Toward an Implied Cost of Capital
Parker Center for Investment Research Working Paper
78 Pages Posted: 27 Dec 2000
Date Written: October 27, 2000
In this study, we propose an alternative technique for estimating the cost of equity capital. Specifically, we use a discounted residual income model to generate a market implied cost-of-capital. We then examine firm characteristics that are systematically related to this estimate of cost-of-capital. We show that a firm's implied cost-of-capital is a function of its industry membership, B/M ratio, forecasted long-term growth rate, and the dispersion in analyst earnings forecasts. Together, these variables explain around 60% of the cross-sectional variation in future (two-year-ahead) implied costs-of-capital. The stability of these long-term relations suggests they can be exploited to estimate future costs-of-capital. We discuss the implications of these findings for capital budgeting, investment decisions, and valuation research.
Keywords: Valuation; Equity; Cost of capital; Residual income; Discounted cash flow; Capital budgeting; Investments; Earnings forecasts
JEL Classification: M40, M41, M46, G31
Suggested Citation: Suggested Citation