Corporate valuation using imprecise cost of capital

If the estimated cost of capital bears a standard error, the estimation remains imprecise and firm values are biased on average, even though the estimator of the cost of capital is unbiased. Literature contributes approaches using adjusted discount factors to correct for such biases. This paper examines the theoretical and practical problems arising from the use of these approaches which are most likely to occur in the context of terminal value estimation. The adjusted discount factors imply time-dependent discount rates. Therefore, the commonly used valuation formula for perpetuities (Gordon formula) is no longer suitable to estimate unbiased terminal values. To continue application of this formula, this paper derives a new formula to directly adjust the cost of capital for estimation errors which yields unbiased terminal values.