Alternative Estimates of the Cost of Equity Capital for Australian Firms

Abstract

We estimate the cost of equity capital for a sample of Australian firms using the CAPM and valuation models which are based on analyst forecasts of earnings and dividends. We find that the use of a composite of time-series and analyst forecasts rather than raw analyst forecasts results in cost of capital estimates that better explain the cross-sectional variation in future stock returns. Cost of capital estimates from the CAPM provide the weakest explanation of future stock returns. Cost of capital estimates from the valuation models are also found to be significantly related to key firm characteristics such as size, book-to-market and financial leverage. A variant of the dividend discount model provides the best cost of capital estimates when judged by their ability to explain the cross-section of future returns and their association with firm risk characteristics.