Financial Theory and Corporate Policy/ THOMAS E. COPELAND Professor of Finance University of California at Los Angeles Firm Consultant, Finance McKinsey & Company, Inc. J. FRED WESTON Cordner Professor of Managerial Economics and Finance University of California at Los Angeles • •• ADDISON-WESLEY PUBLISHING COMPANY Reading, Massachusetts • Menlo Park, California • New York Don Mills, Ontario • Wokingham, England • Amsterdam Bonn • Sydney • Singapore • Tokyo • Madrid • San Juan This book is dedicated to our wives, Casey and June, who have provided their loving support; and to the pioneers in the development of the modern theory of finance: Hirshleifer, Arrow, Debreu, Miller, Modigliani, Markowitz, Sharpe, Lintner, Jensen, Fama, Roll, Black, Scholes, Merton, Ross, and others cited in the pages that follow. Without their intellectual leadership this text could not exist. Library of Congress Cataloging-in-Publication Data Copeland, Thomas E., 1946– Financial theory and corporate policy. Includes bibliographies and index. 1. Corporations—Finance. I. Weston, J. Fred (John Fred), 1916– . II. Title. HG4011.C833 1988 658.1'5 87-12595 ISBN 0-201-10648-5 Many of the designations used by manufacturers and sellers to distinguish their products are claimed as trademarks. Where those designations appear in this book, and Addison-Wesley was aware of a trademark claim, the designations have been printed in initial caps or all caps. Copyright © 1988 by Addison-Wesley Publishing Company, Inc. 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, photocopying, recording, or otherwise, without the prior written permission of the publisher. Printed in the United States of America. Published simultaneously in Canada. ABCDEFGHIJ–DO-898 Preface In this third edition we seek to build on our experiences and the suggestions of users of the two previous editions. The feedback that we have received from all sources confirms our original judgment that there is a need for a book like Financial Theory and Corporate Policy. Therefore, we will continue to emphasize our original objectives for the book. Primarily, our aim is to provide a bridge to the more theoretical articles and treatises on finance theory. For doctoral students the book provides a framework of conceptual knowledge, enabling the students to understand what the literature on financial theory is trying to do and how it all fits together. For MBAs it provides an in-depth experience with the subject of finance. Our aim here is to equip the MBA for his or her future development as a practicing executive. We seek to prepare the MBA for reading the significant literature of the past, present, and future. This will help the practicing financial executive keep up to date with developments in finance theory, particularly as they affect the financial executive's own thinking processes in making financial decisions. As before, our emphasis is on setting forth clearly and succinctly the most important concepts in finance theory. We have given particular attention to testable propositions and to the literature that has developed empirical tests of important elements of finance theory. In addition, we have emphasized applica- tions so that the nature and uses of finance theory can be better understood. A. PURPOSE AND ORGANIZATION Over the past 30 years a branch of applied microeconomics has been developed and specialized into what is known as modern finance theory. The historical demarcation point was roughly 1958, when Markowitz and Tobin were working on the theory of portfolio selection and Modigliani and Miller were working on capital structure and valuation. Prior to 1958, finance was largely a descriptive field of endeavor. Since then major theoretical thrusts have transformed the field into a positive science. As evidence of the changes that have taken place we need only look at the types of people who teach in the schools of business. Fifty years ago the faculty were drawn from the ranks of business and government. They were respected and experienced statesmen within their fields. Today, finance faculty are predominantly academicians in the traditional sense of the word. The majority of them have no business experience except for consulting. Their interest iii iV PREFACE and training is in developing theories to explain economic behavior, then testing them with the tools provided by statistics and econometrics. Anecdotal evidence and individual business experience have been superseded by the analytic approach of modern finance theory. The rapid changes in the field of finance have profound implications for management education. As usual, the best students (and the best managers) possess rare intuition, initiative, common sense, strong reading and writing skills, and the ability to work well with