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Best Practice for Cost-of-Capital Estimates

Abstract

Cost-of-capital assessments with factor models require quantitative forward-looking estimates. We recommend estimating Vasicek-shrunk betas with 1–4 years of daily stock returns and then shrinking betas a second time (and more for smaller stocks and longer-term projects), because the underlying betas are themselves time-varying. Such estimators also work well in other developed countries and for small-minus-big (SMB) and high-minus-low (HML) exposures. If own historical stock returns are not available, peer betas based on market cap should be used. Historical industry averages have almost no predictive power and should never be used.

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Copyright
Corresponding author
* Levi, ylevi@marshall.usc.edu, Marshall School of Business, University of Southern California; Welch (corresponding author), ivo.welch@anderson.ucla.edu, Anderson School of Management, University of California at Los Angeles.
Footnotes
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1

We thank Zhi Da (the referee), Jarrad Harford (the editor), Susan Huot (the business and preproduction manager), many colleagues, and seminar participants at California State University at Fullerton, the University of California at Los Angeles, Cornell University, the Federal Reserve Board, and Brigham Young University.

Footnotes
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Journal of Financial and Quantitative Analysis
  • ISSN: 0022-1090
  • EISSN: 1756-6916
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