Hostname: page-component-78c5997874-lj6df Total loading time: 0 Render date: 2024-11-15T08:56:05.807Z Has data issue: false hasContentIssue false
  • English
  • Français

Best Practice for Cost-of-Capital Estimates

Published online by Cambridge University Press:  21 April 2017

Yaron Levi  and
Ivo Welch
Rights & Permissions [Opens in a new window]

Abstract

Core share and HTML view are not available for this content. However, as you have access to this content, a full PDF is available via the ‘Save PDF’ action button.

Cost-of-capital assessments with factor models require quantitative forward-looking estimates. We recommend estimating Vasicek-shrunk betas with 1–4 years of daily stock returns and then shrinking betas a second time (and more for smaller stocks and longer-term projects), because the underlying betas are themselves time-varying. Such estimators also work well in other developed countries and for small-minus-big (SMB) and high-minus-low (HML) exposures. If own historical stock returns are not available, peer betas based on market cap should be used. Historical industry averages have almost no predictive power and should never be used.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 52 , Issue 2 , April 2017 , pp. 427 - 463
Copyright
Copyright © Michael G. Foster School of Business, University of Washington 2017 

Footnotes

1

We thank Zhi Da (the referee), Jarrad Harford (the editor), Susan Huot (the business and preproduction manager), many colleagues, and seminar participants at California State University at Fullerton, the University of California at Los Angeles, Cornell University, the Federal Reserve Board, and Brigham Young University.

