Corporate Environmental Responsibility and the Cost of Capital: International Evidence

Abstract

We examine how corporate environmental responsibility (CER) affects the cost of equity capital for manufacturing firms in 30 countries. Using several approaches to estimate firms’ ex ante equity financing costs, we find in regressions that control for firm-level characteristics as well as industry, year, and country effects that the cost of equity capital is lower when firms have higher CER. This finding is robust to addressing endogeneity through instrumental variables, to using alternative specifications and proxies for the cost of equity capital, and to accounting for noise in analyst forecasts. We conclude that investment in CER reduces firms’ equity financing costs worldwide.

Appendices

Appendix 1

Cost of Equity Models

In this appendix, which is adapted from El Ghoul et al. (2015), we describe the cost of equity models used in this paper. We start by defining variables and specifying assumptions common to all models. We then successively cover each model and its assumptions.

Common Variables and Assumptions

K _CT = implied cost of equity from the Claus and Thomas (2001) model;

K _GLS = implied cost of equity from the Gebhardt et al. (2001) model;

K _OJ = implied cost of equity from the Ohlson and Juettner-Nauroth (2005) model;

K _ES = implied cost of equity from the Easton (2004) model;

P _t  = stock price measured 10 months after the fiscal year end;

FROE _t+τ  = forecasted return on equity for year t + τ;

FEPS _t+τ  = forecasted earnings for year t + τ;

B _t  = current (beginning of period) book value per share;

k _t  = expected dividend payout at time t;

B _t+τ  = forecasted book value per share for year t + τ, measured using the clean surplus relationship; i.e., B _t+τ  = B _t+τ−1 + FEPS _t+τ (1 − k _t+τ );

ae _t+τ  = forecasted abnormal earnings for year t + τ;

LTG _t  = forecasted long-term earnings growth at time t; and

i _t  = expected perpetual earnings growth at time t.

We require firms to have positive 1-year-ahead (FEPS _t+1) and 2-year-ahead (FEPS _t+2) earnings forecasts, and either a 3-year-ahead forecast (FEPS _t+3) or a long-term growth forecast (LTG _t ). If a 3-, 4-, or 5-year-ahead forecast is not available in I/B/E/S, we impute it from the previous year forecast and the LTG forecast, i.e., FEPS _t+τ  = FEPS _t+τ−1 · (1 + LTG _t ). Similarly, if the LTG forecast is missing, we impute it from the growth rate implied by the 3- and 2-year-ahead forecasts, i.e., ${\text{LTG}}_{t} = \frac{{{\text{FEPS}}_{t + 3} - {\text{FEPS}}_{t + 2} }}{{{\text{FEPS}}_{t + 2} }}.$

We estimate the expected dividend payout (k _t ) using the average dividend payout over the previous 3 years. If this ratio is missing or outside [0, 1], we replace it with the country–year median. We estimate the expected perpetual earnings growth (i _t ) using next year’s realized inflation rate.

Model Descriptions

Model 1: Claus and Thomas (2001)

This model assumes clean surplus accounting, allowing current share price to be expressed in terms of the cost of equity, current book value, forecasted abnormal earnings, and a perpetual abnormal earnings growth. Forecasted abnormal earnings is forecasted earnings minus a charge for the cost of equity. The explicit forecast horizon is set to 5 years, beyond which forecasted residual earnings grow at the expected inflation rate. The valuation equation is given by:

$$P_{t} = B_{t} + \sum\limits_{\tau = 1}^{5} {\frac{{{\text{ae}}_{t + \tau } }}{{(1 + K_{\text{CT}} )^{\tau } }} + \frac{{{\text{ae}}_{t + 5} (1 + i_{t} )}}{{(K_{\text{CT}} - i_{t} )(1 + K_{\text{CT}} )^{5} }}},$$

(2)

where ae _t+τ  = FEPS _t+τ  − K _CT · B _t+τ−1.

