COSTS OF EQUITY CAPITAL: Results for a Broad Cross-Section 4

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Recall that, for each of the three models, the estimate of the expected excess return for Bay State Gas is not very sensitive to the presence of economically plausible “pricing uncertainty,” represented by aa. As the results in Tables II-IV demonstrate, for values of aa up to 5%, the posterior mean of Bay State Gas’s a remains within 2% of its prior mean of zero, even though the least-squares estimate a, based on over 21 years of data, ranges between 5% and 8% for the three models. Here For the other 1,993 firms in our cross-section, the degree to which the cost of equity is sensitive to
Note that the elements of b are assumed to be constant during the T periods for which the stock’s historical returns are used in (3) and (7). In the empirical analysis reported above, we take T to be the stock’s entire history, at least back through July 1963.

Thus, we essentially use “long-run” betas and ignore potential fluctuations in individual-stock betas over time. Several alternative approaches could be pursued. For example, T might be restricted to at most 60 months, as is consistent with common practice.