The Cost of Capital, Corporation Finance and the Theory of Investment
Author(s): Franco Modigliani and Merton H. Miller Source: The American Economic Review, Vol. 48, No. 3 (Jun., 1958), pp. 261-297 Published by: American Economic Association Stable URL: http://www.jstor.org/stable/1809766 Accessed: 10/09/2009 09:51 Your use of the JSTOR archive indicates your acceptance of JSTOR's Terms and Conditions of Use, available at http://www.jstor.org/page/info/about/policies/terms.jsp. JSTOR's Terms and Conditions of Use provides, in part, that unless you have obtained prior permission, you may not download an entire issue of a journal or multiple copies of articles, and you may use content in the JSTOR archive only for your personal, non-commercial use. Please contact the publisher regarding any further use of this work. Publisher contact information may be obtained at http://www.jstor.org/action/showPublisher?publisherCode=aea. Each copy of any part of a JSTOR transmission must contain the same copyright notice that appears on the screen or printed page of such transmission. JSTOR is a not-for-profit organization founded in 1995 to build trusted digital archives for scholarship. We work with the scholarly community to preserve their work and the materials they rely upon, and to build a common research platform that promotes the discovery and use of these resources. For more information about JSTOR, please contact support@jstor.org. American Economic Association is collaborating with JSTOR to digitize, preserve and extend access to The American Economic Review. http://www.jstor.org T h e Ame rican e conomic R e v l e w VOLUME XLVIII JUNE 1958 NUMBER T HR EE T HE COST OF CAPIT AL, COR POR AT ION FINANCE AND T HE T HEOR Y OF INVEST MIENT By FR ANCO MODIGLIAN1 AND MER T ON H. MILLER * Wh at is th e "cost of capital " to a firm in a w orl d in w h ich funds are use d to acquire asse ts w h ose yie l ds are unce rtain; and in w h ich capital can be obtaine d by many diffe re nt me dia, ranging from pure de bt instru- me nts, re pre se nting mone y-fixe d cl aims, to pure e quity issue s, giv ing h ol de rs onl y th e righ t to a pro-rata sh are in th e unce rtain v e nture .? T h is que stion h as v e xe d at l e ast th re e cl asse s of e conomists: (1) th e cor- poration finance spe cial ist conce rne d w ith th e te ch nique s of financing firms so as to e nsure th e ir surv iv al and grow th ; (2) th e manage rial e conomist conce rne d w ith capital budge ting; and (3) th e e conomic th e orist conce rne d w ith e xpl aining inv e stme nt be h av ior at both th e micro and macro l e v e l s.' In much of h is formal anal ysis, th e e conomic th e orist at l e ast h as te nde d to side -ste p th e e sse nce of th is cost-of-capital probl e m by pro- ce e ding as th ough ph ysical asse ts-l ike bonds-coul d be re garde d as yie l ding know n, sure stre ams. Giv e n th is assumption, th e th e orist h as concl ude d th at th e cost of capital to th e ow ne rs of a firm is simpl y th e rate of inte re st on bonds; and h as de riv e d th e famil iar proposition th at th e firm, acting rational l y, w il l te nd to push inv e stmne nt to th e point * T h e auth ors are , re spe ctiv e l y, profe ssor and associate profe ssor of e conomics in th e Grad- uate Sch ool of Industrial Administration, Carne gie Institute of T e ch nol ogy. T h is articl e is a re v ise d v e rsion of a pape r de l iv e re d at th e annual me e ting of th e Econome tric Socie ty, De ce m- be r 1956. T h e auth ors e xpre ss th anks for th e comme nts and sugge stions made at th at time by th e discussants of th e pape r, Ev se y Domar, R obe rt Eisne r and Joh n Lintne r, and subse - que ntl y by J'ame s Due se nbe rry. T h e y are al so gre atl y inde bte d to many of th e ir pre se nt and forme r col l e ague s and stude nts at Carne gie T e ch w h o se rv e d so ofte n and w ith such re mark- abl e patie nce as a critical forum for th e ide as h e re pre se nte d. 1 T h e l ite rature be aring on th e cost-of-capital probl e m is far too e xte nsiv e for l isting h e re . Nume rous re fe re nce s to it w il l be found th rough out th e pape r th ough w e make no cl aim to compl e te ne ss. One ph ase of th e probl e m w h ich w e do not conside r e xpl icitl y, but w h ich h as a conside rabl e l ite rature of its ow n is th e re l ation be tw e e n th e cost of capital and publ ic util ity rate s. For a re ce nt summary of th e "cost-of-capital th e ory" of rate re gul ation and a brie f dis- cussion of some of its impl ications, th e re ade r may re fe r to H. M. Some rs [201. 262 T HE AMER ICAN ECONOMIC R EVIEW w h e re th e marginal yie l d on ph ysical asse ts is e qual to th e marke t rate of inte re st.2 T h is proposition can be sh ow n to fol l ow from e ith e r of tw o crite ria of rational de cision-making w h ich are e quiv al e nt unde r ce rtain- ty, name l y (1) th e maximization of profits and (2) th e maximization of marke t v al ue . According to th e first crite rion, a ph ysical asse t is w orth acquiring if it w il l incre ase th e ne t profit of th e ow ne rs of th e firm. But ne t profit w il l incre ase onl y if th e e xpe cte d rate of re turn, or yie l d, of th e asse t e xce e ds th e rate of inte re st. According to th e se cond crite rion, an asse t is w orth acquiring if it incre ase s th e v al ue of th e ow ne rs' e quity, i.e ., if it adds more to th e marke t v al ue of th e firm th an th e costs of acquisi- tion. But w h at th e asse t adds is giv e n by capital izing th e stre am it ge n- e rate s at th e marke t rate of inte re st, and th is capital ize d v al ue w il l e xce e d its cost if and onl y if th e yie l d of th e asse t e xce e ds th e rate of inte re st. Note th at, unde r e ith e r formul ation, th e cost of capital is e qual to th e rate of inte re st on bonds, re gardl e ss of w h e th e r th e funds are acquire d th rough de bt instrume nts or th rough ne w issue s of common stock. Inde e d, in a w orl d of sure re turns, th e distinction be tw e e n de bt and e quity funds re duce s l arge l y to one of te rminol ogy. It must be acknow l e dge d th at some atte mpt is usual l y made in th is type of anal ysis to al l ow for th e e xiste nce of unce rtainty. T h is atte mpt typical l y take s th e form of supe rimposing on th e re sul ts of th e ce rtainty anal ysis th e notion of a "risk discount" to be subtracte d from th e e x- pe cte d yie l d (or a "risk pre mium" to be adde d to th e marke t rate of inte re st). Inv e stme nt de cisions are th e n suppose d to be base d on a com- parison of th is "risk adjuste d" or "ce rtainty e quiv al e nt" yie l d w ith th e marke t rate of inte re st.3 No satisfactory e xpl anation h as ye t be e n pro- v ide d, h ow e v e r, as to w h at de te rmine s th e size of th e risk discount and h ow it v arie s in re sponse to ch ange s in oth e r v ariabl e s. Conside re d as a conv e nie nt approximation, th e mode l of th e firm constructe d v ia th is ce rtainty-or ce rtainty-e quiv al e nt-approach h as admitte dl y be e n use ful in de al ing w ith some of th e grosse r aspe cts of th e proce sse s of capital accumul ation and e conomic fl uctuations. Such a mode l unde rl ie s, for e xampl e , th e famil iar Ke yne sian aggre gate inv e st- me nt function in w h ich aggre gate inv e stme nt is w ritte n as a function of th e rate of inte re st-th e same riskl e ss rate of inte re st w h ich appe ars l ate r in th e syste m in th e l iquidity-pre fe re nce e quation. Ye t fe w w oul d maintain th at th is approximation is ade quate . At th e macroe conomic l e v e l th e re are ampl e grounds for doubting th at th e rate of inte re st h as 2 Or, more accurate l y, to th e marginal cost of borrow e d funds since it is customary, at l e ast in adv ance d anal ysis, to draw th e suppl y curv e of borrow e d funds to th e firm as a rising one . For an adv ance d tre atme nt of th e ce rtainty case , se e F. and V. Lutz [131. a T h e cl assic e xampl e s of th e ce rtainty-e quiv al e nt approach are found in J. R . Hicks [8] and 0. Lange [11]. MODIGLIANI AND MILLER : T HEOR Y OF INVEST MENT 263 as l arge and as dire ct an infl ue nce on th e rate of inv e stme nt as th is anal ysis w oul d l e ad us to be l ie v e . At th e microe conomic l e v e l th e ce r- tainty mode l h as l ittl e de scriptiv e v al ue and prov ide s no re al guidance to th e finance spe cial ist or manage rial e conomist w h ose main probl e ms cannot be tre ate d in a frame w ork w h ich de al s so cav al ie rl y w ith unce r- tainty and ignore s al l forms of financing oth e r th an de bt issue s.4 Onl y re ce ntl y h av e e conomists be gun to face up se riousl y to th e prob- l e m of th e cost of capital cum risk. In th e proce ss th e y h av e found th e ir inte re sts and e nde av ors me rging w ith th ose of th e finance spe cial ist and th e manage rial e conomist w h o h av e l iv e d w ith th e probl e m l onge r and more intimate l y. In th is joint se arch to e stabl ish th e principl e s w h ich gov e rn rational inv e stme nt and financial pol icy in a w orl d of unce r- tainty tw o main l ine s of attack can be disce rne d. T h e se l ine s re pre se nt, in e ffe ct, atte mpts to e xtrapol ate to th e w orl d of unce rtainty e ach of th e tw o crite ria-profit maximization and marke t v al ue maximization- w h ich w e re se e n to h av e e quiv al e nt impl ications in th e spe cial case of ce rtainty. With th e re cognition of unce rtainty th is e quiv al e nce v anish e s. In fact, th e profit maximization crite rion is no l onge r e v e n w e l l de fine d. Unde r unce rtainty th e re corre sponds to e ach de cision of th e firm not a unique profit outcome , but a pl ural ity of mutual l y e xcl usiv e outcome s w h ich can at be st be de scribe d by a subje ctiv e probabil ity distribution. T h e profit outcome , in sh ort, h as be come a random v ariabl e and as such its maximization no l onge r h as an ope rational me aning. Nor can th is difficul ty ge ne ral l y be dispose d of by using th e math e matical e xpe cta- tion of profits as th e v ariabl e to be maximize d. For de cisions w h ich affe ct th e e xpe cte d v al ue w il l al so te nd to affe ct th e dispe rsion and oth e r ch aracte ristics of th e distribution of outcome s. In particul ar, th e use of de bt rath e r th an e quity funds to finance a giv e n v e nture may w e l l in- cre ase th e e xpe cte d re turn to th e ow ne rs, but onl y at th e cost of in- cre ase d dispe rsion of th e outcome s. Unde r th e se conditions th e profit outcome s of al te rnativ e inv e stme nt and financing de cisions can be compare d and ranke d onl y in te rms of a subje ctiv e "util ity function" of th e ow ne rs w h ich w e igh s th e e xpe cte d yie l d against oth e r ch aracte ristics of th e distribution. Accordingl y, th e e xtrapol ation of th e profit maximization crite rion of th e ce rtainty mode l h as te nde d to e v ol v e into util ity maximization, some time s e xpl icitl y, more fre que ntl y in a qual itativ e and h e uristic form.5 T h e util ity approach undoubte dl y re pre se nts an adv ance ov e r th e ce rtainty or ce rtainty-e quiv al e nt approach . It doe s at l e ast pe rmit us 4 T h ose w h o h av e take n a "case -me th od" couirse in finance in re ce nt ye ars w il l re cal l in th is conne ction th e famous Liquigas case of Hunt and Wil l iams, 19, pp. 193-961 a case w h ich is ofte n use d to introduce th e stude nt to th e cost-of-capital probl e m and to poke a bit of fun at th e e conomist's ce rtainty-mode l . 6 For an atte mpt at a rigorous e xpl icit de v e l opme nt of th is l ine of attack, se e F. Modigl iani and M. Ze man [141. 264 T HE AMER ICAN ECONOMIC R EVIEW to e xpl ore (w ith in l imits) some of th e impl ications of diffe re nt financing arrange me nts, and it doe s giv e some me aning to th e "cost" of diffe re nt type s of funds. How e v e r, be cause th e cost of capital h as be come an e sse ntial l y subje ctiv e conce pt, th e util ity approach h as se rious draw - backs for normativ e as w e l l as anal ytical purpose s. How , for e xampl e , is manage me nt to asce rtain th e risk pre fe re nce s of its stockh ol de rs and to compromise among th e ir taste s? And h ow can th e e conomist buil d a me aningful inv e stme nt function in th e face of th e fact th at any giv e n inv e stme nt opportunity migh t or migh t not be w orth e xpl oiting de pe nd- ing on pre cise l y w h o h appe n to be th e ow ne rs of th e firm at th e mome nt? Fortunate l y, th e se que stions do not h av e to be answ e re d; for th e al te r- nativ e approach , base d on marke t v al ue maximization, can prov ide th e basis for an ope rational de finition of th e cost of capital and a w orkabl e th e ory of inv e stme nt. Unde r th is approach any inv e stme nt proje ct and its concomitant financing pl an must pass onl y th e fol l ow ing te st: Wil l th e proje ct, as finance d, raise th e marke t v al ue of th e firm's sh are s? If so, it is w orth unde rtaking; if not, its re turn is l e ss th an th e marginal cost of capital to th e firm. Note th at such a te st is e ntire l y inde pe nde nt of th e taste s of th e curre nt ow ne rs, since marke t price s w il l re fl e ct not onl y th e ir pre fe re nce s but th ose of al l pote ntial ow ne rs as w e l l . If any curre nt stockh ol de r disagre e s w ith manage me nt and th e marke t ov e r th e v al uation of th e proje ct, h e is fre e to se l l out and re inv e st e l se w h e re , but w il l stil l be ne fit from th e capital appre ciation re sul ting from man- age me nt's de cision. T h e pote ntial adv antage s of th e marke t-v al ue approach h av e l ong be e n appre ciate d; ye t anal ytical re sul ts h av e be e n me age r. Wh at ap- pe ars to be ke e ping th is l ine of de v e l opme nt from ach ie v ing its promise is l arge l y th e l ack of an ade quate th e ory of th e e ffe ct of financial struc- ture on marke t v al uations, and of h ow th e se e ffe cts can be infe rre d from obje ctiv e marke t data. It is w ith th e de v e l opme nt of such a th e ory and of its impl ications for th e cost-of-capital probl e m th at w e sh al l be con- ce rne d in th is pape r. Our proce dure w il l be to de v e l op in Se ction I th e basic th e ory itse l f and to giv e some brie f account of