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We generalize Ohlson's (1995) model to stochastic interest rates while making no specific assumptions about the stochastic process of interest rates. Our analysis of the case when earnings suffice for valuation yields three insights. (1) In the valuation function, the multiplier for forthcoming earnings depends on the current rate, but the multiplier for current earnings depends on the lagged rate. (2) In the residual earnings dynamic, the persistence of residual earnings increases in the current rate and decreases in the lagged rate. (3) In the earnings dynamic, the traditional random walk requires an additional term, current earnings multiplied by the percentage change in interest rates.

We estimate implied cost of equity capital (r e ) for a sample of firms from 1984 to 1998 using the Ohlson and Juettner (2000) model that does not make restrictive assumptions about clean surplus and payout policies. We find that r e is strongly positively associated with conventional risk factors such as earnings variability, systematic and unsystematic return volatility, and leverage, and is negatively associated with analyst following. These associations are robust to controls for industry membership and to running the regression in changes instead of levels. Our results support the Ohlson-Juettner metric as a robust and appealing measure of r e .1