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MIKE DEMPSEY

The Modigliani and Miller Propositions: The History of a Failed Foundation

for Corporate Finance?

The Modigliani and Miller (MM) propositions provide a foundation for corporate finance theory. Nevertheless, this paper argues that their adop- tion has led to a disengagement of such theory from the humanity of business, as well as, more broadly, from concepts of corporate strategic management. As a result, the context within which textbooks allow corpo- rate investment and financial decisions to take place is severely distorted from reality. The paper argues that we require the context of behavioural and strategic corporate management if we are to accommodate the reality of business, the behaviour of formalised groups, and an ethical dimension to business.

Key words: Capital structure; Corporate finance; Dividends; Investments; Modigliani and Miller propositions.

This paper argues that the focus on the Modigliani and Miller (MM) propositions as the foundation of corporate management has led to a stylized representation of corporate financial decision making that is far removed from reality. Specifically, it has brought about a disengagement from the behavioural and corporate strategic contexts within which corporate financial decision making actually functions.

It is not, I note, a case of whether the MM propositions are ‘right’ or ‘wrong’. It is, for example, possible to build a working model of the solar system with the Earth at the centre (such a model existed at the time of Copernicus) but this model has distorted what is actually central and therefore cannot be extended to understanding the universe outside the solar system. The model is more or less exhausted. Similarly, with MM theory, the problem is that experiences are not actually illuminated by the model’s core assumptions, but by postulating contradictions to those assumptions. The model ‘can go no further’. The broader galaxy of strategic corporate manage- ment, the elements of reputation and trust underlying corporate and financial activ- ity, and recognition of an ethical dimension to behaviour are outside its domain.

Mike Dempsey ([email protected]) is a Professor in the School of Economics, Finance and Marketing, RMIT University, Melbourne, Australia. The author wishes to show his appreciation for conversations with Professors Kevin Keasey, Robert Hudson, Graham Partington and Imad Moosa, which have motivated this essay.

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ABACUS, Vol. 50, No. 3, 2014 doi: 10.1111/abac.12030

In the aftermath of the global financial crisis (GFC), we have become more aware of the limitations of MM theory. My purpose in the present paper is to argue that we require not so much continued adjustments to the MM basis of financial theory but, rather, an acknowledgement of the fact that financial challenges cannot always be resolved with more sophisticated mathematics of rational behaviour. Progress requires that we recognize the social science nature of corporate decision making not as an add-on, but as central to an understanding of how formalized groups of people with responsibilities for outcomes actually make decisions.

DISSENTING VOICES

A concern with the widening gap between academic research and finance as a practitioner activity is articulated by Keasey and Hudson (2007).1 These authors contend that, rather than continue to build elaborate theoretical models with limited success to explain the actions of financial advisers, finance academics should leave their offices and go and talk with them. The ability to speak with the objects of one’s study is, after all, the advantage of a social science over the pure sciences. The authors argue that academic teaching and research within finance must bridge the gap with actual financial activities and take account of the interactions of individual investors, institutional investors, financial intermediaries, companies, and the market itself if the subject area is not to become moribund. Keasey and Hudson (2007, p. 947) state,

The real question which this paper gives rise to is how finance as a subject is going to progress. In the context of ‘traditional’ finance the research community, unfortunately, tends to act as though all important insights are already contained within the existing core of financial theory. All that remains is a protracted tidying up process whereby any remain- ing anomalies or puzzles are somehow reconciled with the existing core theory no matter how complex and unlikely are the manoeuvres necessary to do this . . . One way forward will be to actively engage with each of a set of participants and try to understand their beliefs and actions. Once the participant sets are better understood in their own terms, then interactions between them can be explored from a sound base.

McSweeney (2009) emphasizes that academia has embedded the perception that financial markets are efficient and self-correcting. This agrees with economists Akerlof and Shiller (2009), who argue that we have been deceived by a theory that said nothing dangerous could happen. For these authors, the weakness of the theo- ries of market behaviour is that they ignore the role of ‘animal spirits’. Furthermore, the possibility that financial activities are often highly imperfect and that financial

1 Keasey and Hudson’s (2007) critique follows an altogether too thin line of financial criticism from financial academics, including Whitley (1984, 1986), McGoun (1995), Dempsey (1996), and Hudson et al. (1999). More recently, critiques of financial markets have been forthcoming from economists and financial observers, including Partnoy (2004), Das (2006), Froud et al. (2006), McKenzie (2006, 2009), Fine and Milonakis (2009), Fox (2009), McSweeney (2009), and in a special issue of this journal, from Cai et al. (2013), Dempsey (2013a, b), and Moosa (2013), but with counter support for asset pricing theory from Benson and Faff (2013), Berkman (2013), Bornholt (2013), Brown and Walter (2013), Partington (2013), Smith and Walsh. (2013), and Subrahmanyam (2013).

