FISCHER BLACK' S GLOSSARY FOR Fn;Al:CE: SUPPLEflEtiT
FEBRUARY 1983
1
After-tax discounting
For a firm that pays taxes, the right way to find the present value of a
series of cash flows is to estimate the conditional after-tax cash flows
and then discount them at the after-tax interest rate.
If you are discounting the cash flows from a current coupon bond, then
discounting the before-tax cash flows at the before-tax interest rate
will give the current value of the bond, and discounting the after-tax
cash flows at the after-tax interest rate will give the current value of
the bond. However, when discounting a single cash flow, the two
procedures give different results.
If we use the capital asset pricing model, then the correct way to do
after-tax discounting is to use a form of the capital asset pricing ~odel
that contains only the after-tax interest rate.
Bankruptcy costs
When a firm enters bankruptcy, lawyers' fees and other ou t-of-pocke t
costs as a percentage of the value of the firm tend to be quite small.
However, there are other indirect costs which can be quite large. The
firm's suppliers will want to be paid in cash, which may be difficult for
a firm in bankruptcy, and more important, the firm's customers may be
uncomfortable with dealing with a firm that may not be here next year.
They may feel that the firm will not stand behind the products and
services that they buy from it. Thus, total bankruptcy costs are likely
to be quite large as a percentage of the value of the firm, a:od are
likely to far exceed the out-of-pocket bankruptcy costs of the firm.
,?
2
Book return on capital
A fi nn' s or a country's book return on capi tal ind ica tes how we 11 the
finn or the country has been doing in the past. ,fuen the market price of
the firm's stock has been rising, or when the market prices of a
portfolio of the country's stocks have been rising, then the return on
capital or return on equity is likely to be high.
Since it often better to invest in sectors that have been doing well tha~
in sectors that have been doing badly, the return on capital may well
indicate differentials in the return to new investments in these
sectors. Thus, we expect to find that investment in sectors shovdng a
high return on capital is higher than investment in sectors showing 10\,return
on capital.
Changes over time in the book return on capital, however, ,,-ill not tell
us anything that changes in market value don't already tell .....
Conditional cash flows
us •
:~-
A conditional cash flo\! is a cash flml estimated by assuoing that the
return on the market in each period before the cash flow is equal to the
interest rate. If the period is shorter than a year, then we say the
return on the market is equal to interest in each period prior to the
cash flow. One way to find the present value of a project is to estinate
the conditional cash flows from the project and then discount them at the
interest rate.
3
Contestable market
A contestable market is one where there is entry without cost or where
the entrant can recoup the cost of entry if he leaves the industry. In
principle, a market can be contestable even when there are certain kinds
of economies of scale in the market.
For example, there may be a kind of economy of scale in the provision of
airline services between two points. A new entrant would be an airline
that sets up service between those two points in competition "'ith the
existing airlines serving that market. The economy of scale comes from
being able to fill more seats on each flight. The costs of entry and
exit are relatively low, because the planes can be moved to and from
other routes.
If economies of scale are su:ficient, then the service in a contestable
market will be priced at average cost, according to the theory. If it
were priced higher than that the provider would be making profits and a
new entrant would be able to set a lower price and take away all the
business of the old participant in the market.
In practice, however, it is not clear that any markets are close to fully
contestable, because the costs of entering a market seem normally to be
quite large. Moreover, it is very rare that a new entrant will
completely drive out an old participant in a market even when there are
economies of scale. It seems more likely that there will be a
complicated battle for the business and the en~ result will be that the
two participants will share the market.
4
Corporate investment in bonds
Corporate investment in bonds is a zero net present value investment.
Assume that a firm has reached an optimum capital structure. This means
that small changes in the capital structure between bonds and stocks will
not affect the value of the firm or the value of its stock. In
particular, it means that issuing stock to buy the firm's bonds will not
change the value of the stock. But the firm's bonds are an almost
perfect substitute for other bonds. Thus, issuing the firm's stock to
buy other bonds will not change the value of the stock, and it is clear
that issuing the firm's bonds to buy the bonds of other firms will not
change the value of the firm's stock, because the two bonds will cancel.
Thus, at the optimal capital structure, small investments in bonds by a
firm will have about a zero net present value. The firm will be
indifferent to buying small amounts of bonds even though the interest is
taxable.
5
Corporate investment in stocks
Corporate investment in stocks is a negative net present value
investment.
