Risk, Expected Return and the Cost of Equity Capital

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.