A Critical Review of the Implied Cost of Equity: A New Way to Estimate the Expected Return

For the last three decades, the Capital Asset Pricing Model (CAPM) has been a dominant model to calculate expected return. In early 1990% Fama and French (1992) developed the Fama and French Three Factor model by adding two additional factors to the CAPM. However even with these present models, it has been found that estimates of the expected return are not accurate (Elton, 1999; Fama F Fama F Dimson, Marsh & Staunton, 2002). Because the risk free rate is easy to find, even though some arguments still exist, the key factor to compute the equity premium is expected return (or, equivalently, cost of equity). In search for ways to estimate the expected return, Sharpe (1964), h t n e r (1965), and Black (1972) made significant contiibutions by developing the capital asset pricing model (CAPM). CAPM has been the dominant model used to calculate the expected return for the last three decades in the financial community for both academicians and practitioners. However, Fama and French (1992 & 1993) argued that market data alone is not good enough to explain the expected return and included two more factors (size and the book-to-market equity ratio) in the model. This extended model is known as the Fama and French Three Factor model and gained popularity in late 1990's. However, even with these models, it has been found that estimates of the expected return are not accurate (Elton, 1999; Fama & French, 1997). Botosan (199'7) introduced a new approach to estimate the expected return. Her approach employs an equity valuation model to calculate the internal rate of return (IRR) which is often called, "implied cost of equity capital" as a proxy for the expected return. Tbe approach has been investigated extensively by many researchers in recent years. Our study provides a critical review of the literature regarding ths newly developed approach. We believe that this critical review will provide valuable knowledge to the hospitaJq accounting and finance researchers and hopefully encourage them to implement this new approach in their studies. This paper d l discuss the equity premium issue as the first pan of the critical review of literature. The CAPM and the Fama and French Three Factor Model will be discussed in the second part and the implied cost of equity capital literature will be extensively reviewed as the final part of the critical review scction. Apphcations to the hospitality literature will be followed and the study wiU end with our conclusions. Review of the Literature I. Equity Premium Equity premium has been one of the most important numbers in fmancial literature and community (Dimson, et al., 2002). The term is defmed as the difference between expected return and the risk free rate (Cornell, 1999). In other words, equity premium is the additional return, on top of the risk free rate, that investors require in order to invest in risky stocks. Two government securities have often been used as a proxy of the risk free rate, the short-term treasury bills and long-term treasur). bonds. Among sholt-tern treasury bids, the 1-month FIU ReM'ew Vol. 24 No. 2 Page: 1