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Validating implied cost of capital with realized returns by using alternative measures of cash-flow news

Author

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  • Ketterer, Simeon
  • Dionysiou, Dionysia
  • Eierle, Brigitte
  • Tsalavoutas, Ioannis

Abstract

We outline analytically that, when testing different implied cost of capital (ICC) estimates for validation by employing the Vuolteenaho (2002) framework, the cash-flow news in the validation framework should be defined in a way that considers the ICC model specific assumed sequence of future cash flows. This is based on market expectations, as proxied by analysts' forecasts. We then propose adjusting the cash-flow news proxies accordingly and implement these adjustments empirically. Consistent with the theoretical predications, the results from these tests show that ICC estimates are significantly positively related to realized returns. Informed by these findings, we employ the adjusted cash-flow news proxies in the validation framework and compare the correlation between adjusted and unadjusted for analysts' bias ICC estimates with realized returns. These tests show no difference in these correlations. This suggests that it is not the analysts' bias that weakens the validity of ICC estimates, as argued by prior literature. It is the proxies used in the validation framework that lead to the suggestion in removing analysts’ optimism from ICC estimates. Overall, our proposed alternative framework not only unlocks the gate for extensive use of the existing ICC estimates but also enables future researchers to develop more reliable and meaningful ICC estimates.

Suggested Citation

  • Ketterer, Simeon & Dionysiou, Dionysia & Eierle, Brigitte & Tsalavoutas, Ioannis, 2023. "Validating implied cost of capital with realized returns by using alternative measures of cash-flow news," The British Accounting Review, Elsevier, vol. 55(6).
    • Handle: RePEc:eee:bracre:v:55:y:2023:i:6:s0890838923000616
    DOI: 10.1016/j.bar.2023.101220
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    JEL classification:

    • M41 - Business Administration and Business Economics; Marketing; Accounting; Personnel Economics - - Accounting - - - Accounting
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Fixed Investment and Inventory Studies
    • 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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