f+ +09+ +weston+ +finance+theory

8/12/2019 F+ +09+ +Weston+ +Finance+Theory

1/19

Developments in Finance Theory

Author(s): J. Fred WestonSource: Financial Management, Vol. 10, No. 2, Tenth Anniversary Issue: The Evolution of theFinance Discipline (1981), pp. 5-22Published by: Blackwell Publishing on behalf of the Financial Management AssociationInternationalStable URL: http://www.jstor.org/stable/3665429Accessed: 12/09/2008 06:57

Your use of the JSTOR archive indicates your acceptance of JSTOR's Terms and Conditions of Use, available at

http://www.jstor.org/page/info/about/policies/terms.jsp. JSTOR's Terms and Conditions of Use provides, in part, that unless

you have obtained prior permission, you may not download an entire issue of a journal or multiple copies of articles, and you

may use content in the JSTOR archive only for your personal, non-commercial use.

Please contact the publisher regarding any further use of this work. Publisher contact information may be obtained at

http://www.jstor.org/action/showPublisher?publisherCode=black.

Each copy of any part of a JSTOR transmission must contain the same copyright notice that appears on the screen or printed

page of such transmission.

JSTOR is a not-for-profit organization founded in 1995 to build trusted digital archives for scholarship. We work with the

scholarly community to preserve their work and the materials they rely upon, and to build a common research platform that

promotes the discovery and use of these resources. For more information about JSTOR, please contact [email protected].

Financial Management Association InternationalandBlackwell Publishingare collaborating with JSTOR to

digitize, preserve and extend access to Financial Management.

http://www.jstor.org
http://www.jstor.org/stable/3665429?origin=JSTOR-pdfhttp://www.jstor.org/page/info/about/policies/terms.jsphttp://www.jstor.org/action/showPublisher?publisherCode=blackhttp://www.jstor.org/action/showPublisher?publisherCode=blackhttp://www.jstor.org/page/info/about/policies/terms.jsphttp://www.jstor.org/stable/3665429?origin=JSTOR-pdf


2/19

a j o r dvances n Finance iterature

evelopmentsn Finance TheoryJ. Fred Weston

J. Fred Weston s Professor f ManagerialEconomics nd Financeat the GraduateSchool of Managementat the UniversityofCalifornia,Los Angeles.

* Developments n financetheory in recentyearshave been so substantial hat anotherassessmentofourprogressandprospects houldbe useful.I do notknowwhetheranyoneelse benefits rom theexercise,butI find t helpfulperiodicallyo tryto think hrougha conceptualframeworkfor approaching inancialdecisions. When I now review my Scope andMethodologybook [108],I findthat muchseems ob-solete, but that much also continues o be relevant.The New Themes [107]have continued o evolvealongthe lines then projected.FinancialTheoryandCorporatePolicy[21]represents synthesisof impor-tant developments, elatedempirical ests, and theirimplications or financialdecision-making.This paper aims to be complementary toHakansson[46], whose surveyemphasizes ssues offinancialeconomics.My reviewwill seekto: 1) sum-marizeimportant hemesand their relationships, )indicate their larger context in finance theory, 3)analyze the methodologyof the related empirical

My thanks to Thomas Copeland, Harry DeAngelo, RobertGeske, Clement Krouse, Kwang Chung, Ronald Bibb, Nai-fu Chen,and to the anonymous reviewers for helpful suggestions. The con-tributions of Ashok Korwar, Wayne Olson, and Patricia Peat wereparticularly valuable.

work,and4) highlightsome key unresolvedareas.Everyonemust have a conceptualframework obringto the literature.Otherwise ne is overwhelmedby the quantityand diversityof the subjectmattercovered.Manytheoreticalarticlesmakeassumptionswhichmake the papera specialcase of moregeneraltheory.Theempiricalestsmustbecritically eviewedas to 1)their heoreticalunderpinnings,) therelationbetween empirical materials and the underlyingtheory,and 3) the implicitassumptionsof the tests.The Main Theoretical Doctrinesand Their RelationshipsIt is possible n 1981to viewmodern inanceas acoherent framework for analysis, answering thegeneralquestion, Howdo individuals,irms,and oursociety make decisionsto allocate scarce resourcesthrougha pricesystembasedonthevaluationof riskyassets? Within this broad question,we study in-dividualpreferencesand decisions to determine hebehaviorof firmsandmarkets, he creationof assetsandclaims,and theattendantproblemsof riskandofcostly information.Beforethe late 1950s, he finance ieldwas largely

S


3/19

FINANCIALMANAGEMENT ENTHANNIVERSARY SSUE/1981

descriptive.The year 1958 was an importantwater-shed. In that year, Tobin's LiquidityPreferenceasBehaviorTowardRisk [106]appearedn the Reviewof Economic Studies. This was an important develop-mentin the application f demand heory o financialassets, with risk a central point of analysis.Hirshleifer'sarticle, On the Theory of OptimalInvestmentDecision [51]appearedn the JournalofPoliticalEconomy n August1958. It emphasizedheroleof time-dependenttility n the demand or bothproductive nd financial ssetsandprovided founda-tion for furtherwork in capital budgetingand theseparationprinciple.The foundations or state-pref-erencetheorywere also laid during his period.Theanalysesof pureor primitive ecuritiesby Arrow[3],Arrow and Debreu[5] and Debreu[28]wereappliedand extendedby Hirshleifer 49, 50] to broaden hechoice-theoretic framework of financial decision-making.Markowitz's ook on portfolio electionwasin final manuscript n the same year, althoughitappearedwith a 1959publicationdate. His work,ofcourse, representeda majoradvancein the formalanalysis of risk in investment decisions on assetswhose returnsare not independent.ModiglianiandMiller's first of a series of majorcontributionsoncapital structure and valuation appeared in TheAmerican Economic Review in June 1958 [79], givingdepth o thestudyof therelationshipsf theholdersofdifferent ypes of claimsagainstproductive ssets offirms. Throughthese pioneeringstudiesand subse-quentdevelopments,he fieldof financehas had con-siderablenfluencen thepast twentyyearson micro-economics,on macroeconomics, nd on the theory,practice,and curriculum f businessmanagement.The foundation f modern inance s utility theory.From the utilityaxioms,powerful heorieshavebeenderived, includingmean-varianceportfolio theory,state-preference heory, the concept of stochasticdominance,and theoriesof the pricingof contingentclaims.Theoriesof assetpricing, ncludinghecapitalassetpricingmodel and the arbitragepricing heory,are equilibriumconstructswhich follow from theapplicationof utility theoryto choicesamong riskyalternatives. nteractions f individualpreferencesnmarkets for such alternativesprovide signals tosociety n the form of assetprices,makingpossibleanefficientallocationof resources ver ime andbetweenconsumption nd investment.The consideration f costlyinformation nd trans-actions costs leadsto importantmodificationsn theneoclassicalheoryof the firm. New approaches aveincludedanalysisof agencycosts, information sym-

metries, and signaling behavior. Considerationofthese additionaldimensionshas raisedquestionsofwhether the valuation of the firm is affected byvariations in the patterns of contracting amongdifferent ombinations f suppliers f capital,bearersof risk, and managersof productive ctivities.Parallelwiththenewdevelopmentsn thetheoryoffinance,an impressive odyof empirical videncehasappeared.'Theoreticalpropositions ave beentested,usingthe latestand bestdevelopmentsn quantitativemethods.The recentdevelopmentsn financetheory to beconsideredn this paperare:Asset pricingmodels:

Roll'scritiqueof thecapitalassetpricingmodel;Ross's contribution o arbitragepricing heory;Financialpolicyof the firm:Capitalstructure;Dividendpolicy;Problemsn costly nformation nddivergentncen-tives:Agencycosts;Agencyin the theoryof the firm;Signalingbehavior;Contingent laimsanalysis;andMerger heoryand studiesof mergerperformance.

My conclusion considers key issues in financetheorythat are yet to be resolved.The CAPMand APT

Important new developments in the financialliteraturehaveimplicationsor the valuationof riskyassets and their role in allocatingresources n theeconomy.A summary ufficient o providea basisforfurtheranalysiswill be attempted.Roll's Critique

Roll'scritiqueof thecapitalassetpricingmodelhasshaken he roots of the beta revolution nd raisedthe question, Is beta dead? 87, 89]. Roll does notcontest the internalvalidity of the CAPM or therelatedtwo-parameter ero-beta model. Rather,heexposes fundamentalproblemsof the models whentheyareapplied o empiricalwork,with thefollowingconclusions:1. The traditionalCAPM is not testableunless heexact compositionof the true market portfolio isknown 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].

