R&D expenditures and implied equity risk premiums

• Published in: Review of quantitative finance and accounting Vol. 43; no. 3; pp. 441 - 462
• Main Authors: Alam, Pervaiz, Liu, Min, Peng, Xiaofeng
• Format: Journal Article
• Language: English
• Published: Boston Springer US 01-10-2014; Springer Nature B.V
• Subjects: Accounting; Accounting/Auditing; Analysis; Asymmetry; Bond ratings; Capital expenditures; Corporate Finance; Cost of capital; Costs; Earnings; Econometrics; Economics and Finance; Equity capital; Finance; Hypotheses; Information sources; Investments; Operations Research/Decision Theory; Original Research; Portfolio management; R&D; Rates of return; Research & development; Research & development expenditures; Return on assets; Risk factors; Risk premiums; Stock prices; Studies; Valuation; Risk premium; Market adjusted return; R&D; G11; Cost of capital; Portfolio choice; Abnormal return; M40; M41; O30
• ISSN: 0924-865X; 1573-7179
• DOI: 10.1007/s11156-013-0381-9

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.