Developments in Finance Theory Author(s): J. Fred Weston Source: Financial Management, Vol. 10, No.

2, Tenth Anniversary Issue: The Evolution of the Finance Discipline (1981), pp. 5-22 Published by: Blackwell Publishing on behalf of the Financial Management Association International Stable URL: http://www.jstor.org/stable/3665429 Accessed: 12/09/2008 06:57
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Major

Advances

in

Finance

Literature

in Finance Developments
J. Fred Weston

Theory

J. Fred Weston is Professor Economics and Finance of Managerial at the GraduateSchool of Managementat the Universityof California,Los Angeles.

* Developmentsin finance theory in recent years have been so substantialthat anotherassessmentof our progressand prospectsshouldbe useful.I do not know whetheranyoneelse benefitsfrom the exercise, but I findit helpfulperiodically to try to thinkthrough a conceptual frameworkfor approachingfinancial decisions. When I now review my Scope and Methodologybook [108], I find that muchseems obsolete, but that much also continuesto be relevant. The "New Themes" [107] have continuedto evolve along the lines then projected.FinancialTheoryand a synthesisof imporCorporate Policy [21]represents tant developments, relatedempiricaltests, and their implicationsfor financialdecision-making. This paper aims to be complementary to Hakansson [46], whose surveyemphasizesissues of financialeconomics.My reviewwill seek to: 1) summarize importantthemes and their relationships, 2) indicate their larger context in finance theory, 3) analyze the methodology of the related empirical
My thanks to Thomas Copeland, Harry DeAngelo, Robert Geske, Clement Krouse, Kwang Chung, Ronald Bibb, Nai-fu Chen, and to the anonymous reviewers for helpful suggestions. The contributions of Ashok Korwar, Wayne Olson, and Patricia Peat were particularly valuable. S

work, and 4) highlightsome key unresolvedareas. Everyonemust have a conceptualframeworkto Otherwise one is overwhelmed bringto the literature. by the quantityand diversityof the subject matter covered.Many theoreticalarticlesmake assumptions whichmake the papera specialcase of more general tests mustbe criticallyreviewed theory.The empirical as to 1)theirtheoretical underpinnings, 2) the relation between empirical materials and the underlying theory, and 3) the implicitassumptionsof the tests.

The Main Theoretical Doctrines and Their Relationships

It is possiblein 1981 to view modernfinanceas a coherent framework for analysis, answering the generalquestion,"How do individuals, firms,andour society make decisions to allocate scarce resources througha pricesystembasedon the valuationof risky assets?" Within this broad question, we study individualpreferencesand decisions to determinethe behaviorof firms and markets,the creationof assets and claims,and the attendant problemsof risk and of costly information. Beforethe late 1950s,the financefield was largely

TENTHANNIVERSARYISSUE/1981 FINANCIALMANAGEMENT

descriptive.The year 1958 was an importantwatershed. In that year, Tobin's "LiquidityPreferenceas in the Review Behavior TowardRisk" [106]appeared
of Economic Studies. This was an important develop-

of demandtheoryto financial ment in the application assets, with risk a central point of analysis. Hirshleifer'sarticle, "On the Theory of Optimal in the Journalof Investment Decision"[51] appeared the PoliticalEconomyin August 1958.It emphasized role of time-dependent utilityin the demandfor both assetsandprovided a foundaand financial productive tion for furtherwork in capital budgetingand the separationprinciple.The foundationsfor state-preference theory were also laid duringthis period.The analysesof pure or primitivesecuritiesby Arrow [3], Arrowand Debreu[5] and Debreu[28] were applied and extendedby Hirshleifer[49, 50] to broadenthe choice-theoretic framework of financial decisionbook on portfolioselectionwas making.Markowitz's in final manuscriptin the same year, although it date. His work, of appearedwith a 1959 publication course, representeda major advance in the formal analysis of risk in investmentdecisions on assets whose returnsare not independent.Modiglianiand Miller's first of a series of major contributionson capital structure and valuation appeared in The
American Economic Review in June 1958 [79], giving

of the holdersof depthto the studyof the relationships assets of differenttypes of claims againstproductive firms. Throughthese pioneeringstudies and subsethe field of financehas had conquentdevelopments, influencein the past twentyyears on microsiderable and on the theory, economics, on macroeconomics, of businessmanagement. practice,and curriculum The foundation of modernfinanceis utilitytheory. From the utility axioms,powerfultheorieshave been derived, including mean-varianceportfolio theory, state-preferencetheory, the concept of stochastic dominance,and theoriesof the pricingof contingent the capital claims.Theoriesof asset pricing,including asset pricingmodel and the arbitragepricingtheory, are equilibriumconstructs which follow from the applicationof utility theory to choices among risky in of individual Interactions alternatives. preferences markets for such alternatives provide signals to societyin the formof asset prices,makingpossiblean overtime andbetween efficientallocationof resources and investment. consumption and transThe consideration of costly information in the actions costs leads to importantmodifications have firm. New of the neoclassical theory approaches includedanalysisof agencycosts, information asym-

metries, and signaling behavior. Considerationof these additionaldimensionshas raised questionsof whether the valuation of the firm is affected by variations in the patterns of contracting among of suppliers differentcombinations of capital,bearers of risk, and managersof productive activities. in the theoryof Parallelwiththe newdevelopments evidencehas finance,an impressive body of empirical Theoreticalpropositions have been tested, appeared.' in quantitative usingthe latest and best developments methods. The recent developmentsin finance theory to be consideredin this paperare: Asset pricingmodels: Roll's critiqueof the capitalasset pricingmodel; Ross's contribution to arbitragepricingtheory; Financialpolicy of the firm: Capital structure; Dividendpolicy; incenin costlyinformation anddivergent Problems tives: Agency costs; Agency in the theory of the firm; Signalingbehavior; Contingentclaims analysis;and Mergertheoryand studiesof mergerperformance. My conclusion considers key issues in finance theorythat are yet to be resolved.

The CAPMand APT

Important new developments in the financial for the valuationof risky literature have implications assets and their role in allocating resourcesin the sufficient to providea basisfor economy.A summary furtheranalysiswill be attempted. Roll's Critique Roll'scritiqueof the capitalassetpricingmodelhas and raised shakenthe roots of the "beta revolution" the question,"Is beta dead?"[87, 89]. Roll does not contest the internal validity of the CAPM or the relatedtwo-parameterzero-beta model. Rather, he exposes fundamentalproblemsof the models when work,with the following they are appliedto empirical conclusions: CAPM is not testableunlessthe 1. The traditional exact composition of the true market portfolio is known and used in the test. And then the only
'See [10, 12, 13, 20, 25, 29, 30, 31, 32, 33, 34, 35, 36, 37, 38, 40, 41, 54, 55, 64, 65, 77, 83, 84, 85, 88, 89, and 98].