6


4/19

WESTON/DEVELOPMENTSN FINANCETHEORY

hypothesis hat can be testedis that the marketport-folio is efficient.2. Usinga proxyfor themarketportfolio, uchasastock market index, also involvesproblems.If theproxychosenis not mean-variance fficient,the ef-ficient set mathematics predict that the CAPMrelationshipwill not hold.3. If the chosenproxyis mean-variance fficient,thisdoesnot establish hatthemarketportfolio s alsoonthe mean-variancefficient rontier. nanysampleof observations n individual eturns, egardless f thegeneratingprocess,there will alwaysbe manywhicharemean-variance fficientportfolios,viewed x post.For the betas calculatedagainsta mean-variance f-

ficientportfolio, he linearity elationship etween heex postmean returnand betawillbe satisfiedexactly,whetheror not the true marketportfoliois mean-varianceefficient.4. In testingthe two-parameter ero-betavariantof theCAPM,a similarproblemarises.If anefficientproxy portfolio is chosen as an index, a zero-betaportfoliocanbeconstructedn relation o the selectedefficient ndex.If theproxyportfolio urnsoutto be expost efficient, heneveryassetwill fall exactlyon thesecuritymarket line - there will be no abnormalreturns.If there are systematicabnormalreturns, tsimplymeans hat the indexselected s not ex postef-ficient.5. Thusanytest of the CAPM or the two-param-eter assetpricingmodel of Blackis a test of the effi-ciency of the proxy market portfolio. The chosenproxy may turn out to be inefficient,but this aloneprovesnothingabout the true marketportfolio'sef-ficiency.6. Most plausibleproxiesare likely to be highlycorrelatedwithone anotherand with the truemarketportfolio,whetheror not they are mean-variance f-ficient.Thishighcorrelationmaysuggest hattheex-act compositionis unimportant.Small differencesfrom the true marketportfolio,however,can causesubstantialbiases in the measurement f risk and ex-pectedreturns.As noted above, the Roll critiquedoes not arguethat the CAPM and its two-parameterzero-betavariantareinvalid.It argues hatempiricalests mustbe constructed ndinterpretedwithgreatcaution. Ifthe indexused as theproxyfor themarketportfolio sex postefficient, heregression f returns n betaswillbeperfectlyinear.If theproxy ndexchosen s expostinefficient, he resultingrisk-return elationships e-penduponwhichinefficient ndexhas been selected.Untilthetotalmarketportfolio ontaining llassets s

known and measured,ambiguitiesn the tests of theasset pricingmodelsand of security nvestmentper-formancewill remain.Roll's criticismsdo not applyto residualanalysis.Roll'sresponse o MayersandRiceon thispoint s asfollows:

MayersandRicesay (p. 17):Roll'sconclusion..can be easilyinterpreted s beingcriticalof the em-piricalmethodology nownasresidual nalysis.But Inever mentioned this technique.Section 5 of my(1978) paper... supportsresidualanalysis as ap-proximately alid even if the market ndexproxyisnot ex ante efficient[90, p. 397].In summary,whether esidualanalysisandperfor-

mancemeasurement re equivalentdependson thetreatment f theintercepterm ... If theinterceptsestimated rom the data insteadof specifiedaccord-ing to the CAPM's predictions,residualanalysisshouldgiveanunbiased stimateof thevalueof infor-mation associatedwith the eventunderstudy[90,p.399].So even though measurementof performance ssubject o the strictures hat Roll sets forth,residualanalysis performedappropriately scapes most ofthese criticisms. The large numbersaspect of thecumulativeaverageresidualmethodologyprotects tfrom hecriticismof non-stationaryetasas well.(See[50].)

The Arbitrage Pricing TheoryOne way to explainthe risk-returnrelationshipswhile avoiding some of the problems of using asingle-market ndex is the arbitragepricing theory(APT). In introducingan early presentationof theAPT, Ross effectivelysummarized ts setting.

There are at present wo major heoretical rame-works or the analysisof markets orriskyassets: hestate space preferenceapproach and, the meanvariancemodeland its variants.Thearbitragemodelwhichwe will develop s a thirdapproach o capitalmarkettheory,empiricallydistinguishablerom themeanvarianceheoryand moredirectly elated o thestatespaceapproach.Whileformallyall modelsmaybe viewed as specialcases of the state space pref-erenceframework,t is in the restrictionsmposedeither on preferencesor distributionshat the em-piricalcontentof thevarious heoriesie [96,p. 190].

Thus the APT aims to be a more generalformulation of asset pricing. Ross starts with the re-quirement of equality between rates of return onriskless assets. The aim of APT is to provide a theoryfor risky assets analogous to that for riskless assets.Building on this base, if asset markets are perfectly

7


5/19


competitive and frictionless, it can plausibly beassumed that the return on the ith asset can bewritten:2

ri = Ei + bj,il + ... + bikk + i,. (1)In Equation 1), E, is the expectedreturn, j (j=l,.., k) areriskyfactorscommon o all assets- ran-domvariableswithzeromeans;bij s thesensitivity fthereturnon asseti to the fluctuationsn factor ; and,i is the unsystematic iskcomponent diosyncraticto the ith asset with El{i, = 0 for all j. Inequilibrium, he expectedreturn on the ith asset isgivenby:

Ei = Xo+ X,bi, + X2bi2+ ... + Xkb,k (2)In Equation (2), Xj (j=l, ..., k) are the returnsassociatedwith the risky factorsbj, while Xo s thereturnon the risk-freeasset(or zero-betaportfolio).Thegeneralpricingequationof theAPT for a port-folio of (k+l) independentssetsandk riskyfactors swrittenas:

Ep= Xo+ (E - Xo)' V-1 Cov (?p,r) (3)

(whereunderliningndicatesvectors).Previous asset pricingmodels are in some sensespecialcases of the generalrelationshipset forthinEquation (3). For example, letting k = 1and S = (?mEm), he CAPM is obtained:Ep = Xo + (Em - Xo) (m2)-1 Cov (?p,rm). (4)

Furthermore, s Schallheimand DeMagistris 97]have shown,a single-factorarbitragepricingmodelgenerates he market model in the followingform:ti = E(ti) + fTS + ii (5)

wherei,= return on securityi;pi = the ex antebetacoefficient;= a mean zero common factor representingthe deviationof the market rom ts mean;and,i = a mean zero disturbanceerm.From Equation (5), Schallheimand DeMagistrisalso summarize rom the Ross Return,Risk andAr-bitrage paperthe two-parameter r Black model:

2Theseresults are taken from Nai-fu Chen [16].

E(ft) = E(fo) + [E(aM) - E(o)] /3r. (6)Followingthe earlierempiricalwork of Roll andRoss [91, 92], Chen[16, 17]has obtained he follow-ing results. The APT has consistentlyoutperformedthe CAPM, as implementedo datewith the marketproxiesused.Themarketproxiesusedwerethe S&P500index,which s value-weighted,ndthe NewYorkStock Exchangeplus the AmericanStock Exchangesecurities,on both a value-weighted nd an equally-weightedbasis.Thiscomparisons on the basisof ad-justedR2.Theadjustmento R2 akes nto account hegreaternumberof explanatory ariables n the APTtests.TheAPT is also testedagainstspecificalternatives.After the risk factors of the APT are takeninto ac-

count,the own-variancemeasuresof risk have no ex-planatorypower on the returns. In addition, thepreviousperiods'returnshave no explanatorypoweron the currentperiod'sreturns.Finally, the firms'market values, one measure of size, have no ex-planatorypoweron returns.

Financial PolicyThepublications f ModiglianiandMiller[74, 78,79, 80] set in motionimportantnewdevelopmentsnfinancial conomicsdealingwithcapitalstructure nddividendpolicy.In recentyears,significantadvancesin both areashave continued.

Capital StructureAfterMM [79],the theoryof financehadacceptedthe propositionthat, in the absence of taxes, thecapitalstructure f thefirmwas rrelevanto itsvalue.Withtaxes, becausedebt interest s deductiblewhilecommon stock dividendsare not, debt had been

thoughtas always preferable o equity.An optimalfinancial tructurewith less than 100% ebtrequiredotherfactors(e.g., high bankruptcy osts) whichin-crease with leverageto offset the tax advantage odebt.In his Presidential Address to the AmericanFinance Association in 1977, Miller reopenedthequestionwith a startlingdemonstrationhat capitalstructurewasa matterof indifferenceo the individualfirmeven n thepresenceof taxes.This resultfollowsfrom the personaltax effects for the individual n-vestor- thatinterest ncome from debtis taxedat ahigherratethan arecapitalgainsfromequity.Millershowed hattherewill be an optimaldebt-equitymix

8


6/19


for the economy as a whole, but not for each in-dividual firm. Firms with low leveragewill find aclienteleamong investors n high bracketsand viceversa.

DeAngeloand Masulis[26,27] formalizedand ex-tendedMiller'sargument.Theyshowthathis result srobust o alternate ssumptions bout hepersonalaxcode,but fails underalternateassumptions boutthecorporate tax code and/or leverage-relatedcosts(which,Millerhadargued,were nsignificantx ante).DeAngeloand Masulisuse a state-preferencemodel.They derive two principles: Aggregate SupplyResponse ASR) andTax InducedPositiveAggregateDemand(TIPAD). On the supplyside (i.e., the firmside), when PB(s) = PE(s) (l-Tc), all firms are indif-ferent as to how they packagetheirsecurities.PE(S)and PB(s)are the state-contingentprices for equityanddebt,respectively, ndTc s thecorporateaxrate,the same for all firms. At any other level of the twoprices,eitheronlydebt oronlyequity s suppliedbyallfirms. This is ASR.On the investor side (TIPAD), we only need toassume hat there s at leastone investorneach of thethree tax brackets:

1. (1-TPB)> (1-TPE)1-TC)2. (l1-TPB) = (l-TPE) (l-TC)3. (l-TPB) < (l-TPE) (l-Tc).TuB is the investor'spersonaltax rate on incomefromdebtsecurities, ndTPEs the investor's ersonaltax rateon incomefromequitysecurities.The returnon equity is proportional to (1-TpE)/PE(s) and thaton debt to (1-T IB)/PB(s). Then, it can be shown that,when PB(s) < PE(s) (1-Tc), the return on debt isgreater han on equityfor investorsn brackets1 and2. When PB(s) > PE(S) 1-Tc), the return on equity isgreater han on debt for brackets2 and 3.Returning o the supplyside, marketequilibriumrequires PB(S) = PE(s) (1-Tc) because only then arefirmsindifferentbetweensupplyingdebt and equity,and so will supplyboth, satisfyingall investors.Forexample, if PB(s) < PE(s) (1-Tc), then firms onlysupplyequity,but then bracket1 and2 investorsgounsatisfied.Thus,Miller'sresults[73]areconfirmed.The con-ditionthat therebesome investorsn each of the threebracketsaboveis a relativelyweak requirement.DeAngeloand Masulisalso consider he case wherethere are leverage-relatedosts like bankruptcy nd

agency costs. The result is the familiar nteriorop-timum.The merit of the DeAngelo-Masulisanalysis

is that they show that, by operatingat the margin,suchcosts can forceaninterioroptimum non-trivial)even whenthey areverysmall in absolutemagnitude(contrary o Miller'sintuition).Further,when therearenon-debt ax shieldsavailable o the firm,like in-vestment tax credits, at some debt level total taxcredits shield all income.Beyondthis point, furtherdebt is of no advantage o the firm, and it is morecostly than equity because of rulingmarketprices.Thisalsogivesaninterioroptimum,different or eachfirm.The criticalpointis that non-cashchargesand taxcreditscause heexpectedmarginal orporateax sav-ingto declinewithleverage.Thisleads to the testablehypothesis:Other things being equal, decreases ineffectiveinvestment-relatedax shields(depreciationdeductions r investmentax credits)will increase heuse of debt. In cross-sectionalanalysis, holdingbefore-taxearningsconstant,firms with smaller in-vestment-relatedax shieldswill employ greaterdebtin theircapitalstructure 27, p. 21].Dividend Policy

