The Cost of Capital, Corporation Finance and the Theory of Investment
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The Cost of Capital, Corporation Finance and the Theory of Investment By Franco Modigliani and Merton H. Miller David Dodge 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 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 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 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 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 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 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) 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 Method Partial Equilibrium Capital Market theory parallels Marshallian Price Theory Firm classes are groups where shares of the firms therein are homogenous—perfect substitutes for one another. In Marshall, the homogenous item was the commodity produced by the firms Empirical verification 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 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 firm’s debt to equity ratio. The higher the debt, the higher the required return on equity 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 Data Electricity Utilities (43) data from 1947-48 drawn from Allen (1954) Oil company (42) data from 1953 drawn from Smith (1955) Results Coefficients from both studies (Allen and Smith) confer legitimacy on Propositions I & II 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 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 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 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 & Miller’s (1958) (1961) research in the cost of capital and capital structure My question: under imperfect information, how is a firm’s capital structure affected when there are derivatives written on its shares?