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Cost of capital: reflections of a CEO.

*George N. Hatsopoulos is Chairman of the Board and President, Thermo Electron, Waltham, MA. The author gratefully acknowledges the invaluable assistance of Dr. James M. Poterba, Professor of Economics at the Massachusetts Institute of Technology, for his many contributions to this article.

1 See footnotes at end of text.

After some background on the cost of capital concepts, the author summerizes the latest literature on the evolution of the cost of capital gap between the U.S. and other industrialized nations, showing how this gap has affected innovation in U. S. industry. He describes methods used to reduce the cost of capital for his company. Then he lists the types of actions the federal government must take to close the gap in the cost Of capital between the U.S. and its principal foreign competitors.

OVER THE PAST decade, many U. S. industries have lost their international market positions to Japan, our principal industrial competitor. I am convinced that the major cause of this alarming trend is the difference in cost of capital prevailing in the United States and Japan. My coauthors and I have tried to articulate this view in several articles,(1) the first published in 1983. To our surprise, we found some skepticism concerning this thesis among many successful businessmen.

The purpose of this article is to promote a better understanding of issues relating to the cost of capital.


In a world free of both taxes and risk, corporations could finance any and all projects through borrowing, provided that those projects were sure to return more than the interest rate demanded by lenders. In such a world, the cost of capital would be the interest rate. Moreover, if competition were "perfect," the return on all projects would be the same, and it would be identical to the cost of capital.

In the real world, of course, things are quite different. Taxes have to be paid under rather complicated rules, and predictions cannot be made with certainty. Therefore, all projects involve risks, and those risks represent a significant burden to prospective investors. At some price, lenders are willing to bear a certain level of risk. In practice, most of that risk is borne by holders of equity.

Equity holders are represented by corporate managers whose obligation is to provide, as best they can, their investors' return. It follows that corporate managers should invest only in those projects that promise to return a pretax profit sufficient to provide the taxes required by law, the interest required by lenders, and the dividends and capital gains required by equity holders. The cost of capital for an investment is the least return that satisfies all the requirements cited above.

In making investments, corporations use two sources of funds: equity and debt. Each source differs in its exposure to risk, in its taxation, and its cost. The use of equity exposes a corporation to the least risk, because it involves no fixed obligation to provide either returns or repayments. For the same reason, the supplier of equity funds is exposed to the greatest risk. On the other hand, use of interest-bearing debt exposes a corporation to the greatest risk, and the supplier of funds to the least, because it involves a fixed obligation to provide returns and to repay the funds.

The two sources of funds impose different corporate tax burdens on the return to investors. Payments to equity holders are taxed, whereas payments to debt holders are not. As a result, for a given return demanded by investors, the after-tax cost of debt is much smaller than the cost of equity.

Stockholders invest in corporate equities in order to have future monetary returns. Corporations invest the stockholders' equity in order to make an after-tax profit. Part of that profit is paid back to investors, and part of it is retained for reinvestment to generate progressively larger profits.

A corporation's cost of equity is the rate of return stockholders demand. The pretax cost of debt is the interest rate, i.e., the rate of return that lenders demand. Whereas the after-tax cost of debt to a corporation is less than the interest rate, the cost of equity in America is the same as the return demanded by stockholders because no corporate tax deduction is provided for the payments to corporations' stockholders.

The term "stockholders' required return," although widely used in economics, may sound strange to anyone but an economist. Everyone knows how lenders can enforce their demand to receive interest payments from a corporation. A loan constitutes a contractual obligation between the lender and the borrower, and, if the borrower does not pay the contracted return, the lender can take legal action.

On the other hand, equity holders have no legal recourse when a company fails to earn what stockholders require. They can, however, bid down the shares of the company until the share price reflects the earning power of the company and the required rate of return. A continuing market valuation of a company much below the replacement value of its net assets will at best deprive the company of access to new equity capital; at worst, the management may be replaced. This replacement can occur either through the action of the company's board of directors or, as often happens today, through an unfriendly takeover. To prevent such actions, managers will tend to increase payouts in the form of dividends or stock repurchases and will reduce new investments. Although these managers may not recognize it, this is an important mechanism through which the high cost of capital can reduce investment.

