The Value of the Firm as a Nexus of Heterogeneous Contracts

Abstract

The standard securities economy assumption is relaxed, and the firm is valued as a bundle of securities and operating contracts. The latter are generally nonsecuritizable,and lack objective valuations. Cash (working capital) optimally solves problems arising from admitting non-security contracts into the theory. Competitive equilibrium in the mixed contracts economy yields results at the level of the individual, the firm, and society. Specifically, i) the firm must hold, depending on production details, adequate cash if its non-financial input-providers are to contract efficiently, ii) managers can boost productivity (NPV per invested dollar) with cash-reducing operating strategies,and optimally return the freed-up cash as dividends, and iii) adequate cash is critical for maximizing the aggregate welfare. The first result explains working capital. The second is a productivity-rationale for risk management and the level of dividends. The third rationalizes the firm and its boundaries (characteristics of transactions conducted outside the markets). The firm with adequate cash exists to overcome the limitations of the markets in protecting the holders of non-security contracts. With cash in the firm, investors' cash flows are the firm's net operating income less its incremental working capital investments, and stock price is the value of expected earnings plus the balance sheet cash. However, contract heterogeneity is unimportant, cash and the firm are difficult to explain, and the Modigliani-Miller and Coasian intuitions reemerge, if the firm has no operating risk or is assumed to exist into perpetuity.