcomponent indices of policy uncertainty, which are available only for the U.S.

T
These indices are based on disagreement about purchases of goods and services by federal,

IP
state, and local governments, dispersion in CPI forecasts, and the dollar value of expiring tax

R
provisions. We also use an aggregate index that is given as the weighted average of the news-

SC
based index and the three subcomponent indices.24 In contrast to the news-based PU index, the

subcomponent indices do not depend on textual analysis.

U
Because the data for the subcomponent indices are available only for the U.S., we need
N
to adapt our empirical design. Following Frank and Shen (2016) and Gulen and Ion (2016), we
A

include firm and year fixed effects. We further adjust standard errors for clustering at the firm
M

and year levels. The individual PU indices are again calculated as the logarithms of the twelve-
D

month arithmetic average of the respective index. Table 7 reports the results.
TE

We use the aggregate index in columns 1 and 2 of Table 7. As expected, PU carries a

negative sign, and PU has a moderating effect on the negative link between investment and
EP

WACC. In column 2, the two components of the cost of capital have a strong negative effect
CC

on investment, which is again adversely affected by PU as indicated by the significantly

positive coefficients on both COD×PU and COE×PU.

A

To facilitate comparison, we use the news-based index to the U.S. sample in columns 3

and 4. The results are similar to those for the aggregate index. This is not surprising, given the

24
The weights in the aggregate index are 1/2 for the news-based component and 1/6 each for the government
purchases component, the CPI forecast dispersion component, and the tax expiration component.
28
high weighting (50%) of the news-based index in the aggregate index. Because it is applied to

a cross-country dataset in all of our analyses above, the results for the subsample of U.S. firms

lend further support for our evidence based on an international sample.

In columns 5 and 6, we report results using the federal/state/local government purchases

index to capture policy uncertainty. We find no evidence that PU affects the sensitivity of

investment to the cost of capital for either the interaction between PU and WACC or the

T
IP
interactions between PU and COD or COE. However, in contrast to other countries in our full

sample, only a small fraction of U.S. firms are classified as highly dependent on government

R
consumption. When we separately consider U.S. firms with high and low government

SC
consumption (similarly to the approach in Table 4), the coefficient on WACC×PU becomes

U
significantly positive for the small subsample of highly government-dependent firms. It
N
remains insignificant for the subsample of firms with low dependence on government
A
consumption (not reported).
M

Insert Table 7 here

D

Using the CPI forecast disagreement index in columns 7 and 8, we observe that policy
TE

uncertainty related to inflation has a significantly negative effect on investment in the WACC,

COD, and COE specifications. The coefficients of interest, WACC×PU in column 7 and
EP

COD×PU and COE×PU in column 8, are all statistically significant. Finally, when we use the
CC

tax expiration index in columns 9 and 10, the results for PU and its effect on the relation

between investment and the cost of capital are again qualitatively similar.
A

Taken together, the results in Table 7 show that the moderating effect of policy

uncertainty that we find in our full sample holds for the U.S. sample using both the aggregate

index and the news-based measure of policy uncertainty used above. The moderating effect

29
persists when we measure policy uncertainty using the dispersion in CPI forecasts and the value

of expiring tax provisions. However, it does not hold when we measure policy uncertainty

using future government purchases.

5.3. Individual measures of the implied cost of equity

Our approach to estimating the cost of debt closely follows that of Frank and Shen

T
(2016). We test along the time dimension to ensure that our WACC-based estimates capture the

IP
relevant cost of capital faced by a firm when making investment decisions. We thus replace

R
𝐾𝐷𝑒𝑏𝑡,𝑡 , the cost of debt, in the cost of capital measures with the average of 𝐾𝐷𝑒𝑏𝑡,𝑡 and

SC
𝐾𝐷𝑒𝑏𝑡,𝑡+1 , and re-estimate our main model. The results (not reported) show that all of the

coefficients of interest are virtually unchanged when we adjust the timing of the two cost of

U
capital components. Our results are still of comparable magnitude for both the cost of debt and
N
the cost of equity estimates.
A

To estimate the cost of equity, we follow prior research (Hail and Leuz, 2006; Chen et
M

al., 2011; Hou et al., 2012; Barth et al., 2013) and use the mean of the ICC estimates of Claus
D

and Thomas (2001; KCT), Ohlson and Juettner-Nauroth (2005; KOJN), Easton (2004; KMPEG),
TE

and Gebhardt et al. (2001; KGLS), KEquity. To mitigate concerns that our results are driven by one

particular model and its assumptions, we use the individual ICC measures (KCT, KOJN, KMPEG,
EP

and KGLS) to calculate the cost of capital in Equations (2) and (3). Table 8 shows the results.
CC

Insert Table 8 here

A

For all four individual ICC measures, investment loads significantly at the 1% level on

WACC and WACC×PU in Table 8, suggesting that our main results are not driven by our use

of the mean of the four measures. When we decompose WACC into COD and COE, the results

from the WACC specification hold for COE, since COE and COE×PU consistently exhibit the

30
expected significant effect on investment. However, the moderating effect of PU on the link

between investment and the cost of debt is observed only for KMPEG and KGLS.

5.4. Cross-regional effects

One may wonder whether the sensitivity effect we observe is driven by particular

countries in our sample, and/or confounded by differences in countries’ legal systems. For

T
example, it is possible that managerial decisions are less sensitive to policy uncertainty in

IP
countries with strong institutions, or that the 2007-2009 subprime mortgage crisis had a region-

R
specific effect on firms’ investment decisions. While we analyze U.S. firms separately in Table

SC
7 above, to further address these concerns, we rerun our main analysis for the following

subsamples of firms: the “rest of the world” (i.e., non-U.S. firms), the Americas, and a group

comprised of Europe, Asia, and Australia.

U
N
Table 9 shows the results. The effects we find for the full sample are not concentrated
A

in any of the subsample groups. This indicates that our results are unlikely to be confounded
M

by differences in national characteristics or national institutional settings.25

D

Insert Table 9 here

TE

5.5. Additional control variables

EP

One potential concern with our main analysis is that it does not include Tobin’s q. This

is because we extend the specification of Frank and Shen (2016), who empirically analyze Abel
CC

and Blanchard’s (1986) model. While their model does not include q per se, it does include the
A

25
Grouping countries allows us to test the full specification that we use in our main analysis. We can exploit
cross-country variations in policy uncertainty and other more general country-level effects through the inclusion
of fixed effects and country-level control variables. Nevertheless, to examine whether the sensitivity effect that
we document is driven by individual countries in our sample, we estimate the investment model for each country
separately. These country-level results are in line with our main findings. In particular, seventeen of the twenty-
one regressions yield positive coefficients on WACCPU. This suggests that the distortive effect of policy
uncertainty on the relation between investment and WACC is not driven by a small group of countries.
31
components that determine q. Theoretically, q captures the marginal expected present value of

an investment. Given the lack of a direct measure of an investment’s marginal q, the typical

approach is to use average q. It follows that q can be interpreted as profitability discounted at

the cost of capital.26 Our main specification controls for two factors by including CF as a

measure of profitability and WACC as a measure of the cost of capital. Nevertheless, in this

section, we address this concern by including a firm’s market-to-book ratio, the conventional

T
proxy for q, in our main regression specifications.

