REVEALED PREFERENCE METHODS AND THE PURE THEORY OF THE COST OF CAPITAL

Abstract

IN A CLASSIC 1958 PAPER Professors Modigliani and Miller (MM) [6] showed, given assumptions of 1) existence of equivalent return classes, 2) perfect capital markets (i.e. no taxes, transactions costs, etc.) with atomistic competition prevailing and 3) existence of a bond market in which both firms and investors can borrow at same certain rate of interest, that the market value of any firm is independent of its capital structure From this it directly follows that . average cost of capital to any firm is completely independent of its capital structure The equivalent return or were deemed to be closely related to industry groupings, identifiable only by resort to empirical methods (footnote 9). The conclusions reached by authors in paper are substantiated by invoking arguments within these classes. Needless to say, a part of literature subsequently generated dealt with rationality of assumption of risk classes and effectiveness of process in establishing desired relations. Unfortunately arguments made along these lines are empty ones. The very same authors, some years later in a footnote to an equally prominent paper [5, footnote 26], recognize (in discussion of dividend policy) that and arbitrage are unnecessary. But it wasn't until some years later that theorists took up challenge to prove propositions set forth in original work sans arbitrage and, in fact, this original method of proof is reproduced in virtually all corporate finance texts. Hirshleifer [2], [3], [4] was apparently first on record to show that MM holds without arbitrage. He employed state-preference approach to analyze investor choice under risk. Robichek and Myers [9] extend analysis of capital structure in state-preference framework and find that with respect to Proposition I, no restrictions are necessary concerning possible growth patterns in operating income. In addition an original assumption of homogeneous expectations [6, p. 129] is unnecessary. However, riskless borrowing assumption is required since costly bankruptcy will lead to a violation of Proposition I. An additional ceteris paribus assumption is required since it is possible for changes in future investment and financing decisions made in conjunction with (current) capital structure decision to result in a deviation from market value invariance.