Knowledge that Transforms

Considerable literature in the investment, growth, and financing of the corporation has developed in recent years. While theoretical studies in this area have contributed importantly to the understanding of the firm's time-optimal decision program, they have generally been limited in scope to the all-internally-funded firm and steady-state dynamics. The well-known analyses of Gordon ]7[ and Lintner ]13[ are typical of this restricted focus. Herein we relax these specializing conditions, both by permitting external equity as a financing alternative and by not a priori requiring the firm to make identical (earnings proportional) investment and financing decisions at every time instant such that it progresses only along a constant, exponentially growing earnings path.

In this paper the traditional capital asset pricing model is reformulated as a system of simultaneous equations in which returns on similar securities are treated as endogenous variables and in which pertinent financial data for particular firms and a market factor are treated as exogenous variables. Such a system is estimated, and serious questions are raised concerning the tenability of the simple linear model so often used to explain capital asset prices under uncertainty.

The weighted average cost of capital is a widely used concept in the theoretical literature of finance as well as in the analysis of capital expenditures of business firms. The importance of the concept derives from its use as the cutoff point for investment in capital projects and as an indicator of optimal capital structure. Differences between the weighted average cost of capital and the true overall cost of capital are typically attributed to deviations of market values from book values, changes in the proportional use of specific capital sources, or alterations in the risk characteristics of the stream of payments to owners and creditors. This paper abstracts from the aforementioned problems to focus on the mathematical error of using weighted average cost of capital to represent the true overall capital cost. It is determined that, in general, the calculation of weighted average cost leads to an erroneous value of the minimum acceptable level of return. The fault lies in the general inability to express the root(s) of a polynomial as an algebraic combination of the roots of other related polynomials.

The attempt to incorporate securities market imperfections other than proportional taxes within a mean-variance security valuation context has met with modest success. Lintner [5], however, has recently considered imperfections by the device of segmented markets. His paper has motivated the following taxonomy. Securities markets are defined as weakly segmented if some of the securities in at least one market are available to some investors but not to others, partially segmented if the sets containing both investors and available securities in each market are disjoint, and completely segmented if additionally the sets of firms in each market are disjoint. Segmented markets effectively relax the separation property of mean-variance equilibrium models (i.e., all investors, irrespective of differences in present wealth or preferences, divide their wealth between the same two mutual funds; one is risk-free and the other is the market portfolio of risky securities). This property unfortunately implies that each investor must hold a portion of every available risky security. This is empirically unrealistic, primarily due to restrictions on borrowing and shorting and scale economies in security analysis and brokerage. Moreover, even in the absence of these complications, ownership of nonmarketable assets, nonhomogeneous beliefs, or breakdown of the separation property due to tastes or nonnormality will motivate individuals to hold different risky portfolios. The device of segmented markets embodies in extreme form these obstacles to diversification and portfolio similarity.

In response to the suggestions of the editorial and reviewing staff of this journal, some additional explanation and extensions of the model presented in an earlier paper [4] seem desirable at this time. In that paper the investor in securities was assumed to have a utility function that depended on the first n moments of the statistical distribution of returns rather than just on the mean and variance. When the borrowing-lending possibility was introduced as in the Sharpe-Lintner model, the investor's perceived risk premium could be expressed in the higher moments' dimensions as well as in terms of the variance.

The bear market of the late sixties amidst inflation has led to growing concern over the validity of the proposition that stocks provide a good hedge against inflation. Conflicting arguments have been raised on both sides of the issue but a synthesis has as yet failed to emerge. The gains resulting from a careful assessment of the various propositions are obvious. If stock prices are adversely affected by inflation, the financial analyst must search for other hedges against the erosion of the purchasing power of money, while the economist must note that inflation has a depressing effect on economic growth through the rise of the cost of capital.

The field of investment analysis provides an example of a situation in which individuals or corporations make inferences and decisions in the face of uncertainty about future events. The uncertainty concerns future security prices and related variables, and it is necessary to take account of this uncertainty when modeling inferential or decision-making problems relating to investment analysis. Since probability can be thought of as the mathematical language of uncertainty, formal models for decision making under uncertainty require probabilistic inputs. In financial decision making, this is illustrated by the models that have been developed for the portfolio selection problem; such models generally require the assessment of probability distributions (or at least some summary measures of probability distributions) for future prices or returns of the securities that are being considered for inclusion in the portfolio (e.g., see Markowitz [11] and Sharpe [19]).

The current merger movement has been characterized by the willingness of the management of some acquiring companies to pay substantial merger premiums. A merger premium exists when the common stockholders of an acquired company receive cash and/or securities possessing a value greater than the company's premerger market value. The rationalization or justification of these “premiums” is based on a merger synergy concept. Contemporary merger literature recognizes two broad forms of merger synergy — the potential for greater operating efficiencies [14] and/or potential financial benefits — with the latter containing instantaneous [12] and real elements [1, 7, 9, 10, 11, 13].

The current assets and current liabilities of a firm are the stock reflections of closely interrelated operational and financial cash flows. The net effect of these combined flows must be recognized in searching for the optimal credit, inventory, or short-term borrowing policies. Yet, the vast majority of models for short-term investment and borrowing decisions do not allow for the interrelationships of this system.

The majority of corporate bonds are callable before maturity at the option of the issuer. Unlike other security options (warrants, convertible bonds, etc.), the call provision cannot be resold; its value can be realized only by exercising it. The problem is to choose the optimal time to perform refunding (including the alternative of not refunding before maturity).