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, including industry, beta, size, and illiquidity. Other firm characteristics are unrelated to COE estimates or provide relations contradicting academic evidence. Bank-estimated COE is positively related to COE disclosed by the firms, but this relation is largely explained by firm characteristics. Banks use significantly higher COE values in management buyouts, which potentially underestimates target value, making the bid more attractive for target shareholder approval.