Empirical determination of the cost of equity is a complicated and frequently misunderstood process. To illustrate the point, consider the following example: Assume a company has net income of $50,000 per year, and the replacement value of its assets, less its liabilities, is $1 million. Thus, its return on equity is 5 percent. Let us further assume that the company pays out to its stockholders $20,000 per year, reinvests $30,000 per year at its historical return of 5 percent, and has a cost of equity equal to 10 percent. Under these assumptions, it is reasonable to expect the market value of the company's stock to be $350,000. This figure reflects $200,000 for the $20,000 of distributed earnings that is valued at 10 to 1, plus $150,000 that represents $30,000 reinvested at half the required return. Thus, the market value of the company's equity would be only 35 percent of its replacement value. (Note that if this company distributed all of its earnings as dividends, its value would be 50 percent of its assets' replacement cost.) The return on the company's market value would be $50,000/$350,000, or 14.3 percent and, the price-to-earnings ratio of the company would be 7, namely, the inverse of 0.143. It is evident from the above that the cost of equity (10 percent) differs from the return on equity at replacement (5 percent), and from the inverse of the price-to-earnings ratio (14.3 percent), In general, these three parameters will also differ for any real-world company.

The example above shows why the price-to-earnings ratio does not define, per se, the cost of equity for a firm. In general, firms with higher prospects for earnings growth enjoy higher price-to-earnings ratios than other firms, even though the required return on equity may be the same for all.


There are two kinds of corporate investments: investments in hard assets, such as plant and equipment; and soft investments, such as research and product development, the development of new markets, and the training of employees. Different kinds of investments may have different costs of capital.

One difference in the cost of capital among investments comes from differences in taxation. For example, the depreciation rate allowed by the tax code is different for structures and for equipment. However, the principal difference in the cost of capital among the assets of the same corporation comes about because of differing sources of funds applicable to various assets. In one extreme, general purpose real estate can be financed mostly by low-cost debt whereas, in the other extreme, soft investments can only be financed through equity.

The cost of capital for soft investments is identical to the cost of equity for two reasons. The first is that it is nearly impossible for lenders to assess the value of soft assets with any degree of certainty. Consequently, such assets do not provide suitable collateral for debt financing. The second reason is that accounting rules in all countries require that most soft investments be charged against current income. A reduction of current income can only be justified to stockholders if they perceive that it is likely to produce future income that exceeds, in discounted present value, the cost of the investment. The applicable rate for such a discounting exercise is the cost of equity. The after-tax cost of equity not only controls the amount of the soft investments that a corporation makes, but also the time horizons of such investments.


Economists assume that corporate managers use capital and labor in their productive activities in such a proportion as to maximize corporate profits for any given output. Accordingly, the principal determinant of the capital-to-labor ratio in an industry is expected to be the cost of capital divided by the cost of labor. Because capital-to-labor ratio is an important determinant of labor productivity, capital costs affect production costs both directly and indirectly.

Historically, the rate of fixed capital formation was an important determinant of the industrial competitiveness of a country. In recent years, however, investments in soft assets have become increasingly more important. In fact, they may well be the most important type of capital for the industrial competitiveness of high-wage countries such as the United States, Germany, and Japan.

The reason for this shift is that several countries have reached a stage of technological development sufficient to compete with the United States in technology-intensive industries. These industries command a higher price per unit of labor than do commodity-oriented industries, because fewer countries can enter the market. in addition, there are markets such as consumer electronics in which market dominance and product quality can provide a competitive edge sufficient to allow the leading companies to command higher prices. Achievement of such dominance combined with a reputation for quality requires heavy long-term intangible investments not only in product development but also in marketing and service. Thus, for a high-wage country to be competitive, a low cost of capital for soft or intangible investments is essential.

America's competitiveness problem in technology-based industries is due neither to the lack of basic research, nor to a lack of innovations. In fact, our failure stems from the inadequate rate at which U. S. firms bring new products to market. There are numerous examples, ranging from robots to flat-screen displays, of American inventions that were first exploited commercially by foreign corporations. America's extraordinary ability to create new technologies derives both from the high value American society places on individualism and entrepreneurship, and from the support the U. S. government provides for research. On this latter point, it should be noted that, although Japan spends a greater share of its gross national product in nondefense research and development than does the United States, it spends a trivial amount for basic research. Nevertheless, American industry misses many opportunities to utilize domestically created technology by showing reluctance to make the necessary long-term investments in product development and marketing.

