Empirical Analysis of the Hsia Option-Pricing Based Model Cost of Capital

The cost of capital is a fundamental concept in strategic decisions such as capital investments, capital structure, new issues, mergers and acquisitions, spin-offs and other corporate restructurings. This paper explores empirically the option-based model developed by Hsia (1991) for estimating the cost of equity and the cost of capital of the firm. The composition of the sample in this exploratory study is all 17 non-financial companies listed in the Euronext Lisbon that are included in the market index PSI20. The Hsia model is used for estimating the cost of equity and the cost of capital of the firm for these 17 companies and is compared to the estimates obtained from the Capital Asset Pricing Model (CAPM) and the traditional weighted average cost of capital (WACC).The difference between the means of the cost of equity estimated by Hsia model and CAPM is not statistically significant at 1% level and their correlation of 46.2% is statistically significant at 1% level. However, the differences at the individual level are quite large. One of the limitations found in this study was the inconsistency on the computation of the cost of debt. The problem arise from the fact that the cost of debt do not follow the pattern expected in the theory, but we also find that the Hsia model is unable to deal with potential inconsistencies of the financial market