RDP 9107: The Cost of Equity Capital in Australia: What can we Learn from International Equity Returns? 1. Introduction

Recent policy discussions in Australia have focused on the cost of capital faced by Australian firms. The real cost of capital depends both on the real cost of debt to firms and the real cost of equity, as well as the mix by which corporate activities are financed.^[1] This paper focuses on the cost of equity, and uses data for national stockmarkets to investigate the evidence on the cost of equity in Australia and overseas.^[2]

Three approaches can be used to investigate the cost of equity. The first two, relying on realised rates of return over long periods, and earnings/price ratios, yield conflicting results, though there are reasons for preferring the results of the latter method which suggest that the cost of equity is higher in Australia. The third method considers the risk properties of equities which might influence the way that they are priced. It starts from the premise that Australian equities are part of a world market, and hence must be priced in a manner that reflects their risk in an international context. For its theoretical framework, this method draws on the Capital Asset Pricing Model (CAPM), the Arbitrage Pricing Theory (APT) model, and their extensions into an international framework. I find some tentative evidence that Australian stockmarket returns show more risk than would be justified by the relatively low debt/equity ratios of Australian companies. Furthermore, I provide other evidence from national accounts data which suggest that real earnings in Australia may be relatively risky when measured against the benchmark of world earnings.

The paper is organized as follows. Section 2 presents the data used in this study. In Section 3, a number of methods of calculating the cost of equity are presented, including a brief survey of the relevant literature on international asset pricing. Section 4 contains estimates on the cost of equity based on realised rates of return and earnings/price ratios. In Section 5, a simple model of international asset pricing is estimated for a number of countries, and the implications for the cost of equity in Australia are discussed. Section 6 considers whether or not this financial market risk has its origin in earnings risk in the real economy. Section 7 provides further discussion of the asset pricing models that this paper has estimated, and a brief discussion on the effect of personal taxes. Finally, Section 8 suggests some implications from this research.

Footnotes

Note that references to the “cost of capital” in this paper correspond more closely to the standard corporate finance definition, which is sometimes also referred to as the “cost of funds”. Other papers, especially in the tax policy literature (e.g. Ryan, 1990) adopt a “user cost of capital” approach which begins with the cost of funds and then also includes the effect of depreciation allowances and investment tax credits. In the corporate finance literature, these last two adjustments would typically be made at the cash flow level, before applying the cost of funds as the discount rate. McCauley and Zimmer (1989, p. 6) and Hodder (1991, p. 87) provide further discussion of these points. [1]

See the Australian Manufacturing Council (1990) and Irvine (1991) for conflicting recent views. Another recent study, by Pappas Carter Evans and Koop, is discussed in the Australian Financial Review (27/3/91, p. 52) but at the time of writing a paper was not available, so that approach will not be discussed in this study. [2]