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Journal of Financial and Quantitative Analysis

Charles Lee

David Ng

Bhaskaran Swaminathan

Testing International Asset Pricing

Models Using Implied Costs of Capital

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Why implied costs of capital

Realized returns are extremely noisy proxies ofexpected return;

Implied cost of capital are much more stable in

predicting expected return;

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Objective

The main objective is to test whether the impliedcost of capital method leads to sharper inferences

about economic relations.

In international asset pricing:

Are risks priced locally or globally?

Are currency risks priced?

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Method for computing ICC

The cost of equity capital for each firm iscomputed as the IRR that equates the present

value of future free cash flows to equity (FCFE) to

current stock price, in U.S. dollars.

Pt= current stock price in U.S. dollars; FE= earnings forecast;

b= plowback rate;

re= cost of equity capital.

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Earnings forecasting

Forecast explicitly for years 1 and 2 (get themfrom IBES);

Forecast year 3 as the growth rate between years

1 and 2;

Individual firms earnings growth rates are

assumed to revert exponentially to the long-run

nominal world GDP growth rate after year 3;

After year 10, the terminal value is computedusing the Gordon growth model.

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Other forecasts

Plowback rate: 1 minus the firmsdividend payoutratio;

Exchange rate: Economist Intelligence Unit (EIU)

forecasts;

Since analysts are slower in updating theirforecasts than the market is in updating the stock

prices, some ICCs may be biased;

Uses correction recommended by Guay et al.

(2005)

Measurement error

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Three alternate ICCs

Modified-PEG model of Easton (2004):

Ohlson and Juettner-Nauroth (2005):

Claus and Thomas (2001)

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RRPsvolatility is 10

times higher than

IRPs, irrespective of

the valuation model

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Tries to show that IRP and ex-

post RRP have a positiverelation

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Key results in table 5 are

not sensitive to the use of

alternate measures of

implied costs of capital

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Similar regression

coefficients, but with

lower statistical

significance

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Size and BM are

positively related even

after controlling fordifferent characteristics

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Conclusion Findings support a broader use of the implied

cost of capital in the financial literature,particularly in international asset pricing;

Findings are interesting to finantial practitioners

who wish to estimate the cost of equity capital fortheir international investments;

Need to develop alternate asset pricing modelsthat accomodate the fact that firm characteristicsare priced;

ICC approach can provide important new insightsinto the cross sectional determinants of firm levelexpected retuns in the international context.