Generalization of the Modigliani–Miller Theory for the Case of Variable Profit

Abstract

AbstractFor the first time, we have generalized the world-famous theory by Nobel Prize winners Modigliani and Miller for the case of variable profit, which significantly extends the application of the theory in practice, specifically in business valuation, ratings, corporate finance, etc. We demonstrate that all the theorems, statements and formulae of Modigliani and Miller are changed significantly. We combine theoretical and numerical (by MS Excel) considerations. The following results are obtained: 1. Discount rate for leverage company changes from the weighted average cost of capital, WACC, to WACC − g (where g is growing rate), for a financially independent company from k0 to k0 − g. This means that WACC and k0 are no longer the discount rates as it takes place in case of classical Modigliani–Miller theory with constant profit. WACC grows with g, while real discount rates WACC − g and k0 − g decrease with g. This leads to an increase of company capitalization with g. 2. The tilt angle of the equity cost ke(L) grows with g. This should change the dividend policy of the company, because the economically justified value of dividends is equal to equity cost. 3. A qualitatively new effect in corporate finance has been discovered: at rate g < g* the slope of the curve ke(L) turns out to be negative, which could significantly alter the principles of the company’s dividend policy. KeywordsGeneralization of Modigliani and Miller theoryVariable profitCompany capitalizationEquity costThe weighted average cost of capitalWACC