Robert C. Merton, On the Pricing of Corporate Debt: The Risk Structure of Interest Rates, The Journal of Finance, Vol. 29, No. 2, Papers and Proceedings of the Thirty-Second Annual Meeting of the American Finance Association, New York, New York, December 28-30, 1973 (May, 1974), pp. 449-470

Everyone seems to agree that there are significant interactions between corporate financing and investment decisions. The most important argument to the contrary — embodied in Modigliani and Miller's (MM's) famous Proposition I — specifically assumes the absence of corporate income taxes; but their argument implies an interaction when such taxes are recognized. Interactions may also stem from transaction costs or other market imperfections. The purpose of this paper is to present a general approach for analysis of the interactions of corporate financing and investment de-cisions, and to derive some of the approach's implications. Perhaps the most interesting implication is that the weighted average cost of capital formulas proposed by MM and other authors are not always correct. Except in certain special cases, a more general "Adjusted Present Value " rule should, in principle, be used to evaluate investment opportunities. The paper is organized as follows. Section II presents the