The Implied Cost of Capital: Accounting for Growth

Abstract

This paper provides a review and critique of research that estimates an Implied Cost of Capital (ICC) by reverse engineering accounting-based valuation models. The focus is on the estimated growth rate inserted into those models. The paper makes two points. First, the growth rate is determined by the accounting for other inputs in the calculation, namely book value and near-term earnings forecasts. Thus an accounting consistency condition must be satisfied. Second, the accounting principles for these inputs imply that the consequent growth rate informs about risk and this must be recognized in an ICC calculation that also conveys risk. Empirical tests indicate that ICC calculations fail to incorporate this information.