IP
Columns 1-4 of Table 10 show results after including the market-to-book ratio, MTB,

R
in our main specifications. In all four models, the coefficient on MTB takes the expected

SC
positive and significant sign, and the adjusted R-squared increases slightly. However, despite

U
its significant impact on investment and the incremental explanatory power that MTB adds to
N
the model, our main findings persist. In particular, the moderating effect of PU on the
A
sensitivity of investment to the cost of capital is not diluted by the inclusion of MTB.
M

Insert Table 10 here

D

As an additional test, we include proxies for the level of a country’s stock and debt
TE

market development to control for the possibility that the cost of capital measures we use

capture information that relates to the availability of financing, which can affect investment.
EP

We extend Equation (2) by including a country’s total market capitalization to GDP as a proxy

for the level of stock market development, and private credit to GDP as a proxy for the level
CC

of debt market development. The results, reported in columns 5-8 of Table 10, suggest that our

findings are not affected by the omission of these variables, because all of our main results
A

persist.

26
The derivation of this relation is provided in detail in Abel and Blanchard (1986) and Frank and Shen (2016).
32
 Finally, we address the concern that the effect we attribute to policy uncertainty is only

an artifact of few investment opportunities arising during states of high policy uncertainty. As

we discuss in section 2, periods of high policy uncertainty tend to coincide with poor economic

conditions. Although Baker et al. (2016) show that their PU index has explanatory power

beyond economic conditions, we follow Gulen and Ion (2016) and add proxies for the expected

future state of the economy to our regressions to mitigate omitted variables concerns. We use

T
real and nominal GDP forecasts from the OECD economic outlook. We also add the consumer

IP
confidence index (CCI) and the composite leading indicator (CLI) from the OECD’s main

R
economic indicators. CCI is constructed from household surveys about major purchases and

SC
general economic conditions at both the time of the survey and in the near future. CLI is an

U
indicator of upcoming turning points in the economy that is constructed from a selection of
N
short-term economic indicators. The results, shown in columns 9-12 of Table 10, continue to
A
support our main results.
M

5.6. Other robustness tests

In this section, we implement a battery of other robustness tests. First, we replace 𝑃𝑈𝑡
D

with 𝑃𝑈𝑡−1 in our main specification to test the persistence of the moderating effect of policy
TE

uncertainty on the strength of the relationship between investment and the cost of capital. In
EP

unreported results, we find that 𝑃𝑈𝑡−1 has a persistent and negative effect on the level of

investment (except in the firm fixed effect specifications), but its effect is weaker than that of
CC

𝑃𝑈𝑡 . This finding is consistent with the result in Gulen and Ion (2016) that policy uncertainty

decreases investment for four or five quarters, but has a positive effect thereafter.
A

More importantly, when we turn to the interaction terms between 𝑃𝑈𝑡−1 and the cost of

capital measures, we observe no sensitivity effect. Ex ante, one should not expect to find a

distorting effect on corporate investment. If prices are informationally efficient (as opposed to

33
revelatory efficient), prices are unlikely to be systematically influenced by the degree of policy

uncertainty in the previous year. Therefore, in contrast to the pure level effect of policy

uncertainty on investment, the sensitivity effect, which describes the strength of the

relationship between investment and the cost of capital, is not persistent.

Second, our results could be driven by the recent financial crisis, which led to supply-

side financial constraints that severely affected investments of financially weak firms (Berger

T
IP
et al., 2018). Survey evidence reported by Campello et al. (2010) shows that 85% of the

responding CFOs of constrained firms indicate they were forced to forgo profitable investment

R
opportunities. Our results on the investment-to-cash flow sensitivity could thus be confounded

SC
by the financial crisis. Prior studies show that the subprime mortgage crisis covered the 2007-

U
2009 period (Campello et al., 2010; Duchin, Ozbas, and Sensoy, 2010; Almeida, Campello,
N
and Weisbach, 2011; Kahle and Stulz, 2013). Using this period to date the crisis, we exclude
A
the crisis years and re-estimate our main regression. All of our findings (not reported) remain
M

unchanged.

Third, it is possible that policy uncertainty affects our sample composition. In particular,
D

the mix of firms could change, so that the fraction of firms with less informative prices
TE

increases. To control for this potential bias, we exclude firms that enter or exit the sample when
EP

the PU index is in the top/bottom tercile of the distribution of the respective country. We then

re-estimate our main regression specification using this “constant” firm sample (in the sense of
CC

constant price informativeness in the sample over time).

The results (not reported) show that our findings for both the cost of capital measures
A

and their interaction terms with policy uncertainty persist. We conclude that our results are not

driven by a shift in sample composition toward firms with less informative prices, i.e., firms

with unobserved characteristics that cause them to exhibit lower sensitivity of investment to

34
cost of capital. Such a time trend in the mix of firms should decrease investment sensitivity to

cost of capital in years with a change in sample composition even if price informativeness, all

else equal, has not changed. The results here refute this alternative explanation.

Fourth, we incorporate financial leverage (LEV) as well as the corresponding interaction

terms with the PU index into our baseline regression model. Recent studies show that higher

financial intermediation costs and the accompanying higher cost of external capital in response

T
IP
to an increase in political uncertainty lead to a decrease in leverage. For example, Cao et al.

(2013) find that leverage ratios are negatively related to political uncertainty.

R
Gungoraydinoglu, Colak, and Öztekin (2017) further find that financial intermediation costs

SC
increase with policy uncertainty, which increases firms’ costs of issuing new equity and debt

U
capital and ultimately leads to lower leverage. It is therefore possible that the increase in
N
external financing costs and its effect on adverse selection risk and on leverage explains the
A
distorting effect of policy uncertainty on corporate investment and the sensitivity of investment
M

to the cost of capital. We find that this explanation does not drive our results: When we

incorporate controls for a firm’s leverage and its interaction with policy uncertainty into our
D

main model, our findings (not reported) continue to hold.27

TE

Finally, our results continue to hold after controlling for direct and indirect effects of
EP

policy uncertainty on financial frictions and cash flow. This robustness test is important, given

that Baum, Caglayan, and Talavera (2010) show that uncertainty measures affect investment
CC

behavior even in the presence of Tobin’s q, debt, and a measure of cash flow. When we allow

the cash flow sensitivity of investment to increase in the presence of policy uncertainty, as
A

27
We note that a firm’s leverage ratio is part of the calculation of its WACC. Therefore, including the leverage
ratio in the regression model alters the interpretation of the coefficient on WACC and all of the interaction terms
that involve WACC.
35
captured by an interaction term between cash flow and policy uncertainty, our results (not

reported) remain virtually unchanged.

