Efficiency of banks in the Third Federal Reserve District
Over the years, scholars from several different fields, including corporate finance, transaction cost economics, and law, have challenged the famous Modigliani & Miller Irrelevance Hypothesis. Under what conditions, they have inquired, does the choice between debt and equity finance affect the firm’s average cost of capital? Although these scholars have made substantial progress in selected areas, no unified theory of corporate finance has yet emerged. This paper proposes a new theory based on what Oliver Williamson has described as the "measurement branch" of transaction cost economics. The valuation hypothesis, as I characterize it, asserts that debt and equity finance reflect the value of the corporate enterprise in various alternative uses. By defining property rights -- and residual claimancy -- to these value flows, corporate financial claims provide their holders with the incentive to specialize in gathering accurate information about the value of the firm’s intangible assets and thus to avoid the pricing errors that can distort ex ante investment. The resulting improvement in resource allocation maximizes the net value of the firm, or, what amounts to the same thing, minimizes its average cost of capital. According to the valuation hypothesis, moreover, the corporation’s hierarchy of financial claims identifies an overall quasi-rent structure that serves as a real-world proxy for asset specificity that promises to operationalize the specific assets hypothesis. As thus conceived, the valuation hypothesis resolves a number of anomalies in the literature on security, bankruptcy, and corporate reorganizations, and sheds considerable light on the optimal choice of business form.
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