others. But those with the greatest competitive advantage also have strong technical training in the analytical and quantitative skills of management. Modern finance theory emphasizes these skills. It is to the students and faculty who seek to employ them that this textbook is addressed. The six seminal and internally consistent theories upon which modern finance is founded are: (1) utility theory, (2) state-preference theory, (3) mean-variance theory and the capital asset pricing model, (4) arbitrage pricing theory, (5) option pricing theory, and (6) the Modigliani-Miller theorems. They are discussed in Chapters 4 through 8 and in Chapter 13. Their common theme is "How do individuals and society allocate scarce resources through a price system based on the valuation of risky assets?" Utility theory establishes the basis of rational decision making in the face of risky alternatives. It focuses on the question "How do people make choices?" The objects of choice are described by state-preference theory, mean-variance portfolio theory, arbitrage pricing, and option pricing theory. When we combine the theory of choice with the objects of choice, we are able to determine how risky alternatives are valued. When correctly assigned, asset prices provide useful signals to the economy for the necessary task of resource allocation. Finally, the Modigliani-Miller theory asks the question "Does the method of financing have any effect on the value of assets, particularly the firm?" The answer to this question has important implications for the firm's choice of capital structure (debt-to-equity mix) and dividend policy. It is important to keep in mind that what counts for a positive science is the development of theories that yield valid and meaningful predictions about ob- served phenomena. The critical first test is whether the hypothesis is consistent with the evidence at hand. Further testing involves deducing new facts capable of being observed but not previously known, then checking those deduced facts against additional empirical evidence. As students of finance, we must not only understand the theory, but also review the empirical evidence to determine which hypotheses have been validated. Consequently, every effort has been made to summarize the empirical evidence related to the theory of finance. Chapter 7 discusses empirical evidence on the capital asset pricing model and the arbitrage pricing theory. Chapter 8 includes studies of how alternative option pricing models perform. Chapter 9, newly added to this edition, discusses the theory and evidence on futures markets. Chapter 11 covers evidence on the efficient markets hypoth- esis. Chapter 14 reviews evidence on capital structure; Chapter 16 on dividend policy; Chapter 20 on mergers and acquisitions; and Chapter 22 on international finance. Finally, in addition to the theory and empirical evidence there is always the PREFACE V practical question of how to apply the concepts to difficult and complex real- world problems. Toward this end, Chapters 2 and 3 are devoted to capital budgeting, Chapter 14 shows how to estimate the cost of capital for a large, publicly held corporation, and Chapter 16 determines the value of the same company. Chapter 18, another change in this edition, emphasizes the theory and evidence on topics of interest to chief financial officers: pension fund management, interest rate swaps, and leveraged buyouts. Throughout the text we attempt, wherever feasible, to give examples of how to apply the theory. Among other things we show how the reader can estimate his or her own utility function, calculate portfolio means and variances, set up a cross-hedge to reduce the variance of equity returns, value a call option, determine the terms of a merger or acquisition, use international exchange rate relationships. In sum, we believe that a sound foundation in finance theory requires not only a complete presentation of the theoretical concepts, but also a review of the empirical evidence that either supports or refutes the theory as well as enough examples to allow the practitioner to apply the validated theory. B. CHANGES IN THE THIRD EDITION We have tried to move all the central paradigms of finance theory into the first half of the book. In the second edition this motivated our shifting the option pricing material into Chapter 8. In this third edition we decided to add a com- pletely new chapter on futures markets—Chapter 9. It covers traditional material on pricing both commodity and financial futures, as well as newer issues: why futures markets exist, why there are price limits in some markets but not others, and empirical evidence on normal backwardation and contango. In the materials on portfolio theory we have added a section on how to use T-bond futures