The Corporate Financiers

Williams, Modigliani, Miller, Coase, Williamson, Alchian, Demsetz, Jensen, Meckling

C. Read

• Éditeur: Palgrave Macmillan
• Année: 2014
• ISBN:
  9781137341280
• Sujet: Economics
• Sous-sujet: Econometrics

The Corporate Financiers is the fifth book in aseries of discussions about the great minds in the history and theory offinance. While the series addresses the contributions of scholars in ourunderstanding of modern finance, this volume presents the ways in which acorporation creates value.Morethan two centuries ago, Adam Smith explained the concept of division of laborand the efficiencies of specialization as the mechanism in which a firm createsvalue. However, corporations now find themselves outsourcing some processes toother firms as an alternative way to create value. There must be other economicforces at work than simply the internal efficiencies of a firm. We begin bydescribing the work of a rather obscure scholar named John Burr Williams who demonstratedin 1938 how the earnings of a firm are capitalized into corporate value throughits stock price. We then delve into the inner workings of the moderncorporation by describing the contributions of Nobel Memorial Prize winnersRonald Coase and Oliver Williamson. More than any others, these scholarscreated a renewed appreciation for our understanding of the institutionaldetail of the modern corporation in reducing costs and increasing efficiency.WhileCoase and Williamson provided meaningful descriptions of the advantage of acorporation, they did not offer prescriptions for the avenues the corporationcan create more value in an era when new technologies make outsourcing andtelecommuting increasingly possible. Michael Jensen and William Mecklingdescribe in greater detail the nature of the implicit contracts a corporationemploys, and recommend remedies to various problems that arise when the goalsof the corporation are not aligned with the incentives of its agents. We alsodescribe the further nuances to these relationships as offered by Armen Alchianand Harold Demsetz. We treat the lives of these extraordinary individuals wholooked at a very familiar problem in a sufficiently novel light to change theway all look at corporations ever since. That is the test of genius.

1

Introduction

Corporations create value. Financial intermediation in the United States represented just 2 percent of Gross Domestic Product in 1870, but this had risen to almost 9 percent of GDP by 2010.¹ The addition of direct business investment brings this share to more than 18 percent of GDP, or about double the representation of finance markets in the size of the American economy. This mobilization of capital supported the rapid expansion of global trade over the period of the Industrial Revolution. But, the freezing of capital markets has plunged nations and the world into recessions and depressions on several different occasions, including the recent Global Financial Meltdown. Even the layperson now realizes that financial markets are essential for the smooth operation of the global economy. Yet, while most all this activity depends crucially on the correct valuation of the value corporations create, accurate models of corporate value have existed for only the last few generations.

In 1776, just as a new nation declared its independence from Great Britain, the global economic superpower of the day, Adam Smith, in his An Inquiry into the Nature and Causes of the Wealth of Nations, offered the first treatment of the creation of corporate value.² More than a century and a half later, Ronald Coase’s The Nature of the Firm, treated below, began to formalize the foundations for our understanding of the role of the entrepreneurial manager in creating value within the firm. In that same era, Frank Hyneman Knight (November 7, 1885–April 15, 1972) described the nature of risk and the risk–reward trade-off.³ And, at about the same time as Coase described the nature of a firm, a little known financial analyst in Boston, with the aristocratic name John Burr Williams, created the first thorough treatment of how rational markets ought to capitalize the value corporations create.

As we shall see, the contributions of both Williams and Coase went underappreciated for several decades. This oversight can be attributed to the compelling beauty of scholars’ focus on an alternate, and more mathematical, but less helpful, description of the market system, known as the neoclassical model, in sharp contrast to the untidy, complex, and nuanced inner workings of the modern corporation.

This volume documents the rise of our understanding of the capital structure and value creation of the modern corporation since 1937. I begin by providing a brief description of what we thought we understood for so long, since the publication of Adam Smith’s Wealth of Nations. I demonstrate that so much work was done to formalize Smith’s depiction of markets, and with such fantastic economy and success, that finance and economics scholars proceeded to pat ourselves on the back and reveled in what we now call the neoclassical model. From its inception in 1969, the first few presentations of the Nobel Memorial Prize in Economic Sciences recognized those still living economists and financial theorists who contributed to our understanding of the modern market economy. Almost every prize over the last couple of decades has encouraged a different line of discovery. They have increasingly recognized those theorists that help explain when and why the neoclassical model does not work well, and how to correct these flaws. The Committee also began to recognize those individuals who help determine the nuanced and myriad ways value is created within the walls of the modern corporation.

In this book I tell a story of this process of our discovery of corporate value. I begin with a brief description of the neoclassical model. I do so in much less detail than is treated in the other volumes of this series that are devoted to the workings and mathematical detail of financial markets. Instead, I provide an overview of the reasons why such a compelling neoclassical model of markets captivated the majority of our attention for so long.

