Use of Forecasts of Earnings to Estimate and Compare Cost of Capital Across Regimes

Abstract

I critically examine several of the methods used in the recent literature to estimate and compare the cost of capital across different accounting/regulatory regimes. I focus on the central importance of expectations of growth beyond the short period for which forecasts of future pay-offs (dividends and/or earnings) are available. I illustrate, using the stocks that comprised the Dow Jones Industrial Average (DJIA) at December 31, 2004 as an example, the differences between the growth rates implied by the data, and growth rates that are often assumed in the literature. My analyses show that assumptions about growth beyond the (short) forecast horizon may seriously affect the estimates of the expected rate of return and may lead to spurious inferences.

Keywords: Cost of capital, accounting regimes, GAAP differences

JEL Classification: G12, G30, M41