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Problems with the Concept of the Cost of Capital

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  • Haley, Charles W.
  • Schall, Lawrence D.

Abstract

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.

Suggested Citation

  • Haley, Charles W. & Schall, Lawrence D., 1978. "Problems with the Concept of the Cost of Capital," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 13(5), pages 847-870, December.
    • Handle: RePEc:cup:jfinqa:v:13:y:1978:i:05:p:847-870_01
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    Cited by:

    1. Vitaliano, Peter, 1981. "An Empirical Analysis of the Cost of Long-Term Debt Financing for Cooperative and Proprietary Agricultural Marketing Firms," 1981 Annual Meeting, July 26-29, Clemson, South Carolina 279435, American Agricultural Economics Association (New Name 2008: Agricultural and Applied Economics Association).
    2. Lawrence D. Schall, 2015. "Valuation of an Equity Interest," Review of Pacific Basin Financial Markets and Policies (RPBFMP), World Scientific Publishing Co. Pte. Ltd., vol. 18(04), pages 1-25, December.
    3. Robert S. Harris & John J. Pringle, 1983. "Implications Of Miller'S Argument For Capital Budgeting," Journal of Financial Research, Southern Finance Association;Southwestern Finance Association, vol. 6(1), pages 13-23, March.
    4. Magni, Carlo Alberto, 2009. "Correct or incorrect application of CAPM? Correct or incorrect decisions with CAPM?," European Journal of Operational Research, Elsevier, vol. 192(2), pages 549-560, January.

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