Review of Accounting Studies

, Volume 14, Issue 2, pp 246-259

First online:

Open Access This content is freely available online to anyone, anywhere at any time.

On the relation between expected returns and implied cost of capital

  • John HughesAffiliated withUniversity of California Los Angeles Email author 
  • , Jing LiuAffiliated withUniversity of California Los Angeles
  • , Jun LiuAffiliated withUniversity of California San Diego


We examine the relation between implied cost of capital and expected returns under an assumption that expected returns are stochastic, a property supported by theory and empirical evidence. We demonstrate that implied cost of capital differs from expected return, on average, by a function encompassing volatilities of, as well as correlation between, expected returns and cash flows, growth in cash flows, and leverage. These results provide alternative explanations for findings from empirical studies employing implied cost of capital on the magnitude of the market risk premium; predictability of future returns; and the relations between cost of capital and a host of firm characteristics, such as growth, leverage, idiosyncratic risk and the firm’s information environment.


Expected return Implied cost of capital Weighted average cost of capital

JEL Classifications

G12 G14 M41