Implied Cost Of Capital Research Articles

Validating implied cost of capital with realized returns by using alternative measures of cash-flow news

We outline analytically that, when testing different implied cost of capital (ICC) estimates for validation by employing the Vuolteenaho (2002) framework, the cash-flow news in the validation framework should be defined in a way that considers the ICC model specific assumed sequence of future cash flows. This is based on market expectations, as proxied by analysts' forecasts. We then propose adjusting the cash-flow news proxies accordingly and implement these adjustments empirically. Consistent with the theoretical predications, the results from these tests show that ICC estimates are significantly positively related to realized returns. Informed by these findings, we employ the adjusted cash-flow news proxies in the validation framework and compare the correlation between adjusted and unadjusted for analysts' bias ICC estimates with realized returns. These tests show no difference in these correlations. This suggests that it is not the analysts' bias that weakens the validity of ICC estimates, as argued by prior literature. It is the proxies used in the validation framework that lead to the suggestion in removing analysts’ optimism from ICC estimates. Overall, our proposed alternative framework not only unlocks the gate for extensive use of the existing ICC estimates but also enables future researchers to develop more reliable and meaningful ICC estimates.

Estimating an Equity Yield to Maturity: Deficiencies of the Implied Cost of Capital (ICC) and an Alternative

Estimating an Equity Yield to Maturity: Deficiencies of the Implied Cost of Capital (ICC) and an Alternative

A study of the reliability of cross-sectional earnings forecasting models for estimating IPO firms’ implied cost of capital

PurposeThis study aims to evaluate the earnings forecasting models of Hou et al. (J Account Econ, 53:504–526, 2012) and Li and Mohanram (Rev Account Stud, 19:1152–1185, 2014) in terms of bias and accuracy and validity of the implied cost of capital (ICC) estimates for a sample of initial public offerings (IPOs).Design/methodology/approachThe authors use a sample of 1,657 NYSE, Amex and Nasdaq IPOs from 1972 to 2013.FindingsThe models of Hou et al. and Li and Mohanram produce relatively inaccurate and biased earnings forecasts, leading to unreliable ICC estimates, particularly for small and loss-making IPOs that constitute the bulk of new listings. As a remedy, the authors propose a new earnings forecasting model, a combination of Hou et al.’s and Li and Mohanram’s earnings persistence models, and show that it produces more accurate and less biased earnings forecasts and more valid ICC estimates.Originality/valueThe study contributes novel results to the literature on the validity of cross-sectional earnings models in forecasting IPO firm earnings and estimating the ICC. The findings are directly relevant for practitioners, who can improve their earnings forecasting accuracy for IPO firms and related ICC estimates. The insights can be extended to other settings where investors have limited access to financial information, such as acquisitions of private targets.

Is the new issue puzzle real? Evidence from implied cost of capital

PurposeThis study aims to provide new explanation of the new issue puzzle.Design/methodology/approachThis study uses market implied cost of capital (ICC), rather than ex post realized returns, as proxy for ex ante expected returns, and sheds new light on the question why initial public offering (IPO) firms underperform the market within a 3–5 years period after the offerings.FindingsUsing ICC, the author finds that the market expects to earn higher risk premium for new listing firms than similar firms, which is contradictory to the documented new issue puzzle. The higher expected returns come from higher idiosyncratic volatility for newly listed firms, which are young and have more growth opportunities. The author also reports that investors are negatively surprised by lower-than-expected performances of newly listed firms.Originality/valueThe author’s results provide new empirical evidence that the new issue puzzle does not exist. Previous results observed IPO firms' under-performance is attributable to that ex post realized returns are a noisy proxy for ex ante expected returns, especially for newly listed firms with limited information.

Company Reputation, Implied Cost of Capital and Tax Avoidance: Evidence from Korea

This study aims to investigate the relationship between company reputation and the implied cost of capital in Korean companies from 2003 to 2016, based on research by Cao et al. (2015). In addition, we would like to examine the effect of tax avoidance. Company reputation increases corporate sustainability and enables sustainable management. In this study, Brandstock Top Index (BSTI), which represents Korea’s top 100 brands, was used as an interest variable representing company reputation. To examine the relationship between company reputation and implied cost of capital, the multiple linear regression analysis was conducted using various measures of implied cost of capital as a dependent variable. As a result of empirical analysis, company reputation and implied cost of capital showed a significant negative relationship. The higher the company’s reputation, the less information asymmetry in the stock market, indicating that the implied cost of capital decreases. A significant negative relationship between company reputation and implied cost of capital was not found in a group that was aggressive in tax avoidance. The contributions of this study are as follows. First, we presented the empirical result that company reputation and implied cost of capital were negatively related in Korea. It showed empirically the importance of company reputation in the Korean stock market. Second, in addition to the relationship between company reputation and implied cost of capital, prior research was expanded considering tax avoidance.

