Knowledge that Transforms

Sanford Baum, Robert C. Carlson, James V. Jucker, Some Problems in Applying the Continuous Portfolio Selection Model to the Discrete Capital Budgeting Problem, The Journal of Financial and Quantitative Analysis, Vol. 13, No. 2 (Jun., 1978), pp. 333-344

It has been shown by Haley and Schall [4], Modigliani and Miller [7], Myers [8], Solomon [10], and Vickers [12] that if (1) a firm's investments always yield cash flows that are constant forever, and if (2) the firm maintains, likewise into perpetuity, a constant debt/equity ratio in terms of market values, a constant per period cost of capital can be derived which involves as weights the market values of debt and equity. Since these sufficient conditions, which were set forth for positive purposes, pose severe limitations on the usefulness of these results for normative purposes, derivations which are less restrictive would be helpful for decision making.

Stephen P. Bradley, Sherwood C. Frey, Jr., Equivalent Mathematical Programming Models of Pure Capital Rationing, The Journal of Financial and Quantitative Analysis, Vol. 13, No. 2 (Jun., 1978), pp. 345-361

The finance literature has devoted considerable attention to the study of yields, yield spreads, and rating classification for fixed income securities. In the corporate market, authors such as Hickman [6], Johnson [7], Sloane [9], and Van Home [12] have investigated the behavior of yields and yield spreads over time. Johnson found that the yield differential, defined as the corporate yield minus the equal maturity Treasury rate, was unrelated to maturity. Van Home found that this differential widened during recessionary periods; he interpreted this to reflect either a higher default probability or greater investor risk aversion. In his important paper published in 1959, Lawrence Fisher [4] employed cross-sectional data at five points in time to relate corporate yield spreads to four key variables which serve as proxies for default and marketability risks. Pogue and Soldofsky [8] extended Fisher's approach to explain not corporate bond yield spreads but rather bond ratings. As explanatory variables, Pogue and Soldofsky chose several measures of the firm's income and debt capacity.

The capital asset pricing model specifies that relative risk is a sufficient descriptor of security risk. This result holds under both the Sharpe-Lintner version, and the more general Black version of the model, where = expected rate of return on asset i, Rf = riskless rate of interest, = expected return on the market portfolio, = expected return on any “zero-beta” asset or portfolio of such assests, and = relative risk of asset i in the market portfolio of assests.

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.

In recent years, a number of studies have been published evaluating alternative bond portfolio strategies. These studies basically simulate risk-return characteristics for a variety of strategies designed for use by financial institutions. Typical strategies considered include portfolios of bonds that have laddered or barbell (dumbbell) maturity structures. In laddered strategies, bonds are spaced evenly among a number of consecutive maturities, while in barbell strategies, bonds are concentrated in short and long maturities. The results of these studies tend to differ and conflict. For example, in a recent article in this journal, Fogler, Groves, and Richardson (FGR) conclude that “dumbbell portfolio strategies are not as efficient as indicated by previous analyses.” Among the previous studies to which they refer is one by Watson, who concluded that “portfolios split between a spaced group of short maturity bonds and a longer investment security” (barbell portfolios) are most efficient. Similar results are reported by Wolf and by Bradley and Crane.

The commercial banking industry has been buffeted by a variety of forces in recent years. Alternating periods of intense monetary restraint and the severity of the 1973–74 economic contraction (especially as it affected the real estate industry), huge losses on loan portfolios, a heavy commitment of funds to less developed countries on the part of a few major banks, and the failures of a number of individual banks have created considerable discussion about the stability of the banking system. Questions have been raised about the risk involved in committing funds to the securities of banking organizations. Moreover, the importance of these questions has been underscored for bank management by the necessity for many banking organizations to raise substantial amounts of external funds to prevent further depletion of existing capital ratios.

Roger N. Craine, James L. Pierce, Interest Rate Risk, The Journal of Financial and Quantitative Analysis, Vol. 13, No. 4, Proceedings of Thirteenth Annual Conference of the Western Finance Association, June 20-26, 1978 (Nov., 1978), pp. 719-732

Bruce K. MacLaury, OPEC Surpluses and World Financial Stability, The Journal of Financial and Quantitative Analysis, Vol. 13, No. 4, Proceedings of Thirteenth Annual Conference of the Western Finance Association, June 20-26, 1978 (Nov., 1978), pp. 737-743