PART II Corporate Policy: Theory, Evidence, and Applications T HE FIRST PART OF THE text covers most of what has come to be recognized as a unified theory of decision making under uncertainty as applied to the field of finance. The theory of finance, as presented in the first half of the text, is applicable to a wide range of finance topics. The theoretical foundations are prerequisite to almost any of the traditional subject areas in finance curricula; e., portfolio management, corporation finance, commercial banking, money and capital markets, financial in- stitutions, security analysis, international finance, investment banking, speculative markets, insurance, and case studies in finance. Since all these topics require a thorough understanding of decision making under uncertainty, all use the theory of finance.
The second half of this text focuses, for the most part, on applications of the theory of finance to a corporate setting. The fundamental issues are: Does financing matter? Does the type of financing (debt or equity) have any real effect on the value of the firm? Does the form of financial payment (dividends or capital gains) have any effect on the value of claims held by various classes of security holders? Because these issues are usually discussed in the context of corporate finance they may seem to be narrow. This is not the case. First of all, the definition of a corporation is very broad.
The class of corporations includes not only manufacturing firms but also commercial banks, savings and loan associations, many brokerage houses, some investment banks, and even the major security exchanges. Second, the debt equity decision applies to all individuals as well as all corporations. Therefore although the language is narrow, the issues are very broad indeed. They affect almost every economic entity in the private sector of the economy.
357 358 CORPORATE POLICY: THEORY, EVIDENCE, AND APPLICATIONS As we shall see, the theoretical answer to the question "Does financing matter?" is often a loud and resounding "Maybe." Often the answer depends on the assumptions of the model employed to study the problem. Under different sets of assumptions, different and even opposite answers are possible. This is extremely disquieting to the student of finance. Therefore we have presented empirical evidence related to each of the theoretical hypotheses.
Frequently, but not always, the preponderance of evi- dence supports a single conclusion. It is important to keep in mind that hypotheses cannot be tested by the realism of the assumptions used to derive them. What counts for a positive science is the development of theories that yield valid and meaningful predictions about observed phenomena. On the first pass, what counts is whether or not the hypothesis is con- sistent with the evidence at hand.
Further testing involves deducing new facts capable of being observed but not previously known, then checking those deduced facts against additional empirical evidence. As students of finance, which seeks to be a positive science, we must not only understand the theory, but also study the empirical evidence in order to determine which hypothesis is validated. Chapter 11 is devoted to various empirical studies related to the efficient market hypothesis. Most of the evidence is consistent with the weak and semistrong forms of market efficiency but inconsistent with the strong form.
In certain situations, individuals with inside information appear to be able to earn abnormal returns. In particular, corporate insiders can beat the market when trading in the securities of their firm. Also, block traders can earn abnormal returns when they trade at the block price, as can purchasers of new equity issues. The last two situations will surely lead to further research because current theory cannot explain why, in the absence of barriers to entry, there appear to be inexplicable abnormal rates of return.
Chapter 12 returns to the theoretical problem of how to evaluate multiperiod investments in a world with uncertainty. It shows the set of assumptions necessary in order to extend the simple one-period CAPM rules into a multiperiod world. It also discusses two interesting applied issues: the abandonment problem, and the technique for dis- counting uncertain costs. Chapter 13 explores the theory of capital structure and the cost of capital.
This is the first of the corporate policy questions that relate to whether or not the value of the firm is affected by the type of financing it chooses. Also, we define a cost of capital that is consistent with the objective of maximizing the wealth of the current shareholders of the firm. This helps to complete, in a consistent fashion, the theory of project selection. Capital budgeting decisions that are consistent with shareholder wealth maximization require use of the correct technique (the NPV criterion), the correct definition of cash flows (operating cash flows after taxes), and the correct cost of capital definition.
Chapter 14 discusses empirical evidence on whether or not the debt-to-equity ratio (i., the type of financing) affects the value of the firm. This is one of the most difficult empirical issues in finance. Although not conclusive, the evidence is consistent with increases in the value of the firm resulting from increasing debt (up to some range) in the capital structure. However, much work remains to be done in this area.
Chapter 14 also provides a short example of how to actually compute the cost of capital. CORPORATE POLICY: THEORY, EVIDENCE, AND APPLICATIONS 359 Chapter 15 looks at the relationship between dividend policy and the value of the firm. There are several competing theories. However, the dominant argument seems to be that the value of an all-equity firm depends on the expected returns from current and future investment and not on the form in which the returns are paid out.
If investment is held constant, it makes no difference whether the firm pays out high or low dividends. On the other hand, a firm's announcement of increase in dividend payout may be interpreted as a signal by shareholders that the firm anticipates per- manently higher levels of return from investment, and of course, higher returns on investment will result in higher share prices. Chapter 16 presents empirical evidence on the relationship between dividend policy and the value of the firm that, for the most part, seems to be consistent with the theory—namely, that dividend policy does not affect shareholders' wealth. The chapter also applies the valuation models (presented in Chapter 15) to an example.
