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Über dieses Buch

This fifth book in the series describes the contribution of nine great minds in finance who explained how to quantify and generate corporate value. It describes the theories governing the creation and measurement of corporate value not in isolation, but rather in the context of the void in understanding which these great minds successfully filled.

Inhaltsverzeichnis

Frontmatter

Introduction

1. Introduction

Corporations create value. Financial intermediation in the United States represented just 2 percent of Gross Domestic Product in 1870, but this had risen to almost 9 percent of GDP by 2010.1 The addition of direct business investment brings this share to more than 18 percent of GDP, or about double the representation of finance markets in the size of the American economy. This mobilization of capital supported the rapid expansion of global trade over the period of the Industrial Revolution. But, the freezing of capital markets has plunged nations and the world into recessions and depressions on several different occasions, including the recent Global Financial Meltdown. Even the layperson now realizes that financial markets are essential for the smooth operation of the global economy. Yet, while most all this activity depends crucially on the correct valuation of the value corporations create, accurate models of corporate value have existed for only the last few generations.

Colin Read

From Art to Science

Frontmatter

2. A Fly in the Ointment

In 1776, economics became a discipline and studies of the advantages of the corporate structure became its primary subject of analysis. Ever since Adam Smith’s An Inquiry into the Nature and Causes of the Wealth ofNations, economics has rejoiced in and been hindered by what we now refer to as the neoclassical model.

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3. The Early Life of John Burr Williams

John Burr Williams was the founding father of a new field of corporate finance. This seems somehow appropriate since his ancestors founded a new nation, and he wore their names like a badge.

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4. The Times

The 1930s saw a tremendous increase in skepticism about financial markets and corporate reporting, but also a dramatic growth in the appreciation for the application of more scientific methods to areas such as industry, economy, and finance. During the so-called Roaring Twenties, it seemed almost impossible not to succeed in investing on the financial markets. In the 1930s, those investors courageous enough to risk any of their remaining financial capital sought value like never before, and insisted in delving much more deeply into the sometimes arcane finances of publicly traded corporations. The discipline of finance was ripe for analysis based on greater scientific methodology.

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5. The Theory — A New Finance Paradigm

Central to an emerging approach to asset pricing in the 1920s and 1930s was the principle of the time value of money. While Williams was not the first to originate the concept, he is the first to use it to such substantial analytic effect.

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6. Legacy and Later Life

In a treatise that was published by an engineer turned economist and financier, who persevered and even had to pay for the publication of his great work, Williams established the field of fundamentals analysis and, for the first time, provided a scientifically-based methodology to value corporations and their securities. His methodology of securities pricing based on discounted present values formed the foundation of modern asset pricing and also formed the foundation for securities returns, which was later augmented by measures of risk and uncertainty.

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Is a Corporation’s Capital Structure Irrelevant?

Frontmatter

7. The Early Years of Franco Modigliani

Some people achieve greatness for just a brilliant idea or two. Franco Modigliani is almost unique in that he had many big ideas, and his ideas spanned decades. His work encompassed many collaborations, and many sub disciplines. He was also legendary in his academic generosity. His legendary eclecticism is a product of his life and of his good fortune.

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8. The Early Years of Merton Miller

While Merton Howard Miller’s namesake may denote he is the keeper of the mill, his contributions to finance are by no means run of the mill.

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9. The Times

The chief financial officer (CFO) of a corporation in bygone times was charged with determining the optimal capital structure of the firm. The CFO had to answer certain questions. Should the corporation borrow to expand, should it issue additional preferred or common stock, or should it expand out of retained earnings and perhaps forego a dividend? Until Modigliani and Miller provided clarity to these important questions, the choices were considered more of an art than a science, despite John Burr Williams’s contribution in 1938. Franco Modigliani and Merton Miller showed that, under certain circumstances, the method of financing does not matter, at least with respect to shareholder value.

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10. The Great Idea

Andrew Carnegie (November 25, 1835–August 11, 1919) was a Scottish immigrant who epitomized the American Dream during its Gilded Age. He oversaw an immense expansion of both the transportation and steel industries in the United States which allowed a new America to overtake his former homeland of Great Britain as the world’s largest economy. Carnegie achieved his remarkable success through the adoption of a new and distinctly American model of entrepreneurship and free markets. In turn, Andrew Carnegie went on to develop a philanthropic philosophy which he chronicled in his 1889 article that was later reprinted and commonly called The Gospel of Wealth.1

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11. Applications

There is probably no concept so widely taught in every introductory course in corporate finance that has garnered so much controversy and criticism. Often, the concept of the neutrality of capital structure is taught immediately after students have spent time mastering the calculation of the weighted average cost of capital. Then, students are taught that the choice of debt or equity financing does not matter.

