The Cost of Capital, Corporate Finance and The Theory of Investment-Modigliani Miller

American Economic Association
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
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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.
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
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,.
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.
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.
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
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.
(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.
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.
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,).
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.
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.
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.
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."
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 .
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.
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.
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.
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
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.
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.
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
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.
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.
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.
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.
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.
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.
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.
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.
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.
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. Ne w York 1951.
3. D. DUR AND, "Costs of De bt and Equity Funds for Busine ss: T re nds
and Probl e ms of Me asure me nt" in Nat. Bur. Econ. R e se arch , Confe r-
e nce on R e se arch in Busine ss Finance . Ne w York 1952,
pp.
215-47.
4. W. J. EIT EMAN, "Financial Aspe cts of Promotion," in Essays on Busi-
ne ss Finance by M. W. Wate rford and W. J. Eite man. Ann Arbor,
Mich . 1952, pp. 1-17.
5. M. J. GOR DON and E. SHAPIR O, "Capital Equipme nt Anal ysis: T h e
R e qufire d R ate of Profit," Manag. Sci., Oct. 1956, 3, 102-10.
MODIGLIANI AND MILLER : T HEOR Y OF l iNVEST MENT 297
6. B. GR AHAM and L. DODD, Se curity Anal ysis, 3rd e d. Ne w York 1951.
7. G. GUT HMANN and H. E. DOUGALL, Corporate Financial Pol icy, 3rd e d.
Ne w York 1955.
8. J. R . HICKS, Val ue and Capital , 2nd e d. Oxford 1946.
9. P. UIUNT and M. WILLIAMS, Case Probl e ms in Finance , re v . e d. Home -
w ood, Il l . 1954.
10. J. M. KEYNES, T h e Ge nze ral T h e ory of Empl oyme nt, Inte re st and Mone y.
Ne w York 1936.
11. 0. LANGE, Price Fl e xibil ity and Empl oyme nt. Bl oomington, Ind. 1944.
12. J. LINT NER , "Distribution of Income s of Corporations among Div i-
de nds, R e taine d Earnings and T axe s," Am.. Econ. R e v ., Mfay 1956, 46,
97-113.
13. F. LUT Z and V". LUT Z, T h e T h e ory of Inv e stme nt of th e Firm. Prince ton
1951.
14. F. MODIGLIANI and M. ZEMAN, "T h e Effe ct of th e Av ail abil ity of
Funds, and th e T e rms T h e re of, on Busine ss Inv e stme nt" in Nat. Bur.
Econ. R e se arch ,
Confe re nce
on R e se arch in Busine ss Finance . Ne w
York 1952, pp. 263-309.
15. WV. A. MOR T ON, "T h e Structure of th e Capital Marke t and th e Price of
Mone y," Am. Econ. R e v ., May 1954, 44, 440-54.
16. S. M. R OBBINS, Managing Se curitie s. Boston 1954.
17. H. V. R OBER T S, "Curre nt Probl e ms in th e Economics of Capital Bud-
ge ting," Jour. Bus., 1957, 30 (1), 12-16.
18. D. T . SMIT H,
Effe cts
of T axation on Corporate Finiancial Pol icy. Boston
1952.
19. R . SMIT H, "Cost of Capital in th e Oil Industry," (h e ctograph ). Pitts-
burgh : Carne gie Inst. T e ch . 1955.
20. H. M. SOMER S, " 'Cost of MAone y' as th e De te rminant of Publ ic Util ity
R ate s," Buffal o Law R e v ., Spring 1955, 4, 1-28.
21. J. B. WILLIAMS, T h e T h e ory of Inv e stme nt Val ue . Cambridge , Mass.
1938.
22. U. S. Fe de ral Communicatiol ns Commission, T h e Probl e m of th e "R ate
of R e turn" in Publ ic Util ity R e gul ation. Wash ington 1938.

The Cost of Capital, Corporate Finance and The Theory of Investment-Modigliani Miller

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The Cost of Capital, Corporate Finance and The Theory of Investment-Modigliani Miller

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

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