It has long puzzled inance heoristswhy corpora-tions continueto pay out billions of dollars in divi-dendseveryyear,althoughdividends retaxed to theinvestorattax rateshigher han hose oncapitalgains.The lack of usefulthingsto do withthe fundscannotbe an explanation,because he corporations oncur-rentlyraiseadditionalexternalcapital.In a spiritsimilar o Miller[73],MillerandScholes[75] suggestthat the explanationmight be that in-vestorsshield theirdividend ncomecompletelywithinterestpaymentson loanstakenspecifically or thatpurpose.Theproceedsof the loanscan beusedto buymore stock, therebyconverting he dividend ncomeintocapitalgains.If the investorwishes o shelter hedividendncomerisklessly,he can do so by usingtheproceedsof borrowing o purchasea life insurancepolicy instead of new stock. Pension plans aresuggestedas an alternative o the life insuranceplan.Hence, investorsshouldbe indifferentbetweendivi-dendandcapitalgainsincome,andthe firm'smarketvalue should be unaffectedby its dividendpayoutpatterns.MillerandScholes observe hat, although he con-ceptualseparation f the investor'severageand divi-denddecisions s useful for certainpurposes,new in-sights are to be obtainedwhen we think of themtogether.However,they point out some difficulties.For both'dividendand leverage rrelevance o hold

9


7/19


simultaneously, he effective capital gains tax ratemust be zero, else dividends,whichcan be shielded,are always preferredover capital gains. Further,asMiller [73] showed, everage rrelevance equires hemarginalinvestorto have a marginaltax rate onbondsequalto the corporate ax rate. But the samestrategyusedto shielddividend ncomecanbeusedtoshield interest income. DeAngelo and Masulis con-clude hattherelativepriceconditionswhichmake heMiller and Scholesdividendshelterattractive o in-vestors would also cause firms to eliminate alldividends,obviating he usefulnessof the shelter[26,pp.463-464].Thus,therearestillunresolvedssues nthe regionwhereleverageand dividendpolicy meet.

On the empiricalside, Litzenbergerand Rama-swamy[63]have testedfordividend rrelevance. heyderivean after-taxvaluationmodel:E(R) - rF = a + b3i1+ c(di-rF)

wheredi is the dividendyield.If dividendsare irrelevant o marketvalues,the ccoefficientwouldbe zero.They use GLS estimators o take care of the con-temporaneous correlation between disturbancesacrosssecurities.Usingmonthlydata,theyfind,con-

trary to the Miller and Scholes results, a strongpositive relationshipbetween returnsand dividendyields.Miller and Scholes have developeda furtherem-piricaltest of the dividend-returnelationship 76].They assume that announcementsof increases ordecreasesn dividends reknown o contain nforma-tion about the firm's prospects.It is important oseparate hisinformation ffectfrom heeffectsof taxincentives.Litzenbergerand Ramaswamytried toeliminatethis effect by using the previousperiod'sdividendas a proxyforthe currentperiod'sexpecteddividend,ratherthan usingthe actualdividendpaidout,whenboththe declaration f the dividend ndtheex-dividenddate fell in the samemonth. MillerandScholesarguethat this approach ails to removethebias from the denominatorof the dividendyieldvariable:dit/Pi,t-,.Further,Litzenberger nd Rama-swamy reata declared ividend f zeroas thesameasno decisionon dividends.But surely hereis adverseinformation n a directors'meetingwherethe deci-sionis madenot to declarea dividend,when he com-panynormallydoes. WhenMillerand Scholesmod-ify the work of Litzenberger nd Ramaswamy orthesetwodifferences,heyfind hedividend ield ermto be insignificant,as their modelpredicts.Further

workin this field shouldconcentrate n formulatingalternatemodelsfor the expecteddividendyieldandon distinguishing etween ax effects andnon-taxef-fects.

Agency TheoryAdditional dimensions of capital structureandotherfinancialpolicydecisionshaveemergedwiththedevelopment f the literature nagency heory.JensenandMeckling timulatedhenewagency iteraturebyextending he analytical ormulations f the relation-shipsbetweenownersand managers[56]. They ex-amine the agency problem which arises when a

manager wns essthanthetotal common tockof thefirm. Private and individualconsumptionby themanager f thefirm'swealthcostshimonlyinpropor-tion to the fractionof his ownership f the firm,theremainderbeingborneby the otherowners.Agencycosts occurbecause he manager'sncentivesdivergefromthoseof the firm as a whole.Such costs are ofthree kinds: monitoringexpendituresby the otherowners o try to prevent hiskind of behaviorby themanagers; bonding assurances provided by themanageras agent that he will not pursuehis self-interest at the expense of the other owners;andresiduallosses - real inefficienciescausedby thismarket mperfection.Theagencyproblemswhicharise romthe relationsbetween shareholdersand debtholders are sum-marizedby Barnea,Haugen,and Senbet [6]. Debtfinancingwith limitationson shareholders'iabilitymay give rise to a) shareholderncentives o selecthigherrisk projects han those whichare optimaltothe firm as a whole, transferringwealth frombondholderso shareholders,)shareholderncentivesnot to take up the option on new profitablein-vestments Myers,81], andc) bankruptcy osts gen-erated n allocatingresourcesunder nsolvency.Another ypeof agencyproblems causedbyinfor-mationalasymmetryabout the prospectivevalue ofthefirm.Akerlof[1]discusses hisproblemnthecon-text of the usedcar market.Ownersare assumed ohavebetter nformation n theircarsthanprospectivebuyerspossess.Througha self-selectionprocess,thecarswhichareoffered orsalebyownerswillexhibitalower averagequality than the stock of cars as awhole.Becauseof theirpoorer nformation boutpar-ticularcars, prospectivebuyersbasetheir bids upontheir informationas to the averagequalityof carsoffered or sale.Thus,the sellerwho knowshiscartobe of highqualitymustbear he costof theprospective

10


8/19


buyers' gnorance;he seller who knows his carto beof low qualitywill benefit from the same source.Asimilar argument could be advanced regardingproductive ssetsor firmswhosesecurities re offeredfor sale.The incidenceof these agencycosts will vary ac-cording o their source.Thosepecuniary ostsarisingfromdivergentncentives f ownersandmanagerswillbe borneby managers, eflected n the reducedpricesat whichoutsiders rewilling o purchasehesharesofowner-managersnd the reduced ompensation ack-ages which the ownersas a whole will offer to man-agers. Those arising from divergentincentives ofshareholders nd bondholderswill be borneby share-holdersreflected n the reducedpricewhich nvestorswillpayfor the firm'sbonds.Thosearising rom nfor-mation asymmetriesbetweensellers and buyers ofassetswillbe bornebythe sellersof assets of a qualityabovethe averageof assets offeredfor sale and bybuyersof assetsof a qualitybelowthat average.Theincidenceof deadweightosses is indeterminate.Fama [31] relates the agency problem to thebroader heory of the firm. He begins by observingthatthe issueof theseparation f ownership nd con-trolhasbeena problem acedby economists or sometime. Some economists who rejectedthe classicalmodel of a firm controlledby an owner-managerdeveloped he behavioraland managerial heories ofthe firm. Newer theorieshave rejected he classicalmodel of the firm but assume classical forms ofeconomicbehavior,suchas utilitymaximization,onthe part of agentswithin the firm.Fama observes hat both Alchianand Demsetz[2]andJensenandMeckling 56]viewthefirmas a setofcontractsamong factors of production.The firm isseen as a team whosemembersact from self-interestandwho recognize hat their returnsdepend,at leastto somedegree,on the survivalqualitiesof their firmteam in competitionwith otherteams. Fama arguesthatthisview doesnotgo farenough.He considers heagency problemin a multi-periodworld. His mainthesis is that the separationof ownership nd controlis an efficient orm of economicorganizationwithinaset-of-contracts erspective.Fama contends hat the manager's eputation, ndtherefore he market for his services,is greatly in-fluencedby the performance f the firm.Thesignalsprovidedby an efficient capital market about thevalueof a firm's securitiesare likelyto be importantfor the evaluation of the firm's managersin themanagerialabormarket.A basicquestion s the extentto which the signals

providedby the managerial abor market and thecapital market actuallydiscipline managers.Famaassertsthat the managerialabormarketoutside thefirmexertsdirectpressures,becausean ongoingfirmis continuallyn the market o hire or fire managers.He further asserts that capital markets causemanagers o monitoreach other.Eachmanagerhasastake in the performance f the firm in the capitalmarketsandso monitorsothermanagers,both aboveand belowhim in rank.The roleof the boardof direc-tors is to providea relativelyow cost mechanism orreplacingor re-rankingop managers.Smith and Warner[101] argue that the marketmechanismsare not sufficient to resolve agencyproblems.Theyexamine he natureof bondcovenantsto assemble vidence onsistentwiththeir costlycon-tractinghypothesis. Theyconclude:

... [Since] our analysisindicatesthat observedbond ovenantsnvolve eal osts, heremustbesomebenefitnhaving ebt n thefirm's apital tructure;otherwise,hebondholder-stockholderonflictanbecostlesslyliminatedynotissuing ebt.Henceourevidencendicates otonlythatthere s anoptimalformof debtcontract,butanoptimalamountof debtas well [101,pp. 153-154].Barnea,Haugen,andSenbet[6] extendthe Smithand Warner discussion of the impact of agencyproblems ncapitalstructure ecisions.Theydescribehow call provisions,conversionprivileges,incomebonds,and the maturity tructure f debtareconsis-tent withthe efficienthandlingof agency problems.Thus,buildingon the seminalwork of JensenandMeckling,scholarshave identified hreemajortypesof agencyproblems:1) stockholder ncentives o gainat the expenseof bondholdernterests,2) excesscon-sumptionof perquisitesby managerswith fractionalownership,and 3) informationasymmetry.Famaargues that value-maximization rbitrage protectsbondholder interests and that the market for

managersdealswithperks.Smithand Warnerarguefrom the contentsof bond ndentures hat direct andcostly) contracting in individual company cir-cumstances s needed o supplementhe market.Thethird agency problem,informationasymmetry,hasgivenrise to anotherdistinctstreamof literature x-tendingthe earlierwork of Spence [104] on labormarket mechanisms.

