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On the Separability of Real and Financial Decisions

Author

Listed:
  • Alfonso Herrero de Egaña

    (Universidad Nacional de Educación a Distancia (UNED))

  • Carmen Soria Bravo

    (Universidad Nacional de Educación a Distancia (UNED))

  • Alberto Muñoz Cabanes

    (Universidad Nacional de Educación a Distancia (UNED))

Abstract

The financial manager faces two basic problems: first, the firm’s investment or capital budgeting decision, and second, the financing decision. Capital investment and financing decisions are typically analyzed independently. Capital budgeting criteria proceeds under the simplest possible assumption about financing, namely all-equity financing. The only link between investment and financing decisions is the cost of capital. The basic idea behind Modigliani and Miller’s famous proposition I is that in perfect markets, changes in capital structure do not affect value. As long as the total cash flow generated by the firm’s assets is unchanged by capital structure, value is independent of capital structure. This paper is the first attempt to prove that leverage affects the mathematical structures of the cash flow of financing, and that different mathematical structures of financing cash flows may change the total cash flows generated by the firm or the project, thus altering the value of the firm even in perfect markets. The purpose of this paper is to explore the validity of the separation rule through net present value (NPV) and internal rate of return (IRR) rules, as representatives of academic and business practice, and compare their results with simulations that will include the financial decision of the firm. A singular experiment proving that we can change the IRR or NPV of an investment modifying the financial structure cannot be used to affirm a universal statement, but it can be used to show that a theory is wrong.

Suggested Citation

  • Alfonso Herrero de Egaña & Carmen Soria Bravo & Alberto Muñoz Cabanes, 2016. "On the Separability of Real and Financial Decisions," International Advances in Economic Research, Springer;International Atlantic Economic Society, vol. 22(2), pages 211-224, May.
    • Handle: RePEc:kap:iaecre:v:22:y:2016:i:2:d:10.1007_s11294-016-9578-8
    DOI: 10.1007/s11294-016-9578-8
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    References listed on IDEAS

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    1. Dorfman, Robert, 1981. "The Meaning of Internal Rates of Return," Journal of Finance, American Finance Association, vol. 36(5), pages 1011-1021, December.
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    More about this item

    Keywords

    Financing decision; Capital investment; Cash flows; Corporate finance;
    All these keywords.

    JEL classification:

    • G30 - Financial Economics - - Corporate Finance and Governance - - - General

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