I then move on to describe the life, times, and contributions of John Burr Williams. Williams, trained as a chemical engineer at Harvard, became both fascinated and flummoxed by the gyrations of financial markets in the 1920s and 1930s. When Williams was young his father was a senior executive for a large American insurance company, so Williams understood that market fundamentals, based on his model of the discounted cash flow of corporate earnings, do not fluctuate to nearly the extent suggested by their stock prices. Williams set out to correct what he saw as a failure of financial markets to properly perceive value. In doing so, he developed the principal models of corporate earnings valuation that we now call fundamentals analysis and which is now taught in every ‘introduction to corporate finance’ class.

At the same time, but for very different reasons, a British scholar named Ronald Coase produced a classic treatise on the nature of value creation within the firm. He, too, was inspired by the events of the Great Depression. Around the time he completed his undergraduate studies at the London School of Economics, he was offered a scholarship to travel around Depression-era United States for a summer to study how great American companies create value with so much more efficiency than their British counterparts. These American businesses had increasingly pioneered a more scientific approach to corporate efficiency following the World War I. Coase visited both shop floors and executive offices and returned enamored with both American commerce and the United States itself. The result of his travels was a little appreciated paper that described how he saw corporate value created within the corporation. In doing so, he reinvented a New Institutional Economics that relies on arguments which more closely resemble the way law is studied rather than the increasingly mathematical approach that was, and remains, in vogue in finance and economics.

Coase’s work went either unappreciated or underappreciated for decades. He had written during the height of the Great Depression at a time when desperate nations sought explanations of the failure of global markets. A year after John Maynard Keynes (June 5, 1883–April 21, 1946) produced his seminal 1936 contribution to the ways in which a modern economy functions,⁴ Coase described the creation of corporate value in The Nature of the Firm. A generation later, Coase produced another seminal paper, The Problem of Social Cost,⁵ which attracted much more attention. In his later paper, he applied his same logic about the importance of the reduction of transactions costs within the corporation to the implications of zero transactions costs on market transactions. His revolutionary approach caused scholars to take a second look at his earlier paper and over the course of the ensuing decade, there sprouted a new field, now called New Institutional Economics.

Coase was remarkable and unusual not only in the clarity of his intuition and observations, but also in his reliance not on the compactness and formality of mathematics but rather on logic and painstaking descriptions of previously inadequately described institutions. As a consequence, his analyses were very accessible and provocative to scholars and practitioners alike. However, he wrote at a level of generality that required more formal treatment if professors were to teach his concepts, business leaders were to incorporate them, and financial analysts were to be able to use his ideas to demonstrate the potential for corporations to create synergistic profits and an intangible asset value in excess of their book value. Often, courts had to mediate disputes over this goodwill, and they too needed a more meaningful explanation of how such intangible value is created. Coase, and his followers, provided that explanation.

In the next dozen years, three sets of scholars each elaborated upon the concepts created by Coase. First, Oliver Williamson offered a much more formal description of the nature of the transactions costs a firm can avoid by creating value in-house. Coase had presented the concept that a firm creates value by avoiding the costly exercise of contracting within the marketplace each time it needed to complete a process. According to his analysis it can economize instead by insourcing these processes with employees and entities with whom it can negotiate and renegotiate an implicit production contract as often and as inexpensively as possible. The economy of these implicit internal contracts offers the corporation an advantage over the more cumbersome, and necessarily more generic free market. Williamson described such a nexus of contracts as the primary advantage a corporation can exploit to create value. Contrary to conventional wisdom, he even argued that increased vertical integration of a corporation can enhance these opportunities. Rather than an economic threat, vertical integration can act as an efficiency enhancer and a value creator.

Coase and Williamson shared a quality that others would subsequently follow. Both scholars adopted a multidisciplinary approach to their explorations. In fact, their work was almost immediately embraced by corporate law scholars who would otherwise avoid more technical treatises in economics and finance. Indeed, both Williamson and Coase became closely associated with the law schools at their respective institutions, and each helped found and edit a new journal that combined the disciplines of law and economics.

Their work directed corporate leaders to ways in which value can be enhanced, sometimes by combining units, and, at other times, by breaking up units that have become so complex that the necessary implicit contracting within a firm became cumbersome and bureaucratic. However, Coase and Williamson would leave to others the identification of other related forms of corporate value, even though they hinted at additional avenues for research.

As Coase and Williamson were developing the New Institutional Economics, a pair of more mainstream scholars, eventual Nobel Prize laureates Franco Modigliani and Merton Miller, permanently established in the modern study of corporate finance what Williams intuited decades earlier – that corporations can expand using debt or equity with equal efficiency. Meanwhile, two other pairs of scholars offered these additional insights. Michael Jensen and William Meckling described a new vocabulary, called the principal–agent problem, or agency theory, that could be employed to more fully describe the nature of the relationship between a principal who wants to have a task performed to satisfy its goals, and an agent it hires to perform the task. Unless the understanding and the quid pro quo of the mutual relationship between the principal and the agent is well-specified and exceedingly well-designed, the differing preferences of the principal and the agent invariably create suboptimal results. Once the divergent goals of the principal and the agent are better described, a better implicit or explicit contract can be created.

