Handbook of Corporate Finance
Edited by David J. Denis
Roger Ahlbrandt Sr. Chair in Finance, University of Pittsburgh, USA
RESEARCH HANDBOOKS IN MONEY AND FINANCE
Cheltenham, UK • Northampton, MA, USA
© David J. Denis 2024
All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical or photocopying, recording, or otherwise without the prior permission of the publisher.
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Library of Congress Control Number: 2023951004
This book is available electronically in the Economics subject collection http://dx.doi.org/10.4337/9781800373891
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Contributors
Nihat Aktas, WHU – Otto Beisheim School of Management, Germany
Alice Bonaimé, University of Arizona, USA
Audra Boone, Texas Christian University, USA
Murillo Campello, Cornell University, USA
Jeffrey L. Coles, University of Utah, USA
Naveen D. Daniel, Drexel University, USA
David J. Denis, University of Pittsburgh, USA
Diane Denis, University of Pittsburgh, USA
Isil Erel, Ohio State University, USA
Murray Z. Frank, University of Minnesota, USA
Laurent Frésard, Università della Svizerra italiana, Switzerland
Vidhan K. Goyal, Hong Kong University of Science and Technology, Hong Kong
Kristine W. Hankins, University of Kentucky, USA
Jarrad Harford, University of Washington, USA
Gerard Hoberg, University of Southern California, USA
Yeejin Jang, University of New South Wales, Australia
Kathleen Kahle, University of Arizona, USA
Gaurav Kankanhalli, University of Pittsburgh, USA
Jonathan M. Karpoff, University of Washington, USA
Mark Leary, Washington University, St. Louis, USA
Michelle Lowry, Drexel University, USA
viii Handbook of corporate finance
Nadya Malenko, Boston College, USA
Lalitha Naveen, Temple University, USA
Greg Nini, Drexel University, USA
Naman Nishesh, University of North Carolina, USA
Vasudha Nukala, Washington University, St. Louis, USA
Paige Ouimet, University of North Carolina, USA
Gordon M. Phillips, Dartmouth University, USA
Elena Simintzi, University of North Carolina, USA
David C. Smith, University of Virginia, USA
Luxi Wang, University of Pittsburgh, USA
Michael S. Weisbach, Ohio State University, USA
Michael D. Wittry, Ohio State University, USA
Introduction to the Handbook of Corporate Finance
David J. Denis
This volume provides a collection of chapters summarizing scholarly research in the field of corporate finance. The field studies how companies acquire and allocate scarce capital. Accordingly, corporate finance research encompasses topic areas such as corporate financing and payout policies, investment decisions, and governance arrangements that protect the interests of capital providers. The chapters in this volume provide readers with a snapshot of the ‘state-of-the art’ critical thinking and evidence on a variety of issues within these general topic areas. Though the topics covered are arguably among the most important in corporate finance, they are not meant to be an exhaustive set under the corporate finance umbrella. Nonetheless, the volume should serve as a comprehensive resource for doctoral students, faculty, and practitioners interested in corporate finance.
In this introduction, I provide a brief overview of the chapters that make up the book. My purpose in doing so is to provide readers with a roadmap of the topics covered and how the various chapters fit together. It is not meant to be a substitute for reading the chapters themselves.
The book begins with Chapter 1 by Diane Denis on the corporate objective function. Although there is a long history within finance of relying on shareholder wealth maximization as the appropriate criterion for evaluating corporate finance decisions, increased political and societal demands for corporate social responsibility (CSR) have led some to argue that the corporate objective function should be re-evaluated. Denis details the economic underpinnings of the shareholder wealth maximization objective and critically evaluates alternative approaches, such as stakeholder welfare maximization. Her analysis reveals significant problems with these alternative approaches, and reaffirms shareholder wealth maximization as the most appropriate criterion for evaluating corporate decisions.
Part II of the book summarizes research in the classic corporate finance questions of Corporate Financing and Payout Policies. In Chapter 2, Murray Frank and Vidhan Goyal note that, after more than 50 years of research, corporate capital structure decisions remain a challenging puzzle to understand. Over this time, finance scholars have uncovered a number of useful empirical facts that establish important roles for taxes, funding needs, and informational imperfections in explaining observed capital structure decisions. Yet, after summarizing the available empirical evidence, Frank and Goyal conclude that there is still no generally accepted unified theory that can account for all of the stylized facts. Their survey thus points to the need for continued research in this area.
Chapters 3 and 4 survey the literature on corporate payout policy. In Chapter 3, Mark Leary and Vasudha Nukala survey studies that empirically analyze dividend policy. As their survey indicates, this literature has uncovered a large set of stylized facts about the nature of (and trends in) dividend policies that are not in dispute. At the same time, however, there remains considerable disagreement on whether and why dividends matter. For example, do dividends directly impact firm value or are they simply signaling
value-relevant information to investors? In summarizing the evidence on the various possibilities, Leary and Nukala highlight the most productive areas for future research.
In Chapter 4, Alice Bonaimé and Kathleen Kahle document that share repurchases have become an increasingly common form of corporate payout, totaling nearly $1 trillion in 2018, an amount that exceeded total dividends paid in that year by U.S. companies. Bonaimé and Kahle survey the recent literature that seeks to understand: why companies increasingly prefer share repurchases to dividends; whether these motives lead to decisions that are value-increasing for shareholders; and how repurchases interact with other corporate finance policies such as liquidity management, investment decisions, and hedging policy, as well as other important considerations such as product market competition and labor contracts.
In Chapter 5, David Denis and Luxi Wang explore the causes and consequences of corporate cash holdings. As their survey indicates, cash has become an increasingly large component of corporate balance sheets over the past 50 years. Their survey assesses: (i) cross-sectional and time-series patterns in cash holdings; (ii) theoretical explanations for these patterns; and (iii) recent empirical evidence that sheds light on the primary causes and consequences of such holdings.
In Chapter 6, Greg Nini and David Smith document an important innovation in the corporate financing market – the use of leveraged loans. Their analysis reveals that this market has grown to a size comparable to that of high-yield corporate bonds, thereby providing risky issuers important access to debt capital. Because these issuers have sharply different risk profiles from those of investment-grade bond issuers and bank borrowers, Nini and Smith focus much of their survey on the distinct features of primary markets, secondary markets, and contracting structures within the leveraged loan market.