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12. The Prize

The Nobel Memorial Prize is the only prize associated with Alfred Nobel that is awarded to the social sciences. Yet Nobel had not actually founded what is now formally called the Sveriges Riksbank Prize in Economic Sciencesin Memory of Alfred Nobel. Nobel lamented his creation of dynamite, which had yielded numerous ways to contribute to the social good, but also produced some less benign applications. When Nobel determined he would create a legacy that would celebrate contributions by intellectuals to the social good, the disciplines of finance and economics had not yet entered the scientific realm. Only with the subsequent development of economics and finance as a social science which could inform and enhance the public good have these disciplines become candidates for recognition by the Nobel Committee.

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13. The Later Years of Merton Miller

As mentioned earlier, Merton H. Miller, in collaboration with Franco Modigliani, developed the Modigliani—Miller theorem of corporate finance. With Harry M. Markowitz and William F. Sharpe, Miller was awarded the Nobel Memorial Prize in Economics in 1990.

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14. The Later Years of Franco Modigliani

The Later Years of Franco Modigliani Following his most productive years at the Carnegie Institute of Technology, Modigliani moved to one of the other two prestigious institutes of technology, the Massachusetts Institute of Technology (MIT), to which he moved in 1960. He was to remain there for the rest of his career. At MIT, he continued his work on the business cycle, rational expectations, personal finance, and the financial valuation of firms that he had first addressed with Merton Miller. There, Modigliani also remained very innovative and open to new research techniques. Early in the introduction of computational methods to finance, Modigliani helped develop some of the first large-scale econometric models of the United States economy. These tools were continued by the National Bureau of Economic Research and the United States Federal Reserve. Modigliani resided at MIT when he heard he had won the Nobel Prize in Economics Sciences.

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Transactions Costs and the Value of a Firm

Frontmatter

15. The Early Life of Ronald Harold Coase

There are few Nobel Memorial Prize winners in finance or economics who are as unique in personality and academic character as Ronald Harold Coase (pronounced like “rose” or “chose”). Nor have there been many with as unassuming an upbringing, or as simple, but profound, a contribution to the literature. A single paper early in his career, entitled “The Nature of the Firm,” and another much later, have had a profound influence on our financial intuition. They have transformed how we think about our disciplines in ways as fundamental as the concept of free markets espoused by Adam Smith in 1776, or the not unrelated intuition of efficient markets, espoused first by John Burr Williams, and, three decades later, by Eugene Fama. In between these two dates, an unassuming individual of most modest means made a simple statement that revolutionized how we think both about organizations and also about property.

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16. The Times and the Theory

The modern corporation is exceedingly complex. The subtlety of its operations and the complexity of its systems has daunted all but the most academically courageous researchers. So many factors could weigh in on the creation of corporate value and the corresponding price of a corporate equity that, until the publication of John Burr Williams’s treatise, financial analytics was regarded as an art rather than a science. Even the financing decisions a corporation could employ to expand was so varied that, until Modigliani and Miller produced their theorem, decisions as to the best capital structure were best left to intuition and business style. Only once a great mind comes along who can simplify the problem and hone our intuition could observers see the forest through the trees and begin to understand the important determinants of corporate value. Ronald Coase’s seminal paper on the essential advantage of the corporate structure was one such high mark in our understanding of corporate finance.

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17. Life and Legacy

Coase lobbed the first ball into the court. The neoclassical model assumes markets work without friction, much as the theory of gases assumes that molecules can move freely within a container. In fact, it was economists bent on creating a social science with the same mathematical foundation as that found in physics which gave rise to the perfect and atomistic neoclassical ideal of the competitive market in the first place. It should come as no surprise that frictionless markets formed the foundation of a market-oriented economics. It might be surprising, though, to imagine it took so long for the economics and finance profession to realize and acknowledge the legacy of such an oversimplification.

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18. The Early Life of Oliver Eaton Williamson

Ronald Howard Coase and Oliver Eaton Williamson shared an unassuming and humble nature, and both of them championed a completely original and unconventional approach to the valuation of the corporate form. However, while Ronald Coase also had a humble name, his contemporary, Oliver Eaton Williamson, had a name that had a distinguished heritage.