its e mpirical re l e v ance . In Se ction II, w e sh ow h ow th e th e ory can be use d to answ e r th e cost-of-capital que s- tion and h ow it pe rmits us to de v e l op a th e ory of inv e stme nt of th e firm unde r conditions of unce rtainty. T h rough out th e se se ctions th e approach is e sse ntial l y a partial -e quil ibrium one focusing on th e firm and "industry." Accordingl y, th e "price s" of ce rtain income stre ams w il l be tre ate d as constant and giv e n from outside th e mode l , just as in th e standard Marsh al l ian anal ysis of th e firm and industry th e price s of al l inputs and of al l oth e r products are take n as giv e n. We h av e ch ose n to focus at th is l e v e l rath e r th an on th e e conomy as a w h ol e be cause it MODIGLIANI AND MILLER : T HEOR Y OF INVEST MENT 265 is at th e l e v e l of th e firm and th e industry th at th e inte re sts of th e v ari- ous spe cial ists conce rne d w ith th e cost-of-capital probl e m come most cl ose l y toge th e r. Al th ough th e e mph asis h as th us be e n pl ace d on partial - e quil ibrium anal ysis, th e re sul ts obtaine d al so prov ide th e e sse ntial buil ding bl ocks for a ge ne ral e quil ibrium mode l w h ich sh ow s h ow th ose price s w h ich are h e re take n as giv e n, are th e mse l v e s de te rmine d. For re asons of space , h ow e v e r, and be cause th e mate rial is of inte re st in its ow n righ t, th e pre se ntation of th e ge ne ral e quil ibrium mode l w h ich rounds out th e anal ysis must be de fe rre d to a subse que nt pape r. I. T ih e Val uation of Se curitie s, Le v e rage , and tih e Cost of Capital A. T 'h e Capital ization R ate for Unce rtain Stre ams As a starting point, conside r an e conomy in w h ich al l ph ysical asse ts are ow ne d by corporations. For th e mome nt, assume th at th e se corpora- tions can finance th e ir asse ts by issuing common stock onl y; th e intro- duction of bond issue s, or th e ir e quiv al e nt, as a source of corporate funds is postpone d until th e ne xt part of th is se ction. T h e ph ysical asse ts h e l d by e ach firm w il l yie l d to th e ow ne rs of th e firm-its stockh ol de rs-a stre am of "profits" ov e r time ; but th e e l e - me nts of th is se rie s ne e d not be constant and in any e v e nt are unce rtain. T h is stre am of income , and h e nce th e stre am accruing to any sh are of common stock, w il l be re garde d as e xte nding inde finite l y into th e future . WT e assume , h ow e v e r, th at th e me an v al ue of th e stre am ov e r time , or av e rage profit pe r unit of time , is finite and re pre se nts a random v ari- abl e subje ct to a (subje ctiv e ) probabil ity distribution. We sh al l re fe r to th e av e rage v al ue ov e r time of th e stre am accruing to a giv e n sh are as th e re turn of th at sh are ; and to th e math e matical e xpe ctation of th is av e rage as th e e xpe cte d re turn of th e sh are .6 Al th ough indiv idual inv e s- tors may h av e diffe re nt v ie w s as to th e sh ape of th e probabil ity distri 6 T h e se propositions can be re state d anal ytical l y as fol l ow s: T h e asse ts of th e ith firm ge ne r- ate a stre am: Xi (I), Xi (2) ... Xi (T ) w h ose e l e me nts are random v ariabl e s subje ct to th e joint probabil ity distribution: Xi [Xi (1), Xi (2) .. *X\i (t)J. T h e re turn to th e ith firm is de fine d as: l iT Xi-= l im - Xsit). 7--co T t= Xi is itse l f a random v ariabl e w ith a probabil ity distribution diW(Xi) w h ose form is de te rmine d unique l y by Xi. T h e e xpe cte d re turn Xi is de fine d as Xi=E(Xi) =fxXib(X,)dX;. If Ni is th e numbe r of sh are s outstanding, th e re turn of th e ith sh are is xi= (1/N)X; w ith probabil ity distribution Oi(xi)dx1=4i(Nxi)d(Nxi) and e xpe cte d v al ue 9i=(1/N)X,. 266 T HE AMER ICAN ECONOMIC R EVIEW bution of th e re turn of any sh are , w e sh al l assume for simpl icity th at th e y are at l e ast in agre e me nt as to th e e xpe cte d re turn.7 T h is w ay of ch aracte rizing unce rtain stre ams me rits brie f comme nt. Notice first th at th e stre am is a stre am of profits, not div ide nds. As w il l be come cl e ar l ate r, as l ong as manage me nt is pre sume d to be acting in th e be st inte re sts of th e stockh ol de rs, re taine d e arnings can be re garde d as e quiv al e nt to a ful l y subscribe d, pre -e mptiv e issue of common stock. He nce , for pre se nt purpose s, th e div ision of th e stre am be tw e e n cash div ide nds and re taine d e arnings in any pe riod is a me re de tail . Notice al so th at th e unce rtainty attach e s to th e me an v al ue ov e r time of th e stre am of profits and sh oul d not be confuse d w ith v ariabil ity ov e r time of th e succe ssiv e e l e me nts of th e stre am. T h at v ariabil ity and unce r- tainty are tw o total l y diffe re nt conce pts sh oul d be cl e ar from th e fact th at th e e l e me nts of a stre am can be v ariabl e e v e n th ough know n w ith ce rtainty. It can be sh ow n, furth e rmore , th at w h e th e r th e e l e me nts of a stre am are sure or unce rtain, th e e ffe ct of v ariabil ity pe r se on th e v al ua- tion of th e stre am is at be st a se cond-orde r one w h ich can safe l y be ne g- l e cte d for our purpose s (and inde e d most oth e rs too).8 T h e ne xt assumption pl ays a strate gic rol e in th e re st of th e anal ysis. We sh al l assume th at firms can be div ide d into "e quiv al e nt re turn" cl asse s such th at th e re turn on th e sh are s issue d by any firm in any giv e n cl ass is proportional to (and h e nce pe rfe ctl y corre l ate d w ith ) th e re turn on th e sh are s issue d by any oth e r firm in th e same cl ass. T h is assumption impl ie s th at th e v arious sh are s w ith in th e same cl ass diffe r, at most, by a "scal e factor." Accordingl y, if w e adjust for th e diffe re nce in scal e , by taking th e ratio of th e re turn to th e e xpe cte d re turn, th e probabil ity distribution of th at ratio is ide ntical for al l sh are s in th e cl ass. It fol l ow s th at al l re l e v ant prope rtie s of a sh are are unique l y ch ar- acte rize d by spe cifying (1) th e cl ass to w h ich it be l ongs and (2) its e xpe cte d re turn. T h e significance of th is assumption is th at it pe rmits us to cl assify firms into groups w ith in w h ich th e sh are s of diffe re nt firms are "h omoge - ne ous," th at is, pe rfe ct substitute s for one anoth e r. We h av e , th us, an anal ogue to th e famil iar conce pt of th e industry in w h ich it is th e com- modity produce d by th e firms th at is take n as h omoge ne ous. T o com- pl e te th is anal ogy w ith Marsh al l ian price th e ory, w e sh al l assume in th e 7T o de al ade quate l y w ith re fine me nts such as diffe re nce s among inv e stors in e stimate s of e xpe cte d re turns w oul d re quire e xte nsiv e discussion of th e th e ory of portfol io se l e ction. Brie f re fe re nce s to th e se and re l ate d topics w il l be made in th e succe e ding articl e on th e ge ne ral e quil ibrium mode l . 8 T h e re ade r may conv ince h imse l f of th is by asking h ow much h e w oul d be w il l ing to re bate to h is e mpl oye r for th e priv il e ge of re ce iv ing h is annual sal ary in e qual month l y instal l me nts rath e r th an in irre gul ar amounts ov e r th e ye ar. Se e al so J. M. Ke yne s [10, e sp. pp. 53-541. MODIGLIANI AND MILLER : T HEOR Y OF INVEST MENT 267 anal ysis to fol l ow th at th e sh are s conce rne d are trade d in pe rfe ct mar- ke ts unde r conditions of atomistic compe tition.9 From our de finition of h omoge ne ous cl asse s of stock it fol l ow s th at in e quil ibrium in a pe rfe ct capital marke t th e price pe r dol l ar's w orth of e xpe cte d re turn must be th e same for al l sh are s of any giv e n cl ass. Or, e quiv al e ntl y, in any giv e n cl ass th e price of e v e ry sh are must be propor- tional to its e xpe cte d re turn. Le t us de note th is factor of proportional ity for any cl ass, say th e kth cl ass, by l /Pk. T h e n if pi de note s th e price and sj is th e e xpe cte d re turn pe r sh are of th e jth firm in cl ass k, w e must h av e : (1) pj =-xj; Pk or, e quiv al e ntl y, (2) = Pk a constant for al l firms j in cl ass k. pi T h e constants Pk (one for e ach of th e k cl asse s) can be giv e n se v e ral e conomic inte rpre tations: (a) From (2) w e se e th at e ach Pk iS th e e x- pe cte d rate of re turn of any sh are in cl ass k. (b) From (1) l /Pk is th e price w h ich an inv e stor h as to pay for a dol l ar's w orth of e xpe cte d re - turn in th e cl ass k. (c) Again from (1), by anal ogy w ith th e te rminol ogy for pe rpe tual bonds, Pk can be re garde d as th e marke t rate of capital iza- tion for th e e xpe cte d v al ue of th e unce rtain stre ams of th e kind ge n- e rate d by th e kth cl ass of firms.10 B. De bt Financing and Its Effe cts on Se curity Price s Hav ing de v e l ope d an apparatus for de al ing w ith unce rtain stre ams w e can now approach th e h e art of th e cost-of-capital probl e m by drop- ping th e assumption th at firms cannot issue bonds. T h e introduction of de bt-financing ch ange s th e marke t for sh are s in a v e ry fundame ntal w ay. Be cause firms may h av e diffe re nt proportions of de bt in th e ir capi- 9 Just w h at our cl asse s of stocks contain and h ow th e diffe re nt cl asse s can be ide ntifie d by outside obse rv e rs are e mpirical que stions to w h ich w e sh al l re turn l ate r. For th e pre se nt, it is sufficie nt to obse rv e : (1) Our conce pt of a cl ass, w h il e not ide ntical to th at of th e industry is at l e ast cl ose l y re l ate d to it. Ce rtainl y th e basic ch aracte ristics of th e probabil ity distributions of th e re turns on asse ts w il l de pe nd to a significant e xte nt on th e product sol d and th e te ch - nol ogy use d. (2) Wh at are th e appropriate cl ass boundarie s w il l de pe nd on th e particul ar prob- l e m be ing studie d. An e conomist conce rne d w ith ge ne ral te nde ncie s in th e marke t, for e xampl e , migh t w e l l be pre pare d to w ork w ith far w ide r cl asse s th an w oul d be appropriate for an inv e s- tor pl anning h is portfol io, or a firm pl anning its financial strate gy. 10 We cannot, on th e basis of th e assumptions so far, make any state me nts about th e re l a- tionsh ip or spre ad be tw e e n th e v arious p's or capital ization rate s. Be fore w e coul d do so w e w oul d h av e to make furth e r spe cific assumptions about th e w ay inv e stors be l ie v e th e proba- bil ity distributions v ary from cl ass to cl ass, as w e l l as assumptions about inv e stors' pre fe re nce s as be tw e e n th e ch aracte ristics of diffe re nt distributions. 268 T HE AMER ICAN ECONOMIC R EVIEW tal structure , sh are s of diffe re nt companie s, e v e n in th e same cl ass, can giv e rise to diffe re nt probabil ity distributions of re turns. In th e l anguage of finance , th e sh are s w il l be subje ct to diffe re nt de gre e s of fil ancial risk or "l e v e rage " and h e nce th e y w il l no l onge r be pe rfe ct substitute s for one anoth e r. T o e xh ibit th e me ch anism de te rmining th e re l ativ e price s of sh are s unde r th e se conditions, w e make th e fol l ow ing tw o assumptions about th e nature of bonds and th e bond marke t, th ough th e y are actual l y stronge r th an is ne ce ssary and w il l be re l axe d l ate r: (1) Al l bonds (in- cl uding any de bts issue d by h ouse h ol ds for th e purpose of carrying sh are s) are assume d to yie l d a constant income pe r unit of time , and th is income is re garde d as ce rtain by al l trade rs re gardl e ss of th e issue r. (2) Bonds, l ike stocks, are trade d in a pe rfe ct marke t, w h e re th e te rm pe rfe ct is to be take n in its usual se nse as impl ying th at any tw o com- moditie s w h ich are pe rfe ct substitute s for e ach oth e r must se l l , in e qui- l ibrium, at th e same price . It fol l ow s from assumption (1) th at al l bonds are in fact pe rfe ct substitute s up to a scal e factor. It fol l ow s from as- sumption (2) th at th e y must al l se l l at th e same price pe r dol l ar's w orth of re turn, or w h at amounts to th e same th ing must yie l d th e same rate of re turn. T h is rate of re turn w il l be de note d by r and re fe rre d to as th e rate of inte re st or, e quiv al e ntl y, as th e capital ization rate for sure stre ams. We now can de riv e th e fol l ow ing tw o basic propositions w ith re spe ct to th e v al uation of se curitie s in companie s w ith diffe re nt capital structure s: Proposition I. Conside r any company j and l e t Xi stand as be fore for th e e xpe cte d re turn on th e asse ts ow ne d by th e company (th at is, its e xpe cte d profit be fore de duction of inte re st). De note by Di th e marke t v al ue of th e de bts of th e company; by Sj th e marke t v al ue of its com- mon sh are s; and by Vj=Sj+Dj th e marke t v al ue of al l its se curitie s or, as w e sh al l say, th e marke t v al ue of th e firm. T h e n, our Proposition I asse rts th at w e must h av e in e quil ibrium: (3) Vi (Sj + Dj) = Xjl /pk, for any firm j in cl ass k. T h at is, th e marke t v al ue of any firm is inde pe zde ntt of its capital structure and is giv e n by capital izinzg its e xpe cte d re turn at th e rate Pk appropriate to its cl ass. T h is proposition can be state d in an e quiv al e nt w ay in te rms of th e firm's "av e rage cost of capital ," Xj/Vj, w h ich is th e ratio of its e xpe cte d re turn to th e marke t v al ue of al l its se curitie s. Our proposition th e n is: xj Xj (4) - = Pk, for any firm j, in cl ass k. (Sj + Di) Va T h at is, th e c av e rage cost of capital , to any firm 'IS comipl e te l y inde pe nde nt of MODIGLIANI AND MILLER : T HEOR Y OF INVEST MENT 269 its capital structure and is e qual to th e capital ization rate of a pure e quity stre am of its cl ass. T o e stabl ish Proposition I w e w il l sh ow th at as l ong as th e re l ations (3) or (4) do not h ol d be tw e e n any pair of firms in a cl ass, arbitrage w il l take pl ace and re store th e state d e qual itie s. We use th e te rm arbitrage adv ise dl y. For if Proposition I did not h ol d, an inv e stor coul d buy and se l l stocks and bonds in such a w ay as to e xch ange one income stre am for anoth e r stre am, ide ntical in al l re l e v ant re spe cts but se l l