Risk, Expected Return, and the Cost of Equity Capital
In applying the Capital Asset Pricing Model (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.