Toward an Implied Cost of Capital

Toward an Implied Cost of Capital In this study, we propose an alternative technique for estimating the cost of equity capital. Specifically, we use a discounted residual income model to generate a market implied cost‐of‐capital. We then examine firm characteristics that are systematically related to this estimate of cost‐of‐capital. We show that a firm's implied cost‐of‐capital is a function of its industry membership, B/M ratio, forecasted long‐term growth rate, and the dispersion in analyst earnings forecasts. Together, these variables explain around 60% of the cross‐sectional variation in future (two‐year‐ahead) implied costs‐of‐capital. The stability of these long‐term relations suggests they can be exploited to estimate future costs‐of‐capital. We discuss the implications of these findings for capital budgeting, investment decisions, and valuation research. http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png Journal of Accounting Research Wiley

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Publisher
Wiley
Copyright
University of Chicago on behalf of the Institute of Professional Accounting, 2001
ISSN
0021-8456
eISSN
1475-679X
DOI
10.1111/1475-679X.00007
Publisher site
See Article on Publisher Site

Abstract

In this study, we propose an alternative technique for estimating the cost of equity capital. Specifically, we use a discounted residual income model to generate a market implied cost‐of‐capital. We then examine firm characteristics that are systematically related to this estimate of cost‐of‐capital. We show that a firm's implied cost‐of‐capital is a function of its industry membership, B/M ratio, forecasted long‐term growth rate, and the dispersion in analyst earnings forecasts. Together, these variables explain around 60% of the cross‐sectional variation in future (two‐year‐ahead) implied costs‐of‐capital. The stability of these long‐term relations suggests they can be exploited to estimate future costs‐of‐capital. We discuss the implications of these findings for capital budgeting, investment decisions, and valuation research.

Journal

Journal of Accounting ResearchWiley

Published: Jun 1, 2001

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