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4 Introduction in Part III, analyzes the monitoring of management by one or several securityholders (large shareholder, main bank, venture capitalist, etc.). As we just discussed, the monitors in a sense are insiders themselves as they must be given proper incentives to fulfill their mission. The material reviewed in Part III might therefore be more correctly described as the study of financing in the presence of multiple insiders (managers plus monitors). We will, however, maintain the standard distinction between nonexecutive parties (the securityholders, some of which have an active monitoring role) and executive offi- cers. But we should keep in mind the fact that the division between insiders and outsiders is not a foregone conclusion. Chapter 8 investigates the social costs and bene- fits of passive monitoring, namely, the acquisition, by outsiders with purely speculative motives, of information about the value of assets in place; and it shows how they relate to the following questions. Why are entrepreneurs and managers often compensated through stocks and stock options rather than solely on the basis of what they actually deliver: profits and losses? Do shareholders who are in for the long term benefit from liquid and deep secondary markets for shares? The main theme of the chapter is that a firm’s stock market price continuously provides a measure of the value of assets in place and therefore of the impact of managerial behavior on investor returns. In Chapter 9, by contrast, active monitoring curbs the borrower’s moral hazard (alternatively, it could alleviate adverse selection). Monitoring, however, comes at some cost: mere costs for the monitors of studying the firms and their environment, monitors’ supranormal profit associated with a scarcity of monitoring capital, reduction in future competition in lending to the extent that incumbent monitors acquire superior information on the firm relative to competing lenders, block illiquidity, and monitors’ private benefits from control. Part IV develops a control-rights approach to corporate finance. Chapter 10 analyzes the allocation of formal control between insiders and outsiders. A firm that is constrained in its ability to secure financing must allocate (formal) control rights between insiders and outsiders with a view to creating pledgeable income; that is, control rights should not necessarily be granted to those who value them most. This observation generates a rationale for “shareholder value” as well as an empirically supported connection between firms’ balance-sheet strength and investors’ scope of control. The chapter then shows how (endogenously) better-informed actors (management, minority block shareholders) enjoy (real) control without having any formal right to decide; and argues that the extent of managerial control increases with the strength of the firm’s balance sheet and decreases with the (endogenous) presence of monitors. Finally, Chapter 10 analyzes the allocation of control rights among different classes of securityholders. While the paradigm reviewed in Part III already generated conflicts among the securityholders by creating different reward structures for monitors and nonmonitors, this conflict was an undesirable side-product of the incentive structure required to encourage monitoring. As far as monitoring was concerned, nonmonitors and monitors had congruent views on the fact that management should be monitored and constrained. Chapter 10 shows that conflicts among securityholders may arise by design and that control rights should be allocated to securityholders whose incentives are least aligned with managerial interests when firm performance is poor. Chapter 11 focuses on a specific control right, namely, raiders’ ability to take over the firm. As described in Chapter 1, this ability is determined by the firm’s takeover defense choices (poison pills, dual-vote structures, and so forth), as well as by the regulatory environment. In order not to get bogged down by country- and time-specific details, we first develop a “normative theory of takeovers,” identifying their two key motivations (bringing in new blood and ideas, and disciplining current management) and studying the social efficiency of takeover policies adopted by the firms. The chapter then turns to the classical theory of the tendering of shares in takeover contests and of the free-rider problem, and studies firms’ choices of poison pills and dual-class voting rules. A third branch of modern corporate finance, reviewed in Part V, takes into account the existence of investors’ clienteles and thereby returns to the
Introduction 5 classical view that securityholders differ in their preferences for state-contingent returns. For instance, it emphasizes the fact that individual investors as well as corporations attach a premium to the possibility of being able to obtain a decent return on their asset portfolio if they face the need to liquidate it. Chapter 12 therefore studies consumer liquidity demand. Consumers who may in the future face liquidity needs value flexibility regarding the date at which they can realize (a decent return on) their investment. It identifies potential roles for fi- nancial institutions as (a) liquidity pools, preventing the waste associated with individual investments in low-yield, short-term assets, and (b) insurers, allowing consumers to smooth their consumption path when they are hit by liquidity shocks; and argues that the second role is more fragile than the first in the presence of arbitrage by financial markets. It then studies bank runs. Finally, the chapter argues that heterogeneity in the consumers’ preference for flexibility segments investors into multiple clienteles, with consumers with short horizons demanding safe (low-information-intensity) securities and those with