The firm-specific and time-varying cost of equity implied by Merton's distance to default measure

Motivated by the problems inherent in estimating the cost of equity using traditional methods such as the Capital Asset Pricing Model (CAPM), I provide an entirely new method of formulating the firm-specific expected return on equity. Using a derivation of the Merton (1974) distance to default model and the information inherent in Standard & Poor’s credit ratings, I construct a forward-looking model that is grounded in theory and requires no assumption about the unobservable market portfolio. I find substantial support for the power of my expected return measures using both quartile comparisons and firm-specific Ordinary Least Squares (OLS) regressions. Crucially, my model performs well over the entire sample period, and exhibits clear risk-return relationships over a subsequent time period spanning at least five years from the cost of equity formation date. In contrast, I find that alternative measures that have been found to explain returns, including size, beta and the book-to-market ratio, often exhibit spurious return relationships over my 1985-2008 sample period. Given the poor observed performance of these commonly employed risk factors, my results have important ramifications for practitioners looking to estimate the cost of equity for capital budgeting purposes