The Effect of Free Float on Cost of Equity Capital in the Companies Listed in Tehran Stock Exchange

Transcription

1 International Journal of Basic Sciences & Applied Research. Vol., 2 (6), , 2013 Available online at ISSN VictorQuest Publications The Effect of Free Float on Cost of Equity Capital in the Companies Listed in Tehran Stock Exchange Moslem Rostami*, Driush Javid, Mahmoud Hematfar Department of Accounting, Borujerd Branch, Islamic Azad University, Borujerd, iran *Corresponding Author iran8878@yahoo.com Abstract The present study aimed to investigate the effect of free float on the cost of equity capital in the companies listed in Tehran Stock Exchange (TSE). In this regard, the research hypothesis was developed to propose that there is a significant relationship between free float and the cost of equity capital. A number of 65 companies listed in TSE were selected as the sample. The research hypothesis was examined using linear regression analysis and correlation coefficient. The results showed a significant positive relationship between free float and the cost of equity capital. This suggests that, although increased free float percentage may increase stock trading, it will increase the cost of equity capital in practice and affect shareholders assets. Keywords: Free float percentage, Cost of equity capital. Introduction Accounting objectives originate from information needs of the users. The main goal of accounting is reporting financial status and performance of enterprises for extra-organizational users, which may help them make financial decisions and investment. Basic financial statements are the main tool of conveying information to investors. Every company has its own risks and returns. Each category of investors such as bondholders, holders of preferred and common stocks demand certain levels of returns that meet their risks. Cost of capital is the minimum return rate that a company needs to attain in order to meet the investors expectations of returns. The main application of the concept of cost of capital may be laid down as follows: shareholders wealth will increase when the rate of return on investment exceeds its cost of capital and once the return increases without increased levels of risk. The reason is that when the return rate exceeds the cost of capital in a company, bondholders and holders of preferred stock will achieve their stable return as they expect while the remainder of the return will be allocated to the holders of common stock that exceeds their expected return. Free float is a percentage of company shares that are traded in the exchange market so that investors may buy and/or sell these shares. Considering the fact that cost of capital is the minimum rate that a company pays to attract investors, increased free float percentage on offer may prove effective only when the cost of equity capital increases. This is because the cost of equity capital changes return on equity so that investors show interest in trading shares. In the current study, we aim to address the question how much the variations of free float will affect the cost of equity capital in the companies listed in TSE. Literature review In their study entitled the effect of conditional conservatism on the cost of common stocks, Hashemi et al (2011) investigated the two factors of conditional conservatism and the cost of common stock together. They used Fama French threefactor model to study the effect of conditional conservatism on the cost of common stock at the company and stock portfolio levels. The results showed a positive relationship between conditional conservatism and the capital cost of common stock portfolio. This relationship maintains true about the stock portfolio in companies with moderate and high conservatism. However, it is not significant about the stock portfolio in the companies with low conservatism. Chan et al (2004) investigated the role of free float in stock liquidity. They studied the market sections where there were no adverse changes in the liquidity of shareholders market. Similar to the results obtained from free float, they found that the groups controlling stocks outside free float played influential roles in price changes (lotfi, 2004). Rahmani & Fallah Nezhad (2010) conducted a study entitled the effect of the quality of accruals on the cost of common stock.they investigated the effect of accruals on the cost of common stock in 107 companies over six years. They reported a significant relationship between the quality of accruals and the cost of common stock. They found a stronger relationship between 536

