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.

Contrary to existing theory, even in perfect markets (with symmetric information, no taxes, and competitive, transaction costless capital markets) callable debt can induce investment incentives that are inferior (as well as superior) to those induced by non-callable debt, the outcome depending on cash flow and interest rate distributions. We derive necessary conditions for callable debt to induce inferior investment decisions, and define the “Call-Default Condition” as the cash flow distortion where calling prevents default that would have occurred with non-callable debt. These results complicate the argument that investment incentives explain the presence of the call provision in debt contracts.