Part II concludes with Chapter 7, by Kristine Hankins and Gerard Hoberg, on corporate risk management policies. If access to capital is important to firms, the ability to manage the uncertainty of cash flows should be valuable to shareholders. At the same time, risk management can be a vehicle for tailoring the company’s risk profile to managerial preferences rather than shareholder preferences. Hankins and Hoberg provide a broad taxonomy for categorizing corporate risks, and analyze how managing risk can be valuable for various corporate stakeholders. With this taxonomy in mind, their chapter also surveys the broad array of financial and operational hedging tools studied in the literature.
Part III of the book explores research in the areas of Mergers, Acquisitions, and Takeover Defenses. M&A transactions represent some of the largest discrete investment decisions that companies make, and result in a substantial restructuring of the ownership and control of corporate assets. An enormous body of scholarship has documented (among other things) the motives for these transactions, their wealth consequences for various stakeholders and parties to the deals, the sources of these wealth consequences, and the various forms that the transactions can take. Part III focuses on more recent research that extends this prior literature in several directions, including: the intricacies of the deal process; the proliferation of cross-border merger activity; the existence of merger waves; and the various defensive tactics employed by firms in the face of unwanted takeover advances.
In Chapter 8, Nihat Aktas and Audra Boone survey the nascent literature on the private component of the takeover process. Historically, merger negotiations have been secretive
and their details beyond the reach of finance scholars. However, access to mandated merger-related regulatory filings and surveys of practitioners has opened the ‘black box’ of the negotiations process to empirical analysis. Aktas and Boone summarize novel evidence in three areas: (i) the primary drivers of deal initiation and target-acquirer matching; (ii) the role played by internal M&A teams and external advisors; and (iii) the determinants of the method of sale.
In Chapter 9, Isil Erel, Yeejin Jang, and Michael Weisbach explore the causes and consequences of cross-border mergers and acquisitions. Although most prior research has focused on domestic deals, Erel et al. note that roughly one-third of merger activity around the world since 1990 has involved cross-border deals. Their survey highlights research on the factors leading firms to acquire a firm in another country. These factors include differences in economic development, laws, institutions, culture, labor rights, protection of intellectual property, taxes, and corporate governance.
In Chapter 10, Jarrad Harford surveys the literature on the underlying drivers of merger waves. This literature encompasses aggregate merger waves, industry-specific waves, and waves of cross-border transactions. Although no single explanation for waves seems to dominate, the bulk of the evidence supports the conclusion that merger waves are a response to shocks to operating environments that facilitate the efficient reallocation of corporate assets. The clustering of transactions is often driven by financing conditions that are conducive for completing the deals. In addition, there is some evidence that market misvaluation potentially plays a role as well.
Part III closes with Chapter 11, by Jonathan Karpoff and Michael Wittry, which traces the evolution of takeover defenses over several decades. Their survey summarizes how firms use takeover defenses, the extent to which they forestall takeovers, the costs and benefits of adding/removing defenses, and the net effect of such defenses on firm value and operations. This literature shows that the costs and benefits of defenses vary across firms and over an individual firm’s life cycle.
Part IV summarizes recent work in the important areas of Corporate Ownership and Governance Structures. In Chapter 12, Jeffrey Coles, Naveen Daniel, and Lalitha Naveen review the large literature that analyzes how corporate boards perform their two primary functions: monitoring executive performance and advising the top executive, with a particular focus on studies that have emerged over the past 15 years. These studies analyze how factors such as director characteristics, skill sets, personal connections, busyness, and incentives affect the ability and willingness of the board to perform their duties as monitors and advisors. Moreover, because the assignment of directors to firms is not random, a large part of this literature must address the endogeneity between board structure and firm outcomes. Coles, Daniel and Naveen also review the various ways in which this issue has been addressed in the recent literature.
Much of the research in corporate finance over the years has focused on public companies because: (i) these companies have traditionally been economically more important; and (ii) data has been more readily available for public than for private companies. As data constraints have been reduced, an increasing amount of research has incorporated findings from private firms. In Chapter 13, Michelle Lowry reviews research that documents how private companies have chosen to remain private longer in recent years, and that they increasingly resemble public companies. First, there is growing overlap in the sources of capital for public and private firms. Second, governance structures of private firms have
evolved to meet the demands that are more often associated with public firms. Third, although a frequently stated motivation for going public has traditionally been the desire to obtain liquid shares to be used as acquisition currency, firms are increasingly growing via acquisitions even prior to going public. The bottom line is that markets have evolved such that there is now considerably less distinction between public and private ownership of firms.
In Chapter 14, Nadya Malenko combines aspects of ownership structure and governance in providing an overview of research on information flows within corporations. Because effective decision-making requires information, but such information is dispersed among multiple agents within a firm, both the firm’s organizational structure and its governance arrangements can affect how information is produced and ultimately used. In surveying the theoretical and empirical studies on this topic, Malenko focuses on three key areas: (i) the choice between centralized and decentralized decision-making; (ii) the composition and decision-making of the board of directors; and (iii) the role of shareholder activism in affecting communication among shareholders and between shareholders and management.
Much of the research in corporate finance explores the impact of market frictions on corporate finance decisions. Traditionally, this research has focused on frictions related to asymmetric information and agency problems. This focus has considerably deepened our understanding of how decisions are made and their impact on stakeholders. In recent years, however, scholars have identified several other important influences on corporate decisions. Part V of the book – Other Important Influences on Corporate Finance Decisions – highlights research on three of these influences: uncertainty, product market competition, and considerations related to labor.
In Chapter 15, Murillo Campello and Gaurav Kankanhalli note that uncertainty over future business conditions is a ubiquitous feature of corporate decision-making. However, this uncertainty can arise from many different sources and can be difficult to measure. After providing a simple conceptual framework for understanding how several corporate decisions are affected by uncertainty, Campello and Kankanhalli review recent advances in the measurement of uncertainty, distinguishing between aggregate uncertainty and firm-specific uncertainty. They then survey the evidence on how uncertainty shapes important corporate financial decisions, such as corporate investment, the composition of firm assets, innovation, liquidity management, corporate payouts, and mergers.