The unfortunate behavior of U. S. corporate managers can be explained in two ways. Either U.S. managers follow the dictates of their stockholders more or less competently or, for some reason, they do not. I shall examine these two possibilities later, but first, I shall review what is known about differences in the cost of capital among industrialized nations.


The most comprehensive empirical study of the cost of capital in the major industrialized nations was that of McCauley and Zimmer (1989).(2) In comparing the United States, Germany, and Japan, they found the cost of capital in the 1980s for all types of assets to be the highest in the United States and the lowest in Japan. The real after-tax cost of debt was quite different in the three countries during the 1970s, but converged to about the same value in the late 1980s.

The cost of capital advantages enjoyed by Japanese and German firms have derived from different factors at different times in the past two decades. In the 1970s their advantage was the result of high leverage, i.e., high debt-to-equity ratios. In the 1980s, however, Japanese and German leverage declined significantly while U.S. leverage increased. Concurrently, however, the cost of equity in both Germany and Japan declined dramatically. McCauley and Zimmer's results indicate that both countries have a cost of equity advantage of between 4 and 6 percentage points over the United States.

To illustrate how a 5-percentage-point difference in the cost of equity can affect long-term investment decisions, consider the following example. An investment in R&D that lowers earnings by $1 now, yet was sure to raise earnings by $2 ten years from now would be considered an irresponsible act if the cost of equity were 10 percent - but worthy of praise if the cost of equity were 5 percent.


According to finance theory, an investment decision is supposed to proceed as follows: A risk-adjusted hurdle rate for that investment is first determined, and then the projected future cash flows from that investment are estimated. If the discounted present value of these future cash flows is larger than the initial disbursement, then the investment is worth making.

In practice, the process does not work quite that way. In making an investment decision, corporate management considers many issues, some of which take precedence over purely financial considerations. These issues include the competitive position of the firm, its reputation in the marketplace, its past practices, its objectives for growth, and other considerations that are not readily quantifiable. To be sure, in most cases, cash flow projections are made, an internal rate of return is estimated, and a subjective judgment is made as to whether the expected return is sufficiently high to justify the perceived risks. My discussions with many chief executive officers over the years have led me to believe that, although the results of a discounted cash flow analysis play a role in their investment decisions, they play a lesser role than do strategic issues.

These observations may lead one to conclude that the cost of capital prevailing in a country plays a minor role in the rate of corporate investments, or in the time horizons of such investments. Such a conclusion is incorrect. The other objectives that drive investment decisions, such as market positioning, may indirectly be influenced by the managers' mandate ultimately to achieve returns greater than the cost of capital. If that is the case, it is puzzling that managers accord slight attention to hurdle rates. One possible reason may be that analysis frequently becomes complicated and uncertain, so that intuition is used instead.

The hurdle rate that most managers have in mind does not derive from an analysis of their firm's cost of capital. Rather, it is set subjectively and based mostly on what is generally acceptable in the business community. Many managers find it difficult to accept that the norms for project evaluation affecting their investment decisions are shaped by the nation's cost of capital. Accordingly, they find it difficult to accept that Japanese managers who invest in projects with returns much lower than those acceptable in the United States can survive for long. Moreover, many managers believe that the cost of equity is relevant to them only if they need to raise new equity and fail to recognize that the prevailing cost of equity affects not only hurdle rates but also dividend policy for all corporations - including those that never sell shares.

My own observations have convinced me that the principal objective of most corporate CEOs is to optimize the long-term return to their stockholders. The fact that they frequently fail to achieve their objective is more related to limitations of human skills than to intent.

Management expertise depends more on experience-based intuition than analysis. One thus would expect that excellence in management develops more readily in periods of economic stability than in periods when the economic environment changes rapidly. Indeed, the golden era of U.S. corporations was the 1960s, after a long period of relatively constant cost of capital. During that period the investment rate was quite consistent with the required return on equity, as evidenced by a ratio of the market value to the replacement value of corporate equities (Tobin's Q) that was near unity.

During the 1970s, with inflation rising, the required return on equity rose significantly and caught corporate managers unprepared. They continued to invest at high rates using invalid historical criteria, and, as a result, the market value of equities fell significantly below replacement value.

