A Practical Method for Sharpening Estimates of Industry Equity Capital Costs

27 Pages Posted: 15 Dec 2020

See all articles by Mike Aguilar

Mike Aguilar

University of North Carolina (UNC) at Chapel Hill - Department of Economics

Robert A. Connolly

Miami Herbert Business School - Department of Finance

Jiaxi Li

University of North Carolina (UNC) at Chapel Hill

Date Written: December 3, 2020

Abstract

We propose a method for reducing standard errors associated with industry equity capital costs (ECC), a problem studied by Fama French (1997). Approximately 90% of the uncertainty regarding ECC estimates comes from the factor risk premia, as opposed to factor exposures. Furthermore, at least 75% of the uncertainty regarding these risk premia is driven by the standard error of the second pass regression. These standard errors are inflated by seasonal noise in the return process. By filtering this noise, we generate ECC estimates that are unchanged on average, but with standard errors that are about one-quarter of the size without filtering.

Keywords: equity capital cost, standard error, filtering, risk premium decomposition

JEL Classification: G11, G30, G31, C58

Suggested Citation

Aguilar, Mike and Connolly, Robert A. and Li, Jiaxi, A Practical Method for Sharpening Estimates of Industry Equity Capital Costs (December 3, 2020). University of Miami Legal Studies Research Paper No. 3742221, Available at SSRN: https://ssrn.com/abstract=3742221 or http://dx.doi.org/10.2139/ssrn.3742221

Mike Aguilar

University of North Carolina (UNC) at Chapel Hill - Department of Economics ( email )

Chapel Hill, NC 27599
United States

HOME PAGE: http://mikeaguilar.web.unc.edu

Robert A. Connolly (Contact Author)

Miami Herbert Business School - Department of Finance ( email )

P.O. Box 248094
Coral Gables, FL 33124-6552
United States

HOME PAGE: http://https://drbobconnolly.com/

Jiaxi Li

University of North Carolina (UNC) at Chapel Hill ( email )

102 Ridge Road
Chapel Hill, NC NC 27514
United States

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