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Arithmetic versus geometric mean estimators: Setting discount rates for capital budgeting

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  • Ian Cooper

Abstract

This paper addresses an issue central to the estimation of discount rates for capital budgeting: should the geometric mean or arithmetic mean of past data be used when estimating the discount rate? the use of the arithmetic mean ignores estimation error and serial correlation in returns. Unbiased discount factors have been derived that correct for both these effects. In all cases, the corrected discount rates are closer to the arithmetic than the geometric mean.

Suggested Citation

  • Ian Cooper, 1996. "Arithmetic versus geometric mean estimators: Setting discount rates for capital budgeting," European Financial Management, European Financial Management Association, vol. 2(2), pages 157-167, July.
    • Handle: RePEc:bla:eufman:v:2:y:1996:i:2:p:157-167
    DOI: 10.1111/j.1468-036X.1996.tb00036.x
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    References listed on IDEAS

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    1. Poterba, James M. & Summers, Lawrence H., 1988. "Mean reversion in stock prices : Evidence and Implications," Journal of Financial Economics, Elsevier, vol. 22(1), pages 27-59, October.
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    Cited by:

    1. Breuer, Wolfgang & Gürtler, Marc, 2010. "Implied rates of return, the discount rate effect, and market risk premia," Working Papers IF33V3, Technische Universität Braunschweig, Institute of Finance.
    2. Rui Alpalhao & Paulo Alves, 2005. "The Portuguese equity risk premium: what we know and what we don't know," Applied Financial Economics, Taylor & Francis Journals, vol. 15(7), pages 489-498.
    3. Alan Gregory, 2011. "The Expected Cost of Equity and the Expected Risk Premium in the UK," Review of Behavioral Finance, Emerald Group Publishing Limited, vol. 3(1), pages 1-26, April.
    4. Christoph Kaserer, 2022. "Estimating the market risk premium for valuations: arithmetic or geometric mean or something in between?," Journal of Business Economics, Springer, vol. 92(8), pages 1373-1415, October.
    5. Wolfgang Breuer & Karsten Kohn & Klaus Mark, 2017. "A note on corporate valuation using imprecise cost of capital," Journal of Business Economics, Springer, vol. 87(6), pages 709-747, August.
    6. Chandra Shekhar Bhatnagar & Riad Ramlogan, 2012. "The capital asset pricing model versus the three factor model: A United Kingdom Perspective," International Journal of Business and Social Research, LAR Center Press, vol. 2(1), pages 51-65, February.
    7. Missiakoulis, Spyros & Vasiliou, Dimitrios & Eriotis, Nikolaos, 2012. "Forecasting Performance with the Harmonic Mean: Long-Term Investment Horizons in Shanghai Stock Exchange," Review of Applied Economics, Lincoln University, Department of Financial and Business Systems, vol. 8(1), pages 1-11, May.
    8. Helena Jasiulewicz & Wojciech Kordecki, 2016. "Multiplicative parameters and estimators: applications in economics and finance," Annals of Operations Research, Springer, vol. 238(1), pages 299-313, March.
    9. Mark Freeman & Ben Groom, 2015. "Using equity premium survey data to estimate future wealth," Review of Quantitative Finance and Accounting, Springer, vol. 45(4), pages 665-693, November.
    10. Brian McCulloch, 2003. "Geometric Return and Portfolio Analysis," Treasury Working Paper Series 03/28, New Zealand Treasury.
    11. Philip Ndikum, 2020. "Machine Learning Algorithms for Financial Asset Price Forecasting," Papers 2004.01504, arXiv.org.
    12. Chandra Shekhar Bhatnagar & Riad Ramlogan, 2012. "The capital asset pricing model versus the three factor model: A United Kingdom Perspective," International Journal of Business and Social Research, MIR Center for Socio-Economic Research, vol. 2(1), pages 51-65, February.
    13. Sonntag, Dominik, 2018. "Die Theorie der fairen geometrischen Rendite [The Theory of Fair Geometric Returns]," MPRA Paper 87082, University Library of Munich, Germany.
    14. Eduardo Walker, 2016. "Cost of Capital in Emerging Markets: Bridging Gaps between Theory and Practice," Latin American Journal of Economics-formerly Cuadernos de Economía, Instituto de Economía. Pontificia Universidad Católica de Chile., vol. 53(1), pages 111-147, December.
    15. Helena Jasiulewicz & Wojciech Kordecki, 2016. "Multiplicative parameters and estimators: applications in economics and finance," Annals of Operations Research, Springer, vol. 238(1), pages 299-313, March.
    16. Burkhard Pedell, 2007. "Kapitalmarktbasierte Ermittlung des Kapitalkostensatzes für Zwecke der Entgeltregulierung," Metrika: International Journal for Theoretical and Applied Statistics, Springer, vol. 18(1), pages 35-60, April.

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