ing at a l ow e r price . T h e e xch ange w oul d th e re fore be adv antage ous to th e inv e s- tor quite inde pe nde ntl y of h is attitude s tow ard risk.1' As inv e stors e xpl oit th e se arbitrage opportunitie s, th e v al ue of th e ov e rprice d sh are s w il l fal l and th at of th e unde rprice d sh are s w il l rise , th e re by te nding to e l iminate th e discre pancy be tw e e n th e marke t v al ue s of th e firms. By w ay of proof, conside r tw o firms in th e same cl ass and assume for simpl icity onl y, th at th e e xpe cte d re turn, X, is th e same for both firms. Le t company 1 be finance d e ntire l y w ith common stock w h il e company 2 h as some de bt in its capital structure . Suppose first th e v al ue of th e l e v e re d firm, V2, to be l arge r th an th at of th e unl e v e re d one , Vi. Con- side r an inv e stor h ol ding S2 dol l ars' w orth of th e sh are s of company 2, re pre se nting a fraction a of th e total outstanding stock, S2. T h e re turn from th is portfol io, de note d by Y2, w il l be a fraction ac of th e income av ail abl e for th e stockh ol de rs of company 2, w h ich is e qual to th e total re turn X2 l e ss th e inte re st ch arge , rD2. Since unde r our assumption of h omoge ne ity, th e anticipate d total re turn of company 2, X2, is, unde r al l circumstance s, th e same as th e anticipate d total re turn to company 1, XI, w e can h e re afte r re pl ace X2 and Xi by a common symbol X. He nce , th e re turn from th e initial portfol io can be w ritte n as: (5) Y2- a(X - rD2). Now suppose th e inv e stor sol d h is aS2 w orth of company 2 sh are s and acquire d inste ad an amount Sl = a(S2+D2) of th e sh are s of company 1. He coul d do so by util izing th e amount aS2 re al ize d from th e sal e of h is initial h ol ding and borrow ing an additional amount aD2 on h is ow n cre dit, pl e dging h is ne w h ol dings in company 1 as a col l ate ral . He w oul d th us se cure for h imse l f a fraction sl /S = a(S2+?D2)/S, of th e sh are s and e arnings of company 1. Making prope r al l ow ance for th e inte re st pay- me nts on h is pe rsonal de bt aD2, th e re turn from th e ne w portfol io, Y1, is giv e n by: 11 In th e l anguage of th e th e ory of ch oice , th e e xch ange s are mov e me nts from ine fficie nt points in th e inte rior to e fficie nt points on th e boundary of th e inv e stor's opportunity se t; and not mov e me nts be tw e e n e fficie nt points al ong th e boundary. He nce for th is part of th e anal ysis noth ing is inv ol v e d in th e w ay of spe cific assumptions about inv e stor attitude s or be h av ior oth e r th an th at inv e stors be h av e consiste ntl y and pre fe r more income to l e ss income , ce te ris paribus. 270 T HE AMER ICAN ECONOMIC R EVIEW (6) - cx~(S2 + D2) V2 (6) Y, = t(S2 X - raD2 = a - X - raD2. Si V1 Comparing (5) w ith (6) w e se e th at as l ong as V2> V1 w e must h av e Y1 > Y2, so th at it pays ow ne rs of company 2's sh are s to se l l th e ir h ol d- ings, th e re by de pre ssing S2 and h e nce V2; and to acquire sh are s of com- pany 1, th e re by raising Si and th us V1. We concl ude th e re fore th at l e v e re d companie s cannot command a pre mium ov e r unl e v e re d com- panie s be cause inv e stors h av e th e opportunity of putting th e e quiv al e nt l e v e rage into th e ir portfol io dire ctl y by borrow ing on pe rsonal account. Conside r now th e oth e r possibil ity, name l y th at th e marke t v al ue of th e l e v e re d company V2 is l e ss th an V1. Suppose an inv e stor h ol ds ini- tial l y an amount s1 of sh are s of company 1, re pre se nting a fraction cx of th e total outstanding stock, Si. His re turn from th is h ol ding is- Si Y -S X = agx. Si Suppose h e w e re to e xch ange th is initial h ol ding for anoth e r portfol io, al so w orth s1, but consisting of S2 dol l ars of stock of company 2 and of d dol l ars of bonds, w h e re s2 and d are giv e n by: S2 D2 (7) S2=- 1, d =-s. V2 V2 In oth e r w ords th e ne w portfol io is to consist of stock of company 2 and of bonds in th e proportions S2/V2 and D2/V2, re spe ctiv e l y. T h e re turn from th e stock in th e ne w portfol io w il l be a fraction S2/S2 of th e total re turn to stockh ol de rs of company 2, w h ich is (X- rD2), and th e re turn from th e bonds w il l be rd. Making use of (7), th e total re turn from th e portfol io, Y2, can be e xpre sse d as fol l ow s: S2 D2 s1 S Y2= - (X - rD2) + rd = - (X - rD2) + r V-S =- X = - X S2 V2 V2 V2 V2 (since si = aSi). Comparing Y2 w ith Yi w e se e th at, if V2 <SI V1, th e n Y2 w il l e xce e d Y1. He nce it pays th e h ol de rs of company l 's sh are s to se l l th e se h ol dings and re pl ace th e m w ith a mixe d portfol io containing an appropriate fraction of th e sh are s of company 2. T h e acquisition of a mixe d portfol io of stock of a l e v e re d company j and of bonds in th e proportion Sj/Vj and D1/Vj re spe ctiv e l y, may be re garde d as an ope ration w h ich "undoe s" th e l e v e rage , giv ing acce ss to an appropriate fraction of th e unl e v e re d re turn Xj. It is th is possibil ity of undoing l e v e rage w h ich pre v e nts th e v al ue of l e v e re d firms from be - ing consiste ntl y l e ss th an th ose of unl e v e re d firms, or more ge ne ral l y pre v e nts th e av e rage cost of capital jl /Vj from be ing syste matical l y h igh e r for l e v e re d th an for nonl e v e re d companie s in th e same cl ass. MODIGLIANI AND MILLER : T HEOR Y OF INVEST MENT 271 Since w e h av e al re ady sh ow n th at arbitrage w il l al so pre v e nt V2 from be ing l arge r th an VI, w e can concl ude th at in e quil ibrium w e must h av e V2= VI, as state d in Proposition I. Proposition II. From Proposition I w e can de riv e th e fol l ow ing propo- sition conce rning th e rate of re turn on common stock in companie s w h ose capital structure incl ude s some de bt: th e e xpe cte d rate of re turn or yie l d, i, on th e stock of any company j be l onging to th e kth cl ass is a l ine ar function of l e v e rage as fol l ow s: (8) = pk + (Pk - r) DJ/Sj. T h at is, th e e xpe cte d yie l d of a sh are of stock is e qual to th e appropriate capital ization rate pk for a pure e quity stre am in th e cl ass, pl us a pre mium re l ate d to financial risk e qual to th e de bt-to-e quity ratio time s th e spre ad be tw e e n pk and r. Or e quiv al e ntl y, th e marke t price of any sh are of stock is giv e n by capital izing its e xpe cte d re turn at th e continuousl y v ariabl e rate ij of (8).12 A numbe r of w rite rs h av e state d cl ose e quiv al e nts of our Proposition I al th ough by appe al ing to intuition rath e r th an by atte mpting a proof and onl y to insist imme diate l y th at th e re sul ts w e re not appl icabl e to th e actual capital marke ts.'3 Proposition II, h ow e v e r, so far as w e h av e be e n abl e to discov e r is ne w .14 T o e stabl ish it w e first note th at, by de finition, th e e xpe cte d rate of re turn, i, is giv e n by: Xi2- rD. (9)ij - Si From Proposition I, e quation (3), w e know th at: Xi = pk(Sj + Dj). Substituting in (9) and simpl ifying, w e obtain e quation (8). 12 T o il l ustrate , suppose X= 1000, D=4000, r= 5 pe r ce nt and pk= 10 pe r ce nt. T h e se v al ue s impl y th at V= 10,000 and S= 6000 by v irtue of Proposition I. T h e e xpe cte d yie l d or rate of re turn pe r sh are is th e n: 1000 - 200 4000 6000 6000 3 's Se e , for e xampl e , J. B. Wil l iams [21, e sp. pp. 72-73]; Dav id Durand [3]; and W. A. Morton [15]. None of th e se w rite rs de scribe in any de tail th e me ch anism w h ich is suppose d to ke e p th e av e rage cost of capital constant unde r ch ange s in capital structure . T h e y se e m, h ow - e v e r, to be v isual izing th e e quil ibrating me ch anism in te rms of sw itch e s by inv e stors be tw e e n stocks and bonds as th e yie l ds of e ach ge t out of l ine w ith th e ir "riskine ss." T h is is an argu- me nt quite diffe re nt from th e pure arbitrage me ch anism unde rl ying our proof, and th e diffe r- e nce is crucial . R e garding Proposition I as re sting on inv e stors' attitude s tow ard risk l e ads ine v itabl y to a misunde rstanding of many factors infl ue ncing re l ativ e yie l ds such as, for e x- ampl e , l imitations on th e portfol io composition of financial institutions. Se e be l ow , e sp. Se ction I.D. 14 Morton doe s make re fe re nce to a l ine ar yie l d function but onl y" .. for th e sake of sim- pl icity and be cause th e particul ar function use d make s no e sse ntial diffe re nce in my concl u- sions" [15, p. 443, note 21. 272 T HE AMER ICAN ECONOMIC R EVIEW C. Some Qual ifications and Exte nsions of th e Basic Propositions T h e me th ods and re sul ts de v e l ope d so far can be e xte nde d in a num- be r of use ful dire ctions, of w h ich w e sh al l conside r h e re onl y th re e : (1) al l ow ing for a corporate profits tax unde r w h ich inte re st payme nts are de ductibl e ; (2) re cognizing th e e xiste nce of a mul tipl icity of bonds and inte re st rate s; and (3) acknow l e dging th e pre se nce of marke t impe rfe c- tions w h ich migh t inte rfe re w ith th e proce ss of arbitrage . T h e first tw o w il l be e xamine d brie fl y in th is se ction w ith some furth e r atte ntion giv e n to th e tax probl e m in Se ction II. Marke t impe rfe ctions w il l be dis- cusse d in Part D of th is se ction in th e course of a comparison of our re - sul ts w ith th ose of re ce iv e d doctrine s in th e fie l d of finance . Effe cts of th e Pre se nt Me th od of T axing Corporations. T h e de duction of inte re st in computing taxabl e corporate profits w il l pre v e nt th e arbi- trage proce ss from making th e v al ue of al l firms in a giv e n cl ass propor- tional to th e e xpe cte d re turns ge ne rate d by th e ir ph ysical asse ts. In- ste ad, it can be sh ow n (by th e same type of proof use d for th e original v e rsion of Proposition I) th at th e marke t v al ue s of firms in e ach cl ass must be proportional in e quil ibrium to th e ir e xpe cte d re turn ne t of taxe s (th at is, to th e sum of th e inte re st paid and e xpe cte d ne t stock- h ol de r income ). T h is me ans w e must re pl ace e ach Xi in th e original v e r- sions of Propositions I and II w ith a ne w v ariabl e Xj7 re pre se nting th e total income ne t of taxe s ge ne rate d by th e firm: (10) XJr--(Xi - rDi)(1 - T ) + rDi 7jT + rDj, w h e re fr-t re pre se nts th e e xpe cte d ne t income accruing to th e common stockh ol de rs and r stands for th e av e rage rate of corporate income tax.'5 Afte r making th e se substitutions, th e propositions, w h e n adjuste d for taxe s, continue to h av e th e same form as th e ir original s. T h at is, Propo- sition I be come s: 27 (11) _= Pk, for any firm in cl ass k, and Proposition II be come s (12) rP + (Pkr - r) Dl ,/S Si w h e re Pkl is th e capital ization rate for income ne t of taxe s in cl ass k. Al th ough th e form of th e propositions is unaffe cte d, ce rtain inte rpre - tations must be ch ange d. In particul ar, th e afte r-tax capital ization rate 15 For simpl icity, w e sh al l ignore th rough out th e tiny e l e me nt of progre ssion in our pre se nt corporate tax and tre at r as a constant inde pe nde nt of (Xi-rD,). MODIGLIANI AND MILLER : T HEOR Y OF INVEST MENT 273 PkT can no l onge r be ide ntifie d w ith th e "av e rage cost of capital " w h ich iS Pk = XjVT Ij. T h e diffe re nce be tw e e n Pk and th e "true " av e rage cost of capital , as w e sh al l se e , is a matte r of some re l e v ance in conne ction w ith inv e stme nt pl anning w ith in th e firm (Se ction II). For th e de scription of marke t be h av ior, h ow e v e r, w h ich is our imme diate conce rn h e re , th e dis- tinction is not e sse ntial . T o simpl ify pre se ntation, th e re fore , and to pre - se rv e continuity w ith th e te rminol ogy in th e standard l ite rature w e sh al l continue in th is se ction tQ re fe r to Pk as th e av e rage cost of capital , th ough strictl y spe aking th is ide ntification is corre ct onl y in th e abse nce of taxe s. Effe cts of a Pl ural ity of Bonds and Inte re st R ate s. In e xisting capital marke ts w e find not one , but a w h ol e famil y of inte re st rate s v arying w ith maturity, w ith th e te ch nical prov isions of th e l oan and, w h at is most re l e v ant for pre se nt purpose s, w ith th e financial condition of th e borrow e r.16 Economic th e ory and marke t e xpe rie nce both sugge st th at th e yie l ds de mande d by l e nde rs te nd to incre ase w ith th e de bt-e quity ratio of th e borrow ing firm (or indiv idual ). If so, and if w e can assume as a first approximation th at th is yie l d curv e , r = r (D/S), w h ate v e r its pre cise form, is th e same for al l borrow e rs, th e n w e can re adil y e xte nd our propositions to th e case of a rising suppl y curv e for borrow e d funds.'7 Proposition I is actual l y unaffe cte d in form and inte rpre tation by th e fact th at th e rate of inte re st may rise w ith l e v e rage ; w h il e th e av e rage cost of borrow e d funds w il l te nd to incre ase as de bt rise s, th e av e rage cost of funds from al l source s w il l stil l be inde pe nde nt of l e v e rage (apart from th e tax e ffe ct). T h is concl usion fol l ow s dire ctl y from th e abil ity of th ose w h o e ngage in arbitrage to undo th e l e v e rage in any financial structure by acquiring an appropriate l y mixe d portfol io of bonds and stocks. Be cause of th is abil ity, th e ratio of e arnings (be fore inte re st. ch arge s) to marke t v al ue --i.e ., th e av e rage cost of capital from al l 16 We sh al l not conside r h e re th e e xte nsion of th e anal ysis to e ncompass th e time structure of inte re st rate s. Al th ough some of th e probl e ms pose d by th e time structure can be h andl e d w ith - in our comparativ e statics frame w ork, an ade quate discussion w oul d re quire a se parate pape r. 17 We can al so de v e l op a th e ory of bond v al uation al ong l ine s e sse ntial l y paral l e l to th ose fol - l ow v e d for th e case of sh are s. We conje cture th at th e curv e of bond yie l ds as a function of l e v e r- age w il l turn out to be a nonl ine ar one in contrast to th e l ine ar function of l e v e rage de v e l ope d for common sh are s. How e v e r, w e w oul d al so e xpe ct th at th e rate of incre ase in th e yie l d on ne w issue s w oul d not be substantial in practice . T h is re l ativ e l y sl ow rise w oul d re fl e ct th e fact th at inte re st rate incre ase s by th e mse l v e s can ne v e r be compl e te l y satisfactory to cre ditors as compe nsation for th e ir incre ase d risk. Such incre ase s may simpl y se rv e to raise r so h igh re l a- tiv e to p th at th e y be come se l f-de fe ating by giv ing rise to a situation in w h ich e v e n norrmal fl uctuations in e arnings may force th e company into bankruptcy. T h e difficul ty of borrow ing more , th e re fore , te nds to sh ow up in th e usual case not so much in h igh e r rate s as in th e form of incre asingl y stringe nt re strictions impose d on th e company's manage me nt and finance s by th e cre ditors; and ul timate l y in a comnpl e te inabil ity to obtain ne w borrow e d funds, at l e ast from th e instituitional inv e stors w h o normal l y se t th e standar(ds in th e marke t for bonds. 