Academic journal article Journal of Small Business Management

Small Firm Equity Cost: Evidence from Australia

Academic journal article Journal of Small Business Management

Small Firm Equity Cost: Evidence from Australia

Article excerpt

The belief that small firms pay more for equity financing than do their larger brethren is so prevalent that many would classify the inverse association of size and money cost as a self-evident truth. Unfortunately, until recently, financial economists have shed little positive light on the subject. Anecdotes and normative advice have been offered; but little scientific empirical evidence has been forthcoming.

The purpose of this article is to provide some direct evidence regarding the cost of money to small firms. Standard size-effect technology is used and applied to a large sample of Australian companies. This data set allows testing outside of the usual sample space, which allows examination of firms that are much smaller than those usually studied.

Broadly speaking, the folklore is supported: the smaller the firm, the more it apparently pays for equity finance. Evidence is provided that small firms' capital market illiquidity is a promising explanation of the high cost.


Until about 25 years ago, saying anything about equity cost was difficult. In the first place, financial economists lacked broad-based, high-quality data with which to test hypotheses. That state of affairs changed, however, with the work of the University of Chicago's Center for Research in Security Prices (CRSP). Today, the typical research unit has monthly data on firms listed on the New York Stock Exchange (NYSE), dating from the middle 1920s. Some units use daily data on NYSE and American Exchange (AMEX) firms, dating from the early 1960s. Recently, daily information on NASDAQ (National Association of Securities Dealers Automated Quotes) firms, dating from the early 1970s, has also become available.

Furthermore, prior to the middle 1960s little precise guidance existed concerning how risk should be handled. But development of partial equilibrium pricing regimes, most notably the capital asset pricing model, has gone far in prescribing the treatment of risk in empirical studies. With the stage so set--the data available and analytic procedures specified--the 1980s was a decade rich in useful empirical study.

One of the most fruitful (or at least exhaustive) avenues of investigation has been dubbed the "size effect." The average return of small firms (measured by equity market value) has exceeded that of large firms. The size effect can be taken to mean that on average the cost of equity of comparatively large firms is comparatively low.

Moreover, this phenomenon is remarkably robust. While considerable nonstationarity exists, the effect holds, on average, across the size spectrum (hence the term "size of effect"). It holds for NYSE firms (Banz 1981) and AMEX firms (Reinganum 1981); and preliminary evidence indicates it holds for firms quoted on NASDAQ (Lamoureux and Sanger 1989).

To the extent that risk differences track the inverse association of size and return, the pattern is merely a regularity, i.e., an empirical observation without a clear theoretical justification. But perhaps the reason that the size effect has been so prominent in the literature is its lack of explanation. While risk differences certainly exist for firms of different sizes, the size effect is still in evidence when technology is used to account for those differences. In other words, size is inversely related to abnormal (after risk adjustment) returns. Such an unjustified regularity is popularly dubbed an anomaly.

To summarize from the viewpoint of one interested in small business management, the existing literature is troublesome for two reasons. First, the vast majority of small firm financial research has defined "small" in relative rather than absolute terms. For example, Reinganum (1981) deserves praise for studying AMEX and NYSE firms; but many others exclude the AMEX, which is dominated by "small" companies (at least by Big Board standards).

However, for many purposes even AMEX firms are not particularly small. …

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