Theory of Investment
Theory of Investment
“In a perfect capital market, the total value of a firm is equal to the market
value of the total cash flows generated by its assets and is not affected by
its choice of capital structure.”
- i.e. a firm with pure equity financing and one with leveraged financing
will have the same market value
- If otherwise identical firms with different capital structures have
different values, the Law of One Price would be violated and an
arbitrage opportunity would exist.
According to Proposition I, the
average cost of capital within a
given class k should tend to
have the same value
independently of the degree of
leverage.
- i.e. the cost of equity is a linear function of the firm’s debt to equity ratio. The
higher the debt, the higher the required return on equity.
According to our Proposition II the
expected yield on common stock,,
in any given class, should tend to
increase with leverage as
measured by the ratio D/S. The
relation should tend to be linear
and with positive slope.
- It can be shown that "arbitrage" will make values within any class a function
not only of expected after-tax returns, but of the tax rate and the degree of
leverage.
- This means that the tax advantages of debt financing are somewhat greater
than they originally suggested and, to this extent, the quantitative difference
between the valuations implied by their position and by the traditional view is
narrowed
Implications – Investment & Proposition III
Proposition III – “The cut-off point for investment in the firm will in all cases be Pk
and will be completely unaffected by the type of security used to finance the
investment”
This is illustrated using bonds, retained earnings, and common stock for financing
Proposition III deems the variety of instrument used in financing immaterial to the
evaluation of the investment
“People often ask: Can you summarize your theory quickly? Well, I say, you
understand the M&M theorem if you know why this is a joke: The pizza delivery
man comes to Yogi Berra after the game and says, “Yogi, how do you want this
pizza cut, into quarters or eighths?” And Yogi says, “Cut it in eight pieces. I’m
feeling hungry tonight.” Everyone recognizes that’s a joke because obviously the
number and shape of the pieces don’t affect the size of the pizza. And similarly,
the stocks, bonds, warrants, et cetera, issued don’t affect the aggregate value of
the firm. They just slice up the underlying earnings in different ways.”
Conclusion