Proceedings of Applied International Business Conference 2008
COST OF EQUITY IN MALAYSIA:
HAVE THEY CHANGED FOR THE BETTER OR WORSE?
Foong Swee Sim
ψ
and Goh Kim Leng
University of Malaya, Malaysia
Abstract
Cost of equity is a crucial factor in investment decisions. Several studies document evidence for a clear
decline in cost of equity following the liberalization and deregulation of world financial market. This
study aims to examine the change in cost of equity for the Malaysian stock market at the sectoral level.
The popular Capital Asset Pricing Model (CAPM) is used to measure cost of equity for the period
2000- 2006. Overall, declining cost of equity is observed for most sectors up to 2004. Finance, Trade &
Service and Tin & Mining experienced the sharpest decline in cost of equity. Interestingly, Finance and
Trade & Service have the largest market capitalization. The findings suggest a possible link between
size and cost of equity for the Malaysian market. Sectors that are smaller in size tend to show higher
cost of equity while larger sectors are most likely to enjoy a reduction in cost of equity.
Keywords: CAPM; Cost of equity; Sectoral analysis.
JEL Classification Codes: G10; F30.
1. Introduction
The past four decades witnessed gradual openness of developing countries to international trade as part
of their quest for economic and social progress. The surge in capital flows into emerging markets in the
1990s has been remarkable. The share of foreign direct investment (FDI) inflows to developing
countries increased from 18% during the period of 1986-1990 to 25% in 2002 (United Nations, 2008).
Among others, Malaysia has emerged as an important investment destination for many world largest
transnational corporations. In 2007, FDI net inflows for Malaysia rose by 54.4% to reach $9.4 billion,
with manufacturing, particularly the electrical and electronics subsector, contributing more than half
the total (Asian Development Bank, 2008).
Liberalization of financial markets can accelerate the decline in cost of equity as a market becomes
internationally integrated. Some believe emerging markets should have a higher cost of capital than
their developed counterparts because they tend to be less integrated with global markets. Harvey (1995)
reveals that the cost of capital in non-integrated markets is higher than in integrated markets because
investors will require compensation for bearing the local risk. Accordingly, Stulz (1999) suggests that a
market should experience a decline in cost of equity as it becomes internationally integrated. Bekaert
and Harvey (2000) found that liberalization in financial markets brings about a clear decline in the cost
of equity. Collins and Abrahamson (2006) also reported a decline in cost of equity between mid-1990s
and early 2000s for the African markets.
The cost of equity is a crucial consideration before any investment decision is made. Under normal
circumstances, lower cost of equity is desirable because it means a lower cost of borrowing for firms.
The higher the cost of equity, the harder a firm has to work to earn returns that surpass the hurdle rate
to compensate stockholders. At industry level, low equity cost may lead to economic growth, especially
if it involves the larger sector in the market. If firms take advantage of the lower cost of equity to raise
capital for business expansion, the impact on economic growth can be significant. Given the potential
gain from a lower cost of equity, it is the interest of this study to explore the case for the Malaysian
industries.
Specifically, this study aims to examine the change in cost of equity for Malaysia by conducting a
sectoral analysis on the stock market. Overall, declining cost of equity is observed for most sectors up
ψ
Corresponding author: Foong Swee Sim, Department of Applied Statistics, Faculty of Economics and
Administration, University of Malaya, 50603 Kuala Lumpur. Corresponding author Email:
[email protected]
Proceedings of Applied International Business Conference 2008
to 2004 but it turned to an uptrend thereafter. As with the results from Collins and Abrahamson (2006),
we also document a link between size and change in cost of equity.
This paper consists of four further sections. The next section provides the motivation for sectoral level
analysis. Section 3 describes the method used in measuring cost of equity. Section 4 presents the results
across sectors. Section 5 concludes and discusses possible implications of the results.
2. Sectoral Cost of Equity
It is not an easy task to measure cost of equity although the best-selling finance textbooks will gladly
point out the constant growth dividend model (also known as the Gordon model), and Capital Asset
Pricing Model (CAPM) as the approaches commonly used in estimating cost of equity. For the
domestic market, CAPM of Sharpe (1964) and Lintner (1965) becomes the dominant theory of
determination of prices of financial securities. Nonetheless, CAPM is subject to various disputes
among academics, from how to measure the risk-free rate of return to estimating equity market risk
premium. Not to mention the controversial use of beta as the only risk measure in the model. Despite
the criticisms, CAPM remains the preferred model by firms for estimating cost of equity (Bruner et al.,
1998).
