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Abstract
In this paper we propose a dynamic version of the Market-Derived Capital Pricing Model (MCPM) of McNulty, Yeh, Schulze and Lubatkin (2002).By introducing the competitive advantage period "CAP" in the algorithm of this model, we develop the Dynamic Market-Derived Capital Pricing Model (DMCPM). The economic theoretical foundation of the DMCPM is based on the competitive economic equilibrium concept. A sample of 80 U.S. firms and cross section data are used in the empirical analysis. We compare the cost of capital estimation results from the DMCPM with those from the CAPM. Also, we test the explanatory power of the marginal return to cost of capital ratio from the DMCPM compared to that from the CAPM. The results of difference tests, Cox tests and J tests of Davidson and MacKinnon (1981) show the relevance of the estimated cost of capital from the DMCPM.
JEL classification numbers: G12, G30, C52
Keywords: Cost of equity, Cost of capital, competitive advantage period, capital asset pricing model
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1 Introduction
The cost of capital is a key concept in modern financial theory. Indeed, the cost of capital is the major link between investment decisions and financing decisions. In addition, it is a fundamental concept in strategic decisions such as new securities issues, corporate restructuring, mergers and acquisitions. Moreover, the cost of capital is essential in managing for value in governance systems and performance evaluation based on measures such as economic value added. In all cases, an accurate measure of the cost of capital is essential.
Several models have been developed to estimate the cost of equity, the most complex part of the cost of capital. In financial theory we distinguish two approaches to estimate the cost of equity: the ex post and ex ante models.
Among the ex post models of estimating the cost of equity, let us mention the CAPM of Sharpe (1964) and Lintner (1965), the APT of Ross (1976), the three-factor pricing model of Fama and French (1993), the ICAPM of Merton (1973), the CCAPM of Breeden (1979), the model of Cox, Ingersoll and Ross (1985), the model of Campbell (1987, 1993), etc. All these models use historical data to estimate the cost of equity and assume that the past relationship...