Information Asymmetry and SignalingRoss [95] describeshow signalingand managercompensation rrangementsan be used to deal with

11


9/19


information symmetry.He beginswith a reviewof anumberof alternateexplanationsof financialstruc-turethat he findsinadequate.He then notesthat theModigliani-Millerheoremon the irrelevance f thefinancial tructuremplicitlyassumes hatthe markethas full information boutthe activitiesof firms.Themodelhe formulates ssumes nformation symmetryand an incentive ystemthat allowsthe possibilityofsignaling.The assumptionsRoss makes to construct hismodelincludethe following:1. Manager-insiders ave informationabout theirown firms not possessedby outsiders.2. Investors use the face amount of the debt ordividends he managerdecidesto issueas a signalofthe firm'stype. With reference o a criticallevel ofdebt,the marketperceiveshefirm o betype A if itissuesdebtgreater hanthis amountandtype B if itissues debt less than this amount.3. A penalty s assessedagainst he manager f hisfirmexperiencesbankruptcy.4. A managermay not trade in the financial n-strumentsof his own firm. This avoids the moralhazardproblemas well as violationsof the incentivestructuren (3).A signaling equilibrium is achieved if Amanagerschoose financing evels above the criticalleveland B managers hoosefinancingevelsbelowthe critical evel.An A managerwillhaveno incen-tive to change, for the compensation ystem max-imizeshis returnunder he signal.The B managerwillnothaveanincentiveo signal alsely hathis firmis of type A because hepenaltybuilt ntothe incen-tive structurewould reducehis compensation.Ina finalpartof hispaper,Ross introduces modelin which firms have randomreturnsX, uniformlydistributedon [0,t] where manager-insidersknowtheir own firm's t value . . . [95, p. 35]. Again, thereis a bankruptcy enalty ncompensationo managers.He concludes that the MM irrelevancy heoremholds within a risk class, i.e., given t . . . [p. 36]. Bychanging he levelof debthe selects,the manager-in-sideraltersthe market'sperception f the firm'sriskclass and thereforeits currentvalue. This processproducesa uniqueoptimal evel of debtfinancing oreach firmtype.Ross discussessome empirical mplicationsof thesignaling heory.One is thatthe cost of capitalwillbeunaffectedby the financingdecisioneventhoughthelevelof debtis uniquelydetermined.A higher evelofdebt increasesbankruptcyrisk and hence tends todecrease he value of the firm.

Haugenand Senbet[47]seekto implementRoss'spenalty unction hrough he useof contingent laims.Theyrequire hat the managersimultaneouslyell acombination f calls andputsso that,if the firm s anA firm in Ross'sterminology,hemanagers com-pletely hedged,sufferingno penalty f the firm turnsoutto be an A firm.On the otherhand, f thefirmturnsout to be a B firm(a firmof lowervalue hanA ), then priorto the expirationof the contingentclaims,the holdersof theputswillexercise hemwitha consequentpenaltyfor managercompensation.This alsoprovides controlontheagencyproblem.If the manager onsumesan excessiveamountof per-quisites, hevalueof thefirmwilldecline.Ineffect,hemakesan A firminto a B firm.Again,the putswill be exercisedand the managerwill suffer he con-sequencesof his havingcaused a decline.Leland and Pyle [60] use informationasymmetryinfluences o rationalize he existenceof financial n-termediationnstitutions,which raditionalmodelsoffinancial markets have difficulty explaining.Theyarguethat transactions osts are not of a sufficientmagnitude to provide an adequate explanation.Insteadthey find informational symmetrieso be aprimaryexplanation or the existenceof intermedi-aries.Forassets,particularlyhose related o individ-ualssuch as mortgagesor insurance,nformationnotpubliclyavailablecan be developedat somecost. Assuch information s valuable o potential enders, fthere are economies of scale, firms would bedeveloped o assemble nformationand to sell it.Twoproblemswouldarise f the firmsought o sellthe informationdirectly to investors. One is thepublicgood aspectof information.Purchasersofinformation ouldshareit with or resellit to otherswithoutdiminishingts usefulness o themselves.Thesecondproblemrelatesto the reliabilityof the infor-mation.It will be difficultfor potentialusersto dis-tinguishbetweengoodand bad nformation.Thusthepriceof informationwillreflect ts averagevalue,andthe average value of informationoffered for salewouldbe lower than the averagevalue of the totalstock of information,as in the used car discussionabove.Indeed, f entry s easyfor firmsofferingpoorinformation,his can lead to marketfailure.Bothproblemsncapturing returnoninformationare overcomeby a financial ntermediarywhichbuysandholds assetson thebasisof accumulatednforma-tion.The valueof thefirm's nformations reflectedna privategood, the returns romits portfolio.LelandandPyleraise hequestion f howthepotentialbuyersof theintermediaries'laimscan udgewhetherhein-

12


10/19


termediary has developed valuable information. Theysuggest that information can be conveyed throughsignaling - the organizers' willingness to invest intheir firm's equity [60, p. 384]. But this seems to implya one-period model. Realistically, the historical per-formance record of the financial intermediaryis likelyto be used as an indicator of its effectiveness inassembling and utilizing information.

Contingent Claims Analysis:The Option Pricing Model (OPM)3A prodigious literature has appeared on optionpricing and related issues since the Black-Scholes

paper in 1973 [11]. One critical development has beenthe recognition that a hypothetical risk-free hedgewould facilitate a solution to the option pricingproblem. (Black and Scholes noted this came from asuggestion by Merton [11, p. 641, ftn. 3].)The key (as summarized by Copeland and Weston[21, p. 394]) was the following:Andif we continuously djustourhedge portfolioto maintain a ratio of stock to call options of1/(6c/6S), the hedge will be perfectly risk free.Therefore,he risk-freehedgeportfoliowill earntherisk-free atein equilibriumf capitalmarketsare ef-ficient.This is reallythe maininsight.It is possible,given continuous rading,to form risk-freehedgeswith only two securities, he underlying sset and acall option.Thisequilibrium elationships expressedas

dVH= rfdt.VHThisfact and the fact that the risklesshedge s main-tainedby purchasing ne shareof stock andsellingl/(6c/6S) calls,

Q =l, Q=- 6S)(bc/bS)leads to the Black andScholesvaluation ormula.

The resulting equation involved five parameters:The priceof the underlyingecurity, ts instanta-neousvariance, he exercisepriceon the option,thetime to maturity,and the risk-free ate.Onlyone ofthese variables,the instantaneousvariance,is notdirectlyobservable.Theoptionpricedoes notdependon (1) individual iskpreferences r (2) the expectedrate of returnon the underlying sset. Both results

3This section summarizes an overview of the subject which mycolleague, Robert Geske, outlined for me.

follow from the fact that option prices are deter-mined rompurearbitrage onditions vailableo theinvestorwho establishesperfectlyhedged portfolios[21, p. 400].The call price is an increasing function of the stock

price, the time to maturity, the risk-free rate, and theinstantaneous variance of the stock price; it is adecreasing function of the exercise price. Of the fiveparametersthe instantaneous variance is the most dif-ficult to estimate. But in the theoretical articles whichwere subsequentlydeveloped, at one time or anothereach of the five parameters was permitted to vary.Analytic solutions were developed for a range ofassumptions about the behavior of each of the fiveparameters.The issue of the underlying behavior of the stockprices became critical when some systematic depar-tures of actual option prices from those predicted bythe Black-Scholes model were observed [7]. TheBlack-Scholes formula was said to underprice deep-out-of-the-money options, near-maturity options andhigh-variance options. It seemed to overpricedeep-in-the-money options and low-variance options. This ledto questioning the assumption that the variance ofstock prices was known and constant.Subsequentanalysis has fallen into three categories.The first deals with the nature of stock price changes.Cox and Ross [23] look at pure jump processes asresulting in an underlying Poisson distribution. Mer-ton [72] combines the idea of a Poisson event with thediffusion process. He treats the underlyingbehavior asessentially a diffusion process, with at any time thepossibility that new events may change the param-eters of the diffusion process, and he develops a newequation similar in form to the original Black-Scholesmodel, except that the distribution is the sum of nor-mals instead of one normal distribution.In a second approach, Cox [22] treats the varianceas no longer a constant. But the variance in the diffu-sion process has a constant elasticity. The ratio of thepercentage change in the variance of the stock pricewith respect to percentagechanges in the stock price isequal to some constant.In a third approach, Geske [44] analyzes theproblem within the framework of the valuation ofcompound options. Whereas the Black-Scholes modelassumes that the varianceof the stock's returnis not afunction of the stock price, in the compound optionmodel the variance of the return on the stock is in-versely related to the stock price. If the stock pricefalls while the face amount of debt is unchanged, thedebt-equity ratio rises, resultingin increasedrisk. The

13


11/19


increased risk is reflected by a rise in the variance ofthe returns on the stock. The relationship used byGeske is that the instantaneous standarddeviation ofthe return on the stock is the product of the instan-taneous standard deviation of the return on the valueof the firm as a whole multiplied by the elasticity ofthe stock price with respect to the value of the firm.He observes that percentage changes in the stock'sreturnwill be largerwhenpriceshave fallen than whenthey have risen. If the stock pricehas fallen (risen), theincreased (decreased) variance of the returns on thestock will act to raise (lower) the price of the option onthe stock.

