52 Pages Posted: 29 Nov 2012 Last revised: 15 Feb 2015
Date Written: January 21, 2005
We develop a pricing method and derive an optimal equity financing strategy for a unlevered firm with constant production cost, constant production rate, stochastic output price and an option to expand in a non-competitive economy. The effects of taxes, transaction costs and non-liquidity on the share values and the optimal equity financing policy is studied. Shares of common stock in the firm are treated as contingent claims on two underlying instruments: the firm's retained earnings and the stochastic output price. The paper presents a numerical procedure for computing both the share value and the marginal rate of substitution of retained earnings (MRSRI). It is shown that in the absence of taxes and transaction costs, the MRSRI for a perfectly liquid firm is reduced to the constant 1 — this is a restatement of the classical Modigliani-Miller proposition in the context of dynamic programming. The study of the MRSRI in an economy with frictions may be viewed as an extension of the Modigliani-Miller proposition.
Keywords: Dividend Policy, Theory of the Firm
JEL Classification: G30, G32, G35
Suggested Citation: Suggested Citation
Copeland, Thomas E. and Lyasoff, Andrew, Valuation of Shares and Equity Financing in an Economy with Frictions but No Leverage: The Value of Retained Earnings (January 21, 2005). Boston U. School of Management Research Paper No. 2013-1. Available at SSRN: https://ssrn.com/abstract=2182134 or http://dx.doi.org/10.2139/ssrn.2182134