Aaltodoc publication archive (Aalto University institutional repository)
School of Business | Department of Management and International Business | International Business | 2013
Thesis number: 13655
The validity of the implied cost of capital method: Mechanical earnings forecasts and the incorporation of clean earnings and total dividend figures
|Title:||The validity of the implied cost of capital method: Mechanical earnings forecasts and the incorporation of clean earnings and total dividend figures|
|Year:||2013 Language: eng|
|Department:||Department of Management and International Business|
|Academic subject:||International Business|
|Index terms:||kansainväliset yhtiöt; international companies; johdon laskentatoimi; managerial accounting; yrityksen arvo; company valuation; tulos; return|
|Key terms:||Implied Cost of Capital, CAPM, Corporate Valuation, Expected Returns|
Researchers, investors and managers need a measure that accurately predicts a firm's cost of equity capital, respectively its future expected returns. Therefore, these estimates are a fundamental part of the finance and accounting literature. Among the most recog-nized are the Capital Asset Pricing Model (CAPM) or the Fama French Three-Factor-Model. Irrespective of the great efforts to develop such models the resulting estimates are not satisfactory. A major critique resides in the models dependence on noisy real-ized returns. Using corporate valuation models and current market prices of firms, the implied cost of capital method (ICC) estimates the discount rate that the market applies on a firm's future expectations. While this approach circumvents the use of noisy real-ized returns and relies on intuitively appealing reasoning, the validity of the various ICC models remains unclear, given the current state of literature. The goal of this study is to shed further light on the validity of the ICC method. Therefore, the current state of the literature is reviewed and the most important ICC models are presented. Furthermore, the difficulties of their execution are identified. Afterwards, an empirical analysis on a sample of firms from 1970 to 2005 is performed. ICC estimates for the sample firms are calculated and their performance is evaluated.
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