A Firm's Cost of Capital

To create value, a firm must invest in projects that provide a return greater than the cost of capital. The cost of capital is not observed and its estimation requires assumptions on investors' consumption, savings, and portfolio 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 various approaches to estimating the cost of capital and the assumptions justifying these approaches.