This is assuming reinvestment of depreciation and no external equity financing, although we have developed a more complex model incorporating these. This relationship between debt, return on assets, and equity returns was stated in very much the same form by ModiglianiFrancoMillerM. H. in “The Cost of Capital, Corporation Finance and The Theory of Investment,”American Economic Review, XLVIII:3, 261–297.
2.
Ezra Solomon discussed the idea of general and specific (project-related) debt capacity which is quite consistent with our formulation; see “Measuring a Company's Cost of Capital,”Journal of Business, XXVIII:4 (Oct. 1959), 240–252. Gordon Donaldson's approach to debt capacity is based on the firm's cash flow profile over time and treats the company as an aggregate; see Corporate Debt Capacity (Boston: Division of Research, Graduate School of Business Administration, Harvard University, 1961).
3.
We argue that, unless a corporation has a homogeneity of risks among its investments, the debt capacity is the sum of individual debt capacities, adjusted for the general corporate debt capacity arising out of the portfolio effect. That is, it would be expected that the portfolio debt capacity would exceed the summed individual debt capacities. This is the same as saying that the portfolio stability would normally be expected to exceed the stability of its individual components. In this respect, our position derives more from Solomon's than from Donaldson's, although Donaldson's cash flow profile appears to be a fruitful approach to evaluating project debt capacity.
4.
HuntPearsonWilliamsCharles M.DonaldsonGordon, Basic Business Finance (Homewood, Ill.: Richard D. Irwin, Inc., 1958). See also FerraraWilliam L., “Should Investment and Financing Decisions be Separated?”Accounting Review, XLI:1 (Jan. 1966), 106–114.
5.
This figure can be found by solving equation (3) for the necessary rate of return (r) and then substituting r into the equation
