Implied Cost Of Equity Capital Research Articles

An empirical evaluation of dynamic approaches for estimating firms’ expected cost of equity capital

AbstractWe develop and empirically validate dynamic approaches of implied cost of equity capital (ICC), facilitating the estimation of firms’ expected cost of equity capital at any required estimation date. Using on average 246,090 monthly observations, we empirically validate conflicting approaches for dynamic ICC estimation by analyzing the inferred market risk premia and assessing correlations with common risk factors. While the adjustments suggested by Daske et al. (2006) yield important and systematic deviations in the course of the year, the dynamic residual income model of Kempkes and Wömpener (2019) is robust to the choice of the estimation period.

Role of Analyst Following in the Relationship between Integrated Reporting Quality (IRQ) Disclosure and Cost of Equity Capital in Developed Markets

The study aims to examine the role of analyst following (AF) in the relationship between IR quality (IRQ) disclosures and implied cost of equity capital (ICC) in the developed market in Australia and New Zealand. The study also examined whether companies with higher-quality integrated reporting (IR) benefit from the cost of equity capital reduction. The main objective is to identify the role of AF in explaining the relationship between IRQ disclosure and ICC. Besides, the study highlighted the average effects of IR benefits, which increase when there is more information asymmetry between firms and investors. Furthermore, IR could play a bigger role (with greater information asymmetry) than cross-sectional tests. The study used a common sample of 100 top companies based on Standard and Poor's market capitalisation in Australia and New Zealand (2014-2016), with 870 observations of post-implementation IR. This study showed a significant, negative relationship between IRQ and the ICC with top companies in Australia and New Zealand. Also, the results showed that AF is a partial mediator in explaining the relationship between IRQ and the cost of equity capital. The findings also indicated that AF has a vital role in IRQ disclosures, associated with a subsequent reduction in the cost of equity capital in the developed market.

Impact of Integrated Reporting Quality Disclosure on Cost of Equity Capital in Australia and New Zealand

This study aims to ascertain the relationship between the integrated reporting quality (IRQ) disclosures and the implied cost of equity capital (ICC) in the developed markets of Australia and New Zealand. The study provides empirical results on whether companies producing higher-quality integrated reporting (IR) under a regular process can reduce equity capital costs. This study focuses on the benefits of IR and notes that there is actually more information asymmetry between firms and investors than previously believed. The study concludes that IR plays a salient role in capital costs (when information asymmetry is greater) than cross-sectional tests. The 100 companies studied were chosen based on Standard and Poor market capitalization listed in Australia and New Zealand from 2014 until 2016. The study considered a total of 870 observations of post-implementation IR. Further, data were collected from a validated secondary database. This study showed a significant, negative relationship between IRQ and the ICC in the developed market. The results of this study encourage companies that have not yet adopted IR to do so for accelerating reduction in the ICC. Consequently, this study can help promote IR and attract more countries to implement IR policies to enhance IR research.

Effect Open Interest on Implied Cost of Equity Capital of Firms Listed Single Stock Futures in the Derivatives Market

Effect Open Interest on Implied Cost of Equity Capital of Firms Listed Single Stock Futures in the Derivatives Market

Does corporate social responsibility affect the cost of equity in controversial industry sectors?

PurposeThis paper aims to examine whether corporate social responsibility influences the cost of equity capital of firms operating in controversial industry sectors.Design/methodology/approachThis paper computes the ex-ante cost of equity capital implied in analyst earnings forecasts and stock prices for a sample of 2,006 US firm-year observations belonging to controversial industry sectors (alcohol, tobacco, gambling, military, firearms, nuclear power, oil and gas, cement and biotechnology) during the period 1991-2012. The baseline regression model links CSR score to the implied cost of equity capital (ICC) and controls for firm-specific characteristics, industry factors and economic or market-wide factors. This model enables to capture the differential effect of CSR on ICC when the firm belongs to a specific sector of the controversial industries by adding an interaction term between CSR and the dummy variable representing this belonging.FindingsThe findings show two main results. First, CSR engagement significantly reduces the implied cost of equity capital (ICC) in all controversial industry sectors, taken as a group, as well as in each one of these sectors individually. Second, this effect is more pronounced when the firm belongs to the alcohol and tobacco industry sectors.Practical implicationsThe findings have two important practical implications. First, they should increase managers’ confidence and incentives, in controversial industry sectors, to pursue CSR activities. Second, policymakers can encourage managers to undertake CSR initiatives in controversial industry sectors through tax incentives (e.g. reduce taxes for CSR related investment projects).Originality/valueThis paper extends prior studies that investigate the perceptions of capital market participants of firm’s CSR commitment (Sharfman and Fernando, 2008; Goss and Roberts, 2011; El Ghoul et al., 2011; Jo and Na, 2012; Bouslah et al., 2013) by examining the effect of CSR on ICC in the controversial industry sectors. It contributes to the debate around the relevance of CSR in controversial sectors by providing evidence of the reduction effect of CSR activities on ICC in controversial industries and by showing that this reduction impact is more pronounced when the firm belongs to alcohol, tobacco industry sectors.

