Cost of Capital Dynamics Implied by Firm Fundamentals

• In Event: Accounting Information and the Cost of Capital

Abstract

We provide a tractable stock valuation model that allows us to study the dynamics of discount
rates using only two firm fundamentals: the book-to-market ratio and expected return
on equity. We find that the model is easily applied to a large cross-section of firms and that
firm level discount rates vary over time and are highly persistent. The model is able to forecast
stock returns up to three years into the future and tracks economic conditions. During normal
or expansion periods in the economy, the dynamics of cost of capital generate an upward sloping
term structure, however in times of high economic uncertainty the term structure flattens
and can be downward sloping.

Authors

• Charles CY Wang, Harvard University

• Matthew Lyle, University of Toronto