MN1019 Lecture 2 Notes

Housekeeping

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Intended Learning Outcomes

After today’s lecture you should be able to describe:

Theories of the firm
Interest rates
Capital structure

Theories of the Firm

Theories of the firm explain how businesses operate, make decisions, and interact with the market. The following theories will be discussed:

Classical Theory
Neoclassical Theory
Behavioral Theory
Transaction Cost Economics
Agency Theory
Resource-Based View (RBV)
Dynamic Capabilities Theory
Stakeholder Theory
Institutional Theory
Network Theory

These theories provide lenses through which to analyze firm behavior, decision-making, and strategic management, offering insights into the complexities of how firms operate in different environments.

Classical Theory

Focus: Production efficiency and profit maximization.
Key Idea: Firms are viewed as production units that combine resources to maximize output and minimize costs.

Neoclassical Theory

Focus: Market equilibrium and marginal analysis.
Key Idea: Firms make decisions based on marginal costs and marginal revenues, aiming to maximize profits by adjusting production levels.
- Profit gap: $\pi = TR - TC$
- The profit gap is widest where the tangent to the total cost (TC) curve is parallel to the total revenue (TR) curve.
- The slope of the TC curve is the marginal cost (MC), and the slope of the TR curve is the marginal revenue (MR).
- In equilibrium, $MR = MC$

Behavioral Theory

Focus: Decision-making processes within firms.
Key Idea: Firms are influenced by the bounded rationality of decision-makers, leading to satisficing behavior rather than profit maximization.
- Satisficing describes a decision-making strategy where individuals only search for possible solutions until they find an acceptable option.
- The word “satisficing” is a combination of the words ‘satisfying’ and ‘sufficing’ and it is accredited to Nobel laureate Herb Simon in his seminal paper Simon, H. A. (1956). Rational choice and the structure of the environment. Psychological Review, 63(2), 129–138. https://doi.org/10.1037/h0042769

Transaction Cost Economics

Focus: Cost of transactions and contracts.
Key Idea: Firms exist to minimize transaction costs associated with buying and selling goods and services in the market.
- As the founder of Transaction Cost Economics (TCE), Nobel laureate Oliver Williamson’s research was focused on how variations in transactions explain the existence and structure of business firms and all the other organizations that govern trade in a market economy.

Agency Theory

Focus: Relationships between principals and agents.
Key Idea: Explores conflicts of interest between shareholders (principals) and managers (agents), emphasizing the need for governance mechanisms to align interests.

Resource-Based View

Focus: Internal resources and capabilities.
Key Idea: A firm's competitive advantage arises from its unique resources and capabilities, which are valuable, rare, inimitable, and non-substitutable.

Dynamic Capabilities Theory

Focus: Adaptation and innovation.
Key Idea: Firms must develop dynamic capabilities to adapt to changing environments and maintain competitive advantage over time.

Stakeholder Theory

Focus: Relationships with various stakeholders.
Key Idea: Firms have responsibilities not only to shareholders but to all stakeholders (employees, customers, suppliers, community) and should consider their interests in decision-making.
Stakeholder theory is based on six principles – the principle of entry and exit, the principle of governance, the principle of externalities, the principle of contract cost, the principle of agency, and the principle of limited immortality.
Internal stakeholders: Employees, Manager, Owners/Shareholders
External stakeholders: Suppliers, Society, Government, Creditors, Customers
Principle of Entry and Exit: Policies about employee recruitment and dismissal should be framed in plain language.
Principle of Governance: Rules and policies for managing the relationship between an organization and its stakeholders can be amended with unanimous consent.
Principle of Externalities: Anyone affected by an organization’s business decisions can be considered a stakeholder.
Principle of Contract Cost: The involved parties must bear the cost of doing the business to the extent of their involvement.
Principle of Agency: The management is held responsible to the shareholders and stakeholders.
Principle of Limited Immortality: An organization isn’t immortal, but its existence can be extended to benefit the stakeholders, through proper succession planning.

Institutional Theory

Focus: Influence of social norms and institutions.
Key Idea: Firms are shaped by the institutional context in which they operate, including regulations, norms, and cultural expectations.

Network Theory

Focus: Relationships and networks.
Key Idea: Firms operate within networks of relationships that influence their behavior, decisions, and performance.
Network theory views firms as nodes in a complex network of relationships, where resources, information, and opportunities are exchanged and co-created.
Schwenkler, Gustavo and Zheng, Hannan and Zheng, Hannan, The Network of Firms Implied by the News (February 20, 2024). Boston University Questrom School of Business Research Paper No. 3320859, Available at SSRN: https://ssrn.com/abstract=3320859 or http://dx.doi.org/10.2139/ssrn.3320859
- Paper introduces a natural language processing methodology that leverages financial news to construct firm networks. Applying authors' methodology to Reuters between 2006 and 2013, to extract a vast network of 8,400 links between 2,000 firms and make it openly accessible. The size of a node is proportional to the logarithm of one plus the number of times that firm is mentioned in the news data.

