Best Practice for Cost-of-Capital Estimates

65 Pages Posted: 4 Oct 2015 Last revised: 21 Feb 2017

See all articles by Yaron Levi

Yaron Levi

University of Southern California - Marshall School of Business

Ivo Welch

University of California, Los Angeles (UCLA); National Bureau of Economic Research (NBER)

Date Written: September 23, 2016

Abstract

Cost-of-capital assessments with factor models require quantitative forward- looking estimates. We recommend estimating Vasicek-shrunk betas with one to four years of daily stock returns, and then — because the underlying betas are themselves time-varying — shrinking betas a second time (and more for smaller stocks and longer-term projects). Such estimators also worked well in other OECD countries and for SMB and HML exposures. If own historical stock returns are not available, market cap-based peer betas should be used. Historical industry averages have almost no predictive power and should never be used.

Keywords: cost of capital, capital budgeting, CAPM

JEL Classification: G31

Suggested Citation

Levi, Yaron and Welch, Ivo, Best Practice for Cost-of-Capital Estimates (September 23, 2016). Marshall School of Business Working Paper No. 17-4, Available at SSRN: https://ssrn.com/abstract=2667735 or http://dx.doi.org/10.2139/ssrn.2667735

Yaron Levi

University of Southern California - Marshall School of Business ( email )

Marshall School of Business
Los Angeles, CA 90089
United States

Ivo Welch (Contact Author)

University of California, Los Angeles (UCLA) ( email )

110 Westwood Plaza
C519
Los Angeles, CA 90095-1481
United States
310-825-2508 (Phone)

HOME PAGE: http://www.ivo-welch.info

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Do you have negative results from your research you’d like to share?

Paper statistics

Downloads
1,520
Abstract Views
5,318
Rank
22,865
PlumX Metrics