This blog post makes an article analysis using the keywords of cost of capital, corporate finance, theory of investment, cost of capital vs discount rate and weighted average cost of capital. This analysis is kind of a summary of the article by Franco Modigliani and some reviews on it. You can comment under this blog post about your questions on cost of capital.
Cost of Capital vs Discount Rate
Franco Modigliani and Merton H. Miller collaborated to write the article with the title “The Cost of Capital, Corporate Finance and the Theorty of Investment”. The two writers claim that minimizing tax liability and maximizing corporate wealth can reduce the cost of capital. In this sense, the article can be taken into consideration as an objection to corporate finance’s traditional view. The paper starts with asking a question that says “What is the “cost of capital” to a firm in a world in which funds are used to acquire assets whose yields are uncertain?…” (Modigliani, Miller 1958) and relates the answer of the question with three aspects such as survival and growth, capital budgeting and investment behavior.
Cost of Capital vs Taxes
The writers make some assumptions in their research such as no taxes, bankruptcy costs, transaction costs and also they take the borrowing costs of investors and companies equal and lastly they assume that the investors and companies both have the same level of information. The writers explain these assumptions by saying “ These and other drastic simplifications have been necessary in order to come to grips with the problem at all” (Modigliani, Miller 1958).
In the proportion and theory part, firstly the paper mentions the M&M 1 theory which assumes that there are no bankruptcy costs and no taxes. In the paper, it is stated that “They rely merely on the fact that a given commodity cannot consistently sell at more than one price in the market; or more precisely that the price of a commodity representing a “bundle” of two other commodities cannot be consistently different from the weighted average of the prices of the two components” (Modigliani, Miller 1958). This sentence means that the weighted average cost of capital has to be constant while the capital structure of the company is being changed. M&M 1 theory with corporate taxes states that because of the interest tax, the company that has the greater proportion of debt is more profitable and M&M1 theory without corporate taxes says that there is no importance of a company’s relative equity and proportions.
Weighted Average Cost of Capital
Later, the M&M II theory is mentioned and it deals with the weighted average cost of capital. It simply states that there is a linear correlation between the increase in the proportion of debt in the capital structure of the company and the return of it on equity to shareholders. M&M II with taxes touches upon the corporate tax savings from the deduction of the interest tax. So, the conclusion of M&M II with taxes is weighted average cost of capital is affected by the debt-equality ratio. The weighted average cost of capital decreases as the proportion of debt increases. To compare the two theories of M&M, the main difference is the debt benefit in a capital structure and this heads away from the tax benefit that comes from the interest payments.