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markets are unstable and evolving is eschewed; instead, there is denial that either government, regulators, or even shareholders should interfere in the market’s operations, to warn against excesses (leveraged speculation at the levels of the corporate and financial sectors), call for stronger balance sheets for banks, or curtail executive pay. Shiller (2010) quotes Paul Krugman as stating that the professions went astray because they mistook beauty, clad in impressive-looking mathematics, for truth.

The feeling that academic finance has become stultified in its adherence to the core physics of its underlying principles is voiced by Lo and Mueller (2010), who observe that, only a few decades ago, any challenge to the notion of market efficiency was anathema and that papers claiming to have discovered departures in the data from what was predicted by the capital asset pricing model (CAPM) were ‘routinely rejected from the top economics and finance journals, in some cases, without even being sent out to referees for review’ (p. 18). In the introduction to their paper, the authors explain,

The quantitative aspirations of economists and financial analysts have for years been based on the belief that it should be possible to build models of economic systems—and financial markets in particular—that are as predictive as those in physics (p. 13).

As a reaction to the GFC, Hopwood (2009) warns of the growing distance of the academic finance base from the complexities of practice and practical institutions. The author considers that academics often have a very limited understanding of finance in practice and that their teaching lacks appropriate consideration for the wider consequences of financial practice: ‘Not only has a great deal of finance research become focused on more abstract considerations but it also is as if a diversity of research perspectives and traditions cannot be tolerated’ (p. 549). For such as Hopwood, the idea of finance as a ‘history’ of events, a social science calling on students to consider, discuss, and formulate essays in defence of their view point—while recognizing that financial history never exactly repeats itself—has given way to the expectation that students be able to demonstrate an understanding of facts and competences in idealized computational problems.

CORPORATE FINANCE AND THE PARADIGM OF THE MM PROPOSITIONS

By the late 1950s, the writings of Karl Popper had done much to exalt the philo- sophical basis of science as the rational process, progressing towards objective truth on the basis of the falsification method of theory selection. At that time, too, the high prestige of the natural sciences encouraged the belief that the modelling of decision making and resource allocation problems could be identified with the elaboration of optimization models and the general extension of techniques from applied math- ematics. In a scientific world, the logical structure of decision making implied that practising managers were likely to make more optimal decisions when supplied with a richer set of positive theories that provided a better understanding of the conse- quences of their choices. It was natural, therefore, that finance theory (along with other social science disciplines) should seek to identify with the scientific method.

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It was into this environment in the late 1950s that MM ushered in their agenda for the modern theory of corporate finance. The objective of the firm was to maximize the wealth of shareholders (as owners of the firm). Thus, the ‘value’ of the firm was its price in the marketplace. The discipline was thereby transformed from an insti- tutional normative literature—motivated by and concerned with topics of direct practitioner relevance, such as the operations of financial institutions and proce- dures for raising long-term finance—into a microeconomic positive science centred around corporate policy decisions and addressing questions such as what are the effects of alternative investment, financing, and dividend policies on a firm’s share price? In this way, corporate financial decision making was formulated as an appli- cation of economic asset valuation models with reference to perfect capital markets (e.g., Fama, 1976, Ch. 5). The idea that corporate financial decision making is inte- grated with ‘management’ in ensuring that the firm can survive and grow—while leaving it to financial markets to offer fair prices to investors—was denied. The outcome is that theories of corporate financial behaviour and of investment finance, such as portfolio investment theory, must be integrated as two sides of the same investment coin.

