“IRRELEVANCE theory” contains one of the most startling conclusions in economic thought. In two papers, published in 1958 and 1963, Franco Modigliani and Merton Miller argued that a firm’s financial structure—its split between equity and different sorts of debt, its dividend policy and so on—made no difference to its total value. Financial structure merely affected how the corporate pie was shared out; it had no effect on the size of the pie itself. Managers and owners should therefore waste no time agonising about gearing, dividends and such like, and instead devote themselves to maximising the value of their firms.
This insight helped win Modigliani and Miller Nobel prizes in economics (although two such giants would surely have earned them without it). Unfortunately, it also set back for a generation the study by economists of corporate finance. The problem is not that irrelevance theory is wrong but that it is true only in circumstances so rare that they are the exception rather than the rule: that the choice of financial structure does indeed affect the value of a firm.
That choices about debt, equity and so forth do matter is the underlying theme of a magnificent new book, “The Theory of Corporate Finance”, by Jean Tirole, of the University of Toulouse*. This is far more than the mere textbook it purports to be; it has a plausible claim to be the first truly comprehensive overview of corporate finance by an economist. Perhaps this only goes to show how slow economists have been.
Means to a different end
Mr Tirole starts not with Modigliani and Miller but with Adolph Berle and Gardiner Means, who in 1932 published a classic book documenting the separation of the ownership and control of firms in America. This separation, they found, allowed managers considerable discretion, which could be abused at the expense of owners—ie, shareholders. It is only in the past 30 years that economists have started to explore seriously the implications of these “agency costs”—the financial loss to the “principal” (the shareholders) due to the abuse of discretion by the “agent” (the manager) hired to run the firm.
In the world of Modigliani and Miller, no account was taken of agency costs. The size of the pie was taken as given, without considering whether managers were making it as big as they could. For Mr Tirole, the “premise behind modern corporate finance is that corporate insiders need not act in the best interests of the providers of the funds”. Much of the innovation in corporate finance in recent decades has been based on that premise. A lot of work has gone into designing ways of enabling investors to entrust money to managers with a reasonable expectation of getting something back.
Nowadays, an understanding of agency costs is a standard tool in any economist’s kit. Since they have been looking seriously, economists have identified numerous areas of potential conflict between managers and owners. Mr Tirole groups these into four categories: insufficient effort; extravagant investments; entrenchment strategies (actions, such as anti-takeover “poison pills”, that are costly to shareholders and make it harder to remove managers); and self-dealing (from legally consuming perks to promoting friends or even outright theft). Ominously, Mr Tirole notes that in recent corporate scandals self-dealing may have been prominent only because it is “somewhat easier to discover and especially demonstrate than insufficient effort, extravagant investments or entrenchment strategies”. Misbehaviour you can see is, he says, merely the “tip of the iceberg”.
At its simplest, issuing debt tackles agency problems (but does not resolve them fully) because a bond legally obliges managers to pay interest and repay the sum borrowed on specified dates. Equity is much less effective, because it carries no formal obligation to pay shareholders back. Yet in recent years much progress has been made in understanding how to reduce equity agency costs, argues Mr Tirole. Besides increasing the ratio of debt to equity in a firm’s balance sheet, an idea that gained popularity in the 1980s, there are two main methods: incentives (such as share options) that align managers’ and owners’ interests; and better monitoring of managers.
True, neither of these is perfect. Economists, inevitably, have found that every innovation in corporate governance has costs as well as benefits. For instance, share options can encourage managers to take far bigger risks than shareholders would wish when they are under water (that is, when the exercise price of the share option is above the market price of the share). Even so, as Mr Tirole explains in great detail, economists have gained a much better grasp of which mix of incentive and monitoring is likely to work best in which circumstances.
One puzzle is why economists took so long to get there. Maybe, speculates Mr Tirole, this is because from the 1930s to 1970s they were mostly obsessed with macroeconomics and, in particular, theories of general equilibrium. These assumed that markets were perfectly competitive, free of informational asymmetries such as those identified by Berle and Means.
Although Modigliani and Miller slowed the development of economic theories of corporate finance, their work became a foundation stone of financial economics. Financial economists’ starting point is the investor rather than the firm: how, they ask, can people best spread their money over a range of assets (including corporate bonds and shares)? While corporate-finance economists increasingly emphasise agency problems, many financial economists still play them down, says Mr Tirole. Would debt and equity markets work better if capital’s suppliers and corporate consumers found the same theories relevant?