When a firm is at its optimal capital structure, small changes in the
capital structure between bonds and stocks will have no effect on the
value of the firm's stock. In particular, if the firm issues bonds to
buy back a small amount of its stock, there will be no change in the
value of the firm or its stock. Thus, the firm will be indifferent to
buying back a small amount of its own stock.
However, if it buys stock in other firms, it will pay taxes that it would
not pay if it bought stock of its own. It will pay some dividend taxes,
assuming that it pays taxes, and it will pay capital gains taxes if it
realizes capital gains.
Thus, the firm will not be indifferent to investment in stocks of at'.er
firms. It would prefer not to make such investments, at least as a first
approximation.
6
Demand and price with rate of return regulation
In a competitive market, higher demand means a higher price. When demand
is higher than it was expected to be, the price will be higher than it
was expected to be. If regulation is to emulate competition, then we
might expect the same relation between demand and price under
regulation. We'd want a system of regulation under which unexpectedly
high demand will be associated with unexpectedly high price. This will
certainly be true in an industry that shows constant returns to scale and
perhaps does not need to be regulated in the first place.
However, rate of return regulation does not give this result. In the
short run, an increase in demand will not change the rate base but will
provide more units of demand and thus more sources of income to spread
over the rate of return that is allowed on the rate base. When there is
no regulatory lag, an increase in demand in the short run will cause a
decrease in the unit price, because it must leave total ope ra t inL
revenues and thus total rate of return on rate base unchanged.
Regulatory lag will ease this problem but will not eli~inate it. Surely
we would like a system of regulation which will work well when there is
no regulatory lag.
When there are economies of scale in the regulated industry, we might in
fact want the unit price and service provided by the industry to fall
with an increasing demand.
rate base to rise in the
However, we would also want the value of
short run, even when there have been
the
no
additions to the rate base through new investment. Standard methods 0'
rate of return regulation will not give an increase in the value of the
rate base when there is an increase in demand.
7
Differential cash flows
One way to decide on whether or not to undertake a project is to estimate
the differences between the cash flows on the project and the cash flows
on another project, or the differences between the cash flows from this
project and the cash flows that someone else would obtain from the same
project.
For example, a merger will generally make sense only if the buyer will
get higher cash flows than would have been obtained in the absence of the
merger. The premium that can be paid in achieving the merger is the
present value of the difference between the cash flows with the merger
and the cash flows without it.
Similarly, a divestiture is likely to be sensible only if the seller will
receive lower cash flows from the division being sold than the buyer will
receive. The present value of this differential indicates the potential
gain fro~ the divestiture.
Diffuse ownership
The ownership of a firm's stock is diffuse when there are many owners and
no one owner holds a very large percentage of the stock. In this
situation, it will be hard to coordinate the interests of the owners
because no one owner will feel it worthwhile to put out the money or time
that would be required to exercise full control over the directors 0,
managers of the firm. The benefits of any effort put out by one o'tner
wi 11 be shared by the other owners even if they do not themselves pu tout
any effort. This is the cost of diffuse o,mership.
However, diffuse ownership also has a benefit. The benefit is that each
of the owners of the company can own it as a part of a diversified
portfolio of stocks. One way to have the benefits of diffuse ownership
without the costs is to have the firm owned by a few financial
institutions who hold widely diversified portfolios that are in turn held
by individuals.
8
Economic banb"uptcy
A firm faces economic bankruptcy when stockholders are unwilling or
unable under the terms of their debt contracts to use cash on hand, plus
cash available from the sale of assets, plus cash available from issuing
new securities or from new borrowing, to make a currently due payment to
a creditor.
Estimates based on market prices
If we want to estimate the value of a firm that has traded stock, the
first step is to take the market price of the firm's stock. If we have
been estimating cash flows for projects within a firm, and the firm's
stock goes up, or stocks of other firms in similar businesses go up, then
we should doubtless increase our estimates of the cash flows from these
projects. The result is that we will be more likely to take on a given
project the more a firm's stock has been going up ane the more other
related market prices have been going up.
If we need to estimate future interest rates, we can use the tero
structure of interest rates to calculate forward rates. If we neec to
estimate future commodity prices on which there are futures contracts, we
can use the futures prices as if they were the known future commodity
prices.
9
Forward interest rates
If we need to estimate future interest rates, the best way to do so seems
to be to take forward interest rates from bonds of different maturity.