Corporate Governance, Chaebol Affiliated and Implied Cost of Equity Capital

Corporate Governance, Chaebol Affiliated and Implied Cost of Equity Capital

Commentary on: Implied Cost of Equity Capital Estimates as Predictors of Accounting Returns and Stock Returns

The expected rate of equity returns is a central input into various managerial and investment decisions that affect the allocation of scarce resources. Research on capital markets has devoted significant effort to studying how and why expected returns vary over time and across firms. Cochrane (2011) called these questions the central organizing agenda in contemporary asset-pricing research. At the heart of this research agenda lies a longstanding measurement problem: ex-ante expected returns are unobservable and ex-post realized returns are noisy proxies (Campbell, 1991; Vuolteenaho, 2002). Since Botosan (1997), the accounting literature offered a promising solution to this measurement problem: the development of a novel class of expected-return proxies (ERPs), collectively known as the implied cost of equity capital (ICC).

Compliance with goodwill-related mandatory disclosure requirements and the cost of equity capital

Theory suggests that increased levels of corporate disclosure lead to a decrease in cost of equity via the reduction of estimation risk. We examine compliance levels with International Financial Reporting Standard 3 Business Combinations and International Accounting Standard 36 Impairments of Assets mandated goodwill-related disclosure and their association with firms’ implied cost of equity capital (ICC). Using a sample of European firms for the period 2008–2011, we find a median compliance level of about 83% and significant differences in compliance levels across firms and time. Non-compliance relates mostly to proprietary information and information that reveals managers’ judgement and expectations. Overall, we find a statistically significant negative relationship between the ICC and compliance with mandated goodwill-related disclosure. Further, we split the sample between firms meeting (or not) market expectations about the recognition of a goodwill impairment loss in a given year to study whether variation in compliance levels mainly plays a confirmatory or a mediatory role. We find the latter: higher compliance levels matter only for the sub-sample of firms that do not meet market expectations regarding goodwill impairment. Finally, our results hold only in countries where enforcement is strong.

An “Enhanced Multiple” Corporate Valuation Model: Theory and Empirical Tests

In this article, we develop an enhanced corporate valuation model based on the implied cost of equity capital (ICC). We argue that the enhanced method extends the standard market multiples and discounted cash flow (DCF) methods to corporate valuation. Specifically, it incorporates positive aspects of the market comparables and DCF methods while mitigating the shortcomings of both. Unlike the traditional market comparables method, the enhanced method takes account of the full-term structure of earnings forecasts. Unlike the DCF method, it does not require estimation of the cost of equity capital. While other applications of the ICC, such as using it to estimate the cost of equity capital, are reported in the literature, our approach differs in that we do not treat the ICC as a discount rate, but rather as an enhanced multiple that allows estimation of equity value for a company based on publicly available information on projections and market prices for comparable companies and publicly available projectio...

An 'Enhanced' Corporate Valuation Model: Theory and Empirical Tests

In this paper, we develop an enhanced corporate valuation model based on the implied cost of equity capital (ICC). We argue that the enhanced approach extends the standard market multiples and discounted cash flow (DCF) approaches to corporate valuation. Specifically, it incorporates positive aspects of the market comparables and DCF approaches while mitigating the shortcomings of both. Unlike the traditional market comparables approach, the enhanced approach takes account of the full term structure of earnings forecasts. It does so by using the ICC calculated for the comparable companies as an “enhanced multiple” which translates the entire stream of cash flow forecasts into a value estimate. Unlike the DCF approach it does not require estimation of the cost of equity capital. As such, it avoids the complexity and uncertainty associated with estimating the cost of equity capital. In our empirical tests, we find the enhanced approach to be more accurate than either of the two traditional approaches.

Does compliance with the German Corporate Governance Code pay off?

Purpose – This paper aims to empirically investigate the relationship between the level of compliance with the German Corporate Governance Code’s (GCGC) recommendations and the implied cost of equity capital (ICC). German listed companies are required by law to annually disclose their compliance with the recommendations of the GCGC. Whether the GCGC achieves its aim to promote the trust of stakeholders in the management and supervision is still an open question. Design/methodology/approach – ICC is regressed on a score that captures compliance with the GCGC and several control variables. The dataset covers the period of 2003-2012 with declarations of compliance from 447 companies. ICC is chosen as an outcome variable, as it captures general investment risk as well as risk arising from asymmetric information and mistrust of investors in management. Findings – The results of the empirical analysis demonstrate that a higher level of GCGC compliance is associated with lower ICC. Research limitations/implications – It is expected that the results of this study will strengthen acceptance of the GCGC and empirically support the work of the government commission that is responsible for it. It has not been analyzed yet whether the firms cite good reasons why they do not adhere to certain items. Originality/value – This empirical analysis is the first to provide statistically reliable evidence on how compliance with the GCGC affects ICC and whether the work of the government commission reflects good corporate governance as perceived by capital markets.

