IDEAS home Printed from https://ideas.repec.org/a/bpj/jbvela/v14y2019i1p14n3.html
   My bibliography  Save this article

The Corporate Life Cycle and the Cost of Equity

Author

Listed:
  • Bravo Sergio

    (ESAN Graduate School of Business, Jirón Alonso de Molina 1652, Santiago de Surco 15023, Lima, Perú)

Abstract

A widely used methodology for estimating the beta of companies with the Capital Asset Pricing Model (CAPM) uses comparable firms based only on industry or sector classifications (Bancel, F., and U. R. Mittoo. 2014. “The Gap between the Theory and Practice of Corporate Valuation: Survey of European Experts.” Journal of Applied Corporate Finance 26, no. 4 (Fall): 106–17. doi:https://doi.org/10.1111/jacf.12095, 112; KPMG. 2017. “Cost of Capital Study 2017: Diverging Markets, Converging Business Models.” Accessed September 28, 2018. https://assets.kpmg.com/content/dam/kpmg/ch/pdf/cost-of-capital-study-2017-en.pdf, 37). We hypothesize that even within industries, there is a significant relationship between the cost of equity and the life cycle of a firm. We argue that these variables are correlated because different life-cycle stages exhibit different degrees of systematic risk. Therefore, as the firm moves along its life cycle, its unlevered beta decreases. We define the stages of the firm life cycle based on a modification of the theoretical typology of (Miller, D., and P. Friesen. 1984. “A Longitudinal Study of the Corporate Life-Cycle.” Management Sciences 30 (10): 1161–83. http://www.jstor.org/stable/2631384, 1162–3) and then classify a sample of listed companies into these stages using (Dickinson, V. 2011. “Cash Flow Patterns as a Proxy for Firm Life-Cycle.” The Accounting Review 86 (6): 1969–94. doi:https://doi.org/10.2308/accr-10130) cash flow statements methodology. We construct value-weighted portfolios that are formed based on our life-cycle stages classification, adapting the procedure of (Fama, E., and K. R. French. 1993. “Common Risk Factors in the Returns on Stocks and Bonds.” Journal of Financial Economics 33 (1): 3–56. doi:https://doi.org/10.1016/0304-405X(93)90023-5). Finally, we compare the betas (levered and unlevered) of these portfolios to determine whether there are statistically significant differences. Our results show clear evidence of a relationship between betas and the corporate life cycle and that this relationship is robust to both changes in the period of analysis and omitted variables bias (when controlling with the four-factor model of (Carhart, M. M. 1997. “On Persistence in Mutual Fund Performance.” The Journal of Finance 52 (1): 57–82. doi:https://doi.org/10.1111/j.1540-6261.1997.tb03808.x). We believe our results show an important shortcoming in a widely used methodology among practitioners for estimating the CAPM.

Suggested Citation

  • Bravo Sergio, 2019. "The Corporate Life Cycle and the Cost of Equity," Journal of Business Valuation and Economic Loss Analysis, De Gruyter, vol. 14(1), pages 1-14, February.
    • Handle: RePEc:bpj:jbvela:v:14:y:2019:i:1:p:14:n:3
    DOI: 10.1515/jbvela-2018-0009
    as

    Download full text from publisher

    File URL: https://doi.org/10.1515/jbvela-2018-0009
    Download Restriction: For access to full text, subscription to the journal or payment for the individual article is required.
    File URL: https://libkey.io/10.1515/jbvela-2018-0009?utm_source=ideas
    LibKey link: if access is restricted and if your library uses this service, LibKey will redirect you to where you can use your library subscription to access this item
    ---><---

    As the access to this document is restricted, you may want to search for a different version of it.