longer horizons being rewarded through equity premia for holding risky securities. Part VI analyzes the implications of corporate finance for macroeconomic activity and policy. Much evidence has been gathered that demonstrates a substantial impact of liquidity and leverage problems on output, investment, and modes of financing. As we will see, the agency approach to corporate finance implies that economic shocks tend to be amplified by the existence of financial constraints, and offers a rationale for some macroeconomic phenomena such as credit crunches and liquidity shortages. Economists since Irving Fisher have acknowledged the role of credit constraints in amplifying recessions and booms. They have distinguished between the “balance-sheet channel,” which refers to the influence of firms’ balance sheets on investment and production, and the “lending channel,” which focuses on financial intermediaries’ own balance sheets. Chapter 13 sets corporate finance in a general equilibrium environment, enabling the endogenous determination of factor prices (interest rates, wages). It also shows that transitory balance-sheet effects may have long-term (poverty-trap) effects on individual families or countries altogether, and investigates the factors of dynamic complementarities or substitutabilities. Capital reallocations (mergers and acquisitions, sales of property, plants and equipment) serve to move assets from low- to high-productivity uses, and, as emphasized in several chapters, may further be driven by managerial discipline and pledgeable income creation concerns. Chapter 14 endogenizes the resale value of assets in capital reallocations. It first focuses on specialized assets, which can be resold only within the firm’s industry. Their resale value then hinges on the presence in the industry of other firms that have (a) a demand for the assets and (b) the financial means to purchase them. A central focus of the analysis is whether firms build too much or too little “financial muscle” for use in future acquisitions. Second, the chapter studies nonspecialized assets, which can be redeployed in other industries, and looks at the dynamics of credit constraints and economic activity depending on whether these assets are or are not the only stores of value in the economy. Chapter 15 investigates the very existence of stores of value in the economy, as these stores of value condition the corporate sector’s ability to meet liquidity shocks in the aggregate. It builds on the analysis of Chapter 5 to derive individual firms’ demand for liquid assets and then looks at equilibrium in the market for these assets. It is shown that the private sector creates its own liquidity and that this “inside liquidity” may or may not suffice for a proper functioning of the economy. A shortage of inside liquidity makes “outside liquidity” (existing rents, government-created liquidity backed by future taxation) valuable and has interesting implications for the pricing of assets. Laws and regulations that affect the borrowers’ ability to pledge income to their investors, and more generally the many public policies that influence corporate profitability and pledgeable income (tax, labor and environmental laws, prudential regulation, capital account liberalization, exchange rate management, and so forth) have a deep impact on the firms’ ability to secure funding and on their design of financial structure and governance. Chapter 16 defines “contracting institutions” as referring to the
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6 Introduction public policy environment at the time at which borrowers, investors and other stakeholders contract; and “property rights institutions” as referring to the resilience or time-consistency of these policies. Chapter 16 derives a “topsy-turvy principle” of policy preferences, according to which for a widespread variety of public policies, the relative preference of heterogeneous borrowers switches over time: borrowers with weak balance sheets have, before they receive funding, the highest demand for investorfriendly public policies, but they are the keenest to lobby to have these policies repudiated once they have secured financing. This principle is applied to public policies affecting the legal enforcement of collateral, income, and control rights pledges made by borrowers, and is shown to alter the levels of collateral, the maturity of debts, and the allocation of control. The chapter then shows that borrowers exert externalities (mediated by the political process) through their design of financial structures. Finally, it studies the emergence of public policies in an environment in which policies are set by majority rule. The book contains a large number of exercises. While some are just meant to help the reader gain familiarity with the material, many others have a dual purpose and cover insights derived in contributions that are not surveyed or little emphasized in the core of the text; a few exercises develop results not available in the literature. I would like to emphasize that solving exercises is, as in other areas of study, a key input into mastering corporate finance theory. Students will find many of these exercises challenging, but hopefully eventually rewarding. With this perspective, the reader will find in Part VII answers and hints to most exercises as well as a few review questions and exercises. Also see the website for the book at http://www.pupress.princeton.edu/ titles/8123.html, where these exercises, answers, and some lecture transparencies are available for lecturers to download and adapt for their own use, with appropriate acknowledgement. Approach While tremendous progress has been made on the theoretical front in the past twenty years, the lack of a unified framework often disheartens students of corporate finance. The wide discrepancy of assumptions across