contracts for cross-hedging. In Chapter 7 we have updated the literature review on the Capital Asset Pricing Model and the Arbitrage Pricing Model. Chapter 8 contains new evidence on option pricing. The materials on capital structure (Chapters 13 and 14) and on dividend policy (Chapters 15 and 16) have been completely rewritten to summarize the latest thinking in these rapidly changing areas of research. Chapter 18 is completely new. Many topics of importance to chief financial officers are applications of finance theory. Pension fund management, interest rate swaps, and leveraged buyouts are the examples developed in this chapter. Chapters 19 and 20 on mergers and acquisitions, restructuring, and corporate control represent up-to-date coverage of the burgeoning literature. Similarly, Chapters 21 and 22 reflect the latest thinking in the field of international financial management. We made numerous other minor changes. In general, we sought to reflect all of the new important literature of finance theory—published articles and treatises as well as working papers. Our aim was to keep the book as close as possible to the frontiers of the "state-of-the-art" in the literature of finance theory. Vi PREFACE C. SUGGESTED USE IN CURRICULUM At UCLA we use the text as a second course in finance for MBA students and as the first finance course for doctoral students. We found that requiring all finance majors to take a theory-of-finance course before proceeding to upper- level courses eliminated a great deal of redundancy. For example, a portfolio theory course that uses the theory of finance as a prerequisite does not have to waste time with the fundamentals. Instead, after a brief review, most of the course can be devoted to more recent developments and applications. Because finance theory has developed into a cohesive body of knowledge, it underlies almost all of what had formerly been thought of as disparate topics. The theory of finance, as presented in this text, is prerequisite to security analysis, portfolio theory, money and capital markets, commercial banking, speculative markets, investment banking, international finance, insurance, case courses in corporation finance, and quantitative methods of finance. The theory of finance can be, and is, applied in all of these courses. That is why, at UCLA at least, we have made it a prerequisite to all the aforementioned course offerings. The basic building blocks that will lead to the most advantageous use of this text include algebra and elementary calculus; basic finance skills such as discount- ing, the use of cash flows, pro-forma income statements and balance sheets; elementary statistics; and an intermediate-level microeconomics course. Conse- quently, the book would be applicable as a second semester (or quarter) in finance. This could occur at the junior or senior undergraduate year, for MBAs during the end of their first year or beginning of their second year, or as an introductory course for Ph.D. students. D. USE OF THE SOLUTIONS MANUAL The end-of-chapter problems and questions ask the students not only to feed back what they have just learned, but also to take the concepts and extend them beyond the material covered directly in the body of the text. Consequently, we hope that the solutions manual will be employed almost as if it were a supplementary text. It should not be locked up in the faculty member's office, as so many instructor's manuals are. It is not an instructor's manual in a narrow sense. Rather, it is a solutions manual, intended for use by the students. Anyone (without restriction) can order it from the publisher. We order it, through our bookstore, as a recommended supplemental reading. Understanding of the theory is increased by efforts to apply it. Consequently, most of the end-of-chapter problems are oriented toward applications of the theory. They require analytical thinking as well as a thorough understanding of the theory. If the solutions manual is used, as we hope it will be, then students who learn how to apply their understanding of the theory to the end-of-chapter problems will at the same time be learning how to apply the theory to real-world tasks. PREFACE Vii E. ACKNOWLEDGMENTS We have received help from many persons on the three editions of the book. We especially benefited from the insightful corrections, clarifications, and suggestions of Eugene Fama, Herb Johnson, and Kuldeep Shastri. Nai-fu Chen and Ronald Bibb wrote Appendixes B and D, respectively. Ron Masulis rewrote Chapter 5. We also wish to acknowledge the help of the following: Ed Altman, Enrique Arzac, Dan Asquith, Warren Bailey, Gerry Bierwag, Diran Bodenhorn, Jim Brandon, Michael Brennan, William Carleton, Don Chance, Nai-fu Chen, Don Chew, Kwang S. Chung, Halimah Clark, Peter