262 THE AMERICAN ECONOMIC REVIEW where the marginal yield on physical assets is equal to the market rate of interest.?This proposition can be shown to follow from either of two criteria of rational decision-making which are equivalent under certain- ty,namely (1)the maximization of profits and(2)the maximization of market value. According to the first criterion,a physical asset is worth acquiring if it will increase the net profit of the owners of the firm.But net profit will increase only if the expected rate of return,or yield,of the asset exceeds the rate of interest.According to the second criterion,an asset is worth acquiring if it increases the value of the owners'equity,i.e.,if it adds more to the market value of the firm than the costs of acquisi- tion.But what the asset adds is given by capitalizing the stream it gen- erates at the market rate of interest,and this capitalized value will exceed its cost if and only if the yield of the asset exceeds the rate of interest.Note that,under either formulation,the cost of capital is equal to the rate of interest on bonds,regardless of whether the funds are acquired through debt instruments or through new issues of common stock.Indeed,in a world of sure returns,the distinction between debt and equity funds reduces largely to one of terminology. It must be acknowledged that some attempt is usually made in this type of analysis to allow for the existence of uncertainty.This attempt typically takes the form of superimposing on the results of the certainty analysis the notion of a "risk discount"to be subtracted from the ex- pected yield (or a"risk premium"to be added to the market rate of interest).Investment decisions are then supposed to be based on a com- parison of this"risk adjusted"or"certainty equivalent"yield with the market rate of interest.3 No satisfactory explanation has yet been pro- vided,however,as to what determines the size of the risk discount and how it varies in response to changes in other variables. Considered as a convenient approximation,the model of the firm constructed via this certainty-or certainty-equivalent-approach has admittedly been useful in dealing with some of the grosser aspects of the processes of capital accumulation and economic fluctuations.Such a model underlies,for example,the familiar Keynesian aggregate invest- ment function in which aggregate investment is written as a function of the rate of interest-the same riskless rate of interest which appears later in the system in the liquidity-preference equation.Yet few would maintain that this approximation is adequate.At the macroeconomic level there are ample grounds for doubting that the rate of interest has 2 Or,more accurately,to the marginal cost of borrowed funds since it is customary,at least in advanced analysis,to draw the supply curve of borrowed funds to the firm as a rising one. For an advanced treatment of the certainty case,see F.and V.Lutz [13]. The classic examples of the certainty-equivalent approach are found in J.R.Hicks [8]and O.Lange [11]. This content downloaded from 202.120.21.61 on Thu,30 Nov 201707:07:36 UTC All use subject to http://about.jstor.org/terms262 THE AMERICAN ECONOMIC REVIEW where the marginal yield on physical assets is equal to the market rate of interest.2 This proposition can be shown to follow from either of two criteria of rational decision-making which are equivalent under certain- ty, namely (1) the maximization of profits and (2) the maximization of market value. According to the first criterion, a physical asset is worth acquiring if it will increase the net profit of the owners of the firm. But net profit will increase only if the expected rate of return, or yield, of the asset exceeds the rate of interest. According to the second criterion, an asset is worth acquiring if it increases the value of the owners' equity, i.e., if it adds more to the market value of the firm than the costs of acquisi- tion. But what the asset adds is given by capitalizing the stream it gen- erates at the market rate of interest, and this capitalized value will exceed its cost if and only if the yield of the asset exceeds the rate of interest. Note that, under either formulation, the cost of capital is equal to the rate of interest on bonds, regardless of whether the funds are acquired through debt instruments or through new issues of common stock. Indeed, in a world of sure returns, the distinction between debt and equity funds reduces largely to one of terminology. It must be acknowledged that some attempt is usually made in this type of analysis to allow for the existence of uncertainty. This attempt typically takes the form of superimposing on the results of the certainty analysis the notion of a "risk discount" to be subtracted from the ex- pected yield (or a "risk premium" to be added to the market rate of interest). Investment decisions are then supposed to be based on a com- parison of this "risk adjusted" or "certainty equivalent" yield with the market rate of interest.3 No satisfactory explanation has yet been pro- vided, however, as to what determines the size of the risk discount and how it varies in response to changes in other variables. Considered as a convenient approximation, the model of the firm constructed via this certainty-or certainty-equivalent-approach has admittedly been useful in dealing with some of the grosser aspects of the processes of capital accumulation and economic fluctuations. Such a model underlies, for example, the familiar Keynesian aggregate invest- ment function in which aggregate investment is written as a function of the rate of interest-the same riskless rate of interest which appears later in the system in the liquidity-preference equation. Yet few would maintain that this approximation is adequate. At the macroeconomic level there are ample grounds for doubting that the rate of interest has 2 Or, more accurately, to the marginal cost of borrowed funds since it is customary, at least in advanced analysis, to draw the supply curve of borrowed funds to the firm as a rising one. For an advanced treatment of the certainty case, see F. and V. Lutz [131. a The classic examples of the certainty-equivalent approach are found in J. R. Hicks [8] and 0. Lange [11]. This content downloaded from 202.120.21.61 on Thu, 30 Nov 2017 07:07:36 UTC All use subject to http://about.jstor.org/terms