Determinants of Sectoral Cost of Equity for an Emerging Market: The Case of Malaysian Firms

Abstract

The use of capital asset pricing model (CAPM) in measuring cost of equity for emerging markets with the assumptions that the markets are either fully integrated or completely segmented has come under question. Among them, Harvey (1995) and Erb et al. (1996) found no significant relation between standard CAPM’s beta with expected returns. Hence, the current study proposes modifications to the CAPM so that the characteristic of partial integration of emerging markets into the world market is better reflected in the model. The downside risks proposed by Estrada (2000) were also considered. Annual estimates of cost of equity were obtained for 354 firms categorised into seven sectors in the stock exchange for the period 2001-2008. The results showed that the downside risk of the semi-deviation approach provides the most relevant measure for calculating cost of equity. In the second part of this study, semi-deviation estimates were employed to investigate determinants of cost of equity. Pooled, fixed-effect, randomeffect, and dynamic difference- and system-GMM panel models were considered. The results showed that the determinants of cost of equity are not necessarily the same across different sectors, thereby highlighting the importance of sectoral analysis. Several implications were derived from the results of this study.