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Abstract
In this study, we examine the relation between implied cost of capital and expected returns under an assumption that expected returns are stochastic, a property supported by theory and empirical evidence. We demonstrate that implied cost of capital differs from expected return, on average, by a function encompassing volatilities of, as well as correlation between, expected returns and cash flows, growth in cash flows, and leverage. These results provide alternative explanations for findings from empirical studies employing implied cost of capital on the magnitude of the market risk premium; relations between cost of capital, growth, leverage, and idiosyncratic risks; predictability of future returns, and characteristics of the firm's information environment.
Highlights
We theoretically analyze the properties of ‘‘implied cost of capital,’’ defined as the internal rate of return that equates stock price with the present value of the expectedThe assumption of constant expected returns can be challenged on both theoretical and empirical grounds
We show that implied cost of capital differs from expected return, and this difference is a function of leverage, growth in cash flows, expected return volatility, cash flow volatility, and the correlation between expected return news and cash flow news
While it is tempting to conclude that these analyses discovered priced risk factors not previously identified in the asset pricing literature, our results demonstrate that even if risk is entirely captured by factor betas in determining expected return, given stochastic expected returns, implied cost of capital is correlated with growth, leverage, and idiosyncratic risk after controlling for betas
Summary
We theoretically analyze the properties of ‘‘implied cost of capital,’’ defined as the internal rate of return that equates stock price with the present value of the expected. Studies by Gebhardt et al (2001); Gode and Mohanram (2003) examined whether implied cost of capital measures capture previously unidentified priced risks in the cross section They found that such measures are significantly correlated with firm characteristics such as growth, leverage, and idiosyncratic risk, after controlling for beta. Measures as proxies for priced risks by investigating whether those measures have predictive power with respect to future stock returns While their general result is insignificant for all implied cost of capital measures, they found improvement in significance when they controlled for analyst forecast inefficiency or firm growth.
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