In Chapter 16, Laurent Frésard and Gordon Phillips review the literature that studies how product markets and competition interact with corporate financial decisions. This work shows that not only are firm decisions influenced by the product market(s) in which they operate, but that these decisions also directly shape those markets and the resulting competition. Specifically: the nature and intensity of interactions in the product market appears to influence the ability of firms to obtain financing (and on what terms); it impacts their investment, acquisition, and innovation decisions; and it helps shape their organizational and governance structures. Frésard and Phillips conclude that product market considerations have first-order effects on firm decisions.
In Chapter 17, Naman Nishesh, Paige Ouimet, and Elena Simintzi survey the relatively nascent literature that lies at the intersection of labor economics and corporate finance. As is true in the literature on product markets and corporate finance, a common theme that runs through the labor/finance literature is that decisions made by firms have an
impact on labor, while labor market considerations affect firm decisions. The authors review evidence in three primary areas: (i) the relationship between ownership and labor market outcomes; (ii) the relationship between capital structure decisions and labor markets; and (iii) the connection between labor and inequality within firms and investments in technology adoption.
These chapters provide a thorough survey of the important work that has been done on some of the most critical decisions corporate financial managers make. Of equal importance, however, is that each set of authors outline a number of unresolved issues that should be addressed in future research. As noted at the outset, this introduction is meant to give readers an overview of how the book is organized and how the chapters fit with one another. I hope that it has provided readers with the motivation to dig deeper into a careful reading of these excellent contributions.
1. The corporate objective function
Diane Denis*
INTRODUCTION
A corporation exists to produce a product or service to sell to consumers; this is its fundamental purpose. There may be many ancillary goals that are related to this fundamental purpose – for example, to provide jobs or to make the world a better place. At the end of the day, however, a firm cannot achieve any of these things unless it remains in business, and it cannot remain in business unless it produces something that consumers are willing to buy.
A corporation’s objective function – which is the subject of this chapter – is a rule or set of rules to guide managerial decision making as it seeks to accomplish this purpose. The need to define a corporate objective function is relatively trivial for firms that are solely owned by individuals who also manage their firms. Such individuals are free to define whatever goals they see fit, and presumably have every incentive to make decisions that are consistent with those goals. If long-term survival is a goal, owner/ managers must ensure that their businesses cover their costs on an ongoing basis, including whatever returns they require on their own efforts and financial capital. However, sole owner/managers are free to take their own rewards in whatever form they see fit. To the extent that they value non-pecuniary returns, they can assess the extent to which non-pecuniary benefits make up for any resulting shortfall in financial returns on their capital.
The careful specification of an objective function becomes much more important for firms in which professional managers act as decision-making agents for diffuse sets of investors who are otherwise uninvolved in the firms’ operations. While this setup presents many advantages for all concerned, it introduces significant potential for conflicts of interest between investors and the professional managers who make decisions on their behalf. A clearly stated corporate objective function can ameliorate this problem by defining the basis on which managers make decisions and providing a basis for judging their performance
A long-standing corporate objective function is that managers should make decisions to maximize shareholder wealth. Bebchuk and Tallarita (2020) indicate that this shareholder model of the firm has been widely accepted and sanctioned by case law since at least the 1920s. Its focus on shareholders reflects the fact that shareholders are the residual claimants to firm cash flows: the many other parties involved in producing firms’ outputs and revenues receive their rewards ahead of the shareholders. As long as the payments promised to these parties result from arm’s length negotiations in competitive markets, maximizing shareholder wealth is equivalent to maximizing the cash flows that remain after everyone else has received appropriate rewards. The focus on shareholder wealth, as opposed to some broader measure of shareholder welfare, reflects the fact that diffusely held firms have many shareholders, whose valuations of non-pecuniary benefits vary and
are unknown to firm managers. Maximizing financial returns provides their shareholders with the greatest potential to pursue their desired non-pecuniary benefits outside the firm. Although widely accepted, the shareholder model has attracted naysayers for as long as it has been around. Such objections have increased significantly over the last two decades, as evidenced by the popularity of the corporate social responsibility (CSR) and environmental/social/governance (ESG) movements. Benabou and Tirole (2010) cite a number of possible reasons for increased political and societal pressure, including: increased economic prosperity; wider availability of information about corporate practices; increases in environmental and social externalities; and greater awareness of the long-run costs of such externalities. Whatever its motivation, this increased attention suggests the need for a re-examination of shareholder wealth maximization as the corporate objective function and consideration of potential alternative models. This chapter details such an analysis.
The analysis begins with the classical model of firm decision making in perfect capital markets, as laid out by Fama and Miller (1972). Their model establishes the basis for maximizing shareholder wealth but does not seek to address in any detail rewards to parties other than the shareholders. Alchian and Demsetz (1972) and Jensen and Meckling (1976) build on the classical model to present the firm as a set of contracts among various factors of production, establishing the role of contracts in allocating rewards across all parties involved in firms. Jensen and Meckling also model the evolution of a firm from single to multiple owners, formalizing the manager–shareholder agency problem that is fundamental to the importance of specifying a corporate objective function. This literature articulates why shareholders must be the residual claimants of the firm, and why this naturally leads to shareholder wealth maximization as the appropriate objective function.
The vast majority of critics of shareholder wealth maximization point to stakeholder theory as an alternative corporate objective function. Although stakeholder theory is best described as a collection of approaches – rather than a theory per se – the basic idea common to all of the approaches is that managers should seek to maximize the welfare of all stakeholders in their firms, rather than of the shareholders alone. It is important to note at the outset that there is considerable overlap between shareholder and stakeholder views of the firm. In order to maximize shareholder wealth, firms must offer rewards sufficient to attract and retain the participation of a variety of stakeholders. Where the two views come into conflict is in expectations that managers should also be willing to provide rewards to non-shareholder stakeholders that reduce shareholder wealth, including above market returns to stakeholders who are directly involved with the firm and expenditures to solve social problems that are unrelated to the firm’s business. Such expectations are common among advocates of stakeholder theory but are clearly inconsistent with maximizing shareholder wealth. The discussion of stakeholder theory in this chapter focuses on this area of disagreement.
