The chapter discusses the validity of Modigliani and Miller propositions on ‘’Cost of Capital’’ after thirty years of their intense scrutiny and bitter controversy. Author in the very beginning of the chapter declares that some of the propositions now stand settled. For Instance, Proposition I, according to which, value of the firm is independent of its capital structure, is now accepted as an implication of equilibrium in perfect capital markets and also, the so called M and M propositions apart from corporate finance, have now spread beyond the filed of banking, fiscal policy and international finance. Thus, it is clear that proposition I is now accepted in economic theory but the chapter deals with the still undecided emperical significance of the MM Proposition I in its original field of corporate finance.
He cites that this approach could not be validated during 1958 because then people had to be convinced that there could be conditions, even in a frictionless world, where a firm would be indifferent between issuing securities as different in legal status, investor risk and apparent cost as debt and equity. Interest rate on debt at that time was 3-5 percent while cost of equity was 15-20 percent and the paradox of indifference(line 7-8 of this paragraph) in the face of such huge spreads in the apparent cost of financing was resolved by Proposition II, which indicated that when Proposition I held, the cost of equity capital was a linear increasing function of the debt/equity ratio. Thus, any gains from using more of what might seem to be the cheaper debt capital would thus be offset by the correspondingly higher cost of the now riskier equity capital. He concluded the initial discussion, that both Proportion I and Proportion II implied that the weighted average cost of these cost of capital to a firm will remain the same no matter what combination of financing sources the firm actually does.
Further, taking his discussion to an extended level, author cited the name of David Durand and said that it was who introduced two polar approaches to valuing shares. First, that the investors shall ignore the firm’s then existing capital structure and will prize the whole firm by capitalizing its operating earnings before interest and taxes. However, David himself rejected his own view in favor of conventional view that investors capitalized the firm’s net income after interest and taxes with only a loose, qualitative adjustment for the degree of leverage in the capital structure.
Finally, after discussing his own propositions relating one value and with taxes propositions, he concludes the chapter by commenting on MM propositions and recent tax reforms. According to him, he agrees that any debt and equity equilibrium if achieved by corporate sector in 1980’s by balancing cost of debt finance against MM tax gains from leverage must surely have been shattered by the Tax Reform Act of 1986 and the profession may even see changes in tax regime drastic enough for the path of return to a new equilibrium to stand out sharply against the background of market noise.
Works Cited
Miller, M. The Modigliani and Miller Proposition after thirty years. In Risk Management (pp. 127-140). Chicago: University of Chicago.
