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Title:Estimating the cost of capital for divisions of a firm: A spanning approach
Author(s):Krueger, Mark Kelley
Doctoral Committee Chair(s):Linke, Charles M.
Department / Program:Finance
Degree Granting Institution:University of Illinois at Urbana-Champaign
Subject(s):Economics, Finance
Abstract:The purpose of this thesis is to develop a better methodology for the estimation of a division's cost of equity capital. Current procedures developed to address this problem have faced much resistance from the corporate community. The primary problem has been the inability to accurately measure the market risk of a nontraded entity.
This paper develops a new approach for estimating the risk of a division of a firm. It is shown that the risk characteristics of all assets are functions of the assets' systematic cash flow variabilities. The law of one price is used to prove that two assets with identical cash flow variability measures must have identical required returns. Consequently, portfolios composed of traded firms that span the systematic cash flow variability measures of a division must provide unbiased estimates of the division's required return.
Principal component factor analysis is used to measure the systematic cash flow variability measures for the division and a large collection of traded firms. A simultaneous equations model is then used to construct each spanning portfolio. The required return for a division is proxied by the mean of several spanning portfolio estimates. Because traded firms are treated as divisions in all tests, market risk measures are used to determine the validity of the spanning approach. Empirical tests conducted on regulated and nonregulated firms support the validity of the spanning approach.
Issue Date:1989
Rights Information:Copyright 1989 Krueger, Mark Kelley
Date Available in IDEALS:2011-05-07
Identifier in Online Catalog:AAI8924868
OCLC Identifier:(UMI)AAI8924868

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