Financial Theory and Corporate Policy/ THOMAS E. COPELAND Professor of Finance University of California at Los Angeles Firm Consultant, Finance McKinsey & Company, Inc. FRED WESTON Cordner Professor of Managerial Economics and Finance University of California at Los Angeles • •• ADDISON-WESLEY PUBLISHING COMPANY Reading, Massachusetts • Menlo Park, California • New York Don Mills, Ontario • Wokingham, England • Amsterdam Bonn • Sydney • Singapore • Tokyo • Madrid • San Juan This book is dedicated to our wives, Casey and June, who have provided their loving support; and to the pioneers in the development of the modern theory of finance: Hirshleifer, Arrow, Debreu, Miller, Modigliani, Markowitz, Sharpe, Lintner, Jensen, Fama, Roll, Black, Scholes, Merton, Ross, and others cited in the pages that follow. Without their intellectual leadership this text could not exist.
Library of Congress Cataloging-in-Publication Data Copeland, Thomas E., 1946– Financial theory and corporate policy. Includes bibliographies and index.1'5 87-12595 ISBN 0-201-10648-5 Many of the designations used by manufacturers and sellers to distinguish their products are claimed as trademarks. Where those designations appear in this book, and Addison-Wesley was aware of a trademark claim, the designations have been printed in initial caps or all caps. Copyright © 1988 by Addison-Wesley Publishing Company, Inc.
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ABCDEFGHIJ–DO-898 Preface In this third edition we seek to build on our experiences and the suggestions of users of the two previous editions. The feedback that we have received from all sources confirms our original judgment that there is a need for a book like Financial Theory and Corporate Policy. Therefore, we will continue to emphasize our original objectives for the book. Primarily, our aim is to provide a bridge to the more theoretical articles and treatises on finance theory.
For doctoral students the book provides a framework of conceptual knowledge, enabling the students to understand what the literature on financial theory is trying to do and how it all fits together. For MBAs it provides an in-depth experience with the subject of finance. Our aim here is to equip the MBA for his or her future development as a practicing executive. We seek to prepare the MBA for reading the significant literature of the past, present, and future.
This will help the practicing financial executive keep up to date with developments in finance theory, particularly as they affect the financial executive's own thinking processes in making financial decisions. As before, our emphasis is on setting forth clearly and succinctly the most important concepts in finance theory. We have given particular attention to testable propositions and to the literature that has developed empirical tests of important elements of finance theory. In addition, we have emphasized applica- tions so that the nature and uses of finance theory can be better understood.
PURPOSE AND ORGANIZATION Over the past 30 years a branch of applied microeconomics has been developed and specialized into what is known as modern finance theory. The historical demarcation point was roughly 1958, when Markowitz and Tobin were working on the theory of portfolio selection and Modigliani and Miller were working on capital structure and valuation. Prior to 1958, finance was largely a descriptive field of endeavor. Since then major theoretical thrusts have transformed the field into a positive science.
As evidence of the changes that have taken place we need only look at the types of people who teach in the schools of business. Fifty years ago the faculty were drawn from the ranks of business and government. They were respected and experienced statesmen within their fields. Today, finance faculty are predominantly academicians in the traditional sense of the word.
The majority of them have no business experience except for consulting. Their interest iii iV PREFACE and training is in developing theories to explain economic behavior, then testing them with the tools provided by statistics and econometrics. Anecdotal evidence and individual business experience have been superseded by the analytic approach of modern finance theory. The rapid changes in the field of finance have profound implications for management education.
As usual, the best students (and the best managers) possess rare intuition, initiative, common sense, strong reading and writing skills, and the ability to work well with others. But those with the greatest competitive advantage also have strong technical training in the analytical and quantitative skills of management. Modern finance theory emphasizes these skills. It is to the students and faculty who seek to employ them that this textbook is addressed.
The six seminal and internally consistent theories upon which modern finance is founded are: (1) utility theory, (2) state-preference theory, (3) mean-variance theory and the capital asset pricing model, (4) arbitrage pricing theory, (5) option pricing theory, and (6) the Modigliani-Miller theorems. They are discussed in Chapters 4 through 8 and in Chapter 13. Their common theme is "How do individuals and society allocate scarce resources through a price system based on the valuation of risky assets?" Utility theory establishes the basis of rational decision making in the face of risky alternatives. It focuses on the question "How do people make choices?" The objects of choice are described by state-preference theory, mean-variance portfolio theory, arbitrage pricing, and option pricing theory.
When we combine the theory of choice with the objects of choice, we are able to determine how risky alternatives are valued. When correctly assigned, asset prices provide useful signals to the economy for the necessary task of resource allocation. Finally, the Modigliani-Miller theory asks the question "Does the method of financing have any effect on the value of assets, particularly the firm?" The answer to this question has important implications for the firm's choice of capital structure (debt-to-equity mix) and dividend policy. It is important to keep in mind that what counts for a positive science is the development of theories that yield valid and meaningful predictions about ob- served phenomena.
