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Portfolio Theory and Industry Cost of Capital Estimates

Published online by Cambridge University Press:  19 October 2009

Robert H. Litzenberger  and
C. U. Rao
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Extract

Under certainty the firm's average cost of capital is a directly observable magnitude — the rate of interest. Under uncertainty the firm–s average cost of capital is an ex ante expectational concept which is not directly observable. In a seminal application of their prior theoretical contributions to corporation finance, Miller and Modigliani (M-M) [11] obtained indirect econometric estimates of the cost of capital for electric utility firms. A sample of electric utilities was ideal for an empirical application of the A M-M valuation model which is rooted in the partial equilibrium framework of an equivalent risk class. For other industries where interfirm differences in operating risk are greater, the equivalent risk class assumption would be less appropriate. That is, each firm in a heterogeneous industry may be considered in a unique risk class and the concept of an industry cost of capital would be suspect. Furthermore, the M-M theoretical construct does not provide insights into the relationship among costs of capital of firms in divergent risk classes.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 7 , Issue 2 , March 1972 , pp. 1443 - 1462
Copyright
Copyright © School of Business Administration, University of Washington 1972

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