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19. The Times and the Theory

In 1937, Ronald Coase, then a young 27-year-old lecturer at the London School of Economics, had posed a provocative puzzle. When should a firm outsource an intermediate factor of production, and when should it produce the good or service in-house? This relatively simple question spawned the first academically rigorous explanation for the modern corporation and provided a theoretical explanation for the valuation of a corporation that is in excess of its book value of assets.

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20. Applications

The insights of Coase and Williamson were transformational in nature. Their fresh insights and new analysis forced us to look at all too familiar problems under an entirely new light. Corporations have been evolving in ways that appear on the surface to differ from the monolithic firms Coase visited during the Great Depression. Henry Ford saw value in vertical integration in his constant effort to increase efficiencies. When he received wooden crates of parts, he sought a way to reuse the wood. From these crates he created Kings-Ford, or Kingsford charcoal briquettes for barbequers. He created his own transportation networks to bring cars to dealers. And he maintained such a tight and exclusive relationship with his new car dealer network that, even though these franchisees were independent business people, they appeared to be the downstream terminus of a vertically integrated conglomerate. His efforts to create an immense vertically integrated enterprise was loved by some and loathed by others. Despite the antitrust regulations that constrained Gilded Age market concentration, by the 1920s and 1930s, it appeared that firms were becoming larger, more integrated, more profitable, and more efficient. Ford began a post-Gilded Age wave that, despite some setbacks, continues to this day. Yet, such vertical integration, and the efficiencies it created, was not universally embraced by regulators.

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21. Life and Legacy of Ronald Coase

Coase made a memorable contribution to our understanding by pointing out starkly just how little we understood, but which managers take for granted. The notion that markets function costlessly, and that firms operate efficiently may be a convenient extreme but it is invariably untrue. Instead, it is clear that information within the firm is costly, and that within the market it is very costly, and the ability to prevent shirking and human opportunism is a challenging one.

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22. Life and Legacy of Oliver Williamson

With the exception of a two-year period, from 1963 to 1965, when he taught at the University of California, Berkeley, Williamson spent the majority of his early career barely a stone’s throw away from the Carnegie Institute of Technology. Much of his career was devoted to the Department of Economics at the University of Pennsylvania, where he spent the academic years from 1965–6 to 1983. There he twice chaired the economics department, in 1971–2 and in 1976–7. He eventually earned a joint appointment and worked with colleagues at their School of Public and Urban Policy and with the School of Law.

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Alchian and Demsetz

Frontmatter

23. Alchian and Demsetz

As much as some spend a lifetime denying it, our heritage typically creates an indelible imprint on our nature, for better or for worse. Armen Albert Alchian’s life was formed in the wake of conflict and genocide. It is perhaps an interesting juxtaposition for a great mind who devoted a career to understanding how organizations can create symmetries and function as cohesive teams.

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24. Harold Demsetz

Harold Demsetz had a legacy that has not been all that unusual for pioneers in finance. His roots can be traced back to the countries of the Austro-Hungarian Empire that produced such great minds as John von Neumann. However, the amazing innovativeness of the Austro-Hungarian Empire was not broadly shared among its residents.

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25. The Times

In the late 1940s, business and finance were emerging out of the shadow of economics. Previous scholars had set the stage for more advanced and quantitative business studies, but few programs in business were prepared to move beyond a relatively simple narrative in business studies. Chicago was the exception in this respect. In the 1950s, Chicago had almost singlehandedly formalized a new quantitative approach to finance that was mathematically rigorous and free market-oriented. Left by the wayside, though, were the important institutional subtleties within the corporate black box.

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26. The Great Idea

Armen Alchian and Harold Demsetz epitomized the Los Angeles School that added flesh to the bare bones neoclassical model. Their work on a new definition of the firm was both their magnum opus and an important contribution to an understanding that has now been integrated into the fabric of finance and corporate value.

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27. Applications and Extensions

Like many great ideas, Alchian and Demsetz present an argument that seems obvious after the fact: That the ability to coordinate teams creates synergies for which value exceeds the sum of its parts. The philosophy of the Boston Red Sox baseball team and the New England Patriots American Football team is in the promotion of teamwork over individualism, in sharp contrast to the criticism levelled against their arch-rivals, the New York Yankees or New York Jets, respectively, which are sometimes seen as a collection of individual stars who lack team spirit.

