Firms' Perceived Cost of Capital

We analyze firms’ perceptions of their cost of capital using hand-collected data. We show that firms with a higher perceived cost of capital invest less and earn higher returns on invested capital, suggesting that the perceived cost of capital determines the long-run allocation of capital. In inefficient markets, firms aiming to maximize their current market value should set their perceived cost of capital equal to the expected returns on their debt and equity. We strongly reject this market-value maximization benchmark, as little variation in firms’ perceived cost of capital can be explained by variation in market-based expected returns. Alternatively, firms may aim to maximize their fair value, which is the value corrected for financial market inefficiencies. We find evidence in favor of this approach, as a fundamental risk benchmark explains half the variation in the perceived cost of capital. Most variation in the perceived cost of capital can be explained by firms incorporating investors’ biased return expectations, which is inconsistent with firms maximizing their current market value. Using a quantitative model, we find that distortions in the perceived cost of capital can generate substantial capital misallocation and thereby reduce aggregate productivity.