At the same time as the basic conceptual models of efficient capital markets were being tested against databases of historical capital market price movements, the theoretical implications of the models for business financial decision making were being clarified. It followed that the firm’s key financial decision making nodes, that is, (i) where the firm should be making financial investments (the investment decision), (ii) how the firm should be financing those investments, given available sources of investment finance (the capital structure decision), and (iii) at what point the firm should be returning the fruits of those investments to investors (the dividend decision), must be understood on the basis of providing the firm’s inves- tors with a rate of financial return that at least matches their comparable oppor- tunities elsewhere. In other words, investors’ required expectation of financial return represents a firm’s cost of financial capital, on the basis of which all financial decisions are assessed.

The logical outcome was that firms were exhorted to justify their investment decisions on the basis of the net present value (NPV) of their expected cash flows, discounted by a cost of capital calculated from the CAPM. Notwithstanding the reluctance of practitioners to be in accord with a literal interpretation of the NPV investment criterion, researchers in management accounting and finance by the mid-1970s were generally won over by a belief in its efficacy. A great deal of activity developed around surveying and documenting the extent to which capital budgeting decision makers used, or did not use, various techniques for analysing potential investments. The implication was always that the use of NPV revealed sophistication, whereas the use of methods such as payback and accounting rates of return revealed either ignorance of better methods or irrationality in refusing to adopt better methods. Miller (of MM) (1977) questioned why ‘the pay-back criterion continues to thrive despite having been denounced as Neanderthal in virtually every textbook in finance and accounting over the last 30 years?’ (p. 274).

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Leading from the paradigm of the cost of financial capital, the market value of a firm was pronounced independent of both the firm’s capital structure and its divi- dend policy and the financial objective of management was reduced to identifying those investment opportunities the expected cash flows of which, discounted by the market opportunity cost of investment capital employed, produce a positive NPV (Modigliani and Miller, 1958). When corporate and personal taxes were introduced, it was suggested that firms should never pay dividends and strive to have 100% debt in their capital structures (Modigliani and Miller, 1963; Farrar and Selwyn, 1967; Brennan, 1970). Individuals within the corporation are ignored at this stage, either by assuming that they act as well-trained robots (as in the investment decision) or by paralysing them with the ceteris paribus assumptions that underlie the classical capital structure propositions (Brennan, 1995). Similarly, individuals with whom a corporation must deal—investors, banker, underwriters, bidders, customers, employ- ees, and others—were rendered essentially uninteresting, by treating them as price takers.

In response to the unrealistic corner point solutions generated from such assumptions, the early leading candidates for the study of departures from the MM conditions were bankruptcy costs, financial ‘distress’, transaction costs, and ‘signal- ling’ theory. An explosion of models based on agency theory—with information asymmetry, the nature of implicit and explicit contracts, as well as non-pecuniary considerations, such as reputation and effort aversion—has been motivated by the need to attain reconciliation between the directives of theory and observed prac- tice. Nevertheless, contributions that acknowledge institutional/behavioural dimen- sions are expected to confront the paradigm of perfect markets and present arguments in the language of its terms of reference. As Ross recognizes in a 1988 review of the MM propositions that ‘economists now do look at finance through the eyes of MM’ (p. 133), thereby supporting Weston (1989) and Miller’s (1988) contention (in his own review chapter of the MM propositions) that ‘showing what doesn’t matter can also show, by implication, what does’ (p. 100). Or, again, as Stiglitz (1988) puts it,

Some of the most productive responses to the MM results have come from those who did not feel able to accept the conclusion that financial policy is irrelevant. The MM results force those sceptics to identify which of the assumptions underlying the MM theorem should be modified or rejected (p. 122).

Thus we observe that reconciliation of observed practice with theoretical models continues to be pursued within an MM/cost of capital framework, where mathemati- cal coherence and integrity are a condition for contribution. It may be deemed that a stream of literature has thereby been successfully generated, as a result of which the understanding of corporate financial behaviour has been hugely stimulated and consequently greatly sharpened from both theoretical and empirical perspectives. A glance at such as the Journal of Corporate Finance or the Journal of Finance reveals the striking departure that has taken place from everyday language as a medium in which to develop concepts and ideas to that of the mathematically skilled and the academically rigorous and abstract.

