Showing papers in "Journal of Financial and Quantitative Analysis in 1977"
TL;DR: In this article, the authors applied the technique for valuing compound options to the risky coupon, bond problem and derived a formula which contains n-dimensional multivariate normal intecjrals.
Abstract: This paper applies the technique for valuing compound options to the risky coupon, bond problem. A formula is derived which contains n-dimensional multivariate normal intecjrals. It is shown that, for some compound option problems, the special correlation structure allows an application of an integral reduction which may simplify the numerical evaluation. The effects of various indenture restrictions on the formula are discussed, and a new formula for evaluating subordinated debt is presented.
901 citations
TL;DR: The best known of these was derived by Black and Scholes, in their original article, from the assumption that the value of the asset underlying the contingent claim follows a geometric Brownian motion as discussed by the authors.
Abstract: Since the seminal article by Black and Scholes on the pricing of corporate liabilities, the importance in finance of contingent claims has become widely recognized. The key to the valuation of such claims has been found to lie in the solution to certain partial differential equations. The best known of these was derived by Black and Scholes, in their original article, from the assumption that the value of the asset underlying the contingent claim follows a geometric Brownian motion.
408 citations
TL;DR: In this article, the authors derived a general form of the term structure of interest rates and showed that the expected rate of return on any bond in excess of the spot rate is proportional to its standard deviation.
Abstract: The paper derives a general form of the term structure of interest rates. The following assumptions are made: (A1) The instantaneous (spot) interest rate follows a diffusion process; (A2) the price of a discount bond depends only on the spot rate over its term; and (A3) the market is efficient. Under these assumptions, it is shown by means of an arbitrage argument that the expected rate of return on any bond in excess of the spot rate is proportional to its standard deviation.
408 citations
TL;DR: In this paper, the authors used runs analysis and spectral densities to compare the stock market indexes of the Bombay, New York, and London Stock Exchanges, and found that the performance of the London F.T.-A. was significantly different from the other two indexes studied.
Abstract: The object of the present study was to test the random-walk model, by runs analysis and spectral densities, against representative stock market indexes of the Bombay, New York, and London Stock Exchanges. The three indexes examined were the Bombay Variable Dividend Industrial Share Index (BVDISI), consisting of 603 industrial stocks, the New York Standard and Poor's 425 Common Stock Index (S & P 425), and the London Financial Times-Actuaries 500 Stock Index (London F.T.-A.). The test period covered 132 monthly observations for each index for the 11-year period 1963–1973.The general characteristics of the London F.T.-A. were found to be slightly different from the other two indexes studied. The first difference series the London F.T.-A. has higher mean and variance than BVDISI and S & P 425. However, the first differences of the log indexes did not show any significant differences. In this study, no effort was made to explain any inconsistencies between the London F.T.-A. and the other indexes, although previous studies [4, 12, 13, 20] have attributed such differences partly to institutional The behavior of the BVDISI is statistically indistinguishable from the London F.T.-A. and S & P 425 in terms of the tests of this paper. In runs analysis of consecutive price changes of the same sign, the study confirmed that the expected number of runs and observed number of runs are very close each other. For all the indexes, the actual and expected distribution of length turns out to be extremely similar, with probability equal to 0.5 rise or fall.Further, the spectral densities, estimated for the first difference (raw and log transformed) of each index, confirmed the randomness of the and no systematic cyclical component or periodicity was present. Based tests, it is evident that stocks on the Bombay Stock Exchange obey a random walk and are equivalent in this sense to the behavior of stock prices in markets of advanced industrialized countries examined in this article.
200 citations
TL;DR: The empirical distributions of price changes for speculative assets (e.g., common stocks, bonds, etc.) measured over calendar time yield a higher frequency of observations near the mean and at the tails than would be expected for a normal distribution.
Abstract: The empirical distributions of price changes for speculative assets (e.g., common stocks, bonds, etc.) measured over calendar time yield a higher frequency of observations near the mean and at the tails than would be expected for a normal distribution. The sample kurtosis is almost always greater than 3—the value expected for a normal distribution—and the distributions are commonly characterized as fat-tailed and peaked (i.e., leptokurtic).
173 citations
TL;DR: The concept of duration has been used to measure the average maturity of an income stream as mentioned in this paper, which is a weighted average of the dates at which the income payments are received, where the weights add to unity and are related to the present value of the income stream.
