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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.

The authors show that the public market equivalent approach is equivalent to assessing the performance of private equity (PE) investments using Rubinstein’s dynamic version of the CAPM. They developed two insights: (1) one need not compute betas of PE investments, and any changes in PE cash flow betas due to changes in financial leverage, operating leverage, or the nature of the business are automatically taken into account; (2) the public market index used in evaluations should be the one that best approximates the wealth portfolio of the investor considering the PE investment opportunity.We provide the theoretical foundation for the use of the public market equivalent (PME) measure, which is often used to evaluate private equity (PE) performance. We show that the PME is equivalent to valuing cash flows using Rubinstein’s dynamic capital asset pricing model. Establishing this link enables us to show that the Kaplan and Schoar PME measure is surprisingly robust. The PME gives an estimate of the risk-adjusted performance of PE funds without having to calculate any betas, even if the betas of the cash flows vary over the life of the investments, for example, owing to changes in financial leverage, operating leverage, or the nature of the businesses. Further, a PE fund cannot artificially increase its PME by increasing its leverage. The discount rate used to calculate the PME should approximate the return on the investor’s overall wealth portfolio, and it may vary across investors, even for the same fund. Unlike the standard CAPM, the PME does not evaluate performance relative to the market returns of other investments with similar risks. Instead, the PME evaluates investment performance as an integrated part of the investor’s overall portfolio. Because the PME is derived from a formal asset-pricing model, it does not suffer from the problems of the internal rate of return (IRR), which is an alternative performance measure that is often used to evaluate PE performance. Unlike the IRR, the PME always exists, and it is always unique. Because the PME is equivalent to a present value (PV) calculation, it cannot be manipulated, for example, by PE funds’ deliberately choosing the timing and magnitudes of their investments, unlike the IRR. Compared with the standard CAPM, the PME also has several advantages: it is easier to calculate, it does not require any betas—which are typically estimated from the market risks of comparable traded companies—and it doesn’t require any assumptions about the expected market risk premium. Overall, the PME appears to be an attractive, robust, and easily applicable method for evaluating PE funds’ past performance or the performance of other alternative assets for which regularly quoted market prices and returns are unavailable.

A major problem in finance is to understand why different financial assets earn vastly different returns on average. In this paper, we survey various econometric approaches that have been developed to empirically examine various asset pricing models used to explain the difference in cross section of security returns. The approaches range from regressions to the generalized method of moments, and the associated asset pricing models are both conditional and unconditional. In addition, we review some of the major empirical studies.

We show that several asset pricing models that rely on long-run risks imply that the state of the economy can be captured by factors derived from the price-dividend ratios of stock portfolios. We find two factors with small growth and large value tilts are important for this purpose, thereby relating the Fama-French model and the Bansal-Yaron and Merton intertemporal asset pricing models. As predicted by the model, these price-dividend ratio factors track consumption volatility and predict future consumption and stock dividends, and the covariance of returns with their innovations explains the cross-section of average returns of several stock portfolios. (JEL G19)