Careful consideration of stakeholder theory reveals at least two significant sets of problems with stakeholder welfare maximization as an alternative corporate objective function. First, it does not provide managers with any clear rules by which to make decisions. Instead of allowing people to act on their own behalf via market transactions and counting on governments to address social problems that the market cannot solve, managers alone must decide who are legitimate stakeholders and which social problems to address,
which parties should receive excess rewards, and from which other parties they should be taken. In addition to being a difficult task for well-intentioned managers, this provides additional cover to managers who are inclined to act in their own interests, greatly exacerbating the managerial agency problem. Second, firms must be competitive in both product and capital markets if they are to survive in the long run. Pursuing stakeholder welfare maximization presents considerable threats to both. The payment of excess rewards reduces expected cash flows to shareholders with no commensurate reduction in the risk they bear. Shareholders will respond by reducing the amount of equity capital they invest accordingly. Moreover, firms cannot compete in product markets if they must pay above market prices for labor and other inputs while receiving only market prices for their outputs; and even less so if they also expend resources to solve social problems that are unrelated to their businesses.
An objective function that results in significant increases in agency problems and significant reductions in firm competitiveness is not an equilibrium solution. Although the shareholder model of the firm is not perfect – there is no such thing as a perfect model in an uncertain and imperfect world – it remains the model best suited to ensuring that firms achieve their fundamental purpose.
THE CLASSICAL MODEL OF THE FIRM
In their 1972 book The Theory of Finance, Eugene Fama and Merton Miller elegantly lay out the classical model of decision making in the firm. In their model, the existence of a well-functioning capital market allows individuals and firms to independently allocate resources over time, thereby allowing firms to choose productive investments without considering the individual preferences of their investors.
Decision Making under Certainty
Fama and Miller’s model is an application of the economic theory of choice to the allocation of financial resources over time. This theory rests on axioms of comparability, transitivity, nonsatiation, and convexity, and results in well-behaved consumption indifference curves that represent individuals’ tastes and preferences. In Fama and Miller’s two-period model, individuals choose from an opportunity set of period 1/period 2 consumption pairs, which they achieve by borrowing or lending in a perfect capital market. A perfect capital market is one in which all participants have equal information, take all security prices as given, and are not subject to taxes or transactions costs. Figure 1.1 represents this choice process.
In this figure, utility-function-based indifference curves for an individual decision maker interact with the capital market line, the slope of which is determined by the market rate of interest for financial transactions, r. The tangency point between an indifference curve and the capital market line represents the combination of period 1 and period 2 resources that provides the individual with the highest possible utility. In Figure 1.1 that occurs at point x, at which the individual consumes c1 * in period 1 and c2 * in period 2.
Individuals whose initial allocation of wealth combined with their period 1 and period 2 incomes puts them at a point other than x can borrow or lend in the capital market to
reach point x. For example, an individual who is at point v would borrow funds against period 2 income to reach point x, while someone at point z would reach point x by lending excess period 1 funds.
In addition to transferring wealth across time periods by borrowing and lending, economic agents can invest in productive assets. Figure 1.2 outlines the joint equilibrium of production and consumption decisions for an individual.
In this figure, an individual owner-manager whose only resources come from productive opportunities would reach the highest possible utility indifference curve by investing in such opportunities to the point y, at which the internal rate of return on productive investment is equal to the market rate of interest. The optimal consumption pattern for this individual is at point z, which necessitates borrowing in period 1 against period 2 returns.
Note that the optimal investment in productive assets is independent of the individual’s consumption preferences. An important implication of this independence is that the optimal production decision remains the same even if there are multiple investors whose preferred consumption patterns vary. Fama and Miller show that, given perfect capital markets and nonsatiation, investors all prefer that the firm maximize the market value of their holdings. Figure 1.3 depicts this situation.
In this figure, investors A and B have different consumption preferences. The tangency between the production opportunity set and the capital market line, however, does not depend on owner preferences. Investment in productive assets to point y provides both investors with the highest possible financial resources, which they can move across time in the capital market to reach their own preferred consumption pattern. In this example, investor A would borrow and investor B would lend in period 1 in order to achieve their desired consumption patterns. Thus, the manager need only follow the market value rule, which calls for investing in productive assets until the marginal rate of return is equal to
Figure 1.1 Preferred allocation
the market interest rate; that is, until the net present value of the marginal investment reaches zero.
Decision Making under Uncertainty
To use the market value rule, firms’ decision makers must understand how market value is determined. Under certainty and in a perfect capital market the cash flows associated with any investment in productive assets are risk free, and a single market determined interest rate is the appropriate required rate of return for all projects. In an uncertain
Figure 1.2 Joint equilibrium of production and consumption decisions
Figure 1.3 Equilibrium production and consumption decisions for the multiowner firm Figure
world, however, identifying a cutoff rate requires a more detailed specification of investor tastes. Managers must be able to characterize risky alternatives available to investors in terms of a finite number of parameters.
Fama and Miller show that if security returns are normally distributed, risk-averse investors rank portfolio choices based on the means and standard deviations of their expected returns.1 The varying utility functions of individual investors combine in the market to determine the tradeoff between expected return and risk along the efficient set; that is, the set of risk/return combinations for which no investment offers either a higher expected return with an equal or lower standard deviation or a lower standard deviation with an equal or higher expected return. Firms consider this market-determined tradeoff, not the utilities of their individual investors, when making production decisions. Thus, as in a certain world, firms in an uncertain world need only follow the market value rule, which calls for investing in productive assets until the risk-adjusted marginal expected rate of return is equal to the risk-adjusted market interest rate; that is, until the net present value of the marginal investment reaches zero.
This classical model of the firm provides firms with a clear and objective decision rule, one that is independent of investors’ preferences. Decision makers in firms need only concern themselves with maximizing shareholders’ wealth, which depends only on the value of their holdings in the firm, rather than worrying about shareholders’ welfare, which also depends on individual tastes and preferences that likely vary across investors. This fundamental result remains important even as the model of the firm has evolved over time.
EVOLUTION IN THE MODEL OF THE FIRM
Fama and Miller (1972) establish an objective criterion by which decision makers in firms can maximize the wealth of their shareholders. Because it is concerned only with decision making on behalf of the shareholders, their model does not address the other constituencies whose efforts contribute to production in the firm. In addition, because the authors assume for purposes of their model that all parties have costless access to full information, they do not address the issue of whether managers can be counted on to make these valuemaximizing decisions in a world characterized by information asymmetry.2 Subsequent evolution in the model of the firm addresses the allocation of rewards across various firm constituencies and the agency conflict that arises when professional managers make decisions on behalf of investors. This section traces that evolution and establishes that shareholder wealth maximization remains the best objective function in models that incorporate real-world imperfections.
