Dynamical Internal Cost of Capital Driven by Cash Flow Growth

David Solo, Didier Sornette and Florian Ulmann
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David Solo: Diversified Credit Investments, LLC
Didier Sornette: ETH Zürich - Department of Management, Technology, and Economics (D-MTEC); Swiss Finance Institute; Southern University of Science and Technology; Tokyo Institute of Technology
Florian Ulmann: ETH Zurich

No 21-24, Swiss Finance Institute Research Paper Series from Swiss Finance Institute

Abstract: Based on the insight that risk exposure as quantified in the consumption based asset pricing model (CCAPM) is linearly proportional to the cash flow growth rate, we introduce a discounted cash flow model with a time-varying expected return structure matching the implicitly assumed risk exposure at each future point in time in the valuation model, i.e. the assumed cash flow growth rate process. This reduces the range of reasonable valuations outcomes to useful levels, given that the linearly proportional term structures of potential cash flow growth rates and equity risk premia are complementary, offsetting variables in a discounted cash flow pricing model. In the same manner we elaborate a time-varying internal cost of capital (ICC) model that reflects the implied risk exposure at each future point in time and thus has a clear interpretation as an expected return process. This time-varying ICC model is superior to the constant ICC model in a Fama-MacBeth regression setting to predict future realised returns. And using the expected return of the time varying ICC model as control in a Fama-MacBeth regression of the profitability, the investment and the value factor, both the profitability and the value factor become insignificant in explaining future realised returns. The superiority and economic significance of the time-varying ICC model is further con firmed in a trading strategy with yearly rebalancing.

Keywords: Internal Cost of Capital; consumption based asset pricing model; cash flow growth; equity risk premium; implied risk; Fama-MacBeth regression; time-varying risk premium; trading strategy (search for similar items in EconPapers)
JEL-codes: C20 C53 G11 G12 O16 (search for similar items in EconPapers)
Pages: 41 pages
Date: 2021-03
New Economics Papers: this item is included in nep-cfn, nep-cwa and nep-ore
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Persistent link: https://EconPapers.repec.org/RePEc:chf:rpseri:rp2124

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