Knowledge that Transforms

In the early sixties a number of papers developed stock value models in which the cost of equity capital is a function of the firm's equity investment rate.The conclusions reached, however, have for the most part been rejected in the subsequent literature.Instead, it has become widely accepted both in the theoretical work and in the textbooks on finance that the cost of equity capital is equal to the yield at which a firm's stock is selling, and the latter is independent of the firm's investment rate.In fact, one frequently finds the two terms, share yield and cost of equity capital used interchangeably in the literature.However, contributions to the literature during the last few years provide additional support for and clarification of the alternative theory, and a broad reconsideration of the subject is in order.Part I below critically reviews the literature of the early sixties on both sides of the subject and certain subsequent papers which contributed to the conclusion that share yield and cost of equity capital are equal and independent of investment policy.Parts II and III examine the recent contributions which have materially strengthened the theoretical basis for the contrary conclusion, that the cost of equity for a firm is an increasing function of its investment rate.Part IV reviews the empirical evidence on the subject, and Part V both summarizes the conclusions reached and discusses the areas in which the model requires further development.