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R&D expenditures and implied equity risk premiums

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Abstract

This study investigates the relationship between research and development (R&D) expenditures and risk premiums implied in the costs of equity capital. We posit that R&D expenditures represent an information risk factor resulting from both information asymmetry about R&D between investors and managers and low-quality R&D reporting that impairs the coordination between investors and managers with respect to managers’ investment decisions. Our results support our position by showing a positive association between R&D expenditures and implied equity risk premiums. From this research along with prior studies, investors can have better knowledge about the risky nature of R&D expenditures that drive up implied risk premiums and at the same time provide opportunities to earn excess returns in a short to long horizon. Accounting standard setters can benefit from this study’s findings that R&D expenditures represent an off-balance-sheet risk factor and thus warrant reconsidering SFAS No. 2 for potential capitalization of R&D expenditures.

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Notes

  1. We omit the elaboration of assumptions, terminal values, and empirical procedures for these valuation models because they have been extensively discussed in previous literature (e.g., Bernard 1995; Penman 1998; Penman and Sougiannis 1998; Botosan and Plumlee 2005).

  2. Here, the long-term growth rate, γ – 1 = r f  – 3 %, accounts for the effects of inflation. This method has been used in previous literature (e.g., Gode and Mohanram 2003; Guay et al. 2005; Botosan and Plumlee 2005).

  3. The forecasted earnings per share is the mean forecast of earnings per share. We substitute the mean forecast with the median forecast of earnings per share, and we obtain qualitatively similar empirical results.

  4. We also use all available firms with fiscal year end in December and non-December to re-do our analyses. Despite slightly weak relationship among variables, the results using all available firms are qualitatively similar to our reported results. Because firms with fiscal year end in December make up the majority of our sample, we present results based on the firms with fiscal year end in December.

  5. Untabulated descriptive statistics show that our sample covers a wide range of industries based on the Fama and French’s (1997) industry classification.

  6. Using CRSP equally-weighted market index yields the results similar to those employing CRSP value-weighted market index.

  7. After deletion of firms in the financial institution and utility industries, the full sample contains 35,105 observations with 5,834 distinct firms.

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Acknowledgments

We are thankful to two anonymous referees, L. Parker, L. Klein, and R. Ramakrishnan for valuable comments and suggestions, and we are grateful for the Institutional Brokerage Estimation System (IBES) for providing analysts’ forecast data. The corresponding author would like to thank Washburn University School of Business for Beatrice Summer Research Chair Grant. The usual disclaimer applies.

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Authors and Affiliations

  1. Department of Accounting, College of Business Administration, Kent State University, Kent, OH, 44242, USA

    Pervaiz Alam

  2. Business Division, ASA Institute, New York, NY, 11201, USA

    Min Liu

  3. School of Business, Washburn University, Topeka, KS, 66621, USA

    Xiaofeng Peng

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  1. Pervaiz Alam
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  2. Min Liu
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  3. Xiaofeng Peng
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Correspondence to Xiaofeng Peng.

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Alam, P., Liu, M. & Peng, X. R&D expenditures and implied equity risk premiums. Rev Quant Finan Acc 43, 441–462 (2014). https://doi.org/10.1007/s11156-013-0381-9

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