Abstract: The asset and liability portfolios of financial institutions generate patterns of future cash flows that must conform to many restrictions in order to assure solvency and profitability. Many institutions, including insurance companies and pension funds, have definite and certain future commitments of funds. These institutions may wish to invest funds now so that their cash inflows (investment with accumulated earnings) will match their future commitments. In principle, the simplest way to meet future commitments exactly is to purchase single payment notes (or zero coupon bonds) which mature on the commitment dates. For long-term commitments, such instruments are not readily obtainable, at least in the United States. Most available bonds promise coupon payments over time so that these payments would have to be reinvested at unknown future interest rates in order to realize an accumulated sum at any future date when a commitment must be discharged. Since future interest rates are unknown at the initial moment of investment, it is not certain what accumulated earnings will be at future dates. In the absence of default, the risk of not meeting future commitments may be minimized by adopting investment strategies based on the concept of duration. Duration is a measure of the average maturity of an income stream; it is a weighted average of the dates at which the income payments are received, where the weights add to unity and are related to the present value of the income stream. Dating from the initial work of Macaulay [9] and Hicks [6], duration has been shown to be important in constructing portfolios that are hedged or ‘immunized’ from the possible ravages of interest rate uncertainty.
170 citations
TL;DR: In this article, the authors empirically test Stone's two-index model and find that adding a bond index term for the bank sample only marginally improves the model's explanatory power although the index is more important than the equity index.
Abstract: The purpose of this paper has been to empirically test Stone's Two-Index Model. The results are mixed, but generally favor the model. Adding a bond index term for the bank sample only marginally improves the model's explanatory power although the index is more important than the equity index. The lack of importance of the bond index for banks is not surprising upon further consideration, however. Banks and their earnings should be more sensitive to short-term rather than long-term rates, and the index reflects primarily long-term rates. To the extent that short- and long-term rates moved in different directions during the sample period, negative correlation is introduced between bank's returns and the index.The bond index improves in performance for the 30 Dow Jones firms and contributes to the explanatory power of the model in 80 percent of the cases. There is some instability in signs and, contrary to Stone's speculations, omission of the bond index does not bias the equity beta estimates.Finally, we caution the reader against generalizing about the long-run value of the two-index model. The short time period used here does not allow us to say anything about the relationship between interest rate movements and the stability of beta. Moreover, during the 1969–1972 period the returns on the bond and equity indexes did not behave as Capital Market Theory would predict. The average monthly return on the bond portfolio was .5 percent and the average return on the equity portfolio was .2 percent. Our findings must, therefore, be interpreted with care, but overall the introduction of interest rate effects into the single-index model looks promising.
115 citations
TL;DR: In this article, the authors investigated whether the application and qualification of a firm for listing on one of the two major American securities exchanges constitute an event with which were associated abnormal positive investment returns on the shares involved.
Abstract: The broad import of the evidence is that the application and qualification by a firm for listing on one of the two major American securities exchanges did, at least during the years encompassed by our investigation, constitute an event with which were associated abnormal positive investment returns on the shares involved. Even though a portion of those returns seem subsequently to have been surrendered, the initial net effect from application through listing date was quite substantial, and the later correction thereto was much more modest. The average combined impact visible in Table 3 during the six-month period beginning with the listing application, for example, was a net positive annualized return approximately 17 percent above that enjoyed concurrently by the general run of comparable-systematic-risk securities in the market. The explicit consideration of such risk distinguishes the present investigation from earlier studies in the area [7] [8] [10] [12] [13] [18].On balance, then, it appears not unreasonable to conclude that listing did indeed “have value” for the companies examined. While one could argue that it was, intrinsically, the corporate developments (and the dissemination of the news thereof) which led to listing that were the real sources of value, the observed concentration of excess returns in the close proximity of the various application and listing dates would suggest that those actions provided useful market signals which did, in themselves, have a detectable favorable payoff—perhaps if only by way of accelerating the investment community's appreciation of the improvement in the applying firm's underlying operating circumstances. We interpret the evidence as supportive of that hypothesis.The implications of the same evidence for questions of market efficiency, however, are somewhat more ambiguous. There would seem, as noted, to be in the data indications of certain possible information-response time lags that are not totally consistent with efficiency; and there is an apparent systematic initial price overreaction to application-cum-listing which is later remedied. Transactions costs, on the other hand, have not been considered here, and these clearly would impede the adjustment process by raising the threshold for investor action. Despite some cause for suspicion, therefore, a definitive judgment about efficiency must await further investigation.
112 citations
TL;DR: In this paper, the authors investigated the properties of the measure called "duration" and found that it is a good indicator of the average life of a payments stream and that it measures the elasticity of the present value of such a stream with respect to the discount rate.