The inflation rate subsided during the 1980s, but real interest rates rose. The required rate of return on equities fell below that of the 1970s yet remained higher than that of the 1960s. The market value of equities was closer to replacement value than in the 1970s, but (probably because of the uncertainty created by frequent changes in the tax law) Tobin's Q never approached unity as it did in the 1960s.

American managers in general follow the dictates of the market as well as do managers in other countries. The fact that Japanese managers invest more and for a longer term is a reflection of the economic environment in which they operate rather than their possession of better insight. Support for this thesis emerges from my own recent study, which finds comparable values of Tobin's Q in America and Japan.

My conclusion does not imply that the behavior of all of industry is consistent with the broad dictates of market. There are companies whose managers follow agendas that are inconsistent with the best interests of their stockholders. I believe, however, that such instances are few, except during periods of rapid change in the economic environment, because under steady conditions even our system of corporate governance, with all its flaws, will reject managers who deviate from their obligations.

I have come to the same conclusions concerning a frequently heard complaint of corporate executives: the undesirable influence that short-sighted money managers exert on corporations. Such interferences occur during periods of economic change, but if the economic environment is kept steady, the interests of all types of investors will coincide.


A nation's cost of equity has a significant effect on the time horizons of native companies. Such a relationship will be obvious to anyone who has dealt with corporate finance. What is less obvious is the possibility that time horizons of U.S. corporations have been adversely influenced by the entry into our domestic markets of foreign corporations that have low equity cost.

Long-term technological advancements, such as the development of integrated circuits, can offer tremendous benefits to end users. In such cases, a high cost of equity applicable to all corporations need not deter any one corporation from undertaking such a project, because it would eventually be in a position to recover its costs. Prior to the 1470s, U. S. technology-based corporations had few foreign competitors and, therefore, could maintain long time horizons in spite of high equity costs. More recently, however, the emergence of firms from Japan and Germany with strong technologies and lower equity costs has significantly limited the range of long-term projects that U.S. corporations can pursue profitably.

Another issue relating to time horizons is often misunderstood. Two companies with differing price-to-earnings ratios can have the same cost of equity, provided the company with the higher price-to-earnings ratio has an appropriately higher expected growth rate. Two such companies, however, would tend to have a different propensity for long-term investments, because the signals prom the equity markets are different. What stockholders are telling the company with the high price-to-earnings ratio is that they are more interested in its future growth rather than its current earnings. The message to the other company is the opposite: future growth is not expected; current earnings are more important.


The cost of capital varies more from company to company in any one country than it does on average from country to country. Much of the variation is due to factors that are beyond the control of corporate executives. Such factors include public policy and the stage of the corporation's development. Nevertheless, there are many things corporate managers can do to affect their firms' cost of capital significantly.

The most obvious and broadly recognized tool is management of the company's financial leverage. It is well known that for any firm there is an optimum leverage that minimizes its cost of capital. Such an optimum depends on many factors, such as the firm's line of business. It is also well known that the corporation's relationships with its creditors and its stockholders are most important. Yet the managers of most U. S. corporations do not appear to understand the extent to which they can influence not only the perceptions their stockholders have about their companies, but also the composition of the stockholders.

The top management of my company, Thermo Electron Corporation, decided twenty years ago to drive the ownership of our stock into the hands of individuals and institutions that are both interested in understanding our businesses and intent on investing for the long term. We believe we have accomplished our objective, as witnessed by the fact that over the past fifteen years the price of our stock has averaged 20 times earnings. We have never paid a dividend, and our declared policy is not to pay dividends in the foreseeable future.

We accomplished our objective by keeping in almost daily contact with many of our stockholders to inform them of not only favorable but also unfavorable developments and to clearly articulate our strategy. Such a sustained effort causes a shift of stock ownership from short-term to long-term investors. This can have an important effect on a company's time horizon. Even when all investors require identical returns on equity, they may differ in the degree of credibility they assign to a company's prediction of high future returns from a given investment. Attracting investors who view such forecasts as credible will enable the firm to undertake longer-horizon projects.

One class of investors we pursued was Europeans, who are typically more long-term oriented than Americans. Moreover, most Europeans pay no capital gains tax on the appreciation of equities, thus making our shares of particular interest. Many American companies raise equity and convertible debt in Europe, but few follow up by keeping in near constant contact with their international investors, especially in bad times. The contrast we provided to European investors by our frequent visits has been particularly effective. The result of our twenty-year campaign has been to increase the ownership of our shares in Europe from less than 10 percent in 1970 to more than 30 percent in 1990.

