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

Modigliani, Franco, and Merton Miller, 1958, “The Cost of Capital, Corporation Finance, and the Theory of Investment,” The American Economic Review, Vol. 48, No. 3, 261-297.

Purpose:  This paper proposes a theory explaining how a firm’s stock price (market value) is impacted by managers’ capital structure decisions.

Motivation:  Previous work regarding the cost of capital treats assets as having known income streams, and adjusts for uncertainty simply by subtracting “risk discounts” from the expected rates of return.  This treatment of risk is inadequate.  A market-value approach—where the cost of capital is the return on an investment that does not affect a firm’s stock price—has promise, but we need a theory describing the impact of a firm’s capital structure on its market value.

Theory:

  • Model 1:  Corporations can only issue common equity
    • Assume perfect markets, no agency problems, and an economy where all assets are owned by corporations that can only finance operations with common equity.  Therefore, the rate of return on one share equals expected return to the share divided by share price.
      • Since there are no agency problems, retained earnings are the same as cash dividends.
    • Assume classes of corporations where each share’s expected return is perfectly correlated with all others in the class.  Then there is one rate of return for each class, and all shares in a class are perfect substitutes (up to a scale factor).
  • Model 2:  Corporations can issue bonds in addition to common equity
    • Assume bonds trade in perfect markets and all corporations and households have a perfect credit rating.  Then all bonds are perfect substitutes (up to a scale factor), and have the same expected rate of return.
    • Market value is independent of capital structure.
      • If an individual values leverage, he can take it on himself by borrowing money to buy more stock in an unlevered company.
    • The expected rate of return on stock in a levered company is the rate of return on a pure-equity company from its same class, plus a premium equal to the debt-to-equity ratio times the spread between the class-specific equity return and the [universal] cost of debt.
  • Model 3:  Corporate interest payments are tax-deductible
    • The debt-vs-equity consideration is important for overall corporate liquidity management due to taxes, timing, market sentiment, investor tax profiles, etc.
    • However, all that matters in project financing is the cost of capital.  A preference for one type of financing over another does not make a project more or less profitable.

Empirical Evidence and Conclusion:

  • Using data from the only two relevant studies:
    • There is no significant relationship between leverage and cost of capital.
    • As leverage increases, expected return to equity increases.
  • The amount of leverage can be important over the life of a corporation, but is irrelevant in determining the profitability of a project.