This is likely to be better than asking economists what they thin;-_
interest rates are going to be doing in the future.
Roughly speaking, the forward interest rate is the interest rate that
when compounded with the interest rate on a short-term bond gives the
interest rate on a long-term bond. We can compute forward rates fro[!l
either taxable bonds or tax-exempt bonds. Forward rates on both kinds of
bonds will be affected by default risk, and default risk is often higber
with tax-exempt bonds than with taxable governments.
Moreover, the forward rates on both kinds of bonds will be affected by
the likelihood of tax law changes in the future. If all capital is taxed
at the same rate, and if taxes on capital are suddenly eliminated, then
we would expect taxable interest rates to remain the saQe but tax-exe~?t
interest rates to rise sharply and prices of tax-exeQpt bonds to fall.
If taxes on firms and taxes on real assets are held constant, while taxes
on interest are eliminated, then we would expect taxable interest rates
to fall sharply and tax-exempt rates to remain about the same.
Both these possible changes will affect the differential between forward
taxable rates and forward tax-exe[!lpt rates.
10
Futures prices
The futures price for an agricultural commodity need not be the price
that it is expected to have in the future. The futures price may be
affected by risk premiums associated with
However, the farmer or a processor can
that commodity price •
• ~ .,.YA,,~1
use the futures price as if it
were the price that were known to be the price that the commodity will
have in the future. Using the actual expected future price of the
commodity and then discounting using the appropriate risk premium will
give the same result as using the futures price as if it were he actual
price in the future.
Thus, there is no need to know the risk premiums associated with
commodity prices or the actual expected future prices.
11
General equilibrium and transaction costs
In the standard general equilibrium model, all trading takes place at the
beginning of the economy. Transaction costs are zero and there are
individual securities corresponding to every possible future state at
every possible future time.
However, if there are costs in trading these time- and state-indexed
commodi ties, and if these costs areg~-"at.er .. !he farther in.~_h0.u_~.U.t'e .. ~
th.,,-tj.me .. .in. .. whi.ch .. th~..s;oJll]IlQ(l.l.tJ:"s._"!.11be spotc_o_IDIrl.~..cl.iti.e~, then we \lOU 1d
expect not all trading to take place at the beginning.
Some spot markets might not have corresponding futures markets at all.
Other spot markets might have corresponding futures markets only for a
short time before they become spot markets. This kind of model would
seem to fit the world better than the standard general equilibrium model
with no transaction costs.
Assuming that the transact ion
market, but are the costs to
costs are not tl-je costs of setting u;:> a
t rr-uJf - f? -" "" ,..I )
individuals of trading in the market, we
might still find that a competitive equilibrium in a model like this is
optimal. Thus, we might find that a competitive equilibrium can be
optimal in a model with incomplete markets, if the reason for the
incomplete markets is costly trading in the securities associa ted ,d th
those markets.
12
Gold standard with zero reserves
A gold standard is a system under which the price of gold is fixed in
terms of the local currency. If the local currency is dollars, this
means fixing the price of gold in dollars at any given point in time.
The dollar price of gold may change over time so long as the government
determines what it is at any given point in time.
The simplest way for a government to fix the price of gold is to stand
ready to buy or sell gold at that price. If the government's willingness
to buy or sell gold at that price is unrestricted, then gold will have to
sell for that price.
It might seem that the government would run out of gold fo110,,"ing this
policy, or would accumulate stocks of gold that would be too high. In
fact. though, the government can buy or sell gold at a fixed price
without either running up or running down its stocks of gold
significantly. The key to this is having other transactions Hhich affect
the stock of gold.
A gold standard with zero reserves is one in which the government holds
only working balances of gold and does not hold stocks of gold beyond
these working balances.
If a government is fixing the price of gold by standing ready to buy or
sell it freely at a certain price, it can control its stocks of gold by
engaging in open market operations. For example, if the government buys
bonds with currency, then people receiving that currency who feel that
they have too much currency will reduce the amount of currency that they
have by exchanging it for gold. This will eliminate any excess supply of
gold the government may have.
Similarly, if the government runs down its stocks of gold, it can se 11
bonds in exchange for currency and people who are trying to increase
their stocks of currency will turn gold into the government. Thus, the
government will be able to operate a gold standard wi th no reserves
beyond what it needs for its working inventories.
