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.

In recent years intensive work has been done applying the Sharpe-Lintner-Mossin Capital Asset Pricing Model to the multiperiod investment decision under uncertainty. The purpose of this paper is to develop a practical working procedure for use by the financial manager. We first develop the multiperiod capital budgeting decision criterion in a form that lends itself to application. Second, we propose a method of implementation, one that we have made operational in computer programs currently on the Columbia University computer system. This makes it possible to extend the evaluation to encompass typical capital budgeting problems which, until now, have been discussed only under certainty. In particular we deal with the case of capital rationing. We employ programming techniques for this analysis and interpret the meanings of the dual variables.