This document summarizes a seminar presentation on Franco Modigliani and Merton Miller's seminal work on the cost of capital and capital structure. The presentation outlines Modigliani and Miller's original theory, as well as comments and critiques by other researchers including David Durand and Dowson Brewer and Jocab Michaelsen. Modigliani and Miller then provide replies to the various comments, defending their original theory while acknowledging some limitations and areas for further development. Overall the discussion analyzes the implications and complexities of Modigliani and Miller's groundbreaking theory on how a firm's value and cost of capital are independent of its capital structure.

1. COURSE TITLE: SEMINAR IN FINANCE COURSE CODE: MPH 622
Presentation on
The cost of capital, corporation finance, and
the Theory of Investment: Comment
by:
David Durand
Massachusetts Institute of Technology
Published in: The American Economic Review, Vol. XLIX, No. 4, September 1959, pp. 639-55.
16th April, 2011

2. Presentation Outline
 The cost of capital, corporation finance, and the Theory of
Investment
Prof. David Durand
 The Cost of Capital, Corporation Finance, and the Theory of
Investment: Reply
Franco Modigliani and Metron H. Miller
 The Cost of Capital, Corporation Finance, and the Theory of
Investment: Comment
Dowson E. Brewer and Jocab B. Michaelsen
 The Cost of Capital, Corporation Finance, and the Theory of
Investment: Reply
Franco Modigliani and Metron H. Miller

3. Background
MM 1958 have articulated three propositions
that contradict widely accepted beliefs against
traditional view of capital structure.
The Proposition I is the basic, which states, in a
perfect market, the total value of all
outstanding securities of a firm is independent
of its capital structure.

4. Back…..
Assumptions for Proposition I
i) Arbitrage is possible between securities in an
equivalent return class
ii) A firm falls into none of the standard ownership
categories but is a sort of hybrid
iii) Exclude risk, and
iv) A long-run equilibrium in which stocks sell at
book value.
Comment: unrealistic
Objective: To expose the difficulties of justifying MM
proposition I.

5. Arbitrage is a powerful equalizer; but it is not
ordinarily possible in corporate securities when
there is lack of perfect substitution of security.
Effectiveness of arbitrage depends upon the
equivalence of exchange not upon equivalence of
income.
Suggested substitute for arbitrage are hedge position,
the switching of investment, and the financial
operations.
MM states switching exist between levered and
unlevered firms and arbitrage occurs. (No premium
for levered over unlevered firm)
I. Proposition I and Arbitrage

6. 1950 1959
S&P bond Return 2.60% 4.30%
Dividend Yield 5.35% 3.90%
Earnign Yield 8.10% 5.40%
Opportunity Bond finance Sell bonds
Investors have the opportunity of borrowing on
personal account. But, only a limited opportunity for
most investors.
In practice, those who seek to reduce capital cost by
adjusting capital structure must ascertain conditions
in the current market, and act rapidly to exploit
them.

7. II. Market Imperfections:
Restrictions on Margin Buying
 Produced comments on the grounds
 MM visualize a highly competitive market
 If market deviates it provides an opportunity for profit
but whom?
 Bond issue requires time to arrange
 Why discriminate against the corporations?
 Legal issues on margin buying. Margin buying permitted
small investors but restrict many of the largest
investors.

8. III. The Risks of Margin Buying
MM’s no additional risk of switching
does not apply in a world of high risk.
All bonds are assumed to yield a
constant income regardless of the issuer
but which is also doubtful.

9. IV. The Problem of Retention
and Growth
100% dividend payout is not a realistic.
If, yes. price (Po) = book value (Bo).
Retain and reinvest means change in growth and the
book value of the stock and price. Stocks do not sell in
book value.
MM neglect to set the price (Pf) at which the
hypothetical transaction takes place.
NXppXApPf k )*/()1(*  suggested by Todhunter (1937)

10. The regression results in table-1 showed that
the successive reductions in the RSS as
addition of earning, and dividend payout ratio.
Table-2 another regression price/book on
earning/book and dividend/earning shows
that the reduction in RSS is significant.
Based on these results, it is concluded that
dividend policy exerts an influence on stock
prices and the cost of capital.

11. V. Problems of Empirical
Analysis
The empirical analysis on capital structure
encounters bunch of obstacles like
Lack of reliable and pertinent data like price
quotations, dividend rates, earnings
Difficulties of assembling a sample of
corporations.
Type of analysis
Homogenous stock groups, etc.

12. The cost of capital, corporation finance,
and the Theory of Investment: Reply
by:
Franco Modigliani and Metron H. Miller
Carnegie Institute of Technology
Published in: The American Economic Review, Vol. XLIX, No. 4, September 1959,
pp. 655-59.

