This paper presents a new derivation of the Modigliani and Miller (1958, 1963, 1966) propositions using the simple model of capital market equilibrium with incomplete information presented in Merton (1987). The model is used to relate the maximization of stockholder expected utility to the selection of assets and to the financing and investment decisions within firms in a context of incomplete information. Expressions of the cost of capital are presented with and without corporate taxes in the presence of shadow costs of incomplete information.
JEL: G11, G12, G31, G32
Keywords: Incomplete information; Cost of capital; Arbitrage
The effects of uncertainty in financial and economic decision making have been studied without an explicit treatment of the implications of information uncertainty. The main conceptual frameworks are provided first by Modigliani and Miller, MM, (1958, 1963,1966). These authors develop a homogenous risk-class concept in order to eliminate the need for a general equilibrium model. Markowitz (1952), Sharpe (1964), Limner (1965) and Mossin (1966) provide a basis for making investment decisions using the market model or the capital asset pricing model. Hirshleifer (1964, 1965, 1966) provides a time-state preference approach to prove the Modigliani and Miller, MM no-tax proposition I. Unfortunately, this last approach does not lead to practical decision rules for capital budgeting within the firm.
This paper derives the three MM Propositions using Merton's (1987) model of capital market equilibrium under incomplete information. The use of Merton's (1987) model is motivated by the increasing importance of information and its role in the process of valuation of firms and their assets. An important question in financial economics is how frictions affect equilibrium in capital markets since in a world of costly information, some investors will have incomplete information. As in Hamada (1969), this approach avoids the arbitrage proof in MM, the risk class assumption. The new derivation follows the analysis in Hamada (1969). A model is used relating the maximization of stockholder expected utility to the portfolio selection to, the financing and investment decisions in the corporation. This analysis provides a link between two branches of finance.
Differences in information are important in financial and real markets. They are used in several contexts to explain some puzzling phenomena like the "home equity bias", the "weekend effect", "the smile effect", etc. Kadlec and McConnell (1994) conclude that Merton's shadow cost of incomplete information, reflects also the elasticity of demand and that it may proxy for the adverse price movement aspect of liquidity.(footnote 19, page 629). Foerster and Karolyi (1999) construct an empirical proxy for the shadow cost of incomplete information for each firm, using the methodology in Kadlec and McConnell (1994). Their results are supportive of the Merton (1987) hypothesis and consistent with Kadlec and McConnell (1994). There is a main difference between Merton's (1987) model and the model in Peress (2000). In both models agents spend time and resources to gather information about the security's payoff, but in Merton's model investors are not all aware of the existence of the security but, if they are, they have information of the same quality.
Merton (1987) advances the investor recognition hypothesis in a mean-variance model. This assumption explains the portfolio formation of informationally constrained investors (ICI). The investor recognition hypothesis (IRH) in Merton's context states that investors buy and hold only those securities about which they have enough information.
Merton (1987) adapts the rational framework of the static CAPM to account for incomplete information. Increasing empirical support for IRH-consistent behavior appeared in Falkenstein (1996), Huberman (1999), Shapiro (2000) among others. …