Leverage, Diversification and Capital Market Effects on a Risk‐adjusted Capital Budgeting Framework

Tuttle, Donald L.; Litzenberger, Robert H.

doi:10.1111/j.1540-6261.1968.tb00818.x

Cited by 48 publications

(25 citation statements)

References 9 publications

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“…17. MM, for example, were careful in [16] to note the limitations of their cost of capital analysis. One could also cite Tuttle and Litzenberger [27], Hamada [8] …”

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Interactions of Corporate Financing and Investment Decisions-Implications for Capital Budgeting

Myers¹

1974

The Journal of Finance

142

108

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INTkODUCTIONEveryone seems to agree that there are significant interactions between corporate financing and investment decisions. The most important argument to the contrary -embodied in Modigliani and Miller's (MM's) famous Proposition I -specifically assumes the absence of corporate income taxes; but their argument implies an interaction when such taxes are recognized.Interactions may also stem from transaction costs or other market imperfections. Also, assume that:Available investment opportunities can absorb $1 million at most. The investment generates a perpetual stream of after-tax cash flows.Let the expected average value of these flows be c • In this case C = .09y. 2.Assume the market will capitalize the retutms at a rate p_ = .10. Thus, if all-equity financing is used, these assets generate a net present value of -$.10 per dollar Invested.3.New debt is limited to 40 percent of new Investment. 4.The firm has $800,000 in cash available. 5.Any excess cash is paid out in dividends.6.The additions to debt and equity are expected to be permanent.In order to specify the objective function in the simplest possibly way, I will assume that MM's view of the world is correct.If so, it is sufficient to maximize the overall market value of the firm. V is given V = V + PVTS (1) where V = the market value of the firm given all-equity financing, and PVTS = the present value of tax savings due to corporate debt. The problem is to maximize \p, subject to:0^= Yt -Z^1 0, t = 0, 1, . . ., T.0^= """j^jtThe borrowing rate, r, is assumed constant for simplicity, as is the corporate tax rate t. In general, r will be a function of the other variables. III.

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“…17. MM, for example, were careful in [16] to note the limitations of their cost of capital analysis. One could also cite Tuttle and Litzenberger [27], Hamada [8] …”

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“…= not applicable. 27 The uncertainty about the accuracy of step (1) estimates implies a certain tolerance for minor errors in step (2). How serious can these errors be, considered relative to the possible errors in step (1)?…”

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Interactions of Corporate Financing and Investment Decisions-Implications for Capital Budgeting

Myers¹

1974

The Journal of Finance

142

108

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“…We may then say that a project is worth undertaking if its disequilibrium value exceeds its cost: Other outstanding scholars have formulated capital budgeting criteria: Tuttle and Litzenberger (1968), Hamada (1969), Mossin (1969), Stapleton (1971), Bierman and Hass (1973), Bogue and Roll (1974), starting from the CAPM relations as well, present criteria for valuing project profitability. These criteria are actually equivalent to Rubinstein's (and therefore equivalent one another).…”

Section: The Use Of the Capm For Investment Decisionsmentioning

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Theoretical Flaws in the Use of the CAPM For Investment Decisions

Magni

2005

SSRN Journal

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Abstract. This paper uses counterexamples and simple formalization to show that the standard CAPM-based Net Present Value may not be used for investment valuations. The reason is that the standard CAPM-based capital budgeting criterion implies a notion of value which does not comply with the principle of additivity. Framing effects arise in decisions so that different descriptions of the same problem lead to different choices. As a result, the CAPM-based NPV as a tool for valuing projects and making investment decisions is theoretically unsound, even if the CAPM assumptions are met.

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“…3 This paper focuses on the disequilibrium beta: A vast array of papers have shown that the disequilibrium beta, as well as the equilibrium beta, is logically deducted from the CAPM assumptions (e.g. Tuttle and Litzenberger, 1968;Hamada, 1969;Litzenberger and Budd, 1970;Rubinstein, 1973, Senbet andThompson, 1978;Magni, 2007). However, this work aims at warning against its use for valuation and decision-making as well.…”

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Firm Value and the Mis-Use of the CAPM for Valuation and Decision Making

Magni

2009

SSRN Journal

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Abstract.The use of CAPM-based disequilibrium betas and Net Present Value (NPV) for investment decisions and valuations is widespread in finance. Actually, its use is logically deducted from the CAPM assumptions. This paper deals with decisions about purchase of a firm and the related issue of firm valuation. In particular, it contrasts disequilibrium betas and NPVs with Modigliani and Miller's Proposition I, and shows that disequilibrium betas and NPVs should not be used because they lead to irrational valuations and unreliable decisions; in particular, they lead decision makers to infringe Modigliani and Miller's Proposition I. To prove the thesis, a counterexample is shown where two firms with same expected free cash flows are valued, one of which is levered, the other one is unlevered. A formal generalization is also provided. The results indicate that the use of disequilibrium NPV should be avoided, because valuations are incorrect and decisions are unsafe, leaving decision makers open to framing effects and arbitrage losses.

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Leverage, Diversification and Capital Market Effects on a Risk‐adjusted Capital Budgeting Framework

Cited by 48 publications

References 9 publications

Interactions of Corporate Financing and Investment Decisions-Implications for Capital Budgeting

Interactions of Corporate Financing and Investment Decisions-Implications for Capital Budgeting

Theoretical Flaws in the Use of the CAPM For Investment Decisions

Firm Value and the Mis-Use of the CAPM for Valuation and Decision Making

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