Analysis of the effects of ESOP adoption on the company cost of capital

Abstract

Purpose

The purpose of this study is to examine whether employee stock ownership plans (ESOPs) add or destroy value from a new perspective by examining the relation of the adoption of ESOP and the company cost of capital.

Design/methodology/approach

The capital asset pricing model is used to estimate the company's cost of equity capital, and the cost of debt is estimated using bond yield spreads. The weighted average cost of capital (WACC) is calculated as the weighted percentage of the firm funded by equity, preferred stock, and debt multiplied by the individual costs of capital. Univariate and multivariate analyses are conducted around the event of adoption to determine if the cost of capital changes after the adoption of ESOP.

Findings

Results from the univariate analysis show that firms adopting leveraged as well as non‐leveraged ESOP plans experience decreases in costs of equity and debt capital as well as decreases in their WACC. However, the multivariate analysis demonstrates that only the non‐leveraged common ESOPs are negatively correlated to cost of equity, cost of debt, and WACC. Robustness tests confirm that the reduction in the cost of equity capital drives the decline in WACC.

Originality/value

The findings contribute to the cost of capital literature and have implications for firms that decide to engage in ESOP plans. It is found that ESOPs benefit from decreased cost of capital related to the ability to increase debt capacity for the firm as well as the existing tax preferential treatments of ESOP plans.

Citation

Ivanov, S.I. and Zaima, J.K. (2011), "Analysis of the effects of ESOP adoption on the company cost of capital", Managerial Finance, Vol. 37 No. 2, pp. 173-188. https://doi.org/10.1108/03074351111103695