Best Practice for Cost-of-Capital Estimates

65 Pages Posted: 4 Oct 2015 Last revised: 21 Feb 2017

See all articles by Yaron Levi

Yaron Levi

University of Southern California - Marshall School of Business

Ivo Welch

University of California, Los Angeles (UCLA); National Bureau of Economic Research (NBER)

Date Written: September 23, 2016

Abstract

Cost-of-capital assessments with factor models require quantitative forward- looking estimates. We recommend estimating Vasicek-shrunk betas with one to four years of daily stock returns, and then — because the underlying betas are themselves time-varying — shrinking betas a second time (and more for smaller stocks and longer-term projects). Such estimators also worked well in other OECD countries and for SMB and HML exposures. If own historical stock returns are not available, market cap-based peer betas should be used. Historical industry averages have almost no predictive power and should never be used.

Keywords: cost of capital, capital budgeting, CAPM

JEL Classification: G31

Suggested Citation

Levi, Yaron and Welch, Ivo, Best Practice for Cost-of-Capital Estimates (September 23, 2016). Marshall School of Business Working Paper No. 17-4. Available at SSRN: https://ssrn.com/abstract=2667735 or http://dx.doi.org/10.2139/ssrn.2667735

Yaron Levi

University of Southern California - Marshall School of Business ( email )

Marshall School of Business
Los Angeles, CA 90089
United States

Ivo Welch (Contact Author)

University of California, Los Angeles (UCLA) ( email )

110 Westwood Plaza
C519
Los Angeles, CA 90095-1481
United States
310-825-2508 (Phone)

HOME PAGE: http://www.ivo-welch.info

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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