106 Corporate Finance
Exhibit 4.11 Cost of equity estimation procedure
Procedure Percentage of 177 respondents
Historical dividend yield plus estimate of growth 3.4
Return required by investors 35.60
Current dividend yield plus estimate of growth 26.0
Dividend yield estimate only 1.70
Cost of debt plus risk premium 13.0
E/P ratio 15.80
Market return adjusted for risk 22.60
Exhibit 4.12 Survey responses to the question: Does your firm estimate the cost of equity capital? If yes, how?
Percentage always Size Industry
or almost always Small Large Manufacturers Others- CAPM 73.49 2.49 3.27 3.02 2.87
- Average historical return 39.41 1.80 1.65 1.60 1.84
on common stock - Multi-beta CAPM 34.29 1.39 1.70 1.69 1.49
- Dividend discount model 15.74 0.96 0.87 0.98 0.80
- Whatever our investors 13.93 1.22 0.86 0.80 0.97
tell us - By regulatory decisions 7.04 0.37 0.50 0.44 0.44
Liquidity and the Cost of Capital
Although modern finance theory hypothesizes that only systematic risk matters for pricing risky assets, one
study in America indicates that portfolios of less liquid stocks provide investors with significantly higher
returns, on average, than highly liquid stocks even after adjusting for risk.^7 Why? Investors price securities
after considering transaction costs. Given two stocks with same cash flows but with different liquidity, the
less liquid stock will trade at lower prices. Thus, a liquidity premium is attached to illiquid stocks. What this
implies is that managers of these companies must earn higher returns than that suggested by CAPM or any
asset pricing model to increase shareholder value.
This also means that managers can increase the value of their companies by increasing the liquidity of the
company’s stocks and bonds. But increasing liquidity is not costless. For instance, one way to increase
liquidity is an initial public offering, which involves underwriting costs. Voluntary disclosure of information
is another way to increase liquidity and lessen cost of equity.
Disclosure and the Cost of Capital
CFOs considering whether they should gratuitously provide corporate information to the capital markets
must weigh the costs and benefits of disclosure. Among the potential costs are the risks of a shareholders’
lawsuit or a weakened competitive position, which could impact the company’s future earnings and the price
of the stock. On the other hand, providing certain types of information may lower the cost of equity capital
for a given level of earnings, and thus enhance the stock price. Voluntary disclosure of information can also
provide some benefits. It might lower investors’ estimation of risk by defusing their uncertainty about the
(^7) Amihud, Yakov and H Mendelson (1988). ‘Liquidity and Asset Prices’, Implications’, Financial Management, Vol. 17 (Spring).