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CORPORATE MANAGEMENT AND STRATEGY

Prior to the MM propositions, textbook writers’ recommendations and prescriptions on corporate finance were formulated as a distillation of experience interpreted by the writer. The major corporate finance textbook prior to the late 1950s was published by Dewing (1919), who advanced principles of judgment for a firm’s investment, financing, and dividend policies on the basis of his observations and experiences over a career covering a wide range of firms.2 Dewing’s argument was that the firm’s most fundamental investment decision is that of determining whether economic circumstances call for either the firm’s expansion or contraction. As simple as the concept may appear, Dewing regarded the enactment of the principle as the essential determinant of a firm’s success or failure—as well as being the decision that most called on management acumen and entrepreneurial skill. He considered that the production of a firm was a direct result of a relatively constant factor in the form of fixed capital investment and a variable factor in the form of human labour, the whole administered by an intangible economic value called entrepreneurial ability. The firm is in equilibrium when its investment strategy is at the point of decreasing returns with expansion.

Dewing’s text progresses to discuss the financial problems incident to obtaining financing for extensions, with special reference to sources of new capital. Neverthe- less, Dewing’s understanding of entrepreneurial activity is never divorced from an understanding of what he terms the humanity of business. His text emphasizes repeatedly that motives other than economic are at play: ‘The impelling springs of human action are difficult to fathom’. For Dewing, business managers retain their human attributes and their solutions of the difficult problems of business expansion often cannot be readily forecast in accordance with economic tenets.3

2 In the MM world, the intuitive normative approach contributions of the early writers could be ignored. Brennan (1995, p. 11), for example, singles out Dewing’s contribution as, ‘detailed institutional fussi- ness’ and Smith’s (1990, p. 3) The Theory of Corporate Finance: a Historical Overview singles out Dewing for dismissal while requiring only a single paragraph to account for corporate finance theory prior to the late 1950s:

The finance literature through the early 1950s consisted in large part of ad hoc theories and institutional detail, but little systematic analysis. For example, Dewing (1919, 1953), the major corporate finance textbook for generations, describes the birth of a corporation and follows it through various policy decisions to its death (bankruptcy). Corporate financial theory prior to the 1950s was riddled with logical inconsistencies and was almost totally prescriptive, that is, norma- tively orientated. The major concerns of the field were optimal investment, financing, and dividend policies, but little consideration was given to the effects of individual incentives, or to the nature of equilibrium in financial markets.

3 Dewing (1919, Vol. 4, p. 4) established the tone of his study of corporate investment decision making with the opening passage to his text:

Four main motives have led men to expand business enterprises. On the whole they are not economic, but rather psychological; they are the motives incident to the struggle for conquest and achievement—the precious legacy of man’s ‘predatory barbarism’. Primarily a man measures the success of a business by increased size, and secondarily by increased profits . . . The race-old instinct of conquest becomes translated in our twentieth century economic world into the prosaic terms of

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The development of frameworks within which the decisions of firms as organi- zations might be understood has continued. Such development, however, is con- strained within what we term management literature, which is effectively divorced from finance. Since early years, management authors have emphasized a world in which managers face overwhelming complexity: decision problems are poten- tially ‘messy’ (Ackoff, 1970), ‘ill-structured’ (Mintzberg et al., 1976; Mitroff and Emshoff, 1979), with ‘wicked problems of organized complexity’ (Mason and Mitroff, 1981, p. 12; Duhaime and Thomas, 1983). The outcome is that problems of investment and financing as encountered by the firm are characterized by challenges of complexity, interconnectedness, uncertainty, ambiguity, conflict, and societal constraints.

Consequently, management authors have stressed that organizations experience tremendous difficulty in responding to change (Starbuck and Hedberg, 1977; Pettigrew, 1985) and that structural and political factors create additional inertia (Mintzberg, 1978; Miller and Friesen, 1980, 1984; Pettigrew, 1985). Dent (1990) considers that this may be explained by the fact that organizations have been selected more or less deterministically to their distinct niches in the first place, on the basis that their particular capabilities are valued. From this perspective, we must be careful even as to the extent to which an organization has volition in its choices (Astley and Van de Ven, 1983). Certainly the capabilities of firms are defined by sunk costs, irreversible investments, and the characteristics of its per- sonnel built up in the past, so that the organization’s strategies are determined by where they have been in the past and by what they have done. Investment deci- sions that are directed at realigning a firm’s competitive posture in terms of new competitive strengths and distinctive competences are the exception (Pfeffer and Salancik, 1978).