The Firm as a Set of Contracts
Alchian and Demsetz (1972) and Jensen and Meckling (1976) propose models of the firm as a set of contracts among all factors needed for production.3 In these models, parties that contribute to production are self-interested economic agents, and contracts establish clearly defined property rights. Thus, while their models represent departures from Fama and Miller’s classical model, they – like Fama and Miller – assume classical economic behavior on the part of all involved.
Alchian and Demsetz view the firm as a vehicle for cooperative productive activity. They term such activity “team production” and define it as production in which several types of resources are used and the product is not a sum of separable outputs of individual resources. This makes it difficult for counterparties in the market to measure the marginal productivity of individual contributors and reward them in a way that motivates them to work efficiently. The firm, on the other hand, allows for the appointment of one person who is common to all input contracts and can observe input behavior, and is therefore able to monitor the performance of all team members. To incentivize the monitor to work efficiently, Alchian and Demsetz propose that the monitor be given title to the net earnings that remain after all other inputs are compensated; that is, the monitor should be the residual claimant. They emphasize the importance of having only the monitor compensated via residual earnings as profit sharing for multiple parties will increase shirking by the central monitor. Adding to the monitor’s rights the right to sell these rights results in a combination of rights that defines the ownership of the free enterprise firm.
Alchian and Demsetz apply this notion of ownership to the limited liability corporation by noting that firms need to raise equity capital to undertake productive investment, and that it is most efficient to do so by raising small amounts of money from each of a large number of investors. The bureaucratic costs and inclination to shirk associated with a large number of owners necessitates the transfer of decision authority to a smaller group. With this discussion, the authors point towards, but do not carefully develop, the notion of the separation of ownership and control that characterizes the large modern corporation.
Like Coase (1937, 1960) and Alchian and Demsetz (1972), Jensen and Meckling (1976) believe that property rights, specified via contracts, determine how costs and rewards are allocated in the firm. Although they sympathize with Alchian and Demsetz’s focus on monitoring, Jensen and Meckling believe that the emphasis on joint production by employees is too narrow. They view firms as legal fictions that serve as a nexus for a set of contracting relationships among all of the many types of individuals who are involved with the firm.
Fama (1980) points out that the decision maker in Fama and Miller’s classical model, as well as in the Alchian/Demsetz and the Jensen/Meckling models, is some form of the entrepreneur or owner-manager, who also owns a significant portion of the firm’s equity and therefore has both ownership and control rights. Thus, these models do not directly apply to the typical large modern corporation, in which professional managers who own little or none of the firm’s equity make decisions on behalf of a large set of investors, the vast majority of whom have no day-to-day involvement in firm operations. Fama specifically addresses this separation of ownership and control and explains how it can be an efficient form of organization within a contracts model in which the firm is disciplined by competition with other firms and individual firm participants face the discipline and opportunities provided by the market for their services.
Although the phrase ‘separation of ownership and control’ continues to be used widely, the idea that shareholders of a diffusely held firm are ‘owners’ of that firm is controversial. Fama (1980) sets aside the idea that a corporation has owners in any meaningful sense. Each factor in a firm is owned by someone – shareholders own only the common stock of the firm. Fama focuses instead on risk bearing and management as factors that are traditionally combined in the sole-owned entrepreneurial firm but naturally separable in
the set of contracts that constitute the modern firm. In this view shareholders are risk bearers, rather than owners, and control rests with management. In other words, Fama divides the rights that Alchian and Demsetz assign to their monitor into those assigned to the shareholders – namely the right to hold or sell the residual claim to the firm’s cash flows – and those assigned to management – namely to be party to all contracts with the joint inputs and to renegotiate such contracts.
Whether we speak of the separation of ownership and control or the separation of risk bearing and management, the ability to create such separation provides considerable benefits to the economy. Individuals who have managerial talent can raise the financial capital required to build firms of efficient size, regardless of their own risk aversion and wealth constraints. Individuals who have financial capital to invest can invest in many different firms, reaping the financial benefits afforded by both productive investment and portfolio diversification (Denis, 2016). However, this separation brings with it the considerable disadvantage of potential conflicts of interest between the risk bearers and the decision makers.
The Agency Problem in the Firm
Under the classical model of the firm, well-diversified shareholders are made best off if managers – acting as agents for the shareholders – maximize the combined value of their cash flow from and holdings of the shares of the firm. The agency problem arises because managers of publicly traded firms typically own only small fractions of the firms they run and, at the same time, must invest much of the present value of their human capital in a single firm. The combination of these characteristics and managers’ potential desires to consume perquisites, remain in power, and maximize the resources under their control results in many decisions where managers’ interests conflict with those of the shareholders. This is the well-known agency problem of the firm, recognized by Berle and Means (1932) and formally modeled by Jensen and Meckling (1976).
Jensen and Meckling (1976) model the change in incentives that occurs when 100% owner-managers sell portions of their residual claims on firms’ cash flows to outside investors. As the firm’s decision maker, a manager can choose to consume non-pecuniary benefits at the expense of the pecuniary benefits. Jensen and Meckling show that a manager who owns 100% of the firm’s equity will bear the full loss of any financial return and will therefore consume non-pecuniary benefits to the point at which the marginal value to the manager of $1 of non-pecuniary benefits equals that of $1 of pecuniary benefits. A manager who owns less than 100% of the firm’s equity, however, will not bear the full loss of financial return occasioned by the consumption of non-pecuniary benefits. A manager who owns 50% of the equity, for example, will personally lose only $0.50 of financial return for every $1 of non-pecuniary benefits consumed, and will therefore have an incentive to consume a higher level of non-pecuniary benefits.
