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

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

From a fourth perspective, the shift can be seen as a move from analyzing the implications of existing institutional arrangements, to that of justifying such arrangements as optimal responses to particular problems, then to considering alternative institutions. In parallel to this, efforts have shifted from the development of normative rules for corporate decision makers to the development of normative propositions about such institutional arrangements as insider trading rules, disclosure, the payment of greenmail, and the erection of other takeover defenses.

The reader should be aware that a survey of this nature is likely to suffer from the ex-post selection bias that plagues many empirical studies: it will concentrate on what turned out to be successful and of enduring interest. The historian of science is likely to be as interested in those avenues of endeavor that were subsequently abandoned or became moribund. It is therefore worth recalling that in 1970 the term "financial economics" was not yet in common usage, and the battle between finance as a subfield of management science and as a subfield of economics was not yet over. Major research topics at that time included the use of linear programming to design capital budgets, models of cash management based on inventory theory, models for accounts receivable management based on credit scoring, and Markov Chain models of credit losses. All of these topics have since been abandoned by most scholars in finance and now find only occasional mention in the standard textbooks. Other topics such as leasing, bond refunding, and the estimation of discount rates for capital budgeting,(2) once the focus of considerable research effort, have fallen out of fashion, either because the problems are deemed to have been "solved" or to be intractable so that further progress seems impossible or because the research paradigms that are of most interest today have little or nothing to say about them.

I start this brief survey by sketching the state of corporate financial theory 25 years ago and then describing how the prevailing paradigm broke down under the weight of new developments. In the balance of the paper, I identify some new key concepts and theoretical drivers that have fundamentally changed our way of looking at the world of corporate finance. My focus is on the changing conceptual framework within which problems in corporate finance are analyzed, and I make no attempt to provide an exhaustive survey of the various topics, such as mergers and acquisitions, initial public offerings, etc., that now fall within the purview of the subject, since that would be a considerably more ambitious undertaking. Nor do I give more than passing attention to the now voluminous empirical literature.

I. The State of Financial Theory 25 Years Ago

In 1970, the corpus of corporate financial theory was, on the one hand, the Fisherian separation of consumption and investment decisions that gave rise to the unanimous support among stockholders for value-maximizing decisions, at least in a world of complete capital markets, and on the other hand, the Modigliani-Miller irrelevance propositions and their tax-adjusted counterparts. The pure theory of corporate investment was supplemented for practical purposes by the recently developed Capital Asset Pricing Model, which offered new insights into the determinants of investors' required rates of return, and although management science techniques, such as Monte Carlo analysis and decision trees, were advocated as practical decision tools, little effort was made to integrate these into the corpus of financial theory. Thus, it remained unclear, for example, either what discount rates were to be employed in computing the present values generated by the simulations or how the distribution of present values yielded by the simulations was to be interpreted. However, it was becoming widely recognized that corporate valuations of investment projects could not be divorced from investor valuations of securities. The state of the art in valuing corporate securities was a poorly integrated combination of discounted cash flow analysis, as represented for example by the dividend discount model, which is essentially multi-period, and the capital asset pricing model, which at that time was strictly a single-period model. At this juncture, the abstract simplicity of the Arrow-Debreu model yielded few insights for corporate finance beyond the principle of value additivity that was used to refute the conventional wisdom that conglomerate mergers added value by providing corporate diversification.