IN FINANCETHEORY WESTON/DEVELOPMENTS

hypothesisthat can be tested is that the marketportfolio is efficient. 2. Using a proxyfor the marketportfolio,suchas a stock market index, also involves problems. If the efficient, the efproxy chosen is not mean-variance ficient set mathematics predict that the CAPM will not hold. relationship 3. If the chosen proxy is mean-variance efficient, this does not establishthat the marketportfoliois also on the mean-variance efficientfrontier.In any sample of observations on individual of the returns, regardless generatingprocess,there will alwaysbe many which are mean-variance efficientportfolios,viewedex post. For the betas calculatedagainsta mean-variance efficientportfolio,the linearityrelationship betweenthe ex post meanreturnand beta will be satisfiedexactly, whetheror not the true market portfolio is meanvarianceefficient. 4. In testing the two-parameter zero-beta variant of the CAPM, a similarproblemarises.If an efficient proxy portfolio is chosen as an index, a zero-beta in relationto the selected portfoliocan be constructed efficientindex.If the proxyportfolioturnsout to be ex post efficient,then every asset will fall exactlyon the security market line - there will be no abnormal returns.If there are systematicabnormalreturns,it simplymeansthat the indexselectedis not ex post efficient.

known and measured,ambiguitiesin the tests of the asset pricingmodels and of securityinvestmentperformancewill remain. Roll's criticismsdo not applyto residualanalysis. Roll's responseto Mayersand Rice on this pointis as follows:
Mayersand Rice say (p. 17):Roll's conclusion... can be easily interpreted as beingcriticalof the emknownas residual piricalmethodology analysis.ButI never mentionedthis technique. Section 5 of my (1978) paper... supports residual analysis as apvalid even if the marketindex proxy is proximately not ex ante efficient[90, p. 397]. In summary, whetherresidualanalysisand performance measurement are equivalentdependson the treatment of the intercept term ... If the intercept is estimatedfrom the data insteadof specifiedaccording to the CAPM's predictions,residual analysis shouldgive an unbiased estimateof the valueof informationassociatedwith the eventunderstudy [90, p. 399].

So even though measurementof performanceis subjectto the stricturesthat Roll sets forth, residual analysis performed appropriatelyescapes most of these criticisms. The large numbers aspect of the cumulativeaverageresidualmethodologyprotectsit fromthe criticismof non-stationary betasas well.(See
[50].)

5. Thus any test of the CAPM or the two-parameter asset pricingmodel of Black is a test of the efficiency of the proxy market portfolio. The chosen proxy may turn out to be inefficient,but this alone proves nothingabout the true marketportfolio'sefficiency.

6. Most plausibleproxies are likely to be highly with one anotherand with the true market correlated efportfolio,whetheror not they are mean-variance ficient.This high correlation may suggestthat the exact composition is unimportant.Small differences from the true market portfolio, however,can cause substantial biases in the measurement of risk and expected returns. As noted above, the Roll critiquedoes not argue that the CAPM and its two-parameterzero-beta variantare invalid.It arguesthat empirical tests must be constructed and interpreted with great caution.If the indexused as the proxyfor the marketportfoliois ex post efficient,the regression of returns on betaswill be perfectlylinear.If the proxyindexchosenis ex post deinefficient,the resultingrisk-returnrelationships which inefficient index has been selected. pend upon Until the total marketportfoliocontaining all assetsis

The Arbitrage Pricing Theory One way to explain the risk-returnrelationships while avoiding some of the problems of using a single-marketindex is the arbitragepricing theory (APT). In introducingan early presentationof the its setting. APT, Ross effectivelysummarized
Thereare at presenttwo majortheoreticalframeworksfor the analysisof marketsfor riskyassets:the state space preference approach and, the mean variancemodeland its variants.The arbitrage model whichwe will developis a thirdapproachto capital markettheory, empiricallydistinguishable from the meanvariance theoryandmoredirectlyrelatedto the state spaceapproach. Whileformallyall modelsmay be viewed as special cases of the state space preference framework,it is in the restrictionsimposed either on preferencesor distributions that the empiricalcontentof the varioustheorieslie [96, p. 190]. Thus the APT aims to be a more general formulation of asset pricing. Ross starts with the requirement of equality between rates of return on riskless assets. The aim of APT is to provide a theory for risky assets analogous to that for riskless assets. Building on this base, if asset markets are perfectly

TENTHANNIVERSARYISSUE/1981 FINANCIALMANAGEMENT

competitive and frictionless, it can plausibly be assumed that the return on the ith asset can be
written:2 ri = Ei + bj,il + ... +
bikk

E(ft) = E(fo) + [E(aM) - E(o)] /3r.

(6)

+ i,.

(1)

In Equation(1), E, is the expectedreturn, j (j=l, .., k) are risky factorscommonto all assets- ranof dom variables withzero means;bijis the sensitivity in factorj; and the returnon asset i to the fluctuations risk componentidiosyncratic ,i is the "unsystematic" = 0 for all j. In to the ith asset with El{i j,| equilibrium,the expected returnon the ith asset is given by:
Ei = Xo+ X,bi, + X2bi2+ ... In Equation (2), Xj (j=l, ..., + Xkb,k (2)

k) are the returns

associatedwith the risky factors bj, while Xois the returnon the risk-freeasset (or zero-beta portfolio). The generalpricingequationof the APT for a portfolio of (k+l) independent assetsandk riskyfactorsis writtenas:
Ep= Xo+ (E - Xo)' V-1 Cov (?p,r) (3)

Followingthe earlier empiricalwork of Roll and Ross [91, 92], Chen [16, 17] has obtainedthe following results. The APT has consistentlyoutperformed the CAPM, as implemented to date with the market proxiesused. The marketproxiesused werethe S&P 500 index,whichis value-weighted, andthe New York Stock Exchangeplus the AmericanStock Exchange and an equallysecurities,on both a value-weighted is on the basis of adweightedbasis.This comparison to R2takesinto accountthe justedR2.The adjustment variablesin the APT greaternumberof explanatory tests. The APT is also testedagainstspecificalternatives. After the risk factors of the APT are taken into acmeasuresof risk have no excount, the own-variance planatory power on the returns. In addition, the power previousperiods'returnshave no explanatory on the currentperiod's returns. Finally, the firms' market values, one measure of size, have no explanatorypower on returns.

Financial Policy
of Modiglianiand Miller [74, 78, The publications in motion in set 79, 80] importantnew developments and financialeconomicsdealingwithcapitalstructure dividendpolicy. In recentyears, significantadvances in both areas have continued.

indicatesvectors). (whereunderlining Previous asset pricing models are in some sense set forth in special cases of the generalrelationships
Equation (3). For example, letting k = 1and S = (?m-

Em),the CAPM is obtained:

Capital Structure
Ep = Xo + (Em - Xo) (m2)-1 Cov (?p,rm). (4)

as Schallheimand DeMagistris[97] Furthermore, have shown, a single-factorarbitragepricing model generatesthe marketmodel in the followingform:
ti = E(ti) + fTS + ii (5)

where pi = the ex antebetacoefficient; = a mean zero common factor representing the deviationof the marketfromits mean;and term. ,i = a mean zero disturbance From Equation(5), Schallheimand DeMagistris also summarize fromthe Ross "Return,Risk andAror Black model: bitrage"paperthe two-parameter
2These results are taken from Nai-fu Chen [16].

i, = return on security i;

After MM [79], the theoryof financehad accepted the propositionthat, in the absence of taxes, the to its value. of the firmwasirrelevant capitalstructure while is deductible interest debt With taxes, because been had debt are dividends stock common not, An to as optimal thought always preferable equity. debt required with less than 100% financialstructure other factors (e.g., high bankruptcy costs) which increase with leverageto offset the tax advantageto debt. In his Presidential Address to the American Finance Association in 1977, Miller reopened the that capital questionwith a startlingdemonstration to the individual structure was a matterof indifference firm evenin the presenceof taxes. This resultfollows from the personaltax effects for the individualinvestor- that interestincomefromdebt is taxed at a higherrate than are capitalgains from equity.Miller showedthat therewill be an optimaldebt-equitymix