Jensen and Meckling’s approach proved to be a framework that not only described and helped correct the divergent goals of principals and agents on the shop floor, but also demonstrated potential misalignments between the goals of the shareholders and the corporation’s executive officers. Jensen and Meckling’s approach created an entire literature on the optimal design of compensation schemes that align the principal’s goals with the agent’s performance and compensation. This topic remains one of the most intuitive and discussed factors among corporate directors, and even for regulators intent on ensuring that our financial system does not again suffer the meltdown that was induced by poorly designed compensation schemes.

Finally, Armen Alchian and Harold Demsetz helped to insert two additional terms into the corporate vernacular. They described the concepts of moral hazard and shirking, which allow us to more fully understand some of the human forces that Jensen and Meckling sought to avoid. The term moral hazard has been used in recent decades to describe the dangers that loom when an individual or entity makes financial decisions not based on whether they contribute to overall corporate and economy-wide efficiency, but rather on the perverse incentives offered to the agent. For instance, banks too big to fail may take on greater than optimal risk based on their ability to capitalize on potentially large profits if the risk pans out, but with the knowledge that taxpayers may indemnify their costly mistakes if the risk instead causes a significant financial loss. This notion and the problems that arise when there are privatized gains and socialized losses is exactly the scenario envisaged by Alchian and Demsetz.

Like Coase and Williamson before them, both Alchian and Demsetz and Jensen and Meckling formed bridges across disciplines and were likewise embraced by both legal and financial scholars.

In this series, we have described how markets measure value and securities prices and how individuals plan accordingly and arrange their personal finances based on the functioning of markets. But, until the scholars discussed in this volume directed their attention to the inner workings of corporate value creation, it has remained difficult to quantify such creation of value. The scholars in this volume correct our oversight. In doing so, they created a renewed interest in New Institutional Economics that is much more useful conceptually to corporate leaders, directors, analysts, and managers alike. At the same time, they have spawned a series of elaborations that further describe the challenges corporations must overcome and the value they can create. In doing so, these scholars reshaped the theory of the firm and the intuition that is now broadly understood and applied by practitioners who live outside the Ivory Tower of academia.

The theories of these great minds also represent a departure of sorts from the other branches of finance contained in this series. Beyond the formal mathematical analytics of John Burr Williams, most of the great ideas described here can easily be described through words rather than equations. Some of the ideas presented here could also be represented in mathematical form, but the mathematics would provide no great insights into the problems recognized by these great minds. The New Institutional Economics created by these great minds in finance provides a plethora of important insights, but without the burden of advanced mathematics required for other areas of finance treated in this series. As a consequence, the concepts presented here remain both timely and accessible.

Section 1
From Art to Science

The study of the theory of the firm enjoyed a renaissance in the period between the two world wars, but also suffered a curse. Our scrutiny of markets relied on the bright light of a scientific method borrowed from an era of physics that discovered the theory of relativity and quantum mechanics. Many of the same principles were applied to our study of markets and of corporations. By adopting these highly mathematical tools, we had to make a Faustian choice. Because nature is most efficient, one of the primary tools of the analysis of optimization is calculus. To rely on this powerful tool, financial theorists must assume that individual market participants are rational, and profit opportunities are usurped through arbitrage, just as a gas seeks to fill a vacuum and water seeks its own level. By adopting to hastily these convenient and plausible analogies, we glossed over the art of describing the nuances that make every economic entity somewhat unique. We are instead left with what we now know, for better or worse, as the neoclassical model.

John Burr Williams, an engineer by training, took these analogies of arbitrage and optimization and applied them to measure corporate value. While we still use his discounted cash flow model today in our fundamentals analysis of corporations, we also still rely perhaps too readily and conveniently on the neoclassical model. Yet, the analysis of corporate value is, in some sense, at odds with a competitive neoclassical model that predicts firms cannot earn profits in excess of the risk-adjusted rate of return on their investment.

2

A Fly in the Ointment

In 1776, economics became a discipline and studies of the advantages of the corporate structure became its primary subject of analysis. Ever since Adam Smith’s An Inquiry into the Nature and Causes of the Wealth of Nations, economics has rejoiced in and been hindered by what we now refer to as the neoclassical model.

The neoclassical model is somewhat of a paradox, however. In essence, it states that competitive forces ensure that there cannot in reality be any supernormal, or excessive profits. These same competitive forces require firms to strive constantly for greater efficiency. Profit is simply the fair return earned for the risk and sacrifice made by the capitalist. If these profits are excessive, greater capital will flow into simil...

Table des matières

• Cover
• Title
• Copyright
• Contents
• Figures
• Preface
• Preamble
• 1 Introduction
• Section 1 From Art to Science
• Section 2 Is a Corporation’s Capital Structure Irrelevant?
• Section 3 Transactions Costs and the Value of a Firm
• Section 4 Alchian and Demsetz
• Section 5 Jensen and Meckling
• Section 6 What We Have Learned
• Glossary
• Notes
• Index