Implied Cost of Capital and Accounting Conservatism

Posted: 25 Feb 2021

See all articles by Nikolaos I. Karampinis

Nikolaos I. Karampinis

Athens University of Economics and Business - Department of Accounting and Finance

Giannis D. Lessis

Athens University of Economics and Business - Department of Accounting and Finance

Date Written: February 25, 2021

Abstract

In this paper, we illuminate the importance of accounting conservatism adjustments when estimating the implied cost of capital (ICC) with the Residual Income Valuation (RIV) and the Abnormal Earnings Growth (AEG) model. Specifically, we adjust for three main limitations in the research of ICC, that is, accounting conservatism, analyst over-optimism, and the degrees of freedom problem (i.e. different forecasting horizons), and compare their effects. We show that, after conservatism adjustments in either model, the correlation and the explanatory power of ICC for realized returns exhibits a substantial improvement. However, we find that the adjustment for analyst bias generates immaterial changes, while the adjustment for the degrees of freedom problem yields mixed results. Contrary to expectations, the adjustments do not align the estimated ICCs from the two models but make them to diverge more. Finally, the ICC from the AEG model outperforms its counterpart from the RIV model either with or without the adjustments.

Keywords: Implied Cost of Capital, Conservatism, Analyst Overoptimism, Degrees of Freedom Problem

JEL Classification: M41, G12, G31, G32

Suggested Citation

Karampinis, Nikolaos I. and Lessis, Giannis D., Implied Cost of Capital and Accounting Conservatism (February 25, 2021). Available at SSRN: https://ssrn.com/abstract=3792974

Nikolaos I. Karampinis

Athens University of Economics and Business - Department of Accounting and Finance ( email )

76 Patission Street
GR-104 34 Athens
Greece

Giannis D. Lessis (Contact Author)

Athens University of Economics and Business - Department of Accounting and Finance ( email )

76 Patission Street
GR-104 34 Athens
Greece

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