The cost of equity capital: A simplification

Modigliani-Miller's theorem, which asserts that corporate financing policy is of no consequence, has been shown to hold true under a set of assumptions which is less restrictive than the original set used by MM. Preceding proofs were based on the theory of general equilibrium. Basically, this paper examines MM's second proposition—the linearity of the cost of equity capital with respect to financial leverage—when dropping a few of their basic assumptions but retaining their assumption about incomplete markets. In particular, this paper relaxes the assumptions that (a) the inflows are perpetual and that (b) the firm's future returns belong to the same risk class. The results of the analysis indicate that the linearity will be sustained. The nature of the financial risk premium (the slope), however, has to be modified.     

Corporate tax avoidance and cost of equity capital: international evidence

ABSTRACT

This study examines the association between firm’s tax avoidance activities and cost of equity capital across 17 countries. Consistent with the prior study based on the U.S. evidence, within strong investor protection countries, the extent of firm’s tax avoidance is negatively associated with its cost of equity capital. This result indicates that strong investor protection induces investors to perceive firm’s tax avoidance activities as the results of efficient tax planning to reduce tax liabilities. To the contrary, we find that the extent of firm’s tax avoidance is positively associated with its cost of equity capital within weak investor protection countries. This result suggests that investors impose equity risk premium on firm’s tax avoidance activities in weak investor protection countries, where agency conflicts prevail more on firm’s tax avoidance activities. As the first international study on the association between firm’s tax avoidance activities and its cost of equity capital, this study contributes to the literature by suggesting that such an association may vary across countries depending on the strength of investor protection within each country of domicile.     

Taxation,corporate financial policy,and the cost of capital: A comment

Theoretical models of the incidence of the corporate profits tax differ as to whether the tax distorts the allocation of resources, or is a lump-sum tax on the owners of capital. These differences derive from the assumptions made about the special provisions of the tax system with regard to the deduction of interest payments and investment expenditure. Two non-distortionary systems are identified which are shown to be equivalent to a capital levy when the tax is introduced and a zero tax on profits. Under the present UK system, however, a higher rate of corporation tax stimulates investment.     

New approach to estimating the cost of common equity capital for public utilities

The regulatory process for setting public utilities’ allowed rate of return on common equity has generally used the Gordon DCF, CAPM and Risk Premium specifications to estimate the cost of common equity. Despite the widely known problems with these models, there has been little movement to adopt more recently developed asset pricing models to provide additional evidence for estimating the cost of capital. This paper presents, validates empirically and applies a general yet simple consumption-based asset pricing specification to model the risk-return relationship for stocks and estimate the cost of common equity for public utilities. The model is not necessarily superior to other models in its practical results, yet these results do indicate that it should be used to provide additional estimates of the cost of common equity. Additionally, the model raises doubts as to whether assets such as utility stocks are a consumption (business cycle) hedge.     

Financial development,financial liberalization and social capital

The relationship between financial liberalization policies and financial development is controversial. The impact of these policies differs greatly across countries. In the literature, the quality of formal institutions has been identified as an important source of this heterogeneity, as countries with a weak institutional environment generally fail to benefit from financial liberalization. Using panel data covering 82 countries for the period 1973–2008, we find evidence that social capital may substitute for formal institutions as a prerequisite for effective financial liberalization policies. In particular, we find that during the post Washington-consensus period countries with a high prevailing level of social capital can ensure that financial liberalization positively influences financial development, despite the poor quality of their formal institutions.     

