Implied Cost of Capital: A Stochastic Perspective
27 Pages Posted: 19 Dec 2012 Last revised: 13 May 2013
Date Written: May 13, 2013
Implied cost of capital has been a research method to measure ex-ante market risk premia using analysts' forecasts and observable share prices. Despite its theoretical appeal, commonly used firm level as well as portfolio level implied cost of capital methods reveal differing empirical results. Criticism is provided by Hughes et al. (2009) who show in their theoretical model that implied cost of capital may be misspecified up to three percent (in both directions) from the true cost of capital when considering stochastic components in the underlying valuation formulas. In this paper we develop an econometrically motivated approach for calculating company values with common discounted cash flow and residual income techniques by considering stochastic components in the cost of capital and cash flows. Therefore, we use a statistically consistent distribution for the discount factor and derive company values by integrating over their resulting skewed distributions. With this approach we are able to provide stylized facts which show a one-directional impact on company values with the capability to interpret inconsistent results from firm level as well as portfolio level implied cost of capital estimates reported by former research. In addition, our approach reveals new insights for company valuation highlighting parameters that need to be considered in future research.
Keywords: Implied Cost of Capital, Valuation, Beta, Capital Asset Pricing Model
JEL Classification: C15, C34, G12, G30, M41
Suggested Citation: Suggested Citation