RDP 9205: Measuring the Cost of Capital in Australia 1. Introduction

The cost of capital is a somewhat nebulous concept. The concept referred to in economic analysis, where the focus is on how the cost of capital in Australia has changed over time, how it compares with other countries, and how it affects firms' investment decisions, may be different from that considered important by the business community. As well as conceptual differences, there are substantial difficulties with measurement. Furthermore, the cost of capital refers, strictly speaking, to expected returns. Realised returns, although often the only kind of data available, may not be a good guide. It is not surprising that a wide range of estimates of Australia's cost of capital has been produced over the last decade or so.

This paper outlines the relationship between the cost of funds and the cost of capital and the underlying variables which comprise them. The difficulties in measuring these concepts, and the variety of estimates that can be derived from different but plausible approaches are illustrated by some calculations. Various Australian studies are surveyed to underscore how differences in concept and measurement translate into significant differences in estimated magnitudes.