    References listed on IDEAS

    as
    1. N. Berger, Allen & F. Udell, Gregory, 1998. "The economics of small business finance: The roles of private equity and debt markets in the financial growth cycle," Journal of Banking & Finance, Elsevier, vol. 22(6-8), pages 613-673, August.
    2. DeAngelo, Harry & DeAngelo, Linda & Stulz, Rene M., 2006. "Dividend policy and the earned/contributed capital mix: a test of the life-cycle theory," Journal of Financial Economics, Elsevier, vol. 81(2), pages 227-254, August.
    3. Jonathan Levie & Benyamin B. Lichtenstein, 2010. "A Terminal Assessment of Stages Theory: Introducing a Dynamic States Approach to Entrepreneurship," Entrepreneurship Theory and Practice, , vol. 34(2), pages 317-350, March.
    4. Gort, Michael & Klepper, Steven, 1982. "Time Paths in the Diffusion of Product Innovations," Economic Journal, Royal Economic Society, vol. 92(367), pages 630-653, September.
    5. Hasan, Mostafa Monzur & Habib, Ahsan, 2017. "Firm life cycle and idiosyncratic volatility," International Review of Financial Analysis, Elsevier, vol. 50(C), pages 164-175.
    6. Hasan, Mostafa Monzur & Hossain, Mahmud & Cheung, Adrian (Wai-Kong) & Habib, Ahsan, 2015. "Corporate life cycle and cost of equity capital," Journal of Contemporary Accounting and Economics, Elsevier, vol. 11(1), pages 46-60.
    7. Eugene F. Fama & Kenneth R. French, 2004. "The Capital Asset Pricing Model: Theory and Evidence," Journal of Economic Perspectives, American Economic Association, vol. 18(3), pages 25-46, Summer.
    8. Anthony, Joseph H. & Ramesh, K., 1992. "Association between accounting performance measures and stock prices : A test of the life cycle hypothesis," Journal of Accounting and Economics, Elsevier, vol. 15(2-3), pages 203-227, August.
    9. Pereiro, Luis E., 2006. "The practice of investment valuation in emerging markets: Evidence from Argentina," Journal of Multinational Financial Management, Elsevier, vol. 16(2), pages 160-183, April.
    10. Franck Bancel & Usha R. Mittoo, 2014. "The Gap between the Theory and Practice of Corporate Valuation: Survey of European Experts[We are ext]," Journal of Applied Corporate Finance, Morgan Stanley, vol. 26(4), pages 106-117, December.
    11. Robert E. Quinn & Kim Cameron, 1983. "Organizational Life Cycles and Shifting Criteria of Effectiveness: Some Preliminary Evidence," Management Science, INFORMS, vol. 29(1), pages 33-51, January.
    12. Klepper, Steven, 1996. "Entry, Exit, Growth, and Innovation over the Product Life Cycle," American Economic Review, American Economic Association, vol. 86(3), pages 562-583, June.
    13. Blume, Marshall E, 1975. "Betas and Their Regression Tendencies," Journal of Finance, American Finance Association, vol. 30(3), pages 785-795, June.
    14. Carhart, Mark M, 1997. "On Persistence in Mutual Fund Performance," Journal of Finance, American Finance Association, vol. 52(1), pages 57-82, March.
    15. Fama, Eugene F. & French, Kenneth R., 1993. "Common risk factors in the returns on stocks and bonds," Journal of Financial Economics, Elsevier, vol. 33(1), pages 3-56, February.
    16. William F. Sharpe, 1964. "Capital Asset Prices: A Theory Of Market Equilibrium Under Conditions Of Risk," Journal of Finance, American Finance Association, vol. 19(3), pages 425-442, September.
    17. Black, Fischer, 1972. "Capital Market Equilibrium with Restricted Borrowing," The Journal of Business, University of Chicago Press, vol. 45(3), pages 444-455, July.
    Full references (including those not matched with items on IDEAS)

