1. Seminar in Finance (622) Synopsis submitted by: Sudarshan Kadariya, 04/’010
The cost of capital, corporation finance, and the Theory of Investment: Comment
Prof. David Durand, Massachusetts Institute of Technology
Background: Modigliani and Miller (MM1958) have enunciated three propositions that contradict
widely accepted beliefs in finance literature. The study analyzed MM's underlying assumptions, which
are subtle and restrictive, and it will indicate some of the difficulties of using these assumptions to
support an operational definition of the cost of capital and a workable theory of investment. The
Proposition I is the basic one which states that in a perfect market, the total value of all outstanding
securities of a firm is independent of its capital structure. There are at least four devices (assumptions)
that aid in building a foundation for Proposition I; arbitrage is possible between securities in an
equivalent return class, a firm falls into none of the standard ownership categories but is a sort of hybrid,
exclude risk and a long-run equilibrium in which stocks sell at book value. But, all of these devices are
unrealistic, and MM have accepted none of them wholeheartedly. Thus, while they speak of arbitrage,
MM describe a process that is not arbitrage at all, but a switch.
Objectives: The study exposed the difficulties of justifying MM Proposition I for real corporations in a
world where arbitrage is usually impossible, where substitutes for arbitrage are restrained and risky, and
where stocks rarely sell at book value.
I. Proposition I and Arbitrage: True arbitrage, when possible, is a powerful equalizer; but it is not
ordinarily possible in corporate securities. For justification, Durand showed the illustrative example of
Petrolease Corp. - Unlevered, and Leverfund Trust. - Levered, later transformed into Closecorp and
concluded that arbitrage no longer exists and there is lack of perfect substitution of security. Author
stated that, effectiveness of arbitrage depends upon the equivalence of exchange not upon equivalence of
income. Also, suggested substitute for arbitrage like - hedge position, the switching of investment
accounts for comparatively unattractive issues into others that seem to offer a higher return for the same
risk and the financial operations. According to MM, switching exist between levered and unlevered firms
and arbitrage occurs so that levered companies cannot command a premium over unlevered companies
because investors have the opportunity of putting the equivalent leverage into their portfolio directly by
borrowing on personal account. But, this is only a limited opportunity for most investors. In practice,
those who seek to reduce capital cost by adjusting capital structure must ascertain conditions in the
current market, and act rapidly to exploit them. For instance, in 1950, S&P yields 2.6% for bonds, as
against dividend yields (DY) of 5.35 and earnings yields (EY) of 8.1% for utility stocks that offered a
golden opportunity to finance with bonds. On the other hand, in 1959, bonds 4.3%, while DY and EY
were down to 3.9 and 5.4% that offered to sell bonds on comparatively favorable terms in 1950 and stock
on comparatively favorable terms in 1959.
II. Market Imperfections: Restrictions on Margin Buying: Author made his comments on the ground that
MM visualize a highly competitive market, if market deviates it provides an opportunity for profit but
whom?, bond issue requires time to arrange, why discriminate against the corporations? Furthermore,
legal issues on margin buying. The small amount of margin buying permitted some investors under
Regulation T where as restrict many of the largest investors, the institutions.
III. The Risks of Margin Buying: MM’s arguments regarding no additional risk of switching does not
apply to corporate stockholders in a world of high risk, though it might apply either to stockholders in a
world of low risk or to limited partners in a world of high risk. All bonds are assumed to yield a constant
income per unit of time, and this income is regarded as certain by all traders regardless of the issuer, is
another argument which is also doubtful.

2. IV. The Problem of Retention and Growth: MM assumed 100% dividend payout; would be completely
realistic for partnerships and almost realistic for such corporations as regulated investment trusts but not
for corporations at large. Thus, they do not actually assume 100% payout. If, a firm fully payout its assets
values remains constant i.e. price (Po) = book value (Bo). When the firm retain and invest at the equal rate
of return, enable to earn more so that the growth appear and the book value of the stock changes as well
as stock price. In operation, stocks do not sell at book value not even approximately. But, MM neglect to
set the price (Pf) at which the hypothetical transaction takes place. The equation is
NXppXApPf k )*/()1(*  is one of the more tractable patterns of uniform growth in perpetuity,
resulting from the retention and reinvestment each year of a fraction X of earnings to yield precisely p*.
