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THE FAMA‐FRENCH MODEL, LEVERAGE, AND THE MODIGLIANI‐MILLER PROPOSITIONS
Author(s) -
Lally Martin
Publication year - 2004
Publication title -
journal of financial research
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 0.319
H-Index - 49
eISSN - 1475-6803
pISSN - 0270-2592
DOI - 10.1111/j.1475-6803.2004.00098.x
Subject(s) - miller , economics , leverage (statistics) , cost of equity , econometrics , equity (law) , empirical evidence , financial economics , cost of capital , microeconomics , mathematics , profit (economics) , statistics , ecology , philosophy , epistemology , political science , law , biology
For a cost‐of‐equity model to conform to the Modigliani‐Miller cost‐of‐capital propositions, any sensitivity coefficients in the model must be related to the firm's leverage. In this paper I apply these principles to the Fama‐French model for the cost of equity and develop the relation between its sensitivity coefficients and firm leverage. I then examine an empirical process developed by Fama and French (1997) to model the evolution through time of their sensitivity coefficients and show that this empirical process is inconsistent with the Modigliani‐Miller propositions. Separable functions are proposed for these sensitivity coefficients that are consistent with the Modigliani‐Miller propositions.