Advanced Corporate Finance
Policies and Strategies
Joseph P. Ogden
University at Buffalo, State University of New York
Frank C. Jen
University at Buffalo, State University of New York
Philip F. O'Connor
Southern Utah University
Upper Saddle River, New Jersey 07458
This textbook provides an advanced, organized, and comprehensive discussion of theoretical and empirical literature on corporate financial policies and strategies, particularly those of U.S. nonfinancial firms. The textbook is written for use in an advanced MBA or advanced undergraduate course in corporate finance. The text is essentially the first to address, on an organized, comprehensive, and focused basis, the needs of students to acquire a thorough understanding of corporate financial policies and strategies.
We define corporate financial policies and strategies broadly to include not only managerial decisions regarding the issuance and retirement of debt and equity securities and the firm's overall capital structure, but also decisions regarding issues such as (a) the firm's governance and ownership structures; (b) contracting between a firm and its management, creditors, and other stakeholders; (c) dividends and stock repurchases; (d) mergers, acquisitions, takeovers, buyouts, equity carve-outs, and spin-offs; (e) financial distress and its resolution; and (f) risk management and the design of securities. The text focuses early and often on theories that have been developed to explain a firm's corporate financial policies and strategies in rational, economic terms. We also discuss a plethora of empirical studies that have been conducted to test these theories. We occasionally illustrate theory by referring to financial decisions made by a specific firm.
From an introductory corporate finance textbook such as Corporate Financial Management (Emery and Finnerty; Prentice Hall, 1997), Principles of Corporate Finance (Brealey and Myers, 6th ed.; McGraw-Hill, 2000), or Corporate Finance (Ross, Westerfield, and Jaffe; McGraw-Hill, 2002), students come to understand that in the modern theory of corporate finance, shareholders' dictum to the firm's management is to maximize the market value of the firm's equity. Students also learn that management must undertake two principal tasks to achieve this objective:
(a) Develop and monitor profitable capital investment projects.
(b) Secure and manage the capital necessary to pursue these projects.
However, the dictum to maximize value leads to a large number of fundamental questions, including, but not limited to, the following: Will the firm's management adhere to this dictum, or will they engage in self-serving, value-reducing behavior? (Alternatively stated, how can shareholders induce management to adhere to this dictum, and at what cost?) If we assume that management is willing to adhere to the dictum, specifically how do they accomplish the task of maximizing the market value of the firm's equity? Are there important interactions between a firm's capital investment decisions and its financing decisions, and if so, what are these interactions and how do firms deal with them?
The treatment of such issues in an introductory corporate finance text tends to be broad, rather than deep, for several reasons: (a) An introductory text must introduce basic aspects of both investment and financing decisions in some detail; (b) students also must become familiar with numerous ancillary topics related to financial markets, basic capital budgeting decisions, the basic roles of financial institutions, and working
capital management; (с) breadth, rather than depth, often must be emphasized for the sake of nonfinance students, because the introductory course may be the only finance course they take; and (d) corporate finance theory, as it relates to both capital investment and financing decisions, has developed such depth and breadth that it cannot be fully addressed in an introductory course.
For example, in an introductory corporate finance course, a student learns that an important decision for a firm is the determination of its optimal capital structure (i.e., the proportions of debt and equity that should be used to finance the firm's assets). The student may learn that taxes and costs of financial distress may influence the capital structure decision. However, the typical student is unlikely to develop an understanding of other factors that affect this decision, such as agency costs of debt, agency costs of managerial discretion, and information asymmetry.
The student may also only begin to understand that a firm's financial policies are likely to interact with other aspects of the firm, such as the industry in which it operates and the nature of its assets. Moreover, an introductory course generally offers a student only a glimpse of the complex financial structures that are characteristic of large firms, as well as the complexity of executive compensation contracts and corporate debt contracts, and the firm's need to manage risk.
For these reasons, most major business schools include advanced courses in corporate finance in their MBA or undergraduate finance curricula. These advanced courses often focus separately on capital investment and financing decisions. Unfortunately, at this point the availability of textbooks breaks down. Indeed, only recently has an advanced textbook been written to address capital investment decisions, Valuation: Measuring and Managing the Value of Companies (Copeland, Koller, and Murrin, 3rd ed.; John Wiley & Sons, 2000), and no advanced textbook presently exists that focuses exclusively on corporate financial policies and strategies at an advanced level.1 Among the most recent textbooks, Financial Markets and Corporate Strategy (Grinblatt and Titman; McGraw-Hill, 1997) claims to have goals similar to those of this text. As the authors state, their text `provides an in-depth analysis of financial theory, empirical work, and practice. It is primarily designed as a text for a second course in corporate finance for MBAs and advanced undergraduates` (p. viii). However, most of the chapters in their text are devoted to reviewing and perhaps slightly expanding or refocusing material covered in an introductory text, so they ultimately fall short in providing a truly advanced and comprehensive treatment of corporate financial policies and strategies. Indeed, the bulk of their text resembles an introductory text, as the authors admit: `we also envision this as a textbook for a first course in finance for highly motivated students with some previous finance background` (p. viii).
