Firm-Theoretic Limitations on Proposition III

Firm-Theoretic Limitations on Proposition III This paper builds on work by Thomadakis [1976] and Peyser [1981] who demonstrated that a disparity normally exists between the "capitalization" rate and the "cutoff" rate. Modigliani and Miller [1958] maintained that the two rates are equal in the absence of capital structure changes and corporate taxation. However, they neglected to analyze the effects of the firm's demand and production functions on the comparative risks embedded in average and marginal returns. This paper used a certainty-equivalence approach to show that the difference in these risks is the source of the disparity and that the firm's demand and production characteristics magnify or attenuate it. Although knowledge of the cutoff rate is necessary for determining the optimal scale of investment, it is not directly observable. However, the cutoff rate turns out to be imputable from an algebraic function of the capitalization rate and either the Lerner Index or Tobin's q ratio. Because common measures of the Lerner Index implicitly assume away the conditions that are necessary to produce disparate discount rates, the q ratio appears to be the preferred alternative for the purpose at hand. http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png Review of Quantitative Finance and Accounting Springer Journals

Firm-Theoretic Limitations on Proposition III

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Publisher
Springer Journals
Copyright
Copyright © 1999 by 1999 Kluwer Academic Publishers, Boston. Manufactured in The Netherlands.
Subject
Finance; Corporate Finance; Accounting/Auditing; Econometrics; Operation Research/Decision Theory
ISSN
0924-865X
eISSN
1573-7179
D.O.I.
10.1023/A:1008372708975
Publisher site
See Article on Publisher Site

Abstract

This paper builds on work by Thomadakis [1976] and Peyser [1981] who demonstrated that a disparity normally exists between the "capitalization" rate and the "cutoff" rate. Modigliani and Miller [1958] maintained that the two rates are equal in the absence of capital structure changes and corporate taxation. However, they neglected to analyze the effects of the firm's demand and production functions on the comparative risks embedded in average and marginal returns. This paper used a certainty-equivalence approach to show that the difference in these risks is the source of the disparity and that the firm's demand and production characteristics magnify or attenuate it. Although knowledge of the cutoff rate is necessary for determining the optimal scale of investment, it is not directly observable. However, the cutoff rate turns out to be imputable from an algebraic function of the capitalization rate and either the Lerner Index or Tobin's q ratio. Because common measures of the Lerner Index implicitly assume away the conditions that are necessary to produce disparate discount rates, the q ratio appears to be the preferred alternative for the purpose at hand.

Journal

Review of Quantitative Finance and AccountingSpringer Journals

Published: Oct 19, 2004

References

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