Corporate finance and the theory of the firm

Table of Contents

LIST OF ABBREVIATIONS

1 INTRODUCTION
1.1 Problem and Objective
1.2 Structure of the Paper

2 THEORY OF CORPORATE FINANCE
2.1 definition and Scope of corporate finance
2.2 Objective of Corporate finance
2.3 FUNDAMENTAL ELEMENTS OF CORPORATE FINANCE

3 THEORY OF THE FIRM
3.1 Definition and Emergence of the Theory of the Firm
3.2 reasons for the Existence of the firm
3.3 DIFFERENT THEORETICAL FRAMEWORKS OF THE FIRM

4 LINKS BETWEEN CORPORATE FINANCE AND THE THEORY OF THE FIRM
4.1 Sources of Connection between Corporate finance and the theory of the firm
4.2 explanation of the links between Corporate finance and the theory of the firm along three Theoretical frameworks
4.2.1 The Firm as a Nexus of Contracts
4.2.2 The Firm as a Collection of Growth Options
4.2.3 The Firm as a Collection of Assets

5 THE HUMAN-CAPITAL INTENSIVE FIRM: THE NEW TYPE OF FIRM AND ITS IMPLICATIONS FOR CORPORATE FINANCE
5.1 Emergence and Comparative description of the Human-Capital Intensive Firm
5.2 Implications for Corporate finance

6 SUMMARY OF CONCLUSIONS AND RECOMMENDATIONS

TABLE OF THE APPENDIX

APPENDIX

REFERENCES

1 Introduction

1.1 Problem and Objective

Corporate finance has become increasingly important during the last fifty years, in theory, empirical research and practice. Major representatives of finace theory such as Markowitz, Miller and Sharpe received Nobel prices in 1990,^[1]significant empirical corporate finance studies of Shleifer/ Vishny and Harris/ Raviv have been published recently,^[2]and the market for corporate finance advisory services grew significantly in the years until 2001.^[3]

Not only has corporate finance gained in significance, but it also experienced major changes. In the last decade, many significant human-capital intensive enterprises emerged, whereas previously large corporations used to own many tangible assets.^[4]The question of the optimal capital structure became increasingly important.^[5]Intensive discussions arose over corporate governance issues.^[6]New valuation methods like the real option approach have been introduced.^[7]These changes can be observed very easily, but the underlying question is: what what are their determinants? An appropriate way to answer this question, is to assess in which way the theory of the firm can be considered as the underlying theoretical basis for corporate finance.^[8]

Therefore the objective of this seminar paper is to analyse the links between corporate finance and the theory of the firm. As a basis for this analysis, theoretical foundations in corporate finance and the theory of the firm are provided. Furthermore, current research on the theory of the firm and corporate finance for the recently emerged type of firm of the human-capital intensive firm are presented.

1.2 Structure of the Paper

The seminar paper consists of four major building blocks: two descriptive chapters about corporate finance (chapter two) and the theory of the firm (chapter three), one chapter about the links between those two (chapter four) and one chapter about the current research on the theory of the firm and corporate finance for human-capital intensive firms (chapter five).

In detail, the paper proceeds in the following way^[9]: chapter two presents definitions and the scope of corporate finance. Moreover, the objective of corporate finance as well as its fundamental elements are described. Chapter three gives a definition of the theory of the firm and analyses its emergence. Continuing, it explains the reasons for the existence of the firm. Furthermore, it presents the three most important theoretical frameworks of the firm as basis for the following chapter. Having provided the necessary theoretical groundings, the links of the theory of the firm and corporate finance are analysed in the fourth chapter. As the first part of this chapter, the sources of connection between the theory of the firm and corporate finance are examined. In the following three subchapters, the paper assesses to what extent the theory of the firm influences corporate finance in detail. This is done in a 3x3 matrix comparing the three previously described theoretical frameworks of the firm with the three important fields of corporate finance. After having discussed the interrelation between corporate finance and the theory of the firm, chapter five presents a new type of the firm - the human- capital intensive firm. This done by presenting the human-capital intensive firm in comparsion to the traditional asset-intensive firm. Moreover, the implications for corporate finance resulting from this new type of firm are analysed in this chapter. Chapter six summarizes the conclusions and recommendations of this paper and gives an outlook on future perspectives for corporate finance in the context of further changes in the theory of the firm.