papers not only lengthens the learning process, but it also makes it difficult for outsiders to identify the key economic elements driving the analyses. This diversity of modeling approaches is a natural state of affairs and is even beneficial for a young, unexplored field, but is a handicap when we try to take stock of our progress in understanding corporate finance. The approach taken here obeys four precepts. The first is to stick as much as possible to the same modeling choices. The book employs a single, elementary model in order to illustrate the main economic insights. While this unified apparatus does not do justice to the wealth of modeling tools encountered in the literature, it has a pedagogic advantage in that it economizes the reader’s investment in new modeling to study each economic issue. Conceptually, this controlled experiment highlights new insights by minimizing modifications from one chapter to the next. (The supplementary material in Chapter 3 discusses at some length some alternative modeling choices.) Second, the exposition aims at simplifying modeling as much as possible. I will try to indicate when this involves a loss of generality. But hopefully it will become clear that the phenomena and insights are robust to more general assumptions. In this respect, I will insist as much as possible on deriving the optimal structure of financing and corporate governance, so as to ensure that the institutions we derive are robust; that is, by exhausting contracting possibilities, we check that the incentive problems we focus on cannot be eliminated. Third, original contributions have been reorganized and sometimes reinterpreted slightly, for a couple of reasons. First, it is common (and natural!) that authors do not realize the significance of their contributions at the time they write their articles; consequently, they may motivate the paper a bit narrowly, without fully highlighting the key insights that others will subsequently build on. Relatedly, a textbook must take advantage of the benefits of hindsight. Second, the book represents a systematic attempt at organizing the field in a coherent manner. Original articles are often motivated by a specific
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Introduction 7 application: dividend policy, capital structure, stock issues, stock repurchases, hedging, etc.; while such an application-driven approach is natural for research purposes, it does not fit well with a general treatment of the field since the same model would have to be repeated several times throughout a book that would be structured around applications. I do hope that the original authors will not take offense at this “remodeling” and will rather see it as a tribute to the potency and generality of their ideas. Fourth, the book is organized in a “horizontal” fashion (by theoretical themes) rather than a “vertical” one (with a division according to applications: debt, dividends, collateral, etc.). The horizontal approach is preferable for an exposition of the theory because it conveys the unity of ideas and does not lead to a repetition of the same material in multiple locations in the book. For readers more interested in a specific topic (say, for empirical purposes), this approach often requires combining several chapters. The links indicated within the chapters should help perform the necessary connections. Prerequisites and Further Reading The following chapters are by and large self-contained. Some institutional and empirical background is supplied in Part I. This background is written with the perspective of the ensuing theoretical treatment. For a much more thorough treatment of the institutions of corporate finance, the reader may consult, for example, Allen, Brealey, and Myers (2005), Grinblatt and Titman (2002), or Ross, Westerfield, and Jaffe (1999). Very little knowledge of contract theory and information economics is required. Familiarity with these fields, however, is useful in order to grasp more advanced topics (again, we will stick to fairly elementary modeling). The books by Laffont (1989) and Salanié (2005) offer concise treatments of contract theory. A more exhaustive treatment of contract theory will be found in the textbooks by Bolton and Dewatripont (2005) and Martimort and Laffont (2002). Shorter treatments can be found in the relevant chapters in Kreps (1990), Mas Colell, Whinston, and Green (1995), and Fudenberg and Tirole (1991, Chapter 7 on mechanism design). At a lower level, Milgrom and Roberts (1992) will serve as a useful motivation and introduction. Let us finally mention the survey by Hart and Holmström (1987), which offers a good introduction to the methodology of moral hazard, labor contracts, and incomplete contracting, and that by Holmström and Tirole (1989), which covers a broader range of topics and is nontechnical. Similarly, no knowledge of the theory of corporate finance is required. Two very useful references can be used to complement the material developed here. Hart (1995) provides a much more complete treatment of a number of topics contained in Part IV, and is highly recommended reading. Freixas and Rochet (1997) offers a thorough treatment of credit rationing and, unlike this book, covers the large field of banking theory.3 Further useful background reading in corporate finance can be found in Newman, Milgate, and Eatwell (1992), Bhattacharya, Boot, and Thakor (2004), and Constantinides, Harris, and Stulz (2003). Finally, the reader can also consult Amaro de Matos (2001) for a treatment at a level comparable with that of this book. Some Important Omissions Despite its length, the book makes a number of choices regarding coverage. Researchers, students, and instructors will therefore benefit from taking a broader perspective. Without any attempt at exhaustivity and in no particular order, this section indicates a few areas in which the omissions are particularly glaring, and includes a few suggestions for further reading. Empirics As its title indicates, the book focuses on theory. Some of the key empirical findings are reviewed in Chapters 1 and 2 and serve as motivation in later chapters. Yet, the book falls short of even paying an appropriate tribute to the large body of empirical results established in the last thirty years, let alone of providing a comprehensive overview of empirical corporate finance. 3. Another reference on the theory of banking is Dewatripont and Tirole (1994), which is specialized and focuses on regulatory aspects
