The Impact of the Research and Development Expenditures of the Firm on its Equity Cost of Capital

Research and development expenditures (R&D) include the expenses on those activities of the firm which were undertaken in order to facilitate the elaboration of new knowledge or the development of a new product. Due to imperfect disclosure of these expenditures in the firm`s financial statements, outside investors encounter significant difficulties while attempt to evaluate future benefits from R&D expenditures. More than that, R&D expenditures of the firm put a strain on its retained earnings in the period when they were incurred. Hence, investors may, ceteris paribus, demand higher return on equity for the firm with higher R&D expenditures. The aim of this article is therefore to investigate the influence that R&D expenditures of the firm exert on its equity cost of capital, employing a mixed sample, which consists of both developed (Republic of Korea, Finland, and Israel) and developing (Russia, Brazil, Poland, and South Africa) capital markets. As R&D expenditures of the firm may correlate positively with its size, the R&D variable was scaled by either the firm`s revenue or its market capitalization, resulting in the so-called R&D-intensity of the firm. For the purpose of investigating the relationship between the R&D expenditures of the firm and its equity cost of capital, the author resorts to various techniques, which involve double-sorting Fama and French (1993) approach to forming portfolios, a three-factor asset pricing model elaborated by the author himself, and Fama and MacBeth (1973) two-step procedure. Employing these empirical instruments, the author succeeds in discovering a statistically significant R&D expenditures-cost of equity relationship, affirms all proposed hypotheses and resolves all set goals. In addition, the author retrieves possible drawbacks of this three-factor asset pricing model, and suggests approaches to adjusting it appropriately.