IN FINANCETHEORY WESTON/DEVELOPMENTS

for the economy as a whole, but not for each individual firm. Firms with low leverage will find a clientele among investorsin high bracketsand vice versa. DeAngeloand Masulis [26, 27] formalizedand extendedMiller'sargument. They showthat his resultis robustto alternate aboutthe personal tax assumptions aboutthe code, but fails underalternateassumptions corporate tax code and/or leverage-relatedcosts ex ante). (which,Millerhad argued,wereinsignificant model. DeAngeloand Masulisuse a state-preference They derive two principles: Aggregate Supply Response(ASR) andTax InducedPositiveAggregate Demand(TIPAD). On the supplyside (i.e., the firm
side), when PB(s) = PE(s) (l-Tc), all firms are indif-

is that they show that, by operatingat the margin, suchcosts can forcean interioroptimum(non-trivial) even whenthey are very small in absolutemagnitude (contraryto Miller's intuition).Further,when there are non-debttax shieldsavailableto the firm, like investment tax credits, at some debt level total tax credits shield all income. Beyondthis point, further debt is of no advantageto the firm, and it is more costly than equity because of ruling market prices. This also gives an interioroptimum,differentfor each
firm.

ferent as to how they packagetheir securities.PE(S) and PB(s)are the state-contingentprices for equity anddebt,respectively, andTcis the corporate tax rate, the same for all firms. At any other level of the two prices,eitheronly debtor onlyequityis supplied by all firms. This is ASR. On the investor side (TIPAD), we only need to assumethat thereis at least one investorin eachof the three tax brackets:
2. (l1-TPB) = (l-TPE) (l-TC) 3. (l-TPB) < (l-TPE) (l-Tc).

The criticalpoint is that non-cashchargesand tax creditscausethe expectedmarginal tax savcorporate ing to declinewith leverage.This leadsto the testable hypothesis:Other things being equal, decreases in effective investment-related tax shields (depreciation deductions or investment tax credits)will increasethe use of debt. In cross-sectional analysis, holding before-taxearningsconstant, firms with smaller investment-related tax shieldswill employgreaterdebt in their capital structure[27, p. 21]. Dividend Policy It has long puzzledfinancetheoristswhy corporations continueto pay out billions of dollars in dividendseveryyear, althoughdividends are taxed to the investorat tax rateshigherthanthoseon capitalgains. The lack of usefulthingsto do with the fundscannot be an explanation,becausethe corporations concurrently raise additionalexternalcapital. In a spiritsimilarto Miller[73], Millerand Scholes [75] suggest that the explanationmight be that investors shield their dividendincome completelywith interestpaymentson loans taken specificallyfor that purpose.The proceedsof the loans can be usedto buy more stock, therebyconvertingthe dividendincome into capitalgains. If the investorwishesto shelterthe dividendincomerisklessly,he can do so by using the proceeds of borrowingto purchasea life insurance policy instead of new stock. Pension plans are to the life insurance suggestedas an alternative plan. Hence, investorsshould be indifferentbetweendividendand capitalgains income,and the firm'smarket value should be unaffectedby its dividendpayout patterns. Miller and Scholes observethat, althoughthe conof the investor'sleverageand diviceptualseparation dend decisionsis useful for certainpurposes,new insights are to be obtained when we think of them together. However,they point out some difficulties. For both 'dividendand leverageirrelevanceto hold

1. (1-TPB) > (1-TPE) (1-TC)

TuB is the investor'spersonaltax rate on income fromdebt securities, andTPE is the investor's personal tax rate on incomefrom equitysecurities.The return on equity is proportional to (1-TpE)/PE(s) and that on debt to (1-T IB)/PB(s). Then, it can be shown that, when PB(s) < PE(s) (1-Tc), the return on debt is

greaterthan on equityfor investorsin brackets1 and

2. When PB(s) > PE(S)(1-Tc), the return on equity is

greaterthan on debt for brackets2 and 3. Returningto the supply side, market equilibrium
requires PB(S) = PE(s) (1-Tc) because only then are

firms indifferentbetweensupplyingdebt and equity, and so will supplyboth, satisfyingall investors.For

example, if PB(s) < PE(s) (1-Tc), then firms only

supplyequity, but then bracket 1 and 2 investorsgo

unsatisfied.

The conThus, Miller'sresults[73] are confirmed. ditionthat therebe some investors in each of the three bracketsabove is a relativelyweak requirement. DeAngeloand Masulisalso considerthe case where there are leverage-related costs like bankruptcy and is costs. The result the familiar interior agency optimum. The merit of the DeAngelo-Masulisanalysis

10

TENTHANNIVERSARYISSUE/1981 FINANCIALMANAGEMENT

simultaneously,the effective capital gains tax rate must be zero, else dividends,whichcan be shielded, are always preferredover capital gains. Further,as Miller [73] showed,leverageirrelevance requiresthe marginal investor to have a marginal tax rate on bonds equal to the corporatetax rate. But the same incomecan be usedto strategyusedto shielddividend shield interest income. DeAngelo and Masulis conwhichmakethe cludethat the relativepriceconditions Miller and Scholes dividendshelterattractiveto investors would also cause firms to eliminate all dividends,obviatingthe usefulnessof the shelter[26, issuesin pp. 463-464]. Thus,thereare still unresolved the regionwhere leverageand dividendpolicy meet. On the empirical side, Litzenbergerand Ramairrelevance. They swamy[63]havetestedfor dividend derivean after-taxvaluationmodel:
E(R) - rF = a + b3i1+ c(di-rF)

on formulating work in this field shouldconcentrate dividend alternatemodels for the expected yield and efnon-tax betweentax effects and on distinguishing fects.

Agency Theory
Additional dimensions of capital structure and otherfinancialpolicydecisionshaveemergedwiththe on agencytheory.Jensen of the literature development the new agencyliterature and Mecklingstimulated by of the relationextendingthe analyticalformulations ships between owners and managers[56]. They examine the agency problem which arises when a ownsless thanthe total commonstockof the manager firm. Private and individual consumption by the of the firm'swealthcosts himonly in propormanager of the firm, the tion to the fractionof his ownership remainder being borne by the other owners.Agency costs occur becausethe manager'sincentivesdiverge from those of the firm as a whole. Such costs are of three kinds: monitoringexpendituresby the other ownersto try to preventthis kind of behaviorby the managers; bonding assurances provided by the manager as agent that he will not pursue his selfinterest at the expense of the other owners; and residual losses - real inefficienciescaused by this marketimperfection. whicharisefromthe relations The agencyproblems between shareholders and debtholders are summarizedby Barnea, Haugen, and Senbet [6]. Debt liability financingwith limitationson shareholders' incentivesto select may give rise to a) shareholder higherrisk projectsthan those which are optimal to the firm as a whole, transferringwealth from incentives to shareholders, bondholders b) shareholder on new not to take up the option profitable incosts genvestments[Myers, 81], and c) bankruptcy eratedin allocatingresourcesunderinsolvency. Anothertype of agencyproblemis causedby informational asymmetryabout the prospectivevalue of in the conthis problem the firm.Akerlof[1] discusses text of the used car market.Ownersare assumedto on theircarsthanprospective havebetterinformation buyerspossess. Througha self-selectionprocess,the carswhichare offeredfor sale by ownerswill exhibita lower average quality than the stock of cars as a aboutparwhole.Becauseof theirpoorerinformation ticularcars, prospectivebuyersbase their bids upon their informationas to the averagequality of cars offeredfor sale. Thus,the sellerwho knowshis car to be of highqualitymustbearthe cost of the prospective