2 Theory of Corporate Finance

This chapter presents theoretical foundations in corporate finance. Its purpose is to pro­vide a basis for the analysis of the links between the theory of the firm and corporate finance. Different definitions of corporate finance as well as the scope of corporate finance are described. Furthermore, the chapter explains the objective function of corpo­rate finance and presents its fundamental elements.

2.1 Definition and Scope of Corporate Finance

For the term corporate finance, different definitions depending on the perspective can be found: derived from the field of economics, the definition of Fama/ Miller states: “the theory of finance is concerned with how individuals and firms allocate resources through time”^[10]. This definition focuses on the capital allocation problem between indi- viduals and firms that is resolved by the existence of capital markets.^[11]Harvey defines corporate finance as “one of the three areas of the discipline of finance. It deals with the operation of the firm - both the investment decision and the financing decision - from that firm's point of view.”^[12]This definition emphasizes the distinction of corporate fi­nance from other finance disciplines like market finance or entrepreneurial finance. A broader definition from Damodaran says: “corporate finance is the study of any deci­sions made by firms that have financial implications”^[13].

Considering the scope of corporate finance, Damodaran describes three main decisions of the firm based on corporate finance: firstly investment decisions, i.e. how projects are selected, secondly financing decisions, i.e. how decisions are taken on the optimal fi­nancing mix for these projects, and thirdly dividend decisions, i.e. how much of the cash flows of these projects are distributed to shareholders.^[14]Instead of the dividend decision, Ross/ Westerfield/ Jaffe consider net working capital management as one of the key corporate finance decisions beside investment and financing decisions.^[15]An important differentiation that has to be made is, as its name reveals, that corporate finance is founded on the form of the corporation, compared to the forms of sole pro­prietorships and partnerships.^[16]A corporation can be defined as a distinct legal entity whose main characteristics are the separation of ownership and management as well as the limited liability of its shareholders.^[17]Limited liability attracts a high number of stockholders financing corporations.^[18]These many dispersed shareholders represent the most efficient form of financing large enterprises despite the occurring agency costs.^[19]

2.2 Objective of Corporate Finance

Having defined the term corporate finance and its scope, the objective of corporate fi­nance is described in more detail in this subchapter. Different views and changes in cor­porate finance theory are based on a different definition of its underlying objective func­tion.^[20]Two exemplary formulations of the objective of corporate finance are: “the ob- jective of corporate financial theory is to maximize firm value”^[21], and “the goal of the corporation is to add value for the stockholders”^[22]. For describing the interests that should be reflected in the objective of a firm, two basic views exist: some argue the firm’s objective should be based on a larger variety of interests of different stake­holders, others want corporations to concentrate on a more focused objective like mar­ket share or profitability.^[23]Furthermore, important assumptions of the corporate finance objective functions have to be mentioned: the existence of efficient markets and the assumption that shareholders’ interests are identical with those of the firm.^[24]The objective function of corporate finance is directly related to its goal: the firm value. The firm value can be defined as “the present value of its expected cash flows, dis­counted back at a rate that reflects both the riskiness of the project and the finance mix used to finance.”^[25]Alternatively, it can be determined via the “balance-sheet model of the firm”^[26]. According to this model, the firm value is calculated by adding up the asset side with current assets, tangible fixed assets and intangible fixed assets or by summing up the liabilities in the form of current liabilities, debt and equity.^[27]

2.3 Fundamental Elements of Corporate Finance

Having defined corporate finance and having described its objective function, three important issues in corporate finance are presented. This is done in order to provide a basis for the analysis of the links between corporate finance and the theory of the firm that will be performed in chapter four. This description is quite brief because further details can be looked up easily in any corporate finance textbook.^[28]The first of these three fundamental elements is capital structure: this field of research analyses the impact of capital structure on the value of the firm.^[29]There are different types of capital structure theories: some are tax-based like Miller/ Modigliani, others are based on asymmetric information models like Myers/ Majluf and moreover, frameworks based on the agency cost theory like Jensen have been developed more recently.^[30]

A second building block of corporate finance is the issue of corporate governance. Ac­cording to Shleifer/ Vishny (1997), “corporate governance deals with ways in which suppliers of finance to corporation secure themselves of getting a return on their in- vestment.”^[31]Corporate governance thus answers questions like: how can managers be controlled effectively? how can managers get enforced to invest in positive NPV pro- jects?^[32]

The third pillar of corporate finance is valuation. There are various valuation methods being used for different markets, industries and types of firms.^[33]Examples of valuation approaches are the DCF method^[34]and the real options approach^[35]; furthermore asset- based valuation methods^[36]exist.