Chapter 17 uses the subject of leasing to bring together a number of further applications of capital structure and cost of capital issues. We also illustrate how option pricing can help clarify the nature of an operating lease under which the lessee may exercise a contractual right to cancel (with some notice and with moderate penalties). Chapter 18 discusses several applied topics of interest to chief financial officers pension-fund management, executive compensation, leveraged buyouts, ESOP's and interest rate swaps. Chapters 19 and 20 consider the widespread phenomenon of mergers.
They begin with the proposition that without synergy, value additivity holds in mergers as it does in other types of capital budgeting analysis. Mergers do not affect value unless the underlying determinants of value—the patterns of future cash flows or the ap- plicable capitalization factors are changed by combining firms. Empirical tests of mergers indicate that the shareholders of acquired firms benefit, on the average, but the shareholders of acquiring firms experience neither significant benefit nor harm. Chapters 21 and 22 conclude the book by placing finance in its increasingly important international setting.
A framework for analyzing the international financial decisions of business firms is developed by summarizing the applicable fundamen- tal propositions. The Fisher effect, which states that nominal interest rates reflect anticipated rates of inflation, is carried over to its international implications. This leads to the Interest Rate Parity Theorem, which states that the current forward exchange rate for a country's currency in relation to the currency of another country will reflect the present interest rate differentials between the two countries. The Purchasing Power Parity Theorem states that the difference between the current spot exchange rate and the future spot exchange rate of a country's currency in relation to the currency of another country will reflect the ratio of the rates of price changes of their internationally traded goods.
We point out that exchange risk is a "myth" in the sense that departures from fundamental parity theorems reflect changes in underlying demand and supply conditions that would cause business risks even if international markets were not involved. The fundamental relations provide the principles to guide firms in adjusting their policies to the fluctuations in the exchange rate values of the currencies in which their business is conducted. The only valid statement is that the current price embodies all knowledge, all expectations and all discounts that infringe upon the market. Morgenstern, Predictability of Stock Market Prices, Heath Lexington Books, Lexington, Mass., 1970, 20 Efficient Capital Markets: Evidence Empirical evidence for or against the hypothesis that capital markets are efficient takes many forms.
This chapter is arranged in topical order rather than chronological order, degree of sophistication, or type of market efficiency being tested. Not all the articles mentioned completely support the efficient market hypothesis. However, most agree that capital markets are efficient in the weak and semistrong forms but not in the strong form. The majority of the studies are very recent, dating from the late 1960s and continuing up to the most recently published papers.
Usually capital market efficiency has been tested in the large and sophisticated capital markets of developed countries. Therefore one must be careful to limit any conclusions to the appropriate arena from which they are drawn. Research into the efficiency of capital markets is an ongoing process, and the work is being extended to include assets other than com- mon stock as well as smaller and less sophisticated marketplaces. EMPIRICAL MODELS USED FOR RESIDUAL ANALYSIS Before discussing the empirical tests of market efficiency it is useful to review the three basic types of empirical models that are frequently employed.
The differences between them are important. The simplest model, called the market model, simply argues that 361 362 EFFICIENT CAPITAL MARKETS: EVIDENCE returns on security j are linearly related to returns on a "market" portfolio. Mathe- matically, the market model is described by Rit = a; + ki Rint + Cit .1) The market model is not supported by any theory. It assumes that the slope and intercept terms are constant over the time period during which the model is fit to the available data.
This is a strong assumption, particularly if the time series is long. The second model uses the capital asset pricing theory. It requires the intercept term to be equal to the risk-free rate, or the rate of return on the minimum variance zero-beta portfolio, both of which change over time. This CAPM-based methodology is written Rit = R ft [Rnz, — R ft ][1j + E ft .32) Note, however, that systematic risk is assumed to remain constant over the interval of estimation.
The use of the CAPM for residual analysis was explained at the end of Chapter 10. Finally, we sometimes see the empirical market line, which was explained in Chap- ter 7 and is written as Rjt j1 ) 0t Lfljt 8 jt• (7.36) Although related to the CAPM, it does not require the intercept term to equal the risk-free rate. Instead, both the intercept, ')i ot , and the slope, j)s,„ are the best linear estimates taken from cross-section data each time period (typically each month). urthermore, it has the advantage that no parameters are assumed to be constant over time.
All three models use the residual term, cit , as a measure of risk-adjusted abnormal performance. However, only one of the models, the second, relies exactly on the theo- retical specification of the Sharpe-Lintner capital asset pricing model.