274 T HE AMER ICAN ECONOMIC R EVIEW source s-must be th e same for al l firms in a giv e n cl ass."8 In oth e r w ords, th e incre ase d cost of borrow e d funds as l e v e rage incre ase s w il l te nd to be offse t by a corre sponding re duction in th e yie l d of common stock. T h is se e mingl y paradoxical re sul t w il l be e xamine d more cl ose l y be l ow in conne ction w ith Proposition II. A significant modification of Proposition I w oul d be re quire d onl y if th e yie l d curv e r=r(D/S) w e re diffe re nt for diffe re nt borrow e rs, as migh t h appe n if cre ditors h ad marke d pre fe re nce s for th e se curitie s of a particul ar cl ass of de btors. If, for e xampl e , corporations as a cl ass w e re abl e to borrow at l ow e r rate s th an indiv idual s h av ing e quiv al e nt pe r- sonal l e v e rage , th e n th e av e rage cost of capital to corporations migh t fal l sl igh tl y, as l e v e rage incre ase d ov e r some range , in re fl e ction of th is diffe re ntial . In e v al uating th is possibil ity, h ow e v e r, re me mbe r th at th e re l e v ant inte re st rate for our arbitrage ope rators is th e rate on broke rs' l oans and, h istorical l y, th at rate h as not be e n notice abl y h igh e r th an re pre se ntativ e corporate rate s.19 T h e ope rations of h ol ding companie s and inv e stme nt trusts w h ich can borrow on te rms comparabl e to ope rat- ing companie s re pre se nt stil l anoth e r force w h ich coul d be e xpe cte d to w ipe out any marke d or prol onge d adv antage s from h ol ding l e v e re d stocks.20 Al th ough Proposition I re mains unaffe cte d as l ong as th e yie l d curv e is th e same for al l borrow e rs, th e re l ation be tw e e n common stock yie l ds and l e v e rage w il l no l onge r be th e strictl y l ine ar one giv e n by th e original Proposition II. If r incre ase s w ith l e v e rage , th e yie l d i w il l stil l te nd to 18 One normal l y minor qual ification migh t be note d. Once w e re l ax th e assumption th at al l bonds h av e ce rtain yie l ds, our arbitrage ope rator face s th e dange r of some th ing comparabl e to "gambl e r's ruin." T h at is, th e re is al w ays th e possibil ity th at an oth e rw ise sound conce rn- one w h ose l ong-run e xpe cte d income is gre ate r th an its inte re st l iabil ity-migh t be force d into l iquidation as a re sul t of a run of te mporary l osse s. Since re organization ge ne ral l y inv ol v e s costs, and be cause th e ope ration of th e firm may be h ampe re d during th e pe riod of re organiza- tion w ith l asting unfav orabl e e ffe cts on e arnings prospe cts, w e migh t pe rh aps e xpe ct h e av il y l e v e re d companie s to se l l at a sl igh t discount re l ativ e to l e ss h e av il y inde bte d companie s of th e same cl ass. 19 Unde r normal conditions, more ov e r, a substantial part of th e arbitrage proce ss coul d be e xpe cte d to take th e form, not of h av ing th e arbitrage ope rators go into de bt on pe rsonal account to put th e re quire d l e v e rage into th e ir portfol ios, but simpl y of h av ing th e m re duce th e amount of corporate bonds th e y al re ady h ol d w h e n th e y acquire unde rprice d unl e v e re d stock. Margin re quire me nts are al so some w h at l e ss of an obstacl e to maintaining any de sire d de gre e of l e v e rage in a portfol io th an migh t be th ough t at first gl ance . Le v e rage coul d be l arge l y re store d in th e face of h igh e r margin re quire me nts by sw itch ing to stocks h av ing more l e v e rage at th e corporate l e v e l . 20 An e xtre me form of ine qual ity be tw e e n borrow ing and l e nding rate s occurs, of course , in th e case of pre fe rre d stocks, w h ich can not be dire ctl y issue d by indiv idual s on pe rsonal account. He re again, h ow e v e r, w e w oul d e xpe ct th at th e ope rations of inv e stme nt corporations pl us th e abil ity of arbitrage ope rators to se l l off th e ir h ol dings of pre fe rre d stocks w oul d act to pre v e nt th e e me rge nce of any substantial pre miums (for th is re ason) on capital structure s con- taining pre fe rre d stocks. Nor are pre fe rre d stocks so far re mov e d from bonds as to make it impossibl e for arbitrage ope rators to approximate cl ose l y th e risk and l e v e rage of a corporate pre fe rre d stock by incurriing a some w h at smal l e r de bt on pe rsonal account. MODIGLIANI AND MILLER : T HEOR Y OF INVEST MENT 275 rise as D/S incre ase s, but at a de cre asing rath e r th an a constant rate . Be yond some h igh l e v e l of l e v e rage , de pe nding on th e e xact form of th e inte re st function, th e yie l d may e v e n start to fal l .21 T h e re l ation be tw e e n i and D/S coul d conce iv abl y take th e form indicate d by th e curv e MD - Y-4. 0 o a: e W _ cr. R AT l O OF D:EST T O T OT ALMAR iKET VALUE- Djl Vj FIGUR E 1 ~~~~~~~~~~~~~~~~~~~.,t I> -, cj ~ ~ ~ ~ ~ ~~- X i~ 0 FIGUR E 1 w ~~~~~~~~~~~~~~~~~~~~~~ 0 0 I-~~~~~~~ in Figure 2, al th ough in practice th e curv ature w oul d be much l e ss pro- nounce d. By contrast, w ith a constant rate of inte re st, th e re l ation w oul d be l ine ar th rough out as sh ow n by l ine MM', Figure 2. T h e dov v nw ard sl oping part of th e curv e MD pe rh aps re quire s some 21 Since ne w l e nde rs are unl ike l y to pe rmit th is much l e v e rage (cf. note 17), th is range of th e curv e is l ike l y to be occupie d by companie s w h ose e arnings prospe cts h av e fal l e n substantial l y since th e time w h e n th e ir de bts w e re issue d. 276 T HE AMIER ICAN ECONOMIC R EVIEW comme nt since it may be h ard to imagine w h y inv e stors, oth e r th an th ose w h o l ike l otte rie s, w oul d purch ase stocks in th is range . R e me mbe r, h ow e v e r, th at th e yie l d curv e of Proposition II is a conse que nce of th e more fundame ntal Proposition I. Sh oul d th e de mand by th e risk-l ov e rs prov e insufficie nt to ke e p th e marke t to th e pe cul iar yie l d-curv e MD, th is de mand w oul d be re inforce d by th e action of arbitrage ope rators. T h e l atte r w oul d find it profitabl e to ow n a pro-rata sh are of th e firm as a w h ol e by h ol ding its stock and bonds, th e l ow e r yie l d of th e sh are s be ing th us offse t by th e h igh e r re turn on bonds. D. T h e R e l ation of Propositions I and II to Curre nt Doctrine s T h e propositions w e h av e de v e l ope d w ith re spe ct to th e v al uation of firms and sh are s appe ar to be substantial l y at v ariance w ith curre nt doctrine s in th e fie l d of finance . T h e main diffe re nce s be tw e e n our v ie w and th e curre nt v ie w are summarize d graph ical l y in Figure s 1 and 2. Our Proposition I [e quation (4)] asse rts th at th e av e rage cost of capital , `j,/V, is a constant for al l firms j in cl ass k, inde pe nde ntl y of th e ir fi- nancial structure . T h is impl ie s th at, if w e w e re to take a samnpl e of firms in a giv e n cl ass, and if for e ach firm w e w e re to pl ot th e ratio of e xpe cte d re turni to marke t v al ue against some me asure of l e v e rage or financial structure , th e points w oul d te nd to fal l on a h orizontal straigh t l ine w ith inte rce pt PkJ, l ike th e sol id l ine mm' in Figure 1 .22 From Proposition I w e de riv e d Proposition II [e quation (8)] w h ich , taking th e simpl e st v e rsion w ith r constant, asse rts th at, for al l firms in a cl ass, th e re l ation be tw e e n th e yie l d on common stock and financial structure , me asure d by Djl Sj, w il l approximate a straigh t l ine w ith sl ope (pk7-r) and inte r- ce pt PkT . T h is re l ationsh ip is sh ow n as th e sol id l ine MM' in Figure 2, to w h ich re fe re nce h as be e n made e arl ie r.23 By contrast, th e conv e ntional v ie w among finance spe cial ists appe ars to start from th e proposition th at, oth e r th ings e qual , th e e arnings- price ratio (or its re ciprocal , th e time s-e arnings mul tipl ie r) of a firm's common stock w il l normal l y be onl y sl igh tl y affe cte d by "mode rate " amounts of de bt in th e firm's capital structure .24 T ransl ate d into our no -2 In Figure 1 th e me asure of l e v e rage use d is Di/l Vy (th e ratio of de bt to marke t v al ue ) rath e r th an Dj/Sj (th e ratio of de bt to e quity), th e conce pt use d in th e anal ytical de v e l op- me nt. T h e Dj/Vj me asure is introduce d at th is point be cause it simpl ifie s comparison and con- trast of our v ie w w ith th e traditional position. 23 T h e l ine MM' in Figure 2 h as be e n draw n w ith a positiv e sl ope on th e assumption th at pk>r, a condition w h ich w il l normal l y obtain. Our Proposition II as giv e n in e quation (8) w oul d continue to be v al id, of course , e v e n in th e unl ike l y e v e nt th at pk'<r, but th e sl ope of MM' w oul d be ne gativ e . 24 Se e , e .g., Grah am and Dodd [6, pp. 464-66]. With out doing v iol e nce to th is position, w e can bring out its impl ications more sh arpl y by ignoring th e qual ification and tre ating th e yie l d as a v irtual constant ov e r th e re l e v ant range . Se e in th is conne ction th e discussion in Durand [3, e sp. pp. 225-37] of w h at h e cal l s th e "ne t income me th od" of v al uationi. MODiGLIANI AND MILLER : 'T HEOR Y OF INVEST MEN'T 277 tation, it asse rts th at for any firm j in th e cl ass k, X+T - rDj #j' Dj (13) - = ik*, a constant for-< Lk Si S, S4 or, e quiv al e ntl y, (14) S,= =j"l ik* He re ik* re pre se nts th e capital ization rate or e arnings-price ratio on th e common stock and Lk de note s some amount of l e v e rage re garde d as th e maximum "re asonabl e " amount for firms of th e cl ass k. T h is assume d re l ationsh ip be tw e e n yie l d and l e v e rage is th e h orizontal sol id l ine ML' of Figure 2. Be yond L', th e yie l d w il l pre sumabl y rise sh arpl y as th e marke t discounts "e xce ssiv e " trading on th e e quity. T h is possibil ity of a rising range for h igh l e v e rage s is indicate d by th e broke n-l ine se gme nt L'G in th e figure .25 If th e v al ue of sh are s w e re re al l y giv e n by (14) th e n th e ov e r-al l mar- ke t v al ue of th e firm must be : xir - rDj X*T (ik* - r) D, (16) Vj1S? + Dj ik* + Dj-i* -+ .i* T h at is, for any giv e n l e v e l of e xpe cte d total re turns afte r taxe s (Y7j) and assuming, as se e ms natural , th at ik*> r, th e v al ue of th e firm must te nd to rise w ith de bt ;26 w h e re as our Proposition I asse rts th at th e v al ue of th e firm is compl e te l y inde pe nde nt of th e capital structure . Anoth e r w ay of contrasting our position w ith th e traditional one is in te rms of th e cost of capital . Sol v ing (16) for Y;/ Vj yie l ds: (17) Xil Vj = ik* - (j1* - r) D,/17V. According to th is e quation, th e av e rage cost of capital is not inde pe n- de nt of capital structure as w e h av e argue d, but sh oul d te nd to fal l w ith incre asing l e v e rage , at l e ast w ith in th e re l e v ant range of mode rate de bt ratios, as sh ow n by th e l ine ms in Figure 1. Or to put it in more famil iar te rms, de bt-financing sh oul d be "ch e ape r" th an e quity-financing if not carrie d too far. Wh e n w e al so al l ow for th e possibil ity of a rising range of stock yie l ds for l arge v al ue s of l e v e rage , w e obtain a U-sh ape d curv e l ike nst in 26 T o make it e asie r to se e some of th e impl ications of th is h ypoth e sis as w e l l as to pre pare th e ground for l ate r statistical te sting, it w il l be h e l pful to assume th at th e notion of a critical l imit on l e v e rage be yond w h ich yie l ds rise rapidl y, can be e pitomize d by a quadratic re l ation of th e form: (15) *,Sii= i* + 13(D,/S,) + a(Dj/Sj)2, a > 0. 21 For a typical discussion of h ow a promote r can, suppose dl y, incre ase th e marke t v al ue of a firm by re course to de bt issue s, se e W. J. Eite man [4, e sp. pp. 11-131. 278 T HE AMER ICAN ECONOMIC R EVIEW Figure 1 .27 T h at a yie l d-curv e for stocks of th e form ML'G in Figure 2 impl ie s a U-sh ape d cost-of-capital curv e h as, of course , be e n re cognize d by many w rite rs. A natural furth e r ste p h as be e n to sugge st th at th e capital structure corre sponding to th e trough of th e U is an "optimal capital structure " tow ards w h ich manage me nt ough t to striv e in th e be st inte re sts of th e stockh ol de rs.28 According to our mode l , by contrast, no such optimal structure e xists-al l structure s be ing e quiv al e nt from th e point of v ie w of th e cost of capital . Al th ough th e fal l ing, or at l e ast U-sh ape d, cost-of-capital function is in one form or anoth e r th e dominant v ie w in th e l ite rature , th e ul timate rational e of th at v ie w is by no me ans cl e ar. T h e crucial e l e me nt in th e position-th at th e e xpe cte d e arnings-price ratio of th e stock is l arge l y unaffe cte d by l e v e rage up to some conv e ntional l imit-is rare l y e v e n re garde d as some th ing w h ich re quire s e xpl anation. It is usual l y simpl y take n for grante d or it is me re l y asse rte d th at th is is th e w ay th e marke t be h av e s.29 T o th e e xte nt th at th e constant e arnings-price ratio h as a rational e at al l w e suspe ct th at it re fl e cts in most case s th e fe e l ing th at mode rate amounts of de bt in "sound" corporations do not re al l y add v e ry much to th e "riskine ss" of th e stock. Since th e e xtra risk is sl igh t, it se e ms natural to suppose th at firms w il l not h av e to pay notice abl y h igh e r yie l ds in orde r to induce inv e stors to h ol d th e stock.30 A more soph isticate d l ine of argume nt h as be e n adv ance d by Dav id Durand [3, pp. 231-33]. He sugge sts th at be cause insurance companie s and ce rtain oth e r important institutional inv e stors are re stricte d to de bt se curitie s, nonfinancial corporations are abl e to borrow from th e m at inte re st rate s w h ich are l ow e r th an w oul d be re quire d to compe nsate 27 T h e U-sh ape d nature of th e cost-of-capital curv e can be e xh ibite d e xpl icitl y if th e yie l d curv e for sh are s as a function of l e v e rage can be approximate d by e quation (15) of footnote 25. From th at e quation, mul tipl ying both side s by Si w e obtain: T rj= X,T _-rD;=ik*Si+?fDi+aD2 /S, or, adding and subtracting ik*Dk from th e righ t-h and side and col l e cting te rms, (18) xi' = ik*(Si + Di) + (, + r - ik*)Di + aDD2/S1. Div iding (18) by Vi giv e s an e xpre ssion for th e cost of capital : (19) X,T /V, = ik* - (ik* - r - O)Di/Vi + aD,2/SiVi = ik* - (ik* - r - O)Dil VJ + a(Di/Vi)2/(1 - D3/Vj) w h ich is cl e arl y U-sh ape d since a is suppose d to be positiv e . 