The use of a sectoral cost of equity overcomes a critical bias in measuring the cost of equity at the
market level. Bekaert and Harvey (1995, p.436) note that a country market return may be weakly or
negatively correlated to the world market return even though it could be perfectly integrated into the
world market, due to its industry mix that is grossly different from the average world mix. An early
paper by Lessard (1974), although documented evidence that place greater importance of national risk
factors relative to industry factors, found significance of an industry factor on the proportion of an
individual stock returns that was unexplained by a world market factor. An important implication from
his results is that the industry factor plays a significant role in explaining the variation of market returns.
Based on equity price indices for 24 countries (including Malaysia), Roll (1992) found that the industry
factor is more important than the exchange rate in explaining stock price behaviour for most countries.
A recent study by Hardouvelis et al. (2007) reveals a strong convergence in the cost of equity across
the member countries of European Union (EU) within a given industrial sector, but little convergence
across the different sectors of a given EU country. The implication for portfolio managers is that
sectoral effects are becoming more important.
3. Methodology
In general, the measure of cost of equity can be summarized as follows:
Cost of Equity = Risk-free Rate + Risk Measure x Market Risk Premium
(1)
Equation (1) basically states that the cost of equity of a firm is comprised of a risk-free rate and the
market risk premium multiplied by some risk measure for the firm. Traditionally, the above measure of
cost of equity has been estimated via a CAPM-based model. The main prediction of the CAPM is
highly consistent with equation (1) where the expected return of an asset is the sum of a risk-free rate
and a risk premium calculated from the asset’s beta and the market risk premium. In CAPM, beta is
linearly related with the expected return and there is no other explanation for variations in expected
return.
Accordingly, the sectoral cost of equity can be written in the following CAPM model:
(
)
CEit = R ft + β i Rmt − R ft + ε it
(2)
where CEit is the rate of return on sector i during period t, R ft is the return on the risk-free asset
during period t, β i signifies systematic risk for sector i, Rmt is the return on the market, and ε it is the
residual or unsystematic risk for sector i.
In the case of Malaysia, one problem that arises with the use of CAPM for calculation of the cost of
equity is the estimation of the market risk premium, Rmt − R ft . Even in a developed market like the
U.S., the calculation of the market risk premium remains the most controversial issue surrounding the
cost of equity determination. Emerging markets have relatively much shorter time series data as
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Proceedings of Applied International Business Conference 2008
compared to the U.S., which has at least a 60 year-long series. Therefore, for Malaysia where the length
of time series available is limited, the calculated market risk premium may turn out to be negative.
To solve the problem, this study applies the data derived by Damodaran using the approach of
sovereign bond premium (Damodaran, 2003). He argues that the equity risk premium of an emerging
economy may be computed as the sum of the premium in a developed market (e.g., the U.S.) and a
country risk premium, given as below:
Emerging Market Risk Premium = Base Premium for Mature Equity Market + Country Premium
(3)
The country premium for the emerging market basically measures the additional risk taken by investors
in transferring their capital from a mature or developed market, to a relatively risky market. To estimate
the long-term country risk premium, Damodaran starts by looking at a country’s rating. He then
estimate the default spread for that rating (based upon traded country bonds) over a default free
government bond rate. This becomes a measure of the added risk premium for the particular country.
This default spread is later added to the historical risk premium for a mature equity market (estimated
from US historical data) to estimate the risk premium for an emerging market.
For this study, the sample period covers January 2000 till December 2006. Observations on annual
market risk premium for Malaysia are collected from Damodaran’s website. This series is calculated
based on the approach of sovereign bond premium. Other time-series data are collected from
DataStream. The weekly price indices for the sectors listed on the Main Board of Bursa Malaysia (Jan
5, 2000 – Dec 27, 2006) are obtained to generate the annual betas for each sector based on the market
model that relates sectoral returns to market returns. These annual betas are later used in the CAPM
model in equation (2) to estimate the annual cost of equity.1 Weekly frequency is preferable because
daily series has more noise. The annual averages of the monthly 3-month treasury bills rate of Malaysia
are used for the risk-free rate.
Price indices are available for 10 sectors in Malaysia. They are Construction, Consumer Products,
Finance, Industrial, Industrial Products, Plantations, Properties, Trade & Services, Technology, and Tin
& Mining. Table 1 provides the average market capitalization of each sector and the weight of that
sector for the period 2000-2006. Trade and Services appear to have the largest market capitalization
with a weighting of 34.21%. The second and third largest sector, Finance and Industrial, have a
weighting of 19.40% and 14.07%, respectively. Together, the trio constitute about 70% of the market
capitalization for all sectors in the Main Board. This scenario questions the appropriateness of a
market-level analysis and makes the argument for a sectoral-level analysis even more relevant
Table 1: Average sectoral market capitalization (2000-2006)
Market
Capitalization
(RM million)
Weight (%)
Trade & Service
212608.86
34.21
Finance
120554.57
19.40
Industrial
87404.71
14.07
Industrial Products
55438.00
8.92
Consumer Products
49999.00
8.05
Plantations
32863.57
5.29
Properties
28695.29
4.62
Construction
24255.14
3.90
Technology
8447.86
1.36
Tin & Mining
1159.43
Source: Calculated based on data from DataStream.
