Financial Theory And Corporate Policy

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 applications 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 tra