Abstract: Much effort has been recently devoted to investigating and expounding the properties of the measure called “duration.” Two properties claimed for duration are (1) that it is a good indicator of the average life of a payments stream and (2) that it measures the elasticity of the present value of such a stream with respect to the discount rate. Unfortunately the theoretical justifications of the second, more important, property have been based upon the analysis of either a change in a discount rate constant for all future time periods, or, more generally, a parallel shift in the term structure of interest rates.
80 citations
TL;DR: In this article, a theory of trading which relates the expected number of trades to the characteristics of the message and the number of participants in the market for an asset is presented. But it does not consider the effect of the probability of trading events.
Abstract: In a world where individuals are assumed to receive new information about an asset in random and sequential order, the volume of trading for a given message is a random variable. If the probabilities of trading events can be specified, it is possible to develop closed form expressions for the expected number of trades and the variance of trading. The result is a theory of trading which relates the number of trades to the characteristics of the message and to the number of participants in the market for an asset.
78 citations
TL;DR: In this article, the authors extended the Bierman-Hass model to include the effect of a second parameter, the terms of settlement in the event of default, and found that the addition of this second parameter did not alter the independence between a bond's risk differential and its maturity.
Abstract: In this paper we have extended the Bierman-Hass model to include the effect of a second parameter, the terms of settlement in the event of default. The addition of this second factor was found to not alter the independence between a bond's risk differential and its maturity. Our analysis of the required risk differential for various borrower credit characteristics demonstrates the tradeoff between p and γ. Throughout, we have assumed the loan size does not affect p or γ.
TL;DR: In this article, an analytic treatment of the abandonment decision in capital investment analysis is presented, which provides a methodology which has application in obtaining better estimates for project value and risk, and has been shown to be useful in obtaining a better estimate for project risk and value.
Abstract: This paper is an analytic treatment of the abandonment decision in capital investment analysis. It provides a methodology which has application in obtaining better estimates for project value and risk.
TL;DR: In this article, the authors discuss the difficulty in generating inputs to the general portfolio model and the difficulty of educating portfolio managers to relate to risk return trade-offs in terms of covariances.
Abstract: The inception of modern portfolio theory dates from Markowitz's pioneering article [7] and subsequent book [8]. Yet despite the early development of a full theory of portfolio management, this theory has rarely been implemented. One problem arises from the difficulty in generating inputs to the general portfolio model. Index models and simple structures for correlation relationships, which go a long way towards solving this problem, have been developed. Yet the time and cost of solving actual portfolio problems (involving the solution of a quadratic programming problem) and more importantly the difficulty of educating portfolio managers to relate to risk return trade-offs in terms of covariances has virtually brought the application of portfolio theory to a halt.
TL;DR: In this paper, the authors deal with the very difficult issue surrounding the practical implementation of the single-index market model in portfolio analysis where significant, nonmarket sources of covariation in security returns are believed to be present.
Abstract: Since its inception the single-index market model has been the subject of a large body of theoretical and empirical research. This study deals with the very difficult issue surrounding the practical implementation of the model in portfolio analysis where significant, nonmarket sources of covariation in security returns are believed to be present.
TL;DR: In this paper, the authors developed a Capital Asset Pricing Model (CAPM) using a mean-lower partial moment framework and provided a distribution-free testable hypothesis for empirical validation of the new CAPM.
Abstract: In this paper, we develop a Capital Asset Pricing Model (CAPM) using a mean-lower partial moment framework. We explicitly derive the valuation formulas for the equilibrium value of risky assets and provide a distribution-free testable hypothesis for empirical validation of the new CAPM. We show the invariance of our results to the problem of estimation risk. We also show that when the probability distribution of security rer turns is the normal distribution, the stable Paretian distribution (with the same characteristic exponent between 1 and 2 and the same skewness parameter (not necessarily zero)), or the multivariate t-distribution, our CAPM reduces to the traditional two-parameter CAPM.
TL;DR: In this paper, a model of securities markets was introduced which implies that the ratio of transaction volume to price change is greater for transactions on which price rises than for those on which prices falls.