6. Conclusion

In this paper, we examine the effect of policy uncertainty on the relation between

investment and the cost of capital. We use a novel news-based measure of economic policy

T
uncertainty and an ex-ante cost of capital measure (the implied cost of equity capital) for firms

IP
from twenty-one countries over the 1989-2012 period. We show that policy uncertainty distorts

R
the negative link between investment and the cost of capital.

SC
To shed further light on the effect of policy uncertainty on the sensitivity of investment

U
to the cost of capital, we rerun our analysis on firm- and industry-level subsamples. The results
N
indicate that the moderating effect of policy uncertainty is stronger in industries that are
A
dependent on government subsidies or consumption as well as in countries with high state
M

ownership. Moreover, we find that our results are driven by firms from countries whose

institutional environments are more opaque, firms with low analyst coverage, firms without
D

credit ratings, and smaller firms. For these firms, revelatory price efficiency is low. Thus,
TE

managers receive little incremental information about their firms from the company’s stock

price in secondary markets that they can use when making investment decisions. This evidence
EP

supports price informativeness as a channel behind the distortive effect of policy uncertainty.
CC

For the sample of firms from the U.S., we rerun our analysis using alternative policy

uncertainty indices. We find that our results are not driven by our use of the news-based index
A

of policy uncertainty. In particular, our results hold when we use CPI forecast disagreement or

the value of expiring tax provisions to measure policy uncertainty. We further show that our

main results are robust to tests that address concerns about, for example, the choice of

36
investment measure, the omission of control variables, the measurement of the cost of capital,

and the distribution of observations across sample countries.

Our results have important implications for firms, investors, and policy makers. Our

heterogeneity analysis suggests that the effect of policy uncertainty on the sensitivity of

investment to the cost of capital varies across firms. In particular, firms that are most affected

by policy uncertainty (e.g., firms that depend on government subsidies and government

T
IP
consumption) are likely to suffer from lower investment efficiency than firms that are less

affected, giving them a competitive disadvantage. Accordingly, these affected firms should

R
consider policy uncertainty risk in their diversification strategies. A similar implication holds

SC
for investors. As Baker et al. (2016) show, policy uncertainty has incremental power beyond

U
real economic indicators to explain economic behavior. Investors should therefore diversify
N
policy uncertainty risk to mitigate investment stagnation within a country characterized by a
A
high level of uncertainty.
M

Our paper’s last, and arguably most important implication, is for policy makers. During

recessions, governments often aim to stimulate investment through debt guarantees or direct
D

financing at below-market rates. However, these efforts may fail to achieve the desired effect
TE

to the extent that policy uncertainty, which generally increases during a recession, reduces the
EP

sensitivity of investment to the cost of capital. Government officials therefore need to reduce

policy uncertainty to make government interventions successful.

CC
A

37
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 R I
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Table 1
Summary statistics by country

U
This table presents the number of firm-year observations, number of distinct firms, periods, and means for the main variables of our analysis for the full sample of 65,486 firm-
year observations from twenty-one countries over the 1989-2012 period. Accounting and stock price data come from Compustat. We restrict the sample to country years for
which data from Baker et al.’s (2016) economic policy uncertainty index are available. INV is the investment ratio. CF is cash flow as a fraction of beginning-of-year fixed

N
assets. MTB is the ratio of market value of assets to book value of assets. WACC is the weighted average cost of capital, computed as 𝐿𝐸𝑉 × 𝐾𝐷𝑒𝑏𝑡 × (1 − 𝑇𝐴𝑋) + (1 − 𝐿𝐸𝑉) ×
𝐾𝐸𝑞𝑢𝑖𝑡𝑦 . KEquity is the average implied cost of equity from the models of Claus and Thomas (2001; KCT), Ohlson and Juettner-Nauroth (2005; KOJN), Easton (2004; KMPEG), and

A
Gebhardt et al. (2001; KGLS). KDebt is the cost of debt, calculated as interest expenses over total debt. LEV is leverage, calculated as the book value of total debt. TAX is the tax
ratio, calculated as total income tax expenses over net income. TA is total assets, expressed in USD millions. All variables are winsorized annually at the 1st and 99th percentiles.

M
Country Obs. Firms Period INV CF MTB WACC KEquity KDebt LEV TA
Australia 2,237 442 1998 - 2012 0.288 1.400 1.685 0.119 0.140 0.121 0.232 2,246.508
Brazil 545 132 1994 - 2011 0.321 1.191 1.419 0.156 0.180 0.190 0.295 7,473.096
Canada 4,204
ED 793 1989 - 2012 0.266 0.671 1.533 0.124 0.151 0.099 0.248 2,247.148
Chile 157 34 1994 - 2011 0.171 0.344 1.420 0.109 0.130 0.068 0.261 3,056.847
China 2,391 808 1996 - 2011 0.296 0.465 1.955 0.110 0.131 0.075 0.221 3,700.279
France 3,184 475 1991 - 2012 0.323 1.632 1.540 0.102 0.123 0.075 0.231 6,623.107
Germany 2,399 442 1994 - 2012 0.339 1.411 1.467 0.114 0.133 0.156 0.203 9,141.770
Hong Kong 349 59 1998 - 2011 0.204 0.539 1.448 0.121 0.141 0.064 0.188 10,003.510
PT
India 1,295 359 2003 - 2012 0.396 0.884 1.995 0.128 0.163 0.141 0.269 2,539.724
Ireland 385 57 1991 - 2012 0.173 0.920 1.490 0.115 0.140 0.084 0.266 1,809.231
Italy 947 184 1997 - 2012 0.218 1.123 1.413 0.101 0.124 0.076 0.247 6,642.873
Japan 7,950 1,326 1989 - 2012 0.163 0.700 1.320 0.078 0.096 0.044 0.199 6,587.357
E

Mexico 359 71 1996 - 2011 0.168 0.621 1.269 0.125 0.148 0.127 0.262 5,548.314
Netherlands 465 99 2004 - 2012 0.242 1.202 1.495 0.113 0.135 0.083 0.242 8,428.267
CC

Russia 277 69 1999 - 2011 0.257 0.796 1.664 0.157 0.195 0.093 0.258 17,801.500
Singapore 620 168 2003 - 2012 0.268 0.893 1.614 0.126 0.152 0.060 0.210 2,080.750
South Korea 828 203 1995 - 2011 0.198 0.400 1.115 0.133 0.170 0.091 0.327 7,188.582
Spain 459 91 2001 - 2011 0.187 0.975 1.609 0.099 0.123 0.101 0.270 9,315.774
Sweden 1,227 219 1994 - 2012 0.256 1.710 1.654 0.117 0.141 0.099 0.224 2,814.286
A

U.K. 5,482 1,145 1997 - 2012 0.250 1.548 1.695 0.117 0.136 0.123 0.217 4,222.013
U.S. 29,726 4,342 1989 - 2012 0.289 1.079 1.800 0.109 0.132 0.105 0.257 4,280.930
Total 65,486 11,518 1989 - 2012 0.269 1.064 1.664 0.109 0.131 0.098 0.241 4,783.342