Due to the dearth of textbooks designed exclusively for an advanced course on corporate financial policies and strategies, professors often use an introductory corporate finance text as a reference text, from which they can at least promote a discussion of many specific advanced issues. They then typically supplement this discussion with class notes, journal articles, or perhaps books such as The Revolution in Corporate Finance (Stern and Chew, 3rd ed.; Blackwell, 1998), Takeovers, Restructuring, and
1The dearth of textbooks in advanced corporate finance is in sharp contrast to the plethora of excellent advanced textbooks in investment management (e.g., Investments by Sharpe, Alexander, and Bailey [Prentice Hall], and Investments by Bodie, Kane, and Marcus [Irwin/McGraw-Hill], to name only two), derivatives (e.g., Options, Futures, and Other Derivatives by Hull [Prentice Hall]), or international financial management (e.g., Foundations of Multinational Finance by Shapiro [Prentice Hall]).
Corporate Governance (Weston, Chung and Siu, 3rd ed.; Prentice Hall, 2001), The Modern Theory of Corporate Finance (Smith, 2nd ed.; McGraw-Hill, 1990), or The New Corporate Finance (Chew, 2nd ed.; McGraw-Hill, 1999).
Indeed, the authors of this textbook have developed extensive class notes for our advanced course on corporate financial policies and strategies over several years, and have now organized and expanded these notes into a textbook. The advantage of having a full textbook to address advanced issues in corporate finance is that it provides the student with an organized, comprehensive, and understandable treatment of the issues, as opposed to the fragmented treatment that results from cobbling together notes, articles, or readings on individual topics.
In addition, our survey of advanced corporate finance courses taught at major universities indicates that in many cases the course is often narrow in scope (e.g., focusing only on mergers and acquisitions). This may be acceptable if the finance program includes several courses that each focus on a narrow topic, but most programs have only one or two advanced corporate finance courses. Under these circumstances, we believe that students will be better served with the more comprehensive treatment of the issues that this text provides.
As noted above, this text is unique in terms of its organized, advanced, and comprehensive focus on corporate financial policies and strategies. It is designed explicitly for an advanced course in corporate finance, so we dispense with lengthy introductory expositions of basic finance theory, focusing instead on advanced theory and how it can be used to explain corporate financial decisions.
In Part I, comprising the first six chapters, we provide a thorough review of corporate finance theory as well as supporting empirical evidence. Chapter 1 provides an initial empirical perspective on issues covered throughout the text. Both cross-sectional and time series composite values of numerous financial variables are shown and discussed, including assets, liabilities, book and market equity, leverage ratios, market-to-book equity ratios, sources and uses of cash, equity ownership distribution, return on equity, price-earnings ratios, dividend payout ratios, and dividend yields.
Chapter 2 provides a review of theory on the effects of corporate financial decisions under ideal, or perfect, market conditions. The chapter reiterates the famous Modigliani-Miller (M&M) proofs of the irrelevance of capital structure and the effects of leverage on the cost of debt and equity capital under ideal conditions. We also introduce both the Capital Asset Pricing Model (CAPM) and the Black-Scholes Option Pricing Model (BSOPM). We introduce these important models at an early stage of the text because they provide important insights into the analysis of corporate financial decisions throughout the remainder of the text. We also show that these three models can be jointly reconciled.
In Chapters 3 through 6, we analyze the principal real-world factors (otherwise known as market imperfections) that affect a firm's financial policies. Chapter 3 discusses the importance of the separation of ownership and control in the modern corporation, and then focuses on the effects of various principal-agent conflicts among the stakeholders on the firm's financial policies. The two conflicts of interest that we are most concerned with are between (a) a firm's management and its shareholders; and (b) the firm's shareholders and its creditors. Chapter 4 discusses the problem of
information asymmetry between the management of a publicly traded firm and outside investors. According to established theory, a firm's management has better information about the true value of the firm than do either shareholders or creditors. This asymmetry can have profound effects on a firm's financial policies. Chapter 5 analyzes the roles of government, securities markets, financial institutions, ownership structure, board oversight, and contracting devices in mitigating deadweight costs that are otherwise associated with these real-world problems. In Chapter 6 we analyze the effects of various real-world factors on a firm's leverage.
