The Cost of Capital,

Corporation Finance and the

Theory of Investment
By Franco Modigliani and Merton H. Miller David Dodge
Motivation

- 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
Motivation
- 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
- 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
- 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
- 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?
- What is the nature of the market price of a share? i.e. “cost of
capital”
- Does the type of security used to finance an investment matter?
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
- Firm classes are groups where shares of the firms therein are
homogenous—perfect substitutes for one another.
Empirical evidence

- Data Electricity Utilities data from 1947-48 drawn from

Allen (1954)
- Oil company data from 1953 drawn from Smith (1955)
- Results Coefficients from both studies (Allen and Smith)
confer legitimacy on Propositions I & II
The Basic Propositions: Proposition I

“In a perfect capital market, the total value of a firm is equal to the market
value of the total cash flows generated by its assets and is not affected by
its choice of capital structure.”

- i.e. a firm with pure equity financing and one with leveraged financing
will have the same market value
- If otherwise identical firms with different capital structures have
different values, the Law of One Price would be violated and an
arbitrage opportunity would exist.
According to Proposition I, the
average cost of capital within a
given class k should tend to
have the same value
independently of the degree of
leverage.

The results of the correlation

test are favorable to the
hypothesis;

Both correlation coefficients

are very close to zero and not
statistically significant The
data in short provide no
evidence of any tendency
for the cost of capital to fall
as the debt ratio increases.
The Basic Propositions: Proposition Il
“The expected yield of a share of stock is equal to the appropriate capitalization
rate 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”

- 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.
According to our Proposition II the
expected yield on common stock,,
in any given class, should tend to
increase with leverage as
measured by the ratio D/S. The
relation should tend to be linear
and with positive slope.

Both correlation coefficients are

positive and highly significant
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
 An array of bonds and interest rates

- It can be shown that "arbitrage" will make values within any class a function
not only of expected after-tax returns, but of the tax rate and the degree of
leverage.
- This means that the tax advantages of debt financing are somewhat greater
than they originally suggested and, to this extent, the quantitative difference
between the valuations implied by their position and by the traditional view is
narrowed
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

Proposition III deems the variety of instrument used in financing immaterial to the
evaluation of the investment

This conveys to managerial economists, financial specialists, and other academic

economists a novel way of appraising alternative investments
Miller once described the MM propositions in an interview this way:

“People often ask: Can you summarize your theory quickly? Well, I say, you
understand the M&M theorem if you know why this is a joke: The pizza delivery
man comes to Yogi Berra after the game and says, “Yogi, how do you want this
pizza cut, into quarters or eighths?” And Yogi says, “Cut it in eight pieces. I’m
feeling hungry tonight.” Everyone recognizes that’s a joke because obviously the
number and shape of the pieces don’t affect the size of the pizza. And similarly,
the stocks, bonds, warrants, et cetera, issued don’t affect the aggregate value of
the firm. They just slice up the underlying earnings in different ways.”
Conclusion

❖ Propositions I and II provide the foundations of a theory of the valuation of

firms and shares in a world of uncertainty.
❖ With the development of Proposition III the main objectives outlined in the
introduction discussion have been reached.
❖ It was shown how this theory can lead to an operational definition of the cost
of capital and how that concept can be used in turn as a basis for rational
investment decision-making within the firm.