28 For a typical state me nt se e S. M. R obbins [16, p. 307]. Se e al so Grah am and Dodd [6, pp. 468-74]. 29 Se e e .g., Grah am and Dodd [6, p. 466]. 80 A typical state me nt is th e fol l ow ing by Guth mann and Dougal l [7, p. 245]: "T h e ore tical l y it migh t be argue d th at th e incre ase d h azard from using bonds and pre fe rre d stocks w oul d counte rbal ance th is additional income and so pre v e nt th e common stock from be ing more attractiv e th an w h e n it h ad a l ow e r re turn but fe w e r prior obl igations. In practice , th e e xtra e arnings from 'trading on th e e quity' are ofte n re garde d by inv e stors as more th an sufficie nt to se rv e as a 'pre mium for risk' w h e n th e proportions of th e se v e ral se curitie s are judiciousl y mixe d." MODIGLIANI AND MILLER : T HEOR Y OF INVEST MENT 279 cre ditors in a fre e marke t. T h us, w h il e h e w oul d pre sumabl y agre e w ith our concl usions th at stockh ol de rs coul d not gain from l e v e rage in an un- constraine d marke t, h e concl ude s th at th e y can gain unde r pre se nt insti- tutional arrange me nts. T h is gain w oul d arise by v irtue of th e "safe ty supe rpre mium" w h ich l e nde rs are w il l ing to pay corporations for th e priv il e ge of l e nding.3' T h e de fe ctiv e l ink in both th e traditional and th e Durand v e rsion of th e argume nt l ie s in th e confusion be tw e e n inv e stors' subje ctiv e risk pre fe re nce s and th e ir obje ctiv e marke t opportunitie s. Our Propositions I and II, as note d e arl ie r, do not de pe nd for th e ir v al idity on any as- sumption about indiv idual risk pre fe re nce s. Nor do th e y inv ol v e any as- se rtion as to w h at is an ade quate compe nsation to inv e stors for assum- ing a giv e n de gre e of risk. T h e y re l y me re l y on th e fact th at a giv e n commodity cannot consiste ntl y se l l at more th an one price in th e mar- ke t; or more pre cise l y th at th e price of a commodity re pre se nting a "bundl e " of tw o oth e r commoditie s cannot be consiste ntl y diffe re nt from th e w e igh te d av e rage of th e price s of th e tw o compone nts (th e w e igh ts be ing e qual to th e proportion of th e tw o commoditie s in th e bundl e ). An anal ogy may h e h e l pful at th is point. T h e re l ations be tw e e n l /pk, th e price pe r dol l ar of an unl e v e re d stre am in cl ass k; 1/r, th e price pe r dol l ar of a sure stre am, and 1/ij, th e price pe r dol l ar of a l e v e re d stre am j, in th e kth cl ass, are e sse ntial l y th e same as th ose be tw e e n, re spe ctiv e - l y, th e price of w h ol e mil k, th e price of butte r fat, and th e price of mil k w h ich h as be e n th inne d out by skimming off some of th e butte r fat. Our Proposition I state s th at a firm cannot re duce th e cost of capital -i.e ., incre ase th e marke t v al ue of th e stre am it ge ne rate s-by se curing part of its capital th rough th e sal e of bonds, e v e n th ough de bt mone y ap- pe ars to be ch e ape r. T h is asse rtion is e quiv al e nt to th e proposition th at, unde r pe rfe ct marke ts, a dairy farme r cannot in ge ne ral e arn more for th e mil k h e produce s by skimming some of th e butte r fat and se l l ing it se parate l y, e v e n th ough butte r fat pe r unit w e igh t, se l l s for more th an w h ol e mil k. T h e adv antage from skimming th e mil k rath e r th an se l l ing w h ol e mil k w oul d be pure l y il l usory; for w h at w oul d be gaine d from se l l ing th e h igh -price d butte r fat w oul d be l ost in se l l ing th e l ow - price d re sidue of th inne d mil k. Simil arl y our Proposition II-th at th e price pe r dol l ar of a l e v e re d stre am fal l s as l e v e rage incre ase s-is an e x- 31 Like Durand, Morton [15] conte nds "th at th e actual marke t de v iate s from [Proposition I] by giv ing a ch anging ov e r-al l cost of mone y at diffe re nt points of th e [l e v e rage ] scal e "' (p. 443, note 2, inse rts ours), but th e basis for th is conte ntion is now h e re cl e arl y state d. Judging by th e gre at e mph asis giv e n to th e l ack of mobil ity of inv e stme nt funds be tw e e n stocks and bonds and to th e psych ol ogical and institutional pre ssure s tow ard de bt portfol ios (se e pp. 444- 51 and e spe cial l y h is discussion of th e optimal capital structure on p. 453) h e w oul d se e m to be taking a position v e ry simil ar to th at of Durand abov e . 280 T HE AMER ICAN ECONOMIC R EVIEW act anal ogue of th e state me nt th at th e price pe r gal l on of th inne d mil k fal l s continuousl y as more butte r fat is skimme d off.32 It is cl e ar th at th is l ast asse rtion is true as l ong as butte r fat is w orth more pe r unit w e igh t th an w h ol e mil k, and it h ol ds e v e n if, for many consume rs, taking a l ittl e cre am out of th e mil k (adding a l ittl e l e v e rage to th e stock) doe s not de tract notice abl y from th e taste (doe s not add notice abl y to th e risk). Furth e rmore th e argume nt re mains v al id e v e n in th e face of instituional l imitations of th e type e nv isage d by Durand. For suppose th at a l arge fraction of th e popul ation h abitual l y dine s in re staurants w h ich are re quire d by l aw to se rv e onl y cre am in l ie u of mil k (e ntrust th e ir sav ings to institutional inv e stors w h o can onl y buy bonds). T o be sure th e price of butte r fat w il l th e n te nd to be h igh e r in re l ation to th at of skimme d mil k th an in th e abse nce such re strictions (th e rate of inte re st w il l te nd to be l ow e r), and th is w il l be ne fit pe opl e w h o e at at h ome and w h o l ike skim mil k (w h o manage th e ir ow n port- fol io and are abl e and w il l ing to take risk). But it w il l stil l be th e case th at a farme r cannot gain by skimming some of th e butte r fat and se l l - ing it se parate l y (firm cannot re duce th e cost of capital by re course to borrow e d funds).3 Our propositions can be re garde d as th e e xte nsion of th e cl assical th e ory of marke ts to th e particul ar case of th e capital marke ts. T h ose w h o h ol d th e curre nt v ie w -w h e th e r th e y re al ize it or not-must as- 32 Le t M de note th e quantity of w h ol e mil k, B/Al f th e proportion of butte r fat in th e w h ol e mil k, and l e t PM, PB and pa de note , re spe ctiv e l y, th e price pe r unit w e igh t of w h ol e mil k, butte r fat and th inne d mil k from w h ich a fraction a of th e butte r fat h as be e n skimme d off. We th e n h av e th e fundame ntal pe rfe ct marke t re l ation: (a) Pa(M- aB) + PBoiB = pMM, O < a < 1, stating th at total re ce ipts w il l be th e same amount pMM, inde pe nde ntl y of th e amount aLB of butte r fat th at may h av e be e n sol d se parate l y. Since pm corre sponds to 1ip, PB to l /r, Pa to 1/i, M to Z and a-B to rD, (a) is e quiv al e nt to Proposition I, S+D=X/p. From (a) w e de riv e : (b) Pa = Mi - aB -PB M-B w h ich giv e s th e price of th inne d mil k as an e xpl icit function of th e proportion of buitte r fat skimme d off; th e function de cre asing as l ong as PB>pM. From (a) al so fol l ow s: (c) I/pa = I/PM + (I/PM - I/PB) Pa(M B) w h ich is th e e xact anal ogue of Proposition II, as giv e n by (8). 33 T h e re ade r w h o l ike s parabl e s w il l find th at th e anal ogy w ith inte rre l ate d commodity marke ts can be push e d a good de al farth e r th an w e h av e done in th e te xt. For instance , th e e ffe ct of ch ange s in th e marke t rate of inte re st on th e ov e r-al l cost of capital is th e same as th e e ffe ct of a ch ange in th e price of butte r on th e price of w h ol e mil k. Simil arl y, just as th e re l a- tion be tw e e n th e price s of skim mil k and butte r fat infl ue nce s th e kind of cow s th at w il l be re are d, so th e re l ation be tw e e n i and r infl ue nce s th e kind of v e nture s th at w il l be unde rtake n. If pe opl e l ike butte r w e sh al l h av e Gue rnse ys; if th e y are w il l ing to pay a h igh price for safe ty, th is w il l e ncourage v e nture s w h ich promise smal l e r but l e ss unce rtain stre ams pe r dol l ar of ph ysical asse ts. MODIGLIANI AND MILLER : T HEOR Y OF INVEST MENT 281 sume not me re l y th at th e re are l ags and frictions in th e e quil ibrating proce ss-a fe e l ing w e ce rtainl y sh are ,34 cl aiming for our propositions onl y th at th e y de scribe th e ce ntral te nde ncy around w h ich obse rv ations w il l scatte r-but al so th at th e re are l arge and syste matic impe rfe ctions in th e marke t w h ich pe rmane ntl y bias th e outcome . T h is is an assump- tion th at e conomists, at any rate , w il l instinctiv e l y e ye w ith some ske p- ticism. In any e v e nt, w h e th e r such prol onge d, syste matic de parture s from e quil ibrium re al l y e xist or w h e th e r our propositions are be tte r de scrip- tions of l ong-run marke t be h av ior can be se ttl e d onl y by e mpirical re - se arch . Be fore going on to th e th e ory of inv e stme nt it may be h e l pful , th e re fore , to l ook at th e e v ide nce . E. Some Pre l imtinary Ev ide ntce on5 th e Basic Propositions Unfortunate l y th e e v ide nce w h ich h as be e n asse mbl e d so far is amaz- ingl y skimpy. Inde e d, w e h av e be e n abl e to l ocate onl y tw o re ce nt stud- ie s-and th e se of rath e r l imite d scope -w h ich w e re de signe d to th row l igh t on th e issue . Pe nding th e re sul ts of more compre h e nsiv e te sts w h ich w e h ope w il l soon be av ail abl e , w e sh al l re v ie w brie fl y such e v ide nce as is prov ide d by th e tw o studie s in que stion: (1) an anal ysis of th e re l ation be tw e e n se curity yie l ds and financial structure for some 43 l arge e l e ctric util itie s by F. B. Al l e n [1], and (2) a paral l e l (unpubl ish e d) study by R obe rt Smith [19], for 42 oil companie s de signe d to te st w h e th e r Al l e n's rath e r striking re sul ts w oul d be found in an industry w ith v e ry diffe r- e nt ch aracte ristics.3Y T h e Al l e n study is base d on av e rage figure s for th e ye ars 1947 and 1948, w h il e th e Smith study re l ate s to th e singl e ye ar 1953. T h e Effe ct of Le v e rage on th e Cost of Capital . According to th e re ce iv e d v ie w , as sh ow n in e quation (17) th e av e rage cost of capital , Yr/V, sh oul d de cl ine l ine arl y w ith l e v e rage as me asure d by th e ratio D/V, at l e ast th rough most of th e re l e v ant range .36 According to Proposition I, th e av e rage cost of capital w ith in a giv e n cl ass k sh oul d te nd to h av e th e same v al ue PkT inde pe nde ntl y of th e de gre e of l e v e rage . A simpl e te st Se v e ral spe cific e xampl e s of th e fail ure of th e arbitrage me ch anism can be found in Grah am anid Dodd [6, e .g.. pp. 646-481. T h e price discre pancy de scribe d on pp. 646-47 is particul arl y curious since it pe rsists e v e n today de spite th e fact th at a w h ol e ge ne ration of se curity anal ysts h as be e n brough t up on th is book! 3 We w ish to e xpre ss our th anks to both w rite rs for making av ail abl e to us some of th e ir original w orksh e e ts. In addition to th e se re ce nt studie s th e re is a fre que ntl y cite d (but appar- e ntl y se l dom re ad) study by th e Fe de ral Communications Commission in 1938 [22] w h ich purports to sh ow th e e xiste nce of an optimal capital structure or range of structure s (in th e se nse de fine d abov e ) for publ ic util itie s in th e 1930's. By curre nt standards for statistical in- v e stigations. h ow e v e r, th is study cannot be re garde d as h av ing any re al e v ide ntial v al ue for th e probl e m at h and. 36 We sh al l simpl ify our notation in th is se ction by dropping th e subscriptj use d to de note a particul ar firm w h e re v e r th is w il l not l e ad to confusion. 