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The Implied Cost of Capital: A New Approach

Author

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  • Hou, Kewei

    (Ohio State University)

  • van Dijk, Mathijs A.

    (Erasmus University Rotterdam)

  • Zhang, Yinglei

    (Chinese University of Hong Kong)

Abstract

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.

Suggested Citation

  • Hou, Kewei & van Dijk, Mathijs A. & Zhang, Yinglei, 2010. "The Implied Cost of Capital: A New Approach," Working Paper Series 2010-4, Ohio State University, Charles A. Dice Center for Research in Financial Economics.
    • Handle: RePEc:ecl:ohidic:2010-4
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    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading
    • G29 - Financial Economics - - Financial Institutions and Services - - - Other
    • 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
    • M40 - Business Administration and Business Economics; Marketing; Accounting; Personnel Economics - - Accounting - - - General
    • M41 - Business Administration and Business Economics; Marketing; Accounting; Personnel Economics - - Accounting - - - Accounting

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