RECENT DEVELOPMENTS IN THE THEORY OF CORPORATE FINANCE

Abstract

The field of corporate finance is a vast one: in order to keep this paper manageable I shall focus on two well-known puzzles of corporate finance. The first has been described by Black (1976) as the dividend puzzle and the second by Myers (1984) as the capital structure puzzle. Underlying these two puzzles are similar considerations. Both originate in the application of competitive equilibrium analysis to corporate financial behaviour in two classic papers by Modigliani and Miller (Modigliani and Miller 1958, Miller and Modigliani 1961). Modigliani and Miller showed that if firms and investors enjoy the same financial opportunities then under conditions of perfectly competitive capital markets, no asymmetries of information between different agents, and no variations in the tax treatment of different forms of finance corporate financial policy is irrelevant. The value of a firm is determined entirely by its real decisions and is completely unaffected by the ratio of debt to equity finance in its capital structure or by the amount of dividends it pays out (for a given investment plan). The stark contrast between Modigliani and Miller's theoretical analysis and empirical observations of the importance attached to capital structure and dividend decisions by both firms and investors is part of the capital structure and dividend puzzles. But it is not all. For it remains true that nearly thirty years after the original Modigliani-Miller paper was first published, despite enormous efforts on the part of many researchers, a proper understanding of what determines companies' borrowing and dividend decisions is still elusive.