In addition to frequent and thorough communications with stockholders, there is another factor hat affects a corporation's cost of equity. It is the degree of comprehension stockholders have of the company's businesses. Because of this comprehension factor, firms with only one product line fare better in the market than more complex businesses. By the early 1980s, the complexity of Thermo Electron had increased substantially by virtue of several new ventures we created, which began to affect our stockholder constituancy.

To offset the negative influences of complexity and, in addition, to preserve the entrepreneurial spirit of our employees as we became larger, we adopted a new strategy in 1983. We incorporated several of our most promising divisions and sold a minority position in each to the public. In doing so we managed to preserve the advantages that accrue to large firms, such as larger pools of capital, technology, and human resources, as well as a broader public recognition. Our strategy has worked exceptionally well. Currently, Thermo Electron's unconventional group consists of the parent, which trades on the New York Stock Exchange, six subsidiaries trading on the American Stock Exchange, and numerous wholly owned subsidiaries.

It was stated earlier that the average cost of debt in the major industrialized nations converged during the 1980s. This convergence is attributed to integration of the world capital markets. The average cost of equity, however, diverged during the same period. There is a reason such an apparent anomaly exists. Although funds to finance government bonds and bonds issued by major corporations flow in large amounts across borders, the flow of funds in traded equities is miniscule. At the end of 1989, for example, 94 percent of the corporate equities owned by U.S. investors were issued by U.S. firms; for Japanese investors, more than 98 percent of their equity investments were domestic. The cross-country investment flows also suggest that the global debt markets have a much greater integration than do the equity markets. In 1989 foreign investors acquired $183.4 billion of U.S. financial assets, yet only $6.6 billion of this amount - less than 4 percent - was corporate equities.(3) I believe that efforts by U.S. management similar to those of our corporation in cultivating foreign equity markets could help substantially in lowering equity costs in the United States.


The price of capital, like that of any other commodity in the marketplace, balances demand with supply. The elimination of barriers to capital flows has created a common source of funds for debt financing available to all countries. As a result, interest rates in various industrialized nations have converged. Equity financing in each country, however, is provided mainly by each nation's pool of savings. For that reason, the low saving rate in the United States is a principal cause of its high equity costs. The net U.S. saving rate in the 1980s was 4 percent of national income - a sharp contrast to 12 percent in Germany and 20 percent in Japan.

The low saving rate in America, however, is not the only cause for high equity costs. National saving provides funds to both equity-financed and debt-financed investments. In the United States, the returns from debt-financed projects are taxed less than those from equity-financed projects. The opposite is true in Germany and Japan.

The high taxation of corporate equity investments in the United States derives from the double taxation of dividends and from the double taxation of retained earnings. Double taxation of dividends is readily apparent: Earnings are taxed at the corporate level and then again at the investor level when paid as dividends. Double taxation of retained earnings, however, is a more abstract concept. It comes about because, on average, corporate shares appreciate directly in proportion to after-tax retained earnings. When an investor buys a corporate share and then sells it later at a higher price, the tax is levied at the capital gains rate - even though the appreciation may be the sole result of the accumulation of after-tax profits.

In Germany, capital gains from equity investments are excluded from taxation at the investor level. The same was true in Japan prior to 1989; since 1989, capital gains from equity investments have been taxed at a small rate that decreases for longer-term investments. In both of these countries, the double taxation of retained earnings is virtually eliminated. Dividends, on the other hand, are given only minor relief from double taxation. That has led corporations in Germany and, in particular, Japan to retain most of their earnings, and to pay only small dividends. These policies cause national saving in our two major competitors to be funneled mostly into corporate equities.

In order to reduce the high cost of equity that is crippling U.S. industry, and to bring it more in line with that of our principal competitors, our government must do two things: Increase national saving and reduce the double taxation of retained earnings.

For the United States to remain a major economic power, our national saving rate must be restored to at least the pre-1980 historical level of 10 percent of national income. The most direct way of accomplishing such a goal is to eliminate the federal deficit without the use of social security surpluses. Incentives that stimulate personal savings would help, although most economists doubt their effectiveness.