Management authors have sought to clarify how, within a paradigm of overarching strategy, a firm’s everyday tactical and implementing activities take place over a range of departments, with engineering, marketing, and production departments responsible for crucial investment decisions (Petty et al., 1975; Ross, 1986; Mukherjee and Henderson, 1987). In this world, although investment proposals must be screened for their strategic fit with a firm, both personal and political reasons (prestige, personal/departmental ambition, empire building) also underlie a project idea’s initial proposal. Thereafter, an individual wishing to carry a new idea through will doubtlessly need the support of others. Negative reactions are part of

corporate growth. Business expansion is the spirit of a modern Tamerlane seeking new markets to conquer. It is a pawn for human ambition. The second motive, less significant, one is led to believe, is the creative impulse . . . It is a commonplace of psychology that somewhere in the mental structure of all of us lies the impulse to build, to see our ideas take form in material results . . . The third motive is the economic. My own observation is that the vast majority of businessmen who plan enlargements, consolidations, and extensions of their business are not actuated primarily by the impulse to make more money, although they unquestionably place this motive uppermost when they need to present plans for enlargement to directors and stockholders . . . And it appears foremost in every business manager’s mind when he attempts to justify a business policy which may have been in the first instance subconsciously prompted by less obvious and more basal motives. . . . The fourth motive is the satisfaction in taking speculative chances . . . All men enjoy the game they think they can play.

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the appraisal process and, for this reason, a new project idea may require a sponsor with reputation who is prepared to back the project and be identified with it (Bower, 1970, p. 77; Hopwood, 1974, p. 134; King, 1975). Reputation based on past perfor- mance and lobbying and exhortations have a part to play as commitment and trust relationships are engendered. Ultimately, the bottom–up development of division plans and top-down portfolio management must come together in the approval of division plans and budgets. At this stage, ultimate endorsement of an investment proposal is likely viewed as an endorsement of the proposer(s) or as a reflection on the track record, prestige, and/or political influence of the proposer(s)/department (e.g., Ross, 1986; Mukherjee and Henderson, 1987). Dempsey (1996) considers the role that managerial credibility has to play in capital investment appraisal by quoting one financial director:

If you get a project and do it well, then you go onto the next one. And then you’ll be given more opportunity. If you don’t, then you’re going to be on the wayside. People are pretty careful. It happens on a human level almost more than on a numbers level. The whole process of who gets selected to do what comes out of people having watched what various people are doing.

Dempsey also references McAulay (1996), who observes that the issue of credibility in management is generally under researched.

From this perspective, managers at tactical and routine levels may more correctly be viewed as implementers rather than as investment decision makers. We might even think of managers as acting out the paradigm of the firm. In this view, a manager’s job is to sense what constitutes a satisfactory level of performance, whose ideas are worth listening to, and what events are significant predictors of future opportunities and calamities. A successful decision maker depends more on an ability to anticipate problems along with an ability to recognize a range of alterna- tive courses of action than on an ability to carefully choose between them. Hence, perhaps, the following managerial response to academic enquiry into their decision making quoted by Dempsey (1996): ‘It’s a matter of applying judgement and common sense. You guys overcomplicate these matters—it’s like I know when the house needs painting!’

Carr et al. (1994) report that German managers view their U.S. and U.K. counter- parts as spending too much time attempting to manipulate financial markets rather than their product base. The German managers believe that a thorough knowledge of the business and the perceived direction of markets, technologies, and competi- tion are more important than financial manoeuvrings and do not believe that the insights of business can be captured in NPV calculations. They consider that the sure grasp of a business can take a lifetime to acquire and that this does not happen for MBA executives who had been parachuted into the industry. Carr et al. (1994, p. 107) quote one chief executive as follows:

Finance is not enough; it must be paired with intuition and intimacy with products, markets and customers. US and UK managers sit too much in their offices over their figures . . . When I talked of intuition it was not just out of the blue. Intuition is the very last thing when you know everything. You have to have every kind of information about your competitors, but the rest is intuition.

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The authors (p. 113) also cite another executive as stating, ‘When it is a success you get a big explosion, and I believed in that explosion’.

