"The Cost of Capital, Corporation Finance and the Theory of Investment": A Standard for Maximizing Market Value Under Uncertainty

In 1958, Franco Modigliani and Merton H. Miller published this groundbreaking paper, challenging conventional views on capital costs and corporate finance at the time. Prior to this, economists often assumed that asset returns were certain, thereby simplifying the cost of capital to bond interest rates. However, the real world is full of uncertainty, and the traditional standard of "profit maximization" becomes difficult to operate in an uncertain environment because each decision corresponds to a distribution of possible outcomes rather than a single value.

The core mechanism proposed by the paper is a shift toward "market value maximization." The authors point out that under conditions of uncertainty, any investment project and its financing plan only need to pass one test: Will the project increase the market value of the company's stock? If the answer is yes, it is worth undertaking; otherwise, its return is below the company's marginal cost of capital. This standard is independent of the current owner's personal preferences because market prices reflect the preferences of all potential owners. Even if existing shareholders disagree with management's valuation, they can sell their shares and reinvest, yet still benefit from the capital appreciation brought about by management's decisions. This definition based on market value provides an operational concept of the cost of capital, resolving the normative and analytical defects of subjective utility approaches.

Furthermore, the paper explores the relationship between capital structure and firm value. Under a series of strict assumptions (such as atomistic competition and easy access to capital markets), the authors argue that a company's market value is unrelated to its capital structure. This means that simply changing the proportion of debt to equity will not change the total value of the company or its weighted average cost of capital. Although these assumptions do not fully hold in reality, this theoretical framework forces managers to focus on the profitability of the assets themselves, rather than merely manipulating financial statements through financial engineering. It reveals why, in some cases, increasing debt does not lower the overall cost of capital, but depends on whether the project itself can enhance market value.