0.19
Sector
1
For the weekly series, Wednesday closing prices are collected to avoid Monday and Friday effects.
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Proceedings of Applied International Business Conference 2008
4. Results and Discussion
Table 2 reports the descriptive statistics for the estimated annual beta for all the sectors, as well as
those for the 3-month treasury bills rate, and equity risk premium.2 Generally, half the sectors have
average beta values of more than 1. Construction has the highest average beta, followed by Technology,
Tin & Mining, Finance, and Trade & Service. These sectors are more responsive to changes in the
market portfolio. On the other hand, another half of the sectors have beta values of less than 1. These
are generally sectoral portfolios that are defensive. Construction, Technology and Tin & Mining also
have among the highest standard deviation for the estimated beta, showing greater uncertainties relative
to the other sectors. Among the five defensive sectors, Consumer Products is least sensitive to market
movements and its standard deviation is also the lowest among all.
Based on the estimated annual beta, the cost of equity is calculated and reported in Table 3. Over the
years, the cost of equity ranges from 5.61% (Consumer Products) to 15.05% (Construction), with most
values averaging at about 9%. The sectors that seem to have the lowest cost of equity are Consumer
Products, Industrial, and Plantations, with an average cost of equity of 6.55%, 7.54% and 7.70%,
respectively. These sectors reflect, on average, lower volatility than the other sectors. On the other hand,
Construction, Technology, and Tin & Mining have the highest cost of equity, reflecting higher
volatility and higher risk than the other sectors. They have an average cost of equity of 10.73%,
10.60% and 10.25%, respectively. These results compliment those given in Table 2 where Construction,
Technology, and Tin & Mining are also found to have more risk (higher beta) and higher volatility
(greater standard deviation).
Table 2: Descriptive statistics for beta, risk free rate and market risk premium
for 2000-2006 (in percentage)
Sector
Construction
Consumer Products
Finance
Industrial
Industrial Products
Plantations
Properties
Trade & Service
Technology
Tin & Mining
Risk Free Rate
Market Risk Premium
Mean
1.2486
0.5886
1.1100
0.7443
0.8514
0.7729
0.9629
1.0671
1.2171
1.1600
2.7571
6.4286
Maximum
1.9100
0.7000
1.1900
0.9000
1.0800
1.2000
1.2500
1.2600
1.8200
1.7600
3.2417
6.8100
Minimum
0.8200
0.4700
0.9700
0.6100
0.6800
0.5600
0.7900
0.9800
0.8300
0.6500
2.3917
6.1500
Standard Deviation
0.3449
0.0855
0.0900
0.1233
0.1260
0.2295
0.2002
0.0959
0.3250
0.3552
0.2712
0.2886
Table 3: Estimated sectoral cost of equity for 2000 to 2006 (in percentage)
Sector
Construction
Consumer Products
Finance
Industrial
Industrial Products
Plantations
Properties
Trade & Service
Technology
Tin & Mining
2000
10.53
7.26
9.70
8.77
8.88
7.33
9.33
10.25
11.01
10.23
2001
8.38
6.02
10.88
6.94
7.42
6.59
8.55
11.35
11.18
11.86
2002
9.83
6.23
10.34
7.23
7.53
7.72
7.90
9.82
11.91
14.20
2
2003
11.80
6.51
10.22
6.61
8.16
7.11
10.52
9.38
14.15
10.84
2004
9.41
5.61
9.42
6.74
7.85
8.37
7.86
8.68
8.58
7.83
2005
10.08
6.60
9.47
8.06
7.72
6.11
7.36
8.69
7.64
9.51
2006
15.05
7.59
9.26
8.45
9.91
10.66
10.95
9.30
9.69
7.26
Average
10.73
6.55
9.90
7.54
8.21
7.70
8.92
9.64
10.60
10.25
Annual betas are estimated using weekly series for the year. The approach is to run a market model,
where the sectoral returns are regressed solely on market returns. The annual regression results for ten
sectors over six years of sample are not reported here to conserve space. They are available upon
request.
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Proceedings of Applied International Business Conference 2008
The results on the annual percentage change in cost of equity from year 2000 to 2006 are presented in
Table 4. Clearly, the most noticeable feature of the results is that most sectors show a decline in cost of
equity up to year 2004. With only three sectors showing a decline in percentage change in 2002, this
number increased to eight in year 2004. In 2005, however, six out of 10 sectors witnessed an increase
in cost of equity. There are eight sectors that experienced an increase in cost of equity in the following
year. It is interesting to note that Finance is the only sector showing a constant decline in cost of equity
every year, except for a slight increase in 2005 (a small change of 0.57% from previous year). This
finding is not surprising as the domestic banking institutions have undergone major consolidation after
the announcement of the merger initiated by the Government in 1999. Tan and Hooy (2004) found that
bank stocks enjoy a reduction in volatility in the post-announcement period. Their results support the
fact that the consolidation has promoted stability in the banking industry and absorbed much of the
risks that evolved from the 1997 financial crisis.