282 T HE AMER ICAN ECONOMIC R EVIEW of th e me rits of th e tw o al te rnativ e h ypoth e se s can th us be carrie d out by corre l ating ,I/V w ith D/V. If th e traditional v ie w is corre ct, th e corre l ation sh oul d be significantl y ne gativ e ; if our v ie w re pre se nts a be t- te r approximation to re al ity, th e n th e corre l ation sh oul d not be signifi- cantl y diffe re nt from ze ro. Both studie s prov ide information about th e av e rage v al ue of D-th e marke t v al ue of bonds and pre fe rre d stock-and of V-th e marke t v al ue of al l se curitie s.37 From th e se data w e can re adil y compute th e ratio D/V and th is ratio (e xpre sse d as a pe rce ntage ) is re pre se nte d by th e symbol d in th e re gre ssion e quations be l ow . T h e me asure me nt of th e v ariabl e YT /V, h ow e v e r, pre se nts se rious difficul tie s. Strictl y spe ak- ing, th e nume rator sh oul d me asure th e e xpe cte d re turns ne t of taxe s, but th is is a v ariabl e on w h ich no dire ct information is av ail abl e . As an approximation, w e h av e fol l ow e d both auth ors and use d (1) th e av e rage v al ue of actual ne t re turns in 1947 and 1948 for Al l e n's util itie s; and (2) actual ne t re turns in 1953 for Smith 's oil companie s. Ne t re turn is de - fine d in both case s as th e sum of inte re st, pre fe rre d div ide nds and stock- h ol de rs' income ne t of corporate income taxe s. Al th ough th is approxima- tion to e xpe cte d re turns is undoubte dl y v e ry crude , th e re is no re ason to be l ie v e th at it w il l syste matical l y bias th e te st in so far as th e sign of th e re gre ssion coe fficie nt is conce rne d. T h e rough ne ss of th e approximation, h ow e v e r, w il l te nd to make for a w ide scatte r. Al so contributing to th e scatte r is th e crude ne ss of th e industrial cl assification, since e spe cial l y w ith in th e sampl e of oil companie s, th e assumption th at al l th e firms be - l ong to th e same cl ass in our se nse , is at be st onl y approximate l y v al id. De noting by x our approximation to Yr/V (e xpre sse d, l ike d, as a pe rce ntage ), th e re sul ts of th e te sts are as fol l ow s: El e ctric Util itie s x = 5.3 + .006d r = .12 (? .008) Oil Companie s x = 8.5 + .006d r = .04. (+ .024) T h e data unde rl ying th e se e quations are al so sh ow n in scatte r diagram form in Figure s 3 and 4. T h e re sul ts of th e se te sts are cl e arl y fav orabl e to our h ypoth e sis. 17 Note th at for purpose s of th is te st pre fe rre d stocks, since th e y re pre se nt an e xpe cte d fixe d obl igation, are prope rl y cl assifie d w ith bonds e v e n th ough th e tax status of pre fe rre d div ide nds is diffe re nt from th at of inte re st payme nts and e v e n th ough pre fe rre d div ide nds are re al l y fixe d onl y as to th e ir maximum in any ye ar. Some difficul ty of cl assification doe s arise in th e case of conv e rtibl e pre fe rre d stocks (and conv e rtibl e bonds) se l l ing at a substantial pre mium, but fortunate l y v e ry fe w such issue s w e re inv ol v e d for th e companie s incl ude d in th e tw o studie s. Smith incl ude d bank l oans and ce rtain oth e r sh ort-te rm obl igations (at book v al ue s) in h is data on oil company de bts and th is tre atme nt is pe rh aps ope n to some que stion. How - e v e r, th e amounts inv ol v e d w e re re l ativ e l y smal l and ch e ck computations sh ow e d th at th e ir e l imination w oul d l e ad to onl y minor diffe re nce s in th e te st re sul ts. MODIGLIANI AND MILLER : T HEOR Y OF INVEST MENT 283 0 3 -t----X e 0 20 30 40 a0 60e 70 a0 0 t F;NANCALST R AOT UR E-(MAR KET VALUEOr SENIOR StCUR IT 1ES$"AR XET 'kLUE OF ALL SECUR mSE 100 FIGUR E 3. COST OF CAPIT AL IN R ELAT ION T O FINA.NCIAL ST R UCT UR E FOR 43 ELECT R ICUT ILIT IES, 1947-48 Lg4 X 0~~~~~~~ X8 .8 + 0.006 0 0 Loo ? 2- X X- 8. + 0.0 0 rD}~ r 0 10 20 30 40 50 60 70 80 D: FINKANCIAL ST R UCT UR E-(MAR KET VALt OF SENIOR SECUrMES/(NAAR KET VALUEOF ALL SECUR IT IESII 100 FIGUR E 4. COST r OF CAPIT AL IN R ELAT ION T O FINANCIAL ST R UCT UR E FOR 42 OIL COMPANIES, 1953 284 T HE AMER ICAN ECONOMIC R EVIEW Both corre l ation coe fficie nts are v e ry cl ose to ze ro and not statistical l y significant. Furth e rmore , th e impl ications of th e traditional v ie w fail to be supporte d e v e n w ith re spe ct to th e sign of th e corre l ation. T h e data in sh ort prov ide no e v ide nce of any te nde ncy for th e cost of capital to fal l as th e de bt ratio incre ase s.38 It sh oul d al so be appare nt from th e scatte r diagrams th at th e re is no h int of a curv il ine ar, U-sh ape d, re l ation of th e kind w h ich is w ide l y be - l ie v e d to h ol d be tw e e n th e cost of capital and l e v e rage . T h is graph ical impre ssion w as confirme d by statistical te sts w h ich sh ow e d th at for both industrie s th e curv ature w as not significantl y diffe re nt from ze ro, its sign actual l y be ing opposite to th at h ypoth e size d.39 Note al so th at according to our mode l , th e constant te rms of th e re - gre ssion e quations are me asure s of PkT , th e capital ization rate s for un- l e v e re d stre ams and h e nce th e av e rage cost of capital in th e cl asse s in que stion. T h e e stimate s of 8.5 pe r ce nt for th e oil companie s as against 5.3 pe r ce nt for e l e ctric util itie s appe ar to accord w e l l w ith a priori e x- pe ctations, both in absol ute v al ue and re l ativ e spre ad. T h e Effe ct of Le v e rage on Common Stock Yie l ds. According to our Prop- osition II-se e e quation 12 and Figure 2-th e e xpe cte d yie l d on com- mon stock, r1/S, in any giv e n cl ass, sh oul d te nd to incre ase w ith l e v e r- age as me asure d by th e ratio D/S. T h e re l ation sh oul d te nd to be l ine ar and w ith positiv e sl ope th rough most of th e re l e v ant range (as in th e curv e MM' of Figure 2), th ough it migh t te nd to fl atte n out if w e mov e 38 It may be argue d th at a te st of th e kind use d is biase d against th e traditional v ie w . T h e fact th at both side s of th e re gre ssion e quation are div ide d by th e v ariabl e V w h ich may be subje ct to random v ariation migh t te nd to impart a positiv e bias to th e corre l ation. As a ch e ck on th e re sul ts pre se nte d in th e te xt, w e h av e , th e re fore , carrie d out a suppl e me ntary te st base d on e quation (16). T h is e quation sh ow s th at, if th e traditional v ie w is corre ct, th e marke t v al ue of a company sh oul d, foi giv e n X, incre ase w ith de bt th rough most of th e re l e v ant range ; according to our mode l th e marke t v al ue sh oul d be uncorre l ate d w ith D, giv e n Y. Be cause of w ide v ariations in th e size of th e firms incl ude d in our sampl e s, al l v ariabl e s must be div ide d by a suitabl e scal e factor in orde r to av oid spurious re sul ts in carrying out a te st of e quation (16). T h e factor w e h av e use d is th e book v al ue of th e firm de note d by A. T h e h ypoth e sis te ste d th us take s th e spe cific form: V/A = a + b(XT /A) + c(D/A) and th e nume rator of th e ratio XT /A is again approximate d by actual ne t re turns. T h e partial corre l ation be tw e e n V/A and DIA sh oul d now be positiv e according to th e traditional v ie w and ze ro according to our mode l . Al th ough div ision by A sh oul d, if anyth ing, bias th e re sul ts in fav or of th e traditional h ypoth e sis, th e partial corre l ation turns out to be onl y .03 for th e oil companie s and -.28 for th e e l e ctric util itie s. Ne ith e r of th e se coe fficie nts is significantl y diffe r- e nt from ze ro and th e l arge r one e v e n h as th e w rong sign. 39 T h e te sts consiste d of fitting to th e data th e e quation (19) of footnote 27. As sh ow n th e re , it fol l ow s from th e U-sh ape d h ypoth e sis th at th e coe fficie nt a of th e v ariabl e (D/V)2 /(1 -DIV), de note d h e re afte r by d*, sh oul d be significant and positiv e . T h e fol l ow ing re gre s- sion e quations and partial s w e re obtaine d: El e ctric Util itie s x = 5.0 + .017d - .003d*; rxd* .d =- .15 Oil Companie s x = 8.0 + .05d - .03d*; rzd* .d = -.14. MODIGLIANI AND MILLER : T HEOR Y OF INVEST MENT 285 far e nough to th e righ t (as in th e curv e MD'), to th e e xte nt th at h igh l e v e rage te nds to driv e up th e cost of se nior capital . According to th e conv e ntional v ie w , th e yie l d curv e as a function of l e v e rage sh oul d be a h orizontal straigh t l ine (l ike MVL') th rough most of th e re l e v ant range ; far e nough to th e righ t, th e yie l d may te nd to rise at an incre asing rate . He re again, a straigh t-forw ard corre l ation-in th is case be tw e e n *#/S and D/S-can prov ide a te st of th e tw o positions. If our v ie w is corre ct, th e corre l ation sh oul d be significantl y positiv e ; if th e traditional v ie w is corre ct, th e corre l ation sh oul d be ne gl igibl e . Subje ct to th e same qual ifications note d abov e in conne ction w ith XT , w e can approximate fr by actual stockh ol de r ne t income .40 Le tting z de note in e ach case th e approximation to fr#/S (e xpre sse d as a pe r- ce ntage ) and l e tting h de note th e ratio DIS (al so in pe rce ntage te rms) th e fol l ow ing re sul ts are obtaine d: El e ctric Util itie s z 6.6 + .017/i r .53 (+ .004) Oil Companie s z 8.9 + .051h r = .53. (? .012) T h e se re sul ts are sh ow n in scatte r diagram form in Figure s 5 and 6. He re again th e impl ications of our anal ysis se e m to be borne out by th e data. Both corre l ation coe fficie nts are positiv e and h igh l y significant w h e n account is take n of th e substantial sampl e size . Furth e rmore , th e e stimate s of th e coe fficie nts of th e e quations se e m to accord re asonabl y w e l l w ith our h ypoth e sis. According to e quation (12) th e constant te rm sh oul d be th e v al ue Of pk' for th e giv e n cl ass w h il e th e sl ope sh oul d be (pe r- r). From th e te st of Proposition I w e h av e se e n th at for th e oil companie s th e me an v al ue of pkT coul d be e stimate d at around 8.7. Since th e av e rage yie l d of se nior capital during th e pe riod cov e re d w as in th e orde r of 3' pe r ce nt, w e sh oul d e xpe ct a constant te rm of about 8.7 pe r ce nt and a sl ope of just ov e r 5 pe r ce nt. T h e se v al ue s cl ose l y ap- proximate th e re gre ssion e stimate s of 8.9 pe r ce nt and 5.1 pe r ce nt re - spe ctiv e l y. For th e e l e ctric util itie s, th e yie l d of se nior capital w as al so on th e orde r of 332 pe r ce nt durinn th e te st ye ars, but since th e e stimate of th e me an v al ue of Pkr from th e te st of Proposition I w as 5.6 pe r ce nt, 40 As indicate d e arl ie r, Snnm'Ith 's data w e re for th e singl e ye ar 1953. Since th e use of a singl e ye ar's profits as a me asure of e xpe cte d profits migh t be ope n to obje ction w e col l e cte d profit data for 1952 for th e same companie s and base d th e computation of Fr/S on th e av e rage of th e tw o ye ars. T h e v al ue of 7T /S w as obtaine d from th e formul a: (ne t e arnings in 1952 -s + ne t e arnings in '1953 2 asse ts in '522 * (av e rage marke t v al ue of common stock in '53). T h e asse t adjustme nt w as introduce d as rough al l ow ance for th e e ffe cts of possibl e grow th in th e size of th e firm. It migh t be adde d th at th e corre l ation compute d w ith 7r/S base d on ne t profits in 1953 al one w as found to be onl y sl igh tl y smal l e r, name l y .50. 286 T HE AMER ICAN ECONOMIC R EVIEW 6 o 4 W& 12_ 0~~~~~~~* *12 04 E 2- uo- uw 20 w .1 0 0 25 I0 750 200 1250 160 350 200 H:- LEVER AGE- [(MAR KET VALUE OF SENIOR SErUR IT IESVtMAR KET VALUE. OF COMMONST OCKS)] 00 FIGUR E 6. YIELD ON COMMON ST OCK IN R ELAT ION T o LEVER AGE FOR 42 OLCR CUILICO T AIES, 1952-538 zo W g _ co S0-o O o f 0 7 O 1 6 7 H: Lv EtR AE -[(MAR KET VALUE Of SENIOR SECUR IT IEqAMAR KET VALUE OF COkMON0 ST OCKS 100 FIGu-R E6. YIELD ON COMMON ST OCK IN R ELAT IONT O LEVER AGEFOR 42 OIL COH-PANIES, 1952-53 MODIGLIANI AND MILLER : T HEOR Y OF INVEST MENT 287 th e sl ope sh oul d be just abov e 2 pe r ce nt. T h e actual re gre ssion e stimate for th e sl ope of 1.7 pe r ce nt is th us some w h at l ow , but stil l w ith in one standard e rror of its th e ore tical v al ue . Be cause of th is unde re stimate of th e sl ope and be cause of th e l arge me an v al ue of l e v e rage (h = 160 pe r ce nt) th e re gre ssion e stimate of th e constant te rm, 6.6 pe r ce nt, is some - w h at h igh , al th ough not significantl y diffe re nt from th e v al ue of 5.6 pe r ce nt obtaine d in th e te st of Proposition I. Wh e n w e add a square te rm to th e abov e e quations to te st for th e pre se nce and dire ction of curv ature w e obtain th e fol l ow ing e stimate s: El e ctric Util itie s z = 4.6 + .004h - .007h 2 Oil Companie s z = 8.5 + .072h - .016z2. For both case s th e curv ature is ne gativ e . In fact, for th e e l e ctric util i- tie s, w h e re th e obse rv ations cov e r a w ide r range of l e v e rage ratios, th e ne gativ e coe fficie nt of th e square te rm is actual l y significant at th e 5 pe r ce nt l e v e l . Ne gativ e curv ature , as w e h av e se e n, runs dire ctl y coun- te r to th e traditional h ypoth e sis, w h e re as it can be re adil y accounte d for by our mode l in te rms of rising cost of borrow e d funds.4' In summary, th e e mpirical e v ide nce w e h av e re v ie w e d se e ms to be broadl y consiste nt w ith our mode l and l arge l y inconsiste nt w ith tradi- tional v ie w s. Ne e dl e ss to say much more e xte nsiv e te sting w il l be re - quire d be fore w e can firml y concl ude th at our th e ory de scribe s marke t be h av ior. Caution is indicate d e spe cial l y w ith re gard to our te st of Proposition IT , partl y be cause of possibl e statistical pitfal l s42 and partl y be cause not al l th e factors th at migh t h av e a syste matic e ffe ct on stock yie l ds h av e be e n conside re d. In particul ar, no atte mpt w as made to te st th e possibl e infl ue nce of th e div ide nd pay-out ratio w h ose rol e h as te nde d to re ce iv e a gre at de al of atte ntion in curre nt re se arch and th ink- ing. T h e re are tw o re asons for th is omission. First, our main obje ctiv e h as be e n to asse ss th e prima facie te nabil ity of our mode l , and in th is mode l , base d as it is on rational be h av ior by inv e stors, div ide nds pe r se pl ay no rol e . Se cond, in a w orl d in w h ich th e pol icy of div ide nd stabil iza- tion is w ide spre ad, th e re is no simpl e w ay of dise ntangl ing th e true e f- fe ct of div ide nd payme nts on stock price s from th e ir appare nt e ffe ct, 4 T h at th e yie l d of se nior capital te nde d to rise for util itie s as l e v e rage incre ase d is cl e arl y sh ow n in se v e ral of th e scatte r diagrams pre se nte d in th e publ ish e d v e rsion of Al l e n's study. T h is significant ne gativ e curv ature be tw e e n stock yie l ds and l e v e rage for util itie s may be part- l y re sponsibl e for th e fact, pre v iousl y note d, th at th e constant in th e l ine ar re gre ssion is some - w h at h igh e r and th e sl ope some w h at l ow e r th an impl ie d by e quation (12). Note al so in conne c- tion w ith th e e stimate of Pk' th at th e introduction of th e quadratic te rm re duce s th e constant conside rabl y, push ing it in fact be l ow th e a priori e xpe ctation of 5.6, th ough th e diffe re nce is again not statistical l y significant. 