Thus, variations in the firm's capital structureinducedby changes n the value of the firm as themarketcontinuously evalues he firm'sprospectivecashflowsaretransmittedhroughhevariance f thestockto affectthepriceof anoptionon thestock[44,p. 74].Systematic empirical studies of the OPM have beenrelativelylimited. The first, by Black and Scholes [12],used price data from the over-the-counter optionmarket for the four-year period, 1966-1969. Buyingundervalued contracts and selling overvaluedcontracts at market prices yielded positive excess

returns. The results indicate that the market uses morethan past price histories to estimate the ex ante instan-taneous variance of stock returns. When the trans-actions costs of trading in options were taken into ac-count, they offset the implied profits.Galai [42] duplicates the Black-Scholes tests, ex-tending them by adjusting the option position eachday. Undervalued options are bought and overvaluedoptions are sold at the end of each day, maintainingthe hedged position by buying or selling the ap-propriate number of shares of common stock. Usingex post hedge returns, Galai found that tradingstrategies based on the Black-Scholes model earnedexcess returns in the absence of transactions costs. Butwith transactions costs of 1% the excess returnsvanished. Tests of spreading strategies yield resultssimilar to those produced by the hedging strategiesjust described. (For a somewhat more complete sum-mary see Copeland and Weston [21, pp. 407-408].)The empirical study by MacBeth and Merville [64]obtains results that differ from previous empiricalobservations. They find that the Black-Scholes modelunderpriced n-the-money options and overpricedout-of-the-money options. With the exception of out-of-the-money options with less than 90 days to expira-tion, the tendencies just described increased with the

extent to which the option was in-the-money or out-of-the-money and decreased as the time to expirationdecreased.They conclude as follows:

Weemphasizehat our resultsareexactlyoppositeto thosereportedby Black(1975),whereinhe statesthat deep in the money(out of the money) optionsgenerallyhave B-S modelpriceswhich are greater(less)thanmarketprices; nd,ourresultsalso conflictwith Merton's(1976) statement that practitionersobserve B-S model prices to be less than marketprices ordeep n themoneyaswell asdeepoutof themoneyoptions.Weproposehat theseconflicting m-piricalobservationsmay,at least npart,be the resultof a nonstationary ariance rate in the stochasticprocessgenerating tock prices[64, pp. 1185-1186].Clearly, additional empirical investigation of theseconflicting results is called for. It is hoped that theCox-Ross-Rubinstein [24] discrete-time model forvaluing options will facilitate furtherempirical testing.The further extensions and applications of OPMmay be organized into four categories: 1) valuing cor-porate securities, 2) valuing other securities, 3) im-plications for corporate managerial policy, and 4) im-plications for other sectors of the economy.The use of the OPM to value corporate securitieswas described in the original Black and Scholes arti-cle. Merton [73] extended and most fully implementedthe potential of the OPM for the valuation of cor-porate securities. In addition, he formulated a modelof the risk structure of interest rates. He demon-strates that the risk structureof interest rates is a func-tion of the variance of the firm, the time to maturity ofthe debt, and the debt-equity ratio of the firm.Other papers dealing with the valuation ofcorporate securities include the analysis by Black andCox [9] of the effects of bond indentureprovisions, thestudies by Ingersoll [52, 53] of convertible securities,and the study by Brennan and Schwartz [14] of con-vertibles.The OPM has also been applied to the valuation ofother securities. Especially significant is the study byBlack [8] of the pricing of commodity contracts.Margrabe [66] analyzed the value of an option to ex-change one asset for another. Fischer [39] used calloption pricing in the valuation of index bonds. Grauerand Litzenberger [45] made further extensions inapplyingthe model in the area of commodity priceun-certainty.Galai and Masulis [43] summarized option theorywith respect to corporate financial policy. They in-vestigate relationships between the beta of the firmand the beta of its stocks and bonds. Changes in the

14


12/19


betas and the resulting changes in the values of thefirm's securities, if we are using the Capital AssetPricing Model, could be predicted by the firm's ac-tivities in a number of areas. These include changingthe firm's investment program, merger activity ordivestiture of assets, and capital distributions (divi-dend policy). Galai and Masulis demonstrate how anymanagerial decision that would change the beta of thefirm or its securities could be analyzed through theOPM.In the fourth category of the extensions of theOPM, we see its great power in application to othersectors of the economy.Myers [81] suggests that the decision to invest canbe placed in an options pricing framework.Sharpe [99] demonstrates how pension funddecisions can be viewed as an option pricing problem.His theory provides a framework for formulating op-timal pension planning to balance the interests of thefirm and its stockholders and the quality of personnel.Brennan and Schwartz [15] investigate the in-surance aspects of options. They show how the op-tions pricing approach can be used by a life insurancecompany which sells equity-linked life insurance poli-cies to optimally hedge against the fluctuating valuesof its equity investments.

Related studies suggest further extensions of theOPM. Potentially these would include a theory offinancial institutions and financial intermediation, in-cluding commercial banking. They would include in-surancegenerally, given the similaritybetweenput op-tions and insurance policies. In addition, the productwarranty policies of business firms would appearto besusceptible to analysis through the OPM.Merger Theory andStudies of Merger Performance

Studies of mergers continue to be an area of greatinterest. In any 12-month period in recentyears, some15 to 20 papers on mergers have been presented atassociation meetings or submitted for publication tojournals. The United States studies have increasinglyfocused on conglomerate mergers for particularreasons. In the United States, the 1950 amendmentsto Section 7 of the Clayton Act have enabled theregulatoryauthorities to virtuallyeliminate horizontalor vertical mergers if either company has somethinglike a 10%market share. Hence the main merger ac-tivity since the 1950s has been conglomerate mergers.A wave of conglomerate mergers was said to haveoccurredduring the late 1960s. Tax and antitrust con-

sequences became less favorable by 1969, and con-glomerate merger activity then declined sharply. Ithas again been on the rise during the late 1970s,though, raising important issues of financialeconomics as well as of public policy.Financial Theory ofPure Conglomerate Mergers

While numerous empirical studies have been made,merger theory has been slow in emerging. Efforts atprogress have been made in this area by Chung [18]and Chung and Weston [19]. They formulate threequestions that a theory of mergers must address: 1)Why do conglomerate mergers occur, 2) What are thecharacteristics of acquiringand acquiredfirms, and 3)What explains fluctuations in the level of aggregateconglomerate merger activity. A valid theory of con-glomerate mergers is required to answer thesequestions simultaneously.In their theory, conglomerate mergers occur for thepurposeof capturingthose investmentopportunitiesinthe acquired firm's industriesthat are relatively morefavorable than those in its own industry. But the ac-quiringfirm needs the firm-specific factors of produc-tion and the organization capital of the acquiredfirmto make the investment successful [Rosen, 93;Prescott and Visscher, 86]. The combined firmbecomes better able to internalize the investment op-portunities by initially lowering the costs of capitaland then developing more organization capital. Thus aconglomerate merger representsthe preservation andbetter utilization of the firm-specific factors of theacquired firm and the more general organizationcapital of the acquiring firm.The benefit of the merger will be greater if themerging firms possess certain characteristics.Characteristics of an acquired firm will include: 1) acost of capital that is higher relative to other firms inits industry, 2) its position in an industry withrelatively favorable growth and profitability pros-pects, and 3) some industry- and firm-specific or-ganizational or managerial capital whose value ispreserved or enhanced by the merger. The acquiringfirms are in industries with growth and profitabilityopportunities less favorable than the average for theeconomy. They have a record of managing assetgrowth effectively. They have more cash than currentopportunities for reinvestment.The basic initiating influence is that the cost ofcapital is lowered by the merger, and thus investmentand production in the acquired firm's operations are

15


13/19


increased.Since the cash flowstreamsof the entitiesarenotperfectly orrelated, ebtcapacity s increased;this effect will be greater if bankruptcycosts aresignificant [Lewellen, 62; Higgins and Schall, 48;Yawitz, Marshall, and Greenberg,111; Stapleton,105].Economiesof scale in flotationexpenses owerthe cost of raisingfunds[Levyand Sarnat,61]. Theuse of excess internalcash flows of acquiring irmseliminatesthe cost of raising funds externallyandprovidesdifferential ax benefits.The threepossiblesources of lowering he cost of capitalare unsettledareasin the finance iterature.Further estingof theissues involved is providedby the merger studiesanalyzing he marketfor capitalassets.

