American Economic Association
The Cost of Capital, Corporation Finance and the Theory of Investment Author(s): Franco Modigliani and Merton H. Miller Source: The American Economic Review, Vol. 48, No. 3 (Jun., 1958), pp. 261-297 Published by: American Economic Association Stable URL: http://www.jstor.org/stable/1809766 Accessed: 10/09/2009 09:51 Your use of the JSTOR archive indicates your acceptance of JSTOR's Terms and Conditions of Use, available at http://www.jstor.org/page/info/about/policies/terms.jsp. JSTOR's Terms and Conditions of Use provides, in part, that unless you have obtained prior permission, you may not download an entire issue of a journal or multiple copies of articles, and you may use content in the JSTOR archive only for your personal, non-commercial use. Please contact the publisher regarding any further use of this work. Publisher contact information may be obtained at http://www.jstor.org/action/showPublisher?publisherCode=aea. Each copy of any part of a JSTOR transmission must contain the same copyright notice that appears on the screen or printed page of such transmission. JSTOR is a not-for-profit organization founded in 1995 to build trusted digital archives for scholarship. We work with the scholarly community to preserve their work and the materials they rely upon, and to build a common research platform that promotes the discovery and use of these resources. For more information about JSTOR, please contact email@example.com.
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THE COST OF CAPITAL, CORPORATION FINANCE AND THE THEORY OF INVESTMIENT By
FRANCO MODIGLIAN1 AND MERTON H. MILLER*
What is the "cost of capital" to a firm in a world in which funds are used to acquire assets whose yields are uncertain; and in which capital can be obtained by many different media, ranging from pure debt instruments, representing money-fixed claims, to pure equity issues, giving holders only the right to a pro-rata share in the uncertain venture.? This question has vexed at least three classes of economists: (1) the corporation finance specialist concerned with the techniques of financing firms so as to ensure their survival and growth; (2) the managerial economist concerned with capital budgeting; and (3) the economic theorist concerned with explaining investment behavior at both the micro and macro levels.'
In much of his formal analysis, the economic theorist at least has tended to side-step the essence of this cost-of-capital problem by proceeding as though physical assets-like bonds-could be regarded as yielding known, sure streams. Given this assumption, the theorist has concluded that the cost of capital to the owners of a firm is simply the rate of interest on bonds; and has derived the familiar proposition that the firm, acting rationally, will tend to push investmnent to the point * The authors are, respectively, professor and associate professor of economics in the Graduate School of Industrial Administration, Carnegie Institute of Technology. This article is a revised version of a paper delivered at the annual meeting of the Econometric Society, December 1956. The authors express thanks for the comments and suggestions made at that time by the discussants of the paper, Evsey Domar, Robert Eisner and John Lintner, and subsequently by J'ames Duesenberry. They are also greatly indebted to many of their present and former colleagues and students at Carnegie Tech who served so often and with such remarkable patience as a critical forum for the ideas here presented. 1 The literature bearing on the cost-of-capital problem is far too extensive for listing here. Numerous references to it will be found throughout the paper though we make no claim to completeness. One phase of the problem which we do not...
References: 1. F. B. ALTLEN, "Does Going into Debt Lower the 'Cost of Capital '?," A nalysts Jour., Aug. 1954, 10, 57-61. 2. J. DEAN, Capital Budgeting. New York 1951. 3. D. DURAND, "Costs of Debt and Equity Funds for Business: Trends and Problems of Measurement" in Nat. Bur. Econ. Research, Conference on Research in Business Finance. New York 1952, pp. 215-47. 4. W. J. EITEMAN, "Financial Aspects of Promotion," in Essays on Business Finance by M. W. Waterford and W. J. Eiteman. Ann Arbor, Mich. 1952, pp. 1-17. 5. M. J. GORDON and E. SHAPIRO, "Capital Equipment Analysis: The RequfiredRate of Profit," Manag. Sci., Oct. 1956, 3, 102-10.
MODIGLIANI AND MILLER: THEORY OF liNVESTMENT
6. B. GRAHAM and L. DODD, Security Analysis, 3rd ed. New York 1951. 7. G. GUTHMANN and H. E. DOUGALL, CorporateFinancial Policy, 3rd ed. New York 1955. 8. J. R. HICKS, Value and Capital, 2nd ed. Oxford 1946. 9. P. UIUNT and M. WILLIAMS, Case Problems in Finance, rev. ed. Homewood, Ill. 1954. 10. J. M. KEYNES, The Genzeral Theory of Employment, Interest and Money. New York 1936. 11. 0. LANGE, Price Flexibility and Employment. Bloomington, Ind. 1944. 12. J. LINTNER, "Distribution of Incomes of Corporations among Dividends, Retained Earnings and Taxes," Am.. Econ. Rev., Mfay1956, 46, 97-113. 13. F. LUTZand V". LUTZ, The Theory of Investment of the Firm. Princeton 1951. 14. F. MODIGLIANI and M. ZEMAN, "The Effect of the Availability of Funds, and the Terms Thereof, on Business Investment" in Nat. Bur. Econ. Research, Conference on Research in Business Finance. New York 1952, pp. 263-309. 15. WV. MORTON, "The Structure of the Capital Market and the Price of A. Money," Am. Econ. Rev., May 1954, 44, 440-54. 16. S. M. ROBBINS, Managing Securities. Boston 1954. 17. H. V. ROBERTS, "Current Problems in the Economics of Capital Budgeting," Jour. Bus., 1957, 30 (1), 12-16. 18. D. T. SMITH, Effects of Taxation on CorporateFiniancial Policy. Boston 1952. 19. R. SMITH, "Cost of Capital in the Oil Industry," (hectograph). Pittsburgh: Carnegie Inst. Tech. 1955. 20. H. M. SOMERS, " 'Cost of MAoney ' as the Determinant of Public Utility Rates," Buffalo Law Rev., Spring 1955, 4, 1-28. 21. J. B. WILLIAMS, The Theory of Investment Value. Cambridge, Mass. 1938. 22. U. S. Federal Communicatiolns Commission, The Problem of the "Rate of Return" in Public Utility Regulation. Washington 1938.
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