One of the principal conclusions we reached in Chapter 4 was related to the description of the firm's cost of money capital. We specified there the full marginal costs of debt and equity capital, and these were related to the full marginal cost of relaxing the money capital availability constraint. Equation (4.47) in Chapter 4 instanced an equilibrium or an optimization relation between these full marginal costs. We begin our discussion of the cost of capital in this chapter by considering those concepts further. In doing so, we adopt a quite different analytical stance from that of the preceding equilibrium asset market theory. There we examined the implications of general equilibrium in perfect financial markets. In what follows, we shall be initially concerned with questions of partial equilibrium in conceivably imperfect markets. We shall return to some general equilibrium considerations in later sections of this chapter.

Illustration of the full marginal cost of relaxing the money capital availability constraint

The following example illustrates the empirical meaning of the full marginal cost of increasing the amount of money capital available to the firm by raising an increment of debt capital. It provides an instance of the concept first introduced in Equation (4.31). It will be useful to keep in mind throughout the discussion the fundamental definition of the firm's cost of money capital.