David Durand, “The Cost of Capital, Corporation Finance, and the Theory of Investment: Comment”, American Economic Association, Vol. 49, No. 4 (Sep., 1959), pp. 639-655. Purpose of the paper
The focus of this paper is to contradict the results of [Franco Modigliani; Merton H. Miller, “The Cost of Capital, Corporation Finance, and the Theory of Investment: Comment”, American Economic Review, June 1958, 48,261-97] (hereafter MM) assumptions in related to cost of capital theory. Foundations
This paper starts with creating unrealistic four foundations that can’t be found anywhere in the real market, but they are in need to backup the possibility of the main example in this paper, which illustrates MM’s assumptions about Propositions I, and the assumptions are: 1. Arbitrage is possible between securities in an equivalent return class. 2. We have a “Hybrid Firm” that doesn’t fill in the will known company categories; it has marketable securities like a corporation, proration of income like a partnership and allocation of financial responsibility like neither. 3. Exclude risk.
4. Long-run equilibrium.
Petrolease, Leverfund Example
The example starts by presenting two companies, Petrolease which is a fictitious corporation whose business consists in leasing oil properties; it earns $10 per share on the average, all of which it pays out in dividends. Leverfund is a fictitious open-end investment trust, whose assets consist solely of Petrolease shares and operates under the following conditions: 1. Assets consist solely of Petrolease shares
2. 1 share of Petrolease = 1 Share of Stock and $100 bond at Interest rate 0.05 (Enforce the arbitrage). 3. Incurs no expenses and pays out all earnings (No additional costs or any kind of risk) 4. open-end fund (Leverfund assets are tradable in open market) a. Issue 1 share + 1 bond = adding 1 share Petrolease
b. Demand 1 share + 1 bond = subtract 1 share Petrolease 5. No...