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Fortnightly Magazine - August 1995
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Knowledge Gained

is Never Lost

In spite of ample arithmetical examples, the basic point made by Lawrence Kolbe and William Tye in "The Cost of Capital Does Not Compensate for Stranded-Cost Risk" (May 15, 1995) is simply wrong. The authors claim that "even if the cost of capital [reflects] full knowledge of the risk of stranded costs," it will not compensate for that risk. This conclusion is nonsensical on its face, since the very notion of efficient capital markets is to account fully for all known risks.

The heart of the authors' error lies in their failure to distinguish between the ex ante and ex post cost of capital. Yes, the ex ante cost of capital (that anticipated before the stranded cost issue arose) will always be insufficient. I do submit, however, that an efficient capital market will fully reflect the probability of stranded costs in the ex post cost of capital (that determined after the issue became known).

The authors' arithmetic is correct, given their assumption that the hypothesized risk of stranded cost warrants a 20-percent cost of capital. But that only means that an efficient market would cause stock prices to fall so as to generate a cost of capital of 20 percent. The mistake is simple: The assumed 12.5-percent cost of capital is internally inconsistent and would not occur under the conditions they postulate.

.Pp

Michael D. Yokell

.Pp

Director, Hagler Bailly

Consulting, Inc.

.Pp

Managing Director,

HB Capital, Inc.

Boulder, CO

Merger Spin Was Misspelled

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