GROWTH STOCKS AND CORPORATE CAPITAL STRUCTURE THEORY

Abstract

MORE THAN A DECADE AGO, with respect to the validity of Modigliani and Miller's homemade leverage thesis-namely, their Propositions I and II (see [24, 25])-under growth, Durand [6] expressed pointed skepticism by arguing that the said thesis is valid only under perfect markets where the market value of stock equals its book value.' Since then many others have questioned the validity-and consistency-of the propositions under growth, resting their theoretical as well as empirical analysis on the traditional valuation model,2 eminently set forth by Williams [34]. On the other hand, MM [25, 29, 30] have not only reaffirmed their original conclusions under growth but also have provided extensive tests of their statistical model [29, p. 348], which, in view of the foregoing, is not unequivocal.3 The purpose of this paper is to examine some of the theoretical issues bearing on the specification of empirically testable models concerning the effect of capital structure on the firm valuation. The motivation for doing so stems in particular from Durand's arguments and in general from the controversial nature of the subject. Insofar as the validity of the capital structure irrelevance proposition is in the final analysis an empirical issue, this paper takes the consistency of the MM Propositions I and II as a useful guide in generating several hypotheses that could be imbedded in the structural form of econometric models. Section I provides a brief introduction to the relevant literature. In Section II, some earlier results (contained in [15, 16, 12]) are succinctly