UBC Theses and Dissertations
Interrelationship between investors portfolios of stocks and firms' portfolios of assets McNeeley, Lennox John Dick
It is widely recognized that a corporation's cost of capital cannot be determined until an analysis is made of how the market values the firm's common stock. There is, however, no widely-accepted theoretical apparatus linking the market valuation of common stock to a corporation's investment-opportunities schedule, dividend payout function, and capital structure. It is the position of this paper that a fundamental reason for the current stalemate over the theoretical apparatus is the single equation nature of recent capital-budgeting and security-valuation models. Since one equation can determine at most one unknown, manipulation of these models has, for the generation of results, necessitated a variety of ad hoc restrictions to reduce each equation to a relationship between two variables only - as, for example, between share price and capital structure. Two consequences emerge: (a) Since there is no consensus, such restrictions tend to be different, (b) More importantly (sic), such variables as share price, capital budget, dividend payout, and capital structure are in the real world jointly determined, and the suppression of this dependency unnecessarily limits the relevance of any theoretical results. ¹ Similarly, this thesis explores many of the facets of finance involved in the interrelationship between investors' portfolios of stocks and firms' portfolios of assets. Lerner and Carleton rejected the one equation model in favour of a two equation model and although a significant contribution to finance was made, again an attempt to simulate real world behaviour by means of equations resulted in the suppression of reality in favour of mathematical rigour. It is this thesis' contention that equations in modern finance have facilitated the division between practitioners and theoreticians, thwarting developments in finance, and thus retarding growth in industrial development. This division has been furthered by the fact that some academics have never fully understood the same business decisions that their models seek to describe. Compounding this problem, at present, research is being conducted which only serves to extend the mistakes made in earlier research. Consequently, the motive of this paper is not to build another extension or test an existing model but to question the very manner in which some financial models are designed. The model which comes in for the most criticism is that of Markowitz whose work was formulated on investment behaviour which is now obsolete; unfortunately his paper has formed the basis of so much later work in finance. After some of the weaknesses in old precepts have been shown, new ideas will be developed in an attempt to integrate investors' portfolios of stocks and firms' portfolios of assets in a dynamic setting. Although the paper may lack mathematical rigour, it is practical in content. There is no attempt to offer a complete solution only to point out how the method of design of models has been faulty and has not shown the realities of real business situations. The purpose of the paper is to show that academics built some models before they should have, before they understood real world behaviour, and before they had investigated the foundations they were building upon. The real world should be more fully investigated, for only through this means will a dynamic model for financial analysis ever be developed that can truly benefit finance and industry. The need for such a model has been furthered by the fact that computers are now available that will facilitate the computations that such a model when developed would require. There has also been a growing awareness in financial circles that the period from 1963 to date was a time "in which both classical economics and decision theories were inadequate to explain some of the major events"² in the business world. Over these years the major corporate decisions have come from the use of exotic financial instruments as weapons in takeovers, as devices for spinoffs, and as vehicles for financing new concepts. Yet financial theory as taught and developed in our business schools has largely ignored this new era of finance in favour of developing decision models concerned with internal growth. With the demonstration of the power of financial instruments by certain companies in the last few years, the whole business world has awakened to the fact that "one good (financial) deal is usually worth five or ten years of brilliant operations"³ and that "an overpriced stock in the hands of an astute user of that stock is a key corporate resource. "⁴ This realization of the power of the new finance is demonstrated by the executive below who states: When L-T-V (Ling-Temco-Vought) took a swing at J. & L. (Jones & Laughlin Steel), and Wall Street with its funny money helped them along....I looked into our plans. I've decided what the game is about. It used to be increased earnings per share, improved return, a bigger share of profitable products --these are all important--but the reality of the game from the chief executives point of view is that if you are a single-product company, you have no choice about where to get a better return or greater earnings per share. So the game is to diversify your efforts, choosing markets and products so that you always have a choice about where to put your money at any one time.⁵ Yet theory has yet to follow the business world and the result has been that the aggressive firms which most need direction to help them have no theory to fall back upon. Also finance school are not preparing students for the responsibilities which will face them in business later. It is therefore the intention of this thes to develop a new hypothesis to describe the new financial era. ¹Eugene M. Lerner and Willard T. Carleton, "The Integration of Capital Budgeting and Stock Valuation, " The American Economic Review, LIX (September, 1964), p. 683. ²John McDonald, "The New Game of Business, " Fortune, LXXIX (May 15, 1969), p. 143.³Martin J. Whitman, "A Road to Instant Wealth--Disparities between Market Reality and Corporate Reality" (talk to the Restaurant Executive Institute, Hotel Warwick, New York City, August 15, 1968), p. 18. ⁴Ibid. ⁵McDonald, op. cit. , p. 286.
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