References

Ait-Sahalia, Y.; Kalnina, I.; and Xiu, D.. “The Idiosyncratic Volatility Puzzle: A Reassessment at High Frequency.” Working Paper, University of Chicago (2014).Google Scholar
Armstrong, C. S.; Banerjee, S.; and Corona, C.. “Factor-Loading Uncertainty and Expected Returns.” Review of Financial Studies, 26 (2013), 158–207.Google Scholar
Baker, M.; Hoeyer, M. F.; and Wurgler, J.. “The Risk Anomaly Tradeoff of Leverage.” Working Paper, Harvard Business School, University of Oxford, and New York University (2016).Google Scholar
Barry, C. B.“Bayesian Betas and Deception: A Comment.” Journal of Financial Research, 3 (1980), 85–90.Google Scholar
Berk, J., and DeMarzo, P.. Corporate Finance, 3rd ed. Boston, MA: Pearson (2014).Google Scholar
Bhardwaj, G.; Gorton, G.; and Rouwenhorst, G.. “Facts and Fantasies about Commodity Futures Ten Years Later.” Working Paper, NBER (2015).Google Scholar
Blume, M. E.“On the Assessment of Risk.” Journal of Finance, 26 (1971), 1–10.Google Scholar
Brealey, R.; Myers, S.; and Allen, F.. Principles of Corporate Finance, 12th ed. New York, NY: McGraw-Hill/Irwin (2016).Google Scholar
Campbell, J. Y.; Sunderam, A.; and Viceira, L. M.. “Inflation Bets or Deflation Hedges? The Changing Risks of Nominal Bonds.” Critical Finance Review, 6 (2017).CrossRefGoogle Scholar
Da, Z.; Guo, R.-J.; and Jagannathan, R.. “CAPM for Estimating the Cost of Equity Capital: Interpreting the Empirical Evidence.” Journal of Financial Economics, 103 (2012), 204–220.Google Scholar
Dimson, E.“Risk Measurement When Shares Are Subject to Infrequent Trading.” Journal of Financial Economics, 7 (1979), 197–226.Google Scholar
Elton, E. J.; Gruber, M. J.; and Urich, T. J.. “Are Betas Best?” Journal of Finance, 33 (1978), 1375–1384.Google Scholar
Fama, E. F., and French, K. R.. “The Cross-Section of Expected Stock Returns.” Journal of Finance, 47 (1992), 427–465.Google Scholar
Fama, E. F., and French, K. R.. “Industry Costs of Equity.” Journal of Financial Economics, 43 (1997), 153–193.Google Scholar
Fama, E. F., and French, K. R.. “The Equity Premium.” Journal of Finance, 57 (2002), 637–659.Google Scholar
Fama, E. F., and MacBeth, J. D.. “Risk, Return, and Equilibrium: Empirical Tests.” Journal of Political Economy, 81 (1973), 607–636.Google Scholar
Fisher, L., and Kamin, J. H.. “Forecasting Systematic Risk: Estimates of ‘Raw’ Beta That Take Account of the Tendency of Beta to Change and the Heteroskedasticity of Residual Returns.” Journal of Financial and Quantitative Analysis, 20 (1985), 127–149.Google Scholar
Frazzini, A., and Pedersen, L. H.. “Betting against Beta.” Journal of Financial Economics, 111 (2014), 1–25.Google Scholar
Graham, J. R., and Harvey, C. R.. “The Theory and Practice of Corporate Finance: Evidence from the Field.” Journal of Financial Economics, 60 (2001), 187–243.Google Scholar
Greene, W. H. Econometric Analysis, 6th ed. Boston, MA: Pearson (2008).Google Scholar
Harvey, C. R., and Liu, Y.. “Rethinking Performance Evaluation.” Working Paper, Duke University and Texas A&M University (2016).Google Scholar
Jacobs, M. T., and Shivdasani, A.. “Do You Know Your Cost of Capital?” Harvard Business Review, 90 (2012), 118–124.Google Scholar
Jacquier, E.; Kane, A.; and Marcus, A. J.. “Optimal Estimation of the Risk Premium for the Long Run and Asset Allocation: A Case of Compounded Estimation Risk.” Journal of Financial Econometrics, 3 (2005), 37–55.Google Scholar
Jagannathan, R.; Matsa, D. A.; Meier, I.; and Tarhan, V.. “Why Do Firms Use High Discount Rates?” Journal of Financial Economics, 120 (2016), 445–463.CrossRefGoogle Scholar
Jagannathan, R., and Wang, Z.. “The Conditional CAPM and the Cross-Section of Expected Returns.” Journal of Finance, 51 (1996), 3–53.Google Scholar
Johnson, D. J.; Bennett, R. E.; and Curcio, R. J.. “A Note on the Deceptive Nature of Bayesian Forecasted Betas.” Journal of Financial Research, 2 (1979), 65–69.Google Scholar
Jostova, G., and Philipov, A.. “Bayesian Analysis of Stochastic Betas.” Journal of Financial and Quantitative Analysis, 40 (2005), 747–778.Google Scholar
Karolyi, G. A.“Predicting Risk: Some New Generalizations.” Management Science, 38 (1992), 57–74.Google Scholar
Kothari, S.; Shanken, J.; and Sloan, R.. “Another Look at the Cross-Section of Expected Returns.” Journal of Finance, 50 (1995), 185–224.Google Scholar
Krasker, W. S.“The Peso Problem in Testing the Efficiency of Forward Exchange Markets.” Journal of Monetary Economy, 6 (1980), 269–276.Google Scholar
Krüger, P.; Landier, A.; and Thesmar, D.. “The WACC Fallacy: The Real Effects of Using a Unique Discount Rate.” Journal of Finance, 70 (2015), 1253–1285.Google Scholar
Levy, M., and Roll, R.. “The Market Portfolio May Be Mean/Variance Efficient After All.” Review of Financial Studies, 23 (2010), 2464–2491.Google Scholar
Lewellen, J.“The Cross Section of Expected Stock Returns.” Critical Finance Review, 4 (2015), 1–44.Google Scholar
Mamaysky, H.; Spiegel, M.; and Zhang, H.. “Estimating the Dynamics of Mutual Fund Alphas and Betas.” Review of Financial Studies, 21 (2007), 233–264.Google Scholar
Mehra, R., and Prescott, E. C.. “The Equity Premium: A Puzzle.” Journal of Monetary Economics, 15 (1985), 145–161.Google Scholar
Officer, L. H.“What Was the Interest Rate Then? A Data Study.” Available at http://www.measuringworth.com/interestrates/ (2014).Google Scholar
Rogoff, K.“Rational Expectations in the Foreign Exchange Market Revisited.” Working Paper, Massachusetts Institute of Technology (1977).Google Scholar
Ross, S.; Westerfield, R.; Jaffe, J.; and Jordan, B.. Corporate Finance, 11th ed. New York, NY: McGraw-Hill/Irwin (2016).Google Scholar
Schulz, F.“On the Timing and Pricing of Dividends: Comment.” American Economic Review, 106 (2016), 3185–3223.Google Scholar
Schwert, G. W.“Stock Returns and Real Activity: A Century of Evidence.” Journal of Finance, 45 (1990), 1237–1257.CrossRefGoogle Scholar
Van Binsbergen, J.; Brandt, M.; and Koijen, R.. “On the Timing and Pricing of Dividends.” American Economic Review, 102 (2012), 1596–1618.Google Scholar
Vasicek, O. A.“A Note on Using Cross-Sectional Information in Bayesian Estimation of Security Betas.” Journal of Finance, 28 (1973), 1233–1239.Google Scholar
Welch, I. Corporate Finance. 3rd ed, Los Angeles, CA: Ivo Welch (2014).Google Scholar
Welch, I.“The (Time-Varying) Importance of Disaster Risk.” Financial Analysts Journal, 72 (2016), 14–30.CrossRefGoogle Scholar
Wilson, J. W., and Jones, C. P.. “A Comparison of Annual Common Stock Returns: 1871–1925 with 1926–85.” Journal of Business, 60 (1987), 239–258.CrossRefGoogle Scholar
Supplementary material: File

Levi and Welch supplementary material

Levi and Welch supplementary material

Download Levi and Welch supplementary material(File)
File 79.4 KB