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Cost-of-Capital in Managerial Finance pp 9–70Cite as

Background: Cost-of-Capital in the Finance Literature

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Part of the book series: Contributions to Management Science ((MANAGEMENT SC.))

Abstract

The literature review in this thesis is distributed over two chapters. The aim of Chap. 2 is to discuss literature from the field of cost-of-capital. This is necessary as a foundation for the subsequent chapter, which is more application-oriented. In Chap. 3, previous empirical results on companies’ cost-of-capital practices are discussed. Research gaps will be identified at the end of that chapter.

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Notes

  1. 1.

    During the current European Debt Crisis, the assumption of risk-free government bonds can be challenged.

  2. 2.

    In this thesis, no tax considerations are discussed.

  3. 3.

    The notion that investors should only be compensated for systematic risk is increasingly questioned in more recent publications. This issue will be discussed in more detail in Sect. 2.1.2.3.

  4. 4.

    The unobtainable market portfolio is only one point of Roll’s famous critique. However, most authors only cite this point and do not mention the other (less straight-forward) issue that Roll pointed out: He shows that if the market-portfolio is mean-variance efficient, the CAPM equation must automatically hold (being a mathematical fact). Therefore, he argues that the CAPM is not testable and all empirical tests are invalid unless they concern the only testable hypothesis, which is the mean-variance efficiency of the market portfolio (Roll 1977). Pollard (2008) provides a short mathematical proof of Roll’s point.

  5. 5.

    Ross (1976) refers to a working paper from 1971 in which he first presented the theory. However, the article from 1976 is usually cited as the original source, since it is the first journal publication on the APT.

  6. 6.

    They use so-called mimicking portfolios to find out the determining variables. This is done by sorting the stocks according to their respective values for each variable (e.g. for size) and building two portfolios—one includes the stocks below the median of the respective variable and the other one the stocks above. By comparing the return on the two portfolios, the influence of the variable can be examined (Fama and French 1993).

  7. 7.

    For information asymmetry in the context of agency theory, please refer to Sect. 2.3.3.

  8. 8.

    For a detailed discussion and evaluation of return measures, see Schlegel (2011).

  9. 9.

    For instance, if the capital measure includes debt, the profit measure should be calculated before interest.

  10. 10.

    Note: At first glance the diversification irrelevancy might seem like a contradiction to portfolio theory. However, also in portfolio theory, the value does not increase with diversification. The advantage lies in the reduction of volatility.

  11. 11.

    In practice and empirical research, corporate cost-of-capital is observable for listed companies, whereas the business unit cost-of-capital is not observable, so that the term “aggregate” is not meant to imply that corporate cost-of-capital is calculated from business unit cost-of-capital. The purpose of this section is just to analyse the relationship between business unit and corporate cost-of-capital as a theoretical background to the determination techniques.

  12. 12.

    According to Pfister (2003) the approach was first published by Lewis and Stelter (1994) in Germany.

  13. 13.

    One of the study’s authors even works for a competitor of Boston Consulting Group (Roland Berger Strategy Consultants) and the method is still evaluated positively, which is an indication of independence.

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  1. Stuttgart, Germany

    Dennis Schlegel

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© 2015 Springer International Publishing Switzerland

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Schlegel, D. (2015). Background: Cost-of-Capital in the Finance Literature. In: Cost-of-Capital in Managerial Finance. Contributions to Management Science. Springer, Cham. https://doi.org/10.1007/978-3-319-15135-9_2

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