Firm-Theoretic Limitations on Proposition III

This paper builds on work by Thomadakis [1976] and Peyser [1981] who demonstrated that a disparity normally exists between the "capitalization" rate and the "cutoff" rate. Modigliani and Miller [1958] maintained that the two rates are equal in the absence of capital structure changes and corporate taxation. However, they neglected to analyze the effects of the firm's demand and production functions on the comparative risks embedded in average and marginal returns. This paper used a certainty-equivalence approach to show that the difference in these risks is the source of the disparity and that the firm's demand and production characteristics magnify or attenuate it. Although knowledge of the cutoff rate is necessary for determining the optimal scale of investment, it is not directly observable. However, the cutoff rate turns out to be imputable from an algebraic function of the capitalization rate and either the Lerner Index or Tobin's q ratio. Because common measures of the Lerner Index implicitly assume away the conditions that are necessary to produce disparate discount rates, the q ratio appears to be the preferred alternative for the purpose at hand. [PUBLICATION ABSTRACT]