In Part II, comprising Chapters 7 through 10, we develop more comprehensive perspectives on a firm's financial policies and strategies, and also introduce techniques and models for the valuation of a firm's equity and debt securities. In Chapter 7 we discuss the effects of a firm's industry on its financial policies and strategies. Chapter 8 follows with a comprehensive view of the firm, including its business environment, external and internal governance structures, business strategy, operational and financial structures, risks, performance, and contingencies. In Chapter 9, we discuss the Efficient Market Hypothesis and the valuation of equity. Finally, Chapter 10 deals with the valuation of corporate bonds.
In Part III, comprising Chapters 11 through 15, we delve deeper into issues related to the management of a firm's equity and debt. These analyses focus on private equity and the acquisition of venture capital (Chapter 11), the initial public offering of stock (Chapter 12), managing internal equity and the offering of seasoned equity (Chapter 13), dividend and stock repurchase policies (Chapter 14), and strategic decisions related to corporate debt (Chapter 15).
Part IV, comprising Chapters 16 through 18, analyzes the implications of decisions related to the markets for corporate control. In Chapter 16, we focus on mergers, acquisitions, takeovers, and buyouts. Chapter 17 features extensive analyses of decisions made by firms under financial distress, including operational restructuring, equity carve-outs, and spin-offs. Chapter 18 deals with decisions associated with severe financial distress, including debt restructuring, bankruptcy, reorganization, and liquidation.
Finally, in Part V, which comprises Chapter 19, we attempt to synthesize the material covered in the previous chapters by presenting the concept of a firm's organizational architecture. The chapter also deals with the burgeoning areas of risk management (which includes, but is not limited to, the use of derivatives to hedge risk) and security design.
In sum, the analyses in this text show that developing a firm's financial policies and strategies is a complex task involving numerous factors, many of which are only partially under management's control. As such, management must (a) have a thorough understanding of the firm's circumstances with respect to these factors, (b) determine the extent to which the firm's circumstances can be altered or `optimized,` and (c) establish appropriate financial policies and strategies.
We conclude this topical discussion with a caveat about two important topics that we do not cover in the textbook. First, we do not focus extensively on international corporate finance issues (e.g., the international activities of U.S. firms, the financial policies and strategies of firms in countries other than the U.S., or the overall financial systems in other countries). Second, we do not directly cover issues associated with capital budgeting and value creation; instead, we address these issues only indirectly as they relate to the firm's financial policies and strategies. We exclude these two topics primarily to avoid information overload, and secondarily because these topics are adequately covered in other textbooks.
Ultimately, corporate finance theory simply attempts to explain rational human behavior, particularly the behavior of corporate managers as they deal with other rational individuals, including shareholders, creditors, customers, and competitors. Nevertheless, the study of advanced corporate finance theory can be a daunting task for any student. For this reason, we have incorporated a number of features into the text to facilitate students' understanding of the material:
• We try to avoid theoretical and mathematical derivations for three reasons: (a) They tend
to be tedious for the reader; (b) points can be made quite adequately without them; and
(c) we provide references to literature where such derivations can be found.
• The text is replete with figures and tables that illustrate both concepts and empirical evi
dence related to the theories and hypotheses being discussed.
• To illustrate the practical application of theory, we include short articles from the financial
press and other practical literature, in a series that we dub `Real-World Focus.`
• We frequently illustrate the practical application of theory by examining financial deci
sions made by an individual firm, in recurring sections titled `A Case in Point.`
• Although we refer extensively to theoretical and empirical studies in the academic litera
ture, we attempt to boil them down their essential content. Still, the relevant literature is
vast, and we cannot cover all topics in full detail. Therefore, we have attempted to be
exhaustive in our lists of references, because each paper provides a unique viewpoint,
whether theoretical or empirical, on a particular issue. References for each chapter can be
found at http://www.prenhall.com/ogden. We encourage readers to pursue these papers for
• At the end of each chapter, we provide a concise summary of the learning objectives covered
in the chapter, as well as an extensive list of end-of-chapter questions and problems, arranged
in three tiers. The first tier includes basic `Review Questions and Problems.` The second tier,
called `Creative Thinking Issues,` raises questions for which no ready answer exists. The
third tier, called `Projects and Analyses,` challenges students to develop their analytical,
research, and financial decision-making skills by analyzing data statistically, developing a
model, or analyzing financial decisions, policies, or strategies of a specific firm.