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The American economic Revlew VOLUME XLVIII JUNE 1958 NUMBER THREE THE COST OF CAPITAL, CORPORATION FINANCE AND THE THEORY OF INVESTMIENT By FRANCO MODIGLIAN1 AND MERTON H. MILLER* What is the "cost of capital" to a firm in a world in which funds are used to acquire assets whose yields are uncertain; and in which capital can be obtained by many different media, ranging from pure debt instruments, representing money-fixed claims, to pure equity issues, giving holders only the right to a pro-rata share in the uncertain venture.? This question has vexed at least three classes of economists: (1) the corporation finance specialist concerned with the techniques of financing firms so as to ensure their survival and growth; (2) the managerial economist concerned with capital budgeting; and (3) the economic theorist concerned with explaining investment behavior at both the micro and macro levels.' In much of his formal analysis, the economic theorist at least has tended to side-step the essence of this cost-of-capital problem by proceeding as though physical assets-like bonds-could be regarded as yielding known, sure streams. Given this assumption, the theorist has concluded that the cost of capital to the owners of a firm is simply the rate of interest on bonds; and has derived the familiar proposition that the firm, acting rationally, will tend to push investmnent to the point * The authors are, respectively, professor and associate professor of economics in the Graduate School of Industrial Administration, Carnegie Institute of Technology. This article is a revised version of a paper delivered at the annual meeting of the Econometric Society, December 1956. The authors express thanks for the comments and suggestions made at that time by the discussants of the paper, Evsey Domar, Robert Eisner and John Lintner, and subsequently by J'ames Duesenberry. They are also greatly indebted to many of their present and former colleagues and students at Carnegie Tech who served so often and with such remark-able patience as a critical forum for the ideas here presented. 1 The literature bearing on the cost-of-capital problem is far too extensive for listing here. Numerous references to it will be found throughout the paper though we make no claim to completeness. One phase of the problem which we do not consider explicitly, but which has a considerable literature of its own is the relation between the cost of capital and public utility rates. For a recent summary of the "cost-of-capital theory" of rate regulation and a brief discussion of some of its implications, the reader may refer to H. M. Somers [201. 262 THE AMERICAN ECONOMIC REVIEW where the marginal yield on physical assets is equal to the market rate of interest.2 This proposition can be shown to follow from either of two criteria of rational decision-making which are equivalent under certainty, namely (1) the maximization of profits and (2) the maximization of market value. According to the first criterion, a physical asset is worth acquiring if it will increase the net profit of the owners of the firm. But net profit will increase only if the expected rate of return, or yield, of the asset exceeds the rate of interest. According to the second criterion, an asset is worth acquiring if it increases the value of the owners' equity, i.e., if it adds more to the market value of the firm than the costs of acquisition. But what the asset adds is given by capitalizing the stream it generates at the market rate of interest, and this capitalized value will exceed its cost if and only if the yield of the asset exceeds the rate of interest. Note that, under either formulation, the cost of