Comment: Portfolio Theory and Industry Cost-of-Capital Estimates

Abstract

Litzenberger's and Rao'ps (L-R) econometric estimate of the cost of capital is in some ways ingenious as well as interesting. The methodology of the estimating procedure is that of the two-stage least squares (2SLS) instrumental variable (IV) approach which was previously used by Miller and Modigliani in their 1966 study. The product differentiation of the L-R study emanates primarily, though not exclusively, from the fact that the valuation equation is derived from capital market line theory. This feature results in the indirect econometric estimates being “useful” for deriving insights into cost of capital variations cum interfirm differences in operating risk. Ergo, Litzenberger's and Rao's empiricism is in no way dependent upon the homogenous risk class concept of Miller and Modigliani.