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?