Small Firm Equity Cost: Evidence from Australia

Data on shares of stock in Australia's capital market are used to document a well-known size effect - that small firms pay more for equity capital than large firms. Even after using conventional controls to neutralize the effects of risk differences, small firms - those worth on average $1.5 million - paid nearly 50% more for equity than did larger firms. No theoretical justification exists for size in and of itself being a causal factor of performance. The illiquidity of the shares is then estimated and found to be highly correlated with equity costs. The relation of size and illiquidity is negative and monotonic; the relation of illiquidity and risk-adjusted performance is positive and virtually monotonic. This result provides support for the notion that a company's market liquidity goes far in explaining the required return of its owners.