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Best Practice for Cost-of-Capital Estimates

Published online by Cambridge University Press:  21 April 2017

Yaron Levi  and
Ivo Welch
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Abstract

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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.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 52 , Issue 2 , April 2017 , pp. 427 - 463
Copyright
Copyright © Michael G. Foster School of Business, University of Washington 2017 

Footnotes

1

We thank Zhi Da (the referee), Jarrad Harford (the editor), Susan Huot (the business and preproduction manager), many colleagues, and seminar participants at California State University at Fullerton, the University of California at Los Angeles, Cornell University, the Federal Reserve Board, and Brigham Young University.

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