13
By choosing the path of the price of gold appropriately, the government
can stabilize the consumer price index or any other index that it chooses
to stabilize.
14
Government deficits
supp!.'.~~_-,-,~..::epresJe simplest kind~f---~~-ve~~ment def-i-;;i-t-- as----,,-,
distribution of government debt without __ Jla)'lIlent by any of the people wh.'O.J
receive it. And suppose we assume that the interest on this debt will be
paid with the proceeds of a tax that falls entirely on capital. This tax
will have the effect of reducing saving even if people have bequest
motives. Thus, if taxes associated with higher government debt fall at
least in part on capital, government deficits will have the effect of
reducing total saving.
This e!fect will be reinforced if some people do not have bequest
motives. These people will experience lower taxes without any offsetting
future increase in taxes. Thus, they will consume more and work less,
which means they will save less. These two effects mean that government
deficits can have a considerable effect on total saving.
Imperfect information
A market has imperfect information if some people have information that
others do not have. If everyone acts rationally, no one will trade on
information. Even those who have information will not trade, because
they will find no one to trade with.
On the other hand, if there are people who enjoy trading on noise or we,o
trade on noise out of ignorance, then there may be trading by both noise
traders and information traders. In a market like this, prices will not
perfectly reflect the information that some people have. However, it is
not clear that the existence of imperfect information will have a:oy
macroeconomic consequences.
15
Incentive problems
Incentive problems are problems in inducing an employee or an agent to do
his job. These problems exist because the employee tends to want to 1001:
but for his own interests rather than for the interests of his employer.
Tools like stock options, bonuses, and the threat of firing are used to
help control incentive problems. When defined in the most general
possible way, incentive problems are just management problems.
16
Income and real exchange rates
The income of a country includes the wages earned by that country's
residents plus the return on capital owned by that country's residents.
Income from capital includes both income from capital within the country
and income from capital that residents of the country own outside the
country. The real exchange rate between two countries is the ratio of
the consumer price index in one country and the consumer price index in
the other times the exchange rate between the countries. The rea 1
exchange rate measures the relative price of goods and services produced
in one country and goods and services produced in the other.
One country's income may grow relative to another country's income
because the first country's residents are thriftier than the residents of
the second country. But business cycles provide the main reason for
fluctuations in a country's income in the short run. There is a \iorld
business cycle which affects all countries and there are regional
business cycles which affect countries located in the same area or
countries with similar cultures. But there are also national business
cycles which affect individual countries independent of what is happening
in other countries.
When a country's income rises relative to the income of other countries,
demand for goods and services produced in that country will rise too.
Thus, the price of goods and services produced by the coun try \-,Those
income rises will normally rise relative to the price of the goods and
services produced by other countries. Rising income wi th in a country
will be associated with an decrease in the real value of that country's
currency relative to the values of other countries currencies.
17
Income and the trade balance
A country's income includes both wage income and income from capital.
The capital may be located anywhere, so long as it is owned by residents
of the country. A country's trade balance is measured by the flow of
goods out of the country minus the flow of goods into the country.
Normally, services are not included. Goods flows are measured in dollars
when we are talking about the U.S., or in the local currency when we are
talking about another country.
When times are good and a country's income rises relative to incomes in
other countries, the residents of that country will start consuming more
goods and services relative to consumption of the residents of other
countries. This means they will tend to export less and import more. If
the trade balance is measured as exports minus imports, an increase in
income will thus be associated with a decrease in the trade balance.
Since high incooe is usually regarded as good, we see that a decrease in
the trade balance is often associated with an improvement in a country's
welfare.
18
Incomplete markets
In a general equilibrium model of an economy, markets are incomplete if
some trading for state contingent claims is not done.
Some economists claim that incomplete markets explain the existence of
such phenomena as unemployment. More likely, though, incomplete markets
simply reflect the costs of setting up the markets. U ---~, !
One can imagine a general equilibrium model in which markets initially do
not exist, but as the time associated with the state contingent claim
approaches, the cost of setting up the market declines and the market
starts to operate. Thus, all spot markets will operate and certain
futures markets will operate for a certain period of time before the spot
market starts to operate.
If costs like these are the reasons for incomplete markets, it is not
clear that they will have any macroeconomic consequences.
19
Inflation
Inflation is the rate at which prices increase. While high inflation is
associated with large changes in relative prices, there is no special
evidence that high inflation causes changes in relative prices.