3 Theory of the Firm

Having provided a theoretical grounding in corporate finance, this chapter considers the theory of the firm in more detail. Firstly, the definition and the emergence of the theory of the firm are presented. Afterwards, reasons for the existence of the firm are explained. Finally, different theoretical frameworks of the firm are described.

3.1 Definition and Emergence of the Theory of the Firm

According to Foss, the term theory of the firm can be understood as the research con­sidering “the existence, the boundaries and the internal organization of the firm”^[37]. Whereas economists have examined the firm’s market behaviour for a long time, the theory of the firm has only been covered for a relatively short period of time.^[38]Never­theless, the theory of the firm has become over time one of the two most important building blocks in microeconomic theory together with the theory of consumer behav- iour.^[39]Before that, the firm was considered a black box that adapts itself passively to market conditions and whose internal structure is unknown.^[40]The theory of the firm has its major roots in transaction cost theory and in agency theory.^[41]

Since the theory of the firm has no systematic overall framework, one has to orientate at the research papers of its most important representatives for getting an overview of this field of research.^[42]These important papers are the following: firstly Coase’s “The Na­ture of the Firm” (1937), continuing with “Production, Information Costs and Economic Organization” from Alchian/ Demsetz (1972), a further important paper was “The Costs and Benefits of Ownership: A Theory of Vertical Integration” from Grossman/ Hart (1986), and finally today’s research work of Williamson, the currently best known re­searcher in the field of the theory of the firm.^[43]These papers as well as other significant research work of this field are used for explaining the reasons for the existence of firms and for describing the most important theoretical frameworks of the firm in the follow­ing two subchapters.

3.2 Reasons for the Existence of the Firm

Having given a definition of the theory of the firm and having explained the emergence of this theory, the reasons for the existence of firms are evaluated. While being one of the most important issues in microeconomic theory, no clearly defined theory of the firm exists describing the reasons for the existence of the firm.^[44]Therefore different approaches explaining the existence of the firm are presented in the following.

Coase, the probably most influential representative of the classical theory of the firm, asked the very fundamental question “why a firm emerges at all in a specialised ex­change economy”.^[45]This author focused on the examination of the reasons why market transactions can be substituted by a hierarchical relationship, i.e. an entrepreneur takes decisions about how assets and human capital are employed.^[46]Concerning the costs and benefits of integration, he considers some transactions between firms as inefficient be­cause it is difficult to agree contracts fully specifying what has to be done in uncertain future situations. Thereupon, firms emerge because of inefficiencies resulting from these incomplete contracts. It is thus more efficient if an entrepreneur can simply em­ploy assets and direct employees in an integrated enterprise without market transactions involved.^[47]According to Coase, drawbacks of an integrated firm are the occurring agency costs like "diminishing returns to management"^[48]and "waste of resources"^[49]. Alchian/ Demsetz consider the following as reason for the existence of the firm: “moni­toring or metering the productivities to match marginal productivities to costs of inputs and thereby to reduce shirking can be achieved more economically (than by across mar­ket bilateral negotiations among inputs) in a firm.”^[50]. According to this, firms only emerge if they can combine input factors more efficiently as it is possible via market transactions. As a result, firms can be seen as a private market competing with regular markets.^[51]

Grossman/ Hart define the reasons for the existence of the firm based on the ownership of assets. According to them, asset ownership is only useful if the integration of assets is more beneficial than contracting. Furthermore, these authors neither distinguish be­tween physical ownership and simple control, nor do they differentiate between inside contractors like employees and outside contractors such as suppliers.^[52]Williamson (1989, 1981) describes the modern corporation on a transaction-cost basis: a firm thus emerges if it is more efficient than the market, i.e. if it has lower transaction costs.^[53]

In summary, one can conclude that different authors have provided quite different rea­sons for the existence of the firm over the last decades. In order to provide a systematic overview of the different approaches, these are clustered into three frameworks in the following subchapter.

[...]

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^[1]See the section about the Nobel laureates in the NOBEL E-MUSEUM.

^[2]See SHLEIFER/ VISHNY (1997), pp. 737-783; HARRIS/ RAVIV (1991), pp. 297-355.

^[3]See ACHLEITNER (2000), pp. 245-249; BRINKER (1998), pp. 1-5; PICOT (2000), p. 3.

^[4]See TRIGEORGIS (1998), pp. 1-21; BORISON (2001), pp. 6-9.

^[5]See HARRIS/ RAVIV (1991), pp. 297-300.

