RDP 8807: The Cost of Capital: Some Issues 6. Summary and Conclusions

This paper has concentrated on measuring the real cost of capital to the firm, defined as the expected real after-tax cost of funds. Trends in its components both pre- and post-deregulation were examined. The cost of debt and equity and the relative importance of each have varied a great deal over time.

The relative influence of the cost of debt and equity finance on the incentive to invest appear to be reflected, at least partly, in the relative abilities of Tobin's q and the EPAC incentive ratio to pick turning points in investment at different points in time. Tobin's q, which is currently increasing, is based largely on stock market data and reflects the cost of equity. The EPAC variable, which remains low, is a debt based measure.

The average cost of capital appears to have risen in the mid 1970s and fallen substantially a little later in the decade. Large falls in the cost of debt as a result of high inflation and the tax deductability of nominal interest payments appear to be the main cause. In the late 1970s, the cost of capital rose sharply. It seems to have fallen, however, in more recent years, although remaining at a high level relative to the early 1970s.

Although the net effect of deregulation on the cost of capital is difficult to isolate, it is likely to have reduced the distorting effects on the cost and availability of funds to firms.

A large amount of work still remains to be done in this area. Further work should involve including a cost of capital term which incorporates both the cost of equity and debt into investment incentive ratios, such as Tobin's q and the EPAC measure.