Abstract: In an earlier paper [1] a model of securities markets was introduced which implies that the ratio of transaction volume to price change is greater for transactions on which price rises than for those on which price falls. Examination of individual transactions data for a sample of corporate bonds showed that price changes and transaction volumes for those securities appears to behave in a manner consistent with the theory. However, the paper raised the question of whether the same is true for stocks. The positive dependence on share price of broker commissions for stocks could easily eliminate, or even reverse the sign of, the predicted positive difference between the absolute values of slopes of buyers' and sellers' reservation demand functions; and it is this difference which leads the model to predict the inequality of the ratios of volume to price change on upticks and downticks. This note records the results of tests of the model with stock data, using volumes and price changes pertaining both to individual transactions and to trading days. The tests indicate that the ratios of volume to price change exhibit the predicted relationship, when one of the two possible measures of volume is employed.
TL;DR: In this article, the authors demonstrate the power and relevance of the recently developed stochastic dominance theorem in ordering investments for groups of investors, and some evidence is presented concerning mutual funds and the DJIA.
Abstract: In a recent paper Joy and Porter [4] used the concept of stochastic dominance to address the question of whether or not mutual funds outperform the Dow Jones Industrial Average (DJIA). Since that time Meyer [5] has proven a theorem in the area of stochastic dominance which allows one to make further application of stochastic dominance to this question. The major purpose of this paper is to demonstrate the power and relevance of the recently developed stochastic dominance theorem in ordering investments for groups of investors. In doing so, some evidence is presented concerning mutual funds and the DJIA.
TL;DR: In this article, the authors examined the stationarity of portfolio beta coefficients, especially in regard to recent major stock market trends, and proposed a more direct method for testing the stock market stationarity.
Abstract: This paper examines the stationarity of beta coefficients, especially in regard to recent, major stock market trends. In addition to the usual correlation tests for stationarity, this paper describes a more direct method for testing the stationarity of portfolio betas. The method involves the use of paired t-tests which show separately the degree of stationarity for each portfolio beta. In the process of testing for stationarity, the portfolio betas also are adjusted for measurement error using a formulation suggested by Blume [3].
TL;DR: In this paper, a linear programming model for selecting the portfolio which provides a given pattern of cash flows at minimum cost is presented. But the model is restricted to the case where bonds are default free, future taxes are known and differences in marketability and callability among issues can be ignored.
Abstract: The problem of bond portfolio selection may be viewed as consisting of two parts. The first is concerned with the maturity profile of the total cash flows (the after-tax coupons and principal repayments) which the investor requires; in general there will be many portfolios of bonds which provide the desired cash flow profile. Accordingly, the second problem is the choice of a particular portfolio of bonds which provides these cash flows in some optimal fashion. If bonds are default free, future taxes are known, and differences in marketability and callability among issues can be ignored, then price is the only relevant criterion in choosing among alternative portfolios. This paper describes a simple linear programming model for this last problem of selecting the portfolio which provides a given pattern of cash flows at minimum cost. This provides a method for improving any initial portfolio, where such improvement is possible, by increasing its yield without reducing any future after-tax cash flows.
TL;DR: In this article, a set of financial ratios are used to describe characteristics of the risk of municipal obligations, which can be effectively used to predict ratings of municipal bond ratings, and the authors attempt to determine if these ratios can be effective in predicting ratings.
Abstract: The financial dilemmas faced by large municipalities, due in general to decreasing tax bases, increasing public services, inflationary pressure and in some cases fiscal irresponsibility, have brought increased attention to the subject of municipal bond ratings. In order to gain insight into those factors which are most significant in explaining the ratings, a set of financial ratios is investigated. Such ratios are frequently used to describe characteristics of the risk of municipal obligations. This paper attempts to determine if these ratios can be effectively used to predict ratings.
TL;DR: Wang et al. as discussed by the authors investigated possible factors affecting the second-pass regression results in capital asset pricing and found that the true functional form used to test the risk-return relation is determined by using Box and Cox's [2] generalized functional form technique.
Abstract: In this paper, possible factors affecting the second-pass regression results in capital asset pricing are investigated in detail. First, the true functional form used to test the risk-return relation is determined by using Box and Cox's [2] generalized functional form technique. Secondly, Box and Cox's residual analysis and transformation technique are used to show the importance of the skewness effect in capital asset pricing. Finally, some other factors affecting the results of second-pass regression coefficient in capital asset pricing also are explored. From these analyses, it is found that the functional form, the skewness effect, and the change of market condition are the most important factors in affecting the empirical conclusions in testing the bias of composite performance measures and the risk-return relation.
TL;DR: In this article, the authors examined the ex-post risk and return experience of individual common stock investors and provided positive evidence on the relationship between acceptable risk levels and expected annual rates of return.
