A preliminary framework to estimate and disclose ex-ante cost of capital for (fair) valuation

Abstract

Fair-value accounting is usually seen as a rule to mark assets to market. While the market was bullish, there was little concern about the implications of a potential downside risk of fair value rules. But with the current world financial crisis triggered by US subprime loans default, pressure surged for it is simply extinction or at least for more flexibility to apply what 'fair' should really mean according to managers' judgment. Critics of fair-value (mark-to-market) accounting raise the question that in some moments market prices decouple from the 'fundamentals' and using it as the value reference can distort financial statements. In other words, they posit that market are not always efficient, markets are prone to positive and negative price bubbles. This is a preliminary work that aims to estimate ex-ante cost of capital (or expected rate of return) using market data and some parameters, like expected equity market risk-premium, its volatility and an average relative risk-aversion of a representative agent. In other words, the main objective is to establish a framework of assumptions, in order to do and disclose inherently subjective estimates of equity market portfolio (or index) ex-ante expected rate of return, in a theoretical coherent manner.