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

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

Shleifer and Vishny (1986) focus on the role of large shareholders as monitors who can facilitate the replacement of management by takeover, while Admati, Pfleiderer, and Zechner (1994) stress the free-rider problem in stockholder monitoring and the costs that this implies for large shareholders. A complete theory of the structure of shareholdings is yet to emerge, although Demsetz and Lehn (1985) represents a promising beginning. Maug (1994) and Warther (1994) analyze the role of the board of directors as monitors.

Vl. Reputation

The idea that a firm or manager might care about their reputation for quality, skill, or some other attribute, is a new one in corporate finance. Gibbons and Murphy (1992), Hirshleifer and Thakor (1992), and Narayanan (1985) show how concern with personal reputation may be a consideration in managerial decision-making. Diamond (1989) shows how a firm's reputation may affect its access to debt markets and demonstrates how this can influence the investment projects it chooses. Boot, Greenbaum, and Thakor (1993) argue that limitations in contracting technology may mean that it is efficient to have some contractual provisions that are legally unenforceable(23) and to rely on reputational considerations for enforcement in most but not all states of the world. They cite as an example the behavior of mutual fund management companies in making voluntary contributions to restore losses on money market funds. Maksimovic and Titman (1991) analyze the interaction between a firm's reputation for product quality and its financial structure. The lack of a legal requirement for a firm to pay preferred dividends, and the prima facie interest of common shareholders to suspend them, appears to be a puzzle that may be explicable in terms of reputational considerations. However, a difficulty with the reputational concept as applied to firms is that it is unclear precisely where the reputation resides if a firm is no more than a "nexus of contracts;" what is it about firms that makes some "good types," and can this not be changed by a new management?

VII. Pre-Commitment and Bonding with Financial Contracts

While outstanding debt can create adverse incentives for investment, which can only be mitigated by the design of appropriate bond indentures (Smith and Warner, 1979), several authors have argued that the risk-increasing incentives of debt can be put to creative use by pre-committing the firm to a particular output policy that will give it a competitive advantage in the product market.(24) Empirical evidence of such effects appears to be lacking,(25) however, and the analysis of Scharfstein and Bolton (1990) suggests rather the reverse. Jensen (1986) claims that an important role of debt is to precommit the firm to pay out its free cash flow rather than wasting it on unprofitable investments, and it is argued that the high leverage employed in many takeovers represents a commitment to dispose of assets. On the other side of the coin, a distinction that is sometimes made between bank debt and publicly held debt is that the former can be renegotiated while the latter is very hard to renegotiate. As Bergman and Callen (1991) show, a firm may sometimes wish to precommit not to renegotiate its debt by issuing public debt.