Academic journal article Financial Management

Ex Ante Cost of Equity Estimates of S&P 500 Firms: The Choice between Global and Domestic CAPM

Academic journal article Financial Management

Ex Ante Cost of Equity Estimates of S&P 500 Firms: The Choice between Global and Domestic CAPM

Article excerpt

We estimate ex ante expected returns for a sample of S&P 500 firms over the period 1983-1998. The ex ante estimates show a better overall fit with the domestic version of the single-factor CAPM than with the global version, but the difference is small. This finding has no trend in time and is consistent across groups formed on the basis of relative foreign sales. The findings suggest that for estimating the cost of equity, the choice between the domestic and global CAPM may not be a material issue for many large US firms.

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The estimation of a firm's cost of equity capital remains one of the most critical and challenging issues faced by financial managers, analysts, and academicians. Although theory provides several broad approaches, recent survey evidence reports that among large US firms and investors, the capital asset pricing model (CAPM) is by far the most widely used model.

Among the variety of decisions to be made in implementing the CAPM is the choice between a domestic or global index for the market portfolio. Although theory suggests that using a domestic market index is appropriate only for an asset traded in a closed, national market, empirical research has thus far failed to establish whether a global or domestic pricing model performs better with US stocks.

We study the choice between the global and domestic CAPM by examining which of the two models provides the better fit with a sample of ex ante expected equity return estimates for large US companies. In contrast to many prior studies that use realized returns, we estimate implied expected returns based on the theory's call for a forward looking measure. The question we ask is whether the domestic or the global version of the single-factor CAPM provides the better fit with the dispersion of the ex ante expected return estimates for a sample of S&P 500 equities. Our study period covers 1983 to 1998.

We find that the domestic US CAPM fits the ex ante expected return estimates better than does the global CAPM. This result shows no trend over time. We also find that except for a few years in the early 1990s, the better fit of the domestic CAPM holds consistently across subsamples formed on the basis of the relative levels of the firms' foreign sales. However, the difference in fit of the two versions of the CAPM is small.

We also find a positive and significant empirical relation between ex ante risk premium estimates and systematic risk estimates. Moreover, we find that the ex ante risk premium estimates for broad industry groups have a high correlation with the corresponding Fama-French (1997) estimates from the CAPM, but not with the estimates from their three-factor model.

The study's practical implications are based on the widespread use of the CAPM in cost of capital estimation by large US firms and investors, where the traditional use of the S&P 500 index as the "market portfolio" continues to be the standard. Our findings support the use of the domestic CAPM to estimate the cost of equity of large US firms. However, finding a relatively small difference in the overall fit of the two CAPM versions suggests that the choice between applying the domestic CAPM and the global CAPM may not be a critical issue for many large US firms.

The paper is organized as follows. Section I reviews related literature. This review includes the domestic and global versions of the single-factor CAPM and why the two models are theoretically likely to result in different expected rates of return for a given asset. Section II discusses the methodology and data for the empirical analysis. Section Ill reports the results of the empirical comparison of the ex ante expected return estimates with the estimates of the two CAPM versions and with corresponding measures of risk. Section IV provides a brief summary and conclusion.

I. Review of Related Literature

Recent survey evidence (Brunet, Eades, Harris, and Higgins, 1998) and Graham and Harvey, 2001) reports that the capital asset pricing model (CAPM) is widely used by large US firms and investors. …

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