42 In our te st, e .g., th e tw o v ariabl e s z and h are both ratios w ith S appe aring in th e de nomi- nator, w h ich may te nd to impart a positiv e bias to th e corre l ation (cf. note 38). Atte mpts w e re made to de v e l op al te rnativ e te sts, but al th ough v arious possibil itie s w e re e xpl ore d, w e h av e so far be e n unabl e to find satisfactory al te rnativ e s. 288 T HE AMER ICAN ECONOMIC R EVIEW th e l atte r re fl e cting onl y th e rol e of div ide nds as a proxy me asure of l ong-te rm e arning anticipations.43 T h e difficul tie s just me ntione d are furth e r compounde d by possibl e inte rre l ations be tw e e n div ide nd pol icy and l e v e rage .44 II. Imtpl ications of th e Anal ysis for th e T h e ory of Inv e stme nt A. Capital Structure and Inv e stme nt Pol icy On th e basis of our propositions w ith re spe ct to cost of capital and financial structure (and for th e mome nt ne gl e cting taxe s), w e can de riv e th e fol l ow ing simpl e rul e for optimal inv e stme nt pol icy by th e firm: Proposition III. If a firm in cl ass k is acting in th e be st inte re st of th e stockh ol de rs at th e time of th e de cision, it w il l e xpl oit an inv e stme nt op- portunity if and onl y if th e rate of re turn on th e inv e stme nt, say p*, is as l arge as or l arge r th an pk. T h at is, th e cut-off point for inv e stme nt in th e firm w il l in al l case s be Pk and w il l be compl e te l y unaffe cte d by th e type of se curity use d to finance th e inv e stme nt. Equiv al e ntl y, w e may say th at re gardl e ss of th e financing use d, th e marginal cost of capital to a firm is e qual to th e av e rage cost of capital , w h ich is in turn e qual to th e capital ization rate for an unl e v e re d stre am in th e cl ass to w h ich th e firm be l ongs.45 T o e stabl ish th is re sul t w e w il l conside r th e th re e major financing al - te rnativ e s ope n to th e firm--bonds, re taine d e arnings, and common stock issue s-and sh ow th at in e ach case an inv e stme nt is w orth unde r- taking if, and onl y if, p =pk.46 Conside r first th e case of an inv e stme nt finance d by th e sal e of bonds. We know from Proposition I th at th e marke t v al ue of th e firm be fore th e inv e stme nt w as unde rtake n w as:47 (20) V0 = Xo/pk 43We sugge st th at fail ure to appre ciate th is difficul ty is re sponsibl e for many fal l acious, or at l e ast unw arrante d, concl usions about th e rol e of div ide nds. 44 In th e sampl e of e l e ctric util itie s, th e re is a substantial ne gativ e corre l ation be tw e e n yie l ds and pay-out ratios, but al so be tw e e n pay-out ratios and l e v e rage , sugge sting th at e ith e r th e association of yie l ds and l e v e rage or of yie l ds and pay-out ratios may be (at l e ast partl y) spurious. T h e se difficul tie s h ow e v e r do not arise in th e case of th e oil industry sampl e . A pre - l iminary anal ysis indicate s th at th e re is h e re no significant re l ation be tw e e n l e v e rage and pay-out ratios and al so no significant corre l ation (e ith e r gross or partial ) be tw e e n yie l ds and pay-out ratios. 45 T h e anal ysis de v e l ope d in th is pape r is e sse ntial l y a comparativ e -statics, not a dynamic anal ysis. T h is note of caution appl ie s w ith spe cial force to Proposition III. Such probl e ms as th ose pose d by e xpe cte d ch ange s in r and in pk ov e r time w il l not be tre ate d h e re . Al th ough th e y are in principl e ame nabl e to anal ysis w ith in th e ge ne ral frame w ork w e h av e l aid out, such an unde rtaking is sufficie ntl y compl e x to de se rv e se parate tre atme nt. Cf. note 17. " T h e e xte nsion of th e proof to oth e r type s of financing, such as th e sal e of pre fe rre d stock or th e issuance of stock righ ts is straigh tforw ard. 47 Since no confusion is l ike l y to arise , w e h av e again, for simpl icity, e l iminate d th e subscripts ide ntifying th e firm in th e e qtuations to fol l ow . Exce pt for Pk, th e subscripts now re fe r to time pe riods. MODIGLIANI AND MILLER : T HEOR Y OF INVEST MENT 289 and th at th e v al ue of th e common stock w as: (21) S0 - V0 - Do. If now th e firm borrow s I dol l ars to finance an inv e stme nt yie l ding p* its marke t v al ue w il l be come : T o + P* _ * (22) VI= - + p*Ip* Pk Pk and th e v al ue of its common stock w il l be : P*I (23) S1 = V1 - (Do + 1) V1' + Do - I Pk or using e quation 21, p*I (24) KSi = So + --- -I. Pk/ He nce S1iS0 as p*<pk.48 T o il l ustrate , suppose th e capital ization rate for unce rtain stre ams in th e kth cl ass is 10 pe r ce nt and th e rate of inte re st is 4 pe r ce nt. T h e n if a giv e n company h ad an e xpe cte d income of 1,000 and if it w e re finance d e ntire l y by common stock w e know from Proposition I th at th e marke t v al ue of its stock w oul d be 10,000. Assume now th at th e manage rs of th e firm discov e r an inv e stme nt opportunity w h ich w il l re quire an outl ay of 100 and w h ich is e xpe cte d to yie l d 8 pe r ce nt. At first sigh t th is migh t appe ar to be a profitabl e opportunity since th e e xpe cte d re turn is doubl e th e inte re st cost. If, h ow e v e r, th e manage me nt borrow s th e ne ce ssary 100 at 4 pe r ce nt, th e total e xpe cte d income of th e company rise s to 1,008 aind th e marke t v al ue of th e firm to 10,080. But th e firm now w il l h av e 100 of bonds in its capital structure so th at, paradoxical l y, th e marke t v al ue of th e stock must actual l y be re duce d from 10,000 to 9,980 as a conse que nce of th is appare ntl y profitabl e inv e stme nt. Or, to put it anoth e r w ay, th e gains from be ing abl e to tap ch e ap, borrow e d funds are more th an offse t for th e stockh ol de rs by th e marke t's discount- ing of th e stock for th e adde d l e v e rage assume d. Conside r ne xt th e case of re taine d e arnings. Suppose th at in th e course of its ope rations th e firm acquire d I dol l ars of cash (w ith out impairing 48 In th e case of bond-financing th e rate of inte re st on bonds doe s not e nte r e xpl icitl y into th e de cision (assuming th e firm borrow s at th e marke t rate of inte re st). T h is is true , more - ov e r, giv e n th e conditions outl ine d in Se ction I.C, e v e n th ough inte re st rate s may be an incre asing function of de bt outstanding. T o th e e xte nt th at th e firm borrow e d at a rate oth e r th an th e marke t rate th e tw o I's in e quation (24) w oul d no l onge r be ide ntical and an additional gain or l oss, as th e case migh t be , w oul d accrue to th e sh are h ol de rs. It migh t al so be note d in passing th at pe rmitting th e tw o I's in (24) to take on diffe re nt v al ue s prov ide s a simpl e me th od for introducing unde rw riting e xpe nse s into th e anal ysis. 290 T HE AMER ICAN ECONOMIC R EVIEW th e e arning pow e r of its asse ts). If th e cash is distribute d as a div ide nd to th e stockh ol de rs th e ir w e al th Wo, afte r th e distribution w il l be : XO (25) Wo = So + I = - Do + I Pk w h e re Xo re pre se nts th e e xpe cte d re turn from th e asse ts e xcl usiv e of th e amount I in que stion. If h ow e v e r th e funds are re taine d by th e company and use d to finance ne w asse ts w h ose e xpe cte d rate of re turn is p*, th e n th e stockh ol de rs' w e al th w oul d be come : Xo + P*I p*S (26) WI = S1 = -Do = So + - Pk PIC Cl e arl y Wi-Wo as p*<pk so th at an inv e stme nt finance d by re taine d e arnings raise s th e ne t w orth of th e ow ne rs if and onl y if p* > Pk.49 Conside r final l y, th e case of common-stock financing. Le t Po de note th e curre nt marke t price pe r sh are of stock and assume , for simpl icity, th at th is price re fl e cts curre ntl y e xpe cte d e arnings onl y, th at is, it doe s not re fl e ct any future incre ase in e arnings as a re sul t of th e inv e stme nt unde r conside ration.50 T h e n if N is th e original numbe r of sh are s, th e price pe r sh are is: (27) Po = SO/N and th e numbe r of ne w sh are s, M, ne e de d to finance an inv e stme nt of I dol l ars is giv e n by: (28) M PO As a re sul t of th e inv e stme nt th e marke t v al ue of th e stock be come s: XO + P*I p*I p*I Si - - Do = So + -NPo + - pk Pk Pk and th e price pe r sh are : (29) p S 1 [NPo + - N + M N + M PC c 49 T h e concl usion th at pk is th e cut-off point for inv e stme nts finance d from inte rnal funds appl ie s not onl y to undistribute d ne t profits, but to de pre ciation al l ow ance s (and e v e n to th e funds re pre se nte d by th e curre nt sal e v al ue of any asse t or col l e ction of asse ts). Since th e ow ne rs can e arn Pk by inv e sting funds e l se w h e re in th e cl ass, partial or total l iquidating distri- butions sh oul d be made w h e ne v e r th e firm cannot ach ie v e a marginal inte rnal rate of re turn e qual to pk. 60 If w e assume d th at th e marke t price of th e stock did re fl e ct th e e xpe cte d h igh e r future e arnings (as w oul d be th e case if our original se t of assumptions abov e w e re strictl y fol l ow e d) th e anal ysis w oul d diffe r sl igh tl y in de tail , but not in e sse ntial s. T h e cut-off point for ne w in- v e stme nt w oul d stil l be pk, but w h e re p*>pk th e gain to th e original ow ne rs w oul d be l arge r th an if th e stock price w e re base d on th e pre -inv e stme nt e xpe ctations onl y. MODIGLIANI AND MILLER : T HEOR Y OF INVEST MENT 291 Since by e quation (28), 1 = MPo, w e can add MPO and subtract I from th e quantity in bracke t, obtaining: P1 N+ L ) Pkc1 Pi- [(N7 + M)PO +-I (30) 1 *Pf =Po + N - P I > Po if7 and onl y if, p*>pk. T h us an inv e stme nt finance d by common stock is adv antage ous to th e curre nt stockh ol de rs if and onl y if its yie l d e xce e ds th e capital ization rate Pk- Once again a nume rical e xampl e may h e l p to il l ustrate th e re sul t and make it cl e ar w h y th e re l e v ant cut-off rate is Pk and not th e curre nt yie l d on common stock, i. Suppose th at Pk iS 10 pe r ce nt, r is 4 pe r ce nt, th at th e original e xpe cte d income of our company is 1,000 and th at manage - me nt h as th e opportunity of inv e sting 100 h av ing an e xpe cte d yie l d of 12 pe r ce nt. If th e original capital structure is 50 pe r ce nt de bt and 50 pe r ce nt e quity, and 1,000 sh are s of stock are initial l y outstanding, th e n, by Proposition I, th e marke t v al ue of th e common stock must be 5,000 or 5 pe r sh are . Furth e rmore , since th e inte re st bil l is .04X5,000 = 200, th e yie l d on common stock is 800/5,000=16 pe r ce nt. It may th e n appe ar th at financing th e additional inv e stme nt of 100 by issuing 20 sh are s to outside rs at 5 pe r sh are w oul d dil ute th e e quity of th e origi- nal ow ne rs since th e 100 promise s to yie l d 12 pe r ce nt w h e re as th e com- mon stock is curre ntl y yie l ding 16 pe r ce nt. Actual l y, h ow e v e r, th e income of th e company w oul d rise to 1,012; th e v al ue of th e firm to 10,120; and th e v al ue of th e common stock to 5,120. Since th e re are now 1,020 sh are s, e ach w oul d be w orth 5.02 and th e w e al th of th e origi- nal stockh ol de rs w oul d th us h av e be e n incre ase d. Wh at h as h appe ne d is th at th e dil ution in e xpe cte d e arnings pe r sh are (from .80 to .796) h as be e n more th an offse t, in its e ffe ct upon th e marke t price of th e sh are s, by th e de cre ase in l e v e rage . Our concl usion is, once again, at v ariance w ith conv e ntional v ie w s,5' so much so as to be e asil y misinte rpre te d. R e ad h astil y, Proposition III se e ms to impl y th at th e capital structure of a firm is a matte r of indiffe r- e nce ; and th at, conse que ntl y, one of th e core probl e ms of corporate finance -th e probl e m of th e optimal capital structure for a firm-is no probl e m at al l . It may be h e l pful , th e re fore , to cl e ar up such possibl e misunde rtandings. 51 In th e matte r of inv e stme nt pol icy unde r unce rtainty th e re is no singl e position w h ich re pre se nts "acce pte d" doctrine . For a sampl e of curre nt formul ationis, al l v e ry diffe re nt from ours, se e Joe l De an [2, e sp. Ch . 3], M. Gordon and E. Sh apiro [51, and Harry R obe rts [171. 292 T HE AMER ICAN ECONOMIC R EVIEW B. Proposition III and Financial Pl anning by Firms Misinte rpre tation of th e scope of Proposition III can be av oide d by re me mbe ring th at th is Proposition te l l s us onl y th at th e type of instru- me nt use d to finance an inv e stme nt is irre l e v ant to th e que stion of w h e th e r or not th e inv e stme nt is w orth w h il e . T h is doe s not me an th at th e ow ne rs (or th e manage rs) h av e no grounds w h ate v e r for pre fe rring one financing pl an to anoth e r; or th at th e re are no oth e r pol icy or te ch - nical issue s in finance at th e l e v e l of th e firm. T h at grounds for pre fe rring one type of financial structure to anoth e r w il l stil l e xist w ith in th e frame w ork of our mode l can re adil y be se e n for th e case of common-stock financing. In ge ne ral , e xce pt for some - th ing l ike a w ide l y publ icize d oil -strike , w e w oul d e xpe ct th e marke t to pl ace v e ry h e av y w e igh t on curre nt and re ce nt past e arnings in forming e xpe ctations as to future re turns. He nce , if th e ow ne rs of a firm dis- cov e re d a major inv e stme nt opportunity w h ich th e y fe l t w oul d yie l d much more th an Pk, th e y migh t w e l l pre fe r not to finance it v ia common stock at th e th e n rul ing price , be cause th is price may fail to capital ize th e ne w v e nture . A be tte r course w oul d be a pre -e mptiv e issue of stock (and in th is conne ction it sh oul d be re me mbe re d th at stockh ol de rs are fre e to borrow and buy). Anoth e r possibil ity w oul d be to finance th e proje ct initial l y w ith de bt. Once th e proje ct h ad re fl e cte d itse l f in in- cre ase d actual e arnings, th e de bt coul d be re tire d e ith e r w ith an e quity issue at much be tte r price s or th rough re taine d e arnings. Stil l anoth e r possibil ity al ong th e same l ine s migh t be to combine th e tw o ste ps by mne ans of a conv e rtibl e de be nture or pre fe rre d stock, pe rh aps w ith a progre ssiv e l y de cl ining conv e rsion rate . Ev e n such a doubl e -stage financing pl an may possibl y be re garde d as yie l ding too l arge a sh are to outside rs since th e ne w stockh ol de rs are , in e ffe