The Cost of Capital

Since Modigliani and Miller first published their famous article on the cost of capital at the end of the 1950s, much has been written in an attempt to answer a number of basic questions on company financing. Is there an inexpensive way of raising capital? Do shareholders benefit therefrom? On what criteria should return on investment be judged? Now as there is universal criticism in France of the lack of equity capital and high real interest rates, the crucial issue of the cost of funds makes those questions more pertinent than ever. In this respect, although shareholders‘ funds confer ownership and therefore have a particular legal status, they can be considered as a simple source of financing. But unlike fixed-interest debt, where the interest expense is known in advance, the cost of equity financing remains equivocal. This issue of Quants is therefore devoted to the cost of shareholders‘ equity. It offers a critical description of the two methods generally used to compute the cost of this type of financing: the Capital Asset Pricing Model (CAPM) and an actuariel approach. When used correctly and comparatively (i.e. by contrasting different companies), both methods can provide substantial amounts of information. However, they can never be totally satisfactory in absolute terms. This issue focuses on how the methods currently in use can be extended.