In fact, it may well be that large changes in relative prices cause high
inflation, especially when there are more goods whose relative prices are
decreasing than there are goods whose relative prices are increasing. It
is then easier to increase the prices of a few goods than to decrease the
prices of many goods, and the rate of inflation may increase. If this is
what is going on, then the rate of inflation will decrease when there are
changes that cause a few things to go down in price relative to many
things.
? '
Inflation does not obviously have significant costs for/t~e e~~=~ It
may be associated with shifts of wealth from one group to another, but it
is relatively easy to index various kinds of contracts. If anyone is
concerned about these shifts of wealth, it is fairly easy for that person
to protect himself against them.
20
Inflation and discounting
When discounting cash flows, one can either discount dollar cash flm;s at
nominal interest rates or real cash flows at real interest rates. In a
world without taxes, these two methods will give the same answer.
As a first approximation, the rate of inflation does not affect the
present value of a corporate project, either actual or proposed. It is
possible, however, that the rate of inflation will affect the taxes on a
proposed project.
interest rates for
It is also possible that it will affect the relevant
the project since it will be affecting taxes and
optimal capital structure for projects and firms throughout the economy.
A more precise form of discounting would take into account these effects
of inflation on both after-tax cash flows and after-tax interest rates
used for discounting. As a first approximation, it appears that one can
assume that inflation changes before-tax interest rates point for point,
and thus that inflation changes after-tax interest rates by less than
point for point.
21
Information traders
Information traders are people who buy information and trade on it in the
hope of making a profit. When there are noise traders, information
traders may in fact consistently make profits. The more noise traders
there are, the more profits information traders will make, although the
efficiency of the market will be lower when there are more noise
traders.
Actions that bring in information traders but do not bring in noise
traders, or that bring in more information traders than noise traders,
will tend to increase the efficiency of the market. It is likely that
traders with more wealth are more likely to be information traders, while
traders with less wealth are more likely to be noise traders. It is
likely that traders with more education and more experience in financial
markets are more likely to be information traders than traders with less
education and less experience in financial markets. Thus, it may be
desirable to structure markets so as to encourage traders with more
information, with more education, and with more wealth, and to discourage
other kinds of traders.
22
Insider trading
Insider trading occurs when an individual who has a business relationship
with a finn trades in that firm's stock on the basis of information
obtained through that business relationship. It may also occur when an
individual has a personal relationship with someone who has a business
relationsoip with the firm, or in other ways.
If the information is confidential,
harmed the firm by trading on
then the individual may well have
the information. Under certain
circumstances, at least, it makes sense for the finn to have the right to
sue the individual to recover any losses caused by that trading. Under
other circumstances, it might pay to have insider trading be a criminal
offense.
However, it is not clear that it makes sense for insider trading to be
./ viewed as an offense against the other side uf the trade. Normally,
people do not need to trade in the shares of individual cOQpanies'
stock. They can own shares of mutual funds, and when they need money,
can redeem those shares.
Hutual funds normally don't need to trade in individual companies shares
either. Most redemption by individuals of mutual fund shares can be
balanced against purchases by other individuals of those shares. It is
also common for a mutual fund facing net redemptions to offer for sale
shares in its entire portfolio, or a substantial part of its portfolio,
rather than individual company shares.
Thus, almost anyone can avoid being hurt by insider trading by simply not
trading in the shares of individual companies' stocks. Since trading by
individuals in the stocks of individual companies does not obviously help
other individuals, there is no clear reason for increasing confidence
that individuals can have in doing such trading.
Thus, control of insider trading for the benefit .9LEgS.llSi.LiJ'_~ markets / ,....,;t;:"';
does not seem justified.
23
Management compensation
There is no substitute for supervision in determining the correct
compensation for a manager. The supervisor can take into account all
kinds of factors that may have affected the manager's performance other
than the manager's skill and effort. Objective measurements of the
manager's performance are likely to have been affected by many factors
beyond the manager's control. Thus, no formula or automatic scheme for
management compensation will be an effective substitute for a
supervisor's judgment.
But if an automatic scheme is to be used, the following scheme seems
better than a system of stock options. Give the _ ~an_~~_e,. ___ a __ base_~s".1-".TY
~~~_s_ _' :._~_~'2~~_ _ ~~.! __ ~~_1z.e,;_tt:,=-J?!:"m __ o! a multiple of the stock price of the
firm he works for. This will give the manager an incentive to do things
that will increase the value of the stock. In other words, it "ill
encourage the manager to maximize the value of the firm, just as we would
like managers to do.
