The Term Structure of Implied Costs of Equity Capital

Using data extracted from forward looking option contracts, we estimate the term structure of implied costs of equity capital and implied risk premia at the firm-level for the years 1996-2009. We are able to reject the assumption that implied firm-level costs of equity capital are constant over time. Instead, we find that the term structure of implied costs of equity capital and of implied risk premia are upward sloping and concave for most years and industries. Interestingly, we also find that the term structure of implied costs of equity capital and risk premia were downward sloping for 2008, which suggests that during the height of the economic crisis investors required a high risk premium in the short term but expected the premium to fall in the future. We further validate the term structure cost of capital estimates by reference to future stock returns. Cross-sectional and time-series asset pricing tests indicate that time varying implied costs of equity capital are positively and significantly associated with future stock returns. In contradistinction, Easton's PEG and the "street" based earnings per share ratio (EPR) implied cost of capital estimates are either not associated with future stock returns or the associations are less robust than the term structure estimates. In addition to bridging the gap between the empirical accounting valuation literature that assumes a .at term structure for implied costs of equity and the extensive empirical evidence that costs of equity capital are time varying, we also contribute to the literature by linking accounting-based valuation and option pricing.