Clark, S. Kerry Cooper, Larry Dann, Harry and Linda E. DeAngelo, Dirk Davidson, David Eiteman, Chapman Findlay, Kenneth French, Dan Galai, Robert Geske, Mark Grinblatt, C. W. Haley, Ronald Hanoian, Iraj Heravi, David Hirshleifer, Tom Ho, Chi-Cheng Hsia, William C. Hunter, Ashok Korwar, Clement Krouse, Steven Lippman, Stephen Magee, Dubos Masson, Bill Margrabe, Charles Martin, Ronald Masulis, David Mayers, Guy Mercier, Edward Miller, Merton Miller, Timothy J. Nantell, Ron Necoechea, Jorge:Nielson, R. Richardson Pettit, Richard Pettway, Richard Roll, Shigeki Sakakibara, Eduardo Schwartz, Jim Scott, Jandhyala Sharma, Kil- man Shin, Ron Shrieves-, Keith Smith, Dennis Soter, Joel Stern, Sheridan Titman, Brett Trueman, Jim Wansley, Marty Weingartner, Richard West, Randy West- erfield, Robert Whaley, Stuart Wood, and Bill Ziemba. For their considerable help in preparation of the text, we thank Susan Hoag and Marilyn McElroy. We also express appreciation for the cooperation of the Addison-Wesley staff: Steve Mautner, Herb Merritt, and their associates. There are undoubtedly errors in the final product, both typographical and conceptual as well as differences of opinion. We invite readers to send suggestions, comments, criticisms, and corrections to the authors at the Anderson Graduate School of Management, University of California, Los Angeles, CA 90024. Any form of communication will be welcome. Los Angeles, California T.E.C. J.F.W. Contents PART I THE THEORY OF FINANCE 1 1 Introduction: Capital Markets, Consumption, and Investment 3 Introduction 3 Transactions Costs and the Breakdown Consumption and Investment without of Separation 14 Capital Markets 4 Summary 15 Consumption and Investment with Problem Set 15 Capital Markets 9 References 16 Marketplaces and Transactions Costs 13 2 Investment Decisions: The Certainty Case 17 Introduction 17 Cash Flows for Capital Budgeting Fisher Separation 18 Purposes 36 The Agency Problem 20 Summary and Conclusion 41 Maximization of Shareholders' Problem Set 41 Wealth 20 References 44 Techniques for Capital Budgeting 25 Comparison of Net Present Value with Internal Rate of Return 31 3 More Advanced Capital Budgeting Topics 46 Introduction 46 The Term Structure of Interest Capital Budgeting Techniques in Rates 65 Practice 47 Summary and Conclusions 71 Projects with Different Lives 49 Problem Set 72 Constrained Capital Budgeting References 74 Problems 55 Capital Budgeting Procedures under Inflation 61 4 The Theory of Choice: Utility Theory Given Uncertainty 77 Five Axioms of Choice under Comparison of Risk Aversion in the Uncertainty 79 Small and in the Large 90 Developing Utility Functions 80 Stochastic Dominance 92 Establishing a Definition of Risk Using Mean and Variance as Choice Aversion 85 Criteria 96 ix X CONTENTS A Mean-Variance Paradox 99 Summary 103 Recent Thinking and Empirical Problem Set 103 Evidence 102 References 107 5 State-Preference Theory 109 Uncertainty and Alternative Future Summary 128 States 110 Problem Set 129 Definition of Pure Securities 111 References 131 Complete Capital Market 111 Appendix A to Chapter 5: Forming a Derivation of Pure Security Prices 113 Portfolio of Pure Securities 133 No Arbitrage Profit Condition 115 Appendix B to Chapter 5: Use of Prices Economic Determinants of Security for State-Contingent Claims in Capital Prices 116 Budgeting 135 Optimal Portfolio Decisions 119 Appendix C to Chapter 5: Application of Portfolio Optimality Conditions and the SPM in Capital Structure Portfolio Separation 122 Decisions 140 Firm Valuation, the Fisher Separation Principle, and Optimal Investment Decisions 124 6 Objects of Choice: Mean-Variance Uncertainty 145 Measuring Risk and Return for a Single Optimal Portfolio Choice: Many Asset 146 Assets 173 Measuring Portfolio Risk and Portfolio Diversification and Individual Return 153 Asset Risk 184 Optimal Portfolio Choice: The Efficient Summary 188 Set with Two Risky Assets (and No Problem Set 188 Risk-Free Asset) 166 References 192 The Efficient Set with One Risky and One Risk-Free Asset 171 7 Market Equilibrium: CAPM and APT 193 Introduction 193 Empirical Tests of the CAPM 212 The Efficiency of the Market The Problem of Measuring Performance: Portfolio 194 Roll's Critique 217 Derivation of the CAPM 195 The Arbitrage Pricing Theory 219 Properties of the CAPM 198 Empirical Tests of the Arbitrage Pricing Use of the CAPM for Valuation: Single- Theory 228 Period Models, Uncertainty 202 Summary 231 Applications of the CAPM for Corporate Problem Set 231 Policy 204 References 235 Extensions of the CAPM 205 8 Pricing Contingent Claims: Option Pricing Theory and Evidence 240 Introduction 240 Combining Options, A Graphic A Description of the Factors That Affect Presentation 245 Prices of European Options 241 Equity as a Call Option 248