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

Modigliani and Miller develop an “operational” theory of a firm’s cost of capital under uncertainty, built on firms grouped into equivalent-risk classes and on the condition that investors can freely substitute personal (“homemade”) leverage for corporate leverage. From this they derive Proposition I: in perfect capital markets with no corporate income tax, the market value of a firm is independent of its capital structure and equals its expected operating income capitalized at the rate appropriate to its risk class, because any gap between a levered and unlevered firm’s value in the same class would let investors profitably arbitrage it away by borrowing or lending on personal account. Proposition II follows directly: the expected yield on a levered firm’s common stock rises linearly with its debt-to-equity ratio, with a slope equal to the spread between the firm’s unlevered capitalization rate and the interest rate – so the larger expected return to leverage exactly offsets, rather than creates, any gain in firm value. The authors report preliminary empirical support from two 1950s cross-sectional studies (43 electric utilities, 42 oil companies): the correlation between the overall cost of capital and leverage is essentially zero in both samples, while the correlation between stock yield and leverage is strongly positive, as their model (and not the traditional view) predicts. From Propositions I and II they derive Proposition III: for a firm behaving in stockholders’ interest, the cutoff rate for any investment is the firm’s unlevered capitalization rate, regardless of how that specific investment is financed – a result they are careful to say does not make all financing choices a matter of indifference once taxes, signaling to the market, and managers’ own preferences are brought back in, and which, once a deductible corporate income tax is reintroduced, implies only a small – not several-fold – cost advantage to debt.

Merton H. Miller | Macro Paper Warehouse

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