Estimating the cost of capital with basis assets

• Published in: Journal of banking & finance Vol. 36; no. 11; pp. 3071 - 3079
• Main Authors: Brown, Stephen J., Lajbcygier, Paul, Wong, Woon Weng
• Format: Journal Article
• Language: English
• Published: Amsterdam Elsevier B.V 01-11-2012; Elsevier Sequoia S.A
• Subjects: Basis assets; Capital costs; Cost estimates; Cost of capital; Estimation; Expected returns; Financial assets; Industry; Price models; Risk equivalent classes; Risk exposure; Stock prices; Studies; Industry; Cost of capital; Basis assets; G32; G12; Risk equivalent classes; G17
• ISSN: 0378-4266; 1872-6372
• DOI: 10.1016/j.jbankfin.2012.07.002

► To estimate the cost of capital, risk-equivalent classes are required. ► Modigliani and Miller (1958) use industry groupings to form risk classes. ► Ross (1988) argues for risk classes according to historical risk/return instead. ► We show returns based risk classes improve cost of capital estimates. ► Such cost of capital estimates use risk-class membership not asset pricing models.
Instead of using industry groups or asset pricing models to estimate the cost of capital we propose using risk equivalent classes known as basis assets. A basis asset is constructed by grouping firms together whose returns indicate they share a common risk exposure, which in theory permits a precise and accurate expected return estimate. Thus, knowing to which basis asset a firm belongs, the firm’s cost of capital can be obtained. Empirically, we show that basis assets lead to superior cost of capital estimates when compared with widely used industry groupings. This means we are no longer reliant on asset pricing models or industry groups to estimate the cost of capital of a firm.