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Corporate Governance Issues and the Financing Decision

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Financing decisions are concerned with how managers raise the funds needed to operate the company. From an accounting or financial statement perspective, the financing methods chosen appear on the liabilities and shareholders’ equity portion of the balance sheet and include bank loans, bonds, capitalized leases, preferred stock, retained earnings, and common stock.

The financing decision is important from a corporate governance perspective because the financial contracts written between the company and the suppliers of capital establish who controls the company and how this control changes if the corporation fails to honor its financial obligations. Just as important, these contracts are used to mitigate conflicts of interests among the stakeholders of the firm. As we've said before, corporate governance is about how the suppliers of capital make sure that they earn a return on the funds placed under the control of managers and make sure that the managers and other stakeholders don't take the money and run.

Financial economists have come a long way in their thinking about financing decisions, a journey that began in the 1950s. At that time, everyone knew that some firms used a lot of debt and others used very little or none. Also, it was apparent that the relative amounts of debt and equity, called financial leverage, also differed by industry. However, no one had really constructed a “scientific” explanation of why and how financial leverage was related to the market value of the company. Thus, the early investigative work focused on questions of market valuation rather than on corporate governance and financial contracting issues and produced a theory of financial leverage under what are called perfect capital market conditions.

We begin with an intuitive explanation of this theory—work for which its developers, Franco Modigliani and Merton Miller, received the Nobel Prize in Economics. The essence of their theory is that in perfect capital markets, the financial decision is irrelevant. But this is not the really interesting prediction made by the theory. The interesting predictions follow from releasing the rigid perfect market assumptions and letting us view financing and financial structure decisions as essentially governance issues with respect to controlling conflicts of interest among corporate stakeholders.
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Document Type: Research Article

Publication date: February 25, 2003

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