47
 Table 2
Descriptive statistics
This table gives the summary statistics for the main variables of our model for the full sample of 65,486 firm-year observations
from twenty-one countries over the 1989-2012 period. Accounting and stock price data come from Compustat. We restrict the
sample to country-years for which data from Baker et al.’s (2016) economic policy uncertainty index are available. PU is the
natural logarithm of the 12-month average of a country’s news-based policy uncertainty index. Q1, Median, and Q3 represent
the 25th, 50th, and 75th percentiles of the distributions of the respective variable. All variables are winsorized annually at the 1st
and 99th percentiles.
Obs. Mean Q1 Median Q3 St. Dev

T
INV 65,486 0.269 0.111 0.191 0.322 0.284
PU 65,486 4.603 4.378 4.594 4.844 0.330

IP
CF 65,486 1.064 0.286 0.513 1.025 1.836
WACC 65,486 0.109 0.080 0.098 0.123 0.048
KEquity 65,486 0.131 0.094 0.115 0.147 0.064

R
KCT 54,293 0.110 0.082 0.100 0.126 0.046
KOJN 52,824 0.132 0.102 0.123 0.152 0.047

SC
KMPEG 61,808 0.145 0.099 0.126 0.169 0.074
KGLS 56,469 0.105 0.076 0.101 0.127 0.043
KDebt 65,486 0.098 0.042 0.065 0.090 0.199
MTB 64,678 1.664 1.078 1.366 1.887 0.986
LEV
TA
65,486
65,486
0.241
4,783.342
0.108
251.450
U 0.225
792.300
0.342
2,674.619
0.175
18,692.380
N
A
M
D
TE
EP
CC
A

48
 Table 3
Investment regression
This table shows the estimation results from regressing investment on cash flow, the cost of capital, and country-level economic
policy uncertainty. PU is the natural logarithm of the twelve-month average of a country’s news-based policy uncertainty
index, as developed by Baker et al. (2016). COD is the cost of debt capital component. 𝐿𝐸𝑉 × 𝐾𝐷𝑒𝑏𝑡 × (1 − 𝑇𝐴𝑋), where
KDebt is the cost of debt, is calculated as interest expenses over total debt. LEV is leverage, calculated as total debt divided by
total assets. TAX is the tax ratio, calculated as total income tax expenses over net income. COE is the cost of equity capital
component, (1 − 𝐿𝐸𝑉) × 𝐾𝐸𝑞𝑢𝑖𝑡𝑦 , where KEquity is the average implied cost of equity from the models of Claus and Thomas
(2001; KCT), Ohlson and Juettner-Nauroth (2005; KOJN), Easton (2004; KMPEG), and Gebhardt et al. (2001; KGLS). WACC is the

T
sum of COE and COD. In columns 3 and 4, we add country-level controls retrieved from the World Bank’s World
Development Indicators. GDP is GDP in current USD. GDP growth is the annual percentage change in GDP. Inflation is the

IP
annual inflation rate. Trade is exports plus imports scaled by annual GDP. All regressions include (unreported) fixed effects
as indicated at the bottom of the table. We add (unreported) interactions between the cost of capital measures (WACC, COD,
and COE) as well as year and country dummies to isolate the effect of policy uncertainty on the link between cost of capital

R
and investment. Standard errors are clustered at the country level. t-statistics are in parentheses. ***, **, and * indicate
significance at the 1%, 5%, and 10% levels, respectively.

SC
(1) (2) (3) (4) (5) (6) (7) (8)
PU -0.075*** -0.095*** -0.045* -0.062** -0.076*** -0.096*** -0.047** -0.065**
(-3.67) (-3.75) (-1.83) (-2.17) (-4.84) (-5.08) (-2.17) (-2.65)
CF 0.066*** 0.065*** 0.08*** 0.079*** 0.066*** 0.064*** 0.080*** 0.079***

WACC
(13.71)
-2.726***
(14.26) (19.57)
-1.815***
(20.6)
U
(13.76)
-2.589***
(14.30) (19.31)
-1.751***
(20.26)
N
(-4.80) (-2.86) (-5.06) (-2.92)
WACCPU 0.636*** 0.304* 0.597*** 0.281*
(4.24) (1.92) (4.52) (1.93)
A
COD -11.396*** -15.208*** -11.535*** -15.620***
(-2.94) (-3.92) (-3.41) (-4.22)
M

CODPU 2.429** 2.602*** 2.465*** 2.708***

(2.64) (2.85) (3.11) (3.19)
COE -2.719*** -1.44** -2.611*** -1.397***
(-5.58) (-2.83) (-5.85) (-2.91)
D

COEPU 0.648*** 0.262* 0.615*** 0.245**

(4.89) (2.08) (5.22) (2.10)
TE

GDP 0.000*** 0.000*** 0.000*** 0.000***

(-3.42) (-3.17) (-3.34) (-3.31)
GDP growth 0.003* 0.003* 0.001 0.001
(1.95) (1.88) (0.61) (0.41)
EP

Inflation 0.000*** 0.000*** 0.000*** 0.000***

(-8.37) (-7.37) (-6.82) (-7.93)
Trade 0.000 0.000 0.000 0.000
(0.85) (0.38) (0.65) (0.82)
CC

Observations 65,486 65,486 65,486 65,486 65,486 65,486 65,486 65,486

Country FE Yes Yes No No Yes Yes No No
Industry FE Yes Yes No No Yes Yes No No
Firm FE No No Yes Yes No No Yes Yes
Year FE Yes Yes Yes Yes Yes Yes Yes Yes
A

Adjusted R² 0.269 0.283 0.175 0.190 0.271 0.285 0.176 0.191

49
 R I
SC
Table 4
Government dependency
This table presents estimation results for the specifications in columns 3 and 4 of Table 3 for different subsamples. PU is the natural logarithm of the twelve-month average of a country’s news-

U
based policy uncertainty index, as developed by Baker et al. (2016). Columns 1- 4 give estimates for firms in industries with high vs. low sensitivity of sales to government subsidies. Industries that
are highly sensitive to government subsidies are two-digit SIC industries whose average correlations between firm sales and subsidies as a fraction of government spending is above the median.

