1、The Cost of Capital,Corporation Finance&The Theory of InvestmentAmerican Economic ReviewMiller&Modigliani,1958Presented by Marc FuhrmannFebruary 1,2007Agenda1.Unique Contributions2.Model Overview3.Propositions I&II 4.Extensions of Propositions I&II5.Proposition III6.Implications7.Limitations&Extensi
2、onsOmitted:Relation to“Current”Doctrines,EmpiricsUnique ContributionsFirst formal use of no-arbitrage argumentsAssumptions led to thorough examination of financial environment:TaxesAgency problemsTransactions and bankruptcy costsFramework widely used in practice(“WACC”)Simple analytical technique,ea
3、sily understoodModel:Overview(I)Simple model to value uncertain returns:All-equity firms belonging to homogeneous risk classes k(only expected returns vary across firms)Then there must be a proportionality factor that relates stock price to expected returnFactor denoted by 1/pk,expected return of fi
4、rm j denoted by xj Then,we have:and pk can be thought of as the required rate of return.Model:Overview(II)Debt Financing AssumptionsAll debt cash flows are certainBonds are traded in a perfect market All bonds are perfect substitutes Bonds sell at the same price per dollar of expected returnProposit
5、ion IOr,equivalently:The average cost of capital is independent of its capital structureProof(Sketch)No-arbitrage argument:2 firms,with identical expected return Firm 1 all-equity,Firm 2 has some debtSuppose V2 V11.Suppose further an investor owns s2 dollars in firm 22.Return Y2 is a fraction of X r
6、D2:3.Now suppose the investor sells the share and acquires instead s1=(X-rD2).The new portfolio thus yields:4.Since V2 V1,we must have Y1 Y2=Levered firms cannot command a premium over unlevered firms.Note:Key assumption is that investors can borrow at the same rate as firmProposition IICapitalizati
7、on rate p for pure equity stream in class kSpread between p and rDebt/Equity RatioExpected yield of a share of stock in firm jProofSimple algebra:by definition of ij by Proposition ISubstitute and simplify to obtain:ExtensionsAllow for:1.Corporate taxation with deductible interest payments2.Multiple
8、 types of bonds and interest rates3.Market imperfectionsExtension I:TaxationAverage corporate tax rateShareholders expected net incomeTaxable incomeResults:Proposition 1 becomes:Proposition 2 becomes:Extension II:Plurality of BondsProposition I remains unaffected Proposition II has to be modifiedPro
9、of of Case 1Recall that and Now,let the firm borrow I dollars for an investment yielding p*.It follows that:And therefore we have:andand finallyImplicationsThe source of funds is irrelevant with respect to the question of whether or not an investment is worthwhile.There remain other reasons to prefe
10、r one type of financing over another:Asymmetric informationTax considerationsManagement interest(not always in conflict with owners)Limitations&ExtensionsThe model provides a framework for capital-structure and investment decisionsIt can be extended in many directionsmore realistic assumptionsgeneral equilibrium contextEmpirical testing is needed Countless extensions and tests over the past 50 years1826 citations according to Google Scholar