A derived effect of the increased nvestmentandproduction ctivities ollowinga merger s to increasefirm-specific rganizationearning.Thiswill shift outthe marginalefficiencyof investment cheduleof thefirmas comparedwiththe alternative f no merger.There is considerable vidence n supportof thesehypotheses rom previousstudies.The P/E ratio islowwhenbusiness isk s high,when inancialeverageis high, or when industrygrowthprospectsare un-favorable. Acquired firms have lower financialleverageand lower P/E ratios than acquiring irms[e.g., Melicherand Rush,70]. Their ndustrygrowthprospectsare hypothesizedo be betterthan for theeconomy as a whole, which is confirmedby theevidence 19].The implicationof these results s thatthe acquiredfirms are risky and thereforehavehighercostsof capital.Financialeverage ypically n-creases after the merger [see Weston and Man-singhka, 109; Shrievesand Pashley, 100]. Becausemergersoccur o internalizenvestment pportunities,thetheorypredicts hatcapitalexpendituresn an ac-quired irm'sbusinesswill increaseafterthe merger.Markham 67]found that newcapitaloutlaysforac-quired ompanies' perationsn thethree-yearperiodfollowingacquisitionsaveraged220%of pre-mergeroutlays for the same time span. Finally, mergerpremiumswere higherwhen acquiring irms had ahigher size-adjustedcash flow rate [Neilson andMelicher,82].In addition,Chung'sstudy of fluctuations n theaggregate evel of mergeractivityis consistentwiththis hypothesis.Investmentopportunities re meas-uredby thegrowthrate of industries ndbyreal ratesof interest.Mergeractivitywouldbe expected o bepositivelyassociatedwithrealGNP growthrates andnegativelyassociatedwith the real rate of returnonhigh gradecorporatebonds.With regardto the in-fluencesof the cost of capitaland fundsavailability,

two additional variables are considered. The riskpremiums n thehigher-risk acquired)irmsprovidepotentials orgreaterreductionsn the cost of capitalthroughdiversification.Variations n risk premiumsare measuredby the ratio of the Baa rateto Aaa rateon long-term corporatebonds.This ratio is expectedto be positively associated with merger activity.Finally,the degreeof monetary tringencynfluencesthe (higher-risk nd lower cash flow) acquired irmsmore thanacquiring irms.This variable s measuredby the ratioof the short-termcommercialpaperrateto the Aaa corporatebondrate.The associations ex-pectedto be positive.In the empirical esults, hepredicted ignsareob-tained and the relationships re significantwhen thedependent variable is the number of pure con-glomeratemergers.Whenproduct xtensionmergersareused as thedependent ariable, het-valuefortheriskpremium ariablebecomes nsignificantndothert-values drop slightly. When market extensionmergersare addedto the productextensionmergers,the t-values drop furtherbut still remainsignificantexcept orthe coefficient f the riskpremium ariable.Theseresultsareconsistentwiththe financial ynergytheoryof pureconglomeratemergers.The data alsoindicate that investment opportunities and theredeployment f internal undsfromacquiringo ac-quired irms areimportant,hough o a lesserdegree,in effectingproductextensionmergersas well.Studies of Merger Performance

Most of the other mergerstudiesin recentyearshave used residual analysis. They have sought tomeasure he impactof valueschangeson the share-holdersof acquired ndacquiringirms.In themergerstudies using residual analysis, relatively largesampleshavebeenused,usuallymorethan 100.Thebehaviorof thereturnon commonstockis studied orupto 100monthsprior o the merger event andforthesurvivingirmsusually or40 months ollowing hemerger.Whilethe 100 or moremergersmayhaveoc-curredover as manyas20 ormorecalendar ears, hemergerevent is the referencedate from whichanalysis of the behaviorof returns is made. Theprocedurebeginswith an adjustmentor the marketriskpremium. n addition,a widerangeof otherin-fluences hat mightoccurat some particular ime isaveragedover the many differenttime periodsandcompanies n the mergersample.

The statisticalprocedures redesigned o holdcon-stant the influencesof all factors other than the

16


14/19


merger event. A comparison can be made between theaverage returns of the merging firms and the returnsthat would have been predicted from the market linerelationships between return and risk. The residualsare averaged over all the merging firms in the samplefor the months before and after the merger event.These average residuals are also cumulated for anumber of months and termed the cumulative averageresiduals or CARs.All studies agree that the shareholdersof acquiredfirms experience significant positive gains as a resultof information on the mergeror tender offer event. Allstudies agree in finding no significantcorrection to theCARs subsequentto the merger or tender event. Forthe acquiringfirms all studies find positive CARs at ornear the announcement of the merger or tender offer.But in the case of Mandelker [65], the positive returnswere not statistically significant. Ellert [30] andKummer and Hoffmeister [57] found that the CARswere positive for acquiring firms during the periodwell before the merger event. This led Ellert tohypothesize that acquiring firms were successful inmanaging assets developed both internally and exter-nally. However, Langetieg [58], using a control group,found that there were similar influences on both theacquiring firms and on the control group.

Key Unresolved IssuesAlthough we have made much progress in thedevelopment of analytical financial models, many keyissues and unsettled areas remain.Should the analysis for investment decisions treatinvestment decisions in isolation or in portfolios?Thisis equivalent to the question of whether a project'sown variance is an important variable or whether onlynon-diversifiablerisk needs to be taken into account.A related question is whether the interdependence

of investments needs to be taken into account. Par-ticularly, are there interdependenciesin mergers?Theliterature is generally skeptical of interdependenciesor synergy in mergers. On the other hand, one couldbe equally skeptical about generating a continuousseries of investment opportunities with positive netpresentvalues. General theory does not provide eitherguidance or solid evidence on the degree or duration ofinvestments with positive NPVs.A related area of significance is the nature and levelof bankruptcycosts. This goes to the heart of definingthe nature of bankruptcy.Is it equivalentto an abruptchange in values? This requiresan analysis of the un-derlying factors that produceda substantial change in

value. The changes in value would applyboth to valuesof the equity or residual claimants as well as to thebondholders. It is likely that when the value of equityshares moves downward by a substantial degree, thevalue of creditor positions will also deteriorate. But ifthe values of the creditor shares decline substantiallywith the decline in the value of the equity shares, thatparticular form of asset value decline described asbankruptcy appears not to be different conceptuallyfrom any other major change in value.Our assessment of the definition, nature, and levelof bankruptcycosts will influence our conclusions onthe relative efficiency of firm versus investor diversi-fication. The question of whetherdiversifiablerisk in-fluences investment decisions is related to this subject.The issue of capital structure decisions in theabsence of taxes is still unresolved. Is there a validbasis for the use of leverage in the absence of taxes?Here there is a potential role for agency influences, in-formation asymmetry, and signaling. While con-tributions in these areas have suggested some promis-ing propositions, little empirical testing has yet takenplace. At issue is the extent to which the formulationsto date permit the development of operational tests ofthe propositions. Inflation and its effect on capitalstructure and asset pricing add new dimensions.

Academic research has made only modest begin-nings in analyzing or understanding the impact ofinflation on either financial theory or corporate prac-tices. For years we judged that inflation was tem-porary; more recently we have recognized that theimpacts of inflation may be longer lasting and noteasily understood.The evidence is strong that inflation has loweredreal rates of return of business firms. Part of the ex-planation is that tax regulations provide for taxing in-flated nominal returns(e.g., small real tax deductions,because depreciationis based on historical ratherthancurrent costs). The pace of real capital spending hasbeen slowed and has been associated with a decline inthe rate of productivity growth.Interest rates have been high, the availability offunds restricted, and negative yield curves have beenrecurrent. In this new economic environment, thefinancial positions of corporations have deteriorated.The evidence of corporate financialweakness is strongwhether measurements are made by the standard li-quidityratios, the ratio of total debt to total assets, theratio of long-term debt to short-term debt, or by in-terest-coverage ratios. Business corporations andfinancial intermediaries are increasinglyvulnerabletothe inflationary economic environment and govern-

17


15/19


mentpolicies o deal withit. Indeed, hefinancialm-pacts of alternative overnmentpoliciesare difficultto modelconceptuallyor to test empirically.Of potentialhelpon thesematters s the continueddevelopmentof informationand financialmodelstoaid businessmanagers n decision-making.Whatarethe implicitunderlyingheoretical tructures f thesemodels?What implicit theories are involved?Arethere mplicitvaluation elationshipsn thesemodels,and do they have a valid basis?Can these financialmodels performa useful role in strategicfinancialplanning and formalize the methodology of theiterative processes for dealing with ill-structuredproblems?Can the results and implicationsof thesefinancial models be operationally ubjected o em-piricaltests? Canthey be reallyusefuluntilthe con-ceptualproblemsof incorporatinghe impactsof in-flation have beenworkedout?The international imensionsneedto beconsideredmore fully. Does internationaldiversification ffectthe pricingof riskyassets?A sub-question ereis theextent to which the underlying heoremsof inter-national inancehold and the conditionsunderwhichthey hold. Is there such a thing as exchangerisk?Finally, he relativeusefulness f alternate pproachesto international djustment rocessess still unsettled.Conclusions

Recent work in finance has expanded into acoherentanalytical tructure, uildinguponthemajornew contributions tarting n the 1950s. Those foun-dations included work on the role of individualpreferencen the demand or assets [Arrow-Debreu,Hirshleifer,Tobin],the natureof efficientportfoliosof riskyassets [Markowitz,Tobin],and the financialstructureof the firm [Modiglianiand Miller].Twomajor ines of developmentincethenhavebeen1)thederivation f generalequilibriummodelsfor thepric-ingof riskyassets,and2) the enrichment f thetheoryof the firmby consideringhe problemsof contract-ing amongownersof the productiveactors. Parallelwiththeoreticaladvancesn theseareas,a substantialbody of empiricalresearchhas been produced.With respectto models of asset markets,notabledevelopmentshave been: 1) Roll's critique of thecapitalasset pricingmodel in some of its empiricalapplications,2) the formulationof the moregeneralarbitragepricing heory,and 3) improvementsn theexplanatory owerandextensionsn theapplication fthe option pricingmodel.

Certain observedpolicies of businessfirms havebeen a continuingsource of controversy n financetheory- particularlyinancialstructure degreeofleverage)and dividendpayouts. Analysis in theseareas has been both stimulatingand inconclusive odate.