N
Columns 5-8 give estimates for subsamples of firms with high vs. low sensitivity of sales to direct government consumption. We use the 2005 OECD input-output tables to calculate government
consumption as a fraction of an industry’s total production by country. Industries that are independent of government consumption are two-digit SIC industries with government dependence of less
than or equal to the median of all industries from a country, as well as industries that sell zero output to the government. All regressions include (unreported) country fixed effects together with year

A
and two-digit SIC industry dummies. Columns 9-12 give estimates for firms from countries with high and low state ownership. We categorize non-U.S. countries along the “government enterprises
and investment” sub-index published in the Fraser Institute’s Economic Freedom report. A country is assigned to the high state ownership category if its index value is above or equal to the median

M
in our sample. We add (unreported) interactions between the cost of capital measures (WACC, COD, and COE) and the year and country dummies to isolate the effect of policy uncertainty on the
links between the cost of capital and investment. Standard errors are clustered at the country level. t-statistics are in parentheses. ***, **, and * indicate significance at the 1%, 5%, and 10% levels,
respectively. We further report statistical difference tests of coefficients between the high and low groups based on seemingly unrelated regressions (SUR). ‡, †, and # denote statistical significance
at the 1%, 5%, and 10% levels, respectively.
ED
High
Government subsidy
Low High Low High
Government dependence
Low High Low High
State ownership
Low High Low
(1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) (12)
PU -0.098*** -0.032† -0.114*** -0.055**# -0.096*** -0.056* -0.112*** -0.067** -0.108*** -0.029† -0.123*** -0.068***
(-4.82) (-1.58) (-4.94) (-2.59) (-4.13) (-2.05) (-4.05) (-2.42) (-5.22) (-1.12) (-4.55) (-3.45)
0.079***‡
PT
CF 0.065*** 0.067*** 0.063*** 0.066*** 0.062*** 0.081***‡ 0.061*** 0.070*** 0.058***# 0.068*** 0.058***#
(18.75) (7.29) (19.30) (7.36) (17.96) (13.69) (18.77) (13.06) (19.76) (8.53) (20.66) (8.54)
WACC -3.894*** -0.240‡ -3.720*** -1.690 -3.499*** -2.103*
(-4.58) (-0.44) (-4.02) (-1.20) (-4.63) (-1.85)
WACCPU 0.873*** 0.079‡ 0.779*** 0.480 0.913*** 0.352
E

(4.08) (0.59) (3.85) (1.48) (5.14) (1.16)

COD -10.918** -11.917*** -12.889*** -2.540† -9.591** -14.208***
CC

(-2.82) (-2.97) (-3.46) (-0.47) (-2.38) (-3.35)

CODPU 2.413** 2.470** 2.732*** 0.303† 2.448** 2.951**
(2.66) (2.44) (3.05) (0.24) (2.33) (2.33)
COE -3.794*** -0.296‡ -3.544*** -2.261 -3.409*** -2.564**
A

(-4.88) (-0.57) (-4.04) (-1.58) (-4.11) (-2.31)

COEPU 0.864*** 0.104‡ 0.751*** 0.599* 0.915*** 0.477
(4.40) (0.84) (4.06) (1.83) (4.87) (1.63)
GDP 0.000*** 0.000*** 0.000*** 0.000*** 0.000*** 0.000*** 0.000*** 0.000*** 0.000* 0.000 0.000* 0.000
(-3.04) (-3.85) (-2.97) (-3.30) (-3.55) (-3.65) (-3.52) (-3.20) (-1.95) (-0.80) (-1.77) (-0.21)
GDP growth 0.003 0.003* 0.002 0.003** 0.003* 0.002 0.003* 0.002 0.002 0.003 0.001 0.002
(1.52) (1.93) (1.27) (2.19) (1.94) (0.97) (1.74) (0.94) (0.93) (1.50) (0.83) (1.04)

50
 R I
SC
Inflation 0.000*** 0.000*** 0.000*** 0.000*** 0.000*** 0.000***‡ 0.000*** 0.000***‡ 0.000*** -0.003***‡ 0.000*** -0.003***‡
(-4.45) (-11.13) (-4.50) (-8.91) (-8.95) (-7.93) (-8.31) (-6.41) (-7.18) (-3.73) (-6.40) (-3.36)
Trade 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000
(0.94) (-0.12) (0.59) (-0.45) (0.65) (0.05) (0.04) (0.04) (-0.02) (0.40) (-0.38) (0.34)

U
Observations 38,384 27,102 38,384 27,102 24,018 17,856 24,018 17,856 49,788 15,698 49,788 15,698
Country FE Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes

N
Industry FE Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes
Year FE Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes
Adjusted R² 0.289 0.247 0.301 0.263 0.289 0.267 0.302 0.282 0.263 0.307 0.279 0.314

A
M
ED
E PT
CC
A

51
 R I
SC
Table 5
Price informativeness
This table gives estimation results for the specifications in columns 3 and 4 of Table 3 for different subsamples. PU is the natural logarithm of the twelve-month average of a country’s news-based

U
policy uncertainty index, as developed by Baker et al. (2016). Columns 1-4 give estimates for country subsamples based on the opacity index proposed by Kurtzman et al. (2004). A country is
classified as highly opaque if the index is above or equal to the sample median, and as low otherwise. We exclude the U.S. from this analysis. Columns 5-8 give estimates for firm subsamples based

N
on analyst coverage. Firms that are covered by more or equally as many (fewer) analysts than the median in the respective country have high (low) analyst coverage. Columns 9-12 give estimates
for subsamples of rated and non-rated firms. Credit ratings are obtained from Capital IQ. Columns 13-16 give estimates for large and small firms. A firm is classified as large (small) if its mean
total assets are in the top (bottom) tercile in its country. All regressions include (unreported) country fixed effects, together with year and two-digit SIC industry dummies. We add (unreported)

A
interactions between the cost of capital measures (WACC, COD, and COE) and the year and country dummies to isolate the effect of policy uncertainty on the link between the cost of capital and
investment. Standard errors are clustered at the country level. t-statistics are in parentheses. ***, **, and * indicate significance at the 1%, 5%, and 10% levels, respectively. We further report

M
statistical difference tests of coefficients between the high and low groups based on seemingly unrelated regressions (SUR). ‡, †, and # denote statistical significance at the 1%, 5%, and 10% levels,
respectively.
Opacity Analyst Coverage Rating Firm Size
Low High Low High High Low High Low Rated Non-rated Rated Non-rated Large Small Large Small

PU
(1)
-0.001
(-0.02)
ED(2)
-0.108 ***# -0.027
(-4.05)
(3)

(-0.60)
(4)
-0.112 *** -0.054
(-3.78)
(5)

(-1.59)
(6)
-0.079 *** -0.065
(-4.69) (-1.69)
(7) (8)
-0.101*** -0.027
(-5.29)
(9)

(-0.92)
(10)
-0.091*** -0.042
(-4.05)
(11)

(-1.37)
(12)
-0.108***# -0.036
(-4.63)
(13)

(-1.42)
(14)
-0.131***# -0.054*
(-2.93)
(15)

(-1.90)
(16)
-0.143***
(-3.16)
CF 0.060*** 0.066*** 0.059*** 0.065*** 0.065 *** 0.067*** 0.064*** 0.066*** 0.067 *** 0.065*** 0.066*** 0.063*** 0.059*** 0.064*** 0.058*** 0.063***
(8.14) (8.06) (8.26) (8.13) (9.06) (17.70) (9.18) (18.40) (19.66) (11.28) (18.27) (11.64) (10.24) (11.08) (10.38) (11.29)
WACC -1.584* -2.882 *** -2.755 ** -2.544 *** -0.807 -3.160*** -1.617 -4.716***#
(-2.19) (-3.28) (-2.34) (-3.96) (-0.57) (-4.47) (-1.59) (-3.39)
PT
WACCPU 0.201 0.703***# 0.422 0.680*** 0.220 0.741*** 0.306 1.111***#
(1.21) (3.39) (1.41) (4.27) (0.67) (4.28) (1.25) (3.22)
COD -14.654** -9.135 * -3.595 -15.580*** -12.545*** -11.131*** ‡ -10.322** -9.477*
(-2.37) (-1.87) (-0.92) (-4.55) (-3.10) (-3.10) (-2.65) (-1.87)
CODPU 1.505 2.374** 1.099 2.991*** 1.727* 2.656** ‡ 2.021** 2.549**
E

