Abstract

We compare estimates of the UK industry cost of equity capital between the unconditional beta Arbitrage Pricing Model (APM), the conditional beta APM and the Capital Asset Pricing Model (CAPM). A statistically significant eight-factor APM leads to the best estimates of the UK industry cost of equity capital. During our full sample time period any of the APMs, unconditional APM or conditional APM, do a much better job than the CAPM.

However at times of extreme market volatility during the 2007 financial crisis, the conditional APM is the best model with the least errors. During a financial crisis investors and market participants’ expectations are revised. Economic forces at play include: increased market uncertainty, increased investors’ risk aversion and capital scarcity. We find that the macroeconomic factors impeded in the Conditional APM that vary over time using the latest information in the market, incorporate the economic forces at play and capture the extreme market volatility. Our findings have direct implications in the financial markets for regulators, corporate financial decision makers, corporations and governments.

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