Analysisof the natureof the firm has broadenedinto studiesthat have includedagencyand informa-tionproblems.Characterizinghefirmnotas an atomof analysis,but as a set of contractsamongsuppliersof capitaland the factors of production, esearchershave identified everalsourcesof agencycosts, haveshownthe relationship f portfoliodiversificationothe separationof ownershipand control, and haveidentified ignalingmechanisms ywhichcostlyinfor-mation of uncertainvalidity may be efficientlydis-tributedand certified.Related to the discussionof the natureof firms isthe questionof mergerperformance whether hecombination f two firms s superior o an individualinvestmenttrategywhich ncludes heirsecuritiesn aportfolio.Research n this area has beenchieflyem-pirical,the majortool beingresidualanalysis n thecontext of the CAPM and its variants.We are likelyto achievecontinued utureprogressin all these areas. Theoreticalandempiricalwork inoption pricing,arbitragepricing,and the CAPMwillprovidea morecompleteunderstandingf the deter-minants of risk and returnrelationships.Attentionfocused oA the contractingrelationshipswithin thefirmwill improveourunderstandingf divergentn-centives,informationcosts, and signalingbehavior.This will enableus to flesh outtheneoclassicalmodelof thefirmandwillcontribute o ourability o explaincorporatefinancialpolicies, such as the degree ofleveragenthecapital tructure.Furthermprovementin our understandingf capital markets on the onehand,andof businessmanagers' ecisionprocessesonthe other,shouldhelpus to analyzeandexplainsuchphenomenaas dividendpayouts and conglomeratemergers on which ourunderstandings yet in theformative tages.References

1. G. A. Akerlof, The Market for 'Lemons:'QualityUncertaintyand the MarketMechanism, QuarterlyJournalof Economics August1970),pp. 488-500.2. A. Alchian and H. Demsetz, Production,nforma-tion Costs, and Economic Organization, TheAmerican Economic Review (December 1972), pp.777-795.

18


16/19


3. K. J. Arrow, Le role des valeurs boursieres pour larepartition la meilleure des risques, Econometrie(1953), pp. 41-48.4. K. J. Arrow, The Role of Securities in the OptimalAllocation of Risk-Bearing, Review of EconomicStudies (April 1964), pp. 91-96.5. K. J. Arrow and G. Debreu, Existence of anEquilibrium for a Competitive Economy, Econo-metrica (1954), pp. 265-290.6. A. Barnea, R. A. Haugen, and L. Senbet, MarketImperfections, Agency Problems, and Capital Struc-ture: A Review, forthcoming in Financial Manage-ment.

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/March1976), pp. 167-179.9. F. Black and J. C. Cox, Valuing Corporate Se-curities: Some Effects of Bond Indenture Provisions,Journal of Finance (May 1976), pp. 351-367.10. F. Black, M. C. Jensen, and M. Scholes, The CapitalAsset Pricing Model: Some Empirical Tests, inStudies 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 andCorporate Liabilities, Journal of Political Economy(May/June 1973), pp. 637-659.12. F. Black and M. Scholes, The Valuation of OptionContracts and a Test of Market Efficiency, Journalof Finance (May 1972), pp. 399-417.13. M. Blume and I. Friend, A New Look at the CapitalAsset Pricing Model, Journal of Finance (March1973), pp. 19-34.14. M. J. Brennan and E. S. Schwartz, ConvertibleBonds: Valuation and Optimal Strategies for Call andConversion, Journal of Finance (December 1977), pp.1699-1715.

15. M. J. Brennan and E. S. Schwartz, The Pricing ofEquity-Linked Life Insurance Policies with An AssetValue Guarantee, Journal of Financial Economics(June 1976), pp. 195-213.16. N. Chen, The Arbitrage Pricing Theory: Estimationand Applications, Graduate School of Management,University of California, Los Angeles, June 1980.17. N. Chen, Empirical Evidence of the Arbitrage Pric-ing Theory, Graduate School of Management, Uni-versity of California, Los Angeles, October 1980.18. K. S. Chung, A Financial Synergy Theory ofConglomerate Mergers, working paper, GraduateSchool of Management, University of California, LosAngeles, August 1980.19. K. S. Chung and J. F. Weston, Diversification andMergers in a Strategic Long-Range Planning Frame-

work, presented at a Conference on Mergers andAcquisitions, Graduate School of Business Ad-ministration, New York University, January 9, 1981.20. T. E. Copeland, Liquidity Changes Following StockSplits, Journal of Finance (March 1979), pp.115-142.21. T. E. Copeland and J. F. Weston, Financial Theoryand Corporate Policy, Reading, Mass., Addison-Wesley Publishing Co., 1979.22. J. Cox, Notes on Option Pricing I: ConstantElasticity of Variance Diffusions, unpublishedpreliminary draft, Stanford University, 1975.23. J. C. Cox and S. A. Ross, The Valuation of Optionsfor Alternative Stochastic Processes, Journal ofFinancial Economics (January/March 1976), pp.145-166.24. J. C. Cox, S. A. Ross, and M. Rubinstein, OptionPricing:A Simplified Approach, Journal of FinancialEconomics (September 1979), pp. 229-263.25. L. Dann, D. Mayers, and R. Raab, Trading Rules,Large Blocks and the Speed of Adjustment, Journalof Financial Economics (January 1977), pp. 3-22.26. H. DeAngelo and R. W. Masulis, Leverage and Divi-dend Irrelevancy Under Corporate and Personal Tax-ation, Journal of Finance (May 1980), pp. 453-464.27. H. DeAngelo and R. W. Masulis, Optimal CapitalStructure Under Corporate and Personal Taxation,Journal of Financial Economics (March 1980), pp.3-30.

28. G. Debreu, Theory of Value,New York, John Wiley &Sons, 1959, Chapter 7.29. P. Dodd and R. Ruback, Tender Offers andStockholder Returns: An Empirical Analysis, Jour-nal of Financial Economics (December 1977), pp.351-373.30. J. C. Ellert, Mergers, Antitrust Law Enforcement,and Stockholder Returns, Journal of Finance (May1976), pp. 715-732.31. E. F. Fama, Agency Problems and the Theory of theFirm, Journal of Political Economy (April 1980), pp.288-307.32. E. F. Fama, The Behavior of Stock Market Prices,The Journal of Business (January 1965), pp. 34-105.33. E. F. Fama, The Empirical Relationships Betweenthe Dividend and Investment Decisions of Firms, TheAmerican Economic Review (June 1974), pp. 304-318.34. E. F. Fama, Foundations of Finance, New York, BasicBooks, 1976.35. E. F. Fama, Portfolio Analysis in a Stable ParetianMarket, Management Science (January 1965), pp.404-419.36. E. F. Fama, Risk, Return, and Equilibrium, Journalof Political Economy (January/February 1971), pp.30-55.37. E. F. Fama, L. Fisher, M. Jensen, and R. Roll, The

19


17/19


Adjustment of Stock Prices to New Information,International Economic Review (February 1969), pp.1-2138. E. F. Fama and J. MacBeth, Risk, Return andEquilibrium: Empirical Tests, Journal of PoliticalEconomy (May/June 1973), pp. 607-636.39. S. Fischer, Call Option Pricing When the ExercisePrice is Uncertain, and the Valuation of Index Bonds,Journal of Finance (March 1978), pp. 169-176.40. I. Friend and M. Blume, Measurement of PortfolioPerformance Under Uncertainty, The AmericanEconomic Review (September 1970), pp. 561-575.41. I. Friend, R. Westerfield, and M. Granito, NewEvidence on the Capital Asset Pricing Model, Jour-nal of Finance (June 1978), pp. 903-920.42. D. Galai, Tests of Market Efficiency of the ChicagoBoard Options Exchange, The Journal of Business(April 1977), pp. 167-197.43. D. Galai and R. W. Masulis, The Option PricingModel and the Risk Factor of Stock, Journal ofFinancial Economics (January/March 1976), pp.53-81.44. R. Geske, The Valuation of Compound Options,Journal of Financial Economics (March 1979), pp.63-82.

45. F. L. A. Grauer and R. H. Litzenberger, The Pricingof Commodity FuturesContracts, Nominal Bonds andOther Risky Assets Under Commodity Price Uncer-tainty, Journal of Finance (March 1979), pp. 69-83.46. N. H. Hakansson, The Fantastic World of Finance:Progress and the Free Lunch, Journal of Financialand Quantitative Analysis (November 1979), pp.717-734.47. R. A. Haugen and L. W. Senbet, New Perspectiveson Informational Asymmetry, Journal of Financialand Quantitative Analysis (November 1979), pp.671-694.48. R. C. Higgins and L. D. Schall, CorporateBankrupt-cy and Conglomerate Merger, Journal of Finance(March 1975), pp. 93-113.49. J. Hirshleifer, Investment Decision Under Uncertain-ty: Applications of the State-Preference Approach,Quarterly Journal of Economics (May 1966), pp.252-277.

50. J. Hirshleifer, Investment Decision Under Uncertain-ty: Choice Theoretic Approaches, QuarterlyJournalof Economics (November 1965), pp. 509-536.51. J. Hirshleifer, On the Theory of Optimal InvestmentDecision, Journal of Political Economy (August1958), pp. 329-352.52. J. E. Ingersoll, Jr., A Contingent-Claims Valuationof Convertible Securities, Journal of FinancialEconomics (May 1977), pp. 289-322.53. J. E. Ingersoll, Jr., A Theoretical and EmpiricalInvestigation of the Dual Purpose Funds:An Applica-tion of Contingent-Claims Analysis, Journal ofFinancial Economics (January/March 1976), pp.

