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| Author: | Ferson, W. E. Locke, D. H. |
| Title: | Estimating the cost of capital through time: An analysis of the sources of error |
| Journal: | Management Science
1998 : APR, VOL. 44:4, p. 485-500 |
| Index terms: | CAPITAL BUDGETING CAPITAL COSTS CAPITAL ASSET PRICING ASSET VALUATION RISK PREMIUM FORECASTING |
| Language: | eng |
| Abstract: | The Capital Asset Pricing Model (or CAPM) has been long relied on by practitioners needing estimates of a firm's equity cost of capital. Recent evidence casts renewed doubt on the validity of the CAPM and beta. There is not much evidence, however, to gauge the importance of the rejections of the CAPM in a practical decision-making context. Evidence is presented on the sources of error in estimating required returns over time. Also, a number of proxies are used. It is found in the paper that the great majority of the error in estimating the cost of equity capital is found in the risk premium estimate, and relatively small errors are due to the risk measure, or beta. This suggests that analysts should improve estimation procedures for market risk premiums, which are commonly based on historical averages. |
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