^[6]See JENSEN/ SMITH (1984), pp. 1-3.

^[7]See BORISON (2001), pp. 6-9.

^[8]See ZINGALES (2000), pp. 1623-1624.

^[9]See figure 1 in the appendix for a graphical overview of the structure of the paper.

^[10]FAMA/ MERTON (1972), p. 1.

^[11]See FAMA/ MERTON (1972), p. 1.

^[12]This definition is given in the financial glossary of HARVEY (2003).

^[13]DAMODARAN (1997), p. 1.

^[14]See DAMODARAN (1997), pp. 3-4, 10.

^[15]See ROSS/ WESTERFIELD/ JAFFE (2002), p. 1.

^[16]See BREALEY/ MYERS (2003), pp. 3-4.

^[17]See FAMA/ JENSEN (1983), pp. 301-303; ROSS/ WESTERFIELD/ JAFFE (2002), pp. 12-13.

^[18]See ALCHIAN/ DEMSETZ (1972), pp. 787-789.

^[19]See JENSEN/ MECKLING (1976), pp. 71-72.

^[20]See DAMODARAN (1997), p. 5.

^[21]DAMODARAN (1997), p. 5.

^[22]ROSS/ WESTERFIELD/ JAFFE (2002), p. 15.

^[23] See DAMODARAN (1997), p. 5.

^[24] See DAMODARAN (1997), p. 5.

^[25]DAMODARAN (1997), p. 5.

^[26]ROSS/ WESTERFIELD/ JAFFE (2002), p. 3.

^[27] See figure 2 in the appendix; ROSS/ WESTERFIELD/ JAFFE (2002), pp. 3-4.

^[28] For further details refer to the following corporate finance textbooks: BREALEY/ MYERS (2003); ROSS/ WESTERFIELD/ JAFFE (2002); DAMODARAN (1997); FAMA/ MERTON (1972).

^[29] See HARRIS/ RAVIV (1991), pp. 297-298; ROSS/ WESTERFIELD/ JAFFE (2002), p. 919.

^[30] See MODIGLIANI/ MILLER (1958), pp. 288-291; MYERS/ MAJLUF (1983), pp. 28-31; JENSEN, (1986), pp. 324-325.

^[31] SHLEIFER/ VISHNY (1997), p. 737.

^[32] See SHLEIFER/ VISHNY (1997), pp. 737-740; WILLIAMSON (1996), pp. 193-194; WILLIAMSON (1988), pp. 588-589.

^[33] See COPELAND/ KOLLER/ JACK (1996), pp. 151-157; FERRIS/ PETITT (2002), pp. 8-13.

^[34] See KAPLAN/ RUBACK (1995), pp. 1091-1092; DRUKARCZYK (2003), pp. 199-208.

^[35] See TRIGEORGIS (1998), pp. 1-21; BORISON (2001), pp. 6-9; BRENNAN/ SCHWARTZ (1985), pp. 135-138, 154; HULL (2003), pp. 660-667.

^[36] See BELLINGER/ VAHL (1992), pp. 256-259.

^[37]FOSS (1999), p. XV.

^[38] See CASSON (1996), p. XIII.

^[39]See WILLIAMSON (1989), p. 1.

^[40] See SCHOPPE et al. (1995), p. 5.

^[41] See REVE (1989), p. 133.

^[42] See COASE (1937), p. 390; BOUDREAUX/ HOLCOMBE (1989), p. 147.

^[43] See FOSS (1999), pp. XV-XVI; COASE (1937), pp. 386-405; ALCHIAN/ DEMSETZ (1972), pp. 777­795; GROSSMAN/ HART (1986), pp. 691-719; WILLIAMSON (1989), pp. 1-25; WILLIAMSON (1988), pp. 567-591.

^[44] See COASE (1937), p. 390; BOUDREAUX/ HOLCOMBE (1989), p. 147.

^[45]COASE (1937), p. 390.

^[46] See BLAIR (1999), p. 63.

^[47] See BOLTON/ SCHARFSTEIN (1998), p. 97.

^[48]COASE (1937), p. 394.

^[49]COASE (1937), p. 395.

^[50]ALCHIAN/ DEMSETZ (1972), p. 794.

^[51] See ALCHIAN/ DEMSETZ (1972), pp. 794-795.

^[52] See GROSSMAN./ HART (1986), pp. 693-695.

^[53] See WILLIAMSON (1989), pp. 8-16; WILLIAMSON (1981), pp. 1563-1565.