83-123.54. M. C. Jensen, The Performance of Mutual Funds inthe Period 1945-1964, Journal of Finance (May1968), pp. 389-416.55. M. C. Jensen, ed., Studies in the Theory of CapitalMarkets, New York, Praeger Publishers, 1972.56. M. C. Jensen and W. Meckling, Theory of the Firm:Managerial Behavior, Agency Costs, and OwnershipStructure, Journal of Financial Economics (October1976), pp. 305-360.57. D. R. Kummer and J. R. Hoffmeister, ValuationConsequences of Cash Tender Offers, Journal ofFinance (May 1978), pp. 505-516.58. T. C. Langetieg, An Application of a Three-FactorPerformance Index to Measure Stockholder Gainsfrom Mergers, Journal of Financial Economics(1978), pp. 365-383.59. D. F. Larcker, L. A. Gordon, and G. E. Pinches,

Testing for Market Efficiency: A Comparison of theCumulative Average Residual Methodology andIntervention Analysis, Journal of Financial andQuantitative Analysis (June 1980), pp. 267-288.60. H. E. Leland and D. H. Pyle, InformationAsymmetries, Financial Structure, and FinancialIntermediation, Journal of Finance (May 1977), pp.371-387.

61. H. Levy and M. Sarnat, Diversification, PortfolioAnalysis and the Uneasy Case for ConglomerateMergers, Journal of Finance (September 1970), pp.795-807.62. W. G. Lewellen, A Pure Financial Rationale for theConglomerate Merger, Journal of Finance (May1971), pp. 521-537.63. R. H. Litzenbergerand K. Ramaswamy, The Effectof Personal Taxes and Dividends on Capital AssetPrices: Theory and Empirical Evidence, Journal ofFinancial Economics (June 1979), pp. 163-196.64. J. D. MacBeth and L. J. Merville, An Empirical Ex-amination of the Black-Scholes Call Option PricingModel, Journal of Finance (December 1979), pp.1173-1186.

65. G. Mandelker, Risk and Return:The Case of Merg-ing Firms, Journal of Financial Economics (1974),pp. 303-335.66. W. Margrabe, The Value of an Option to ExchangeOne Asset for Another, Journal of Finance (March1978), pp. 177-186.67. J. W. Markham, ConglomerateEnterprisesand PublicPolicy, Boston, Harvard Graduate School of BusinessAdministration, 1973.68. H. M. Markowitz, Portfolio Selection, New Haven,Yale University Press, 1959.69. D. Mayers and E. Rice, Measuring Portfolio Per-formance and the Empirical Content of Asset PricingModels, Journal of Financial Economics (March1979), pp. 3-28.70. R. W. Melicher and D. F. Rush, Evidence on the

20


18/19


Acquisition-Related Performance of ConglomerateFirms, Journal of Finance (March 1974), pp.141-149.71. R. W. Melicher and D. F. Rush, The Performance ofConglomerate Firms: Recent Risk and Return Ex-perience, Journal of Finance (May 1973), pp.381-388.72. R. C. Merton, On the Pricing of Corporate Debt: TheRisk Structure of Interest Rates, Journal of Finance(May 1974), pp. 449-470.73. M. H. Miller, Debt and Taxes, Journal of Finance(May 1977), pp. 261-275.74. M. Miller and F. Modigliani, Dividend Policy,Growth, and the Valuation of Shares, TheJournal ofBusiness (October 1961), pp. 411-433.75. M. H. Miller and M. S. Scholes, Dividends and Tax-es, Journal of Financial Economics (December 1978),pp. 333-364.76. M. H. Miller and M. S. Scholes, Dividends and Tax-es: Some Empirical Evidence, preliminary manu-script, January 22, 1981.77. M. H. Miller and M. S. Scholes, Rates of Return inRelation to Risk: A Re-examination of Some RecentFindings, in Studies in the Theory of CapitalMarkets, M. C. Jensen, ed., New York, PraegerPublishers, 1972.78. F. Modigliani and M. H. Miller, Corporate IncomeTaxes and the Cost of Capital, The AmericanEconomic Review (June 1963), pp. 433-443.79. F. Modigliani and M. H. Miller, The Cost of Capital,Corporation Finance, and the Theory of Investment,The American Economic Review (June 1958), pp.261-297.80. F. Modigliani and M. H. Miller, Some Estimates ofthe Cost of Capital to the Electric Utility Industry1954-57, The American Economic Review (June1966), pp. 333-348.81. S. C. Myers, Determinants of Corporate Borrow-ing, Journal of Financial Economics (November1977), pp. 147-175.82. J. F. Nielsen and R. W. Melicher, A FinancialAnalysis of Acquisition and Merger Premiums, Jour-nal of Financial and Quantitative Analysis (March1973), pp. 139-162.83. R. R. Pettit, Dividend Announcements, Security Per-formance, and Capital Market Efficiency, Journal ofFinance (December 1972), pp. 993-1007.84. R. R. Pettit, The Impact of Dividend and EarningsAnnouncement: A Reconciliation, The Journal ofBusiness (January 1976), pp. 86-96.85. R. R. Pettit, Taxes, Transactions Costs and ClienteleEffect of Dividends, Journal of Financial Economics(December 1977), pp. 419-436.86. E. C. Prescott and M. Visscher, OrganizationCapital, Journal of Political Economy (June 1980),pp. 446-461.87. R. W. Roll, Ambiguity When Performance is

Measured by the Securities Market Line, Journal ofFinance (September 1978), pp. 1051-1069.88. R. W. Roll, The Behavior of Interest Rates, NewYork, Basic Books, 1970.89. R. W. Roll, A Critique of the Asset Pricing Theory'sTest, Journal of Financial Economics (March 1977),pp. 129-176.90. R. W. Roll, A Reply to Mayers and Rice, Journal ofFinancial Economics (December 1979), pp. 391-400.91. R. W. Roll and S. A. Ross, An Empirical Investiga-tion of the Arbitrage Pricing Theory, GraduateSchool of Management, University of California, Los

Angeles, revised 1980.92. R. W. Roll and S. A. Ross, An Empirical Investiga-tion of the Arbitrage Pricing Theory, Journal ofFinance (December 1980), pp. 1073-1104.93. S. Rosen, Learning by Experience as Joint Produc-tion, QuarterlyJournal of Economics (August 1972),pp. 367-382.94. S. A. Ross, The Arbitrage Theory of Capital AssetPricing, Journal of Economic Theory (December1976), pp. 341-360.95. S. A. Ross, The Determination of Financial Struc-ture: The Incentive-Signaling Approach, Bell Journalof Economics and Management Science (Spring 1977),pp. 23-40.96. S. A. Ross, Return, Risk, and Arbitrage, in Riskand Return in Finance, I. Friend and J. L. Bicksler,eds., Vol. I, Section 9, Cambridge, Ballinger Publish-ing Company, 1977.97. J. Schallheim and R. DeMagistris, New Estimates ofthe Market Parameters, Financial Management(Autumn 1980), pp. 60-68.98. M. Scholes, The Market for Securities: Substitutionversus Price Pressure and the Effects of Informationon Share Prices, The Journal of Business (April1972), pp. 179-211.99. W. F. Sharpe, Corporate Pension Funding Policy,Journal of Financial Economics (June 1976), pp.183-193.100. R. S. Shrieves and M. M. Pashley, A Test of Finan-cial Economics Through Increased Leverage MergerTheories, presented at the Financial ManagementAssociation meeting, New Orleans, 1980.101. C. W. Smith, Jr., and J. B. Warner, On Financial

Contracting: An Analysis of Bond Covenants, Jour-nal of Financial Economics (June 1979), pp. 117-161.102. K. V. Smith and J. C. Schreiner, A PortfolioAnalysis of Conglomerate Diversification, Journal ofFinance (June 1969), pp. 413-428.103. K. V. Smith and J. Fred Weston, FurtherEvaluationof Conglomerate Performance, Journal of BusinessResearch (March 1977), pp. 5-14.104. M. Spence, Market Signalling: Information Transferin Hiring and Related Processes, Cambridge, HarvardUniversity Press, 1974.105. R. C. Stapleton, Mergers, Debt Capacity and the

21


19/19

FINANCIALMANAGEMENTTENTHANNIVERSARY SSUE/1981

Valuation of Corporate Loans, working paper,ManchesterBusinessSchool,October1980.106. J. Tobin, LiquidityPreference s BehaviorTowardRisk, Review of Economic Studies (February 1958),pp. 65-85.107. J. F. Weston, NewThemes n Finance, ournalofFinance (March 1974), pp. 237-243.108. J. F. Weston, TheScope and Methodology of Finance,EnglewoodCliffs, N.J., Prentice-Hall,nc., 1966.109. J. W.Westonand S. K. Mansinghka, Testsof theEf-ficiencyPerformance f Conglomerate irms, Jour-

nal of Finance September1971),pp. 919-936.110. J. F. Weston, K. V. Smith, and R. E. Shrieves,Conglomerate erformanceUsingthe CapitalAssetPricing Model, The Review of Economics andStatistics (November 1972), pp. 357-363.111. J. B. Yawitz, W. J. Marshall,and E. Greenberg,NegativelyCorrelated ncome as an Incentive orConglomerateMerger, Working Paper No. 33,Center ortheStudyof AmericanBusiness,St. Louis,WashingtonUniversity,July 1978.

EUROPEAN FINANCE ASSOCIA TIONTHE EIGHTH ANNUAL MEETINGSCHEVENINGEN, 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. JonkhartErasmus UniversiteitFaculteit der Ekonomische Wetenschappen H 3-5Burgemeester Oudlaan 503062 PA RotterdamThe NetherlandsTel 0031/10 22 83 74For more information about the EFA, please contact Mrs. Gerry Dirickx-Van Dyck, c/o EFMD-EIASM, 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 EuropeanFoundation for Management Development, in close cooperation with the European Institute for Ad-vanced Studies in Management, providesa professional society for academicians and practitionerswithinterest in financial management and financial theory and its applications. It serves as a center of com-munication for its members residing in Europe or abroad. It also provides a framework for better dis-semination and exchange at the international level.

22

f+ +09+ +weston+ +finance+theory

Documents