Summary Modigliani & Miller
L1 - Modigliani & Miller (1958) ‘The Cost of Capital, Corporation Finance and the Theory of Investment’
This article mainly discusses the cost of capital, the required return necessary to make a capital budgeting project worthwhile. Cost of capital includes the cost of debt and the cost of equity. Theorist conclude that the cost of capital to the owners of a firm is simply the rate of interest on bonds.
In a world without uncertainty the rational approach would be (1) to maximize profits and (2) to maximize market value. When uncertainty arises, these statements vanish and change into a utility maximization. The goal is to get more insight in the effect of financial structure on market valuations.
I. Valuation of Securities, Leverage and the Cost of Capital
A. The Capitalization Rate for Uncertain Streams
In the paper, M&M (1958) assume that firms can be divided into equivalent return classes such that the return on the shares issued by any firm in any given class is proportional to the return on shares issued by any other firm in the same class. This implies that various shares within the same class can differ at most by a scale factor. The significance of this assumption is that it permits us to clarify firms into groups where shares of different firms are homogeneous (perfect substitutes of each other). This again means that in equilibrium in a perfect capital market the price per dollars worth of expected return must be the same for all shares of any given class. This will result in the following formula’s:
=
pj = the price xj = expected return per share of the firm in class k pk= expected rate of return of any share in class k
1/pk = the price which an investor has to pay for a dollars worth of expected return in the class k
B. Debt Financing and its Effects on Security Prices
In this case, shares will be subject to different degrees of financial risk or leverage and hence will no longer be perfect
This article mainly discusses the cost of capital, the required return necessary to make a capital budgeting project worthwhile. Cost of capital includes the cost of debt and the cost of equity. Theorist conclude that the cost of capital to the owners of a firm is simply the rate of interest on bonds.
In a world without uncertainty the rational approach would be (1) to maximize profits and (2) to maximize market value. When uncertainty arises, these statements vanish and change into a utility maximization. The goal is to get more insight in the effect of financial structure on market valuations.
I. Valuation of Securities, Leverage and the Cost of Capital
A. The Capitalization Rate for Uncertain Streams
In the paper, M&M (1958) assume that firms can be divided into equivalent return classes such that the return on the shares issued by any firm in any given class is proportional to the return on shares issued by any other firm in the same class. This implies that various shares within the same class can differ at most by a scale factor. The significance of this assumption is that it permits us to clarify firms into groups where shares of different firms are homogeneous (perfect substitutes of each other). This again means that in equilibrium in a perfect capital market the price per dollars worth of expected return must be the same for all shares of any given class. This will result in the following formula’s:
=
pj = the price xj = expected return per share of the firm in class k pk= expected rate of return of any share in class k
1/pk = the price which an investor has to pay for a dollars worth of expected return in the class k
B. Debt Financing and its Effects on Security Prices
In this case, shares will be subject to different degrees of financial risk or leverage and hence will no longer be perfect