Interest Rates

Interest is the compensation that a borrower of capital pays to a lender of capital for its use.
Interest can be viewed as a form of rent that the borrower pays to the lender to compensate for the loss of use of the capital by the lender while it is loaned to the borrower.
A common financial transaction is the investment of an amount of money at interest.
- The initial amount of money (capital) invested is called the principal.
- The total amount received after a period of time is called the accumulated value.
- The difference between the accumulated value and the principal is the amount of interest earned during the period of investment.
Let $t$ measure time from the date of investment.
- The unit in which time is measured is called the measurement period, or just period.
- The most common measurement period is one year, and this will be assumed unless stated otherwise.
The effective rate of interest $i$ is the ratio of the amount of interest earned during the period to the amount of principal invested at the beginning of the period.
- Simple interest: $1 + it$
- Discount: $1 + it - 1$
- Compound interest: $1 + i^t$
- Discount: $1 + i^{-t}$

Theories of Interest

The main theories of interest rates include:

Classical Theory
Liquidity Preference Theory
Loanable Funds Theory
Fisher Effect
Term Structure Theory
- Expectations Theory
- Liquidity Premium Theory
- Market Segmentation Theory
- Risk Premium Theory

These theories help explain the complexities of interest rate determination in different economic contexts.

Classic Theory

This theory posits that interest rates are determined by the supply and demand for money.
When the demand for loans exceeds the supply of savings, interest rates rise, and vice versa.

Liquidity Preference Theory

Proposed by John Maynard Keynes, this theory suggests that interest rates are determined by the preference of individuals to hold liquid cash versus investing in bonds.
Higher demand for liquidity leads to higher interest rates.

Loanable Funds Theory

This theory argues that interest rates are determined by the supply of savings (loanable funds) and the demand for investments.
An increase in savings will lower interest rates, while higher demand for loans will raise them.

Fisher Effect

This theory, formulated by Irving Fisher, states that the real interest rate is equal to the nominal interest rate minus the expected inflation rate.
It highlights the relationship between inflation and interest rates.

Term Structure Theory

This theory addresses why interest rates on bonds of different maturities differ.
- Expectations Theory: Suggests that long-term interest rates are an average of current and expected future short-term rates.
- Liquidity Premium Theory: Proposes that investors require a premium for holding longer-term securities due to uncertainty and potential illiquidity.
- Market Segmentation Theory: Suggests that the market for bonds is segmented by different maturities, and supply and demand within each segment determine interest rates.
- Risk Premium Theory: This theory indicates that lenders require higher interest rates for riskier loans to compensate for the increased chance of default.

Term Structure of Interest Rates

Normally, long rates should be higher than short rates.
When that is violated we have an inverted yield curve which often signals an economic recession.

Firms' Capital Structure

Assumptions of perfect capital market:

Assumption 1: Capital Markets are Frictionless (i.e., no taxes or transaction costs).
Assumption 2: All Market Participants Share the Same Expectations.
Assumption 3: All market participants are atomistic, i.e., too small individually to affect prices.
Assumption 4: The Firm’s Investment Program is Fixed and Known.
Assumption 5: The Firm’s Financing is Fixed

Levered and Unlevered Firms

Unlevered firm has no debt, i.e., firm value is comprised of equity alone. Levered firm has debt, so firm value is the sum of debt and equity.
Leverage ratio: Debt/(Debt + Equity) or $D/(D+E)$ or $D/V$ where $V=D+E$ is the value of the firm.

Modigliani-Miller

Modigliani, F.; Miller, M. (1958). \"The Cost of Capital, Corporation Finance and the Theory of Investment\". American Economic Review. 48 (3): 261–297
Nobel Prize in Economics Science in 1985 for contributions to macro-finance
Shared Nobel Prize in Economics Science 1990 for contribution to corporate finance

Modigliani-Miller Proposition I (no tax)

The value of the levered firm is the same as the value of the unlevered firm in perfect capital markets.

Modigliani-Miller Proposition II (no tax)

The cost of equity rises with leverage because the risk to equity rises with leverage in perfect capital markets.

Return on Equity

In the context of the Modigliani-Miller (M&M) theorem, the cost of equity ( $r_E$ ) refers to the return that equity investors expect for holding a company's shares.
The M&M theorem, particularly in its original form, emphasizes that under certain assumptions (such as no taxes, no bankruptcy costs, and perfect capital markets), the value of a firm is unaffected by its capital structure. However, the cost of equity can be influenced by leverage.

Return on Debt

Return on debt = $\frac{\text{Total interest expense}}{\text{Total Debt}}$
$r_D = \frac{I}{D}$
- where
  - $I$ = total interest expense
  - $D$ = total amount of debt

Weighted Average Cost of Capital (WACC)

Weights sum to 1
Expected return on assets ( $r_A$ ) is called company cost of capital or weighted average cost of capital (WACC).
WACC = weighted average of the cost of equity ( $rE$ ) and the cost of debt ( $rD$ )
$r{WACC} = rA = \frac{E}{V}rE + \frac{D}{V}rD$

Motivation for WACC

The firm’s investors hold equity or capital or both. They are the suppliers of firm capital.
The phrase “cost of equity” is really “cost of equity capital”.
If $E$ is the amount of equity in the firm, then $r_E \times E$ is the cash flow received by equity holders.
Similarly, $r_D \times D$ is the cash flow received by debt holders.
The firm’s capital $V = D + E$ is equal to the investment supplied by debt holders and equity holders. So in that sense the total cash flow paid out by the firm to these investors (debt holders and equity holders) is like an expense or a cost to the firm.
Thus, the cost of capital to the firm is the return on assets from the investors point:
- $rA = \frac{\text{total cash flow paid to investors}}{\text{value of investment}} = \frac{rD \times D + rE \times E}{V} = rD\frac{D}{V} + r_E\frac{E}{V}$

Possible Capital Structure for Firm Value (V)

Assume perfect capital markets

$V = D + E$
$rA = rE$ for capital structure C when D=0
$rA = \frac{D}{V}rD + \frac{E}{V}r_E$ for capital structures A and B
Capital structure C is unlevered because firm has no debt
Capital structures A and B are levered because of firms’ debt