2 the discretionary component of accruals and the cost of common stock comparing with the non- discretionary component. In their paper entitled quality characteristics of profit and cost of common stock, Kurdestani & Majdi (2007) studied the relations of five properties of earnings quality including stability, predictability, profit-to-equity relevance, timeliness and conservatism with the cost of common stock. The results showed a significant negative correlation between the quality characteristics of earnings and the cost of common stock. However, there was no significant relationship between earnings conservatism and the cost of common stock. Hail and Leuz (2003) examined international differences in the cost of equity capital in 40 countries. They considered security provisions and legal persons of organizations as two important factors contributing to differences. They used four models to predict cost of equity capital. The results showed that the cost of equity capital was lower in countries with strict security provisions and compulsory technology use comparing with the countries with weak legal persons even after risk factor and other influential factors were controlled (Lotfi, 2004). Kashani Pur & Rezaie (2011) conducted a study entitled the effect of free float variations on return on equity in the companies listed in Tehran Stock Exchange. They studied a number of 147 companies over a five year period. The results showed that variations in free float volume bear informational content and significantly reduce return on equity in the companies. Moreover, the results revealed that free float variations exert variable effects on different industries. Ashbaugh et al (2006) investigated the cost of equity capital in public companies. They studied the effect of four components including the quality of financial information, ownership structure, shareholders rights and the structure of board of directors on the cost of equity capital. In their study entitled the effect of free float on liquidity indices in Tehran Stock Exchange, Abbasi & Marzlu (2011) reported that the liquidity indices in the companies with minimum 20% free float were higher than those in the companies with less than 20% free float. The former companies had greater mean number of trading days comparing with the latter companies. Furthermore, there was a negative correlation between the free float percentage and price-earnings ratio; however, the correlation was not statistically significant. Asgari & Iran Pak (2010) studied the effect of free float volume on variation in equity prices in the companies listed in Tehran Stock Exchange in order to seek solutions to the problem. They reported that one of the main objectives of stock markets is to create a regular, transparent mechanism in balancing supply and demand to determine the prices of financial assets. Actual and transparent equity prices are one of the main factors contributing to investors decision to make investments in the stock market. Free float is one of such factors that may increase the volume of trading and decrease stagnant liquidity in the market. The researchers aimed to find approaches so that investors and companies could make more informed decisions in decision-making and releasing tradable shares, respectively. They conducted a descriptive study whereby the independent and dependent variables were free float and equity prices, respectively. Their hypotheses addressed the possible relationship between these two factors across different companies and industries. Considering their aims and objectives, the researchers used simple, linear regression and panel analysis to test research hypotheses. The study was conducted over a four year period from 2005 to 2008 in Tehran Stock Exchange. The inclusion criteria for the statistical population was then determined and a number of 45 companies were selected as the sample. The results showed a significant positive relationship between free float and variations in equity prices. The correlation was different in different industries, though. Cummins and Phillips (2003) addressed the estimating role of the cost of equity capital in creating assets and liabilities resources. They used β coefficient and capm to estimate assets and liabilities. The results showed that a good estimation of assets and liabilities may be a significant factor in predicting the cost of equity capital and equity prices. Vakili Fard (2010) studied the effect of free float in crating price bubbles. They reported that the price index dropped in TSE in Experts and authorities attributed the problem to different factors; however, they generally reported dramatic increase in prices in 2003 and the first half of 2004 as the main reason for price reduction. In economic literature, bubble is the price deviation of commodity market from the equilibrium price. In fact, a bubble occurs when the price of an asset deviates from its inherent value, which is determined by basic factors, and suddenly drops. The researchers studied the relationship between free float and price bubble in the companies listed in TSE. Free float is the percentage of company assets released for trading in the stock market and investors have no limitation in trading such assets. The results of testing hypotheses over 2002 to 2006 showed a significant relationship between free float and price bubble in the companies so that the companies with less than 20% free float were exposed to bubbles comparing with other companies. Methodology In the present study, Gordon growth model was used to calculate the cost of equity capital. Based on Gordon growth model, the stock price is obtained from the following equation: Considering K as the cost of common stock, it can be obtained from the following equation: Where: 535

3 D, is the cash dividend paid per share following the subtraction of increased capital from receivables and cash capital. P, is the price of every share at the beginning of the year. G, is the growth rate of dividend that equals the geometric mean of dividend growth rate. TSE reports, issued quarterly and once collectively at the end of the year, were used to estimate free float in the companies. Pearson correlation coefficient and linear regression analysis were used to examine the relationship between the variables. Results Table 1 illustrates the results of descriptive statistics of the data using SPSS software. Table 1. Descriptive statistics of the research variables. Statistics Cost of equity capital Free float No. of observations Mean Standard error of the mean Median Mode SD Variance Skewness Standard error of skewness Kurtosis Standard error of kurtosis Range Minimum Maximum Total The normality of the research data is one of the assumptions that is considered in using statistical models. When the data on research variables are not normally distributed, non-parametric tests should be used to test research hypotheses. Kolmogorov- Smirnov test was run to examine the normality of the data. In this regard, H0 and H1 hypotheses are as follows: H0 : Variables are normally distributed. H1 : Variables are non-normally distributed. Considering the defined statistical hypotheses, when Sig. is larger than 0.05, H0 is supported. Otherwise, it is rejected. If H0 is rejected, the research variables are non-normally distributed. Table 2 illustrates the results of Kolmogorov-Smirnov test. Table 2. Kolmogorov-Smirnov results of testing the normality of the dependent variable. Description Sig. Kolmogorov-Smirnov test Sig As Sig. is larger than 0.05, H0 is supported, which means that the data on the dependent variable are normally distributed so that the results may be generalized to the population. Lack of correlation among the errors of the model One of the assumptions of the regression model is that the errors of the regression model do not correlate; that is, the errors of the model are independent. In this regard, Durbin Watson test was run to assure the independence of the errors, which yielded a Durbin Watson coefficient of As the obtained value falls within range, there is not a high correlation between the errors of the model. The research hypotheses developed in the present study are as follows: H0 : There is not any positive correlation between timeliness and the cost of equity capital. H1 : There is a positive correlation between timeliness and the cost of equity capital. Considering the output of SPSS software as enclosed in the Appendix section, the level of significance is that is smaller than 0.05; therefore, H1 is supported but H0 is rejected. This suggests that there is a significant positive relationship between timely information disclosure and the cost of equity capital. 536