HUBUNGAN ANTARA KARAKTERISTIK PERUSAHAAN DENGAN IMPLIED COST OF CAPITAL PADA PERUSAHAAN DI INDONESIA

This study, proposes an altenative technique for estimating the cost of capital. Specifically, it use discounted residualincome model. The examine firms characteristic that are systemati- cally related to this estimate of cost of capital, it show that a firm's cost of capital isa function of its long term Debt to Book Ratio (Ln D/B), Long Fim Size (Ln Size), Eaming Variability (Ln Ev) and Long Debt to Market Ratio (Ln D/M). These variables explain around 63% of the coss secional variaton in future implied costof capital. The findings suggest that they can be exploited to estimate future cost of capital in Indonesia.

The role of market efficiency on implied cost of capital estimates: an international perspective

This study examines the role of market efficiency on international differences in the usefulness of the implied cost of capital (ICC) to measure expected stock returns. The analysis exploits cross-country differences in market efficiency around the world using a variety of empirical measures of market efficiency. A key methodological contribution of this paper is to assess the quality of the ICC as estimate of expected returns by evaluating its forecast error for subsequent stock returns. The results show that the accuracy of the ICC as measure of expected stock returns is positively associated with the countries’ level of market efficiency.

The Role of Market Efficiency on Implied Cost of Capital Estimates - an International Perspective

This study examines the role of market efficiency on international differences in the usefulness of the implied cost of capital (ICC) to measure expected stock returns. The analysis exploits cross-country differences in market efficiency around the world using a variety of empirical measures of market efficiency. A key methodological contribution of this paper is to assess the quality of the ICC as estimate of expected returns by evaluating its forecast error for subsequent stock returns. The results show that the accuracy of the ICC as measure of expected stock returns is positively associated with the countries' level of market efficiency.

Predicting stock returns with implied cost of capital: A partial least squares approach

We extract a single factor from popular aggregate implied cost of capital (ICC) measures using partial least squares method. This combined measure strongly predicts future stock market returns, both in-sample and out-of-sample. The predictive power outperforms and complements those of individual ICCs, other combined ICC approaches, as well as macroeconomic and sentiment variables. Cross-sectionally, it strongly predicts various equity portfolio returns, particularly large-size portfolios and portfolios with lower accruals and earnings volatility. The predictive power extends to bond portfolios and monotonically increases with maturities. The results suggest that the combined ICC tracks time-varying discount rate through the macroeconomic uncertainty channel.

Implied Cost of Capital and Mutual Fund Performance

This study provides evidence for a positive association between mutual fund holdings' implied cost of capital (ICC) and future performance. Consistent with large transaction costs of ICC-based investments impeding their exploitation and employing a ICC-based strategy reflecting skill, family-level trading efficiency and manager-level SAT score positively correlate with fund-level ICC. A negative association between ICC and mid-year risk shifting corroborates the notion of fund managers decisively choosing and relying on high-ICC strategies. Institutional investors able to identify funds with high ICC direct their investments accordingly, whereas flows of retail funds are unaffected, consistent with limited investor attention and financial literacy.

Speculative Stock Price and Inadequacy of the Implied Cost of Capital as a Proxy for Expected Return

The implied cost of capital (ICC), the internal rate of return that equates speculative stock price to discounted expected future dividends, includes a mispricing-driven component in addition to expected return. The estimated relation of a mispricing-associated factor (X) with ICC is thus a potentially biased estimate of X’s relation with expected return because it captures X’s relation with both expected return and the mispricing-driven component. The sign of X’s relation with the mispricing-driven component switches between undervalued and overvalued stocks. It is unfeasible to calibrate the sign and magnitude of X’s relation with the mispricing-driven component. Existing methods do not seem able to address the bias resulting from X’s relation with the mispricing-driven component. Therefore, ICC is an inadequate proxy for expected return when examining the relation of a mispricing-associated factor with expected return, which evidence based on eleven mispricing-associated factors shows to be the case.

An Analysis of the Potential Impact of Heightened Capital Requirements on Banks’ Cost of Capital

Critics of recent regulation to increase minimum bank capital requirements contend that this policy will increase the cost of doing business for banks. We investigate the potential impact of heightened capital requirements on banks’ cost of capital. In the cross-section, banks’ cost of equity, measured by the implied cost of capital (ICC), and banks’ cost of debt decline when equity capital increases. The negative association between capital and banks’ ICC is stronger after the onset of the financial crisis, consistent with prior work suggesting that equity is more valuable during periods of financial distress. The negative association between capital and banks’ cost of equity and debt, compensates for the difference in the costs of these sources of financing. As a consequence, the overall cost of capital remains unaltered when capital increases. Thus, our findings do not offer support the claim that additional equity has a negative impact on credit because equity increases banks’ cost of capital. An exception to these findings is found in the sample of large banks. There is no discernible association between capital and the costs of equity and debt of large banks and their WACC increases when they substitute debt with more expensive equity.