Financial integration, capital mobility, and income convergence

Recent studies have found that capital moves 'uphill' from poor to rich countries, and brings little or no growth dividend when it does flow into poor economies. We show that Europe does not conform to this paradigm. In the European experience of financial integration, capital has flown from rich to poor countries, and such inflows have been associated with significant acceleration of income convergence. Analysing broader samples of countries, we find that 'downhill' capital flows tend to be observed above certain thresholds in institutional quality and financial integration. But Europe remains different even when allowing for such threshold effects, and its experience is similar to that of interstate flows within the United States. Our findings are consistent with the notion that financial diversification reduces countries' incentives to save in order to self-insure against specific shocks.
— Abdul Abiad, Daniel Leigh and Ashoka Mody     

Dollarization and financial integration

How does a country's exchange rate regime impact its ability to borrow from abroad? We build a small open economy model in which the government responds to shocks by adjusting monetary policy and foreign borrowing. Sovereign borrowing is subject to endogenous limits, which ensure repayment when the default punishment corresponds to financial autarky. Dollarizing implies renouncing monetary policy, but can make access to international debt markets more valuable, thereby loosening borrowing constraints. This mechanism linking dollarization to financial integration is consistent with observed declines in spreads on foreign-currency debt in countries adopting the dollar or the euro.     

Human capital and the private equity premium

When capital market is imperfect, an entrepreneur has to invest substantial personal funds to start a firm and has to bear large firm-specific risk. Furthermore, if a typical entrepreneur is risk averse, private equity should earn a premium for idiosyncratic risk. In this paper I explore the interaction of human capital with the decision to become an entrepreneur. I calibrate a model of entrepreneurial choice to illustrate a significant attenuating effect of human capital on the premium for firm-specific risk. When an entrepreneur can quit the business and work for hire, the firm-specific risk premium is order of magnitude lower than without this option. While an entrepreneur puts at risk a substantial fraction of financial wealth, she does not commit all human capital to the current business. At stake is only the labor income forgone while managing the firm and the rest of human capital is unaffected by the business risk. Empirical evidence suggests that private equity does not earn any significant premium over publicly traded equity. The model with human capital is consistent with this observation, assuming typical entrepreneur forgoes a small expected return (1.5%) in lieu of intangible benefits of entrepreneurship.     

Franchising,agency problems,and the cost of capital

Explanations for franchising are examined in the context of the US hotel industry. The study is distinct from previous research on franchising because it explicitly recognizes the existence of three organizational forms, whereas previous research has focused exclusively on two of these three forms. The two organizational forms examined in previous work are franchising and company ownership. The additional organizational form is company-management/investor-ownership, which involves management by the franchisor and ownership by outside investor groups. A plausible explanation for the existence of the last organizational form is based on the availability of low cost capital from non-chain sources.     

Debt, interest rates, and integration of financial markets

It is commonly believed that higher budget deficits raise interest rates. However, these crowding out effects of increasing public debt have usually been found to be small or non-existent. One explanation is that on globalised bond markets interest rate differentials are offset due to financial integration. This paper tests crowding out, and measures the degree of integration of government bond markets, using spatial modelling techniques. Our main finding is that the crowding out effect of public debt on domestic long term interest rates is small: a 1% increase in the debt ratio pushes up domestic rates by 2 pp at most. Financial integration implies an important spillover effect via international bond markets, but only between OECD, and in particular EU, countries. The feedback effect from these markets on long term interest rates is as important as the domestic crowding out effect of higher public debt. Emerging markets are not as well integrated into international capital markets, causing a stronger crowding out effect.     

Tax incidence,majority voting and capital market integration

We re-examine, from a political economy perspective, the standard view that higher capital mobility results in lower capital taxes — a view, in fact, that is not confirmed by the available empirical evidence. We show that when a small economy is opened to capital mobility, the change of incidence of a tax on capital–from capital owners to owners of the immobile factor–may interact in such a way with political decision-making so as to cause a rise in the equilibrium tax. This can happen whether or not the immobile factor (labour) can be taxed, and whether or not savings can be subsided under capital mobility.     