wheredi is the dividendyield. to marketvalues, the c If dividendsare irrelevant coefficientwould be zero. They use GLS estimatorsto take care of the contemporaneous correlation between disturbances acrosssecurities.Using monthlydata, they find, contrary to the Miller and Scholes results, a strong positive relationshipbetween returns and dividend yields. Miller and Scholes have developeda furtheremrelationship[76]. pirical test of the dividend-return They assume that announcementsof increases or decreasesin dividendsare knownto containinformation about the firm's prospects.It is importantto effect fromthe effectsof tax separatethis information incentives. Litzenbergerand Ramaswamy tried to eliminate this effect by using the previousperiod's dividendas a proxy for the currentperiod'sexpected dividend,ratherthan using the actual dividendpaid andthe of the dividend out, whenboththe declaration date fell in the same month. Miller and ex-dividend Scholes argue that this approachfails to removethe bias from the denominatorof the dividend yield and Ramavariable:dit/Pi,t-,. Further,Litzenberger as the sameas of zero dividend a declared swamytreat no decisionon dividends.But surelythere is adverse informationin a directors'meeting where the deciwhenthe comsion is madenot to declarea dividend, and Scholes modMiller When does. pany normally and the work of Ramaswamyfor Litzenberger ify dividend the find thesetwo differences, yieldterm they to be insignificant,as their model predicts. Further

IN FINANCETHEORY WESTON/DEVELOPMENTS

11

the sellerwho knowshis car to be buyers'ignorance; of low quality will benefit from the same source. A similar argument could be advanced regarding are offered assets or firmswhosesecurities productive for sale. The incidenceof these agency costs will vary accosts arising cordingto theirsource.Those pecuniary of ownersandmanagers will fromdivergent incentives be borneby managers,reflectedin the reducedprices arewillingto purchase the sharesof at whichoutsiders andthe reduced packcompensation owner-managers ages which the ownersas a whole will offer to managers. Those arising from divergent incentives of will be borneby shareand bondholders shareholders holdersreflectedin the reducedpricewhichinvestors will pay forthe firm'sbonds.Thosearisingfrominformation asymmetriesbetween sellers and buyers of assetswill be borneby the sellersof assetsof a quality above the averageof assets offered for sale and by buyersof assets of a qualitybelow that average.The incidenceof deadweightlosses is indeterminate. Fama [31] relates the agency problem to the broadertheory of the firm. He begins by observing andconof ownership that the issue of the separation trol has been a problemfacedby economistsfor some time. Some economists who rejected the classical model of a firm controlled by an owner-manager developedthe behavioraland managerialtheoriesof the firm. Newer theories have rejectedthe classical model of the firm but assume classical forms of economicbehavior,such as utility maximization,on the part of agents withinthe firm. Fama observesthat both Alchianand Demsetz [2] andJensenand Meckling[56]viewthe firmas a set of contractsamong factors of production.The firm is seen as a team whose membersact from self-interest and who recognizethat their returnsdepend,at least to some degree,on the survivalqualitiesof their firm team in competitionwith other teams. Fama argues the that this viewdoes not go farenough.He considers main world. His in a agency problem multi-period and control thesis is that the separationof ownership withina is an efficientform of economicorganization set-of-contracts perspective. and Fama contendsthat the manager'sreputation, thereforethe market for his services, is greatly inof the firm. The signals fluencedby the performance efficient an provided by capital market about the value of a firm'ssecuritiesare likely to be important for the evaluation of the firm's managers in the manageriallabor market. A basic questionis the extent to whichthe signals

providedby the manageriallabor market and the capital market actually discipline managers. Fama assertsthat the manageriallabor marketoutsidethe firm exertsdirectpressures, becausean ongoingfirm in the marketto hire or fire managers. is continually He further asserts that capital markets cause to monitoreach other.Eachmanagerhas a managers of the firm in the capital stake in the performance both above marketsand so monitorsothermanagers, and belowhim in rank.The role of the boardof directors is to providea relativelylow cost mechanismfor replacingor re-ranking top managers. Smith and Warner [101] argue that the market mechanisms are not sufficient to resolve agency problems. Theyexaminethe natureof bondcovenants to assembleevidenceconsistentwiththeir"costlycontractinghypothesis."They conclude: must besome involve realcosts,there bond covenants in having benefit debtin thefirm's structure; capital canbe conflict thebondholder-stockholder otherwise, debt.Henceour eliminated by not issuing costlessly not onlythatthereis an optimal evidence indicates
formof debtcontract,but an optimalamountof debt as well [101, pp. 153-154]. ... [Since] our analysis indicates that observed

Barnea,Haugen, and Senbet [6] extendthe Smith and Warner discussion of the impact of agency decisions.Theydescribe on capitalstructure problems how call provisions, conversion privileges, income of debt are consisbonds, and the maturitystructure tent with the efficienthandlingof agency problems. Thus, buildingon the seminalwork of Jensenand Meckling,scholarshave identifiedthree majortypes of agencyproblems:1) stockholder incentivesto gain at the expenseof bondholder interests,2) excessconof sumption perquisites by managerswith fractional and information 3) asymmetry. Fama ownership, that value-maximization arbitrage protects argues bondholder interests and that the market for managersdeals with perks. Smith and Warnerargue from the contentsof bondindentures that direct(and in individual company circostly) contracting cumstancesis neededto supplement the market.The third agency problem, informationasymmetry,has given rise to anotherdistinctstreamof literatureextending the earlier work of Spence [104] on labor marketmechanisms.

Information Asymmetry and Signaling

Ross [95] describes how signaling and manager can be used to deal with arrangements compensation

12

FINANCIALMANAGEMENT TENTHANNIVERSARYISSUE/1981

information asymmetry.He beginswith a reviewof a numberof alternateexplanationsof financialstructure that he finds inadequate.He then notes that the of the theoremon the irrelevance Modigliani-Miller the market financialstructure assumes that implicitly has full information aboutthe activitiesof firms.The assumesinformation modelhe formulates asymmetry and an incentivesystemthat allowsthe possibilityof
signaling.

The assumptions Ross makes to construct his model includethe following: 1. Manager-insiders have informationabout their own firms not possessedby outsiders. 2. Investors use the face amount of the debt or dividendsthe managerdecidesto issue as a signal of the firm's type. With referenceto a critical level of the firmto be type "A" if it debt,the marketperceives issuesdebtgreaterthanthis amountandtype "B" if it issues debt less than this amount. 3. A penaltyis assessedagainstthe managerif his firm experiences bankruptcy. 4. A managermay not trade in the financialinstrumentsof his own firm. This avoids the moral hazardproblemas well as violationsof the incentive structurein (3). A signaling equilibrium is achieved if "A" managerschoose financinglevels above the critical levelsbelow level and "B" managers choose financing the criticallevel. An "A" manager will haveno incentive to change, for the compensationsystem maximizes his returnunderthe signal.The "B" manager to signalfalselythathis firm will not havean incentive is of type "A" becausethe penaltybuiltinto the incentive structure would reducehis compensation. In a finalpartof his paper,Ross introduces a model in which "firms have randomreturnsX, uniformly distributedon [0,t] where manager-insidersknow
their own firm's t value . . ." [95, p. 35]. Again, there

to managers. is a bankruptcy penaltyin compensation He concludes that the MM "irrelevancytheorem

holds within a risk class, i.e., given t . . ." [p. 36]. By

changingthe level of debt he selects,the manager-insideraltersthe market'sperception of the firm'srisk class and therefore its current value. This process producesa uniqueoptimallevel of debt financingfor each firm type. Ross discussessome empiricalimplicationsof the signalingtheory.One is that the cost of capitalwill be unaffectedby the financingdecisioneven thoughthe A higherlevel of level of debt is uniquelydetermined. debt increasesbankruptcyrisk and hence tends to decreasethe value of the firm.

