Firm Financial Structure and Investment

Lawrence D. Schall

Journal of Financial and Quantitative Analysis, 1971, vol. 6, issue 3, 925-942

Abstract: The relationship between capital market equilibrium and firm financial policy has received extensive attention in recent years. Until recently, accepted theory was generally consistent in its view that the diversification effect of new investment on firm earnings is a necessary consideration in project selection. In arguing this position, no distinction was made between the perfect market situation exemplified by the models of Modigliani and Miller (M-M) [9, 10, 11] and those of Sharpe [19], Lintner [6, 7] and Mossin [12] (LSM model) and the traditional case in which firm value is not independent of debt policy, e.g., as might be the case if individual investors cannot lever on terms comparable to those available to firms. In a recent article, Mossin [13] examines the implications of the former case of perfect markets. Using a single period model with riskless rate borrowing and lending by individuals and firms, homogeneous expectations, mean-variance portfolio selection, and no taxes, Mossin shows that the effect on the investing firm's value of a new project is independent of the stochastic properties of the other income earned by the firm. This conclusion and the M-M [10] Proposition I follow from the statistical property of Mossin's model that any income stream has the same value regardless of how that stream is divided into the equity or debt streams of one or more firms; or, equivalently, firm value and financial structure are independent. Schall [18] presents a general proof that firm value and financial structure are independent and that firm investment diversification effects are irrelevant in perfect capital markets.

Date: 1971
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