Estimating Cost Of Equity

Abstract

Estimation of cost of equity is required for many financial applications such as capital budgeting and performance evaluation using EVA. A common procedure is to use the Capital Asset Pricing Model [CAPM] which involves estimation of an expected risk premium equal to beta times the expected risk premium on the portfolio, the portfolio containing all assets in the world. Since the market portfolio is not observable a proxy must be used. Typically beta is estimated using a domestic index as a proxy or is purchased from a commercial provider and six to eight percent is used as an estimate for the expected market risk premium. The estimates for beta and the expected market risk premium are then multiplied together. In this paper it is shown that this procedure more than likely yields a biased estimate for the cost of equity and as a result leads to misallocation of funds and biased performance measures. It is shown theoretically that the same index must be used for estimation of beta and the expected market risk premium. Further the estimate for the market risk premium must be adjusted to take into account the correlation between the proxy used and the market portfolio. Finally, a straight forward procedure for obtaining an unbiased estimate for cost of equity is presented.