Dennis W. Draper, James W. Hoag, Financial Intermediation and the Theory of Agency, The Journal of Financial and Quantitative Analysis, Vol. 13, No. 4, Proceedings of Thirteenth Annual Conference of the Western Finance Association, June 20-26, 1978 (Nov., 1978), pp. 595-611

The objective of this paper is to carry out tests of the general hypothesis, most recently urged by Scherer [14, pp. 100–102] and Weston and Brigham [17, p. 689], that the cost-of-equity capital of small industrial corporations is greater than that of large industrial corporations. The paper denotes this cost as ke and defines it as the expected rate of return on the stock of a company when the current price of the stock is in equilibrium. A common designation of ke of course is the equity capitalization rate. It will be noted that this definition of the cost-of-equity capital abstracts from the flotation costs that are usually incurred when companies sell new stock. Archer and Faerber [2] have already shown that these costs are inversely related to the size of companies.

We shall investigate the problem of optimal exercising strategy for option holders for the case in which option holders are averse to risk. A model of stock price changes incorporating the Lognormal random walk assumption will be combined with a class of utility functions containing diminishing marginal utility of money. In general, the strategy of waiting until the last possible day to exercise an option, which maximizes expected value, will not maximize expected utility. The strategy which maximizes expected utility is obtained by a dynamic programming formulation of the decision problem. At each day (or decision stage), the option holder may choose to act (exercise) or wait until the next day. Working backwards from the last day, a series of critical prices are obtained, with the optimal strategy being as follows: act if the stock price on any day is greater than the critical price for that day; otherwise, wait. Using the concept of proportional risk aversion developed by Pratt, we will demonstrate that, under certain conditions, a utility function which exhibits increasing proportional risk aversion is sufficient to create a series of finite critical prices. Moreover, once an option is exercised, the option holder continually faces a tactical decision to hold the stock and wait for capital gains or sell and take profits as ordinary income, thereby avoiding further risk. This decision may also be optimized by a dynamic programming scheme similar to the approach used above.

In this article, I propose a general-equilibrium model with proportional adjustment costs and industry-specific capital to study the firm migration phenomenon across market-to-book ratio. In my model, investors’ desire to diversify their portfolios and investment frictions generate a mean-reverting dynamics of Tobin’s q consistent with the probabilities of migration found in the data, and a non-linear pattern in the conditional volatility of Tobin’s q. In addition, since firms’ market-to-book ratios are function of the state of the economy and contain information about stock returns, stock prices inherit these properties, yielding asset-pricing implications in line with the empirical evidence, namely the value premium and a non-monotone relationship between the volatility of stock returns and the Tobin’s q.

THE EXISTENCE of increasing returns to scale in production poses a number of difficult problems. In general equilibrium theory the problems are obvious. Standard results on the competitive equilibrium guarantee that when an equilibrium exists it is contained in the core of an economy. When the competitive equilibrium fails to exist, as is likely under increasing returns, the core may provide a useful equilibrium concept of its own. However, very little is known about the existence of a core except under conditions of constant returns to scale. One of the objectives of the present paper is to demonstrate the existence of the core in a general economy in which certain types of increasing returns are present. The second objective of this paper concerns partial equilibrium analysis. When it is asserted that a particular industry is an increasing returns industry it is not at all obvious what is being said, particularly when the industry produces more than one output. One aspect of increasing returns is the property of scale economies, which exist if by multiplying all inputs by a factor A > 1 it is possible to increase all outputs by at least a factor of A. A more primitive concept of increasing returns behavior is the concept of subadditivity of a cost function (or superadditivity of the production possibility set). Presumably the properties of subadditivity and economies of scale are both assumed of a given industry when it is said to have increasing returns. One particular problem involving increasing returns which has generated much recent research is the question of sustainability or supportability of natural monopoly.2 For this problem the existence of a core is of great interest, but at present, a set of necessary and sufficient conditions for a core to exist in a completely general model is not known. This paper is an attempt to advance the theory of natural monopoly, and of increasing returns industries in general, by considering a more general model of equilibrium than has previously been used. Thus, the paper is both a very general model of an essentially partial equilibrium problem and a rather specialized model of general economic equilibrium. In the next section, the basic model will be developed and its interpretation for both general and partial equilibrium will be discussed in greater detail.

In his groundbreaking work “Uncertainty, Evolution, and Economic Theory,” Armen Alchian (1950) suggests that survival is the real test of a firm's success. In this paper, I apply the survival test to the use of dual class share structures in the United States. Beginning with its original implementation by the International Silver Company in 1898 to the prevalence of dual class initial public offerings in 2013, I review the evolution and continued sustainability of the dual class structure in the United States. I contrast the structure with the failed use of tracking stocks and illustrate the structure's continued resilience alongside “competitive” anti-takeover devices such as poison pills, staggered boards, and supermajority voting requirements. Despite the external challenges from legislative bodies, shareholder rights groups, and institutional investors, the dual class structure has survived as an alternative means to raise capital for founders and/or controlling stockholders.

This paper reviews recent research on franchising and capital structure. Several key variables that affect capital costs and are common to franchised businesses are identified. The question whether or not franchising exists because franchisees provide capital that has no close substitutes for pioneering entrepreneurs is explored and criticized because alternatives to franchisees' funds are readily available and not used by franchisers. The role of franchisee financing is also examined as a key feature of capital structure in these types of industries.

Biomedical innovation suffers from a “funding gap” between the needs of drug development firms and the availability of funds. The requirement of large investments for drug development projects and the high pipeline risk associated with FDA approval causes this funding gap in part. In this paper, we propose a new financial instrument—the “FDA hedge”—that pays off upon FDA approval failure. We develop a theory to show that the FDA hedge can help eliminate the funding gap. Using novel project-level data, we establish empirically that FDA hedge risk is idiosyncratic, and show how better sharing this risk can spur welfare-enhancing R&D.

In this paper, I draw parallels between the literatures on the effects of law on the financial development of countries and on the effects of accounting standards on financial reporting outcomes. My central thesis is that these literatures are complementary in terms of what they have to say about understanding the effects of law, regulations and accounting standards on economic and financial reporting outcomes. Moreover, both literatures suggest that U.S. securities laws and financial reporting standards have taken a more regulatory direction over time. I then take these themes and draw implications for the effects of the adoption of International Financial Reporting Standards (IFRS) around the world at the time of adoption and over time.