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Estimating Expected Cost of Equity Capital: A Theory-Based Approach

University of Utah Working Paper

47 Pages Posted: 12 Sep 2001  

Christine A. Botosan

University of Utah - School of Accounting and Information Systems

Marlene Plumlee

University of Utah - School of Accounting

Date Written: July 2001

Abstract

In this study, we estimate the expected cost of equity capital using the unrestricted form of the classic dividend discount formula and examine the extent to which these estimates (rDIV ) reliably proxy for expected cost of equity capital. We find that the rDIV estimates are associated with six risk proxies suggested by theory and prior research in a manner consistent with expectations; the explanatory power of the model is approximately 26%. Based on these results we conclude that the rDIV estimates are a valid proxy for expected cost of equity capital.

Estimating rDIV requires a terminal value forecast. Since such forecasts are not always available we also assess the reliability of estimates produced by imposing three alternative terminal value assumptions on the dividend discount model. Specifically, rGORDON (Gordon and Gordon (1997)) imposes a firm-specific assumption; rGLS (Gebhardt, Lee and Swaminathan (2001)) imposes an industry-specific assumption and rOJN (Ohlson and Juettner-Nauroth (2000) and Gode and Mohanram (2001)) imposes an economy-wide assumption. We find that the rGORDON estimates have the highest correlation with rDIV and behave in a manner consistent with expectations with respect to their relationships with the risk proxies. We conclude that, when sufficient data to estimate rDIV is unavailable, rGORDON represents a reasonable substitute. Finally, our data indicate that although rDIV and rGORDON reflect the distribution of expected cost of equity capital, neither measure (nor any of the alternatives) should be relied upon to estimate the magnitude of expected cost of equity capital and/or implied risk premiums.

Keywords: Valuation; Equity; Cost of capital; Residual income; Discounted cash flow; Dividend discount model; Risk; Implied risk premium; Terminal value capital budgeting; Investments; Earnings forecasts

JEL Classification: M40, M41, M46, G31

Suggested Citation

Botosan, Christine A. and Plumlee, Marlene, Estimating Expected Cost of Equity Capital: A Theory-Based Approach (July 2001). University of Utah Working Paper. Available at SSRN: https://ssrn.com/abstract=279309 or http://dx.doi.org/10.2139/ssrn.279309

Christine A. Botosan

University of Utah - School of Accounting and Information Systems ( email )

1655 Campus Center Drive
Salt Lake City, UT 84112
United States
801-581-8695 (Phone)
801-581-7214 (Fax)

Marlene A. Plumlee (Contact Author)

University of Utah - School of Accounting ( email )

1645 E Campus Center Dr
Salt Lake City, UT 84112-9303
United States

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