Risk, Expected Return and the Cost of Equity Capital

Glenn Boyle

No 18947, Working Paper Series from Victoria University of Wellington, The New Zealand Institute for the Study of Competition and Regulation

Abstract: In applying the CAPM to cost of capital calculations practitioners treat the market risk premium as a free parameter to be estimated from data. However this process ignores equilibrium in the cash market and therefore the implications of the CAPM for the premium itself. Full equilibrium relates the premium to underlying fundamental parameters a finding that holds out the promise of identifying time-variation in the cost of capital. Unfortunately this yields extremely volatile cost of capital estimates thereby casting doubt on the risk-return tradeoff specified by the CAPM.

Date: 2005
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