The paper "Can the implied cost of capital from a mechanical earnings forecast model proxy the expected cost of capital" is submitted by LEI Ling for the degree of Master of Philosophy in Accounting at the Hong Kong University of Science and Technology in May, 2000....[ Read more ]

The paper "Can the implied cost of capital from a mechanical earnings forecast model proxy the expected cost of capital" is submitted by LEI Ling for the degree of Master of Philosophy in Accounting at the Hong Kong University of Science and Technology in May, 2000.

Prior research advocates the use of the implied cost of capital from the residual income model to proxy the expected cost of capital because of its superiority over average realized returns. This study examines whether this approach can be extended to firms without analyst coverage using a mechanical model of earnings forecast. While the implied cost of capital calculated with AR (2) model concentrates at around 5-6%, it is unreasonably low. The implied risk premium is negative for over half of the sample years and the median implied risk premium across all firm years is -0.6%. In addition, the regression of the implied risk premium on the three commonly identified risk factors results in a negative beta effect, positive size effect, and negative B/P ratio effect, all contrary to intuition. To serve as a benchmark, I repeat the estimation of the implied cost of capital and the regression on the three risk factors with firms followed by analysts. The comparison indicates that the unreasonably low implied cost of capital is due to the pessimism of AR (2) forecast model and the underestimation of the terminal value in the residual income model for some firms. Since pessimism is a common problem of all mechanical earnings forecast models, I conclude that we can not get an implied cost of capital from the residual income model as the reasonable proxy for the expected cost of capital for firms without analyst coverage.