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Principles of Finance Business theory was not fully developed until the early part of the twentieth century, when modelers started to investigate specific company activities such as production and finance. But it looks like financial principles like time value of money have always existed in the social and business life of people. Building on these foundations, many of the early theories of production, exchange, money and capital were developed. For example, Harrod pioneered the ideas of economic growth and development, Kaldor developed alternative theories of distribution, Wales and Cassel contributed to the evolution of the mathematical principles of competition, and Chamberlin and Robinson published theories on industrial monopolies and monopolistic competition. In 1939 Hicks published Value and Capital, which helped resolve the basic conflicts between business cycle theory and equilibrium theory. These early years witnessed the formation of many fundamental theories, which were used widely by public and private interests to determine foreign trade, investment policies, and prices.
Many of these basic principles evolved into general economic theory, and they therefore contributed to econometrics and business modeling. (Kolb, 1992). My paper traces developments in the theory of corporate finance over the past 70 years emphasizing the last quarter of the century. These include a shift from consideration of how the value of a given cash flow stream is affected by its division among different classes of security holders to a consideration of how the structure of claims affects the cash flow stream itself. A major reason for this shift of emphasis is the attention now paid to the role of individually motivated agents in the corporation. Other important developments include recognition of information asymmetries, the role of private benefits of control, and the application of the option-pricing paradigm to the evaluation of real investments. (Weston, 1993). During the early 1900 s a number of economists realised that there was a clear need for a type of model that described an economy's behaviour, predicting the effects of various decisions made by households, businesses or governments.
Accordingly, the analysis of the statistics and mathematics of economics developed into the science of econometrics. Modem historians disagree as to who founded econometrics. Some argue that Moore's statistical verification of J. B.
Clark's marginal productivity theory of wages was the founding contribution in 1911, whilst others prefer to trace its roots back to the pioneering business cycles analysis of Jevons in the 1870 s. However, the many early contributors to the field included Frisch, the Dutch economist Tinbergen who built and estimated the first macro dynamic model of a business cycle in 1936, and the Norwegian economist Haavelmo who eventually integrated statistical probability theory into econometrics. In 1939, Tinbergen developed the first econometric model of the business cycles in the US economy. This consisted of 48 equations relating 71 variables including exports, imports, building costs and financial stock prices. It was particularly remarkable considering that computers did not become widely available until the 1950 s. (Kolb, 1992). In 1932, the Cowles Commission for Research in Economics had been formed to research mathematical applications to economics.
One of the early areas of study was the investigation and development of the system proposed by Keynes in his General Theory. This view of the economy was popular both during and after the Second World War when most Western governments were making formal pledges to undertake regular and massive peacetime interventions in their economies so as to stabilize unemployment. (Jensen, 1986). After the winds of World War II abated, the economics departments of money center banks were widely regarded as some of the most credible forecasters of our nation and the world's economic fortunes. In fact, a number of the major banks circulated economic newsletters that had a wider distribution than all but a few daily papers in America's major cities.
Citibank published the largest of these. They were read by the industrial and economic elite of America, and by business leaders and government officials throughout the world. (Ross, 1989). In that environment, dozens of talented bank economists rose rapidly through the ranks on the financial management side of their institutions. The most successful of these earned top management titles such as Executive Vice President, Vice Chairman, President, and, in a few cases, CEO. Such noted business economists as Gabriel Have, Wes London, Hebert Prochnow, Lee Prussia, Tom Storrs and others like them, retired as either the number one, two, or three person in major money center and super regional banks. In addition, dozens of other professional bank economists rose to the level of senior vice president or vice president and served as members of the management committees of America's leading banks.
The economist's path to the upper echelon of such banks usually started in the economics department, where they would normally begin by working on macroeconomic analyses and / or in money market forecasting. After rising to head his or her department, the most successful bank economists would then be given added responsibility for strategic planning, the money desk and / or foreign exchange operations. The final and most difficult steps, which usually led directly into the executive suite, involved moving beyond money desk management positions and into the chief financial officer position - alongside the CEO and president of the bank. (Ross, 1989). Along this road to the executive suite, the postwar economist would also often play a leading role as an external spokesperson for the bank.
