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On the relation between expected returns and implied cost of capital

John Hughes¹; Jing Liu^1,2; Jun Liu^1,2

¹ University of California, Los Angeles · ² University of California San Diego

We examine the relation between implied cost of capital and expected returns under an assumption that expected returns are stochastic, a property supported by theory and empirical evidence. We demonstrate that implied cost of capital differs from expected return, on average, by a function encompassing volatilities of, as well as correlation between, expected returns and cash flows, growth in cash flows, and leverage. These results provide alternative explanations for findings from empirical studies employing implied cost of capital on the magnitude of the market risk premium; predictability of future returns; and the relations between cost of capital and a host of firm characteristics, such as growth, leverage, idiosyncratic risk and the firm’s information environment.

DOI

10.1007/s11142-009-9093-8

Volume

14 (2-3)

Pages

246-259

Language

en

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