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

							     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?