4 Table 3. Regression results of testing the research hypothesis. Coefficient of Adjusted coefficient of Mean coefficient of Description Fisher s statistic Sig H0 : There is not any significant correlation between free float and the cost of equity capital. H1 : There is a significant correlation between free float and the cost of equity capital. The results of statistical analysis on the above hypothesis showed that the level of significance is that is smaller than 0.05; thus, H1 is supported but H0 is rejected. In other words, there is a correlation between free float and the cost of equity capital. As the correlation between the two variables is positive, increased free float percentage increases the cost of equity capital. Table 4. Correlation coefficient between research hypotheses. Description Cost of equity capital Free float Cost of equity capital Correlation coefficient Sig Free float Correlation coefficient Sig Discussion and Conclusion One of the issues currently raised in Iran and attended to by investors in selection and purchase of stock is the amount of free float of companies. In the present study, we investigated the relationship between free float and the cost of equity capital in the companies listed in TSE. The study adopted a quasi-experimental design. The independent and dependent variables were considered to be free float and the cost of equity capital, respectively. The study aimed to shed light on the importance of free float in global stock markets so that Iranian investors and companies would understand and notice the importance and the relationship between free float and the cost of equity capital. The results of statistical analysis supported the research hypothesis. The results of Pearson correlation coefficient showed a positive correlation between the independent and dependent variables so that increased free float percentage would increase the cost of common stock. Since increased free float increases the cost of common stock in companies, investors may make decisions on their expected return on equity and the cost of common stocks based on identification of free float. Tehran Securities Exchange Organization may use the present findings to introduce regulations based on the effect of free float on investors expected return on equity, the cost of common stocks and stock portfolio. Considering the present finding indicating a positive relationship between free float and the cost of common stocks, investors and analysts are recommended to notice free float information besides other information in making investment decisions. TSE companies are recommended to find a range of free float that would ensure the investors of the real prices and lack of price manipulation due to the accumulation of shares. It is recommended that future studies use other measures to examine the cost of common stock as discussed in the literature review in order to compare their findings with the present findings. Further topics for future studies may include investigating the effect of free float on the cost of debts and/or weighted average cost of capital. The relationship of other items included in the balance sheet and profit and loss statement with the cost of capital may also be addressed in future studies. References Abbasi E, Marzlu V, Investigating the effect of free float on liquidity indices in Tehran Stock Exchange. Journal of Accounting Research. 3: Asgari MR, Iran Pak M, The effect of free float volume on variation in equity prices in the companies listed in Tehran Stock Exchange and proposing adequate approaches. Basirat Quarterly. 17(45): Ashbaugh H, Collins DW, LaFond R, The effects of corporate governance on firms credit ratings. Journal of Accounting and Economics. 42(1-2): Cummins JD, Phillips RD, Estimating the cost of equity capital for property-liability insurers. The Wharton Financial Institutions Center. Hail L, Leuz Ch, International differences in the cost of equity capital: do legal institutions and security regulation matter?. Working Paper, White Center for Financial Research. Hashemi SA, Farahmand Sh, Joshaghani, Shamirzaie, The effect of conditional conservatism on the cost of common stocks. Journal of Accounting Knowledge. 2: Kashani Pur M, Rezaie A, The effect of free float variations on return on equity in the companies listed in Tehran Stock Exchange. Journal of Financial Accounting Studies. 3: Kurdestani Gh, Majdi RZ, The relationship between quality characteristics of earnings and the cost of common stocks. Accounting and Audit Studies. 14(48):

5 Lotfi E, The effect of financial structure on the cost of capital and market prices of stocks in Iran Khodro Insurance Company and Cement Company listed in Tehran Stock Exchange during the years 1995 to MS thesis, Islamic Azad University, Science and Research Branch, Iran. Rahmani A, Fallah Nezhad F, The effect of the quality of accruals on the cost of common stocks. Journal of Financial Accounting Studies. 2: Vakili Fard HR, Taleb Nia Gh, Kiani M, The relationship between free float and price bubbles in the companies listed in Tehran Stock Exchange. Journal of Financial Engineering and Portfolio Management. 3(9):