https://www.sfu.ca/~wainwrig/Econ400/jensen-meckling.pdf

Theory of the firm: Managerial behavior, agency costs and ownership structure

http://business.unr.edu/faculty/liuc/files/BADM742/Banz_sizeeffect_1980.pdf

The relationship between return and market value of common stocks

This paper integrates elements from the theory of agency, the theory of property rights and the theory of finance to develop a theory of the ownership structure of the firm. We define the concept of agency costs, show its relationship to the ‘separation and control’ issue, investigate the nature of the agency costs generated by the existence of debt and outside equity, demonstrate who bears costs and why, and investigate the Pareto optimality of their existence. We also provide a new definition of the firm, and show how our analysis of the factors influencing the creation and issuance of debt and equity claims is a special case of the supply side of the completeness of markets problem. The directors of such [joint-stock] companies, however, being the managers rather of other people’s money than of their own, it cannot well be expected, that they should watch over it with the same anxious vigilance with which the partners in a private copartnery frequently watch over their own. Like the stewards of a rich man, they are apt to consider attention to small matters as not for their master’s honour, and very easily give themselves a dispensation from having it. Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company. — Adam Smith (1776)

Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure

We develop a positive theory of the hedging behavior of value-maximizing corporations. We treat hedging by corporations simply as one part of the firm's financing decisions. We examine (1) taxes, (2) contracting costs, and (3) the impact of hedging policy on the firm's investment decisions as explanations of the observed wide diversity of hedging practices among large, widely-held corporations. Our theory provides answers to the questions: (1) why some firms hedge and others do not; (2) why firms hedge some risks but not others; and (3) why some firms hedge their accounting risk exposure while others hedge their economic value.

https://www.jstor.org/stable/pdf/2330757.pdf

The Determinants of Firms' Hedging Policies

This article examines corporate debt values and capital structure in a unified analytical framework. It derives closed-form results for the value of long-term risky debt and yield spreads, and for optimal capital structure, when firm asset value follows a diffusion process with constant volatility. Debt values and optimal leverage are explicitly linked to firm risk, taxes, bankruptcy costs, risk-free interest rates, payout rates, and bond covenants. The results elucidate the different behavior of junk bonds versus investment-grade bonds, and aspects of asset substitution, debt repurchase, and debt renegotiation.

Corporate Debt Value, Bond Covenants, and Optimal Capital Structure

IN COMPLETE and perfect capital markets, Hirshleifer [6, 7], Robichek and Myers [13], and Stiglitz [15] have shown that the firm's market value is independent of its capital structure. Although firms may issue conventional types of complex securities, such as common stocks and bonds, if the number of distinct complex securities equals the number of states of nature, individuals are able to create primitive securities. A primitive security represents a dollar claim contingent on the occurrence of a specific state of nature and can be created by purchasing and selling short given amounts of complex securities. Since in a perfect market the firm is a price taker, the market prices of these primitive securities are unaffected by the firm's financing mix. Therefore, given the firm's capital budgeting decisions which determine the firm's returns in each state, the firm's market value is independent of its capital structure. The market value of the firm equals the summation over states of the product of the dollar return contingent on a state and the market price of the primitive security representing a dollar claim contingent on the occurrence of that state. The proof of the Modigliani-Miller [8] independence thesis in a statepreference framework does not depend upon the assumption that the firm will earn its debt obligation with certainty. The firm may not earn the "promised" return on its bonds in some states of the world and would be bankrupt. In these states the firm's bonds are claims on the residual value of the firm. Although the firm's financing mix determines the states in which the firm is insolvent, the value of the firm is not affected since bankruptcy penalties would not exist in a perfect market. Therefore, sufficient conditions for the Modigliani-Miller independence thesis are complete and perfect capital markets. The taxation of corporate profits and the existence of bankruptcy penalties are market imperfections that are central to a positive theory of the effect of capital structure on valuation. A tax advantage to debt financing arises since interest charges are tax deductible. Assuming that the firm earns its debt obligation, financial leverage decreases the firm's corporate income tax liability and increases its after-tax operating earnings. However, a corporate bond is not merely a bundle of contingent claims but is a legal obligation to pay a fixed

A state-preference model of optimal financial leverage

contributions to portfolio analysis have been based on the two parameter (meanvariance) model of portfolio selection. Markowitz's normative theory provides the basis for the positive theory of the valuation of risk assets developed by Sharpe [38] and Lintner [27]. The two parameter capital asset pricing model has been subject to numerous applications including performance measurement, tests of security market efficiency and corporation finance.' Recently, Friend and Blume [15], Black, Jensen and Scholes [5], Miller and Scholes [31], Fama and MacBeth [14], and Blume and Friend [8] have published empirical results which are inconsistent with the traditional form of the SharpeLintner model. These studies suggest that the slope of the capital asset pricing model is lower and the intercept higher than predicted by the traditional theory. Using the Cass-Stiglitz [10] observation that the entire mean variance frontier may be generated by linear combinations of any frontier portfolios, Vasicek [41] and Black [6] show that these empirical results are consistent with capital market equilibrium in the absence of borrowing. Unfortunately, the Vasicek-Black modification results in a weaker positive theory since neither the magnitude of the slope nor the magnitude of the intercept of their capital market model is predicted. Brennan [9] shows that under divergent borrowing and lending rates the modified capital asset pricing model predicts that the intercept is bounded by the borrowing and lending rates and, equivalently, that the slope is bounded by the difference between the market's expected rate of return and the lending rate, and the difference between the market's expected rate of return and the borrowing rate. Although Friend and Blume interpret their empirical results as consistent with a mean variance model under divergent borrowing and lending rates, the Black, Jensen and Scholes' empirical results appear to be inconsistent with the predictions of the Brennan modification since the intercept exceeds the borrowing rate. The present paper extends the capital asset pricing model to incorporate the

Alan Kraus

Papers

A state-preference model of optimal financial leverage

Skewness preference and the valuation of risk assets