1958 The Cost Of Capital, Corporation Finance And

AmericanEconomicAssociationTheCostofCapital,CorporationFinanceandtheTheoryofInvestmentAuthor(s):FrancoModiglianiandMertonH.MillerSource:TheAmericanEconomicReview,Vol.48,No.3(Jun.,1958),pp.261-297Publishedby:AmericanEconomicAssociationStableURL::26/02/200921:51YouruseoftheJSTORarchiveindicatesyouracceptanceofJSTOR'sTermsandConditionsofUse,availableat://=aea.EachcopyofanypartofaJSTORtransmissionmustcontainthesamecopyrightnoticethatappearsonthescreenorprintedpageofsuchtransmission.JSTORisanot-for-profitorganizationfoundedin1995tobuildtrusteddigitalarchivesforscholarship.Weworkwiththescholarlycommunitytopreservetheirworkandthematerialstheyrelyupon,andtobuildacommonresearchplatformthatpromotesthediscoveryanduseoftheseresources.FormoreinformationaboutJSTOR,[e-mail]ioniscollaboratingwithJSTORtodigitize,preserveandextendaccesstoTheAmericanEconomicReview.*Whatisthecostofcapitaltoafirminaworldinwhichfundsareusedtoacquireassetswhoseyieldsareuncertain;andinwhichcapitalcanbeobtainedbymanydifferentmedia,rangingfrompuredebtinstru-ments,representingmoney-fixedclaims,topureequityissues,givingholdersonlytherighttoapro-ratashareintheuncertainventure.?Thisquestionhasvexedatleastthreeclassesofeconomists:(1)thecor-porationfinancespecialistconcernedwiththetechniquesoffinancingfirmssoastoensuretheirsurvivalandgrowth;(2)themanagerialeconomistconcernedwithcapitalbudgeting;and(3)theeconomictheoristconcernedwithexplaininginvestmentbehavioratboththemicroandmacrolevels.'Inmuchofhisformalanalysis,theeconomictheoristatleasthastendedtoside-steptheessenceofthiscost-of-capitalproblembypro-ceedingasthoughphysicalassets-likebonds-couldberegardedasyieldingknown,surestreams.Giventhisassumption,thetheoristhasconcludedthatthecostofcapitaltotheownersofafirmissimplytherateofinterestonbonds;andhasderivedthefamiliarpropositionthatthefirm,actingrationally,willtendtopushinvestmnenttothepoint*Theauthorsare,respectively,professorandassociateprofessorofeconomicsintheGrad-uateSchoolofIndustrialAdministration,CarnegieInstituteofTechnology.ThisarticleisarevisedversionofapaperdeliveredattheannualmeetingoftheEconometricSociety,Decem-ber1956.Theauthorsexpressthanksforthecommentsandsuggestionsmadeatthattimebythediscussantsofthepaper,EvseyDomar,RobertEisnerandJohnLintner,andsubse-quentlybyJ'amesDuesenberry.TheyarealsogreatlyindebtedtomanyoftheirpresentandformercolleaguesandstudentsatCarnegieTechwhoservedsooftenandwithsuchremark-ablepatienceasacriticalforumfortheideasherepresented.1Theliteraturebearingonthecost-of-capitalproblemisfartooextensiveforlistinghere.Numerousreferencestoitwillbefoundthroughoutthepaperthoughwemakenoclaimtocompleteness.Onephaseoftheproblemwhichwedonotconsiderexplicitly,butwhichhasaconsiderableliteratureofitsownistherelationbetweenthecostofcapitalandpublicutilityrates.Forarecentsummaryofthecost-of-capitaltheoryofrateregulationandabriefdis-cussionofsomeofitsimplications,thereadermayrefertoH.M.Somers[201.262THEAMERICANECONOMICREVIEWwherethemarginalyieldonphysicalassetsisequaltothemarketrateofinterest.2Thispropositioncanbeshowntofollowfromeitheroftwocriteriaofrationaldecision-makingwhichareequivalentundercertain-ty,namely(1)themaximizationofprofitsand(2)themaximizationofmarketvalue.Accordingtothefirstcriterion,aphysicalassetisworthacquiringifitwillincreasethenetprofitoftheownersofthefirm.Butnetprofitwillincreaseonlyiftheexpectedrateofreturn,oryield,oftheassetexceedstherateofinterest.Accordingtothesecondcriterion,anassetisworthacquiringifitincreasesthevalueoftheowners'equity,i.e.,ifitaddsmoretothemarketvalueofthefirmthanthecostsofacquisi-tion.Butwhattheassetaddsisgivenbycapitalizingthestreamitgen-eratesatthemarketrateofinterest,andthiscapitalizedvaluewillexceeditscostifandonlyiftheyieldoftheassetexceedstherateofinterest.Notethat,undereitherformulation,thecostofcapitalisequaltotherateofinterestonbonds,regardlessofwhetherthefundsareacquiredthroughdebtinstrumentsorthroughnewissuesofcommonstock.Indeed,inaworldofsurereturns,thedistinctionbetweendebtandequityfundsreduceslargelytooneofterminology.Itmustbeacknowledgedthatsomeattemptisusuallymadeinthistypeofanalysistoallowfortheexistenceofuncertainty.Thisattempttypicallytakestheformofsuperimposingontheresultsofthecertaintyanalysisthenotionofariskdiscounttobesubtractedfromtheex-pectedyield(orariskpremiumtobeaddedtothemarke