Haugenand Senbet [47] seek to implementRoss's claims. penaltyfunctionthroughthe use of contingent sell a the that managersimultaneously They require of calls and puts so that, if the firmis an combination the manageris com"A" firm in Ross's terminology, no pletely hedged,suffering penaltyif the firm turns out to be an "A" firm.On the otherhand,if the firm turnsout to be a "B" firm(a firmof lowervaluethan "A"), then prior to the expirationof the contingent claims,the holdersof the putswill exercisethemwith a consequentpenaltyfor managercompensation. This also providesa controlon the agencyproblem. If the managerconsumesan excessiveamountof perquisites,the valueof the firmwill decline.In effect,he makes an "A" firm into a "B" firm. Again, the puts will be exercisedand the managerwill sufferthe consequencesof his havingcaused a decline. Leland and Pyle [60] use informationasymmetry influencesto rationalizethe existenceof financialinmodelsof whichtraditional termediation institutions, financial markets have difficulty explaining. They argue that transactionscosts are not of a sufficient magnitude to provide an adequate explanation. to be a Insteadthey find informational asymmetries primaryexplanationfor the existence of intermedithose relatedto individaries. For assets,particularly not information uals such as mortgagesor insurance, publiclyavailablecan be developedat some cost. As such informationis valuableto potentiallenders,if there are economies of scale, firms would be developedto assembleinformationand to sell it. Two problemswouldariseif the firmsoughtto sell the information directly to investors. One is the "publicgood" aspect of information.Purchasersof information could share it with or resell it to others its usefulnessto themselves.The withoutdiminishing secondproblemrelatesto the reliabilityof the information. It will be difficultfor potentialusers to disThusthe tinguishbetweengood and badinformation. will reflectits averagevalue,and priceof information the average value of informationoffered for sale would be lower than the averagevalue of the total stock of information,as in the used car discussion above. Indeed,if entryis easy for firmsofferingpoor this can lead to marketfailure. information, a returnon information in capturing Bothproblems whichbuys a financial are overcomeby intermediary informaof accumulated on basis the holds assets and in is reflected tion. The valueof the firm'sinformation a privategood, the returnsfrom its portfolio.Leland of howthe potentialbuyers andPyle raisethe question the inclaimscanjudgewhether of the intermediaries'

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termediary has developed valuable information. They suggest that information can be conveyed through signaling - the organizers' willingness to invest in their firm's equity [60, p. 384]. But this seems to imply a one-period model. Realistically, the historical performance record of the financial intermediary is likely to be used as an indicator of its effectiveness in assembling and utilizing information.

follow from the fact that option prices are deterto the minedfrompurearbitrage conditions available investorwho establishesperfectlyhedgedportfolios [21, p. 400]. The call price is an increasing function of the stock price, the time to maturity, the risk-free rate, and the instantaneous variance of the stock price; it is a decreasing function of the exercise price. Of the five parameters the instantaneous variance is the most difficult to estimate. But in the theoretical articles which were subsequently developed, at one time or another each of the five parameters was permitted to vary. Analytic solutions were developed for a range of assumptions about the behavior of each of the five parameters. The issue of the underlying behavior of the stock prices became critical when some systematic departures of actual option prices from those predicted by the Black-Scholes model were observed [7]. The Black-Scholes formula was said to underprice deepout-of-the-money options, near-maturity options and high-variance options. It seemed to overprice deep-inthe-money options and low-variance options. This led to questioning the assumption that the variance of stock prices was known and constant. Subsequent analysis has fallen into three categories. The first deals with the nature of stock price changes. Cox and Ross [23] look at pure jump processes as resulting in an underlying Poisson distribution. Merton [72] combines the idea of a Poisson event with the diffusion process. He treats the underlying behavior as essentially a diffusion process, with at any time the possibility that new events may change the parameters of the diffusion process, and he develops a new equation similar in form to the original Black-Scholes model, except that the distribution is the sum of normals instead of one normal distribution. In a second approach, Cox [22] treats the variance as no longer a constant. But the variance in the diffusion process has a constant elasticity. The ratio of the percentage change in the variance of the stock price with respect to percentage changes in the stock price is equal to some constant. In a third approach, Geske [44] analyzes the problem within the framework of the valuation of compound options. Whereas the Black-Scholes model assumes that the variance of the stock's return is not a function of the stock price, in the compound option model the variance of the return on the stock is inversely related to the stock price. If the stock price falls while the face amount of debt is unchanged, the debt-equity ratio rises, resulting in increased risk. The

Contingent Claims Analysis: The Option Pricing Model (OPM)3

A prodigious literature has appeared on option pricing and related issues since the Black-Scholes paper in 1973 [11]. One critical development has been the recognition that a hypothetical risk-free hedge would facilitate a solution to the option pricing problem. (Black and Scholes noted this came from a suggestion by Merton [11, p. 641, ftn. 3].) The key (as summarized by Copeland and Weston [21, p. 394]) was the following: And if we continuously adjustour hedgeportfolio to maintain a ratio of stock to call options of 1/(6c/6S), the hedge will be perfectly risk free. the risk-freehedgeportfoliowill earn the Therefore, if capitalmarketsare efrisk-freerate in equilibrium ficient.This is reallythe main insight.It is possible, given continuoustrading, to form risk-freehedges asset and a with only two securities,the underlying is expressed call option.Thisequilibrium relationship as dVH= rfdt.
VH

This fact and the fact that the risklesshedgeis mainone share of stock and selling tained by purchasing l/(6c/6S) calls, Q =l, Q=6S) ' (bc/bS)

leads to the Black and Scholes valuationformula. The resulting equation involved five parameters: The price of the underlying security,its instantaneous variance,the exerciseprice on the option,the time to maturity,and the risk-freerate. Only one of these variables, the instantaneousvariance, is not The optionpricedoes not depend directlyobservable. or (2) the expected risk preferences on (1) individual asset. Both results rate of returnon the underlying
3This section summarizes an overview of the subject which my colleague, Robert Geske, outlined for me.