From a rule of thumb of five years for payback, product line initiatives are now often expected to redeem themselves within the first couple of years. The future thereafter is likely to be so uncertain that all bets are off, which includes NPV calculations. The heavy industries—the building of power stations, rail, the develop- ment of oil fields—with a commitment to long investment horizons combined with a level of predictability (that their outputs will be required many years from now)— provide the best application of NPV. But even in these more stable, long-term industries, it is unlikely that an NPV calculation actually drives the investment decision and even more unlikely that the calculations make up the totality of the decision making process. Strategic concerns that are subjective are voiced and discussed and the ultimate decision typically represents the best consensus of varied positions and even broadly divergent views.

From a management perspective, increasing shareholder wealth requires increas- ing productivity and (real) earnings per share. This, in turn, requires working through an understanding of the firm in its competitive environment and an unfolding economy, with the intent of safeguarding and potentially expanding the firm’s market position. The firm’s value resides in the complexity of managing and moti- vating divisional performance and of identifying synergies between them. The imple- mentation of such strategy, in turn, requires a sustained commitment to managing the multiple challenges of product improvement, production management, costing, budgeting, human resources, marketing, and strategy. The broader management literature addresses these broader issues, which represent the context within which financial corporate decision making actually takes place. Such complexities, however, are conveniently ignored in the idealized model of the firm as identified by academic corporate finance.

RECENT DEVELOPMENTS IN CORPORATE FINANCE

Shefrin (2001) observes that the traditional approach to corporate finance is based on three concepts: (1) rational behaviour; (2) the CAPM; and (3) efficient markets, but that (a) psychological phenomena prevent decision makers from acting in a rational manner, (b) security risk premiums are not determined by security betas, and (c) market prices are regularly at odds with fundamental values. Thus, all three components of the traditional paradigm are effectively undermined.

The outcome of such observations has been a body of corporate financial research aimed at understanding the psychology of market participants, as financial managers and investors. Much of the impetus for these studies derives from the cognitive psychological experiments of Kahneman and Tversky (1979), as well as of Griffin and Tversky (1992) and Kahneman and Lovallo (1993). For example, their experi- ments show how anchoring occurs during normal decision making when individuals overly rely on a specific piece of information to govern their thought processes. Once

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the anchor is set, there is a bias towards adjusting or interpreting other information to reflect the ‘anchored’ information.4

In this work, the psychological attribute of overconfidence has provided a par- ticular focus for investigation in academic finance. Shefrin (2001) makes the case for overconfidence for both markets and firms.5 Such ‘psychology of the markets’ con- nects with the body of evidence that challenges the traditional view that the collec- tive actions of market participants in setting prices are always rational. In early work, Daniel et al. (1998) advance a model of financial market distortions based on investor overconfidence relating to information in combination with a bias to confirm preconceived views when public information subsequently accords with their bias (while remaining indifferent to information that challenges preconceived views). The essence of this contribution is confirmed by Rabin and Schrag (1999), who state that decision makers have a tendency to interpret new information as confirmatory of prior beliefs and expectations.

The implications of overconfidence for specifically corporate financial decision making have subsequently received a good deal of attention. Following Shefrin (2001) are Gervais and Odean (2001, ‘Learning to be overconfident’), Heaton (2002, ‘Managerial optimism and corporate finance’), and Hilary and Menzly (2006, ‘Does past success lead analysts to become overconfident?’). Heaton (2002), Malmendier and Tate (2005a, 2005b, 2008), and Goel and Thakor (2008) focus on CEO overcon- fidence and the implications for firm corporate investment decisions, while Doukas and Petmezas (2007) (who find that overconfident mangers are liable to engage in a run of ultimately unwise acquisitions) and Ferris et al. (2011) focus on CEO over- confidence in relation to mergers and acquisitions.

The application of overconfidence to a firm’s financing arrangements (capital structure) has been developed by Hackbarth (2008), while Ben-David et al. (2007) develop a link between overconfidence and the firm’s dividend policy decisions, and Hilary and Hsu (2011) apply overconfidence to examine managers’ ability to predict earnings. The application of human psychology to shareholders’ assessment of divi- dends has, of course, long been recognized in the literature, for example, the ‘bird in the hand’ argument for dividends, where investors are more confident about imme- diate dividends than future capital gains, has been rebuked by Miller and Modigliani (1961). Shefrin and Statman (1984) and more recently Baker and Wurgler (2004) have developed arguments for ‘dividend preference’ in the context of Kahneman and Tversky’s (1979) prospect theory.

