Firms' Perceived Cost of Capital

We study hand-collected data on firms’ perceptions of their cost of capital. Firms with higher perceived cost of capital earn higher returns on invested capital and invest less, suggesting that the perceived cost of capital shapes long-run capital allocation. The perceived cost of capital is partially related to the true cost of capital, which is determined by risk premia and interest rates, but there are also large deviations between the perceived and true cost of capital. Only 20% of the variation in the perceived cost of capital is justified by variation in the true cost of capital. The remaining 80% reflects deviations that are consistent with managers making mistakes. These deviations lead to misallocation of capital that lowers long-run aggregate productivity by 5% in a benchmark model. Forcing all firms to apply the same cost of capital would improve the allocation of capital relative to current corporate practice. The deviations in the perceived cost of capital challenge standard models, in particular the production-based asset pricing paradigm, and lead us to reject the “Investment CAPM.” We describe actionable methods that allow firms to improve their perceptions and capital allocation.