Model 2: Gebhardt et al. (2001)

This model also assumes clean surplus accounting, allowing current share price to be expressed in terms of the cost of equity, current book value, and forecasted ROE and book values. The explicit forecast horizon is set to 3 years, beyond which forecasted ROE decays to a target ROE by the 12th year, and remains constant afterward. The valuation equation is given by:

$$P_{t} = B_{t} + \sum\limits_{\tau = 1}^{11} {\frac{{{\text{FROE}}_{t + \tau } - K_{\text{GLS}} }}{{(1 + K_{\text{GLS}} )^{\tau } }}B_{t + \tau - 1} + \frac{{{\text{FROE}}_{t + 12} - K_{\text{GLS}} }}{{K_{\text{GLS}} \cdot (1 + K_{\text{GLS}} )^{11} }}B_{t + 11} },$$

(3)

For the first 3 years, FROE _t+τ is set equal to $\frac{{{\text{FEPS}}_{t + \tau } }}{{B_{t + \tau - 1} }}.$ Beyond the third year, FROE _t+τ fades linearly to a target ROE by the 12th year. To determine the target ROE, we compute, for each firm in each year, the average ROE over the previous 3 years. The target ROE is the country–industry–year median. We define industries according to Campbell’s (1996) classification. Negative target ROE is replaced by country–industry median, and if still negative, by country–year median.

Model 3: Ohlson and Juettner-Nauroth (2005)

This model is an extension of the Gordon constant growth model. It allows share price to be expressed in terms of the cost of equity, 1-year-ahead earnings forecast, and near-term and perpetual growth forecasts. The explicit forecast horizon is set to 1 year, after which forecasted earnings grow at a near-term rate that decays to a perpetual rate. The near-term earnings growth is the average of: (i) the growth rate of FEPS from year t + 1 to year t + 2, and (ii) the I/B/E/S LTG forecast. The perpetual growth rate is the expected inflation rate. The valuation equation is given by:

$$P_{t} = \frac{{{\text{FEPS}}_{t + 1} (g_{t} - i_{t} + K_{\text{OJ}} \cdot k_{t + 1} )}}{{K_{\text{OJ}} (K_{\text{OJ}} - i_{t} )}},$$

(4)

where $g_{t} = \frac{1}{2}\left( {\frac{{{\text{FEPS}}_{t + 2} - {\text{FEPS}}_{t + 1} }}{{{\text{FEPS}}_{t + 1} }} + {\text{LTG}}_{t} } \right).$

The model requires that FEPS _t+2 >0 and FEPS _t+1 >0 to yield a positive root.

Model 4: Easton (2004)

This model is a generalization of the PEG model based on Ohlson and Juettner-Nauroth (2005). It allows share price to be expressed in terms of the cost of equity, expected dividend payout, and 1- and 2-year-ahead earnings forecasts. The explicit forecast horizon is set to 2 years, after which forecasted abnormal earnings grow in perpetuity at a constant rate. The valuation equation is given by:

$$P_{t} = \frac{{{\text{FEPS}}_{t + 2} - {\text{FEPS}}_{t + 1} (1 - K_{\text{ES}} \cdot k_{t + 1} )}}{{K_{\text{ES}}^{2} }}.$$

(5)

The model requires that to yield a positive root.

Additional Models

Model 5: Forward Earnings–Price Ratio

This is a special case of the Easton (2004) model assuming that abnormal earnings growth is set to zero. The forward earnings–price ratio is given by;

$$K_{\text{FEYD}} = \frac{{{\text{FEPS}}_{t + 1} }}{{P_{t} }}.$$

(6)

Model 6: Price–Earnings–Growth (PEG) ratio

This is a special case of the Easton (2004) model assuming no dividend payments. The valuation equation is given by:

$$P_{t} = \frac{{{\text{FEPS}}_{t + 2} - {\text{FEPS}}_{t + 1} }}{{K_{\text{PEG}}^{2} }}.$$

(7)

Model 7: Trailing Earnings Yield

This is a special case of the earnings–price ratio where the numerator is current earnings per share:

$$K_{\text{TEYD}} = \frac{{{\text{EPS}}_{t} }}{{P_{t} }}.$$

(8)

Appendix 2

See Table 10.

Table 10 Trucost data explanation

Appendix 3

See Table 11.

Table 11 Variable definitions and data sources