This is a standard actuarial formula for the present value of an income stream starting at Ap* (1 - X)/N,
growing at a rate p*X, and discounted at Pk (suggested by Todhunter (1937)). The regression of price on
book value, earnings, and dividends, for a group of 25 bank stocks in table-1 shows that the successive
reductions in the residual sum of squares and addition of earning, and dividend payout ratio. The
regression results concludes that the payout ratio exerts a significant influence on price-even after the
combined influence of book value and earnings have been taken into account. Similarly, table-2 another
regression price/book on earning/book and dividend/earning shows that the reduction in the sum of
squares is significant. Based on these results, it was concluded that dividend policy exerts an influence on
stock prices and the cost of capital, while failing to explain precisely how the influences is exerted.
V. Problems of Empirical Analysis: The empirical analysis on capital structure encounters the host of
obstacles because of lack of reliable and pertinent data like price quotations, dividend rates, earnings,
difficulties of assembling a sample of corporations capable of supporting a comparative or cross-section,
type of analysis, homogenous stock groups, etc.
VI. Conclusions: Durand made comments on MM’s study in different perspectives as; taken few steps in
the direction of realism; starting with a perfect market in a perfect world, have postulated a world that is
not 100% risk less but it is remarkably safe world (Rf), the equilibrating mechanism in an imperfect
market is unrealistic and also inconsistent, if assume a perfectly free market it is then arguable that
investors can never profit by switching accounts, advise corp. that there is no opportunity to reduce cost
of capital by judicious adjustment of cost of capital structure and thus, promote complacency, a form of
market imperfection, have underestimated the difficulty of setting up an equivalent return class which is
the cornerstone of MM’s study. Thus, author concluded that, it is not easy to formulate an operational
definition of cost of capital for a dynamic economy.
The Cost of Capital, Corporation Finance, and the Theory of Investment: Reply
Franco Modigliani and Metron H. Miller, Carnegie Institute of Technology
This reply article concerned towards the comments produced by David Durand and J.R. Ross. MM
apologized for their failure to adjust explicitly the definition of a “class” when introducing debt,
concerning the comment by Ross.
Regarding the Durand’s comments, MM believed that further elaboration of the model and approach on
four issues might serve a useful purpose. The phrases and works used in reply contain gives some insight
that MM were not happy with the types and ways of issues raised by Durand.
I. The Ability of Investors and Speculators to Enforce Proposition I: MM gave title to the comments
regarding the arbitrage is semantic, and provide the essential features of arbitrage - the simultaneous
purchase and sale and perfect substitutes. The use of other words like “switch”, “hedge”, “home-made”,
“imperfections” and “noise” are also discussed in a way to support original work and proposition I.
II. The Role of Financial Operations by Corporations: Regarding Durand’s objection that Proposition I
may hold not through the behavior of investors and the argument that MM support the market

3. imperfection, MM defend that Proposition I holds need not mean that the cost of capital is independent of
financial arrangement and noted that it offers no support whatever for the traditional U-shaped cost-of-
capital curve (traditional view). The question of Durand’s like gained by whom? How? are answered as
“he means by the cost of capital” and the process described with example in details. MM argued that
‘there is nothing to do with the market imperfections which are supposedly Durand's main concern not
with the U-shaped cost-of-capital curve which was ours’. Thus, MM concluded that the interpretations of
Durand are different from them.
III. Dividends, Growth Opportunities and the Theory of Share Prices: MM cited regarding the comments
by Durand that “Durand is quite correct in pointing out that we nowhere provided and explicit description
of how our model would explain relative share prices in the face of differential opportunities for growth
by firms.” Based on the issue of share prices discussed on Durand comment, MM tried to sketch out the
theory of share prices and stated that formal proof will be postponed to a forthcoming paper.
IV. The Effect of Dividends on Stock Prices: The Empirical Findings and Their Interpretation: Though
the formal proof on the theory of prices have been omitted, MM propose the original conclusion i.e. that
in a world of perfect markets and rational behavior, firm's dividend policy, other things equal, will have
no effect either on the value of the firm or its cost of capital. We can then take the next step and enquire
whether this conclusion is a valid or useful approximation in real-world capital markets. In general,
dividends turn out to have high gross and net correlations with price. From this, it is concluded that the
MM valuation formula, which involves earnings but not dividends, cannot be an adequate representation
of reality.
V. Conclusion: MM once again add more stones to finance literature more confidently and challenges
the traditional view of capital structure and recommend to Prof. Durand’s comment as premature. In
conclusion, MM stated that the framework developed in original paper has already permitted some
progress.
