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Abstract

The estimation of the cost of equity capital (COE) is one of the most important tasks in financial management. Existing approaches compute the COE using historical data, i.e. they are backward-looking methods. This study derives a method to calculate forward-looking estimates of the COE using the current market prices of stocks and stock options. Our estimates of the COE reflect the expectation of the market investors about the COE during the life of the investment project. We test empirically our method and compare it with the Fama/French (1993) three-factor model for the S&P 100 firms. The empirical results indicate that our COE estimates (1) are plausible and stable over the years as required by appropriate discount rates for capital budgeting, (2) yield an equity risk premium close to the market equity risk premium reported by Fama E. F. and French K. R. (2002), (3) generate strong return-risk relationships, and (4) are significantly related with investor sentiment. © 2009 Wiley Periodicals, Inc. Jrl Fut Mark 29: 599–629, 2009