276 THE AMERICAN ECONOMIC REVIEW comment since it may be hard to imagine why investors, other than those who like lotteries, would purchase stocks in this range Remember however, that the yield curve of Proposition II is a consequence of the more fundamental Proposition I. Should the demand by the risk-lovers prove insufficient to keep the market to the peculiar yield-curve MD this demand would be reinforced by the action of arbitrage operators The latter would find it profitable to own a pro- rata share of the firm as a whole by holding its stock and bonds, the lower yield of the shares being thus offset by the higher return on bonds D. The Relation of Propositions I and II to Current Doctrines The propositions we have developed with respect to the valuation of rms and shares appear to be substantially at variance with current doctrines in the field of finance. The main differences between our view and the current view are summarized graphically in Figures 1 and 2 Our Proposition I [equation (4)] asserts that the average cost of capital X,/V,, is a constant for all firms j in class k, independently of their fi- nancial structure. This implies that, if we were to take a sample of firms in a given class, and if for each firm we were to plot the ratio of expected return to market value against some measure of leverage or financial structure, the points would tend to fall on a horizontal straight line with intercept pe, like the solid line mmin Figure 1. From Proposition I we derived Proposition II [equation(8)] which, taking the simplest version with r constant, asserts that, for all firms in a class, the relation between the yield on common stock and financial structure, measured by D / S,, will approximate a straight line with slope (pk'-r) and inter cept prr. This relationship is shown as the solid line MMin Figure 2, to which reference has been made earlier 23 y contrast, the conventional view among finance specialists appears to start from the proposition that, other things equal, the earnings- price ratio (or its reciprocal, the times-earnings multiplier)of a firm's common stock will normally be only slightly affected by " moderate amounts of debt in the firm s capital structure. Translated into our no- 2 In Figure 1 the measure of leverage used is Di/Vi(the ratio of debt to market value) ather than D/S,(the ratio of debt to equity), the concept used in the analytical develop- ment. The Di/V, measure is introduced at this point because it simplifies comparison and con trast of our view with the traditional position 2 The line MMin Figure 2 has been drawn with a positive slope on the assumption that ondition which will normally obtain, Our Prc ue to be valid, of course, even in the unlikely event that pe<r, but the slope MM would be ne gave Graham and Dodd 6, 4666 ng violence to tion, we can bring out its implications more sharply by igne the yield s a virtual constant over the relevant range. See 3, esp pp. 225-37] of what he calls the"net incon d of valuation