A. Gilbert Heebner, Walter Hadley, and Beryl Sprinkel were good examples of economists who played the latter role while serving as members of their banks's enter management committees. Nowadays, only a small handful of the surviving bank economists still play such highly visible roles. And few enjoy the respect that the prior generation of bank economists took for granted. The traditional theory of capital budgeting is to achieve value maximization; therefore, it is improper for modern businesses with risky debts.
In this section, the purpose of a publicly held corporation is restated for the readers (i. e. , stockholder wealth maximization) to lead the expositions to the alternative theory of capital budgeting. (Jensen, 1986). There exists a principal-agency relationship between the stockholders and the manager. It is a contract of trust and confidence, which imposes upon the agent a duty of loyalty to the principal. The manager is forbidden to conduct the business for him or herself and is prohibited to act on behalf of any other parties to the same transaction unless consented by the stockholders. S/he is expected to act for the foremost benefit of the stockholders. (Brigham, 1998).
This peculiar relationship does not necessarily hold up between the manager and the bondholders, although the manager assumes a fiduciary duty in a debt contract. For example, to protect the interest of the bondholders, usually some restrictive covenants are put in bond indentures, e. g. , a minimum ratio of times-interest-earned, a limit on the payment of dividends, and conditions to the recall of the bonds prior to maturity. Although the manager is legally responsible for honoring all the restrictions and limitations by the indentures with utmost loyalty and good faith, s / he is not obligated to take actions to maximize the market value of debt. Therefore, it is fair to state that the manager should work for the best interest of the stockholders in such a way to maximize their wealth. (Myers, 1977). Stockholder wealth maximization being the objective, the manager should look at the OCF for the stockholders and the equity cost of capital.
In this study, the OCF for the stockholders is referred to as the equity cash flow (ECF, hereafter), which consists of the net earnings available for the stockholders plus a part of depreciation. The former is net income after interest payment to the bondholders and taxes (NI), and is given by NI = (1 - [Tau]) (EBIT- R). It is important to note that this "net income" is different from the one in major textbooks quoted previously in this article. To this NI only a part of deprecation is added back to determine the ECF. Since the bondholders and the stockholders fund the initial investment, this amount should be paid back to both groups of investors, and the par value of bonds will be paid to the bondholders at maturity. If the company makes periodic contributions to a sinking fund out of the OCF to pay off the debt, the amount of sinking fund contribution (SF) after considering the time value of money is SF[ (II) (PD) /PE + PD] 1 / ([FVIFA.
sub. r%, M]) (4) where II is the amount of initial investment, PD is the par value of debt, PE is the par value of equity, FVIFA is the future value interest factor of an annuity of $ 1, r is the coupon rate, and M is the life of the bond. Therefore the part of the OCF for the bondholders (BCF) is given by BCF = R + SF. (5) Common stock is a permanent form of financing with no maturity, but the venture will be dissolved after M years, so the par value of common shares will be paid off each year through depreciation. Considering the time value of money, the depreciation expense attributable to the bondholders exceeds the sinking fund contribution of SF, and this excess amount will be given to the stockholders.
Thus the ECF is given by ECF = NI + dn - SF. This ECF is the relevant cash flow to discount for a firm, which maximizes stockholder wealth. To achieve the firm's objective, the equity cost (rather than the WACC) must be used to discount the ECF. By Proposition II, MM (explain some features of the cost of equity as follows: [i.
sub. j] = [[Rho]. sub. k] + ([[Rho]. sub. k] - r) [D.
sub. j]/[S. sub. j]. That is, the expected yield of a share of stock is equal to the appropriate capitalization rate [[Rho]. sub.
k] for a pure equity stream in the class, plus a premium related to financial risk equal to the debt-to-equity ratio times the spread between [[Rho]. sub. k] and r. Or equivalently, the market price of any share of stock is given by capitalizing its expected return at the continuously variable rate. Since dividend payment is not tax deductible, the equity cost shown above represents the after-tax cost to the firm. Assume that ABC Corporation is considering an investment project with a five-year useful life for which an initial investment of $ 1 million is required.
If this company uses the straight-line depreciation method, this project will generate a $ 200, 000 depreciation expense each year for five years. The company will raise this amount by 50 percent equity and 50 percent debt with an eight percent coupon interest rate, incurring a $ 40, 000 interest expense each year. Net sales from this project are expected to reach $ 1 million each year; the variable costs are 67. 5 percent of net sales; and the corporate tax rate is 40 percent. The annual income statement for this project is presented in Table 1.
