A modern approach to corporate finance
April 20, 2022 | By Dean Sevin Yeltekin
In a rapidly shifting business landscape, the discipline of corporate finance is like an old stone building that has withstood the test of time. When it comes to determining a firm's leverage target or designing a corporate payout policy, financial managers can, by and large, rely on theories that have been developed over more than half a century.
But a rigorous approach to corporate finance demands a careful look at new ideas along with the old. That’s exactly what Simon scholars Cliff Smith and Jim Brickley have done in Advanced Introduction to Corporate Finance, an insightful blend of basic principles and emerging evidence.
What motivated you to undertake this project?
Jim Brickley: We identified the demand for a resource that didn’t exist. With the increasing use of cross-functional teams in the workplace, it’s becoming more important for every manager to have a basic understanding of each business discipline, including corporate finance. But when we began investigating current resources used to teach the principles of corporate finance, we found that they fall into two broad categories: standard corporate finance textbooks, which present detailed material in volumes approaching 1,000 pages; and more descriptive books that lack discussion of either theories or evidence. We set out to write a condensed, readable guide that covers the basic building blocks of corporate finance and presents more recent theories and evidence, while providing the interested reader with directions to a wealth of detailed resources for further study.
Cliff Smith: Over the past 60 years, financial economists have created theories to explain fundamental corporate policy decisions. For more than 40 years, I have taught these theories in corporate finance courses at Simon Business School. While most of the theories are still relevant and useful, I would always wind up with some missing puzzle pieces at the close of each term. There were specific areas where textbook theories just did not mesh with what we observed within firms and markets. But I would tell my students to stay tuned, because we would figure it out eventually. And I was right. We have recently developed some new ideas that make more of the puzzle pieces fit together. But our initial exposition of those ideas and evidence was targeted to academics, not the business community. This book provided an opportunity to share our ideas with a wider audience.
What are some of the new theories you present in your new book?
Cliff Smith: One of the most important decisions for managers within any firm is how to finance investment projects. In our book, we review several well-established theories for how these decisions should be made. The Tradeoff Theory focuses on the costs and benefits associated with leverage and suggests a leverage target where the incremental cost equals the incremental benefits. This theory, I should note, talks more about how to select a leverage target than how to manage financing policy around that target. We also discuss the Pecking Order Theory, which argues that corporation managers have a specific preference ordering when it comes to financing activities. They first employ internally generated cash (arguably the cheapest source of funding), followed by external debt, then external equity only as a last resort. Although these theories explain some aspects of corporate behavior, their major shortcoming is that they assume that managers are shortsighted, only considering conditions at a specific moment in time when making financing decisions.
To fill in some of the missing pieces, I worked on a research paper with a former PhD student, Fangjian Fu, as well as Mike Barclay, a longtime Simon School finance faculty member who tragically died before its completion. Our paper suggests a decision-making process that is less myopic and more thoughtful about long-run investment implications. We call it Strategic Financial Management.
Jim Brickley: Cliff’s work on this theory has turned much of what was in standard textbook discussions about corporate financing policy on its head. We present this theory and demonstrate how it pulls together many disparate pieces that before didn’t make sense. Now, when readers consider topics like optimal capital structure and financing sources, they gain a better sense of how financial managers peer into the future and bring those predictions to bear on their current financing decisions.
Who is your intended audience?
Cliff Smith: Our target audience for this book is quite broad. Within business schools, this book could be used as a text in a short course on corporate finance or within a general business course. It also might serve as a useful pre-read or supplementary text for a longer, more detailed corporate finance course. If I were still teaching corporate finance at Simon, I would use this book to organize basic themes and supplement it with articles focused on more narrow topics.
Jim Brickley: We also intend to reach managers who are looking for theories and evidence to inform better investment, financing, and payout decisions. Much of current finance theory is presented to academic audiences that are comfortable with advanced mathematics, and the empirical methods used in testing these theories have become increasingly sophisticated. Our book should be particularly useful for general business professionals and students who do not specialize in finance because we present our analysis in a way that does not require a strong background in either mathematics or statistics. We typically use simple examples rather than complex mathematical proofs that would be lost on a managerial audience.
What are some practical implications for managers?
Jim Brickley: Financial managers must make at least three types of important decisions: what to invest in, how to finance these investments, and how much cash to distribute to the firm’s shareholders. Since the 1950s, scholars have made steady progress in developing theories and evidence to help guide these decisions. Our book begins by summarizing five basic building blocks that underpin modern corporate finance: Efficient Markets Theory, Portfolio Theory, Capital Asset Pricing Theory, Option Pricing Theory, and Agency Theory. We then move on to present the basic theories and evidence related to investment, financing, and payout policies. We stress managerial implications throughout the book.
Cliff Smith: Standard theories imply that equity offerings occur because firm leverage is too high. We argue that most equity offerings are prompted by the development of a large investment project. And rather than waiting until the firm’s debt capacity has been exhausted, equity offerings typically occur near the project’s inception—even in cases where the firm’s current leverage is below its target level. This is exactly what we observe in practice.
How evergreen is the material in this book? What updates do you anticipate?
Cliff Smith: Except for our chapter that presents more recent research on financing policies, the material covers basic theories that have stood the test of time. It’s hard to imagine major changes will be required in these areas. But as theory advances and more evidence accumulates, the book certainly might warrant an update. There remain a number of unresolved questions and issues in corporate finance. We have connected some of the dots, but there is still work to be done to create a completely coherent theory of corporate financial policy. It will be interesting to see what new research insights will be uncovered in the years to come.
Advanced Introduction to Corporate Finance is available for purchase here.
Clifford W. Smith, Jr., is the Louise and Henry Epstein Professor of Business Administration and Professor of Finance Emeritus at Simon Business School.
James A. Brickley is the Gleason Professor of Business Administration at Simon Business School.
Dean, Simon Business School
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