The Implied Cost of Capital: Placing Under the Microscope
37 Pages Posted: 11 Feb 2017
Date Written: February 6, 2017
We conduct a simulation study based on a dynamic pricing framework that embeds time varying cash flows and discount rates, to study two types of measurement errors in the implied cost of capital methodology. First, the constant term structure assumption significantly reduces the variation in the implied cost of capital relative to that of the true expected return, which in turn leads to biases in coefficient estimates in regressions involving the implied cost of capital. Second, the widely acknowledged biases in analyst cash flow forecasts and the failure to capture the dynamics of the true cash flows expectations induce spurious regressions. Our simulation evidence questions the construct validity of the implied cost of capital.
Keywords: Implied cost of capital, measurement error, analyst forecast, discount rate, simulation
JEL Classification: G10, G11, G12, G14, M14
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