RDP 8807: The Cost of Capital: Some Issues 1. Introduction

One factor which is potentially important in determining business investment is the cost of capital to the firm. In this paper a series for the cost of capital is constructed and its behaviour during the recent period of financial deregulation is examined.

Section 2 discusses the importance of the cost of capital in investment decisions and illustrates that both debt and equity sources of financing need to be taken into account. Recent trends in the cost of both debt and equity are examined in section 3. Section 4 discusses the theory of the cost of capital and derives a measure developed by Carmichael and Stebbing (1981). While this measure of the cost of capital is based on a number of assumptions and is subject to the limitations of the available data, it provides a useful summary of the various, and sometimes offsetting, influences that affect the cost of capital for the firm. Movements in the series, both pre- and post-deregulation are discussed in section 5. A conclusion and suggestions for future work are contained in section 6.