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Title: Properties of implied cost of capital under alternative valuation models and analyst behaviour: evidence from the U.K.
Author: Makrominas, Michalis
ISNI:       0000 0004 2745 0802
Awarding Body: University of London
Current Institution: Imperial College London
Date of Award: 2007
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Investors have strong incentives to assess the expected return of common equity as an important variable in portfolio management, capital budgeting, investment appraisal and resource allocation decision. A relatively novel methodology of estimating the expected return links market prices with analyst-issued expected cash flows to deduce the implied cost of equity capital. The purpose of this thesis is to evaluate five earnings-based implied cost of capital estimates and to assess the sensitivity of earnings-based implied cost of capital against a number of parameters introduced by alternative equity valuation models and analyst behaviour. The dissertation utilizes a relatively large dataset ofU.K. firms for the period 1994-2003. The individual and joint assessment of implied cost of capital estimates bears upon the investigation of several empirical questions. In particular, an examination of the average magnitude of implied cost of capital estimates measures the degree of mean-point accuracy of these estimates, in relation to expected return. Comparative statistics and a set of (non)parametric tests of independence are used to assess the proximity/departure of the distributions of alternative implied cost of capital estimates. Cases of extreme divergence among the estimates are marked by relative values of ex-ante characteristics and a break-point level of implied cost of capital. The ability of implied cost of capital to characterize cross-sectional variation in expected equity return is evaluated through tests of linear association between implied cost of capital estimates and a number of firm/industry specific risk factors, including-the special cases of Research and Development and Advertising expenditure. Incrementally, the usefulness of implied cost of capital estimates as parsimonious predictors of realized return is assessed, with return predictability tests carried out against various forecasting horizons, at firm and industry levels, across particular clusters of stocks, and under the assumption that a firm's risk premium is a positive function of the market excess return. Finally, the impact of analyst behaviour on the quality of earnings forecasts and, pervasively, on the quality of earnings based implied cost of capital estimates is examined. Several attributes of analyst behaviour are initially identified as sources of analyst bias. These attributes are then quantified with the use of easily measurable proxy variables facilitating the development of an econometric model that predicts analyst forecasting errors, and the consolidation of fitted values of expected errors in the estimation process of' adjusted' implied cost of capital estimates. The variation of implied cost of capital estimates across analyst investment recommendation is hypothesized and tested, and the cases of analyst forecast sluggishness and/or thin trading leading to information mismatch between analyst expectations and market prices are considered. The results of this thesis are of interest to researchers dedicated to the implied cost of capital, the cross-section of expected returns, earnings based equity valuation, model equivalence, analyst earnings forecasts, analyst behaviour, and, to a minor extent, the U.K. aggregated equity risk premium. The tests performed are sufficient in clearly designating the preferred implied cost of capital estimate. A number of implications for academics and practitioners are discussed.
Supervisor: Not available Sponsor: Not available
Qualification Name: Thesis (Ph.D.) Qualification Level: Doctoral
EThOS ID:  DOI: Not available