The critical first test is whether the hypothesis is consistent 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, we must not only understand the theory, but also review the empirical evidence to determine which hypotheses have been validated. Consequently, every effort has been made to summarize the empirical evidence related to the theory of finance.
Chapter 7 discusses empirical evidence on the capital asset pricing model and the arbitrage pricing theory. Chapter 8 includes studies of how alternative option pricing models perform. Chapter 9, newly added to this edition, discusses the theory and evidence on futures markets. Chapter 11 covers evidence on the efficient markets hypoth- esis.
Chapter 14 reviews evidence on capital structure; Chapter 16 on dividend policy; Chapter 20 on mergers and acquisitions; and Chapter 22 on international finance. Finally, in addition to the theory and empirical evidence there is always the PREFACE V practical question of how to apply the concepts to difficult and complex real- world problems. Toward this end, Chapters 2 and 3 are devoted to capital budgeting, Chapter 14 shows how to estimate the cost of capital for a large, publicly held corporation, and Chapter 16 determines the value of the same company. Chapter 18, another change in this edition, emphasizes the theory and evidence on topics of interest to chief financial officers: pension fund management, interest rate swaps, and leveraged buyouts.
Throughout the text we attempt, wherever feasible, to give examples of how to apply the theory. Among other things we show how the reader can estimate his or her own utility function, calculate portfolio means and variances, set up a cross-hedge to reduce the variance of equity returns, value a call option, determine the terms of a merger or acquisition, use international exchange rate relationships. In sum, we believe that a sound foundation in finance theory requires not only a complete presentation of the theoretical concepts, but also a review of the empirical evidence that either supports or refutes the theory as well as enough examples to allow the practitioner to apply the validated theory. CHANGES IN THE THIRD EDITION We have tried to move all the central paradigms of finance theory into the first half of the book.
In the second edition this motivated our shifting the option pricing material into Chapter 8. In this third edition we decided to add a com- pletely new chapter on futures markets—Chapter 9. It covers traditional material on pricing both commodity and financial futures, as well as newer issues: why futures markets exist, why there are price limits in some markets but not others, and empirical evidence on normal backwardation and contango. In the materials on portfolio theory we have added a section on how to use T-bond futures contracts for cross-hedging.
In Chapter 7 we have updated the literature review on the Capital Asset Pricing Model and the Arbitrage Pricing Model. Chapter 8 contains new evidence on option pricing. The materials on capital structure (Chapters 13 and 14) and on dividend policy (Chapters 15 and 16) have been completely rewritten to summarize the latest thinking in these rapidly changing areas of research. Chapter 18 is completely new.
Many topics of importance to chief financial officers are applications of finance theory. Pension fund management, interest rate swaps, and leveraged buyouts are the examples developed in this chapter. Chapters 19 and 20 on mergers and acquisitions, restructuring, and corporate control represent up-to-date coverage of the burgeoning literature. Similarly, Chapters 21 and 22 reflect the latest thinking in the field of international financial management.
We made numerous other minor changes. In general, we sought to reflect all of the new important literature of finance theory—published articles and treatises as well as working papers. Our aim was to keep the book as close as possible to the frontiers of the "state-of-the-art" in the literature of finance theory. SUGGESTED USE IN CURRICULUM At UCLA we use the text as a second course in finance for MBA students and as the first finance course for doctoral students.
We found that requiring all finance majors to take a theory-of-finance course before proceeding to upper- level courses eliminated a great deal of redundancy. For example, a portfolio theory course that uses the theory of finance as a prerequisite does not have to waste time with the fundamentals. Instead, after a brief review, most of the course can be devoted to more recent developments and applications. Because finance theory has developed into a cohesive body of knowledge, it underlies almost all of what had formerly been thought of as disparate topics.
The theory of finance, as presented in this text, is prerequisite to security analysis, portfolio theory, money and capital markets, commercial banking, speculative markets, investment banking, international finance, insurance, case courses in corporation finance, and quantitative methods of finance. The theory of finance can be, and is, applied in all of these courses. That is why, at UCLA at least, we have made it a prerequisite to all the aforementioned course offerings. The basic building blocks that will lead to the most advantageous use of this text include algebra and elementary calculus; basic finance skills such as discount- ing, the use of cash flows, pro-forma income statements and balance sheets; elementary statistics; and an intermediate-level microeconomics course.
Conse- quently, the book would be applicable as a second semester (or quarter) in finance. This could occur at the junior or senior undergraduate year, for MBAs during the end of their first year or beginning of their second year, or as an introductory course for Ph.