The Cost of Capital, Corporation Finance, and the Theory of Investment: Comment
Dowson E. Brewer and Jocab B. Michaelsen, University of California
An optimum capital structure exists; the traditional view has been challenged by the MM (1958). They
demonstrated quite convincingly that, within the context of the model's assumptions, arbitrage operations
will make the market value of the firm independent of its capital structure. The purpose of the study is to
show that the implications of the relationship between the expected yield on a firm's shares and its debt-
equity ratio; and between the weighted average of the expected yields on a firm's shares and bonds and its
debt-equity ratio in important respects from what MM supposed them to be, and that even when the
appropriate corrections are made, serious doubt remains as to whether either view can be contradicted by
the data.
I. Implications of the Alternative Views in the Absence of Corporate Income Taxes: MM base their entire
analysis on Proposition I i.e. Proposition II and III are based on I. However, MM failed to recognize that
Proposition I also implies the bond-yield function (r = Pk - (i - pk)S/D). As a result, they posited a form
for Proposition II (i = Pk + (Pk - r) D/S) which is inconsistent with assumption about investors' attitudes
toward risk. In the absence of taxes, the MM model implies a linear horizontal relationship whereas the
traditional view implies a U-shaped one. Observable behavior will reflect the impact of the corporate
income tax so that its effect on the weighted average cost of capital must be taken into account.
II. Implications of the Alternative Views in the Presence of the Corporate Income Tax:
In the presence of the corporate income tax, MM distinguish alternative views in two reasons. First, as
MM recognized the effects of the tax, the forms of the relationship between the weighted average cost of
capital and debt-equity ratios are similar for both views under the tax. Second, and perhaps more
important, the tax provides an incentive for rational managers to use debt. The maximizing behavior is

4. likely to lead to similar debt-equity ratios for all firms in the same risk class; consequently, the
relationship between debt-equity ratios and the average cost of capital (and the expected yield) may be
extremely difficult to estimate from the behavior of firms in a given risk class.
It would appear that firms in a given risk class would have utilized debt up to the limits of the
institutional constraints facing them or up to the optimum amount, if such exists, to maximize value of
levered firm. Under both hypotheses, then, firms in a given class will tend to have the same debt-equity
ratios. Apart from measurement error, wide dispersion probably indicates the inclusion in the sample of
firms from different risk classes. It may, therefore, be necessary to expand both hypotheses to include the
effects of variation of institutional constraints and of optimal debt-equity ratios among risk classes to
determine which of them describes the effects of leverage on market value in the real world. In the
absence of such an undertaking it appears likely that tests quite different from those discussed here will
be necessary to distinguish between the two hypotheses.
The Cost of Capital, Corporation Finance, and the Theory of Investment: Reply
Franco Modigliani and Merton H. Miller
Massachusetts Institute of Technology and University of Chicago
MM made re-comments on Messers, Brewer and Michaelsen’s comments on MM (1958) as ‘they have
underestimated the limitations of their theoretical analysis and overestimated the significance of even
their valid results for empirical applications.’
Issue 1: In the Brewer and Michaelson’s comments, authors did not found anything wrong in their
judgment. The only thing they committed is that no precise definition of “risk aversion” is provided. MM
argued that risk aversion is implied by pk greater than riskless r and the concept of risk aversion may
perhaps have some heuristic (experience base) value for rationalizing the gross behavior of the yield
curves in commonsense terms, also doubt that the term can ever defined with sufficient precision and
generality to derive conclusions.
Issue 2: MM convinced that Brewer and Michaelsen have sound ground in derivation of shape of the
share-yield curve, given or bond-yield curve. However being puzzled as to why they think their
discussion of the curvature properties?
Issue 3: MM defend to next issue of the proper measure of the value of the tax saving on debt. They
blamed commenter’s for misunderstanding of what is meant by the “certainty” of the tax deduction for
interest payment. This means that the amount of the interest deduction for tax purposes is conditional on
the amount of the interest actually paid to the bondholders. If so, the present value of the tax saving on
interest should be computed by discounting the “expected value of the tax saving.” With this justification,
MM stated that their assumption is far better than that implied by Brewer and Michaelsen’s. MM also
mentioned that “they have always acknowledged that we have no completely specified the model to
account for these observed differences, though we think we can see some of the important elements out
of which such a more general theory will someday be built.”
With these replies on different issues, MM concluded, empirical research need not grind to a halt.
Differences in capital structure for whatever reasons do exist and they can be exploited to shed much
light on the controversy over the effects of financial policy on market valuation. The empirical problems
are not easy or straightforward, they represent a most severe challenge to the econometrician.
Overall Conclusion: Despite the rigorous analysis and presentation of the original articles as well as
comments forwarded by the different researchers, the MM’s work seems to be very much strong and
wholeheartedly appreciable. Although, the issues raised by the commenter’s may be beyond the scope of
MM’s study, they provide a platform to discuss the issues and complexities in pioneer work.
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