Abstract: A common dilemma faced by investors and portfolio managers is the tradeoff preference between risk and return. The general consensus and convention in finance and economics is that, in the aggregate, investors do not seek risk for its own sake. If so, it is reasonable to assume that returns on individual common stocks vary according to their risk. However, it is not the purpose of this paper to examine the ex post risk and return experience of various financial assets. This and related work have been treated by Sharpe [22] and by others. While some of these are studies of individual common stocks, the majority involves the ex post risk-return relationships of portfolios managed by institutional or professional investors. Although the conclusions are not totally consistent concerning the shape of the risk-return function, there is agreement that a generally positive relationship exists between risk and expected return. To date, little empiricism has been directed specifically to the ex ante risk-return preferences of individual common-stock investors. This paper takes a step in this direction by analyzing the ex ante risk-return preferences and expectations of individual common-stock investors. The purpose is two-fold: (1) to provide positive (as opposed to normative) evidence on the nature of the relationship between acceptable risk levels and expected annual rates of return; and (2) to examine the nature of this relationship between risk and the components of total return, income from dividends and capital appreciation.
TL;DR: This article found a significant relationship between peer ratings of economics departments, using the ratings of the first American Council on Education study by Cartter, and the number of available pages contributed by the department to the leading economic academic journals.
Abstract: Published scholarly research is asserted to be a major criteria used to judge or assess the quality of a university's faculty. This assertion has been supported in many of the academic disciplines by comparing peer ratings of graduate programs and the research productivity of the faculty of those programs. In the economics area, John J. Siegfried [ 7] found a significant relationship between peer ratings of economics departments, using the ratings of the first American Council on Education study by Cartter, and the number of available pages contributed by the department to the leading economic academic journals. A recent study by Klemkosky and Tuttle [6] found the same relationship between an academic institution's published research productivity and the quality of the institution's graduate finance programs as rated by peers, using the survey results of Brooker and Shinoda [3] to determine peer ratings. The importance of published research in turn is recognized by many academic institutions since the relative quality and quantity of published research is one of the major criteria used in making faculty promotion and tenure decisions.
TL;DR: In this article, the authors determine what balance-sheet and income-statement figures, if any, could have been arrayed in an ex post early warning system to spotlight Franklin's developing problems.
Abstract: If the “smart money” was out of Franklin before its financial difficulties became public knowledge, just what elements of Franklin's balance sheet were the sagacious analysts reading and why weren't the banking authorities aware of this information? The purpose of this paper is to determine what balance-sheet and income-statement figures, if any, could have been arrayed in an ex post early-warning system to spotlight Franklin's developing problems.
TL;DR: In this article, the authors demonstrate how the pooled time-series and cross-section data can be used to test the importance of both the firm effect and the time effect in financial studies.
Abstract: In financial analyses, both firm effect and time effect are of interest to the researcher. Bower and Bower [4] and Chung [5] have used the residual tech? nique to deal with the firm effect, but the statistical property of the technique is ambiguous. To the knowledge of these authors, the importance of firm effect and time effect in evaluating alternative corporate policies has never been investigated formally. The main purpose of this study is to demonstrate how the pooled time-series and cross-section data can be used to test the importance of both the firm effect and the time effect in financial studies. Data on electric
TL;DR: The results of the present paper imply that similar examples also arise naturally from realworld data as discussed by the authors, and they also suggest that such examples are rare, and TSD would likely be a suitable approximation to DSD for practical purposes.
Abstract: In our theoretical work on DSD ([17], [18], [19]), specially constructed examples were used to demonstrate that DSD is stronger than TSD. The results of the present paper imply that similar examples also arise naturally from realworld data. They also suggest that such examples are rare. In the specific cases studied here, the differences between these two stochastic orderings are real, but small, and TSD would likely be a suitable approximation to DSD for practical purposes. The differences between the resulting efficient subsets seem relatively less important as the size of the initial portfolio universe increases. For example, the percentage reduction in the efficient TSD subset for a 1000-portfolio problem is smaller than for a typical 100-portfolio problem. This was found to be true throughout the preliminary phases of the study, as well as in the final phase reported here. The (to us) disappointing performance of DSD resulted primarily from the left-tail problem, which became increasingly prevalent as the initial portfolio set expanded. This suggests that DSD would be most useful in problems of choice among relatively few alternatives, perhaps of the capital budgeting type. In addition, there are numerous nonfinancial problems in which DSD could prove to be useful in ranking alternative management policies. Finally, the greater strength of DSD may remain important in theoretical investigations, especially for situations in which the left-tail problem is absent.
