Discount Rate and Cost of Capital: Some More about the Puzzle
19 Pages Posted: 4 Apr 2012
Date Written: May 5, 2011
Abstract
The aim of this paper is to contribute to a deeper knowledge of the CAPM in the framework of company valuation based our reasoning on the differentiation between the so-called purely financial investor and economic risk investor. Our argument is that CAPM is not a good reference to be applied in the valuation of unlisted companies because there is not a market beta for them, so the use of this traditional method to estimate the cost of capital is a wrong way. Further, we show that total beta, as an estimate of market beta when companies are not diversified, is not as good as some experts suggest, because there is no a clear correlation between company return and market return.
Moreover, according to Modigliani and Miller (1958), we show that the company can be considered as a mixed portfolio composed by a riskless asset and a risky portfolio, and so the total return of the a privately held company and, in general, for unlisted companies, is a summative discount rate which include an idiosyncratic risk.
Finally, we empirically demonstrate that the application of this discount rate contributes to reduce the company value according with practice and, therefore, the use of CAPM overestimates the company between 28% and 40%, depending if the companies are listed or not.
Keywords: Firm valuation, CAPM, cost of capital, beta, equity premium, economic risk investor, financial investor
JEL Classification: G10, G12, G309
Suggested Citation: Suggested Citation
Do you have negative results from your research you’d like to share?
Recommended Papers
-
Consumption, Aggregate Wealth and Expected Stock Returns
By Martin Lettau and Sydney C. Ludvigson
-
Risks for the Long Run: A Potential Resolution of Asset Pricing Puzzles
By Ravi Bansal and Amir Yaron
-
Dividend Yields and Expected Stock Returns: Alternative Procedures for Interference and Measurement
-
Resurrecting the (C)Capm: A Cross-Sectional Test When Risk Premia are Time-Varying
By Martin Lettau and Sydney C. Ludvigson
-
Stock Return Predictability: Is it There?
By Geert Bekaert and Andrew Ang
-
Stock Return Predictability: Is it There?
By Geert Bekaert and Andrew Ang
-
Resurrecting the (C)Capm: A Cross-Sectional Test When Risk Premia Wre Time-Varying
By Martin Lettau and Sydney C. Ludvigson