A Firm’s Cost of Capital

Creating firm value often requires investing in capital projects that provide a return greater than the project’s cost of capital. The cost of capital is not observed and its estimation requires assumptions regarding how investors make consumption, savings and portfolio choice decisions. We review the academic literature on firms’ cost of financial capital and the estimation of the different components: cost of equity, cost of debt, and their relative weights. We also review the various approaches to estimate the cost of capital, and the assumptions justifying these approaches.