The%20Cost%20of%20Capital,%20Corporation%20Finance%20and%20the%20Theory%20of%20Investment

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The Cost of Capital, Corporation Finance and the
Theory of Investment

• By Franco Modigliani
• and Merton H. Miller
• David Dodge

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Citation

• Modigliani, Franco and Merton H. Miller, The
  Cost of Capital, Corporation Finance and the
  Theory of Investment, The American Economic
  Review 48(3), June 1958 261-297

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The State of the Literature c. 1950s

• Economic theorists have made detrimental
  simplifications e.g. physical assets (bonds)
  could be assumed to give known, sure streams
• The cost of capital is therefore the rate of
  interest on bonds
• The firm will invest until marginal yield
  marginal interest

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The State of the Literature c. 1950s

• Under certainty, two criteria of rational
  managerial decision-making are prevalent
• The maximization of profits
• The maximization of market value
• Under both, the cost of capital interest rate
  on bonds

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The State of the Literature c. 1950s

• Some attempts had been made to deal with
  uncertainty
• A risk discount subtracted from expected yield
• A risk premium added to the market rate of
  interest
• This works for macro generalization models, but
  not for macro indicators or micro concerns
• Reckless uncertainty bonds only

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The State of the Literature c. 1950s

• Profit maximization from the certainty model had
  led to utility maximization of managers/owners
  i.e. the decision-making application was
  subjective
• Another option market value maximization

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Market Value Max.

• Offers an application function for the cost of
  capital, pk
• Yields a functional theory of investment
• However, capital structure theory and knowledge
  of how structural variability affects market
  value were both lacking

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Primary Questions

• Does capital structure matter in determining the
  market value of a firm? (268)
• What is the nature of the market price of a
  share? i.e. cost of capital (271)
• Does the type of security used to finance an
  investment matter? (288)

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Assumptions

• Assume firms can be divided into classes wherein
  firms with returns on shares proportional to each
  other are grouped together
• Then all firms can be characterized by
• 1) class
• 2) expected return
• Assume bonds yield a constant income per unit of
  time, and that they are traded in a perfect
  market

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Method

• Partial Equilibrium
• Capital Market theory parallels Marshallian Price
  Theory
• Firm classes are groups where shares of the firms
  therein are homogenousperfect substitutes for
  one another.
• In Marshall, the homogenous item was the
  commodity produced by the firms
• Empirical verification

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The Basic Propositions Proposition I

• The market value of any firm is independent of
  its capital structure and is given by
  capitalizing its expected return at the rate pk
  appropriate to its class (268)
• i.e. a firm with pure equity financing and one
  with leveraged financing will have the same
  market value

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The Basic Propositions Proposition II

• the expected yield of a share of stock is equal
  to the appropriate capitalization rate pk for a
  pure equity stream in the class, plus a premium
  related to financial risk equal to the
  debt-to-equity ratio times the spread between pk
  and r (271)
• i.e. the cost of equity is a linear function of
  the firms debt to equity ratio. The higher the
  debt, the higher the required return on equity

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The Basic Propositions Extensions

• A corporate profits tax with deductible interest
  payments
• An array of bonds and interest rates
• Market imperfections that may interfere with
  arbitrage

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Data

• Electricity Utilities (43) data from 1947-48
  drawn from Allen (1954)
• Oil company (42) data from 1953 drawn from Smith
  (1955)

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Results

• Coefficients from both studies (Allen and Smith)
  confer legitimacy on Propositions I II

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Implications Investment Proposition III

• Proposition III the cut-off point for
  investment in the firm will in all cases be pk
  and will be completely unaffected by the type of
  security used to finance the investment
• This is illustrated using bonds, retained
  earnings, and common stock for financing

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Implications Investment Proposition III

• In sum, Proposition III deems the variety of
  instrument used in financing immaterial to the
  evaluation of the investment
• In investment decisions, the marginal cost of
  capital is pk
• This conveys to managerial economists, financial
  specialists, and other academic economists a
  novel way of appraising alternative investments

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Article Evaluation

• The evidence used to argue for the propositions
  consisted of theoretical development, empirical
  evaluation, and an example or analogy
• The richness of evidence was sufficient to
  support the conclusion

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Why is The Cost of Capital relevant?

• My summary will deal specifically with options
  used in financing corporate ventures
• This is an extension of Modigliani Millers
  (1958) (1961) research in the cost of capital and
  capital structure
• My question under imperfect information, how is
  a firms capital structure affected when there
  are derivatives written on its shares?