Equity Factors and Firms’ Perceived Cost of Capital

Abstract

We study how firms’ perceived cost of capital is related to risk factors in financial markets. The analysis is based on hand-collected data from Gormsen and Huber (2022), which cover firms’ perceived cost of capital and discount rates for more than 2,500 firms. Consistent with traditional theory, CAPM betas are strongly reflected in the costs of equity and capital as well as discount rates, and moving from the CAPM to the Fama and French (1993) 3-factor model further improves explanatory power over these. However, less than 10% of the risk factors documented in the asset pricing literature are significantly reflected in the perceived cost of capital, and most are reflected with the wrong sign, indicating substantial wedges between perceived cost of capital and the cost of capital implied by existing equity risk factors. Using machine learning, we construct a parsimonious model of the perceived cost of capital and discount rates and use it to produce a new, publicly available dataset of predicted firm-level values.

JEL Classification: G1, G10, G12, G31, G32, G40