(0.82) (2.24) (1.15) (3.56) (1.88) (2.81) (2.23) (2.12)

COE -1.894** -2.267 ** -2.660 ** -2.388*** -0.744 -3.097*** -1.588 -4.812***#
(-2.66) (-2.93) (-2.25) (-3.77) (-0.49) (-5.27) (-1.58) (-3.43)
CC

COEPU 0.332* 0.571** 0.467 0.671*** 0.209 0.724*** 0.316 1.115***#

(1.97) (3.14) (1.56) (4.37) (0.59) (5.08) (1.32) (3.23)
GDP 0.000 0.000*** 0.000 0.000*** 0.000 *** 0.000*** 0.000*** 0.000** 0.000 *** 0.000* 0.000*** 0.000** 0.000*** 0.000 0.000*** 0.000
(0.45) (5.03) (0.61) (5.30) (-3.23) (-3.11) (-3.08) (-2.67) (-6.08) (-2.08) (-4.86) (-2.20) (-4.04) (-1.13) (-3.49) (-1.25)
GDP growth 0.003 -0.002 0.003 -0.002 0.002 0.004* 0.002 0.004* 0.004 * 0.003* 0.004* 0.003 0.003** 0.005** 0.003* 0.005*
(1.21) (-0.91) (1.27) (-1.55) (1.51) (1.86) (1.18) (1.95) (1.88) (1.78) (1.93) (1.67) (2.11) (2.22) (2.04) (1.99)
A

Inflation 0.001 0.000* 0.002 0.000** 0.000 *** -0.001 0.000*** 0.000 0.000 *** 0.000*** 0.000*** 0.000*** 0.000*** 0.000*** 0.000*** 0.000***
(0.44) (-2.22) (0.61) (-3.12) (-9.85) (-0.33) (-8.10) (0.05) (-9.26) (-5.78) (-9.74) (-5.21) (-7.68) (-7.35) (-8.86) (-6.05)
Trade 0.000*** 0.000 0.000** 0.000 0.000 0.000# 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000
(3.81) (0.11) (2.60) (0.15) (-0.30) (1.52) (-0.40) (1.13) (-0.74) (0.96) (-0.65) (0.48) (0.66) (0.60) (-0.03) (0.65)
Observations 17,368 18,392 17,368 18,392 29,096 32,430 29,096 32,430 26,476 39,010 26,476 39,010 33,501 12,004 33,501 12,004
Country FE Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes
Industry FE Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes
Year FE Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes
Adjusted R² 0.274 0.308 0.283 0.313 0.285 0.270 0.297 0.285 0.289 0.267 0.302 0.282 0.259 0.255 0.268 0.269

52
 Table 6
Placebo test
This table shows average estimates for the coefficient of interest from a placebo test conducted on random samples of PU (𝑃𝑈 ̃)
drawn from the sample distribution of PU. COD is the cost of debt capital component. 𝐿𝐸𝑉 × 𝐾𝐷𝑒𝑏𝑡 × (1 − 𝑇𝐴𝑋), where KDebt
is the cost of debt, is calculated as interest expenses over total debt. LEV is leverage, calculated as total debt divided by total
assets. TAX is the tax ratio, calculated as total income tax expenses over net income. COE is the cost of equity capital
component, (1 − 𝐿𝐸𝑉) × 𝐾𝐸𝑞𝑢𝑖𝑡𝑦 , where KEquity is the average implied cost of equity from the models of Claus and Thomas
(2001; KCT), Ohlson and Juettner-Nauroth (2005; KOJN), Easton (2004; KMPEG), and Gebhardt et al. (2001; KGLS). WACC is the
sum of COE and COD. In columns 3 and 4, we add country-level controls obtained from the World Bank’s World Development

T
Indicators. GDP is GDP in current USD. GDP growth is the annual percentage change in GDP. Inflation is the annual inflation
rate. Trade is exports plus imports scaled by annual GDP. All regressions include (unreported) fixed effects as indicated at the

IP
bottom of the table. We add (unreported) interactions between the cost of capital measures (WACC, COD, and COE) as well
as year and country dummies to isolate the effect of policy uncertainty on the links between cost of capital and investment.
Standard errors are clustered at the country level. t-statistics, based on sample standard errors of the estimated coefficients, are

R
in parentheses. ***, **, and * indicate significance at the 1%, 5%, and 10% levels, respectively.
(1) (2) (3) (4)

SC
̃
𝑃𝑈 -0.001 0.000 -0.001 0.000
(-0.06) (-0.05) (-0.06) (-0.05)
̃
WACC×𝑃𝑈 0.006 0.006
(0.08) (0.08)
̃
COD×𝑃𝑈

̃
0.006
(0.08)
U -0.002
(-0.01)
N
COE×𝑃𝑈 0.006 0.006
(0.08) (0.08)
Controls Yes Yes Yes Yes
A
Country FE Yes Yes Yes Yes
Industry FE Yes Yes Yes Yes
Year FE Yes Yes Yes Yes
M
D
TE
EP
CC
A

53
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Table 7

U
Uncertainty index components analysis
This table gives estimation results using different components of the U.S. policy uncertainty index. The sample is restricted to firms from the U.S. because component data for

N
Baker et al.’s (2016) economic policy index are not available for the full sample of countries. The aggregated index is the average of the individual component indices, using
weights of 1/2 for the news-based PU index and 1/6 each on the tax expirations index, the CPI forecast disagreement index, and the federal/state/local purchases index. Columns

A
1 and 2 correspond to the aggregated PU index, columns 3 and 4 to the news-based PU component index, columns 5 and 6 to the government purchases PU component index,
columns 7 and 8 to the CPI forecast disagreement component index, and columns 9 and 10 to the tax expiration PU component index. All regressions include firm fixed effects,

M
together with year dummies. Standard errors are two-way clustered at the firm and year levels. t-statistics are in parentheses. ***, **, and * indicate significance at the 1%,
5%, and 10% levels, respectively.
PU measure Aggregate index News component Federal/state/local CPI component Tax component
ED government purchases
component
(1) (2) (3) (4) (5) (6) (7) (8) (9) (10)
PU -0.059* -0.088** -0.039 -0.057* -0.039 -0.054* -0.091** -0.123*** -0.016 -0.023**
(-1.74) (-2.30) (-1.51) (-1.79) (-1.30) (-1.74) (-2.80) (-3.19) (-1.50) (-2.19)
CF 0.082*** 0.080*** 0.082*** 0.080*** 0.082*** 0.080*** 0.082*** 0.080*** 0.083*** 0.080***
PT

