Required Return on Investment and Its Financing

Abstract

It is widely accepted that the required return on investment is regarded as the weighted average cost of capital. This method for deciding whether an investment should be executed is theoretically appropriate in only a few models, such as the Modigliani and Miller (1963) hypothesis. In a capital structure model that includes bankruptcy costs and agency costs, this study calculates the required return from the model. We examine difference between the WACC computed from data and the required return estimated from the model. This study also shows that the pecking order hypothesis holds for investment financing in optimal capital structure.