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increased risk is reflected by a rise in the variance of the returns on the stock. The relationship used by Geske is that the instantaneous standard deviation of the return on the stock is the product of the instantaneous standard deviation of the return on the value of the firm as a whole multiplied by the elasticity of the stock price with respect to the value of the firm. He observes that percentage changes in the stock's return will be larger when prices have fallen than when they have risen. If the stock price has fallen (risen), the increased (decreased) variance of the returns on the stock will act to raise (lower) the price of the option on the stock. Thus, variations in the firm's capital structure inducedby changesin the value of the firm as the marketcontinuouslyrevaluesthe firm's prospective cashflowsaretransmitted the variance of the through stockto affectthe priceof an optionon the stock [44, p. 74]. Systematic empirical studies of the OPM have been relatively limited. The first, by Black and Scholes [12], used price data from the over-the-counter option market for the four-year period, 1966-1969. Buying "undervalued" contracts and selling "overvalued" contracts at market prices yielded positive excess returns. The results indicate that the market uses more than past price histories to estimate the ex ante instantaneous variance of stock returns. When the transactions costs of trading in options were taken into account, they offset the implied profits. Galai [42] duplicates the Black-Scholes tests, extending them by adjusting the option position each day. Undervalued options are bought and overvalued options are sold at the end of each day, maintaining the hedged position by buying or selling the appropriate number of shares of common stock. Using ex post hedge returns, Galai found that trading strategies based on the Black-Scholes model earned excess returns in the absence of transactions costs. But with transactions costs of 1% the excess returns vanished. Tests of spreading strategies yield results similar to those produced by the hedging strategies just described. (For a somewhat more complete summary see Copeland and Weston [21, pp. 407-408].) The empirical study by MacBeth and Merville [64] obtains results that differ from previous empirical observations. They find that the Black-Scholes model underpricedin-the-money options and overpriced outof-the-money options. With the exception of out-ofthe-money options with less than 90 days to expiration, the tendencies just described increased with the

extent to which the option was in-the-money or out-ofthe-money and decreased as the time to expiration decreased. They conclude as follows: We emphasize that our resultsareexactlyopposite to those reportedby Black(1975), whereinhe states that deep in the money (out of the money) options generallyhave B-S model prices which are greater (less)thanmarketprices;and,ourresultsalsoconflict with Merton's (1976) statement that practitioners observe B-S model prices to be less than market pricesfor deepin the moneyas well as deepout of the emmoneyoptions.We proposethattheseconflicting piricalobservations may,at leastin part,be the result of a nonstationaryvariancerate in the stochastic stock prices [64, pp. 1185-1186]. processgenerating Clearly, additional empirical investigation of these conflicting results is called for. It is hoped that the Cox-Ross-Rubinstein [24] discrete-time model for valuing options will facilitate furtherempirical testing. The further extensions and applications of OPM may be organized into four categories: 1) valuing corporate securities, 2) valuing other securities, 3) implications for corporate managerial policy, and 4) implications for other sectors of the economy. The use of the OPM to value corporate securities was described in the original Black and Scholes article. Merton [73] extended and most fully implemented the potential of the OPM for the valuation of corporate securities. In addition, he formulated a model of the risk structure of interest rates. He demonstrates that the risk structure of interest rates is a function of the variance of the firm, the time to maturity of the debt, and the debt-equity ratio of the firm. Other papers dealing with the valuation of corporate securities include the analysis by Black and Cox [9] of the effects of bond indenture provisions, the studies by Ingersoll [52, 53] of convertible securities, and the study by Brennan and Schwartz [14] of convertibles. The OPM has also been applied to the valuation of other securities. Especially significant is the study by Black [8] of the pricing of commodity contracts. Margrabe [66] analyzed the value of an option to exchange one asset for another. Fischer [39] used call option pricing in the valuation of index bonds. Grauer and Litzenberger [45] made further extensions in applying the model in the area of commodity price uncertainty. Galai and Masulis [43] summarized option theory with respect to corporate financial policy. They investigate relationships between the beta of the firm and the beta of its stocks and bonds. Changes in the

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betas and the resulting changes in the values of the firm's securities, if we are using the Capital Asset Pricing Model, could be predicted by the firm's activities in a number of areas. These include changing the firm's investment program, merger activity or divestiture of assets, and capital distributions (dividend policy). Galai and Masulis demonstrate how any managerial decision that would change the beta of the firm or its securities could be analyzed through the OPM. In the fourth category of the extensions of the OPM, we see its great power in application to other sectors of the economy. Myers [81] suggests that the decision to invest can be placed in an options pricing framework. Sharpe [99] demonstrates how pension fund decisions can be viewed as an option pricing problem. His theory provides a framework for formulating optimal pension planning to balance the interests of the firm and its stockholders and the quality of personnel. Brennan and Schwartz [15] investigate the insurance aspects of options. They show how the options pricing approach can be used by a life insurance company which sells equity-linked life insurance policies to optimally hedge against the fluctuating values of its equity investments. Related studies suggest further extensions of the OPM. Potentially these would include a theory of financial institutions and financial intermediation, including commercial banking. They would include insurance generally, given the similarity between put options and insurance policies. In addition, the product warranty policies of business firms would appear to be susceptible to analysis through the OPM.

sequences became less favorable by 1969, and conglomerate merger activity then declined sharply. It has again been on the rise during the late 1970s, though, raising important issues of financial economics as well as of public policy. Financial Theory of Pure Conglomerate

Mergers

Merger Theory and Studies of Merger Performance

Studies of mergers continue to be an area of great interest. In any 12-month period in recent years, some 15 to 20 papers on mergers have been presented at association meetings or submitted for publication to journals. The United States studies have increasingly focused on conglomerate mergers for particular reasons. In the United States, the 1950 amendments to Section 7 of the Clayton Act have enabled the regulatory authorities to virtually eliminate horizontal or vertical mergers if either company has something like a 10%market share. Hence the main merger activity since the 1950s has been conglomerate mergers. A wave of conglomerate mergers was said to have occurred during the late 1960s. Tax and antitrust con-

While numerous empirical studies have been made, merger theory has been slow in emerging. Efforts at progress have been made in this area by Chung [18] and Chung and Weston [19]. They formulate three questions that a theory of mergers must address: 1) Why do conglomerate mergers occur, 2) What are the characteristics of acquiring and acquired firms, and 3) What explains fluctuations in the level of aggregate conglomerate merger activity. A valid theory of conglomerate mergers is required to answer these questions simultaneously. In their theory, conglomerate mergers occur for the purpose of capturing those investment opportunities in the acquired firm's industries that are relatively more favorable than those in its own industry. But the acquiring firm needs the firm-specific factors of production and the organization capital of the acquired firm to make the investment successful [Rosen, 93; Prescott and Visscher, 86]. The combined firm becomes better able to internalize the investment opportunities by initially lowering the costs of capital and then developing more organization capital. Thus a conglomerate merger represents the preservation and better utilization of the firm-specific factors of the acquired firm and the more general organization capital of the acquiring firm. The benefit of the merger will be greater if the merging firms possess certain characteristics. Characteristics of an acquired firm will include: 1) a cost of capital that is higher relative to other firms in its industry, 2) its position in an industry with relatively favorable growth and profitability prospects, and 3) some industry- and firm-specific organizational or managerial capital whose value is preserved or enhanced by the merger. The acquiring firms are in industries with growth and profitability opportunities less favorable than the average for the economy. They have a record of managing asset growth effectively. They have more cash than current opportunities for reinvestment. The basic initiating influence is that the cost of capital is lowered by the merger, and thus investment and production in the acquired firm's operations are