Global financial cycle and Brazil’s financial integration

ABSTRACT

Recent studies have discussed the influence of the global financial cycle on capital flows to emerging and developing countries. This paper evaluates the relationship between the greater degree of financial integration, and macroeconomic performance over the last two decades in Brazil. The literature has highlighted the Brazilian experience as being paradigmatic among emerging countries regarding the relationship between financial integration and regulation of capital flows to deal with boom and bust cycles. Methodologically, we employ a vector autoregressive model with error correction that allows us to evaluate the cointegration between the variables. Our main hypothesis is that a greater degree of financial integration is associated with negative developments in variables such as gross domestic product, country risk, interest rates, and exchange rate volatility. In addition, this study presents a further contribution by observing the existence of the interaction between the consequences of financial integration and the global financial cycle. More specifically, we found that: (i) an increase in the degree of financial integration generates deeper effects in downward periods of the global financial cycle; and (ii) a decline in that cycle generates greater impacts when a higher degree of financial integration is present.     

Corporate income tax,investment grants,and the cost of capital

While the influence of the corporate tax system on the cost of capital faced by firms in the corporate sector has been studied extensively, these studies generally assume that government intervention is restricted to alterations in the rates and deductibility allowances of the corporate income tax. In this paper the case where government intervention also includes the payment of investment grants to the corporate sector is considered; it is shown that the interactions between the corporate tax system and the grant structure are crucial in determiningthe cost of capital. In particular, conditions are derived under which a higher grant rate will raise the relative cost of capital.     

Market structure and the cost of capital

We contribute to the finance literature in two main ways. First, we present a theoretical capital asset pricing model (CAPM) to price assets in different market structures. Second, we use our model to analyze whether when markets are partially segmented using the local or the global CAPM yields significant errors in the estimation of the cost of capital for a sample of firms from developed and emerging countries.     

Predictability of equity returns during a financial crisis

An occurrence of a market crash or a financial crisis has long been considered a cause of market inefficiency. An inefficient market commonly implies return predictability and the existence of profitable opportunities for traders and speculators. Technical analysis has been a popular tool to identify predictable patterns in asset prices. The usefulness of a large universe of technical trading rules popularized in the existing literature on technical analysis is tested when they are applied to a set of equity markets that are generally considered developed and efficient during the two most recent periods of major financial turmoil: the 1997 Asian financial crisis and the 2008 global financial crisis. Three major statistical deficiencies that existing studies on return predictability are commonly criticized for – data snooping bias, nonsynchronicity bias and transaction costs – have been incorporated in the analysis. Technical trading rules are largely unable to yield abnormal excess returns over the passive benchmark after data snooping bias, nonsynchronous pricing and transaction costs are accounted for. Chaotic price movements typical for a volatile market during a financial crisis are likely to have an adverse effect on the performance of active trend chasing trading strategies.     

Financial integration and the ASEAN-5 equity markets

The existence of long-run relationships among the ASEAN-5 equity markets is empirically investigated. This study utilized weekly data spanning January 1988 to August 1999. The results of Granger noncausality test due to Toda and Yamamoto (Journal of Econometrics,66, 225–50, 1995) reveal that the Singapore equity market was not affected by other markets except by the Philippines in the long run. This result shows that there exist opportunities for beneficial international portfolio diversification within the context of the Asean-5 equity markets.     

Fixed capital cost,depreciation multiplier and the rate of interest

Suppose in an economy with zero interest rate five new trucks are bought and afterwards the fleet is renewed by investing the annual depreciation quotas. The service life of a truck is four years. What will be the stationary size of the fleet? The assumed answer is four trucks. The correct answer is eight trucks. The difference is measured by a coefficient called depreciation multiplier. The value of the depreciation multiplier is examined for three typical time profiles of fixed assets, and its limits are found to be 1 ?μ?2. It is then shown how the rate of interest can be interpreted as a rate of growth in an economy with unchanged technology. If the rate of interest is made equal to the rate of growth of the economy, the ratio of discounted values of brand new fixed assets and fixed assets of balanced age-distribution is equal to the ratio between gross and net capital in the growing economy with no interest rate.     

The role of domestic financial and economic development in financial integration

Using two-step system generalized method-of-moments on an unbalanced panel of 75 countries from 1996 to 2010, this study shows that financial development’s effect on the pace of a country’s financial integration is conditional on economic development. Indeed, the results validate the observation that greater financial development conditioned on similar levels of economic development should precede closer financial integration.