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8 Introduction As in other fields of economics, some of the most exciting work involves tying the empirical analysis closely together with theory. I hope that, despite its strong theoretical bias, empirical researchers will find the book useful in their pursuit of this endeavor. Theory The book either does not cover or provides insuffi- cient coverage of the following topics. Taxes. To escape the Modigliani–Miller irrelevance results, researchers, starting with Modigliani and Miller themselves, first turned to the impact of taxes on the financial structure. Taxes affect financing in several ways. For example, in the United States and many other countries, equity is taxed more heavily than debt at the corporate level, providing a preference of firms for leverage.4 The so-called “static tradeoff theory,” first modeled by Kraus and Litzenberger (1973) and Scott (1976), used this fact to argue that the firms’ financial structure is determined by a tradeoff between the tax savings brought about by leverage and the financial cost of the enhanced probability of bankruptcy associated with high debt. The higher the tax advantages of debt, the higher the optimal debt–equity ratio. Conversely, the higher the nondebt tax shields, the lower the desired leverage.5 Taxes also affect payout choices; indeed, much empirical work has investigated the tax cost for firms of paying shareholders in dividends rather than through stock repurchases, which may bear a lower tax burden.6 For two reasons, the impact of taxes will be discussed only occasionally. First, the effects are usually conceptually straightforward, and the intellectual challenge is by and large the empirical one of measuring their magnitude. Second, taxes are 4. In order to avoid concluding that firms should issue only debt, and no equity, early contributions assumed that bankruptcy is costly. Because more leverage increases the probability of financial distress, equity reduces bankruptcy costs. (Bankruptcy costs, unlike taxes, will be studied in the book.) 5. These predictions have received substantial empirical support (see, for example, Mackie-Mason 1990; Graham 2003). There is a large literature on financial structures and the tax system (Swoboda and Zechner 1995). A recent entry is Hennessy and Whited (2005), who derive a tax-induced optimal financial structure in the presence of taxes on corporate income, dividends, and interest income (as well as equity flotation costs and distress costs). 6. See Lewellen and Lewellen (2004) for a study of the tax benefits of equity under dividend distribution and share repurchase policies. country- and time-specific, making it difficult to draw general conclusions.7 Bubbles. Asset price bubbles, that is, the wedge between the price of financial claims and their fundamental,8 have long been studied through the lens of aggregate savings and intertemporal efficiency.9 Some recent work was partly spurred by the dramatic NASDAQ bubble of the late 1990s, the accompanying boom in initial public offerings (IPOs) and seasoned equity offerings (SEOs), and their collapse in 2000–2001. Relative to the previous literature on bubbles, this new research further emphasizes the impact of bubbles on entrepreneurship and asset values. An early contribution along this line is Allen and Gorton (1993), in which delegated portfolio management, while necessary to channel funds from uninformed investors to the best entrepreneurs, creates agency costs and may generate short horizons10 and asset price bubbles. Olivier (2000) and Ventura (2004) draw the implications of bubbles that are attached to investment and to entrepreneurship per se, respectively; for example, in Ventura’s paper, the prospect of surfing a bubble at the IPO stage relaxes entrepreneurial financing constraints. Bubbles matter for corporate finance for at least two reasons. First, and as was already mentioned, they may directly increase investment either by altering its yield or by relaxing financial constraints. Second, they create additional stores of value in an economy that may be in need of such stores. Chapter 15 will demonstrate that the existence of stores of value may facilitate firms’ liquidity management. This may create another channel of complementarity between bubbles and investments. The research on the interaction between price bubbles and corporate 7. For similar reasons, we will not enter into the details of bankruptcy law, which are highly country- and time-specific. Rather, we will content ourselves with theoretical considerations (in particular in Chapter 10). 8. Fundamentals are defined as the present discounted value of payouts estimated at the consumers’ intertemporal marginal rate of substitution. 9. On the “rational bubble” front, see, for example, Tirole (1985), Weil (1987), Abel et al. (1989), Santos and Woodford (1997), and, for an interesting recent entry, Caballero et al. (2004a). Another substantial body of research has investigated “irrational bubbles” (see, for example, Abreu and Brunnermeier 2003; Scheinkman and Xiong 2003; Panageas 2004). 10. See Allen et al. (2004) for different implications (such as overreactions to noisy public information) of short trading horizons