4 These biases are examined comprehensively in Behavioural Finance: Insights into Irrational Minds and Markets (Montier, 2002), which links the well-documented biases of Tversky and Kahneman to investment behaviour.

5 Although the recognition of investor confidence as a focus for recent studies is typically regarded as a recent development, it connects with the view of markets prior to the advent of the MM propositions. We are reminded, for example, of Keynes’ animal spirits and his recognition that ‘speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done’(Keynes, 1936).

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The implications of cognitive psychology represent a valid dimension in corpo- rate financial decision making. Nevertheless, we observe that the scope of such contributions is restricted to a micro-level focus on understanding how the tradi- tional elements of (i) rational behaviour, (ii) the CAPM, and (iii) efficient markets are perturbed by the cognitive biases of the individual decision maker, about which the core paradigms remain fixed. In effect, behavioural finance is allowed only a narrow interpretation, which fails, for example, to incorporate the social- ization of the workplace and the dynamics of decision making in groups. Thus, although following the GFC the term behavioural finance has become in vogue, it would be a mistake to think that corporate finance has been liberated from its MM antecedents and that the humanity of business (as understood prior to the MM propositions) has been reinstated. We continue to observe finance through the eyes of the old paradigms. The impact of broader behavioural and strategic considerations on the conditioning of human enterprise continues to be avoided.

In response, I consider in the following section how the diverse literature in the area of strategic management might be integrated with that of corporate finance.

TOWARDS A CORPORATE MANAGEMENT CONTEXT FOR BUSINESS FINANCE: REPUTATION, COMMITMENT AND TRUST

The firm typically faces a complexity of possibilities about which it ‘simply does not know’ and for which there exists the possibility of surprise. In addition, because the future holds genuine uncertainty, there exists the genuine possibility of calamity. Because the firm is unable to assess future cash estimates on the basis of unani- mously agreed upon probability density functions for every possible future state, it faces a problem of fundamental uncertainty in specifying the parameters in any given quantitative market valuation model. Following the GFC, we now counte- nance the fact that, fundamentally, things can go wrong. We recognize that financial activities are often highly imperfect and that financial markets are unstable and evolving.

Within such levels of uncertainty, the MM propositions hold that corporate finance can be grounded on fundamental laws of cause and effect, such that, for example, a positive NPV equates with an increase in share value. The teaching of corporate financial management consequently exhorts that risk and uncertainty can be encapsulated in a single NPV calculation. Thus, a firm’s projects can be lined up with given cash flows and shareholder wealth maximized by choosing the projects with the highest NPVs. But this reasoning is far too simplistic. Real decisions are never made in this manner. Even if it were possible to meaningfully attribute additional earnings into the indefinite future as they might derive from initiatives taken today, there exists the almost impossible task of estimating the cost of capital with any degree of accuracy. The cost of capital, in practice, is a nebulous concept. Fama and French (1997) concede that ‘estimates of the cost of equity are distress- ingly imprecise’ (p. 178), and have concluded that project valuation is ‘beset with

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massive uncertainty’ (p. 179).6 Yet, even in business schools, investment decision making within corporations is still taught as the application of cost of capital dis- counted cash flows. As such, the reality of investment decision making within firms is grossly misrepresented.

Having removed the invisible hand of a cost of financial capital as that which works to coordinate the provision and utilization of investment finance in well- functioning markets, we are obliged to postulate alternative mechanisms of coordi- nation. Dempsey (1996) acknowledges that NPV calculations cannot realistically capture the subjective and strategic dimensions of the investment decision and argues that corporate financial activity is more appropriately recognized and under- stood within a framework of (i) reputations based on past performance and (ii) commitment and trust relationships. For example, important investment decisions are made by personnel who have built their reputations based on their past perfor- mance; the firm’s clients respond to reputation and integrity; and reputation, status, and influence are dependent on commitment and trust relationships within and outside the firm. The outcome is that investment decisions are made by people and not by NPV calculations. Dempsey draws on Kay’s (1993) ‘capabilities for success’ (reputation and networks of relations leading to innovation), which he interprets in terms of a reputation/trust perspective.

