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    The Cost of Capital, Corporation Finance & The Theory of Investment

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    linda zyongwe
    This document summarizes a presentation on "The Cost of Capital, Corporation Finance & The Theory of Investment" by Miller and Modigliani from 1958. It outlines the key contributions of the paper, including being the first to use no-arbitrage arguments and examining the effects of taxes, agency problems, and costs. The presentation then reviews the model and its propositions that the average cost of capital is independent of capital structure and that the value of a levered firm is equal to the value of an unlevered firm plus the present value of the tax shield from debt. Extensions to the model addressing taxation, multiple bond types, and market imperfections are also summarized.

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    The Cost of Capital, Corporation Finance & The Theory of Investment

    Uploaded by

    linda zyongwe
    27 views16 pages
    This document summarizes a presentation on "The Cost of Capital, Corporation Finance & The Theory of Investment" by Miller and Modigliani from 1958. It outlines the key contributions of the paper, including being the first to use no-arbitrage arguments and examining the effects of taxes, agency problems, and costs. The presentation then reviews the model and its propositions that the average cost of capital is independent of capital structure and that the value of a levered firm is equal to the value of an unlevered firm plus the present value of the tax shield from debt. Extensions to the model addressing taxation, multiple bond types, and market imperfections are also summarized.

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    Corporate finance

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

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    This document summarizes a presentation on "The Cost of Capital, Corporation Finance & The Theory of Investment" by Miller and Modigliani from 1958. It outlines the key contributions of the paper, including being the first to use no-arbitrage arguments and examining the effects of taxes, agency problems, and costs. The presentation then reviews the model and its propositions that the average cost of capital is independent of capital structure and that the value of a levered firm is equal to the value of an unlevered firm plus the present value of the tax shield from debt. Extensions to the model addressing taxation, multiple bond types, and market imperfections are also summarized.

    Copyright:

    © All Rights Reserved
    Download as PPT, PDF, TXT or read online from Scribd
    Download as ppt, pdf, or txt
    27 views16 pages

    The Cost of Capital, Corporation Finance & The Theory of Investment

    Uploaded by

    linda zyongwe
    This document summarizes a presentation on "The Cost of Capital, Corporation Finance & The Theory of Investment" by Miller and Modigliani from 1958. It outlines the key contributions of the paper, including being the first to use no-arbitrage arguments and examining the effects of taxes, agency problems, and costs. The presentation then reviews the model and its propositions that the average cost of capital is independent of capital structure and that the value of a levered firm is equal to the value of an unlevered firm plus the present value of the tax shield from debt. Extensions to the model addressing taxation, multiple bond types, and market imperfections are also summarized.

    Copyright:

    © All Rights Reserved
    Download as PPT, PDF, TXT or read online from Scribd
    Download as ppt, pdf, or txt
    of 16

    The Cost of Capital,

    Corporation Finance &


    The Theory of Investment
    American Economic Review
    Miller & Modigliani, 1958

    Presented by Marc Fuhrmann


    February 1, 2007
    Agenda
    1. Unique Contributions
    2. Model Overview
    3. Propositions I & II
    4. Extensions of Propositions I & II
    5. Proposition III
    6. Implications
    7. 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 X
    – 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
    Capitalization Ratio
    rate p for Spread
    pure equity between
    stream in p and r
    class k
    Proof
    Simple algebra:
    by definition of ij

    by Proposition I

    Substitute and simplify to obtain:


    Extensions
    Allow for:
    1. Corporate taxation with deductible interest
    payments
    2. Multiple types of bonds and interest rates
    3. Market imperfections
    Extension I: Taxation

    Results:
    Proposition 1 becomes:

    Taxable
    income
    Proposition 2 becomes: Shareholders’
    Average expected net
    corporate tax income
    rate
    Extension II: Plurality of Bonds
    • Proposition I remains unaffected
    • Proposition II has to be modified
    Proof of Case 1
    • Recall that and
    • Now, let the firm borrow I dollars for an investment
    yielding p*. It follows that:

    and

    and finally

    • And therefore we have:


    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

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