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Ahsan Akbar & Minhas Akbar & Wenjin Tang & Muhammad Azeem Qureshi, 2019. "Is Bankruptcy Risk Tied to Corporate Life-Cycle? Evidence from Pakistan," Sustainability, MDPI, vol. 11(3), pages 1-22, January.
    2. Chen, Kuan-Hau & Su, Xuan-Qi & Lin, Li-Feng & Shih, Yi-Cheng, 2021. "Profitability of moving-average technical analysis over the firm life cycle: Evidence from Taiwan," Pacific-Basin Finance Journal, Elsevier, vol. 69(C).
    3. Hasan, Mostafa Monzur & Habib, Ahsan, 2017. "Firm life cycle and idiosyncratic volatility," International Review of Financial Analysis, Elsevier, vol. 50(C), pages 164-175.
    4. Shahzad, Farrukh & Ahmad, Munir & Fareed, Zeeshan & Wang, Zhenkun, 2022. "Innovation decisions through firm life cycle: A new evidence from emerging markets," International Review of Economics & Finance, Elsevier, vol. 78(C), pages 51-67.
    5. Habib, Ahsan & Hasan, Mostafa Monzur, 2019. "Corporate life cycle research in accounting, finance and corporate governance: A survey, and directions for future research," International Review of Financial Analysis, Elsevier, vol. 61(C), pages 188-201.
    6. Turan G. Bali & Robert F. Engle & Yi Tang, 2017. "Dynamic Conditional Beta Is Alive and Well in the Cross Section of Daily Stock Returns," Management Science, INFORMS, vol. 63(11), pages 3760-3779, November.
    7. Shahzad, Farrukh & Fareed, Zeeshan & Wang, Zhenkun & Shah, Syed Ghulam Meran, 2020. "Do idiosyncratic risk, market risk, and total risk matter during different firm life cycle stages?," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 537(C).
    8. Muhammad Ramzan & Wee‐Yeap Lau, 2023. "Impact of asset preferences on firm performance over its life cycle: Is agency theory or neo‐classical theory more relevant?," Managerial and Decision Economics, John Wiley & Sons, Ltd., vol. 44(1), pages 595-607, January.
    9. Amit Goyal, 2012. "Empirical cross-sectional asset pricing: a survey," Financial Markets and Portfolio Management, Springer;Swiss Society for Financial Market Research, vol. 26(1), pages 3-38, March.
    10. Hasan, Mostafa Monzur & Cheung, Adrian (Wai-Kong), 2018. "Organization capital and firm life cycle," Journal of Corporate Finance, Elsevier, vol. 48(C), pages 556-578.
    11. Ahsan Habib & Md. Borhan Uddin Bhuiyan & Mostafa Monzur Hasan, 2018. "Firm life cycle and advisory directors," Australian Journal of Management, Australian School of Business, vol. 43(4), pages 575-592, November.
    12. Desrousseaux, Luc, 2023. "Are activist hedge funds good business advisors?," Economic Modelling, Elsevier, vol. 125(C).
    13. Montone, Maurizio, 2023. "Beta, value, and growth: Do dichotomous risk-preferences explain stock returns?," Journal of Behavioral and Experimental Finance, Elsevier, vol. 39(C).
    14. Kaserer Christoph & Hanauer Matthias X., 2017. "25 Jahre Fama-French-Modell: Erklärungsgehalt, Anomalien und praktische Implikationen," Perspektiven der Wirtschaftspolitik, De Gruyter, vol. 18(2), pages 98-116, June.
    15. Muhammad Atif & Benjamin Liu & Sivathaasan Nadarajah, 2022. "The effect of corporate environmental, social and governance disclosure on cash holdings: Life‐cycle perspective," Business Strategy and the Environment, Wiley Blackwell, vol. 31(5), pages 2193-2212, July.
    16. Pasaribu, Rowland Bismark Fernando, 2010. "Pemilihan Model Asset Pricing [Asset pricing model selection: Indonesian Stock Exchange]," MPRA Paper 36978, University Library of Munich, Germany.
    17. Paul Schneider & Christian Wagner & Josef Zechner, 2020. "Low‐Risk Anomalies?," Journal of Finance, American Finance Association, vol. 75(5), pages 2673-2718, October.
    18. Minhas Akbar & Ahsan Akbar & Petra Maresova & Minghui Yang & Hafiz Muhammad Arshad, 2020. "Unraveling the Bankruptcy Risk‒Return Paradox across the Corporate Life Cycle," Sustainability, MDPI, vol. 12(9), pages 1-19, April.
    19. Biswas, Pallab Kumar & Habib, Ahsan & Ranasinghe, Dinithi, 2022. "Firm life cycle and financial statement comparability," Advances in accounting, Elsevier, vol. 58(C).
    20. Güler ARAS & İlhan ÇAM & Bilal ZAVALSIZ & Serkan KESKİN, 2018. "Fama-French Çok Faktör Varlık Fiyatlama Modellerinin Performanslarının Karşılaştırılması: Borsa İstanbul Üzerine Bir Uygulama," Istanbul Business Research, Istanbul University Business School, vol. 47(2), pages 183-207, November.

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:bpj:jbvela:v:14:y:2019:i:1:p:14:n:3. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Peter Golla (email available below). General contact details of provider: https://www.degruyter.com .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.