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Estimating the cost of capital with basis assets

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  • Brown, Stephen J.
  • Lajbcygier, Paul
  • Wong, Woon Weng

Abstract

Instead of using industry groups or asset pricing models to estimate the cost of capital we propose using risk equivalent classes known as basis assets. A basis asset is constructed by grouping firms together whose returns indicate they share a common risk exposure, which in theory permits a precise and accurate expected return estimate. Thus, knowing to which basis asset a firm belongs, the firm’s cost of capital can be obtained. Empirically, we show that basis assets lead to superior cost of capital estimates when compared with widely used industry groupings. This means we are no longer reliant on asset pricing models or industry groups to estimate the cost of capital of a firm.

Suggested Citation

  • Brown, Stephen J. & Lajbcygier, Paul & Wong, Woon Weng, 2012. "Estimating the cost of capital with basis assets," Journal of Banking & Finance, Elsevier, vol. 36(11), pages 3071-3079.
    • Handle: RePEc:eee:jbfina:v:36:y:2012:i:11:p:3071-3079
    DOI: 10.1016/j.jbankfin.2012.07.002
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    More about this item

    Keywords

    Cost of capital; Risk equivalent classes; Industry; Basis assets;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G17 - Financial Economics - - General Financial Markets - - - Financial Forecasting and Simulation
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

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