Sunday, May 16, 2010

Performing Corporate Finance

1.0 Introduction

Economics can change the world, and not necessarily for the better. Mainstream economists often do not describe actual capitalist economies, but theorize an imaginary, supposedly ideal world in which everybody pursues their own self-interest, narrowly defined. Participants in this world are then sometimes encouraged by the theory to change institutions and their behavior to come closer to that imaginary world.

This post describes theories that encouraged corporations to become more vulnerable, by taking on large amounts of debt, and to become more short-run oriented, by focusing more on immediate stock market prices. I know about these two contributions to economics more from Bernstein and Cassidy's popularizations than the primary literature. I am deliberately treating some elements that I think have not much appeared in popular discussion since the advent of the global financial crisis.

2.0 Modigliani and Miller (M&M) and Capital Structure

The Modigliani and Miller theorem states that whether a corporation obtains financing with stocks or with bonds has no impact on its stock price. I gather that this follows from an arbitrage argument under admittedly unrealistic assumptions. An individual can buy stock with borrowed money. By buying stock on the margin, individuals can raise the leverage ratio from whatever corporations have decided on to whatever they like.

The M&M theorem serves as a baseline in corporate finance. One considers the implications of existing deviations from the theorem assumptions. Apparently the treatment for corporate taxes in the United States of dividends and interest is one such deviation. Interest on bonds can be deducted as expenses on corporate taxes; stock dividends cannot. Therefore financing by issuing bonds is to be preferred.
"This [proposition] carried not very flattering implications for the top managements of companies with low levels of debt. It suggested that the high bond ratings of such companies in which the management took so much pride, may actually have been a sign of their incompetence; that the managers were leaving too much of their stockholders' money on the table in the form of unnecessary corporate income tax payments [of] many millions of dollars." -- Merton Miller (1988), quoted in Bernstein (2005)
The implication is that corporations should increase their leverage.

3.0 Michael Jensen and Executive Compensation

Most owners (that is, holders of stock) of modern corporations are absentee owners. They would like corporate executives to act in a non self-dealing manner, against their own interests. This is a principal agent problem. The stock holder is the principal, the Chief Executive Officer (CEO), for instance, is an agent. In theory, the problem is how to structure executive pay and corporate incentives such that in value of stock is maximized. (I gather that in this theory, social norms about how stockholders, traders, and executives should behave doesn't come into it.) A supposed answer to the principal agent problem is to pay executives partly with stock options. They will then be encouraged to do their utmost to ensure the market price of the stock exceeds the price specified in their options.

  • Peter L. Bernstein (2005) Capital Ideas: The Improbable Origins of Modern Wall Street, John Wiley & Sons.
  • John Cassidy (2002) "The Greed Cycle: How the Financial System Encouraged Corporations to go Crazy", The New Yorker (Sept. 23): pp. 64-
  • Michael C. Jensen and William H. Meckling (1976) "Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure", Journal of Financial Economics, V. 3, N. 4
  • Meron H. Miller (1988) "The Modigliani-Miller Propositions After Thirty Years", Journal of Economic Perspectives, V. 2, N. 4 (Fall): pp. 99-120.
  • Franco Modigliani and Merton H. Miller (1958) "The Cost of Capital, Corporation Finance, and the Theory of Investment", American Economic Review, V. 48, N. 3 (June): pp. 655-669

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