TABLE 1 ABC Corporation Income Statement for the Year 1995 Net sales $ 1, 000, 000 Variable costs 675, 000 Depreciation expense 200, 000 Earnings before interest and taxes $ 125, 000 Interest expense 40, 000 Earnings before taxes $ 85, 000 Taxes (40 %) 34, 000 Net income $ 51, 000 Relevant Cash Flows Using the income statement and other relevant data, several cash flows defined in the previous sections are calculated in the order that they are presented as follows: NOI = (1 - 40 %) ($ 125, 000) + (40 %) ($ 40, 000) = $ 75, 000 + $ 16, 000: $ 91, 000 OCF = (1 - 40 %) ($ 125, 000) + $ 200, 000 = $ 275, 000 NI = (1 - 40 %) ($ 125, 000 - $ 40, 000) = $ 51, 000 SF = $ 500, 000 / ([FVIFA. sub. 8 %, 5 ]) = $ 500, 000 / 5. 8666 = $ 85, 228 BCF = $ 40, 000 + $ 85, 228 = $ 125, 228 ECF: $ 51, 000 + $ 200, 000 - $ 85, 228 = $ 165, 772 Cost of Capital If the before tax cost of debt is equivalent to the coupon rate, and if the cost of equity is 19. 2 percent, then the WACC is computed as WACC = (1 - 40 %) (8 %) (50 %) + (19. 2 %) (50 %12 %. Evaluation of the Project in the Traditional Way The cash flow in the traditional way is the OCF, therefore Cash flow = $ 275, 000. The cost of capital in the traditional way is the WACC, which is 12 percent.
The up-front capital contribution from the bondholders and the stockholders is $ 1, 000, 000. Therefore Net present value = -$ 1, 000, 000 + ($ 275, 000) ([PVIFA. sub. 12 %, 5 ]) = -$ 1, 000, 000 + ($ 275, 000) (3. 6048) = -$ 1, 000, 000 + $ 991, 320 = -$ 8, 680. Hence, this project would be rejected if the combined wealth of the bondholders and the stockholders were to be maximized. Project Evaluation in the Alternative Way The cash flow in the suggested method is the cash flow for the stockholders only, thus Cash flow = ECF = $ 165, 772. The cost of equity should be used to discount this cash flow stream which is 19. 2 percent.
The stockholders' initial contribution is only $ 500, 000. Therefore, Net present value = -$ 500, 000 + ($ 165, 772) ([PVIFA. sub. 19. 2 %, 5 ]) = -$ 500, 000 + ($ 165, 772) (3. 044) = -$ 500, 000 + $ 504, 610 = $ 4, 610. Thus, this project must be accepted because it improves the wealth of the stockholders contrary to what the traditional approach signals.
Its acceptance is appropriate given the firm's objective and the duty of loyalty of the manager owed to the stockholders. (Myers, 1977). The lower straight line in the Figure shows the net present value of the investment project computed in the traditional way, so it is the change in the combined wealth of the stockholders and the bondholders from the project. The upper straight line represents the net present value of the project computed in the proposed way, thus it measures the change in the wealth of the stockholders only. The manager maximizing the combined wealth would accept the investment project, only if the EBIT is slightly over $ 129, 000. However, the alternative approach suggests to take it at a substantially lower level of the EBIT, i.
e. , approximately $ 123, 000. Therefore capital budgeting decisions made in the traditional way would forfeit the wealth of stockholders when the EBIT is between these two numbers. The shaded area in the Figure indicates thus forfeited stockholder wealth. (Weston, 1993). Options Creation of options and the development of information technologies became an essential part in the financial system. I think they deserve greater part of our attention in this paper. The application of option pricing models (OPM) to information technology (IT) investment evaluation problems recently has been proposed in the information systems (IS) literature (Chalasani et al. 1997; Dos Santos 1991; Kambil et al. 1993; Kumar 1996; Takes 1998).
These papers make a strong case for new methods, in addition to traditional net present value (NPV) or discounted cash flow (DCF) approaches, and especially in lieu of leaving hard decisions that senior managers face regarding IT investment to experienced intuition. Benaroch and Kauffman (1999) are the first to follow up on these proposals. They examine the theoretical basis for applying OPMs to IT investment evaluation as well as the...
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