(9.37) (9.43) (9.35) (9.41) (9.30) (9.35) (9.32) (9.37) (9.35) (9.44)
WACC -3.874*** -3.305*** -0.606 -3.762*** -0.901***
(-3.79) (-3.39) (-1.01) (-3.54) (-6.58)
WACC×PU 0.734*** 0.606*** 0.036 0.726*** 0.114***
E

(3.38) (2.91) (0.28) (3.13) (3.66)

COD -23.876*** -19.048*** -8.843*** -26.870*** -7.621***
CC

(-5.09) (-3.85) (-3.36) (-5.21) (-9.81)

COD×PU 4.127*** 3.062*** 0.901 4.836*** 0.757***
(4.12) (2.91) (1.53) (4.39) (4.86)
COE -3.083*** -2.551** -0.449 -3.039*** -0.692***
(-3.16) (-2.74) (-0.82) (-3.10) (-5.44)
A

COE×PU 0.592*** 0.473** 0.031 0.597** 0.093***

(2.86) (2.39) (0.26) (2.79) (3.33)
Observations 29,726 29,726 29,726 29,726 29,726 29,726 29,726 29,726 29,726 29,726
Firm FE Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes
Year FE Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes
Adjusted R² 0.516 0.529 0.516 0.528 0.516 0.528 0.516 0.529 0.516 0.529

54
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SC
Table 8
Individual measures of implied cost of equity

U
This table gives estimation results for different measures of the implied cost of equity capital. We adjust the regression equations from columns 3 and 4 of Table 3 so that
WACC and COE include the four individual implied cost of equity measures of Claus and Thomas (2001; KCT), Ohlson and Juettner-Nauroth (2005; KOJN), Easton (2004;
KMPEG), and Gebhardt et al. (2001; KGLS) instead of the average KEquity. PU is the natural logarithm of the twelve-month average of a country’s news-based policy uncertainty

N
index as developed by Baker et al. (2016). All regressions include (unreported) country fixed effects together with year and two-digit SIC industry dummies. We add
(unreported) interactions between the cost of capital measures (WACC, COD, and COE) and the year and country dummies to isolate the effect of policy uncertainty on the

A
link between the cost of capital and investment. Standard errors are clustered at the country level. t-statistics are in parentheses. ***, **, and * indicate significance at the 1%,
5%, and 10% levels, respectively.

M
ICC KCT KOJN KMPEG KGLS
(1) (2) (3) (4) (5) (6) (7) (8)
PU -0.084*** -0.095*** -0.086*** -0.096*** -0.062*** -0.080*** -0.088*** -0.109***
(-4.08) (-3.56) (-4.32) (-3.41) (-4.87) (-4.68) (-4.29) (-4.49)
CF ED 0.067*** 0.065*** 0.067*** 0.066*** 0.067*** 0.065*** 0.066*** 0.065***
(13.13) (13.93) (14.00) (14.71) (14.04) (14.62) (12.21) (12.89)
WACC -2.303*** -2.439*** -1.773*** -3.615***
(-2.94) (-3.47) (-5.22) (-3.68)
WACC×PU 0.764*** 0.661*** 0.430*** 0.847***
(3.81) (3.84) (4.87) (3.59)
PT
COD -7.989 -8.283* -11.073*** -9.994**
(-1.67) (-1.77) (-3.41) (-2.44)
COD×PU 1.736 1.725 2.381*** 1.991*
(1.52) (1.55) (3.11) (2.00)
COE -2.352*** -2.432*** -1.663*** -4.137***
E

(-3.43) (-3.41) (-4.99) (-4.28)

COE×PU 0.787*** 0.666*** 0.412*** 1.006***
CC

(4.26) (3.79) (4.81) (4.25)

GDP 0.000*** 0.000*** 0.000*** 0.000*** 0.000*** 0.000*** 0.000*** 0.000***
(-3.23) (-3.24) (-3.05) (-3.11) (-3.20) (-3.01) (-4.00) (-3.76)
GDP growth 0.002 0.002 0.002 0.001 0.003* 0.003* 0.001 0.001
(1.28) (1.17) (1.05) (0.91) (2.00) (1.92) (0.76) (0.51)
Inflation 0.002 0.003 0.000 0.001 0.000*** 0.000*** 0.000 0.000
A

(0.50) (0.72) (0.13) (0.28) (-8.24) (-7.33) (-0.06) (0.06)

Trade 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000
(0.17) (-0.09) (0.42) (0.07) (1.39) (0.89) (0.20) (-0.16)
Observations 54,293 54,293 52,824 52,824 61,808 61,808 56,469 56,469
Country FE Yes Yes Yes Yes Yes Yes Yes Yes
Industry FE Yes Yes Yes Yes Yes Yes Yes Yes
Year FE Yes Yes Yes Yes Yes Yes Yes Yes
Adjusted R² 0.284 0.298 0.283 0.298 0.271 0.285 0.283 0.297

55
 Table 9
Cross-regional effects
This table shows estimation results from regressing investment on cash flow, the cost of capital, and policy uncertainty (PU)
by region. COD is the cost of debt capital component. 𝐿𝐸𝑉 × 𝐾𝐷𝑒𝑏𝑡 × (1 − 𝑇𝐴𝑋), where KDebt is the cost of debt, is calculated
as interest expenses over total debt. LEV is leverage, calculated as total debt divided by total assets. TAX is the tax ratio,
calculated as total income tax expenses over net income. COE is the cost of equity capital component, (1 − 𝐿𝐸𝑉) × 𝐾𝐸𝑞𝑢𝑖𝑡𝑦 ,
where KEquity is the average implied cost of equity from the models of Claus and Thomas (2001; KCT), Ohlson and Juettner-
Nauroth (2005; KOJN), Easton (2004; KMPEG), and Gebhardt et al. (2001; KGLS). WACC is the sum of COE and COD. In columns
3 and 4, we add country-level controls obtained from the World Bank’s World Development Indicators. GDP is GDP in current

T
USD. GDP growth is the annual percentage change in GDP. Inflation is the annual inflation rate. Trade is exports plus imports
scaled by annual GDP. All regressions include (unreported) fixed effects as indicated at the bottom of the table. We add

IP
(unreported) interactions between the cost of capital measures (WACC, COD, and COE) as well as year and country dummies
to isolate the effect of policy uncertainty on the link between cost of capital and investment. Standard errors are clustered at
the country level. t-statistics are in parentheses. ***, **, and * indicate significance at the 1%, 5%, and 10% levels,

R
respectively.
(1) (2) (3) (4) (5) (6)

SC
Europe, Asia, Europe, Asia,
Non-Americas Americas and Australia Non-Americas Americas and Australia
PU -0.085*** -0.079** -0.085*** -0.106*** -0.102** -0.107***
(-4.59) (-4.36) (-3.84) (-6.93) (-4.20) (-6.03)
CF