Consistently, Bruner (2004, 2005), in the context of mergers and acquisitions, reports that business transactions in this area require trust and firms attain sustainability built on reputation. For Bruner, reputation can count for a great deal in shaping the expectations of counterparties. Implicit trust and reputation translate into more effective and economically attractive business transactions. Bonds of trust and reputation actually pay. I would argue that the GFC can be understood as these relationships gone awry, as individuals sacrificed their reputations and that of the firm, along with trust relationships with their clients, because they were seduced by short-term bonuses linked to deal making.

Interestingly, Bruner (2004, 2005) argues that the commitment to advance repu- tation and trust identifies the ethical dimension of business and that unethical practices cannot be expected to provide a foundation for sustainable enterprise. The legacy of a firm’s reputation is the foundation of its sustainability and ‘trust rewards’ when a bond with clients and customers is built by trustworthy behaviour. Bruner (2004) quotes Warren Buffet: ‘We can afford to lose a lot of money. But we cannot afford to lose one shred of our reputation’ (p. 18). In effect, a framework of repu- tation and trust incorporates an ethical dimension for corporate financial activity. It

6 It is interesting to observe that NPV calculations were familiar to early textbook writers. For example, Fisher (1930) considers the choice between alternative investments on the basis of discounted earning streams, with examples of choosing between the allocation of land to farming, forestry, and mining (p. 133). It is even pointed out that the undesirable time shape of the highest discounted earning stream can be remedied by lending out some of the proceeds in earlier years and consequently being paid back with interest in later years. Nevertheless, Fisher states that the choice is being analyzed under unrealistic assumptions of certainty. See also McGoun (1995), who discusses how the methodology of reducing uncertainty to probability distributions was well understood in these earlier times, but that the methods were generally dismissed as not answering managers’ problems facing uncertainty.

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is no longer an add-on to be applied to exceptional circumstances of cheating or deception. Rather, the behavioural practices of institutions and people simultane- ously define the finance industry and its ethical behaviour.

CONCLUSION

In a world where all possible outcomes are quantifiable and risk can be quantified and thereby allowed for, investment decisions are reduced to a quantifiable NPV calculation. In such a world, it may simply be assumed that a firm’s strategy is absorbed by calculations. In practice, it is more likely to be the case that the firm’s investment decisions are absorbed by its strategic priorities, with NPV exercises representing feasibility calculations. Nevertheless, the finance textbooks continue to be embedded in a world of quantifiable NPV calculations.

Good lecturers realize that corporate finance cannot be taught without incorpo- rating what institutions and people actually do and that informed comment, however anecdotal, should be allowed to contribute to a meaningful exposition of the prin- ciples. Nevertheless, a theory’s explanatory capability is circumscribed by the meth- odological approaches it adopts. Thus, with the MM propositions as the paradigm, those contributions that acknowledge the need to allow for an institutional/ behavioural dimension are confined to confront the paradigm of perfect markets and present arguments within its terms of reference. For this reason, the textbooks are advancing only marginally. The GFC is accorded lip service but the subject matter continues to be based on the same static models, which are accepted as truth. In the textbooks, both corporate and investment finance remain subjected to laws of behaviour. Fox (2009) comments that ‘this must be chalked up to the now-universal convention in economics and finance that until something is said mathematically, it has not been said at all’ (p. 31).

The NPV/cost of capital framework remains seductive to business schools that wish to project to students the notion that they are receiving clear and unambiguous knowledge—along with a tool kit for ensuring the correctness of the firm’s invest- ment decisions. The graduate MBA student has been equipped to parachute into a firm and rescue it! But all this is illusion. Indeed, a little knowledge can be danger- ous. What is required is wisdom, a concept that is more difficult to impart to young students with little or no experience of the real world. One reason is that young students are uneasy in the face of ambiguity. Rather than open-endedness, they prefer precise solutions and the traditional finance textbook approach panders to this preference. With mature MBA students, who together possess an assortment of business experiences, the ability to disseminate real-life experiences to the class while maintaining a structure to the lecture (within the lecture’s time frame) will always be challenging. So, again, the easy way out is to follow the textbook, trusting that the (expensive) textbook, by virtue of being a textbook, has authority in the eyes of the class. At the outset, at least, it does. And good lecturers—with sufficient anecdotes and observation of relevant news events—are able to impart real-world wisdom and knowledge. Over-reliance on the textbook, however, will nearly always result in students coming to feel that they are being sold short and that their course

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experience has been reduced to that of being prepared for their final exam questions, with only little expectation of the usefulness of their course thereafter.

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