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The Size Effect Continues to be Relevant When Estimating the Cost of Capital

Last Updated on 10 February, 2024 by Rejaul Karim

In the forthcoming paper “The Size Effect Continues to be Relevant When Estimating the Cost of Capital,” Roger J. Grabowski critically examines the enduring relevance of the size effect and delves into the reasons behind its persistent presence in estimating the cost of capital. This 43-page analysis, penned on October 30, 2018, seeks to debunk common misconceptions and address criticisms of the Size Premia (SP).

Highlighting the inadequacy of using a pure market factor as the sole risk factor in estimating expected returns, Grabowski emphasizes the necessity for adjustments to the CAPM, as evidenced by four decades of research.

The scrutiny of the theoretical framework of the SP and the application of the CRSP Decile Size Premia and Risk Premium Report – Size Study elucidates the author’s conviction that the size premium’s critique by Clifford Ang lacks merit and misrepresents an alternative methodology.

Through this exploration, the paper not only unveils the fallacies surrounding the size effect but also offers pragmatic guidance for the efficient and accurate application of SP.

Abstract Of Paper

In this paper, I will review the size effect, potential reasons why one observes the size effect, and correct common misconceptions and address criticisms of the Size Premia (SP). Throughout this paper, I will show that using a pure market factor as the sole risk factor in estimating the expected return provide an incomplete estimate. For the last four decades, research have shown that adjustments to the CAPM are required. I will address some of the criticism to the theoretical basis of the SP and to the application adopted through the CRSP Decile Size Premia and Risk Premium Report – Size Study. Specifically, I demonstrate that the size premium critique by Clifford Ang is not warranted and that the alternative methodology proposed by that author is misleading and cannot be considered as an alternative to the Duff & Phelps’ SP. The methodology the author is proposing picks up statistical errors that he was set to avoid by proposing a variation of Duff and Phelps’ methodology. Finally, I will provide some practical guidance on efficiently and correctly applying SP.

Original paper – Download PDF

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Author

Roger J. Grabowski
Kroll LLC

Conclusion

In the forthcoming paper “The Size Effect Continues to be Relevant When Estimating the Cost of Capital,” Roger J. Grabowski presents a comprehensive overview that underscores the persistent relevance and intricacies of the size effect in the determination of the cost of capital.

Through an incisive analysis, the author has discredited common misconceptions and addressed criticisms of the Size Premia (SP), shedding light on the inadequacy of using a single market factor for estimating expected returns and the compelling need for adjustments to the CAPM.

The critical examination of the theoretical basis of the SP and the application of the CRSP Decile Size Premia and Risk Premium Report – Size Study has revealed significant shortcomings in alternative methodologies proposed by critics. Grabowski convincingly refutes the critique posed by Clifford Ang and clarifies the misleading nature of purported alternative approaches.

In its conclusive assertion, the paper not only dispels fallacies but also provides practical guidance for the effective and accurate application of SP, making a definitive contribution to the ongoing discourse surrounding the size effect and its implications for estimating the cost of capital.

Related Reading:

Micro Uncertainty and Asset Prices

The Size Premium As a Lottery

FAQ

What is the main focus of the forthcoming paper “The Size Effect Continues to be Relevant When Estimating the Cost of Capital” by Roger J. Grabowski?

The main focus of the paper is to critically examine the enduring relevance of the size effect in estimating the cost of capital. The author explores the reasons behind the persistent presence of the size effect and addresses common misconceptions and criticisms of the Size Premia (SP). The paper emphasizes the inadequacy of using a pure market factor as the sole risk factor in estimating expected returns and advocates for adjustments to the Capital Asset Pricing Model (CAPM).

What does the paper reveal about the theoretical framework of the Size Premia (SP) and its application through the CRSP Decile Size Premia and Risk Premium Report – Size Study?

The paper scrutinizes the theoretical framework of the Size Premia (SP) and evaluates its application through the CRSP Decile Size Premia and Risk Premium Report – Size Study. The author contends that criticisms of the SP, particularly those posed by Clifford Ang, lack merit. The paper aims to demonstrate that alternative methodologies proposed by critics are misleading and cannot be considered as viable alternatives to the Duff & Phelps’ SP. The author provides a critical analysis of the alternative methodology proposed by Clifford Ang, highlighting its statistical errors and misleading nature.

What is the significance of adjustments to the CAPM mentioned in the paper?

The paper argues that adjustments to the Capital Asset Pricing Model (CAPM) are necessary for estimating the expected return accurately. The author emphasizes that using a pure market factor as the sole risk factor provides an incomplete estimate. The significance of adjustments to the CAPM has been supported by four decades of research, and the paper underscores the need for a more nuanced approach in estimating expected returns.

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