Robert A. Haugen, A. James Heins, Risk and the Rate of Return on Financial Assets: Some Old Wine in New Bottles, The Journal of Financial and Quantitative Analysis, Vol. 10, No. 5 (Dec., 1975), pp. 775-784

The general model, 660. — The regression model, 663. — Correlation and regression results, 666. — Evaluation, 667. — Some conclusions, 670. — Appendix, 671.

William L. Baldwin and Thomas J. Velk [1] point out a basic flaw in the famous Modigliani-Miller cost of capital thesis [2]. The purpose of this article is to show that the flaw, while clearly present, can be repaired and that the M-M conclusions are not affected. The M-M thesis basically asserts that two firms cannot have different market values simply by reason of different financial structures. Using the M-M formulation, consider two firms for which the expected return is the same, X. Both firms are of the same risk class; that is, the random variable X representing the distribution of possible earnings before interest on any debt is the same for both. Company 1 is financed entirely by stock S1, and Company 2 by stock S2 and debt D2. Thus: