Knowledge that Transforms

In a recent issue of this journal, Linke and Kim [1], hereafter denoted as L-K, have shown that for finite-time horizons in excess of one period and if, over the same period, the firm's ratio of debt to equity is held constant, the firm's overall required rate of return could be expressed as a weighted average cost of capital. In their proofs L-K distinguish between firms engaging in no financing over the relevant horizon (the nonfinancing case), and those in which such financing is permitted to take place. In the latter case, their procedure is to derive proofs for new debt and equity financing cases separately. In all cases their proofs are correct. However, we wish to draw attention to an implied restriction which must hold in order for their proofs in the financing cases to be valid. Our objective is to set forth a proof which allows both new debt and equity financing simultaneously, and most importantly, which is also free of the implied restriction.

The comment by Linke and Kim correctly observes that the assumption regarding the maintenance of constant proportional use of capital sources is not appropriate for our argument and should be deleted. As our analysis did not make use of this assumption, the two conclusions hold.1. The weighted average cost of capital calculated with the usual weights (original capital structure proportions) is not in general equal to the discount rate which equates the current value of the firm to the present value of future cash flows.2. The above conclusion holds for any weights which can be constructed from the cash flows.

State-preference theory has developed as a choice-theoretic framework through which many problems of finance and economics dealing with time and uncertainty can be analyzed. Hirshleifer [3], [4], [5], [6] has used the approach to provide significant insights to areas such as production and exchange, investment decisions, and speculative behavior. However, the theory has not made progress in attempting to incorporate state-labeled utility functions into the body of the theory. This paper will develop a method of graphically and analytically allowing for differing utility functions across states. As a further step, the impact of belief-deviation upon the tangency optimum will be discussed. Finally, the significance of these findings upon the consideration of risk will be discussed.

Among the risks inherent in international business operations the exchange rate risk represents one of the important considerations for the managers of multinational firms. Three techniques are well known as effective methods against the erosion of value due to the exchange rate fluctuation. These are (1) use of a forward market, (2) use of monetary balance, and (3) use of foreign currency swap arrangements. While the use of a forward market represents an effective tool against the exchange rate loss in ordinary transactions, the other two are designed for different purposes. The use of monetary balance is a protective device against the erosion of the value of the assets due to the exchange rate fluctuation, whereas the foreign currency swap is a device primarily to protect the value of the investment in countries whose currencies are “soft” in that the likelihood devaluation is so high that forward markets do not even exist.

During the last 15 years, the Eurodollar deposit market has grown from perhaps $1 billion to a level now estimated to exceed $200 billion. This growth has prompted numerous arguments and investigations as to its cause [cf. 14, 22, 27], factors influencing it [cf. 24, 28, 29, 32], its import for U.S. banking and monetary policy [cf. 2, 38], its role in international financial market integration [cf. 1, 9, 39], and its impact on the internationalization of U.S. monetary policy [cf. 18, 23]. Over this same period of time, an increasing empirical interest has developed in the term structure of interest rates. Yet most empirical studies of the Eurodollar market [cf. 2, 28, 29, 32] have employed the 90-day Eurodollar CD rate as though it were “the rate of interest” in this market. This tendency has resulted more from the empirical ease of computing covered interest differentials in conjunction with the three–month forward exchange rate than from theoretical considerations [cf. 32, p. 7].

Professor Jennings, in his recent article [2], developed a model to estimate convertible bond premiums. The model incorporates the capital asset pricing model to evaluate convertible bonds. The purpose of this comment is not to criticize the general development of the model but to point out flaws in its implementation which influence Jennings' empirical results.

The literature on security selection and evaluation is quite extensive-Aside from the chart readers, however, there is little or no theoretical framework on the optimal trading price. The theories of technical analysts have been almost completely debunked by the evidence on the random walk nature of price performance. This state of affairs leaves the investor, who has decided to buy or sell a particular security, with very little insight as to the optimum price to trade. The random nature of price performance suggests that both higher and lower prices are likely to be obtainable in the near future. Thus, trading at the current market price may not be the best strategy. On the other hand, waiting for the stock to move decisively in the desired direction exposes one to the risk of an equally large movement in the opposite direction.

Three important methods exist for the treatment of risk in capital budgeting problems: the certainty equivalent method (CE), the risk-adjusted discount method (RAD), and the probability distribution or Hillier-Hertz approach (PD, based on [4]). Each one of these methods evaluates the multiperiod stream of risky returns generated by an investment for given distributions of the returns in each period. A common assumption for all three methods is the certainty of the occurrence of a given risky cash inflow (defined by its distribution) in a given time period. This assumption is probably derived from accounting practices. In references [8] and [9] the PD approach was generalized by removing the certain timing assumption. This paper examines the implications of random timing of cash returns within the framework of the better known CE method.

If I have read Professor Mayer's paper correctly, its basic message is that large banks should be permitted to fail. I agree with that position. Moreover, there have been two large-bank failures of late, and it is safe to infer that at least in a technical sense, the regulatory authorities also agree with Professor Mayer's position. However, implementation of that basic policy raises questions about the continued use of what have proved to be important institutional arrangements. As is well-recognized, failure carries with it a host of socially undesirable consequences, and for that reason an elaborate system of bank examination has been created at both the state and federal level to minimize the frequency of its occurrence. Thus, a policy position which permits any bank, large or small, to fail could imply the abandonment of bank supervision. I for one am not willing to go that far and I do not believe Mayer is either.

Carl F. Meyer, Andre B. Corbeau, The Application of Spectral Analysis to Demonstrate the Stochastic Distortion in the Delta Midrange of Price Series, The Journal of Financial and Quantitative Analysis, Vol. 10, No. 2 (Jun., 1975), pp. 221-230