Abstract
The financial manager faces two basic problems: first, the firm’s investment or capital budgeting decision, and second, the financing decision. Capital investment and financing decisions are typically analyzed independently. Capital budgeting criteria proceeds under the simplest possible assumption about financing, namely all-equity financing. The only link between investment and financing decisions is the cost of capital. The basic idea behind Modigliani and Miller’s famous proposition I is that in perfect markets, changes in capital structure do not affect value. As long as the total cash flow generated by the firm’s assets is unchanged by capital structure, value is independent of capital structure. This paper is the first attempt to prove that leverage affects the mathematical structures of the cash flow of financing, and that different mathematical structures of financing cash flows may change the total cash flows generated by the firm or the project, thus altering the value of the firm even in perfect markets. The purpose of this paper is to explore the validity of the separation rule through net present value (NPV) and internal rate of return (IRR) rules, as representatives of academic and business practice, and compare their results with simulations that will include the financial decision of the firm. A singular experiment proving that we can change the IRR or NPV of an investment modifying the financial structure cannot be used to affirm a universal statement, but it can be used to show that a theory is wrong.
This is a preview of subscription content, log in via an institution to check access.
Similar content being viewed by others
References
Bennouna, K., Meredith, G. G., & Marchant, T. (2010). Improved capital budgeting decision making: evidence from Canada. Management Decision, 48(2), 225–247.
Bierman Jr., H., & Smidt, S. (2012). The capital budgeting decision: economic analysis of investment projects. Routledge.
Brealey R. et al (2010). Fundamentals of corporate finance, Tenth Edition The McGraw-Hill Companies.
Cooper, W. D., Cornick, M. F., & Redmon, A. (2011). Capital budgeting: A 1990 study of Fortune 500 company practices. Journal of Applied Business Research (JABR), 8(3), 20–23.
Dorfman, R. (1981). The meaning of internal rates of return. The Journal of Finance, 36(5), 1011.
Elsas, R., Flannery, M. J., & Garfinkel, J. A. (2014). Financing Major Investments: Information about capital structure decisions*. Review of Finance, 18(4), 1341–1386.
Fama, Eugene F. 1978. The Effects of a Firm’s Investment and Financing Decisions on the Welfare of its Security Holders. American Economic Review, V. 68, No. 2: June, pp 272–84. Reprinted in The Modern Theory of Corporate Finance, Michael C. Jensen and Clifford W. Smith, Jr., Editors, New York: McGraw-Hill, Inc., 1984
Fisher, I. (1930). The theory of interest. New York: Macmillan.
Graham, J. R., & Leary, M. T. (2011). A review of empirical capital structure research and directions for the future. Annu. Rev. Financ. Econ., 3(1), 309–345.
Graham, J. R., Leary, M. T., & Roberts, M. R. (2014). A century of capital structure: the leveraging of corporate America (no. In w19910). National Bureau of Economic: Research.
Jensen, M. C., & Smith, C. W. (1983). The theory of corporate finance: an historical overview. Managerial Economics Research Center, Graduate School of Management: University of Rochester.
Miller, Merton, (1988). The Miller- Modigliani Propositions after Thirty years. Journal of Economic Perspectives. Vol 2, Number 4, 99–120.
Modigliani, F., and Miller, M. H. (1958). The cost of capital, Corporation finance and the theory of investment. the American economic review, 48, N° 3, 261–297.
Myers, S. C. (2001). Capital structure. Journal of Economic Perspectives, 81–102.
Ryan, P. A., & Ryan, G. P. (2002). Capital budgeting practices of the Fortune 1000: how have things changed. Journal of Business and Management, 8(4), 355–364.
Villamil, A. (2008). The Modigliani–Miller theorem. In S. N. Durlauf & L. E. Blume (Eds.), The new Palgrave Dictionary of Economics (2nd ed.). Basingstoke: Palgrave Macmillan.
Villamil, A. P. (2010). The Modigliani–Miller theorem and entrepreneurial firms: an overview. Strategic Change, 19(1–2), 3–7.
Zhu, F. (2014), Corporate Governance and the cost of capital: an International study. International Review of Finance, 14(3), 393–429.
Author information
Authors and Affiliations
Corresponding authors
Rights and permissions
About this article
Cite this article
Herrero de Egaña, A., Soria Bravo, C. & Muñoz Cabanes, A. On the Separability of Real and Financial Decisions. Int Adv Econ Res 22, 211–224 (2016). https://doi.org/10.1007/s11294-016-9578-8
Published:
Issue Date:
DOI: https://doi.org/10.1007/s11294-016-9578-8