Firm size, transaction costs and returns on common equity

Early studies by Banz (1981) and Reinganum (1981) indicate that significant excess or positive risk-adjusted returns can be earned on small equity capitalization firms' stock. Reinganum reports a mean excess return of 18% per year on his lowest equity capitalization ("firm size") portfolio for the period 1963-1977. Similar results are reported by Banz.;This thesis further investigates the source of the "size effect," as Banz first denoted it. It is hypothesized that differences in trading costs across firms contributed to firm size effect findings. The Sharpe-Lintner capital asset pricing model is respecified to include trading costs. Empirical tests of the resulting equilibrium returns indicate that a portion of the size effect can be explained by trading costs.