Is the Cost of Equity Greater than the Risk-Free Rate?
22 Pages Posted: 2 Aug 2019
Date Written: July 29, 2019
Based on recent evidence, we may not be able to reject the hypothesis that the cost of equity for individual common stocks is close to the risk-free rate. One explanation for this outcome would be the combination of excessive optimism with risk aversion, a combination that can generate behavior that is observationally equivalent to risk neutrality or even risk seeking. Moreover, if the cost of equity is near the risk-free rate, expected cash flows are lower than assumed, a possibility that is consistent with firms that are finite, and often short-lived, by contrast to prices explained by infinite dividend discount models with higher discount rates. The hypothesis advanced here can help explain why the R-squared in individual-stock regressions is so low and the relationship between idiosyncratic risk and expected returns. The hypothesis could also help further explain the failure of active investment management in U.S. equities.
Keywords: discount rates, cost of capital, cost of equity, optimism
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