Significance of beta in estimating cost of capital in an emerging economy: the Nigerian evidence

Abstract

The importance of correctly estimating the appropriate discount factor to use in corporate valuation situations such IPOs, mergers and acquisitions, leverage buyouts, capital budgeting decisions, etc. is well understood in the finance literature. A key input in this estimation, and yet the most difficult to calculate correctly, which can induce error in the estimate of the discount factor or cost of capital obtained, is the cost of equity capital. The Capital Assets Pricing Model (CAPM) of Sharpe (1965) and Lintner (1966) provides the most established theoretical basis of estimating the cost of capital. This paper investigates whether the CAPM is a sufficiently valid asset pricing model to use in estimating the cost of equity capital in Nigeria. Jensen (1968) time series methodology is followed in the study. Our results show that the CAPM significantly explains equity returns on the Nigeria market however, there are other risk factors not captured by beta (i.e. systematic risk measure per CAPM definition).