Jensen and Meckling go on to show that outside investors understand ex ante the manager’s revised incentives and reduce the price that they are willing to pay for a portion of the firm’s equity accordingly. Thus, ultimately, partial owner-managers – like 100% ownermanagers – bear the costs of their consumption of non-pecuniary benefits. The difference, however, is that partial owner-managers will consume more non-pecuniary benefits than they would have in a world with no separation between ownership and control, reducing
the value of the firm and the managers’ welfare relative to the 100% ownership case. Losses in firm value and managerial welfare can be ameliorated if outside investors are able to monitor managers’ actions or if managers are able to bond themselves not to act against the interests of the shareholders. Such actions are costly, however, and are unlikely to fully eliminate the conflict of interest. Jensen and Meckling define agency costs as the sum of monitoring expenditures by the shareholders, bonding expenditures by the manager, and the remaining residual loss in firm value.
The Jensen and Meckling model serves as the theoretical basis for a huge literature, both theoretical and empirical, that seeks to: identify the precise nature of the conflicts of interest between managers and shareholders; measure their extent and the characteristics that influence them; identify and measure the effectiveness of monitoring and bonding activities that reduce the agency costs of firms; and measure the extent of the remaining residual loss.4
This agency problem makes it especially important to carefully specify a corporate objective function to guide managerial decision making. Tirole (2001) states that most economic agents place their own welfare above that of society. Left to their own devices, therefore, corporate managers – like all self-interested economic agents – will sometimes fail to do what is best for the firm in favor of what is best for them. This is the downside of the separation of ownership and control, and the foundation for the shareholder model of corporate governance that is followed widely in the U.S. and elsewhere. Under this governance model, the objective function of managers and the boards who advise and monitor them is to maximize shareholder value. According to the classical model of the firm, they do so by following the market value rule. Under the contracts model of the firm, they do so because shareholders bear the residual risk associated with the firm’s cash flows.
STAKEHOLDERS UNDER SHAREHOLDER WEALTH MAXIMIZATION
Both the classical and the contracts models specify that managers should choose actions that maximize shareholder wealth. Shareholders, however, are only one of many constituencies who are involved in or otherwise affected by firms’ actions. Although ideas vary as to who exactly has a stake in a given firm, the broadest definition is that a firm’s stakeholders include any party who affects or is affected by managers’ actions and the outcomes of those actions. This includes such other direct stakeholders as employees, customers, and suppliers, as well as parties who do not have formal relationships with the firm but are – or at least could be – affected by it. Examples of the latter group include the communities in which the firm operates and, increasingly, society more generally. What does shareholder wealth maximization imply about the interests of these other stakeholders?
Direct Firm Stakeholders
Shareholder wealth maximization does not imply that managers should focus only – or even primarily – on a firm’s shareholders. The successful production of net cash flows for the shareholders requires that managers can entice employees to work productively for the
firm, suppliers to provide necessary raw materials to the firm, customers to purchase the goods or services the firm produces, and so on. Only if managers successfully contract with all other necessary constituencies can there be any increase in shareholder wealth. If such contracts are made in competitive markets and enforced in the legal system, stakeholders can choose to become involved with firms that offer them an appropriate set of rewards for doing so. For employees, such rewards could include wages, benefits, job satisfaction, good working conditions, and so on, while customers are rewarded with the ability to purchase products or services they desire at an appropriate price.
Shareholders, too, effectively contract with the firm when they purchase shares of stock, whether in the primary or the secondary markets. Under the terms of this contract, shareholders are entitled to the cash flows that remain after all other direct stakeholders are compensated. The variable nature of shareholders’ rewards distinguishes them from other direct stakeholders, who typically receive payoffs that are largely fixed. Thus, shareholders bear the residual risk – and, indeed, most of the risk – associated with the cash flows of the firms whose shares they hold. This explains why the shareholder model calls for managers to make decisions in the interests of their shareholders. Such a decision rule amounts to maximizing that cash flow that remains after all non-shareholder constituencies have received their appropriate share.
Why is it that only shareholders bear the residual risk? This question comprises two sub-questions. First, why should only one type of constituency bear the residual risk? Alchian and Demsetz (1972) propose that the amount of shirking within the firm –including by the central monitor or manager – increases with the number of parties who share in its residual profits. Thus, having only one party entitled to these profits minimizes a firm’s agency costs. Second, why should shareholders be the one party that bears the residual risk and receives the residual profits? This stems from the fact that shareholders are the constituency most suited to bearing such risk. Because they provide only financial capital to a firm, shareholders can cheaply and easily hold financial claims on many different firms at the same time, thereby diversifying away much of the risk associated with any individual firm’s cash flows. Contrast this with the position of firms’ employees, who generally have the entire value of their human capital tied up in one firm.5
Market Frictions and Externalities
Under the contracts model of the firm, market forces ensure that direct stakeholders earn appropriate returns for their involvement with firms. This requires that stakeholders can contract with firms in a free market; that is, a market that is free of frictions. To the extent that market frictions exist – and they clearly do – stakeholders may not be able to achieve as advantageous an outcome as they would be able to achieve in a fully free market.
Denis (2016) points to monopoly power as one example of a market friction that negatively affects stakeholders. In a perfectly competitive market, no firm can price its products such that they reliably earn economic rents – that is, returns greater than the appropriate risk-adjusted rate of return. If any firm is earning rents in an industry, other firms will have an incentive to enter the market, eventually competing away any rents. However, in the face of market frictions – for example high barriers to entry into the industry – a firm can continue to earn economic rents at the expense of its customers. While the higher
prices paid by customers benefit shareholders, they do so in a way that creates a deadweight loss in the economy.
A second important criticism of the contracts model of the firm is the existence of parties outside the firm who are affected by firms’ actions but have no direct relationship with – and therefore no opportunity to contract with – those firms. Perhaps the most obvious example of a negative externality is pollution created by manufacturing processes. People who live in the vicinity of a plant are clearly affected by any manufacturing byproducts that reduce the quality of the surrounding air or water. To the extent that efforts to reduce such byproducts are costly to a firm, managers who are acting in shareholders’ interests may have no incentive to undertake pollution-reduction measures. Shareholders would bear all of the costs of such measures, while local residents would reap all of the benefits.
Under the shareholder model of the firm, such frictions and externalities are most effectively addressed through market and regulatory forces. Denis (2016) discusses the important roles played by such interrelated forces as popular sentiment, the media, and government in mitigating imperfections that are not easily addressed by contracts between firms and their direct constituencies. Popular sentiment and the media – fueled by and fueling each other – influence firm decision making within the shareholder model whenever ideas about how firms should behave are popular enough to affect firms’ abilities to attract employees, customers, investors, and so on. Problems for which no effective market solutions exist should be the responsibility of the government, with the important caveat that the societal costs of their actions must not exceed the benefits of any resulting reductions in frictions and externalities.
