Corporate finance over the past 25 years - Financial Management Silver Anniversary Commemoration

Financial Management (Financial Management Association), Summer, 1995 by Michael J. Brennan

In fearless youth we tempt the heights of Arts; While from the bounded level of our mind Short views we take, nor see the lengths behind, But, more advanced, behold with strange surprise New distant scenes of endless science rise!

Alexander Pope

It is natural for any generation to think of itself as the culmination of the past - the tip of the arrow of progress. It is less easy for it to see itself as the stepping stone of future generations - to recognize that its perspectives and modes of analysis are likely to appear as limited to them as do the efforts of the past appear to contemporaries. It is therefore instructive to review the history of a science, to see what was unconsciously overlooked, and to recognize the limitations of past perspectives, not to provide a source of self-congratulation to our more enlightened age but rather to provide a sense of humility about our own vision. For just as earlier ages may appear to us as blinkered and obtuse, so are we likely to appear to future generations, and by recognizing this fact, we may possibly become more sensitive to the limitations of our contemporary paradigm. Twenty-five years after the founding of Financial Management, it is an appropriate moment to stop and take stock of what we have accomplished during this quarter century.

From one perspective, the development of corporate finance since 1970 can be thought of in terms of a shift from exploring the valuation implications of alternative ways of allocating given cash flow streams to exploring the implications for the cash flow stream itself of the allocation mechanism used to distribute it: in other words, in terms of the relaxation of the major ceteris paribus assumptions underlying the MM propositions concerning dividend and, particularly, capital structure policy. Whereas MM had taken the firm's net operating income as given and had asked what effect its allocation among different claim holders would have on the total value of the income stream, the new theorists were increasingly concerned with the effect of the structure of claims on the incentives of the individuals whose decisions would determine the income stream. Increased recognition of the importance of the structure of claims to the firm's cash flows has led to a renewed attention to the roles of different types of security issue; under the MM paradigm, these were for the most part a "mere detail" and therefore not amenable to serious analysis. At the same time, recognition that contracts are necessarily incomplete and fail to constrain future decisions completely has led to analysis of the allocation of control or decision rights across claimholders. On the asset side of the balance sheet, there has been a corresponding shift in focus, from asking what investment decision rule investors would unanimously support to asking what rules decision makers are likely to follow, given their incentives. Finally, whereas the old approach was essentially comparative static in nature, comparing corporations with different financial structures, the modern theory has a much more dynamic flavor to it, with analysis focused on particular events or transactions in the life of the corporation, such as initial public offerings, subsequent financings of debt and equity, repurchases of securities and exchange offers, takeover, and bankruptcy.

From a second perspective, the fundamental change has been the recognition of the decisive role of individually motivated agents, both those within the corporation and those with whom the corporation must deal. The corporation of financial theory in the early 1970s ignored individual agents within the corporation either by assuming that they acted as well-trained robots (as in the investment decision)(1) or by paralyzing them with the ceteris paribus assumptions that underlie the classical capital structure propositions. Similarly, it rendered the individuals with whom the corporation must deal - investors, bankers, underwriters, bidders, customers, employees, and others - essentially uninteresting, by treating them as price takers who suffered from no informational disadvantage and had no relevant aims beyond expanding their budget sets. In economic analysis, agents are described by their tastes and their opportunities, and the new theories that have been developed have relied on a more careful (or perhaps more imaginative!) description of both tastes and opportunities. Important features of the opportunity set that have been newly recognized include the informational endowments of agents, their discretionary powers, and the nature of the implicit and explicit contracts that link their actions to their rewards. Newly recognized aspects of tastes include perquisite consumption, control benefits and other non-pecuniary benefits, reputation, and effort aversion. These new concepts have provided richer explanations for newly recognized phenomena.

From a third perspective, the shift can be seen in large part as one of technique. The new technology of games under incomplete information has replaced the price-taking assumption throughout much of the corporate finance literature, and traditional discounted cash flow approaches to valuation have begun to give way to techniques derived from those used to price stock options.