ct, be ing giv e n an inte re st in any simil ar opportunitie s th e firm may discov e r in th e future . If th e re is a re asonabl e prospe ct th at e v e n l arge r opportunitie s may arise in th e ne ar future and if th e re is some dange r th at borrow ing now w oul d pre cl ude more borrow ing l ate r, th e ow ne rs migh t find th e ir inte re sts be st prote cte d by spl itting off th e curre nt opportunity into a se parate subsidiary w ith inde pe nde nt financing. Cl e arl y th e probl e ms inv ol v e d in making th e crucial e stimate s and in pl anning th e optimal financial strate gy are by no me ans triv ial , e v e n th ough th e y sh oul d h av e no be ar- ing on th e basic de cision to inv e st (as l ong as p*>pkP).52 Anoth e r re ason w h y th e al te rnativ e s in financial pl ans may not be a matte r of indiffe re nce arise s from th e fact th at manage rs are conce rne d 62 Nor can w e rul e out th e possibil ity th at th e e xisting ow ne rs, if unabl e to use a financing pl an w h ich prote cts th e ir inte re st, may actual l y pre fe r to pass Up an oth e rw ise profitabl e v e n- ture rath e r th an giv e outside rs an "e xce ssiv e " sh are of th e busine ss. It is pre sumabl y in situa- tions of th is kind th at w e coul d justifiabl y spe ak of a sh ortage of "e quity capital ," th ough th is kind of marke t impe rfe ction is l ike l y to be of significance onl y for smal l or ne w firms. MODIGLIANI AND MILLER : T HEOR Y OF INVEST MENT 293 w ith more th an simpl y furth e ring th e inte re st of th e ow ne rs. Such oth e r obje ctiv e s of th e manage me nt-w h ich ne e d not be ne ce ssaril y in con- fl ict w ith th ose of th e ow ne rs-are much more l ike l y to be se rv e d by some type s of financing arrange me nts th an oth e rs. In many forms of borrow ing agre e me nts, for e xampl e , cre ditors are abl e to stipul ate te rms w h ich th e curre nt manage me nt may re gard as infringing on its pre roga- tiv e s or re stricting its fre e dom to mane uv e r. T h e cre ditors migh t e v e n be abl e to insist on h av ing a dire ct v oice in th e formation of pol icy.53 T o th e e xte nt, th e re fore , th at financial pol icie s h av e th e se impl ications for th e manage me nt of th e firm, some th ing l ike th e util ity approach de - scribe d in th e introductory se ction be come s re l e v ant to financial (as oppose d to inv e stme nt) de cision-making. It is, h ow e v e r, th e util ity func- tions of th e manage rs pe r se and not of th e ow ne rs th at are now in- v ol v e d.14 In summary, many of th e spe cific conside rations w h ich bul k so l arge in traditional discussions of corporate finance can re adil y be supe rim- pose d on our simpl e frame w ork w ith out forcing any drastic (and ce r- tainl y no syste matic) al te ration of th e concl usion w h ich is our principal conce rn, name l y th at for inv e stme nt de cisions, th e marginal cost of capital is Pk. C. T Uh e Effe ct of th e Corporate Income T 'ax on Inv e stme nt De cisions In Se ction I it w as sh ow n th at w h e n an uninte grate d corporate inconme tax is introduce d, th e original v e rsion of our Proposition I, X/V = Pk = a constant must be re w ritte n as: (X-rD)(l -T )+rD X7 (11) Pk= a constant. V V T h rough out Se ction I w e found it conv e nie nt to re fe r to Xl V as th e cost of capital . T h e appropriate me asure of th e cost of capital re l e v ant Simil ar conside rations are inv ol v e d in th e matte r of div ide nd pol icy. Ev e n th ough th e stockh ol de rs may be indiffe re nt as to payout pol icy as l ong as inv e stme nt pol icy is optimal , th e manage me nt ne e d not be so. R e taine d e arnings inv ol v e far fe w e r th re ats to control th an any of th e al te rnativ e source s of funds and, of course , inv ol v e no unde rw riting e xpe nse or risk. But against th e se adv antage s manage me nt must bal ance th e fact th at sh arp ch ange s in div i- de nd rate s, w h ich h e av y re l iance on re taine d e arnings migh t impl y, may giv e th e impre ssion th at a firm's finance s are be ing poorl y manage d, w ith conse que nt th re ats to th e control and profe ssional standing of th e manage me nt. 54 In principl e , at l e ast, th is introduction of manage me nt's risk pre fe re nce s w ith re spe ct to financing me th ods w oul d do much to re concil e th e appare nt confl ict be tw e e n Proposition Il l and such e mpirical findings as th ose of Modigl iani and Ze man [141 on th e cl ose re l ation be tw e e n inte re st rate s and th e ratio of ne w de bt to ne w e quity issue s; or of Joh n Lintne r [121 on th e conside rabl e stabil ity in targe t and actual div ide nd-payout ratios. 294 T HE AMER ICAN ECONOMIC R EVIEW to inv e stme nt de cisions, h ow e v e r, is th e ratio of th e e xpe cte d re turn be fore taxe s to th e marke t v al ue , i.e ., X/V. From (11) abov e w e find: (31) - - T r(D/V) - Pk_ [ T rD] V 1 - 7r I -_ _ Pk'V w h ich sh ow s th at th e cost of capital now de pe nds on th e de bt ratio, de cre asing, as D/V rise s, at th e constant rate rr/(1 -T ).5 T h us, w ith a corporate income tax unde r w h ich inte re st is a de ductibl e e xpe nse , gains can accrue to stockh ol de rs from h av ing de bt in th e capital struc- ture , e v e n w h e n capital marKe ts are pe rfe ct. T h e gains h ow e v e r are smal l , as can be se e n from (31), and as w il l be sh ow n more e xpl icitl y be l ow . From (31) w e can de v e l op th e tax-adjuste d counte rpart of Proposi- tion III by inte rpre ting th e te rm DIV in th at e quation as th e proportion of de bt use d in any additional financing of V dol l ars. For e xampl e , in th e case w h e re th e financing is e ntire l y by ne w common stock, D=0 and th e re quire d rate of re turn pkS on a v e nture so finance d be come s: (32) PkS Pk For th e oth e r e xtre me of pure de bt financing D= V and th e re quire d rate of re turn, pkD, be come s: Pk r l F rl (33\ Pk D = [ p = PkT - _ r._ 1 - ' Pk7 JL PkC r For inv e stme nts finance d out of re taine d e arnings, th e probl e m of de fin- ing th e re quire d rate of re turn is more difficul t since it inv ol v e s a com- parison of th e tax conse que nce s to th e indiv idual stockh ol de r of re ce iv - ing a div ide nd v e rsus h av ing a capital gain. De pe nding on th e time of re al ization, a capital gain produce d by re taine d e arnings may be taxe d e ith e r at ordinary income tax rate s, 50 pe r ce nt of th e se rate s, 25 pe r 56 Equation (31) is ame nabl e , in principl e , to statistical te sts simil ar to th ose de scribe d in Se ction I.E. How e v e r w e h av e not made any syste matic atte mpt to carry out such te sts so far, be cause ne ith e r th e Al l e n nor th e Smith study prov ide s th e re quire d information. Actual l y, Smith 's data incl ude d a v e ry crude e stimate of tax l iabil ity, and, using th is e stimate , w e did in fact obtain a ne gativ e re l ation be tw e e n X/V and DIV. How e v e r, th e corre l ation (-.28) turne d out to be significant onl y at about th e 10 pe r ce nt l e v e l . Wh il e th is re sul t is not concl usiv e , it sh oul d be re me mbe re d th at, according to our th e ory, th e sl ope of th e re gre ssion e quation sh oul d be in any e v e nt quite smial l . In fact, w ith a v al ue of r in th e orde r of .5, and v al ue s of pkJ and r in th e orde r of 8.5 and 3.5 pe r ce nt re spe ctiv e l y (cf. Se ction I.E) an incre ase in DIV from 0 to 60 pe r ce nt (w h ich is, approximate l y, th e range of v ariation of th is v ariabl e in th e sampl e ) sh oul d te nd to re duce th e av e rage cost of capital onl y from about 17 to about 15 pe r ce nt. 56 T h is concl usion doe s not e xte nd to pre fe rre d stocks e v e n th ough th e y h av e be e n cl asse d w ith de bt issue s pre v iousl y. Since pre fe rre d div ide nds e xce pt for a portion of th ose of publ ic util itie s are not in ge ne ral de ductibl e from th e corporate tax, th e cut-off point for ne w financing v ia pre fe rre d stock is e xactl y th e same as th at for common stock. MODIGLIANI AND MILLER : T HEOR Y OF INVEST MENT 295 ce nt, or ze ro, if h e l d til l de ath . T h e rate on any div ide nds re ce iv e d in th e e v e nt of a distribution w il l al so be a v ariabl e de pe nding on th e amount of oth e r income re ce iv e d by th e stockh ol de r, and w ith th e adde d com- pl ications introduce d by th e curre nt div ide nd-cre dit prov isions. If w e assume th at th e manage rs proce e d on th e basis of re asonabl e e stimate s as to th e av e rage v al ue s of th e re l e v ant tax rate s for th e ow ne rs, th e n th e re quire d re turn for re taine d e arnings PkR can be sh ow n to be : 1 1i- T d l -T d (34) PkR _ Pkt Pk w h e re T d is th e assume d rate of pe rsonal income tax on div ide nds and Ir is th e assume d rate of tax on capital gains. A nume rical il l ustration may pe rh aps be h e l pful in cl arifying th e re l a- tionsh ip be tw v e e n th e se re quire d rate s of re turn. If w e take th e fol l ow ing round numbe rs as re pre se ntativ e orde r-of-magnitude v al ue s unde r pre se nt conditions: an afte r-tax capital ization rate Pkr of 10 pe r ce nt, a rate of inte re st on bonds of 4 pe r ce nt, a corporate tax rate of 50 pe r ce nt, a marginal pe rsonal income tax rate on div ide nds of 40 pe r ce nt (cor- re sponding to an income of about $25,000 on a joint re turn), and a capi- tal gains rate of 20 pe r ce nt (one -h al f th e marginal rate on div ide nds), th e n th e re quire d rate s of re turn w oul d be : (1) 20 pe r ce nt for inv e st- me nts finance d e ntire l y by issuance of ne w common sh are s; (2) 16 pe r ce nt for inv e stme nts finance d e ntire l y by ne w de bt; and (3) 15 pe r ce nt for inv e stme nts finance d w h ol l y from inte rnal funds. T h e se re sul ts w oul d se e m to h av e conside rabl e significance for curre nt discussions of th e e ffe ct of th e corporate income tax on financial pol icy and on inv e stme nt. Al th ough w e cannot e xpl ore th e impl ications of th e re sul ts in any de tail h e re , w e sh oul d at l e ast l ike to cal l atte ntion to th e re markabl y smal l diffe re nce be tw e e n th e "cost" of e quity funds and de bt funds. With th e nume rical v al ue s assume d, e quity mone y turne d out to be onl y 25 pe r ce nt more e xpe nsiv e th an de bt mone y, rath e r th an some th ing on th e orde r of 5 time s as e xpe nsiv e as is commonl y suppose d to be th e case .57 T h e re ason for th e w ide diffe re nce is th at th e traditional 57 Se e e .g.. D. T . Smith [18]. It sh oul d al so be pointe d out th at our tax syste m acts in oth e r w ays to re duce th e gains from de bt financing. He av y re l iance on de bt in th e capital structure , for e xampl e , commits a company to paying out a substantial proportion of its income in th e form of inte re st payme nts taxabl e to th e ow ne rs unde r th e pe rsonal income tax. A de bt-fre e company, bv contrast, can re inv e st in th e busine ss al l of its (smal l e r) ne t income and to th is e xte nt subje ct th e ow ne rs onl y to th e l ow capital gains rate (or possibl y no tax at al l by v irtue of th e l ooph ol e at de ath ). T h us, w e sh oul d e xpe ct a h igh de gre e of l e v e rage to be of v al ue to th e ow ne rs, e v e n in th e case of cl ose l y h e l d corporations, primaril y in case s w h e re th e ir firm w as not e xpe cte d to h av e much ne e d for additional funds to e xpand asse ts and e arnings in th e future . T o th e e xte nt th at opportunitie s for grow th w e re av ail abl e , as th e y pre sumabl y w oul d be for most succe ssful corporations, th e inte re st of th e stockh ol de rs w oul d te nd to be be tte r se rv e d by a structure w h ich pe rmitte d maximum use of re taine d e arnings. 296 T HE AMER ICAN ECONOMIC R EVIEW v ie w starts from th e position th at de bt funds are se v e ral time s ch e ape r th an e quity funds e v e n in th e abse nce of taxe s, w ith taxe s se rv ing sim- pl y to magnify th e cost ratio in proportion to th e corporate rate . By contrast, in our mode l in w h ich th e re pe rcussions of de bt financing on th e v al ue of sh are s are take n into account, th e onl y diffe re nce in cost is th at due to th e tax e ffe ct, and its magnitude is simpl y th e tax on th e "grosse d up" inte re st payme nt. Not onl y is th is magnitude l ike l y to be smal l but our anal ysis yie l ds th e furth e r paradoxical impl icationi th at th e stockh ol de rs' gain from, and h e nce ince ntiv e to use , de bt financing is actual l y smal l e r th e l ow e r th e rate of inte re st. In th e e xtre me case w h e re th e firm coul d borrow for practical l y noth ing, th e adv antage of de bt financing w oul d al so be practical l y noth ing. III. Concl usion With th e de v e l opme nt of Proposition III th e main obje ctiv e s w e out- l ine d in our introductory discussion h av e be e n re ach e d. We h av e in our Propositions I and II at l e ast th e foundations of a th e ory of th e v al ua- tion of firms and sh are s in a w orl d of unce rtainty. We h av e sh ow n, more ov e r, h ow th is th e ory can l e ad to an ope rational de finition of th e cost of capital and h ow th at conce pt can be use d in turn as a basis for rational inv e stme nt de cision-making w ith in th e firm. Ne e dl e ss to say, h ow e v e r, much re mains to be done be fore th e cost of capital can be put aw ay on th e sh e l f among th e sol v e d probl e ms. Our approach h as be e n th at of static, partial e quil ibrium anal ysis. It h as assume d among oth e r th ings a state of atomistic compe tition in th e capital marke ts and an e ase of acce ss to th ose marke ts w h ich onl y a re l ativ e l y smal l (th ough important) group of firms e v e n come cl ose to posse ssing. T h e se and oth e r drastic simpl ifications h av e be e n ne ce ssary in orde r to come to grips w ith th e probl e m at al l . Hav ing se rv e d th e ir purpose th e y can now be re l axe d in th e dire ction of gre ate r re al ism and re l e v ance , a task in w h ich w e h ope oth e rs inte re ste d in th is are a w il l w ish to sh are . R EFER ENCES 1. F. B. ALT LEN, "Doe s Going into De bt Low e r th e 'Cost of Capital '?," A nal ysts Jour., Aug. 1954, 10, 57-61. 2. J. DEAN, Capital Budge ting. 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