The Valuation of Risk Assets and the Selection of Risky Investments in Stock Portfolios and Caital Budgets

The Review of Economics and Statistics Vol 47, No. 1 1965 pp. 13 - 37

John Lintner

Most people read Sharpe’s paper on CAPM for its elegance and simplicity. I have the same experience. But Lintner’s paer provides a different angle of looking at the risk return relation from the corporate finance perspective. Specifically, he tried to disprove the MM capital structure irrelevance theory. As I share the same thought as Lintner, his work provides further stimulation to my work. His many notes on the paper indicated that there are many unresolved problems in this area. Read more from Mehrling(2005).

It should be noted that the classic paper by Modigliani and Miller [16] was silent on these issues. Corporations were assumed to be divided into homogeneous l=classes having the property that all shares of all corporations in any given class differed (at most) by a “scale factor”, and hence (a) were perfectly correlated with each other and (b) were perfect substitutes for each other in perfect markets (p. 266). No comment was made on the measure of risk or uncertainty (or other attributes) relevant to the identification of different “equivalent return” classes. Both Proposition I (market value of firm independent of capital structure) and II (the linear relation between the expected return on equity shares and the debt-equity ratio for firms within a given class) are derived from the above assumptions (and the further assumption that corporate bonds are riskless securities); they involve no interclass comparisons, “… nor do they involve any assertion as to what is an adequate compensation to investors for assuming a given degree of risk …” (p. 279) (p. 13, 14, note 2)

I share the same understanding on MM’s work.

Any effect of changes in capital budgets on the covariance between the values of different companies’ stocks is ignored. (p. 14, note 6)

This is also true for stock investors. Few, if any, investors will consider future covariance among all the different stocks in the entire market. This means that CAPM is not the model investors actually operate on. Some might argue computationally, optimal portfolios are selected in such a way. But computation with real data never produces satisfactory results.

I also assume that the investment opportunities available to the company in any time period are regarded as independent of the size and composition of the capital budget in any other time period. I also assume thee is no limited liability to corporate stock. (p. 28)

By making such assumptions, Lintner was very much aware that the factors of size, composition of the capital budget and limited liability will affect investment returns.

Following the requirements of the market equilibrium conditions (29) from which equations (36, (37), and (38) were derived --- all means and (c0)variances of present values have been calculated using the riskless rate r*. … the “cost of capital” (as defined for uncertainty anywhere in literature) is not the appropriate discount rate to use in accept-reject decisions on individual projects for capital budgeting. This is true whether the “cost of capital” is to be used as a “hurdle rate” (which the “expected return” must exceeed) or as a discount rate in obtaining present value of net cash inflows and outflows. (p. 32)