SUPER PREMIUM SECURITY PRICES AND OPTIMAL CORPORATE FINANCING DECISIONS

Abstract

DETERMINATION OF the appropriate capital structure for the wealth maximizing firm is a central topic in the study of business finance and has spawned numerous articles and studies by academicians and practitioners alike. An important segment of this body of literature has received notable acclaim from theoreticians and has served to focus all thinking in this area. It consists, at the risk of oversimplification, of derivations of J. B. Williams' [25, 1938] Law of the Conservation of Investment Value-stating that the firm's market value is independent of its financial structure-under ever more general conditions. In their landmark article, Modigliani and Miller [16, 1958] used the now familiar arbitrage argument to prove the Williams' entity theory of value under assumptions which included that firms may be grouped into equivalent risk classes, that corporate debt is riskless, and that perfect capital markets exist. Hamada [8, 1969], in an application of the capital asset pricing model to the problems of business finance, proved the capital structure irrelevance propostion in the absence of the MM risk class assumption. And Stiglitz [23, 1969], also in the context of a market equilibrium model, further generalized the irrelevance thesis to encompass the issuance of risky corporate debt. The systematic investigation of specific types of capital market imperfections has also yielded meaningful results, clarifying both the manner in which markets function and the complex nature of the capital structure problem.' This paper extends the analysis of capital market imperfections by developing positive implications concerning the existence of specific institutional portfolio restrictions for firms' financing decisions. In a companion paper2 a single period, two parameter capital asset pricing model was utilized to demonstrate that statutory investment restrictions imposed on the portfolio choices of major financial institutions and certain practices accompanying the shorting of securities combine to create a market situation wherein some securities sell at unwarranted price premiums from the viewpoint of firms' shareholders. The present paper introduces wealth maximizing firms into this equilibrium model as active decision agents seeking to optimize financial structure by issuing both debt and equity securities. The analysis indicates that some, but not