WACC
0.062***
(10.71)
-3.491***
0.074***
(31.75)
-2.476**
0.060***
(10.57)
3.863*** U 0.061***
(10.73)
0.072***
(31.70)
0.059***
(10.58)
N
(-5.40) (-3.52) (4.25)
WACCPU 0.709*** 0.480** 0.749***
A
(4.20) (2.80) (3.50)
COD -8.910** -13.042** -7.353*
(-2.64) (-3.12) (-1.99)
M

CODPU 2.765*** 2.724** 3.383***

(3.34) (3.02) (4.10)
COE -3.490*** -2.031* 2.848***
D

(-5.89) (-2.70) (3.36)

COEPU 0.710*** 0.445* 0.720***
(4.68) (2.42) (3.54)
TE

GDP 0.000** 0.000** 0.000** 0.000** 0.000** 0.000**

(2.48) (-3.61) (2.53) (2.68) (-4.24) (2.78)
GDP growth 0.002 0.011 0.001 0.002 0.008 0.000
(1.22) (1.39) (0.43) (0.99) (1.30) (0.23)
EP

Inflation 0.000*** 0.000*** -0.001 0.000*** 0.000*** -0.001

(-5.76) (-12.06) (-0.35) (-7.42) (-13.11) (-0.19)
Trade 0.000** 0.000 0.000* 0.000** 0.000 0.000
(2.41) (-0.07) (2.05) (2.27) (-1.41) (1.57)
CC

Observations 35,760 34,991 30,495 35,760 34,991 30,495

Country FE Yes Yes Yes Yes Yes Yes
Industry FE Yes Yes Yes Yes Yes Yes
Year FE Yes Yes Yes Yes Yes Yes
Adjusted R² 0.284 0.261 0.288 0.291 0.283 0.294
A

56
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SC
Table 10
Additional control variables

U
This table presents estimation results using an extended set of control variables. In particular, we extend the regression from Table 3 to control for investment opportunities
and the level of a country’s financial market development. In columns 1-4, we add the market-to-book ratio (MTB). In columns 5-8, we add the country-level variables proposed
by Demirgüç-Kunt and Levine (1996) to proxy for the level of a country’s financial market development. Market cap is total market capitalization divided by GDP. Private

N
credit is private credit by deposit money banks and other financial institutions to GDP. In columns 9-12, we add additional measures of investment opportunities. Real GDP
forecast and Nominal GDP forecast are from the OECD economic outlook. CCI is the consumer confidence index from the OECD main economic indicators. CLI is the

A
composite lead index from the OECD main economic indicators. PU is the natural logarithm of the twelve-month average of a country’s news-based policy uncertainty index
as developed by Baker et al. (2016). All regressions include (unreported) country fixed effects, together with year and two-digit SIC industry dummies. We add (unreported)

M
interactions between the cost of capital measures (WACC, COD, and COE) and year and country dummies to isolate the effect of policy uncertainty on the links between the
cost of capital and investment. Standard errors are clustered at the country level. t-statistics are in parentheses. ***, **, and * indicate significance at the 1%, 5%, and 10%
levels, respectively.
Additional ED MTB Market cap. and private credit Real GDP forecast, nominal GDP forecast, CCI, and CLI
controls
(1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) (12)
PU -0.056** -0.072*** -0.057*** -0.074*** -0.071*** -0.095*** -0.070*** -0.092*** -0.059*** -0.078*** -0.061*** -0.082***
(-2.76) (-2.99) (-3.75) (-4.14) (-5.06) (-7.34) (-4.15) (-6.18) (-4.20) (-4.58) (-4.54) (-5.20)
CF 0.061*** 0.060*** 0.061*** 0.060*** 0.067*** 0.065*** 0.066*** 0.065*** 0.066*** 0.064*** 0.065*** 0.064***
PT
(14.42) (14.64) (14.43) (14.64) (14.06) (14.67) (14.05) (14.67) (13.47) (14.00) (13.40) (13.94)
WACC -2.110*** -1.997*** -2.555*** -2.424*** -2.334*** -2.294***
(-3.71) (-3.79) (-4.33) (-4.25) (-4.39) (-4.23)
WACC×PU 0.553*** 0.519*** 0.577*** 0.536*** 0.534*** 0.524***
(3.80) (4.00) (3.81) (3.67) (3.75) (3.66)
E

COD -8.398** -8.483** -12.352*** -11.997*** -11.777*** -12.482***

(-2.13) (-2.44) (-4.25) (-4.13) (-3.85) (-4.36)
CC

COD×PU 1.902* 1.924** 2.721*** 2.625*** 2.506*** 2.687***

(2.05) (2.39) (3.94) (3.88) (3.38) (3.94)
COE -2.149*** -2.064*** -2.570*** -2.465*** -2.257*** -2.181***
(-4.48) (-4.54) (-4.45) (-4.53) (-4.64) (-4.74)
COE×PU 0.568*** 0.540*** 0.593*** 0.558*** 0.531*** 0.512***
(4.51) (4.70) (3.99) (3.98) (4.01) (4.04)
A

MTB 0.042*** 0.037*** 0.041*** 0.037***

(12.37) (15.14) (12.29) (15.11)
Market cap. 0.001*** 0.001*** 0.000*** 0.000***
(3.06) (2.91) (3.49) (3.53)
Private credit 0.000 0.000 0.000 0.000
(0.17) (-0.05) (-0.57) (-1.43)
Real GDP forecast 0.010** 0.012** 0.004 0.005
(2.57) (2.55) (1.16) (1.41)

57
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SC
Nominal GDP forecast 0.002 0.001 0.004 0.003
(0.66) (0.43) (1.41) (1.20)
CCI 0.002 0.002 0.003 0.002
(0.79) (0.83) (1.08) (1.01)

U
CLI 0.002 0.000 0.025** 0.030**
(0.52) (0.16) (2.63) (2.66)
GDP 0.000*** 0.000*** 0.000*** 0.000*** 0.000*** 0.000***

N
(-3.45) (-3.12) (-4.10) (-4.01) (-3.36) (-3.17)
GDP growth 0.003 0.002 0.003 0.002 -0.025** -0.031**
(1.38) (1.39) (1.47) (1.12) (-2.28) (-2.38)

A
Inflation 0.000** 0.000** 0.000*** 0.000*** 0.002 0.004
(-2.54) (-2.41) (-8.81) (-7.94) (0.80) (1.32)
Trade 0.000 0.000 0.000 0.000 0.000 0.000

M
(0.91) (0.53) (-1.00) (-1.62) (0.53) (0.30)
Observations 64,678 64,678 64,678 64,678 63,671 63,671 63,671 63,671 62,784 62,784 62,784 62,784
Country FE Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes
Industry FE Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes
Year FE
Adjusted R²
ED
Yes
0.285
Yes
0.296
Yes
0.287
Yes
0.297
Yes
0.271
Yes
0.285
Yes
0.273
Yes
0.287
Yes
0.274
Yes
0.289
Yes
0.275
Yes
0.290
E PT
CC
A

58