Society as a Stakeholder
In 1970, Milton Friedman famously opined that the social responsibility of business is “to conduct the business … to make as much money as possible while conforming to the basic rules of the society, both those embodied in law and those embodied in ethical custom”. Because profits ultimately accrue to the shareholders, Friedman’s view is very much in keeping with the shareholder model of the firm. Critics of this view – and there are many –advocate for broader corporate responsibilities as part of movements labeled corporate social responsibility (CSR) and environmental/social/governance (ESG). According to such views, corporations – by virtue of their prominent place in society – have a responsibility to address important social issues, whether or not such issues are related to the businesses in which they engage. I will discuss these views in greater detail when I cover alternative objective functions later in the chapter. In the meantime, some discussion of how CSR and ESG fare under the shareholder model of the firm is warranted.
The first thing to note is that CSR/ESG and shareholder wealth maximization are not necessarily in conflict. To the extent that CSR/ESG is valued by stakeholders with whom firms need to engage, firms that practice these principles may produce higher cash flows by doing so. This is the case, for example, when customers are willing to pay more for the products of socially responsible firms or when higher-quality employees prefer to work for such firms.
If investors value CSR/ESG it is possible that, in addition to leading to increased cash flows, such practices can increase shareholder value by lowering a firm’s cost of capital.
Standard asset pricing models assume that investors value financial assets based on expected payoffs and the market risk of those payoffs. However, financial economists have proposed a number of models that accommodate investor preference for CSR/ESG activities. Fama and French (2007) consider the effect on asset prices of investors who derive consumption value, as well as financial payoffs, from their investments – pointing to socially responsible investing as one example. Heinkel et al. (2001) develop a model in which exclusionary ethical investing raises the cost of capital for polluting firms; and in Pastor et al.’s (2021) model, investors enjoy holding green assets, and therefore demand lower equilibrium returns.
There is ample evidence that there are stakeholders of all types who value CSR/ESG practices. For example, survey research by McKinsey Inc. (Henisz et al., 2019) indicates that more than 70% of consumers would pay 5% more for green products in a number of different industries as long as such products performed as well as non-green alternatives. Investors who wish to limit themselves to investing only in socially responsible firms have many choices of socially responsible investment funds through which to do so. McKinsey reports that global sustainable investment was over $30 trillion in 2019, a 68% increase over 2014. Academic studies provide evidence, albeit mixed, that CSR/ESG activity is associated with higher firm value.6
In the face of market forces and the residual nature of shareholders’ claims on firm cash flows, an objective function centered on maximizing shareholder wealth produces outcomes that are collectively valued by firm stakeholders. The shareholder model does not support firms directly engaging in broader social goals that have negative implications for firm value. However, it is important to note that returns to shareholders put more financial resources into the economy, resources that are available for the pursuit of social good. This allows investors to make their own decisions about which social goods to pursue with these resources.
STAKEHOLDER THEORY
Shareholder wealth maximization via the market value rule has enjoyed wide acceptance as the fundamental objective by which corporate managers should make decisions. Such acceptance has never been universal, however. The most prevalent set of criticisms of the shareholder model of governance centers on the model’s focus on shareholders. The alternative corporate objective function put forth by critics of shareholder wealth maximization is broadly labeled stakeholder theory. Although the precise understanding of and details associated with stakeholder theory vary somewhat across its proponents, the common fundamental idea is that, when making decisions, managers should consider the welfare of all firm stakeholders, rather than only that of the shareholders. In their 2001 survey of stakeholder theory, Freeman and McVea state that: “This area of academic research represents a collection of approaches rather than a coherent theoretical grouping. A broad range of business and social agendas falls under this banner. However, what most of these approaches share is the inclusion of stakeholder groups that have traditionally been omitted from analysis” (p. 10).
One point often emphasized by proponents of stakeholder governance is that proper treatment of stakeholders increases long-term shareholder value and firm survival.
To the extent that this is true, stakeholder governance is fully consistent with shareholder governance.7 As discussed earlier in this chapter, shareholder governance recognizes that managers must satisfy all direct stakeholders in order to run their business profitably – and that doing so is in the interests of the shareholders who are entitled to the residual cash flows. In the discussion below, the focus is specifically on those situations in which stakeholder and shareholder governance do not coincide; that is, on the idea – espoused by many proponents of stakeholder theory – that managers should be willing and able to make decisions that benefit other stakeholders but reduce shareholder value.
Freeman and McVea (2001) trace the academic origin of stakeholder theory to the strategic management discipline in the mid-1980s. They define stakeholders as “any group or individual who is affected by or can affect the achievement of an organization’s objectives” (p. 5). They note that, unlike shareholder theory, stakeholder theory does not rely on a single over-riding management objective. Rather, it is intended to provide a flexible strategic framework in which managers are expected to integrate economic, political, and moral analysis. According to Freeman and McVea, stakeholder theorists seek to expose the shareholder model as being “morally untenable or at least too accommodating to immoral behavior” (p. 20).
The absence of a single over-riding management objective under a stakeholder model of the firm is the most fundamental structural difference between it and the shareholder wealth maximization model. Although a firm’s shareholders and other stakeholders generally share a common interest in its successful continuation, their interests with respect to the myriad day-to-day decisions involved in operating a business often involve tradeoffs. By failing to specify any clear priority across stakeholder groups, stakeholder theory leaves it to managers’ discretion to determine how to make such tradeoffs.
Proponents of stakeholder theory generally view the problem of tradeoffs as at best a secondary issue and do not, therefore, offer meaningful prescriptions for how managers should make decisions about individual tradeoffs. For example, Mayer (2020) states that shareholder value should be an outcome, not an objective, while Edmans (2020) proposes that shareholder value should be a byproduct of creating value for society. Freeman and McVea (2001) indicate that managers must see stakeholder issues as joint and implement processes that satisfy all stakeholders simultaneously rather than offsetting one against another. Stout (2012) notes that the survival of firms requires that many different types of stakeholder make firm-specific investment, and that it is difficult to draft complete contracts for each of these groups. She proposes, therefore, that firms should maximize the sum of returns earned by all stakeholders.
