THE CAPITAL STRUCTURE AND THE COST OF CAPITAL: COMMENT

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IN A RECENT Journal article [1] Haim Ben-Shahar presented a theory of firm's capital structure from standpoint of return-risk framework of investor behavior. He conducts his analysis under the constraint that investor has opportunity to invest his own capital with any proportion of borrowed capital, either in one stock or in a mixed portfolio of that stock and riskless bonds.' The purpose of this comment is twofold: first, to examine some of implicit assumptions on Ben-Shahar's analysis which severely limit generality of his conclusions; and second, following a suggestion made by Ben-Shahar [1, p. 652], to modify and extend his general analysis to more realistic case where investors hold diversified portfolios of common stocks. I. COMMENTS Our first comment is of a conceptual nature and concerns Ben-Shahar's general approach to problem of firm's capital structure. His capital structure theorem is based on a theory of investor behavior toward return and risk. Implicit in his use of first two moments of probability distribution of firm's operating earnings is assumption that investors have homogeneous probability beliefs about and return. The M&M arbitrage construct is not dependent on these cardinal measures of and return. The term equivalent risk class requires only an ordinal concept of (i.e., that investors feel that same degree of is inherent in operating earnings of all firms in same class). An important strength of M&M analysis is that it is consistent with divergent investor probability beliefs about and return. Our second point concerns semantics. Ben-Shahar seems to imply that expected return and standard deviation of return to investors is synonymous with firm's expected earnings and standard deviation of earnings. He defines expected rate of return, 6., and standard deviation of rate of return, beo, on an all equity firm as: