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Any idea for ditching Modern Portfolio Theory gets a thumbs-up from me, and it gets two thumbs up if it’s from David Merkel.

David says it’s time to put MPT and beta in their grave. He suggests a “contingent claims theory.” If I have him right, we ought to view equity, not as a separate animal, but as simply the next point on the process of debt. Equity is the folks who get paid last so they get the highest yield.

I like the logic, but my question is—what if a firm has little or no debt?

Update: David responds:

Good question. The total volatility of a firm can be broken up into three pieces: financial leverage, operating leverage, and sales volatility. Saturday’s piece dealt with financial leverage and its costs. An unlevered firm in the financial sense still possesses operating leverage and volatility of sales. Different unlevered firms have different costs of equity capital because they have different levels of sales volatility, and different degrees of operating leverage.

That will manifest itself in option implied volatility, which is a crude measure of what people would pay to gain and lose exposure to the equity of the company. The cost of equity should be positively related to that. More volatile companies should have a higher cost of equity.

Another way to look at it is to ask what is the effect on the firm if the company issues or buys back equity. How much does the generation of free cash flow change relative to the price paid or received for equity?

Posted by edelfenbein at October 18, 2009 11:10 PM