13. Reply
 Reply on comments by David Durand and J.R.
Ross.
 J.R. Ross - MM apologized for their failure to
adjust explicitly the definition of a “class” when
introducing debt.
 D. Durand - MM believed that further
elaboration of the model and approach on four
issues.

14. Reply
I. The Ability of Investors and Speculators to
Enforce Proposition I:
 MM argued for the comments on arbitrage is
semantic, and describes the features of
arbitrage - the simultaneous purchase and sale
and perfect substitutes.
 Further defined the use of other words like
“switch”, “hedge”, “home-made”,
“imperfections” and “noise” and paved the way
to support original paper.

15. Reply
II. The Role of Financial Operations by
Corporations:
 Durand raised the issue on Proposition I and
regarding MM’s support for the market
imperfection.
 MM defend that it offers no support
whatever for the traditional U-shaped cost-
of-capital curve (traditional view).

16.  MM clarify on the queries like “gained by
whom? How?” as “he means by the cost of
capital” and the process described with
examples.
 Imperfections - MM concluded that the
interpretations of Durand are different
from them.

17. Reply
III. Dividends, Growth Opportunities and the
Theory of Share Prices:
 Based on the issued raised by Durand MM
tried to sketch out the theory of share
prices and stated that formal proof will be
postponed to a forthcoming paper.

18. Reply
IV. The Effect of Dividends on Stock Prices: The
Empirical Findings and Their Interpretation:
 As MM only sketch out the pricing theory
and formal proof on the theory of prices
remains for the next paper.
 MM propose the original conclusion i.e. in a
world of perfect markets and rational
behavior, firm's dividend policy, other things
equal, will have no effect either on the value
of the firm or its cost of capital.

19. The cost of capital, corporation finance,
and the Theory of Investment:
Comment
by:
Dowson E. Brewer and Jocab B. Michaelsen
University of California
Published in: The American Economic Review, Vol. LV, No. 3, June 1965, pp. 516-24.

20. Comment
 Optimum capital structure exists (traditional
view) vs. arbitrage operations will make the
market value of the firm independent of its
capital structure (MM 1958).
 The purpose of the study is to show that the
implications of the relationship between
 i) The expected yield on a firm's shares and its debt-
equity ratio; and
 ii) The weighted average of the expected yields on a
firm's shares and bonds and its debt-equity ratio.

21. I. Implications of the Alternative Views in
the Absence of Corporate Income Taxes
 All MM propositions are based on
Proposition I. However, MM failed to
recognize that Proposition I also implies
the bond-yield function(r = Pk - (i -
pk)S/D).
 In the absence of taxes, the MM’s a linear
horizontal relationship whereas the
traditional view implies a U-shaped

22. II. Implications of the Alternative Views in
the Presence of the Corporate Income
Tax
 In the presence of the corporate income tax,
MM distinguish alternative views in two
reasons.
 First, the relationship between the weighted
average cost of capital and debt-equity ratios are
similar for both views under the tax.
 Second, and perhaps more important, the tax
provides an incentive for rational managers to use
debt.

23.  Finding of positive
curvature is consistent
with both hypotheses.
 In the absence of taxes,
only a finding of negative
curvature can serve to
distinguish the
alternative views.
In capital structure, it would appear that firms in a
given risk class would have utilized debt up to the
limits of the institutional constraints or up to the
optimum amount, the value of the levered firm would
maximize.

24. The cost of capital, corporation finance,
and the Theory of Investment: Reply
by:
Franco Modigliani and Merton H. Miller
Massachusetts Institute of Technology and University of Chicago
Published in: The American Economic Review, Vol. LV, No. 3, June 1965, pp. 524-27.

25. Reply
Issue 1
 Brewer and Michaelson (BM)’s comments
are mostly in favor of MM’s work. Except,
 No precise definition of “risk aversion.”
 MM defended that risk aversion is implied
by pk >riskless r, and the concept of risk
aversion may perhaps have some heuristic
value.

26. Reply
Issue 2
 MM convinced that BM have sound
ground in derivation of shape of the
share-yield curve, given or bond-yield
curve.
 However, puzzled as to why they think
their discussion of the curvature
properties?

27. Reply
Issue 3
 MM defend on measure of the value of the tax
saving on debt. They blamed commenter's for
misunderstanding of what is meant by the
“certainty” of the tax deduction for interest
payment.
 With this justification, MM stated that their
assumption is far better than that implied by
Brewer and Michaelsen’s.

28. Overall Conclusion
 Despite the rigorous analysis and presentation
of the original articles as well as comments
forwarded by different researchers, It seems
that MM’s work is very much strong and
wholeheartedly appreciable.
 The issues raised as comments may be beyond
the scope of MM’s study but they provide a
platform to discuss the issues and complexities
in pioneer work.

29. Thank you.