Some Fallacies in Corporate Finance: A Coaseian Perspective

We argue that the Modigliani and Miller (1958, 1961, 1963) Irrelevance Theorems are subsumed by the Coase Theorem (Coase, 1960). We employ the Coase Theorem to critique two fundamental results in the corporate finance literature. Specifically, we reject the claim by DeAngelo and DeAngelo (2006) that dividends are relevant in frictionless markets. Using the logic of the Coase Theorem, we argue that the solution offered by DeAngelo and DeAngelo (2006) is not in equilibrium. In addition, we reject the claim by Myers (1977) that corporate investment is negatively related to leverage in frictionless markets (the so-called underinvestment problem). If the firm plans to underinvest because of debt overhang, shareholders and debt holders will costlessly re-contract around the debt overhang until the firm takes on the optimal investment. However, if we were to interpret Myers (1977) as implicitly assuming transaction costs or other frictions, then an underinvestment equilibrium could emerge since Coaseian efficiency generally fails to emerge in such settings. In the context of Myers (1977), transaction costs of re-contracting limit the full internalization of externalities engendered by the actions of controlling shareholders and yield underinvestment. Other frictions due to asymmetric information, or free rider and empty core problems in the bargaining/recontracting process, can also undermine Coaseian efficiency and generate underinvestment equilibria.