Overall, majority of the sectors have seen an increase in cost of equity after 2004. Recall that the cost
of equity comprises a risk-free rate and an equity risk premium. In turn, the equity risk premium is
given by a risk measure multiplied by the market risk premium. Hence, the sources of variation over
time are attributed to these three components, namely, the risk-free rate, the risk measure and/or the
market risk premium. The Malaysian treasury bills rate has increased from 2.86% to 3.24% in the
sample period. The risk measure, beta, has also increased in many sectors, for example, Construction,
Consumer Products, Industrial Products, Plantations, and Properties. On the contrary, market risk
premium has steadily decreased over the years, from 6.81% in 2000 to 6.19% in 2006. Since all sectors
are exposed to the same risk-free rate and market risk premium, beta would be the main source for the
differences in cost of equity between sectors. In other words, the sector’s own riskiness has
differentiated itself from the other sectors.
Of the 10 sectors, three sectors recorded, on average, a decline in cost of equity over the sample period.
They are the Finance, Trade & Service, and Tin & Mining sector. What could have caused this decline?
Collins and Abrahamson (2006) discovered a link between size and change in cost of equity. They
found that a larger or dominant sector in a market tends to have low and declining cost of equity. Their
argument proved to provide some merits as Finance and Trade & Service are the two largest sectors in
terms of capitalization in the Malaysian market. It does not, however, explain for the declining cost of
equity for Tin & Mining sector, the smallest sector in the Malaysian market.
Table 4: Annual percentage change of the estimated sectoral cost of equity for 2000 to 2006
Sector
2001
2002
2003
2004
2005
2006 Average
Construction
-20.47
17.35
20.07
-20.25
7.09
49.34
8.85
Consumer Products
-17.16
3.58
4.53
-13.80
17.57
15.07
1.63
Finance
12.19
-4.94
-1.20
-7.87
0.57
-2.24
-0.58
Industrial
-20.85
4.23
-8.61
1.92
19.65
4.80
0.19
Industrial Products
-16.41
1.43
8.33
-3.76
-1.67
28.44
2.73
Plantations
-10.02
17.07
-7.87
17.66
-26.97
74.38
10.71
Properties
-8.28
-7.68
33.21
-25.25
-6.45
48.86
5.73
Trade & Service
10.68
-13.47
-4.51
-7.43
0.18
6.93
-1.27
Technology
1.61
6.51
18.82
-39.34
-11.00
26.87
0.58
Tin & Mining
15.94
19.68
-23.66
-27.72
21.34
-23.62
-3.01
5. Conclusion
The objective of this study is to examine the change in cost of equity in the Malaysian stock market.
The analysis is conducted at the sectoral level. The widely used CAPM is applied in measuring cost of
equity for the period from 2000 to 2006. Overall, there are declines in the cost of equity for most
sectors starting from 2001. The drop is the largest in 2004, with a decline as much as 39% in the
Technology sector. However, in 2005, the cost of equity for more than half of the sectors started to
increase. It also implies an increase in the risk in these sectors.
Interestingly, although Consumer Products, Industrial, and Plantations have the lowest average cost of
equity for the sample period, they do not experience a decline over time. On the contrary, Finance and
Trade & Service which have above average cost of equity, experienced the sharpest decline in the
entire sample period. These sectors have the largest market capitalization. The results lend support to
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Proceedings of Applied International Business Conference 2008
the tendency for declining cost of equity in the dominant sectors. On the other hand, the average
decline in cost of equity is the sharpest for Tin & Mining that has the smallest market capitalization.
This finding warrants further investigation.
The findings from this study have shown a possible link between size and cost of equity for the
Malaysian market. Sectors that are smaller in size tend to show higher cost of equity while larger
sectors are most likely to enjoy a reduction in cost of equity. Therefore, measures to help local firms to
expand are essential for reducing their cost of equity. If firms in the larger sectors take advantage of the
lower cost of equity to raise capital for business expansion, the growth in the sector will have positive
spillover effect to the economy.
Acknowledgement
The first author is a PhD candidate at the University of Malaya. She is grateful for the sponsorship
under the University of Science Malaysia Fellowship Scheme. This research is supported by the
University of Malaya PPP Research Grant (PS076/2008A). The usual disclaimer regarding errors and
omissions applies.
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