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Best Practice for Cost-of-Capital Estimates

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  • Levi, Yaron
  • Welch, Ivo

Abstract

Cost-of-capital assessments with factor models require quantitative forward-looking estimates. We recommend estimating Vasicek-shrunk betas with 1–4 years of daily stock returns and then shrinking betas a second time (and more for smaller stocks and longer-term projects), because the underlying betas are themselves time-varying. Such estimators also work well in other developed countries and for small-minus-big (SMB) and high-minus-low (HML) exposures. If own historical stock returns are not available, peer betas based on market cap should be used. Historical industry averages have almost no predictive power and should never be used.

Suggested Citation

  • Levi, Yaron & Welch, Ivo, 2017. "Best Practice for Cost-of-Capital Estimates," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 52(2), pages 427-463, April.
    • Handle: RePEc:cup:jfinqa:v:52:y:2017:i:02:p:427-463_00
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    1. Trinks, Arjan & Mulder, Machiel & Scholtens, Bert, 2022. "External carbon costs and internal carbon pricing," Renewable and Sustainable Energy Reviews, Elsevier, vol. 168(C).
    2. Guglielmo Maria Caporale & Luis A. Gil-Alana & Miguel Martin-Valmayor, 2021. "Persistence in the market risk premium: evidence across countries," Journal of Economics and Finance, Springer;Academy of Economics and Finance, vol. 45(3), pages 413-427, July.
    3. Hollstein, Fabian & Prokopczuk, Marcel & Wese Simen, Chardin, 2020. "Beta uncertainty," Journal of Banking & Finance, Elsevier, vol. 116(C).
    4. Hollstein, Fabian & Prokopczuk, Marcel, 2022. "Testing Factor Models in the Cross-Section," Journal of Banking & Finance, Elsevier, vol. 145(C).
    5. Boons, Martijn & Duarte, Fernando & de Roon, Frans & Szymanowska, Marta, 2020. "Time-varying inflation risk and stock returns," Journal of Financial Economics, Elsevier, vol. 136(2), pages 444-470.
    6. Kayo, Eduardo K. & Martelanc, Roy & Brunaldi, Eduardo O. & da Silva, Walter E., 2020. "Capital asset pricing model, beta stability, and the pricing puzzle of electricity transmission in Brazil," Energy Policy, Elsevier, vol. 142(C).
    7. Becker, Janis & Hollstein, Fabian & Prokopczuk, Marcel & Sibbertsen, Philipp, 2019. "The Memory of Beta Factors," Hannover Economic Papers (HEP) dp-661, Leibniz Universität Hannover, Wirtschaftswissenschaftliche Fakultät.
    8. Hollstein, Fabian & Prokopczuk, Marcel & Wese Simen, Chardin, 2019. "Estimating beta: Forecast adjustments and the impact of stock characteristics for a broad cross-section," Journal of Financial Markets, Elsevier, vol. 44(C), pages 91-118.
    9. Olivier Dessaint & Jacques Olivier & Clemens A Otto & David Thesmar, 2021. "CAPM-Based Company (Mis)valuations [Credit lines as monitored liquidity insurance: Theory and evidence]," The Review of Financial Studies, Society for Financial Studies, vol. 34(1), pages 1-66.
    10. Hollstein, Fabian, 2020. "Estimating beta: The international evidence," Journal of Banking & Finance, Elsevier, vol. 121(C).
    11. Altavilla, Carlo & Bochmann, Paul & De Ryck, Jeroen & Dumitru, Ana-Maria & Grodzicki, Maciej & Kick, Heinrich & Fernandes, Cecilia Melo & Mosthaf, Jonas & O’Donnell, Charles & Palligkinis, Spyros, 2021. "Measuring the cost of equity of euro area banks," Occasional Paper Series 254, European Central Bank.
    12. Keloharju, Matti & Linnainmaa, Juhani T. & Nyberg, Peter, 2021. "Long-term discount rates do not vary across firms," Journal of Financial Economics, Elsevier, vol. 141(3), pages 946-967.
    13. Trinks, Arjan & Mulder, Machiel & Scholtens, Bert, 2020. "An Efficiency Perspective on Carbon Emissions and Financial Performance," Ecological Economics, Elsevier, vol. 175(C).
    14. Cujean, Julien & Andrei, Daniel & Wilson, Mungo, 2018. "The Lost Capital Asset Pricing Model," CEPR Discussion Papers 12607, C.E.P.R. Discussion Papers.
    15. Matti Keloharju & Juhani T. Linnainmaa & Peter Nyberg, 2019. "Long-Term Discount Rates Do Not Vary Across Firms," NBER Working Papers 25579, National Bureau of Economic Research, Inc.
    16. Mehmet Balcilar & Riza Demirer & Festus V. Bekun, 2021. "Flexible Time-Varying Betas in a Novel Mixture Innovation Factor Model with Latent Threshold," Mathematics, MDPI, vol. 9(8), pages 1-20, April.

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