THE IRRELEVANCE OF financial policy was first noted by J. B. Williams [46] some forty years ago, as he stated that "no change in the investment value of the enterprise as a whole would result from a change in its capitalization."' In 1952, Durand [9], in contrasting the Net Operating Income and the Net Income approaches to market valuation, demonstrated that the value of a firm is independent of its capital structure under the Net Operating Income theory of market valuation. However, it was not until after the publication of Modigliani and Miller's (MM) [31] classic paper in 1958 that the theory of financial leverage began to attract a great deal of attention among researchers in finance and economics. In their paper, Modigliani and Miller first brought out more explicitly the relationship between market valuation and individual portfolio decisions under uncertainty and proved, based upon the risk-class assumption and the arbitrage argument, the famous proposition that the value of a firm is invariant to its capital structure in the absence of corporate income taxes and bankruptcy risk. Several subsequent studies have shown that the same result can be obtained under more general conditions.2 The meaning and the measure of a firm's cost of capital have been the subject of numerous theoretical and empirical inquiries in the past two decades, and the theory of financial leverage has now become an essential part of the modern theory of corporation finance. The cost of debt capital, an integral part of a firm's cost of capital, is defined as the equilibrium required rate of return on a risky corporate bond. Therefore, understanding the theory of corporate bankruptcy and the pricing of risky debt in an equilibrium capital market is the key to a better understanding of the determinants of a firm's cost of debt capital. The purpose of this paper is to review some recent developments in the theory of pricing risky debt and to examine more systematically the determinants of the cost of debt capital. In Section II, we review and discuss the pricing of risky bonds and the determination of the cost of debt capital within a framework of one-period capital asset pricing model under uncertainty. In Section III, the mathematically more elegant models of pricing risky bonds based upon the continuous-time option pricing model are reviewed and discussed. The determinants of the risk premiums