The early stakeholder theory literature focuses primarily on those stakeholders who are directly involved with firms or who are affected by negative externalities associated with firm operations. More recently, this literature has expanded to reflect the advent of the corporate social responsibility (CSR) and environmental/social/governance (ESG) movements. According to proponents of these movements, a firm’s prescribed responsibilities have grown to include parties that are neither directly involved with the firm nor affected by externalities created by the firm. Proponents of CSR suggest that such responsibility stems from the prominent place of the corporation in society and/or the relative ineffectiveness of governments in dealing with social issues. Mayer (2020, p. 901) states: “There is … a
void between market efficiency and regulatory effectiveness, which is increasingly becoming a chasm … As a consequence, governments and regulation are proving to be increasingly incapable of rectifying the growing market failures they confront.”
Although corporate boards of directors in the U.S. have historically had a fiduciary duty to their shareholders, proponents of stakeholder governance suggest that U.S. corporate law supports a stakeholder model. Elhauge (2005) proposes that corporate managers have never had an enforceable legal duty to maximize corporate profits: compliance with such a duty is simply too difficult to monitor. It is for this reason that courts follow the business judgment rule, under which the decisions that managers make are assumed to be good for the firm unless there is clear evidence to the contrary. According to Elhauge, the business judgment rule effectively provides management with the discretion to sacrifice profit. Freeman (2008) indicates that the law has evolved to give de facto standing to claims of groups other than stockholders. Corporate constituency statutes in a majority of U.S. states allow or require managers to take the interests of other constituencies into account. In addition, the vast majority of states either allow or are considering allowing the formation of Benefit Corporations (B Corps), which are for-profit entities that balance shareholder profits with public benefits. Stout (2012) questions the legitimacy of the fundamental justification for shareholder wealth maximization: the claim that shareholders are residual claimants. She indicates that the only time that corporate law comes close to treating shareholders like residual claimants is when the firm is in bankruptcy. At other times shareholders cannot receive cash unless the board of directors decides to pay it out.8
SHAREHOLDER AND STAKEHOLDER MODELS AS COMPETING FORMS OF ORGANIZATION
It bears repeating to start this section that there is considerable overlap between the shareholder and stakeholder models of the firm. Both models view the firm as a set of contracts among various stakeholder groups. To a large extent, appropriate treatment of the many different types of stakeholders involved in the modern corporation is very much in shareholders’ interests. Firms must offer rewards sufficient to attract direct stakeholders to become involved in their businesses. In addition, it is increasingly the case that the willingness of direct stakeholders to be involved with firms – and the terms under which they are willing to be involved – is related to firms’ behavior with respect to broader social issues. For example, some employees and customers prefer to work for and buy from firms they believe are socially responsible, and may also be willing to accept lower wages or pay higher prices in order to do so. Appropriate attention to these issues can increase shareholder wealth.
The shareholder model of the firm relies fundamentally on the existence of a relatively free market in which individual economic agents make their own resource allocation choices and rewards to all agents – both pecuniary and non-pecuniary – are determined by the intersection of supply and demand. If the stakeholder model of the firm is to be a true alternative to the shareholder model, corporate managers must be allowed or expected to make decisions other than those that would be made in the market by the parties involved. There are numerous problems with this approach.
In order to be meaningful, an objective function must map to a relatively clear decision rule or set of rules. Although there can be legitimate disagreement as to which choice will maximize shareholder wealth in a given situation, the rule itself is clear as to the desired outcome. An admonition to maximize the welfare of all stakeholders, on the other hand, does not provide any clear rules by which to make the inevitable tradeoffs involved in allocating a given amount of cash flow across various stakeholder groups. Bebchuk and Tallarita (2020) point out that stakeholder theory advocates typically avoid discussion of the important issues of how to determine which groups are legitimate firm stakeholders and how to balance the interests of their various consistencies. Statements by Mayer (2020) and Blair and Stout (1999), for example, address the issue by indicating simply that directors must be able to make hard choices about how to allocate returns across stakeholder groups.
Such choices are indeed difficult even for managers who seek to act according to the objective functions their firms specify. To the extent that they are asked to leave behind the information provided by the market through people acting on their own behalf, managers are expected to make unilateral decisions about which stakeholders should receive above market rewards and from which stakeholders they should be taken. More importantly, a lack of clear decision rules has the potential to greatly exacerbate the agency problem associated with managers acting in their own interests rather than those of the firms they run. Tirole (2001) points out the difficulty of measuring firm contributions to the welfare of stakeholders other than the shareholders. This makes it difficult to align the interests of the firm and its management by compensating executives based on performance. Furthermore, it allows conflicted managers considerably more leeway to act in their own interests while claiming to act in the interests of one or more groups of nonshareholder stakeholders.
A further problem with a stakeholder model of the firm is the disconnect it creates between risk and rewards. Corporate structure in the U.S. concentrates the residual risk associated with a firm’s operating cash flows with its shareholders. Other types of stakeholders typically receive a payoff that is largely fixed. Shareholder value – whether from cash payments made to them by the board of directors or increases in the value of their shares – is derived from those cash flows that remain after the other stakeholders have received their payoffs. As discussed earlier in the chapter, this structure makes sense because assigning residual rights to one type of stakeholder minimizes managerial shirking (Alchian and Demsetz 1972). Furthermore, shareholders are the logical group to bear this risk because their shareholdings can be easily diversified, whereas the same is not true of most other types of claims on the firm. The rate of return that shareholders require reflects the risk they bear. The stakeholder model seeks to increase the fixed payoffs to other stakeholders without reducing the amount of risk borne by shareholders. Shareholders have many alternatives in which to invest their financial resources and can quickly and easily move between alternatives. The inevitable result is that shareholders will reduce the amount of equity capital they are willing to invest. Finally, long-term survival requires that firms can compete effectively in product as well as capital markets. Firms must be able to purchase their inputs in the same market in which they have to sell their outputs. With respect to broader social issues, CSR/ESG asks companies to effectively pay out cash flows to parties that have no relationship with and provide no marginal benefit to the firm. An equilibrium in which firms are expected to pay
