Expected Stock Returns and Firms’ Perceived Cost of Capital

Abstract

Using data from a decade of surveys of corporate managers, I find evidence that firms with higher expected stock returns have a higher perceived cost of equity and use higher discount rates in capital budgeting. Variation in expected stock returns, as measured by exposure to equity risk factors, is reflected in the perceived cost of equity with implied risk premia close to those observed in financial markets. The equity risk factors are also reflected in hurdle premia and explain up to 26% of the cross-sectional variation in the hurdle rates. The results support the hypothesis that discount rates in financial markets influence corporate discount rates and thereby corporate investment.

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