Leverage and the Cost of Capital: Some Tests Using British Data.

This paper is concerned with the estimation of an econometric model designed to test the Modigliani-Miller (henceforth MM) hypothesis. The primary interest is not in the theoretical validity of the hypothesis. The major sources of theoretical disagreement with Modigliani and Miller arise from the key role they impute to the arbitrage process and the effect of leverage on the expected value of the returns to equity through the increased probability of bankruptcy. These issues have occasioned a number of important contributions in recent years (see especially [2] and [23]). The first section of the paper provides a skeletal outline of the MM hypothesis and discusses the problems of formulating an appropriate econometric model. In the second section an econometric model is developed, which, while drawing on the ideas of several
1 This study is part of a continuing program of research into company financial behavior financed by a grant from the Social Science Research Council. I am indebted to Mrs. Eileen Sutcliffe of the Institute of Social and Economic Research, University of York, and Milton Chen of New York University for assistance with data collection and computer processing, and to the personnel of the SRC Atlas Computer, Chilton, the University of York Computer Center and the New York University School of Commerce Computer Center.
2 References in square brackets are listed on pp. 161-2, below.
3 In terms of the implicit aggregation procedures, the old Liquidity-Preference/ Loanable-Funds controversy has yet to be satisfactorily resolved.
different writers, has certain elements of originality in the way it seeks to incorporate growth and leverage. Finally, in the third section the results of the econometric tests are evaluated. [ABSTRACT FROM AUTHOR]