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Growth options, option exercise and firms’ systematic risk

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Abstract

We develop and empirically test a theoretical model which analyzes the impact of growth options, profitability, and operating and financial leverage on equity’s systematic risk. Conditioning on the relative magnitude of advertising expenditure to research and development (R&D) expenditure, we find that higher beta is associated with higher return volatility, lower book to market ratio, lower return on assets, higher operating and financial leverage, and larger market capitalization (Size). Conditioning on R&D intensity, we show that an increase in the moneyness of firm options, or the exercise of firm options (approximated by increases in capital expenditure, advertising expenditure or profitability) result in more significant decreases in beta. Dynamically estimated high-frequency betas appear to perform well in capturing variation in firm systematic risk associated with growth option factors.

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Notes

  1. For a critical review on accounting for intangibles see Skinner (2008). The issue of mispricing versus risk explanations is assessed in Chambers et al. (2002).

  2. For better tractability, we assume the same horizon for option exercise and the maturity of debt. Furthermore, the independence of value of assets in place with PVGO necessitates an additional assumption which requires that in states where the firm decides to default are not the same with those where it decides to exercise the option to expand. Since PVGO option is exercised when eG A > XG and the equity holders continue operations from existing assets in place when A > (XC +F), this condition can be ensured with an additional assumption that (XC + F) is less or equal to XG/eG.

  3. Available upon request.

  4. These results are verified when we run regressions on R&D and Advertising intensities separately.

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Acknowledgments

We are grateful to participants at the 2012 Multinational Finance Society conference for useful comments and to George Skiadopoulos for useful suggestions and discussion.

Conflict of interest

The authors declare that they have no conflict of interest.

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Authors and Affiliations

  1. Department of Accounting, Finance and Economics, Frederick University Cyprus, 7, Y. Frederickou Str. Pallouriotisa, 1036, Nicosia, Cyprus

    Nicos Koussis

  2. Department of Maritime Studies, Frederick University Cyprus, 7, Y. Frederickou Str. Pallouriotisa, 1036, Nicosia, Cyprus

    Michalis Makrominas

  3. Department of Public and Business Administration, University of Cyprus, P.O. Box 20537, 1678, Nicosia, Cyprus

    Nicos Koussis

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  1. Nicos Koussis
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  2. Michalis Makrominas
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Correspondence to Nicos Koussis.

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Koussis, N., Makrominas, M. Growth options, option exercise and firms’ systematic risk. Rev Quant Finan Acc 44, 243–267 (2015). https://doi.org/10.1007/s11156-013-0405-5

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