The cost of equity: Evidence from investment banking valuations

Abstract

Using manually compiled cost of equity (COE) estimates disclosed in takeover regulatory filings, we provide novel evidence on how finance professionals, i.e., investment bankers, estimate discount rates. COE estimates are related to several risk proxies, such as beta and size. Other firm characteristics are unrelated to COE estimates or provide relations contradicting academic evidence. Bank-estimated COE is positively related to COE disclosed by firm management, though the two are distinct. We explore the role of incentives; banks use significantly higher COEs in management buyouts, which potentially underestimates target value, making the bid more attractive for target shareholder approval.