Stock options, on the other hand, have rather strange behavior. Horst of
all is that the fact is that the compensation to a manager depends not on
the value of the firm but on the change in the value of the firm. Since
most factors affecting the price of the firm's stock are beyond the
manager's control, it seems too volatile a form of compensation to give
the proper incentives to the manager.
Thus the simplest scheme seems to be best. Simply pay the manager p2rt
of his salary in the form of a constant multiple of the stock price of
the firm.
24
Noise traders
Noise traders are people who act like information traders but whose
information is not systematically either correct or incorrect. They are
people who trade on noise as if it were information.
An increase in the number of noise traders in a market, as may be caused
by reducing the barriers to trading that market, will tend to make prices
less efficient and will thus tend to attract more information traders.
Since it is the less efficient prices that attract the information
traders, we know that an increase in the number of noise traders overall
will be associated with a decline in market efficiency, in spite of the
fact that more information may be generated.
Not-for-profit accounting
A firm that is not managed for profit is typically a firm or organization
that relies on donors for much of its income. Taxpayers may also provide
some of the income of the organization in the for~ of special tax credits
for the donors. Thus, the taxpayers and the donors are the residual
claimants in a not-for-profit organization.
Since their claims do not trade, we cannot seek to define an earnings
figure that corresponds to the earnings figure in a for-profit
organization. It makes no sense to have a target price/earnings ratio in
a not-for-profit organization.
The kind of accounting that is of great interest to donors and taxpayers
emphasizes the cost of providing a given unit of service to the
beneficiaries and the cost of raising the money that the organization
gets from donors.
,7
,
'- ,.,..,,,/ .. r
25
Observables
An observable is something that can be estimated with a reasonable amount
of effort. In both finance and economics, there are sharp distinctions
between quantities that are observable and those that are not.
For example, the price of a security is observable because we can see the
prices at which trades occur, and because we can find out about offers to
buy or sell the security. The expected return on a security, though, is
not observable. There is no easy way to estimate what it is, either for
one individual or for the economy as a whole.
Similarly, the interest rate on a bond is observable, and the short-term
interest rate is observable, but the expected return on a long-term bond
over and above the short-term interest rate is not observable.
The risk of a security is observable whether it is measured by beta or by
total risk, because we can usually observe prices for a securi ty at
frequent intervals and use these observations in estimating its risk.
The price of risk, though, is not observable. The price of risk is the
amount of extra return that we get by bearing an extra unit of risk.
Things like expected return and the price of risk can be estima ted only
by looking at the change in a security's price over a long period. This
will give us an estimate of the average expected return or the average
price of risk over the period that we look at, but will not give uS a
good estimate of the current expected return or the current price of
risk.
Since expected return is not observable, it is very difficult to estimate
the process by which expected return changes through time. It is even
hard to find out what factors might affect the expected return.
In accounting, many quantities are not observable. Such key concepts as
cash flow and accounting depreciation are not easily estimated.
26
Similarly, in economics, some of the most important quantities are not
observable: like national income and saving. Total consumption may be
relatively easy to estimate, but since total income is not easy to
estimate, neither is saving, which is the difference between income and
consumption.
One of the major problems in estimating income is deciding how to deal
with changes in the values of assets. If actual changes in asset values
are used in estimating income, then income H11l be very volatile. If
expected changes in asset values are used, then the fact that expected
changes are unobservable will make income unobservable.
27
Optimal asset and liability structure
The more debt a firm has, the lower its taxes wi 11 be, because its
interest payments will be tax deductible. On the other hand, the more
debt the firm has, the higher its costs of avoiding bankruptcy will be,
and the more likely the firm will be to go into bankruptcy. The costs of
avoiding bankruptcy and the costs if the firm goes into bankruptcy are
likely to be high, because suppliers are not going to deal easily with a
firm that may not pay and customers will be reluctant to buy products
from a firm that is not going to be in a position to stand behind them.
The out-of-pocket legal costs of bankruptcy are likely to be but a small
part of the total cost of bankruptcy.
Reduced taxes from debt and increased bankruptcy costs from debt are not
the only factors in the firm's asset and liability structure, however.
