Presidential Address: The Corporation in Finance

To produce significant net present value, an entrepreneur has to differentiate her enterprise from the ordinary. To take collaborators with her, she needs to have substantial ownership, and thus financing. But it is hard to raise finance against differentiated assets. So an entrepreneur has to commit to undertake a second transformation, standardization, that will make the human capital in the firm, including her own, replaceable, so that outside financiers obtain control rights that will allow them to be repaid. A vibrant stock market helps the entrepreneur commit to these two transformations. The nature of firms and financing are intimately linked. ONE OF THE CORNERSTONES of modern corporate finance is the Modigliani-Miller Theorem, which essentially says that, in a world where investors can borrow and lend as easily as corporations, the value of a firm is determined by the present discounted value of its expected cash flows, and not by how these cash flows are allocated to various claimholders. A firm's capital structure is therefore irrelevant to its value, or taken literally, much of what corporate finance spends its time on is of second-order importance. Corporate finance researchers have spent the years since Modigliani and Miller (1958) trying to prove the value of their field by challenging one as- sumption after another of the near-perfect world that Modigliani and Miller postulate. Modigliani and Miller themselves acknowledge the tax deductability of interest, which would imply that firm value should increase with leverage. Seminal contributions by Jensen and Meckling (1976) and Myers (1977) show that capital structure choices affect the firm's investment decisions. These con- tributions have been followed by Myers and Majluf (1984), who suggest that information asymmetries between management and investors also influence the choice of securities that are issued, and hence corporate investment, and by Jensen (1986), who proposes that debt disciplines managerial waste. Corpo- rate finance has thus responded well to the challenge posed by Modigliani and