American Economic Association Financial Contracting Author(s): Oliver Hart Source: Journal of Economic Literature, Vol. 39, No. 4 (Dec., 2001), pp. 1079-1100 Published by: American Economic Association Stable URL: http://www.jstor.org/stable/2698520 Accessed: 26/03/2009 14:50 Your use of the JSTOR archive indicates your acceptance of JSTOR's Terms and Conditions of Use, available at http://www.jstor.org/page/info/about/policies/terms.jsp. JSTOR's Terms and Conditions of Use provides, in part, that unless you have obtained prior permission, you may not download an entire issue of a journal or multiple copies of articles, and you may use content in the JSTOR archive only for your personal, non-commercial use. Please contact the publisher regarding any further use of this work. Publisher contact information may be obtained at http://www.jstor.org/action/showPublisher?publisherCode=aea. 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Introduction that is, the ratio of the market value of its debt to the market value of its FINANCIAL CONTRACTINGmight be equity?2 described as the theory of what kinds of deals are made between finan- Questions like these have been the ciers and those who need financing. Let focus of much of the very large corpo- me motivate the subject matter of this rate finance literature that has devel- article with the following questions: oped over the last forty years, and they have also been studied in the more (A) Suppose an entrepreneur has an idea recent financial contracting literature. but no money and an investor has My plan is to summarize some of the money but no idea. There are gains older literature (section 2) and then -from trade, but will they be realized? move on to some more recent thinking If the idea (project) gets off the (sections 3 and 4). Section 2 will be de- ground, how will it be financed? liberately brief and will not do justice (B) We see companies around the world to the older literature. Fortunately, with a wide variety of financial struc- there are excellent surveys by Milton tures. Almost all companies have Harris and Artur Raviv (1991), Andrei owners (i.e., shareholders or equity Shleifer and Robert Vishny (1997), and holders). Some have other claimants, Luigi Zingales (2000) that the reader e.g., creditors, preferred sharehold- can consult to supplement what I have ers, etc. Why? Does this matter, for to say. (The latter two papers also example, for corporate efficiency or have insightful things to say about the investment behavior? What deter- financial contracting literature.) mines a company's debt-equity ratio, 1 HarvardUniversity and London School of Eco- 2. Established Views nomics. This article is a revised version of the of Financial Structure Nancy L. Schwartz Lecture delivered at North- western University in June 2000. I would like to The modern corporate finance litera- thank Philippe Aghion, Patrick Bolton, Bengt Holmstrom, John Moore, Andrei Shleifer, and ture starts with the famous Modigliani Jean Tirole for helpful comments; Fritz Foley for and Miller (MM) theorem (Franco excellent research assistance; and Ehud Kalai and Mort Kamien for inviting me to give the lecture. I 2 Post-war, the value of long-term debt of large would also like to acknowledge research support U.S. corporations has been about half the value of from the National Science Foundation through the equity. See Franklin Allen and Douglas Gale National Bureau of Economic Research. (2000). 1079 1080 Journal of Economic Literature, Vol. XXXIX (December 2001) Modigliani and Merton Miller 1958). cently) used to illustrate MM with one This striking irrelevance result can be of Yogi Berra's famous (mis-)sayings: paraphrased as follows: "You better cut the pizza in four pieces because Modigliani-Miller (MM): In an ideal world, I'm not hungry enough to eat where there are no taxes, or incentive or in- six."5 Apart from the crumbs, this formation problems, the way a project or firm seems to sum up the proposition pretty is financed doesn't matter. well. MM, although an enormously impor- A simple (too simple) way to under- tant benchmark, does not seem to de- stand this result is the following. A proj- scribe the world very well. To give one ect can be represented by a stream of example of a problem, if MM were uncertain, future cash flows or (net) empirically accurate, we might expect revenues. Each future revenue is firms to use no debt or large amounts equivalent to some amount of cash to- of debt, or firms' debt-equity ratios day; the exact amount is obtained by to be pretty much random. However, applying a suitable discount factor (if Raghuram Rajan and Zingales (1995) the future revenue is uncertain, we find that similar, systematic factors de- might apply a higher discount factor). termine the debt-equity ratio of firms Now add all the cash equivalents to- in different countries. In fact, I think gether to obtain the total value of the that it would be fair to say that, since its project-its present value, V, say. conception, MM has not been seen as a Suppose the project costs an initial very good description of reality; thus, amount C. Then the project is worth much of the research agenda in corpo- undertaking if and only if V > C, that is, rate finance over the last forty years has if and only if it contributes positive net been concerned with trying to find value. Now we get to MM.3 The finan- "what's missing in MM." ciers of the project-who put up the Researchers have focused on two C-have to get their C back. They can principal missing ingredients: taxes and get it back in a variety of ways: they incentive problems (or asymmetric in- could be given a share s of future reve- formation). In both cases the idea is nues, where sV = C. Or they could get that, because of some "imperfections," some debt (riskless or risky) that has a V is not fixed and financial structure present value equal to C. But, however can affect its magnitude. they get it back, they must get C, and simple arithmetic tells us that the en- 2.1 Taxes trepreneur who sets up the project will get the remainder V - C. That is, from The simplest tax story is the follow- the entrepreneur's point of view (and ing. In many countries, the tax authori- from the financiers') the method of ties favor debt relative to equity: in par- financing doesn't matter.4 ticular, interest payments to creditors Merton Miller (who, sadly, died re- are shielded from the corporate income tax while dividends to shareholders are 3 Actually the result that the project should be undertaken if and only if V > C can also be not. As a result, it is efficient for a firm thought of as being part of MM. to pay out most of its profits in the 4 This informal justification of MM can easily be form of interest-this reduces its tax made rigorous for the case where the entrepre- neur and investors are risk neutral. If the parties bill and thus increases the total amount are risk averse, however, a more subtle, "home- available for shareholders and creditors made leverage" argument is required. See Joseph Stiglitz (1974). 5 See Berra (nd). Hart: Financial Contracting 1081 taken together. (Of course, this increase entrepreneur) who initially owns 100 in firm value is at the expense of society percent of a firm. This manager will since the treasury receives less tax choose not to consume perks since each revenue,) dollar of perks costs more than a dollar This simple tax story is too simple: it in market value (and as owner he bears suggests that we should see much the full cost). Now suppose the man- higher debt-equity ratios than we actu- ager needs to raise capital to expand the ally do. For this reason, it has been firm. One way to do this is to issue eq- elaborated on in various ways.6 But ex- uity to outside investors. However, this tensions of the theory, however in- will dilute the manager's stake-he will genious, do not seem to be adequate to now own less than 100 percent of the explain the data: for example, Rajan and firm. As a result, he will consume perks, Zingales (1995) find that, while taxes in- since the cost of these is borne at least fluence debt-equity ratios, other factors partially by others. As noted, this is in- are important too. efficient since total value (firm value In- fact, in the last few years the plus the value of perks) will fall. literature has focused on a different Alternatively, suppose the manager departure from MM: incentives. borrows to raise capital. At least for small levels of debt, this does not dilute 2.2 Incentive (Agency) Problems the manager's stake.