Evaluating Implied Cost of Capital Estimates

We propose a two-dimensional evaluation scheme for assessing the quality of implied cost of capital (ICC) estimates when price is noisy. Under fairly general assumptions, high-quality ICC estimates should: (a) better forecast future realized returns, and (b) better forecast future ICCs. Empirically, we compare seven alternative ICC estimates and show that several perform well along both dimensions. Moreover, we find that the lagged industry median ICC computed using any of the successful models will predict both future firm-level returns and firm-level ICCs. These results offer support for a parsimonious industry-based ICC estimate in investment or capital budgeting decisions. ** All three authors are at Stanford University. Lee ([email protected]) is the Joseph McDonald Professor of Accounting at the Stanford Graduate School of Business (GSB); So ([email protected]) is a Doctoral Candidate in Accounting at the Stanford GSB; Wang ([email protected]) is a Doctoral Candidate in the Department of Economics. We thank seminar participants at the Stanford Accounting Research workshop for helpful comments and suggestions.