The Implied Cost of Capital: Accounting for Growth

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.

Economic Consequences of Corporate Governance Disclosure: Evidence from the 2006 SEC Regulation on Related-Party Transactions

ABSTRACT This paper examines economic consequences of a 2006 Securities and Exchange Commission regulation that mandated public firms to disclose their governance policies on related-party transactions (RPTs). Employing hand-collected RPT data for S&P 1500 firms, we find that the initiation of RPT governance disclosure significantly reduces the occurrence of RPTs, and that the reduction in RPTs is negatively associated with the implied cost of capital (ICC) and positively related to Tobin's Q. These effects are more pronounced for low-monitored firms and for firms with RPTs that are more likely to be opportunistic. We further find that firms with a formal written policy, a designated committee to review and approve RPTs, or more extensive disclosure on RPT governance benefit in terms of lower ICC.

Analyst versus model‐based earnings forecasts: implied cost of capital applications

AbstractWe find that a composite implied cost of capital (ICC) estimate – based on the earnings forecasts generated by cross‐sectional models – is highly correlated with future realised returns in both portfolio‐ and regression‐based tests. By contrast, we find very little evidence for an association with future realised returns for an ICC estimate based on analyst earnings forecasts. We also document the time‐varying nature of expected returns and risk premia, and provide up‐to‐date estimates of an implied Australian market risk premium.

Aggregate implied cost of capital, option-implied information and equity premium predictability

The aggregate implied cost of capital (ICC) from analyst estimates finds a variety of applications in finance and is documented to predict the equity premium. Yet, the construction of the analyst-based ICC is data intensive and imposes restrictions on the employed analyst estimates. We suggest a new way to obtain a market-wide ICC using implied information from index options. We show that the resulting ICC predicts the equity premium in- and out-of-sample. At the same time, we find that the predictive power of the aggregate ICC from analyst estimates is not prevalent in our sample once we control for the persistence of the variable.

Aggregate Implied Cost of Capital, Option Implied Information and Equity Premium Predictability

The aggregate implied cost of capital (ICC) from analyst estimates finds a variety of applications in finance and is documented to predict the equity premium. Yet, the construction of the analyst-based ICC is data intensive and imposes restrictions on the employed analyst estimates. We suggest a new way to obtain a market-wide ICC using implied information from index options. We show that the resulting ICC predicts the equity premium in- and out-of-sample. At the same time, we find that the predictive power of the aggregate ICC from analyst estimates is not prevalent in our sample once we control for the persistence of the variable.

Estimating An Implied Cost of Capital for Australian Firms

We find that a composite implied cost of capital (ICC) estimate - based on the earnings forecasts generated by cross-sectional models is highly correlated with future realised returns in both portfolio- and regression-based tests. By contrast, we find very little evidence for an association with future realised returns for an ICC estimate based on analyst earnings forecasts. We also document the time-varying nature of expected returns and risk premia, and provide up-to-date estimates of an implied Australian market risk premium. Additionally, we provide industry-level estimates; highlighting differences in expected returns and risk perceptions across sectors.

Comparing results of the implied cost of capital and capital asset pricing models for infrastructure firms in Brazil

This study aims to evaluate whether the implied cost of capital (ICC) model is better than the capital asset pricing model (CAPM) in predicting the realized rate of return for infrastructure firms. We selected a sample of 49 listed companies in Brazil for the period from 2002 to 2014. The CAPM yielded a cost of capital of 11.97% per annum, while the ICC yielded 13.39% per annum, a difference of 1.42% annually. We suggest that a possible explanation for this result is the existence of systematic, non-diversifiable risk, potentially due to regulatory intervention in the business environment.

Economic Consequences of Corporate Governance Disclosure: Evidence from the 2006 SEC Regulation on Related-Party Transactions

This paper examines economic consequences of a 2006 Securities and Exchange Commission regulation that mandated public firms to disclose their governance policies on related-party transactions (hereafter RPTs). Employing hand-collected RPT data for S&P 1500 firms, we find that the initiation of RPT governance disclosure significantly reduces the occurrence of RPTs and that the reduction in RPTs is negatively associated with the implied cost of capital (ICC) and positively related to Tobin’s Q. These effects are more pronounced for low-monitored firms and for firms with RPTs that are more likely to be opportunistic. We further find that firms with a formal written policy, a designated committee to review and approve RPTs, or more extensive disclosure on RPT governance benefit in terms of lower ICC.