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Do ethical companies have lower implied cost of equity capital? Evidence from the Korean stock market

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Abstract

This study examines company business ethics (BE) as one of the important factors of corporate valuation. It looks into the causal relations between the level of a company's ethical commitment and risk measures, and the association of both with the costs of equity capital (COC). The link between BE and firm value is examined by investigating (a) the degree of companies’ ethical commitment, (b) implied costs of capital and (c) the valuation of companies listed on the Korean stock market. Our results confirm the existence of a significantly negative association between the level of commitment to BE and the implied COC.

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Notes

  1. Unlike in the field of finance, in accounting literature the terms ‘implied costs of capital’ (the expected rates of returns) and ‘COC’ are often used interchangeably, despite the fact that the implied costs of capital (expected rates of returns) are not exactly equivalent to the COC unless market prices are efficient and analysts’ forecasts of earnings and accounting numbers are unbiased. In other words, it is possible to say the estimates of cost of capital are implied by market prices, analysts’ forecasts of earnings and accounting numbers. Another similar term, ‘weighted average cost of capital’, is not used in valuation unless the discount cash flow model is employed.

  2. In a survey of financial executives, 75 per cent of CEOs said that they would sacrifice economic value to keep earnings rising smoothly (Fox, 2006).

  3. Weak BE and corporate transparency along with poor corporate governance and disclosure inadequacy have also been suggested by business corporations as potential explanations for the so-called ‘Korea discount’ (Baek et al, 2004; Choi and Jung, 2008; Choi and Nakano, 2008; Botosan, 1997; Botosan and Plumlee, 2002; Poshakwale and Courtis, 2005; Dargenidou et al, 2006; Habib, 2006). ‘Korea discount’ is a term used to refer to the fact that in comparison with other countries, companies listed on the Korean stock market are Ceteris paribus substantially undervalued, and thus trade at a discount. This phenomenon can be observed despite similar levels of risk and the fact that the profitability of Korean firms is not lower than the profitability of similar companies in other countries (Guerrera, 2006; Suh and Sim, 2007). Other potential explanations found in the literature include the volatility of the Korean stock market (according to Chang (2005), investors in the Korean stock market bear the characteristics of short-term speculation), excessive restrictions (for example, short-selling restrictions) and weak financial systems (shareholder protection, pension funds restrictions and so on).

  4. Different valuation models use different variables to express a company's CFP. For example, while the dividend discount model uses dividends as the numerator in the formula, the residual earnings model employs earnings and so on. In theory, these models are regarded as identical, as they only differ in the measures they use to express CFP.

  5. Prior studies have used various proxies of CSP, such as (a) survey of corporate reputation as a proxy of CSP (Carroll, 1991), (b) Kinder-Lydenberg-Domini index as a measure of CSP (Waddock and Graves, 1997), (c) corporate philanthropy (Seifert et al, 2003; Brammer and Millington, 2005) or (d) the creation of their own index for social performance (Ruf et al, 1998).

  6. Vogel (1991) comments that if company managers do not behave ethically, they will be punished in the form of media criticism or customer and employee dissatisfaction.

  7. Ruf et al (1998) also constructed their own index for measuring CSP.

  8. The conceptual model used in this study differs from Choi and Jung (2008, p. 452) in that although the referenced model only shows the association between firm value and BE, this study shows that the positive association between CV and BE can be explained by the cost of capital and growth. In other words, Choi and Jung established a link between BE and CV and our study suggests cost of capital and growth as linking factors.

  9. Similarly, a bidirectional association between CSP and CFP has been reported previously (Waddock and Graves, 1997; Simpson and Kohers, 2002; Orlitzky et al, 2003; Orlitzky, 2005).

  10. Similarly, Ruf et al (1998) develop an aggregate systematic measure for CSP index using the Analytic Hierarchy Process. They consider the relative importance of the dimensions by providing a weight (C i ) for each dimension as CSP j =∑ j S ij C i . In this study, equally weighted ethics dimensions were used to avoid subjective measurement error and tests were conducted taking into account the relative weights. Qualitatively, similar results were also obtained after the same analysis without the use of the weights.

  11. Alternative financial measures were also tested as controlling variables. The results were qualitatively identical.

  12. Although the study uses the terms COC and r interchangeably, in a mathematical formula r is preferred.

  13. I also estimated COC from the PEG model (Easton, 2004) as follows: The result was qualitatively similar.

  14. As of 31 December 2007, 745 companies were listed on the Korea Stock Exchange and 1,022 companies on KOSDAQ.

  15. Prior studies suggest that, in general, companies listed in developing countries have a higher COC, because of (a) weaker financial systems (Chang, 2005), (b) poor corporate governance (Baek et al, 2004; Black et al, 2006; Hail and Leuz, 2006) and (c) lack of BE including corporate transparency (Botosan, 1997; Botosan and Plumlee, 2002; Baek et al, 2004; Poshakwale and Courtis, 2005; Dargenidou et al, 2006; Habib, 2006; Lambert et al, 2007; Choi and Jung, 2008; Choi and Nakano, 2008).

  16. Pearson and Kendall's τ−b correlations were also tested. The results were not qualitatively different from the Spearman correlation.

  17. The results of analyses conducted using other CFP proxies such as ROA are qualitatively similar.

  18. Similarly, Preston and O’Bannon (1997) show that a time lag exists between CSP and CFP improvement.

  19. After using other information environment proxies, we obtained qualitatively similar results, reflecting the fact that information measures such as trading volume and size variables are highly correlated with each other (Barth and Hutton, 2004).

  20. For example, Fama and French (1997, 2002) conclude that COC estimated from historic beta is unavoidably imprecise.

  21. The analysis was conducted with various proxy variables. The regression results were not sensitive to the choice of control variables.

  22. The use of ROA draws similar conclusions.

  23. We also used other variables for financial performance. The results were qualitatively similar.

  24. Not tabulated.

  25. The recent promotion of South Korea from the category of ‘emerging market’ to ‘developed status’ according to the FTSE stock market index, due to the improvement in market transparency, also seems to support this conjecture.

  26. One of the plans of the Korean government to tackle unethical practices and increase information quality was the early and voluntary adoption of IFRS in 2009.

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Acknowledgements

I acknowledge the financial support provided by the KDI School of Public Policy and Management and I wish to thank the Center for Accounting Research and Education (CARE) of the University of Notre Dame for providing an excellent research environment and facilities. I appreciate the helpful comments from Peter Easton, Jinhan Pae, Martina Sipkova and seminar participants at the KDI School of Public Policy and Management. I extend my thanks to the anonymous referees. Finally, I gratefully acknowledge the helpful comments from Harukiyo Hasegawa, the general editor of Asian Business & Management.

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  1. KDI School of Public Policy and Management, 207-43 Chungnyang, Dongdaemun, Seoul, 130-868, Korea

    Tae H Choi

  2. Center for Accounting Research and Education, University of Notre Dame, 305 Mendoza, Notre Dame, Indiana, 46556, USA

    Tae H Choi

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Choi, T. Do ethical companies have lower implied cost of equity capital? Evidence from the Korean stock market. Asian Bus Manage 11, 219–246 (2012). https://doi.org/10.1057/abm.2011.32

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