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increased.Since the cash flow streamsof the entities debtcapacityis increased; arenot perfectly correlated, this effect will be greater if bankruptcycosts are significant [Lewellen, 62; Higgins and Schall, 48; Yawitz, Marshall, and Greenberg, 111; Stapleton, 105]. Economiesof scale in flotationexpenseslower the cost of raisingfunds [Levyand Sarnat,61]. The use of excess internalcash flows of acquiringfirms eliminates the cost of raising funds externallyand providesdifferentialtax benefits.The three possible sources of loweringthe cost of capital are unsettled areas in the financeliterature.Furthertesting of the issues involved is provided by the merger studies analyzingthe market for capital assets. A derivedeffect of the increasedinvestmentand activitiesfollowinga mergeris to increase production learning.This will shift out organization firm-specific scheduleof the the marginalefficiencyof investment of no merger. firm as comparedwith the alternative in evidence supportof these There is considerable hypothesesfrom previousstudies. The P/E ratio is low whenbusinessriskis high,whenfinancialleverage is high, or when industrygrowth prospectsare unfavorable. Acquired firms have lower financial leverageand lower P/E ratios than acquiringfirms [e.g., Melicherand Rush, 70]. Theirindustrygrowth to be better than for the prospectsare hypothesized which is confirmed by the as a whole, economy evidence[19]. The implicationof these resultsis that the acquiredfirms are "risky" and thereforehave leverage typicallyinhighercosts of capital.Financial creases after the merger [see Weston and Mansinghka, 109; Shrieves and Pashley, 100]. Because investment opportunities, mergersoccurto internalize in an acthe theorypredictsthat capitalexpenditures the after will increase business firm's merger. quired Markham[67] foundthat new capitaloutlaysfor acin the three-yearperiod operations quiredcompanies' followingacquisitionsaveraged220%of pre-merger outlays for the same time span. Finally, merger premiumswere higher when acquiringfirms had a higher size-adjustedcash flow rate [Neilson and Melicher,82]. In addition, Chung'sstudy of fluctuationsin the aggregatelevel of mergeractivity is consistentwith are measthis hypothesis.Investmentopportunities and by realrates uredby the growthrate of industries of interest. Mergeractivitywould be expectedto be positivelyassociatedwith real GNP growthrates and negativelyassociatedwith the real rate of returnon high grade corporatebonds. With regardto the influencesof the cost of capital and funds availability,

two additional variables are considered. The risk firmsprovide on the higher-risk (acquired) premiums in the cost of capital potentialsfor greaterreductions Variationsin risk premiums throughdiversification. are measured by the ratio of the Baa rateto Aaa rate on long-termcorporatebonds.This ratio is expected to be positively associated with merger activity. influences Finally,the degreeof monetarystringency and lower cash flow) acquiredfirms the (higher-risk firms.This variableis measured more than acquiring paperrate by the ratio of the short-termcommercial is exThe association to the Aaa corporate bondrate. pectedto be positive. In the empiricalresults,the predicted signs are obare significantwhen the tained and the relationships dependent variable is the number of pure conglomeratemergers.Whenproductextensionmergers are usedas the dependent variable,the t-value for the andother becomes variable riskpremium insignificant market extension When t-values drop slightly. mergersare addedto the productextensionmergers, the t-values drop furtherbut still remainsignificant variable. exceptfor the coefficientof the riskpremium the financial with consistent These resultsare synergy theory of pure conglomeratemergers.The data also indicate that investment opportunities and the to acof internalfundsfrom acquiring redeployment to a lesser firms are degree, though important, quired in effectingproductextensionmergersas well. Studies of Merger Performance Most of the other mergerstudies in recent years have used residual analysis. They have sought to measurethe impact of values changeson the sharefirms.In the merger andacquiring holdersof acquired studies using residual analysis, relatively large sampleshave been used, usuallymore than 100. The behaviorof the returnon commonstock is studiedfor up to 100monthspriorto the merger"event"and for firmsusuallyfor40 monthsfollowingthe the surviving the 100 or moremergersmay haveocWhile merger. curredover as manyas 20 or morecalendar years,the which from date is the reference event" "merger The is made. of returns behavior of the analysis market for the an with adjustment begins procedure risk premium.In addition,a wide range of other intime is fluencesthat might occur at some particular averagedover the many differenttime periods and companiesin the mergersample. are designedto hold conThe statisticalprocedures stant the influences of all factors other than the

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merger event. A comparison can be made between the average returns of the merging firms and the returns that would have been predicted from the market line relationships between return and risk. The residuals are averaged over all the merging firms in the sample for the months before and after the "merger event." These average residuals are also cumulated for a number of months and termed the cumulative average residuals or CARs. All studies agree that the shareholders of acquired firms experience significant positive gains as a result of information on the merger or tender offer event. All studies agree in finding no significant correction to the CARs subsequent to the merger or tender event. For the acquiring firms all studies find positive CARs at or near the announcement of the merger or tender offer. But in the case of Mandelker [65], the positive returns were not statistically significant. Ellert [30] and Kummer and Hoffmeister [57] found that the CARs were positive for acquiring firms during the period well before the merger event. This led Ellert to hypothesize that acquiring firms were successful in managing assets developed both internally and externally. However, Langetieg [58], using a control group, found that there were similar influences on both the acquiring firms and on the control group.

Key Unresolved Issues

Although we have made much progress in the development of analytical financial models, many key issues and unsettled areas remain. Should the analysis for investment decisions treat investment decisions in isolation or in portfolios? This is equivalent to the question of whether a project's own variance is an important variable or whether only non-diversifiable risk needs to be taken into account. A related question is whether the interdependence of investments needs to be taken into account. Particularly, are there interdependencies in mergers? The literature is generally skeptical of interdependencies or synergy in mergers. On the other hand, one could be equally skeptical about generating a continuous series of investment opportunities with positive net present values. General theory does not provide either guidance or solid evidence on the degree or duration of investments with positive NPVs. A related area of significance is the nature and level of bankruptcy costs. This goes to the heart of defining the nature of bankruptcy. Is it equivalent to an abrupt change in values? This requires an analysis of the underlying factors that produced a substantial change in

value. The changes in value would apply both to values of the equity or residual claimants as well as to the bondholders. It is likely that when the value of equity shares moves downward by a substantial degree, the value of creditor positions will also deteriorate. But if the values of the creditor shares decline substantially with the decline in the value of the equity shares, that particular form of asset value decline described as bankruptcy appears not to be different conceptually from any other major change in value. Our assessment of the definition, nature, and level of bankruptcy costs will influence our conclusions on the relative efficiency of firm versus investor diversification. The question of whether diversifiable risk influences investment decisions is related to this subject. The issue of capital structure decisions in the absence of taxes is still unresolved. Is there a valid basis for the use of leverage in the absence of taxes? Here there is a potential role for agency influences, information asymmetry, and signaling. While contributions in these areas have suggested some promising propositions, little empirical testing has yet taken place. At issue is the extent to which the formulations to date permit the development of operational tests of the propositions. Inflation and its effect on capital structure and asset pricing add new dimensions. Academic research has made only modest beginnings in analyzing or understanding the impact of inflation on either financial theory or corporate practices. For years we judged that inflation was "temporary;" more recently we have recognized that the impacts of inflation may be longer lasting and not easily understood. The evidence is strong that inflation has lowered real rates of return of business firms. Part of the explanation is that tax regulations provide for taxing inflated nominal returns (e.g., small real tax deductions, because depreciation is based on historical rather than current costs). The pace of real capital spending has been slowed and has been associated with a decline in the rate of productivity growth. Interest rates have been high, the availability of funds restricted, and negative yield curves have been recurrent. In this new economic environment, the financial positions of corporations have deteriorated. The evidence of corporate financial weakness is strong whether measurements are made by the standard liquidity ratios, the ratio of total debt to total assets, the ratio of long-term debt to short-term debt, or by interest-coverage ratios. Business corporations and financial intermediaries are increasingly vulnerable to the inflationary economic environment and govern-

