Best Practice for Cost-of-Capital Estimates
65 Pages Posted: 4 Oct 2015 Last revised: 21 Feb 2017
Date Written: September 23, 2016
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: Suggested Citation