A Replication of “Dividend Taxes and Implied Cost of Equity Capital” (Journal of Accounting Research 2005)

Three major measures of implied cost of equity are sensitive to a summary measure on macroeconomic conditions (the Chicago Fed National Activity Index, or CF3) while changes in the tax rates on investors’ dividend income and capital gains do not appear to be insulated from changes in general business conditions. In the presence of CF3, the measure of dividend tax penalty used in the current empirical research does not seem to be specific to detect the effect of dividend tax capitalization on cost of equity. Future research may need to hold a more nuanced view on the empirical proxy of dividend tax penalty amid major shifts in business cycles.

Goodwill Related Mandatory Disclosure and the Cost of Equity Capital

Theory suggests that increased levels of corporate disclosure lead to a decrease in cost of equity via the reduction of estimation risk. We examine compliance levels with IFRS 3 and IAS 36 mandated goodwill related disclosure and their association with firms’ implied cost of equity capital (ICC). Using a sample of European firms for the period 2008 to 2011, we find a median compliance level of about 83% and significant differences in compliance levels across firms and time. Non-compliance relates mostly to proprietary information and information that reveals managers’ judgment and expectations. Overall, we find a statistically significant negative relationship between the ICC and compliance with mandated goodwill related disclosure. Further, we split the sample between firms meeting (or not) market expectations about the recognition of a goodwill impairment loss in a given year to study whether variation in compliance levels mainly plays a confirmatory or a mediatory role. We find the latter: higher compliance levels matter only for the sub-sample of firms that do not meet market expectations regarding goodwill impairment. Finally, our results hold only in countries where enforcement is strong.

The Impact of Meet and Beat Earnings Benchmark by Accrual Earnings Management on Implied Cost of Equity Capital

The Impact of Meet and Beat Earnings Benchmark by Accrual Earnings Management on Implied Cost of Equity Capital

Real versus Accrual-Based Earnings Management and Implied Cost of Equity Capital

This study investigates whether and how a firm’s cost of equity capital is influenced by the extent of a firm’s real activities management. Using a large sample of U.S. firms, we find that our proxy for the cost of capital is positively associated with the extent of earnings management both through the real activities manipulation and the accrual-based earnings management, but the positive association is stronger for the former than for the latter. We also provide evidence suggesting that outside investors take into account the impact of the Sarbanes-Oxley Act on the relative cost-of-capital effect of real versus accrual-based earnings management when making investment decisions. The main findings are robust to a battery of sensitivity tests. Collectively, our results suggest that while both earnings management activities exacerbate the information quality of earnings used by outside investors, the real earnings management does so to a greater extent than the accrual-based earnings management, and thus the market demands a higher risk premium for the former than for the latter.

Dividend Taxes and Implied Cost of Equity Capital

ABSTRACTWe estimate firm‐level implied cost of equity capital based on recent advances in accounting and finance research and examine the effect of dividend taxes on the cost of equity capital. We investigate whether dividend taxes affect firms' cost of capital by testing the relation between the implied cost of equity capital and a measure of the tax‐penalized portion of dividend yield, which we define as the product of dividend yield and the dividend tax penalty. The results generally support the dividend tax capitalization hypothesis. We find a positive relation between the implied cost of equity capital and the tax‐penalized portion of dividend yield that is decreasing in aggregate institutional ownership, our proxy for tax‐advantaged investors. The evidence in this study adds to the understanding of the effect of investor‐level taxes on equity value.

Dividend Taxes and Implied Cost of Equity Capital

We estimate firm level implied cost of equity capital based on recent advances in accounting and finance research and examine the effect of dividend taxes on the cost of equity capital. We investigate whether dividend taxes affect firms' cost of capital by testing the relation between the implied cost of equity capital and a measure of the tax-penalized portion of dividend yield, which we define as the product of yield and the dividend tax penalty. The results generally support the dividend tax capitalization hypothesis. We find a positive relation between the implied cost of equity capital and the tax-penalized portion of dividend yield that is decreasing in aggregate institutional ownership, our proxy for tax advantaged investors. We further explore the effect of institutional ownership on the dividend tax premium by partitioning institutional owners into groups of relatively homogeneous investors but fail to find consistent results across different institutions or different measures of cost of equity capital. This part of our analysis is exploratory, but we believe that it provides useful insights for future research that can identify stronger settings within which to examine the effects of investor tax attributes on the dividend tax premium.