A look at the actual cost of capital of US firms

Abstract

Abstract:The capital asset pricing model (CAPM) receives both criticism and widespread adoption by practitioners and academics as the weighted average cost of capital (WACC) equity component. This study introduces two new costs of equity measures to address CAPM criticisms and provide new perspective on WACC estimates. The firm-based measure focuses on firm-investor cash flows while the market-based measure focuses solely on actual market returns. This study applies its firm and market-based WACC measures, along with the traditional CAPM-based WACC measure, to a broad sector-based cross section from 1972 to 2015. PUBLIC INTEREST STATEMENTThis work introduces two new equity finance measures to provide perspective on the troublesome equity component of a firm's overall cost of capital. The results confirm that the common equity finance measure, CAPM, is a fair measure for use in computing the overall cost of capital. The results also show that firminvestor cash flows differ significantly from CAPM predictions and actual market returns. In particular, the results suggest that market participants play a significant role alongside firms in actual market returns. Other results of this study provide new perspective on why small firms tend to have higher returns than large firms and raises questions on the role of firm cash flow generation in actual market returns. Finally, the comprehensive sector-based cross-sectional data can serve as a reference for practitioners in their cost of capital estimations.

The systematic risk estimation models: A different perspective

“…In practice, the 10-year U.S. T-Bond yield was often chosen as the risk-free rate (Brotherson et al, 2013). However, our study employed the three-month U.S. T-Bill's secondary market rate because it was stable and consistent with the CAPM as originally derived, returns on stocks and market, and other studies (Fama and French, 1993;Harrington, 1983;Black, 1972;Kothari et al, 1995;Litzenberger and Ramaswamy, 1979;Martin and Simin, 2003;Moore, 2016;Phuoc et al, 2018;Rosenberg et al, 1985;Sharpe, 1971). The S&P 500 index was used as a proxy for the market which was consistent with other studies (Brotherson et al, 2013;Harrington, 1983;Bruner et al, 1998;MacKinlay, 1995;Rosenberg et al, 1985;Sharpe, 1971).…”

“…Besides, this research employed the model fit using Bayesian r-squared (R2B) as suggested in other studies (e.g., Buse, 1973;Lee, 1991;Trzpiot, 2013), the absolute value of alpha since the CAPM considered non-traded factor model, and beta and its standard deviation (Beta Std) in our evaluation. The alpha and beta and beta standard deviation have been employed in other studies (e.g., Shanken, 2017, 2018;Chan and Laskonishok, 1992;French, 1992, 1993;1996a2016;Hou et al, 2015;Kozak et al, 2018;Phuoc, 2018;Phuoc et al, 2018;Stambaugh and Yuan, 2016;Trzpiot, 2013). Importantly, we employed the hypothesis/confidence interval of the interested parameter beta and the mean difference of all interested parameters using two estimators since the parameter estimates themselves did not yield enough information in decision makings.…”

“…Theoretically, the managers may employ one of many different available asset pricing models as suggested in Bertomeu and Cheynel (2016) to estimate their firm's beta and cost of equity. However, some studies (e.g., Association for Financial Professionals, 2011; Bartholdy and Peare, 2005;Da et al, 2012;Jacobs and Shivdasani, 2012;Fama and French, 1996b;Liu et al, 2009;Moore, 2016;Zhang, 2017) showed the capital asset pricing model (CAPM, Black, 1972;Lintner, 1965;Sharpe, 1964Sharpe, , 1966Jensen, 1967Jensen, , 1969 is the preferred model in practice. The reasons the CAPM is popular in practice are 1) the returns on the firm's stock and market are easily accessed and available to all investors.…”

“…Also, the OLS and Bayes estimators yielded similar performance if the sample size of the data is large (Barry, 1980;Phuoc, 2018;Zellner, 1971). In addition, the monthly/quarterly/annual returns data are preferred in the CAPM because of their normality property and availability of data (Ang and Bekaert, 2007;Fama and French, 1992, 1993, 1996a, 1996b, 2004, 2016, 2018Kamara et al, 2016Kamara et al, , 2018Phuoc, 2018;Phuoc et al, 2018;Zhang, 2006). However, the OLS and other parametric estimators are known to be sensitive to outliers or unequal variance data, which are the very common problems in real returns on stocks (Phuoc, 2018), compared with the non-parametric (robust) estimators (Alexander and Chervany, 1980;Baissa and Rainey, 2018;Bian and Dickey, 1996;Bian et al, 2013;Lange et al, 1989;Levy, 1971;Martin and Simin, 2003;Rousseeuw, 1984;Wilcox and Keselman, 2004).…”

Is estimating the Capital Asset Pricing Model using monthly and short-horizon data a good choice?

“…The short-horizon data (3-year or 3 Yr) were from May 2016 to May 2019. The risk-free rate was the three-month U.S. T-Bill's secondary market rate from the Federal Reserve Economic Data (FRED) because it was stable and employed in other studies (e.g., Fama and French, 1993 ; Kothari et al., 1995 ; Martin and Simin, 2003 ; Moore, 2016 ; Phuoc et al., 2018 ; Phuoc and Pham, 2020 ). The market was the S&P 500 index which was consistent with other studies (e.g., Brotherson et al., 2013 ; MacKinlay, 1995 ; Phuoc, 2018 ; Phuoc et al., 2018 ; Phuoc and Pham, 2020 ).…”