Estimating the cost of capital through time: An analysis of the sources of error

  • Ferson W
  • Locke D
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Abstract

Practitioners needing estimates of a firm's equity cost of capital have
long relied on the Capital Asset Pricing Model (CAPM). Recent evidence
casts renewed doubt on the validity of the CAPM and beta. However, there
is not much evidence to gauge the importance of the rejections of the
CAPM in a practical decision-making context. This paper presents
evidence on the sources of error in estimating required returns over
time. We use a number of proxies for the true mean variance efficient
portfolio, allowing that the CAPM is the ``wrong{''} model. The analyst
is assumed to rely on a standard market index. We find that the great
majority of the error in estimating the cost of equity capital is found
in the risk premium estimate, and relatively small errors are due to the
risk measure, or beta. This suggests that analysts should improve
estimation procedures for market risk premiums, which are commonly based
on historical averages. This can be done by using regression models,
such as:have appeared in the recent finance literature, or by purchasing
forecasts from firms that specialize in producing them.

Author-supplied keywords

  • cost of capital; capital budgeting; risk premium;

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Authors

  • W E Ferson

  • D H Locke

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