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Problems with the Concept of the Cost of Capital

Published online by Cambridge University Press:  06 April 2009

Charles W. Haley  and
Lawrence D. Schall
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Extract

The cost of capital concept has for some years permeated both finance theory and textbook treatments of capital structure and business investment decisions. This has been due, to a major extent, to the important works of Modigliani and Miller [10,11] and Solomon [16], among others. In recent years, however, the concept has been the subject of some controversy. A number of authors have shown that the cost of capital, as usually computed, can produce errors except under highly restrictive assumptions and that there continues to be some debate over its proper definition and use. Our purpose in the present paper is to explicate more fully the source of the difficulties with the cost of capital and to suggest that, despite the initial usefulness of the concept, the field of finance would be better off now if it were relegated to history. Both the perfect and imperfect market cases will be considered. We propose that the term “cost of capital” be eliminated from textbooks and research papers and be replaced by superior concepts.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 13 , Issue 5 , December 1978 , pp. 847 - 870
Copyright
Copyright © School of Business Administration, University of Washington 1978

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References

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