TL;DR: In this article, the authors present a reduction ad absurdum argument that, in an economy where corporate interest charges are tax deductible and firms issue risky debt, the total market value of a levered firm using the capital asset pricing model is misspecified.
Abstract: Corporate taxes and default risk are relevant to an understanding of the effect of financial leverage on the total market value of the firm Recently, Kraus and Litzenberger [6] have examined the implications of taxes and default risk for capital structure decisions in a state preference valuation model A parameter preference model as distinct from a state preference model may be applied to continuous probability distributions As the most familiar parameter preference approach, the capital asset pricing model is an obvious alternative approach to incorporate the effects of leverage in a world of taxes and default risks Given the analysis by Hamada [4] of the effects of taxes in absence of default risk and by Stiglitz [16] of the effects of default risk in absence of corporate taxes, such an exercise would superficially appear to be a trivial extension of their studies However, this paper presents a “reduction ad absurdum” argument that, in an economy where corporate interest charges are tax deductible and firms issue risky debt, the total market value of a levered firm using the capital asset pricing model is misspecified
TL;DR: The mean-variance model of portfolio selection is challenged by the existence of opportunities for hedging, including those fostered by short sales and the rapidly expanding markets for warrants, options, and futures as mentioned in this paper.
Abstract: In derivations of the mean-variance model of portfolio selection, authors from Markowitz [6 and 7] and Tobin [11] to Merton [8] and Black [1] rely on the inverse of the matrix of variances and covariances for the returns on risky securities. Unfortunately, as is shown in this paper, such an inverse does not exist when risk-free combinations can be formed from the risky securities. Accordingly, the general validity of the mean-variance model is challenged by the existence of opportunities for hedging, including those fostered by short sales and the rapidly expanding markets for warrants, options, and futures. Fortunately, the mean-variance model is tractable even when the conventional methods for deriving it fail. Alternative solution procedures presented in this paper are valid with or without riskless securities and with either singular or nonsingular variance-covariance matrices. The important properties of the mean-variance model are shown to extend for the previously omitted cases. In particular, the frontier of mean-variance combinations is always well-defined, is always strictly convex, and (the efficient portion of the frontier) is always positively sloped. In addition, the frontier of mean-variance combinations always can be expressed in terms of a pair of mutual funds which are determined on purely technical grounds.
TL;DR: In this article, a set of theorems was derived based on the following set of axioms: financial management seeks to maximize the wealth of existing shareholders; all projects being considered at period 0 are of one period duration and possess the attribute that their adoption or rejection by the firm will not affect the business risk of the firm's asset portfolio.
Abstract: A set of theorems was derived based on the following set of axioms: (1) financial management seeks to maximize the wealth of existing shareholders; (2) all projects being considered at period 0 are of one period duration and possess the attribute that their adoption or rejection by the firm will not affect the business risk of the firm's asset portfolio; and (3) the ratio of debt to total book capital is given as α, and r and k reflect the firm's business and financial risk however perceived by investors.It was shown that the NPV of any project satisfying the above conditions could be evaluated for accept-reject purposes with a CC involving book weights. This CC yielded an NPV numerically equal to the NPV using market value weights under special circumstances, namely, when k = r (1 − λ) or when M0/V0 = 1 − α, a special case of which is M0 = (1 −α)c0, i.e., if the firm were at its investment margin. After determining the book value CC, which is denoted as β, it was shown that it can be applied repeatedly for testing period 0 projects satisfying our axioms, even if these projects are unknown to management at the outset of the period. A market value CC, denoted as γ, was derived which gives identical accept-reject signals as the procedure.
TL;DR: In this article, the effect of asset leasing on the firm's capitalization rate was analyzed and the adjustment factor was developed to obtain the corresponding unlevered cost of capital with leasing leverage.
Abstract: In recent financial literature a large volume of the articles dealt with asset leasing. This author and his colleagues [6] and others [7] developed the conditions under which asset leasing cannot increase the overall firm's value over normal debt leverage. Many others [2, 3, 11] analyzed the “lease-buy” decision using a variety of models and assumptions. None, however, considered the effect of asset leasing on the firm's capitalization rate. While asset leasing per se would not affect the firm's unlevered cost of capital, it should affect its estimation. This paper developed the adjustment factor to obtain the firm's corresponding unlevered cost of capital with leasing leverage. Basically, Modigliani and Miller's methodology [9] was adjusted for the different tax situation with asset leasing. The effective benefit of leasing on the firm's average cost of funds was shown to be not nearly as effective as an equivalent amount of ordinary debt.