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The Implied Cost of Capital: A New Approach

  • Hou, Kewei

    (Ohio State University)

  • van Dijk, Mathijs A.

    (Erasmus University Rotterdam)

  • Zhang, Yinglei

    (Chinese University of Hong Kong)

We propose a new approach to estimate the implied cost of capital (ICC). Our approach is distinct from prior studies in that we do not rely on analysts' earnings forecasts to compute the ICC. Instead, we use a cross-sectional model to forecast the earnings of individual firms. Our approach has two major advantages. First, it allows us to estimate the ICC for a much larger sample of firms over a much longer time period. Second, it is not affected by the various issues that lead to the well-documented biases in analysts' forecasts. Our cross-sectional earnings model delivers earnings forecasts that outperform consensus analyst forecasts. We show that, as a result, our approach to estimate the ICC produces a more reliable proxy for expected returns than other approaches. We present evidence on the implications for the equity premium and a variety of asset pricing anomalies.

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File URL: http://www.cob.ohio-state.edu/fin/dice/papers/2010/2010-4.pdf
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Paper provided by Ohio State University, Charles A. Dice Center for Research in Financial Economics in its series Working Paper Series with number 2010-4.

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Date of creation: Feb 2010
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Handle: RePEc:ecl:ohidic:2010-4
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Web page: http://www.cob.ohio-state.edu/fin/dice/list.htm
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