1 / 16

330 likes | 859 Views

The Cost of Capital, Corporation Finance & The Theory of Investment. American Economic Review Miller & Modigliani, 1958 Presented by Marc Fuhrmann February 1, 2007. Agenda. Unique Contributions Model Overview Propositions I & II Extensions of Propositions I & II Proposition III

Download Presentation
## The Cost of Capital, Corporation Finance & The Theory of Investment

**An Image/Link below is provided (as is) to download presentation**
Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author.
Content is provided to you AS IS for your information and personal use only.
Download presentation by click this link.
While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server.
During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

**The Cost of Capital, Corporation Finance & The Theory of**Investment American Economic Review Miller & Modigliani, 1958 Presented by Marc Fuhrmann February 1, 2007**Agenda**• Unique Contributions • Model Overview • Propositions I & II • Extensions of Propositions I & II • Proposition III • Implications • Limitations & Extensions Omitted: Relation to “Current” Doctrines, Empirics**Unique Contributions**• First formal use of no-arbitrage arguments • Assumptions led to thorough examination of financial environment: • Taxes • Agency problems • Transactions and bankruptcy costs • Framework widely used in practice (“WACC”) • Simple analytical technique, easily understood**Model: 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 return • Factor denoted by 1/pk, expected return of firm j denoted by xj • Then, we have: and pk can be thought of as the required rate of return.**Model: Overview (II)**Debt Financing • Assumptions • All debt cash flows are certain • Bonds are traded in a perfect market • All bonds are perfect substitutes • Bonds sell at the same price per dollar of expected return**Proposition I**Or, equivalently: • The average cost of capital is independent of its capital structure**Proof (Sketch)**No-arbitrage argument: • 2 firms, with identical expected return • Firm 1 all-equity, Firm 2 has some debt Suppose V2 > V1 • Suppose further an investor owns s2 dollars in firm 2 • Return Y2 is a fraction α of X – rD2: • Now suppose the investor sells the share and acquires instead s1=α(X- rD2). The new portfolio thus yields: • 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 firm**Proposition II**Expected yield of a share of stock in firm j Debt/Equity Ratio Capitalization rate p for pure equity stream in class k Spread between p and r**Proof**Simple algebra: by definition of ij by Proposition I Substitute and simplify to obtain:**Extensions**Allow for: • Corporate taxation with deductible interest payments • Multiple types of bonds and interest rates • Market imperfections**Extension I: Taxation**Results: Proposition 1 becomes: Proposition 2 becomes: Taxable income Shareholders’ expected net income Average corporate tax rate**Extension II: Plurality of Bonds**• Proposition I remains unaffected • Proposition II has to be modified**Proof of Case 1**• Recall thatand • Now, let the firm borrow I dollars for an investment yielding p*. It follows that: • And therefore we have: and and finally**Implications**• The source of funds is irrelevant with respect to the question of whether or not an investment is worthwhile. • There remain other reasons to prefer one type of financing over another: • Asymmetric information • Tax considerations • Management interest (not always in conflict with owners)**Limitations & Extensions**• The model provides a framework for capital-structure and investment decisions • It can be extended in many directions • more realistic assumptions • general equilibrium context • Empirical testing is needed • Countless extensions and tests over the past 50 years • 1826 citations according to Google Scholar

More Related