10 Chapter II Literature Review This research examines that any influence ESG rating score with cost of debt in firms’ financing activity. The following literature review is consisting of the previous research development that linked with recent study. II.1. Cost of debt As Merton et al, (1973) explains in his paper on option pricing, interest rates on debt are based on three separate factors. These factors include the risk-free rate, bond characteristics such as time to maturity or liquidity, and default risk, which is the probability that the borrower is not capable of meeting its payment obligations. The risk-free rate is commonly estimated by the interest rate on government bonds. The default risk is proxied in part by credit ratings. Higher default risk is associated with higher yield spreads. Contrary to common belief, yield spreads are more than what can be explained by default risk alone (Collin-Dufresne; Huang & Huang, 2012). It is one of the many determinants of the corporate bond spread, as Huang et al. (2012) show in their paper on the effect of credit risk on yield spreads. Still, the majority of the corporate bond spread can be explained by the default risk (Longstaff, 2004). Underlying characteristics influence the yield spreads on bonds in a variety of ways. For example, an otherwise similar bond with a longer tenor will have a higher yield spread compared to a bond with a shorter tenor. This is explained by interest rate risk. The longer the tenor, the higher is the probability of a change in interest rates, which affects the price and return of the bond. Another important premium which affects spreads is the (il)liquidity premium. Yield spreads are negatively affected by the illiquidity of a bond since investors want to be compensated for the decreased ease with which the bond can be traded (Chen et al. ,2007). Another factor that has a significant effect on corporate bond spreads is the tax premium, which arises from the difference in taxation between corporate and governmental bonds (Elton et al., 2001). 11 II.2. Stock Return Stock return been a focal point of financial research for decades, captivating the attention of investors, economists, and academics as well. This research delves into the extensive body of work that surrounds stock returns, offering an in-depth exploration of key theories, empirical findings, and influential factors that shape our understanding of this critical aspect of financial markets. A fundamental principle in finance, the risk-return trade-off, is encapsulated in Modern Portfolio Theory (MPT) by Harry Markowitz et al. (1952). In end of 1965’s The Efficient Market Hypothesis, was immerse and introduced by Eugene Fama serves as a cornerstone for stock return research. It posits that stock prices always reflect all available information, implying that it is impossible to consistently outperform the market. Early studies in this area focused on testing the various forms of market efficiency: weak, semi-strong, and strong. Empirical results have yielded mixed evidence, leaving room for both proponents and critics of the EMH. The analysis of the factor models is interesting in its own right. Surprisingly, much of the literature on stock return condonement imposes strong restrictions of constant, unit betas with respect to a large number of country and industry factors model (Heston and Rouwenhorst, 1994). We contrast the predictions of these models for stock return condonements with our risk-based models. While flexibility in the modelling of betas is essential in a framework where the degree of market integration is changing over time, this may not suffice to capture the underlying structural changes in the various markets. Therefore, in addition to standard models of risk like the Capital Asset Pricing Model (CAPM) and the Fama and French model, we consider an arbitrage pricing theory (APT) model, where the identity of the important systematic factors may change over time. II.2.1 Stock Raw Return Raw return, also known as total return or simple return, is the actual return generated by an investment over a specific period, typically expressed as a percentage. It takes into account both the capital appreciation (or depreciation) of the asset and any income generated from it, such as dividends or interest payments. 12 II.2.2 Stock Abnormal Return Abnormal return, also known as excess return or abnormal profit, is a measure of how well an investment has performed relative to a benchmark or an expected rate of return. It helps investors assess whether the returns they earned were due to factors specific to the investment (company- specific news or events) or general market movements (systematic risk). II.3. Environment, Social and Governance (ESG) ESG stand for Environment, Social and Governance is coming about as a term in 2004 from a report that 20 financial institutions made. The report was a response to the UN general secretary Kofi Annan’s call to responsible investment (Secretary- General, 2006; UN, 2004). ESG has a broader approach than ESG (corporate social responsibility), which expands to include environment. Further it is also more specific and demands more clear reporting for both social and governance. In ESG governance is only included indirectly (Gillan et al., 2021). ESG is an expansion of ESG and evolves ESG into a modern measuring metric better suited for today's financial analysis. Millennials have high demands for who they want to be employed by and where they invest their money (Barzuza et al., 2019). As problems from ESG issues are becoming more prominent, these issues become what people take an increased interest (BCG, 2022; Kachaner et al., 2020). Human rights and equality are also becoming important, firms need to pay their workers a fair wage, and everyone deserves an equal opportunity, whether it be an entry level job or a C- suite position (UN, 2022a). Gender, race, nationality or disability should not get in the way of getting good and representative people in the workplace(UN, 2015b). ESG disclosure will meet some of the demands of the next generation.