Alexander A. Robichek

Problems in the Theory of Optimal Capital Structure

This paper considers several related problems in the theory of optimal capital structure for corporations. It is divided into four sections, which may be briefly summarized as follows.1. Modigliani and Miller (MM) proposed that under the assumption of perfect markets and in the absence of taxes on corporate income, the total market value of the firm is unaffected by leverage. They showed that the leverage irrelevance proposition holds for “non-growth†firms when all investors agree in their estimates of the expected amount and the risk of each firms future earnings. In section I, we show that this conclusion is not affected by growth trends or heterogeneous investor expectations. However, our analysis uncovers several additional assumptions which must be made explicitly for MMs Proposition I to hold. These additional assumptions pertain to the effects of leverage on the firms future financing needs and future investment decisions. The generalized state-preference framework used for this demonstration is retained for subsequent discussion.

Risk and the Value of Securities

In retrospect, writing about “risk and valuation†is somewhat akin to killing Hydra, the mythical, many-headed creature which would grow two heads whenever one was cut off. It is only fair to admit at the outset that I cannot lay claim to have slain the beast. As a matter of fact, by the time the reader finishes the article, he may have concluded that the beast has more heads than ever!