R&D Expenditures and Implied Equity Risk Premium

41 Pages Posted: 17 Jan 2011

See all articles by Xiaofeng Peng

Xiaofeng Peng

University of Toledo - College of Business and Innovation

Pervaiz Alam

Kent State University

Date Written: January 16, 2011

Abstract

This study investigates the relationship between research and development (R&D) expenditures and risk premiums implied in costs of equity capital. We posit a positive association between R&D expenditures and implied equity risk premiums because R&D expenditures represent information risk by creating both information asymmetry between investors and managers and low-quality reporting for R&D. Consistent with our hypothesis, we report a significantly positive relationship between R&D expenditures and risk premiums implied in costs of equity capital. Sensitivity tests continue to support our hypothesis. Our results add to risk explanation for the association between firms’ R&D capitals and subsequent stock returns by showing a direct relationship between R&D expenditures and risk premiums implied in costs of equity capital. Our study also extends prior literature on information risk by presenting R&D expenditures as sources of information asymmetry and low-quality reporting to explain 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 opportunity to earn excess returns in short to long horizon. Accounting standard setters can benefit from this study along with relevant research 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 to some degree. This study is subject to the limitations in calculating risk premiums implied in costs of equity capital.

Keywords: R&D, risk premium, cost of capital, future benefit variability, market adjusted return

JEL Classification: M41

Suggested Citation

Peng, Xiaofeng and Alam, Pervaiz, R&D Expenditures and Implied Equity Risk Premium (January 16, 2011). CAAA Annual Conference 2011, Available at SSRN: https://ssrn.com/abstract=1742150 or http://dx.doi.org/10.2139/ssrn.1742150

Xiaofeng Peng (Contact Author)

University of Toledo - College of Business and Innovation ( email )

United States

Pervaiz Alam

Kent State University ( email )

P.O. Box 5190
Kent, OH 44242-0001
United States
330-672-1121 (Phone)
330-672-2548 (Fax)

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