Cost of Capital. John H. Cochrane University of Chicago GSB. Standard approach. Question: Should we invest, buy asset or company? Standard answer: Value = Expected Profit / Expected Return (Really, multiperiod version) ER? Use CAPM, ER = Rf + β E(Rm-Rf)
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John H. Cochrane
University of Chicago GSB
Value = Expected Profit / Expected Return
(Really, multiperiod version)
What many people mean
What the formula means
My focus: using the CAPM for cost of capital
Problem 1. We don’t know E(Rm-Rf)! 6% is very rough!
Forecasts made 5 (10) years ahead using D/P regression
Example: Fama-French model
E(Ri-Rf) = bi E(Rm-Rf) + hiE(HML) + si E(SMB)
Problem 1: New premia just as uncertain and vary over time too!
Et(Ri-Rf) = bi Et(Rm-Rf) + hiEt(HML) + siEt(SMB)
What’s E(HML), E(SMB)? Same statistical problem. Even less economic understanding of value/size premium. Less still of how they vary over time. More of them!