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Gresham's Law in Corporate Finance

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Financing patterns in corporate takeovers and private equity deals over the last twenty years demonstrate the widespread application of Rolnick and Weber’s (1986) extension of one of the most venerable principles of monetary economics: Gresham’s Law. Two currencies, corporate securities (bad money) and cash (good money) circulate together with the former playing the dominant role of par money in times when investors exhibit irrational enthusiasm. Heightened social pressure in the form of herding combined with greater uncertainty about the degree and duration of the overvaluation of securities jointly play the role of transactions costs creating a preference for payment in the par money and most deals are financed with equity or debt securities rather than cash. To illustrate, overvalued bank loans were the most common form of financing in the credit bubble up to 2008 while stock deals predominated in takeover financing during the Internet bubble period of the late 1990s. Normal markets, not characterized by irrational enthusiasm, display the use of both corporate securities and cash in funding takeovers with cash deals (good money) enjoying a premium in the form of more favorable stock market reaction. The analysis provides useful insights for both monetary economists and researchers in corporate finance. For the former, it brings a fresh currency to the interpretation and extension of Gresham’s law relating the classic debate to contemporary, as opposed to historical, events. For the latter, the lesson is that principles of monetary economics can enhance understanding of corporate financing choices.

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Article provided by EY Global FS Institute in its journal Journal of Financial Perspectives.

Volume (Year): 1 (2013)
Issue (Month): 2 ()
Pages: 11-16

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Handle: RePEc:ris:jofipe:0020
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