The Relationship Between Implied Cost of Capital and Expected Return: Evidence from a Cross-Sectional Earnings Model

Krisztian Gyepes & Evaldas Kirilovas

Student thesis: Master thesis

Abstract

In this thesis, we investigate the relationship between the implied cost of capital and expected return. We provide the relevant literature overview, theories and motivation that eventually lead to our empirical analysis. We compute five different implied cost of capital (ICC) measures based on model-generated forecasted earnings instead of analysts’ earnings forecasts. Further, we introduce the composite ICC measure, which is in the very focus of our empirical work. As the basis of our empirical analysis we construct a sample of 56,384 unique firm-year observations dating from 1967 to 2012. First, we justify the use and prove the validity of our model-generated ICC measure with the help of the Expected Return Model. Second, we show that ICC performs well in predicting ex-post realized returns on a portfolio level however, our Realized Return Model provides only weak evidence in support of such predictive power. Third, by imposing an assumption on realized return decomposition, we find that there is a difference between ICC and the hypothetical expected returns. This difference is mainly explained by market beta volatility, cash flow volatility and the correlation of expected returns and cash flows.

EducationsMSc in Advanced Economics and Finance, (Graduate Programme) Final Thesis
LanguageEnglish
Publication date2018
Number of pages114