Eliminating the double taxation of retained earnings at a least cost to the Treasury can be achieved in two ways. The first way is to exclude from taxation only prospective capital gains on corporate equities that are held over long periods of time after enactment, say five years. The cost to the Treasury would be minimal for five years and relatively small even after that, because only a small fraction of capital gains that are currently taxed comes from corporate equities.

There are many political problems with such an initiative. Opposition by groups that view reduced taxation of capital gains as a subsidy to the rich will probably remain high. Worse, the support of the groups that currently favor tax relief on capital gains probably will turn hostile. Such groups include investors in real estate and investors who currently hold unrealized gains on equities.

A solution that may be politically more viable is a form of integration of corporate with personal taxation. Under this plan, capital gains would continue to be taxed at the same rate as other income, but a tax credit would be provided against capital gains taxes equal to the taxes paid at the corporate level. The following example serves to illustrate how the proposal would work.

Let someone buy a corporate share for $100 and sell it five years later for $200. The capital gain would be $100, and the tax liability at 30 percent would be $30. Let the corporate earnings per share over the five year period be $50 after corporate tax payments of $20. The individual would be given a tax credit of $20, and the tax liability would be reduced from $30 to a mere $10. If, in addition, the tax credit is limited only to corporate taxes paid after enactment and only for shares held for five years after enactment, costs to the Treasury would be negligible. Long-term investments would be strongly encouraged.


The American public has a major role to play in reducing our cost of capital because in our political system the public has a major influence on what the government does.

Over the first 200 years of its existence, America created the most prosperous society in the world. It started out as a minor player, compared to the European economic giants of the nineteenth century, but ultimately the U.S. overtook all of them by a wide margin. It did so by saving a larger share of its national income than did any other country.

The Great Depression brought the realization that America may have gone too far in accumulating savings and curtailing consumption. Aided by World War II, our society started to consume more and save less. This shift had dramatic beneficial effects that peaked during the 1960s. Feeling omnipotent at that time, we continued to spend more and save less. Today, most of the American public believes that saving is bad, consumption is good, and that the federal deficit does not have much effect on their own well-being. Surveys of the past few years confirm such public attitudes. Americans have seen their wages stagnate over the past dozen years, but attribute the problem to everyone but themselves.

It is time for the public to understand that the economic problems we face are of our own making, and they are not caused by foreigners. If we continue to consume 96 percent of our national income and save only 4 percent, if we continue to depend on foreign lenders to finance our budget deficit, and if we continue to demand more government spending without increasing taxes, our future is bleak. But, if we restore our faith in investing for the future which served this country so well in the past - our society's advantages in natural and human resources will enable America to grow and remain the most prosperous society in the world. Government and business will do their share only when the public understands the root causes of our difficulties.


1 G.N. Hatsopoulos, "High Cost of Capital: Handicap of American Industry," Thermo Electron Corporation, Waltham, MA, 26 April, 1983; G.N. Hatsopoulos and S.H. Brooks, "The Gap in the Cost of Capital: Causes, Effects, and Remedies," in Technology and Economic Policy, R. Landau and D. Jorgenson, Eds. (Ballinger, Cambridge, MA, 1986), pp. 221-280; G.N. Hatsopoulos, P.R. Krugman, L.H. Summers, "U.S. Competitiveness: Beyond the Trade Deficit," Science, 15 July 1988, Volume 241, pp. 299-307; G.N. Hatsopoulos, "Capital Gains Differential: Does It Work?", American Council for Capital Formation, Center for Policy Research Conference, October 1989; G.N. Hatsopoulos, "Technology and the Cost of Equity Capital," National Academy of Engineering Symposium on Technology and Economics, Washington, DC, April 5, 1990.

2 R.N. McCauley and S.A. Zimmer, "Explaining International Differences in the Cost of Capital," Federal Reserve Bank of New York Quarterly Review, Summer 1989.

3 Data on international equity ownership are drawn from K.R. French and J.M. Poterba, "Investor Diversification and International Equity Markets," American Economic Review, Vol. 81, May 1991. Data on financial flows are drawn from the flow of funds of the Federal Reserve System.
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Title Annotation:the necessity of closing the gap in the cost of capital between the U.S. and its foreign competitors
Author:Hatsopolous, George N.
Publication:Business Economics
Date:Apr 1, 1991
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