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Lee, Walker and Christensen, 2006

Executive summary

BACKGROUND

The cost of capital is an essential risk metric for the investment and financial decisions of professional investors and corporate financial managers. It is also a crucial measure in a wide spectrum of research and policy applications, such as accounting policy choice, the regulation of financial disclosure, corporate governance, and the evaluation of systematic capital market efficiency. After all, the principal purpose of corporate security markets is to provide risk capital to companies as cheaply as possible.

The mandatory adoption of International Financial Reporting Standards (IFRS) in 2005 across the European Union (EU) has been hailed as a 'big bang' and a vital step towards global harmonisation of generally accepted accounting principles (GAAP). The key aim of this decision is to improve corporate disclosure quality and the international comparability of financial statements, which is expected to lead to reductions in the cost of capital. In support of this view, the former chairman of the United States Securities and Exchange Commission, Arthur Levitt, once stated that: 'The truth is, high standards lower the cost of capital' (Levitt 1998).

In order to assess such policy assertions, researchers need to track the harmonisation process as it evolves through different stages, from expectation, through transition and into maturity. Ideally, we need to model the evolution of capital costs before, during and after the implementation of IFRS.

The main purpose of this report is to examine the properties of one particular technology for measuring the costs of capital, and changes in the costs of capital, over time. We focus on a cost of capital measure that is based on analysts' expectations. We refer to such measures as 'implied costs of capital'.

For this research, we calculated the implied costs of capital for large samples of European quoted companies, and examined the evolution of the cost of capital in Europe from 1995 to 2005. We also compared UK companies' cost of capital with that for their counterparts in the rest of Europe. Finally, we incorporated some findings from current research on the association between implied costs of capital and actual stock returns (Lee and Walker 2006).

As a precursor to future work on the evolution of the costs of capital after the implementation of IFRS, we present some initial results for UK firms that suggest that mandatory IFRS adoption may have benefited some companies more than others (Christensen et al. 2006). These results are important because they indicate the need to allow -for a heterogeneous response to IFRS adoption when assessing the impact of IFRS on EU firms.

THE STUDY

We estimated the implied costs of equity capital for a large sample of companies from 17 European countries between 1995 and 2005. In addition, we computed the weighted average cost of capital (WACC) to address the fact that companies in most European countries, apart from the UK, are financed mainly by debt. The WACC combines the cost of equity and the cost of debt to produce a cost of capital of the firm by weighting according to the firm's level of debt gearing.

In order to calculate the implied cost of equity capital one needs to assume a valuation model that links current value to expected earnings. We applied the price-earnings growth (PEG) model, which is a parsimonious version of the abnormal earnings growth (AEG) model. While existing studies demonstrate that there is no single superior accounting-based valuation model bearing all the ideal empirical properties, the cost of equity capital derived from the PEG model has been shown to have the best association with commonly accepted risk proxies (Botosan and Plumlee 2005). Like the AEG model, it is also more suited to the European context than the residual income valuation (RIV) model because it does not depend on the clean surplus assumption. In order to assess the reasonableness of our estimates we modelled the cross-firm differences in the implied cost of capital estimates to see if they vary in predictable ways with firm characteristics that are known to cause the cost of capital to vary.

KEY FINDINGS

Equity premium, ie the cost of equity capital minus the risk-free rate of interest, is systematically lower in the UK than in the rest of Europe. This confirms that the higher disclosure requirement and general dominance of equity-based finance in the UK leads to systematically lower costs of equity capital. Companies are not, however, primarily interested in the cost of equity. What matters to a firm is its weighted average cost of capital (WACC), which combines the costs of equity with the costs of debt. In contrast to our results on the costs of equity, we find that the WACC premium, ie the level of WACC above the risk-free rate, shows no statistically significant difference between the UK and the rest of the EU.

If IFRS adoption improves disclosure quality and equity investor interest in companies in the rest of Europe, subsequent studies should observe a reduction in the gap between cost of equity capital for UK companies and that for European companies. If the rest of Europe can achieve this reduction in cost of equity capital, while at the same time maintaining its relatively low cost of debt capital, then the UK could find that its companies have relatively high costs of capital. This suggests that the UK needs to examine and address the reasons for its relatively high costs of debt capital.

Over the study period the cost of equity capital and the WACC in Europe remained fairly stable. This trend persisted despite a continuing decline in the risk-free rate in the sampled countries, which implies there was a relative increase in the risk premium over the study period.

With respect to sector variation in the costs of capital, we observe that the IT hardware, IT software, steel and materials, and mining sectors consistently appeared to be higher, while utilities, electricity, and beverages sectors tended to be lower in both equity and WACC premiums.

The other results of this study appear in two companion papers that are also briefly summarised in this report. Lee and Walker (2006) discuss the extent to which the implied cost of equity capital is associated with future stock returns, ie the relationship between expected and realised returns. In an efficient capital market, investors willing to bear higher risk do so with the expectation that they will ultimately be compensated by higher returns. If the analysts and market expectations are broadly correct, the estimates that we derive for cost of equity capital should broadly predict subsequent stock returns. The results show that this is generally the case in both the UK and the rest of Europe, except for companies that subsequently descend into distress and underperformance. This implies that inferences based on such estimates are reasonably reliable but caution must be applied in interpreting results for highly unstable companies.

Christensen et al. (2006) apply estimates for the implied cost of equity to determine the preliminary impact on UK companies of the decision to adopt IFRS. The study estimates a counter-factual proxy of UK companies' willingness to adopt the IFRS had they been given a chance to do so voluntarily. The results show that UK companies with a higher predisposition towards IFRS experience a decline in their cost of equity capital relative to firms with a low predisposition towards IFRS adoption. This implies that the market perceives mandatory IFRS adoption to be beneficial for some companies, but that the economic consequences of this decision vary across companies depending on their characteristics. In other words, the benefit of IFRS may not be uniform across all adopters as their proponents predicted.

CONCLUSIONS

This report contributes to the current and emerging literature on the impact of IFRS adoption on the cost of capital of companies across Europe in the following ways.

First, given the existing institutional corporate disclosure and capital structure differences between the UK and the rest of Europe, it compares their costs of capital to determine if there are systematic differences between them. Our analyses reveal that the UK has a lower equity premium but not a lower WACC premium. One possible outcome of IFRS adoption could be that the gap in equity premiums will narrow as the adoption process evolves from the current transition stage towards maturity. This is because European companies could improve their disclosure and accounting quality, and attract more equity investors.

Second, we have shown that the relationship between implied cost of capital estimates and realised returns is both complex and problematic (Lee and Walker 2006). In the context of EU firms, the results are particularly sensitive to the returns of firms in financial distress. Such firms appear to have very high implied costs of equity capital, which seems entirely reasonable given their distressed status. Nonetheless, the realised returns on such stocks are typically significantly less than their ex-ante implied cost of capital.

Third, we discuss evidence, which models the changes in cost of capital for UK companies due to mandatory IFRS adoption (Christensen et al. 2006). It is likely that this is conditional on the degree of willingness to comply with mandatory IFRS adoption, which differs across companies owing to variations of benefits they anticipate from IFRS. Companies with a higher willingness to comply with IFRS are shown to experience a relative cost of equity capital decline. Empirical evidence confirms that there are cross-sectional variations in relative benefit from the expectation of IFRS adoption, the notion of uniform benefit suggested by proponents of international accounting harmonisation is challenged.

We believe the aforementioned analyses and observations provide insights for future research examining the impact of IFRS adoption across Europe. As Europe is the new frontier of international accounting harmonisation, the European experience will provide vital insights to regulators worldwide.

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