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ment policiesto deal with it. Indeed,the financialimpacts of alternative government policies are difficult to model conceptuallyor to test empirically. Of potentialhelp on these mattersis the continued developmentof informationand financialmodels to aid businessmanagersin decision-making. What are the implicitunderlying theoreticalstructures of these models? What implicit theories are involved?Are in these models, thereimplicitvaluationrelationships and do they have a valid basis?Can these financial models perform a useful role in strategic financial planning and formalize the methodology of the iterative processes for dealing with ill-structured Can the results and implicationsof these problems? financial models be operationallysubjectedto empiricaltests? Can they be really useful until the conthe impactsof inceptualproblemsof incorporating flation have been workedout? needto be considered The international dimensions affect diversification more fully. Does international here is the the pricingof riskyassets?A sub-question extent to which the underlyingtheorems of internationalfinancehold and the conditionsunderwhich they hold. Is there such a thing as exchange risk? of alternate approaches Finally,the relativeusefulness is still unsettled. to international processes adjustment

Conclusions
Recent work in finance has expanded into a coherentanalyticalstructure, uponthe major building in 1950s. Those founthe new contributions starting dations included work on the role of individual in the demandfor assets [Arrow-Debreu, preference Hirshleifer,Tobin], the natureof efficientportfolios of risky assets [Markowitz, Tobin],and the financial structureof the firm [Modiglianiand Miller]. Two sincethenhavebeen 1)the majorlinesof development modelsfor the pricof generalequilibrium derivation the enrichment of the theory and of 2) ing riskyassets, the problemsof contractof the firm by considering factors.Parallel ing among ownersof the productive with theoreticaladvancesin these areas,a substantial body of empiricalresearchhas been produced. With respect to models of asset markets,notable developmentshave been: 1) Roll's critique of the capital asset pricing model in some of its empirical applications,2) the formulationof the more general in the arbitrage pricingtheory, and 3) improvements of in the application powerandextensions explanatory the option pricingmodel.

Certain observedpolicies of business firms have been a continuingsource of controversyin finance financialstructure(degree of theory - particularly and dividend leverage) payouts. Analysis in these areas has been both stimulatingand inconclusiveto date. Analysis of the natureof the firm has broadened into studiesthat have includedagency and information problems. the firmnot as an atom Characterizing of analysis,but as a set of contractsamongsuppliers of capital and the factors of production,researchers have identifiedseveralsourcesof agencycosts, have shown the relationship of portfoliodiversification to the separationof ownershipand control, and have identified signalingmechanisms by whichcostly information of uncertainvalidity may be efficientlydistributedand certified. Relatedto the discussionof the natureof firms is - whetherthe the questionof mergerperformance of two firmsis superiorto an individual combination in a investment strategywhichincludestheirsecurities portfolio.Researchin this area has been chiefly empirical,the major tool being residualanalysisin the context of the CAPM and its variants. We are likely to achievecontinuedfutureprogress in all these areas. Theoreticaland empiricalwork in optionpricing,arbitrage pricing,and the CAPM will of the deterprovidea more completeunderstanding minants of risk and return relationships.Attention focused oA the contractingrelationshipswithin the firm will improveour understanding of divergentincentives, informationcosts, and signalingbehavior. model This will enableus to fleshout the neoclassical of the firmandwill contribute to our abilityto explain corporate financial policies, such as the degree of in the capitalstructure. Further leverage improvement of capital marketson the one in our understanding decisionprocesseson hand,andof businessmanagers' the other,shouldhelp us to analyzeand explainsuch phenomenaas dividend payouts and conglomerate is yet in the mergers- on which our understanding formativestages.

References
1. G. A. Akerlof, "The Market for 'Lemons:'Quality Quarterly Uncertaintyand the MarketMechanism," Journalof Economics(August 1970),pp. 488-500. Informa2. A. Alchian and H. Demsetz, "Production, tion Costs, and Economic Organization," The
American Economic Review (December 1972), pp. 777-795.

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3. K. J. Arrow, "Le role des valeurs boursieres pour la repartition la meilleure des risques," Econometrie (1953), pp. 41-48. 4. K. J. Arrow, "The Role of Securities in the Optimal Allocation of Risk-Bearing," Review of Economic Studies (April 1964), pp. 91-96. 5. K. J. Arrow and G. Debreu, "Existence of an Equilibrium for a Competitive Economy," Econometrica (1954), pp. 265-290. 6. A. Barnea, R. A. Haugen, and L. Senbet, "Market Imperfections, Agency Problems, and Capital Structure: A Review," forthcoming in Financial Management. 7. F. Black, "Fact and Fantasy in the Use of Options," Financial Analysts Journal (July/August 1975), pp. 36-41. 8. F. Black, "The Pricing of Commodity Contracts," Journal of Financial Economics (January/March 1976), pp. 167-179. 9. F. Black and J. C. Cox, "Valuing Corporate Securities: Some Effects of Bond Indenture Provisions," Journal of Finance (May 1976), pp. 351-367. 10. F. Black, M. C. Jensen, and M. Scholes, "The Capital Asset Pricing Model: Some Empirical Tests," in Studies in the Theory of Capital Markets, M. C. Jensen, ed., New York, Praeger Publishers, 1972. 11. F. Black and M. Scholes, "The Pricing of Options and Corporate Liabilities," Journal of Political Economy (May/June 1973), pp. 637-659. 12. F. Black and M. Scholes, "The Valuation of Option Contracts and a Test of Market Efficiency," Journal of Finance (May 1972), pp. 399-417. 13. M. Blume and I. Friend, "A New Look at the Capital Asset Pricing Model," Journal of Finance (March 1973), pp. 19-34. 14. M. J. Brennan and E. S. Schwartz, "Convertible Bonds: Valuation and Optimal Strategies for Call and Conversion," Journal of Finance (December 1977), pp. 1699-1715. 15. M. J. Brennan and E. S. Schwartz, "The Pricing of Equity-Linked Life Insurance Policies with An Asset Value Guarantee," Journal of Financial Economics (June 1976), pp. 195-213. 16. N. Chen, "The Arbitrage Pricing Theory: Estimation and Applications," Graduate School of Management, University of California, Los Angeles, June 1980. 17. N. Chen, "Empirical Evidence of the Arbitrage Pricing Theory," Graduate School of Management, University of California, Los Angeles, October 1980. 18. K. S. Chung, "A Financial Synergy Theory of Conglomerate Mergers," working paper, Graduate School of Management, University of California, Los Angeles, August 1980. 19. K. S. Chung and J. F. Weston, "Diversification and Mergers in a Strategic Long-Range Planning Frame-

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EUROPEAN FINANCE ASSOCIA TION THE EIGHTH ANNUAL MEETING SCHEVENINGEN, SEPTEMBER 10-12, 1981
The Eighth Annual Meeting of the European Finance Association will be held September 10-12, 1981, in Scheveningen (The Hague), The Netherlands. Dr. Marius J. L. Jonkhart Erasmus Universiteit Faculteit der Ekonomische Wetenschappen H 3-5 Burgemeester Oudlaan 50 3062 PA Rotterdam The Netherlands Tel 0031/10 22 83 74 For more information about the EFA, please contact Mrs. Gerry Dirickx-Van Dyck, c/o EFMDEIASM, Place Stephanie 20, B- 1050 Brussels (Tel. 0032/2 511.91.16). The European Finance Association, established in March 1974 under the aegis of the European Foundation for Management Development, in close cooperation with the European Institute for Advanced Studies in Management, provides a professional society for academicians and practitioners with interest in financial management and financial theory and its applications. It serves as a center of communication for its members residing in Europe or abroad. It also provides a framework for better dissemination and exchange at the international level.