Financial systems and development

Box 7.2 Corporate finance in theory and practice
Much attention has been paid in academic circles to ble dividends, firms help to signa] their confidence
identifying the factors that influence corporate financial about future prospects. This may explain why firms
structure and dividend policies. The seminal article by continue to pay dividends even if they need additional
Modigliani and Miller in 1958 demonstrated that in a external finance or if taxes on capital gains are lower
world with perfect capital markets a corporation's than those on dividend income.
debt-to-equity ratio is irrelevant to the firm's market Furthermore, since the interests of managers may
value. In such a world the value of the firm is deter- differ from those of creditors and shareholders, the latmined
entirely by its investment decisions, which can ter group must incur costs in trying to monitor and
therefore be completely separated from financing deci- affect the way the company is run. Decisions on capital
sions. But markets are never perfect, and in practice structure will be influenced by the ability of creditors
financing decisions are not irrelevant. Subsequent de- and shareholders to get the information they need in
velopments in corporate finance theory relaxed some order to exercise control over managers.
of the explicit or implicit conditions underpinning the Recent theories have provided some plausible explaassumption
of perfect capital markets.
nations for the differences in corporate financing pat-
Corporate taxes and the worldwide practice of tax terns between the bank-based systems of Germany
deductibility of interest payments provide an incentive and Japan, on the one hand, and the market-based
for debt finance. This incentive is weakened, however, systems of the United States and United Kingdom, on
by the direct and indirect costs of financial distress and the other. The two bank-based systems involve greater
bankruptcy, which are more likely to be encountered in corporate indebtedness (although the difference is not
a highly leveraged company. Information flows are not as large as suggested by reported accounting data).
perfect, and this has an important influence on financ- This may be explained by the close relations between
ing decisions. In particular, managers have better infor- banks and industry-that is, by the ability of bankers to
mation on a firm's performance and prospects than do influence the decisions of managers.
outside creditors and shareholders. By maintaining stato
yield a higher return, retained earnings could tries do not once again overinvest and become
provide most of the investment funds required. overindebted when additions to capacity become
Some large, capital-intensive firms-in steel, ce- necessary.
ment, or petrochemicals, for example-have a less To foster sounder corporate financial structures,
predictable income stream. These firms cannot af- governments need to reconsider the policies that
ford to be as highly leveraged as utilities and gave certain classes of firms an incentive to become
should rely more on equity financing, much of highly leveraged. Low prices and high costs left
which can come from retained earnings if the firms many state-owned enterprises dependent on exare
profitable. If they are private and large enough ternal finance for investment. Subsidized credit,
to be known to the public, these firms can obtain tax biases against equity finance, the limited size of
funding by issuing equities or by finding foreign capital markets, and lax or ineffective bankruptcy
partners. Where a particular industry accounts for laws encouraged firms to finance themselves by
a large part of a country's output, it would be de- borrowing rather than by retaining earnings or issirable
for the country to diversify its risk. It could suing equity. In some countries the knowledge
do so by seeking equity funding abroad or by issu- that the government was likely to help troubled
ing debt instruments whose payments are linked firms made it safer to rely on borrowing. In others
to the price of the commodity. Foreign lenders the existence of financial-industrial conglomerates
would thus bear some of the risk of price fluc- in conjunction with weak supervision and regulatuations.
tion of banks worked to the same end.
Many industries in this second group borrowed Increasing the supply of long-term finance-both
heavily during the 1970s to finance large invest- debt and equity-remains a priority, particularly in
ment programs. Too heavily as it turned out: sub- inflationary countries and in countries that have
stantial overinvestment left many of them unable depended on foreign borrowing for most of their
to service their debts. As a result there has been long-term funding. Macroeconomic stability is eslittle
investment in these sectors during the 1980s. sential. Indexation can help to maintain some
Care must be taken that firms in these indus- long-term finance in inflationary economies, but it
99