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firm that spins off a division to the managers of the division can often
be doing a profitable thing. At the same time, the managers of a more
specialized firm will be holding some\;hat less well-diversified
portfolios on average since a part of their portfolios will be less well
diversified. This will increase the amount that the firm will have to
pay these managers in salaries. Horeover, a firm that is more
specialized is less well diversified and therefore will be able to
support less debt or will have a higher probability of bankruptcy.
Finally, the larger the dollar value of the firm's common stock, the more
diffuse the ownership of the stock is likely to be, and the greater the
costs of coordinating the interests of the m;ners are likely to be.
All of these factors will affect the firm's optimal asset and liability
structure.
28
Pro forma earnings statements
It is common to evaluate investment projects in a firm by projecting the
earnings of the project after it has reached a stable state and then
multiplying this normal level of earnings by a price/earnings ratio. The
resulting value can then be discounted to the present.
This is an alternative to projecting cash flows and discounting them to
the present. When one uses a discounted cash flow method, the cash flows
are often smoothed in the same way that earnings figures are, so one is
using a method like the pro forma earnings statement method anyway.
Moreover, in using a cash flow method, the terminal value of the project
often plays an important role in its present value, and the earnings
method may have to be used to estimate the terminal value in any case.
The use of a pro forma earnings statement is likely to be just as
accurate as the use of discounted cash flows in evaluating projects.
29
Purchasing power parity
Purchasing power parity means that the relative price of two goods or
services is independent of monetary arrangements. It means that when a
country is using fixed exchange rates, a devaluation will be followed by
price level changes in that country and in other countries that exactly
offset the effects of the devaluation. Thus, a devaluation will not lead
to any changes in relative prices or any changes in trade patterns that
would not have occurred anyway.
It is extremely difficult to tell whether purchasing power parity holds,
because changes in relat ive prices and in trade pa t terns are cons tan tty
occurring whether or not there are changes in exchange rates. Purchasing
power parity simply says that the international economy
equilibrium.
is in
Thus it seems natural to assume that purchasing power parity holds,
unless we come up with striking evidence to the contrary. None of the
evidence against purchasing power parity produced so far is very
convincing. He can assume that purchasing power parity holds ir, both the
short run and the long run.
Reputation
A good reputation has benefits either for an individual or for ar.
organization. It is a principal factor limiting the desire of the
indi vidual or the organization to take advantage of other part ies. For
example, it helps control the desire of stockholders to take advantage of
bondholders, the desire of managers to take advantage of stockholders,
and in general the desire of agents to act in a way that serves their o\ID
interests rather than the interests of their employers. Under favorable
circumstances, an agent's desire to maintain a good reputation can
sharply reduce the costs of controlling the agent.
30
Residual claim
A residual claim on an asset or a business is a claim that comes after
all better defined claims. For example, in an ordinary corporation, the
common stockholders have the residual claims on the business. Their
claims come after the claims of the government, trade creditors,
bondholders, and preferred stockholders. Claims that are senior to the
residual claims are usually defined so that they are not very risky.
Host of the risk in a business is normally borne by the holders of the
residual claims. Thus, it is natural for the holders of the residual
claims on an asset to be defined as the owners, and to have control over
the asset.
Social security
Social security represents a transfer from young to old.
To the extent that people have bequest motives, social security will
accomplish nothing, since it will simply be given back by the old to the
young in the form of bequests. However, there will always be some people
who do not have operative bequest motives and who do not save much for
retirement. These people will consume more with the social security
system than they would have consumed without social security. They lIill
also work less than they would have worked without social security.
Since they will spend more and earn less, their saving will be sharply
reduced. Counting government saving, the saving of people wi th bequest
motives may not be affected by social security. Thus, overall saving
will be reduced by the existence of a simple social security system.
31
Symmetric claims on excess return
A symmetric claim on an asset's excess return is a claim that is
proportional to the excess return. The holder of the claim will receive
a positive amount when the excess return is positive, and a negative
amount when the excess return is negative.
The present value of a symmetric claim on excess returns will be zero.
It is always possible to construct such a claim by borrowing all of the
money needed to buy the asset. The equity for such a position is zero
and therefore the present value of a payoff stream similar to that
obtained from such a position will be zero too.
Thus, for example, a tax of 50% of the excess return on an asset will
have a zero present value to either the government or the taxpayer.
