Knowledge that Transforms

IN A RECENT PAPER this journal [1] I suggested a formulation of a cost of capital theorem, stating that in equilibrium, within the range of efficient capital structure the firm's cost of capital is constant. As the firm moves to inefficient capital structure, the firm's cost of capital rises. This theorem was derived from the theory of investors' behavior towards return and risk,' under a constraint, i.e., that the investor can invest his own capital, with any proportion of borrowed capital either one stock or a mixed portfolio of one stock and riskless bonds. The purpose of this paper is first to clarify some issues raised the Comments by Litzenberger and Jones (hereafter L&J) and by Haugen and Pappas (hereafter H&P), and second, to reexamine the theorem when the diversification constraint is removed, i.e., when the investor is allowed to diversify his investment among various assets.