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28. Harold Demsetz Later in Life

Armen Alchian and Harold Demsetz established the Los Angeles School that has been influential ever since. Theirs is a school which shares some similarities with Chicago’s emphasis on the free market, Harvard’s tradition of institutional studies, and the strategic thrust of both the RAND Corporation and of the Hoover Institution, to which both contributed intellectually.

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29. The Later Years of Armen Alchian

Alchian, too, harbored similar passions for the intellectual and market freedom the Hoover Institution espoused, and concerns about differential power. His family had also escaped a harsher life in Eastern Europe where there was an intense monopolization of power, and where the populace subsequently revolted to wrest power, only to replace it with another form of coercion. Alchian and Demsetz were kindred spirits in their regard for the often painful power of coercion.

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Jensen and Meckling

Frontmatter

30. The Early Years of Michael Cole Jensen

The advantage of corporations have only been discovered over the last couple of centuries and described and appreciated over the past couple of generations. While John Burr Williams may have explained how a corporation might be valued based on expected future cash flows, and Ronald Coase taught us the importance of property rights and transactions costs, some new thinking was necessary to more fully explain why corporations have advantages, and some disadvantages, over alternative market-based institutions. The majority of those in any field apply conventional wisdom, or perhaps elaborate on this wisdom at its edges. Great minds often reject conventional wisdom and replace it with new and often revolutionary ideas. It is an interesting academic question how these great minds develop novel intuitions. Perhaps the new thinking for Michael Cole Jensen epitomizes a heritage of pioneers who originally settled a new country and who came from the old to the new, attracted by an economic engine like the world has never seen before.

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31. The Early Years of William Henry Meckling

Some children are born to destiny. To demonstrate anything but brilliance shortly following birth with a family name like Bernoulli would be unimaginable. An academic pedigree opens doors for some that are closed for most others. Their family wealth and position assures them the best education at the most elite schools. From there, they enjoy academic careers at other elite schools that cater to the finest students. Few can overcome the challenge of lack of pedigree but succeed nonetheless. William Henry Meckling is one such exception.

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32. The Times

The period following Coase’s 1937 “The Nature of the Firm” was one marked by the increasing ascendency of a reinvented American corporate model. The glamour of the Gilded Age was left in tatters following the excesses of the Roaring Twenties and the challenges of the Great Depression. World War II required a rebuilding of industrial capacity, and the 1950s saw dramatic growth and the creation of the modern military-industrial complex. In these heady days of post-World War II expansion, there was scant interest in Coase’s observations, and the institutional approach to economics and finance was eclipsed by the increasingly quantitative thrust of finance.

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33. The Theory

Jensen and Meckling had a great insight that was destined to become one of the most enduring, intuitive, and useful concepts in corporate management. Their analysis of agency costs and its effect on corporate value has become a classic and one of the most cited articles in finance of all time. The paper, Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure,1 introduced the term “agency theory” to corporate finance — a concept that has been widely applied and adapted ever since.

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34. Applications and Extensions

A few years after the publication of their seminal paper, Michael Jensen combined with the great mind Eugene Fama to further explore the hidden costs of the separation of ownership and management. In their paper “Separation of Ownership and Control,” Fama and Jensen further specified the nature of the decision process. They described four different steps in the decision process: 1.The solicitation and ranking of various corporate projects.2.The selection of the projects that offer a return above the firm’s weighted average cost of capital.3.The implementation of the projects selected; and4.The monitoring of the incentives and their results on each project.

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35. Life and Legacy

The Agency Theory developed by Jensen and Meckling transformed how we view the corporation. Its basic conclusion is that the whole is greater than the sum of its parts. Corporations create value simply by doing what other organizations cannot do through arm’s length market transactions.

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What We Have Learned

Frontmatter

36. Combined Contributions

For more than a century and a half, financial analysts relied upon a story Adam Smith told that explained how corporations create value. In his explanation of how a pin manufacturer uses the specialization of labor to create a corporate synergy, he explained why the value of a corporation exceeds the value of the productive assets it has assembled to do so. The difference between these two sums is what we often call intangible assets.

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37. Conclusions

In a span of 35 years, the field of corporate finance finally found a firm footing. Before 1937, when within a year John Burr Williams and Ronald Coase each showed how corporate value is greater than the sum of its assets, the corporation was viewed as something of a mystery. Financial analysts understood that value was created, but few could really articulate precisely how.

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Backmatter

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