Similarly, an incentive investment advisory fee that is symmetric and is
applied to a portfolio's excess returns will have a zero value to both
the investment advisor and the beneficiary of the portfolio. Hhen the
mmer gives up a symmetric claim on the portfolio, he gives up both some
of the expected excess return on the portfolio and some of the risk.
These two offset one another, so the owner is indifferent.
32
Tender offers
In a tender offer, a firm or group of individuals offers to buy the
shares of a target firm at a price which is generally substantially
higher than the previous market price of the target firm's shares.
A tender offer may be made because the buyers believe they can manage the
target firm better than existing management. The existing managers have
an incentive to try to do a good job, so they won't be fired as a result
of a takeover.
Sometimes tender offers are made by people who believe that the market
price of the target firm's stock is low relative to its value even if the
current managers are kept. Since markets are quite efficient, this
belief is likely to be mistaken more often than it is correct.
Yet another reason for tender offers is that the managers of the firm
making the offer are trying to expand total assets under their control.
They don't mind overpaying for the target firm's stock, because they are
trying to increase the size of the firm they manage and thus their
salaries, rather than trying to maximize the price of the stock of their
firm. The amount of this kind of takeover activity might not increase if
takeovers were made easier, because managers doil.'.~ thi~~rt_ of thiD~
would _be subjec-!:_~-,,-_.tak~Qyer~~h~msel"-~.
For the managers of a potential target firm to resist takeovers by any
means other than working harder is probably not in the long-run interests
of that firm's shareholders. If tender offers are easy to make, then the
premium associated with any given tender offer may not be very high, but
the likelihood of a tender offer will be high. The incentive effects on
managers will tend to increase the price of the firm's stock even if no
actual tender offer occurs.
Thus, it appears that most firms would gain by binding their managers not
to resist tender offers.
33
Transfers and real exchange rates
A transfer is a gift from one country to another. For example, transfers
may take the form of foreign aid. The real exchange rate between two
countries is the ratio of the consumer price indexes in the two countries
times the exchange rate between the countries.
When one country makes a transfer to another, the giver becomes poorer
and receiver becomes richer. Normally, residents of a country will want
more of goods and services produced in that country than they will want
of goods produced in another country. Thus, after a transfer, demand for
goods and services produced by the country receiving the transfer will go
up, and demand for goods and services produced by the country making the
transfer will go down. This means that the relative price of goods and
services produced by the receiving country will rise while the relative
price of goods and services produced by the giving country will fall.
In the normal case, then, the giving country will find that the real
value of its currency rises and the receiving country will find that the
real value of its currency falls.
34
Unemployment
Unemployment arises because individuals make investments under certain
assumptions about future conditions, and those investments turn out to be
inappropriate because conditions turn out to be different than they were
expected to be.
For example, a person may become an expert in timesharing computer
terminals at a time when microcomputers are becoming popular and making
timesharing terminals largely obsolete. That person will then need to
switch, perhaps to being an expert on microcomputers. The process of
making the switch may well result in something that we call
unemployment. There is a cost involved in making this switch but it is a
cost that the individual wants to incur and that society wants him to
incur.
People who are unemployed may be in the process
employer to another within their skill field; or
of moving from
they may be in
one
the
process of moving from one skill field to another, which will usually
take longer; or they may be waiting for conditions to improve wi thin
their skill field before taking another job; or they may be faced by
government restrictions on the availability of jobs for which they are
qualified. For example, minimum wages have the effect of restricting the
availability of jobs for people who would normally earn less than the
minimum wage.
Unemployment fluctuates because business conditions fluctuate, and
business conditions fluctuate because of uncertainty about future demand
and supply conditions. For example, suppose that an expected boOl;] in the
domestic oil business turns into a bust. People employed in the domestic
oil business will have to find other jobs. In the process, many of these
people will be unemployed. Others will simply wait, hoping that the bust
will turn back into a boom, or at least into reasonable demand.
35
Thus, unemployment is associated with fluctuations in demand and supply
across specific sectors of the economy. Total unemployment is simply the
sum of all those unemployed for specific reasons in specific sectors.
When firms and individuals have anticipated correctly what business
conditions will be like, unemployment will tend to be low. However, whelO
firms and individuals have made large mistakes in estimating what
conditions in the future will be like, they will have invested in the
wrong places and will have trained themselves for the wrong jobs, anG
total unemployment will tend to be high.
Under this view of unemployment, there is little that the government can
or should do to change the overall amount of unemployment.
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