Estimating the cost of capital with basis assets |
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| Authors: | Stephen J. Brown Paul Lajbcygier Woon Weng Wong |
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| Affiliation: | 1. Department of Finance, Stern School of Business, New York University, 44 West 4th Street, New York, NY 10012-1126, United States;2. Department of Finance, University of Melbourne, Level 12, 198 Berkeley Street, Victoria 3010, Australia;3. Department of Accounting and Finance, Faculty of Business and Economics, Monash University, Building 11E, Clayton, Victoria 3800, Australia;4. Department of Econometrics and Business Statistics, Faculty of Business and Economics, Monash University, Building 11E, Clayton, Victoria 3800, Australia |
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| Abstract: | 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. |
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| Keywords: | Cost of capital Risk equivalent classes Industry Basis assets |
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