The Cost of Capital for Financial Firms

Most businesses have assets financed by capital providers. The cost of capital is a measure of the returns required by those capital providers. Its main use is to set a target for the profits, which must be achieved on the firm‘s assets in order to satisfy equity and bond holders. This paper describes the classical theory of the cost of capital, and then applies it to the special case of banking and insurance firms. We develop implications for product pricing, performance measurement and capital structure optimisation.