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A getAbstract
compressed History of Corporate Finance
by Jonathan Barron Baskin and Paul J. Miranti Jr. Cambridge University Press, 1999 350 pages
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Take-Aways
Since ancient times, corporate nance has struggled with two issues: risk and information. Early nancial transactions were personal partnerships and loans, not shared ownership. Until recent decades, investors preferred to be creditors holding bonds and debt securities, instead of owners holding equity shares. The imbalance of information between management and shareholders in early markets impeded the fair valuation of equity shares. The immensity of railroad operations led to the creation of modern corporate management structures and the development of broad, impersonal equity markets. The emergence of managerial capitalism permitted vast economies of scale and scope. Innovation in communications and nancial reporting enhanced available information and helped equity markets succeed. When investors are poorly informed, corporations will acquire more debt to maintain the ow of dividends to shareholders. Integrated operations and the extensive accumulation of research and development knowledge benet the modern center rm. Short-term thinking hampers conglomerates and leveraged-buyout partnerships.
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Review
A History of Corporate Finance This thorough, scholarly study balances broad concepts with specic details of the history of nance from the 15th through 20th centuries. Though authors Jonathan Barron Baskin and Paul J. Miranti Jr. assume that the reader has some knowledge of nance and relevant terms, they avoid mathematical models and jargon in favor of plain language. Their book is accessible and valuable to lay readers as well as trained economists, historians, students of nance and anyone coping with an emerging market. The issues they examine remain surprisingly relevant, because as they soon make clear the problems that historical markets once confronted are the same issues of risk and information that markets face today, particularly emerging markets. As a historical study, this book presents no particular prescriptions for success or future action. However, getAbstract.com recommends its explanation of why some structures succeeded and others failed, because those forces have clear implications today.
Abstract
Centuries of Interaction Two central questions of modern nancial theory also shaped nances history: the nancing question focusing on the elements that determine a rms capital structure and the dividend question focusing on factors that control distribution of residual income to shareholders. These questions emerged over ve centuries as risk, knowledge, organization and institutions interacted. Through time, four circumstances drove nancial innovation:
Like many of the unsuccessful industrial mergers of the early twentieth century, the drive to form conglomerates originated from an incomplete understanding of the economics of giant business enterprises.
The inuences that the perennial problems of information and risk have exerted on nance have been evident since the dawn of civilization.
Firms could realize economies of scale and scope by attracting large amounts of capital. Financial innovations could help rms gain from external events, such as weather or war. Firms gained when nancial innovations reduced the perception of risk. Financial innovations helped rms overcome costly imperfections in their markets.
The Pre-Industrial World Even in ancient times, nance was inuenced by the perennial problems of information and risk. In the 10th century, greater literacy and new forms of measurement such as algebra, arithmetic and double-entry bookkeeping spurred an economic revival in Europe. An increase in farm productivity provided a surplus that revived trade with the Byzantine Empire and the Levant. This trade was dominated by Italian citystates, especially Venice and Florence. Italian rms tried to control risk by associating themselves with the state, receiving a state monopoly in exchange for loans to the sovereign.
Florences strategy focused on importing woolens from Northern Europe to correct the chronic trade imbalance between Italy and the North. Most nancial transactions in this period were based on personal contact and relationships. Passive investors of that era wanted debt instruments instead of equity; they preferred being creditors to being
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The South Sea Company experience improved the position of those in the British government who believed that full disclosure of prospective nancing plans was essential for effective nancial markets.
partners. Initially, the Florentines retained the Greco-Roman partnership structure, the societas, a single-voyage arrangement in which partners contributed either equity or labor and each member was potentially liable for the enterprises debts. During the 12th century, though, a new structure arose, the compagnia, which had a more exible capital structure. It was nanced by long-term liabilities, which paid 5% to 10%. The large capitalization of compagnias allowed Florentine banks to expand in scale and scope, diversify their risk, build efcient internal administration structures and experiment with different business strategies. In a different approach to trade, Venice used naval power as leverage to coerce trade concessions from foreign powers. Venetian merchants used the colleganza form of partnership, a single-voyage arrangement similar to the societas, in which one partner contributed funds and remained home while the other contributed time and labor to transporting and selling goods abroad. From 1450 to 1720, oceanic exploration and discoveries, such as the discovery of America and the circumnavigation of the globe, opened new trade channels. In response, the jointstock company was invented. This form beneted from a stable capital base nanced by liabilities with varying maturities, which were supported in turn by transferable equity shares. Equity shares now entered much wider use. By selling stock, these companies increased investor liquidity, reduced transaction costs and concentrated vast amounts of capital, allowing them to achieve previously unattainable economies of scale and scope. Joint-stock companies developed effective management structures for their farung operations, which reduced their information costs. Joint-stock companies allied with the state and used private capital to extend state power. In return, they received Crown monopolies. Starting in the 17th century, England became the leader in creating securities markets. The arrival of mathematical economics and bankings growing exibility fueled innovation. A public debt market arose to help nance Englands wars with France. Dangerous bubbles formed, with Englands South Sea Company and then with Frances rst efforts to create a stock market. Both bubbles ended with crashes that spread across Europe and shattered public condence in equity markets. Markets struggled with high risk and poor information, especially about share valuation. Investors preferred government debt securities because their xed interest payments helped determine their fair market value. Concerns about risk led the English East India Company to establish limited liability status for shareholders in 1662, but the policy did not become general practice until the 19th century.
The most compelling issue in the recent history of U.S. nancial is markets not whether there should be regulatory regimes; it is whether these regimes come within the purview of professional or governmental agencies and what the boundaries of supervisory authority are.
Concerns about risk encouraged efforts during the Middle Ages and the Renaissance to connect the credit of the rm with that of the state.
Broad, anonymous markets rst arose for debt securities because they faced fewer impediments than equity instruments and thus could be more readily sold to distant investors.
The Rise of Modern Industry The rise of railroads, then the worlds most capital-intensive industry, fueled the development of modern corporate nancing and management structures. Early railroads and canals were nanced locally, but the railroads vast expansion required more capital from a larger geographic area, which created broad, impersonal nancial markets. Widespread insider trading and a lack of timely, reliable information retarded the growth of securities markets. Limiting stockholders liability became standard in the U.S. and Britain in the mid-19th century, while the introduction of the telegraph and telephone facilitated transmission of corporate nancial information. Specialized business publications began to appear.
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The development of large-scale trading enterprises was an essential part of the growth of national economies.
The substitution of the rule of law for the divine right of a monarch made investor interests more secure. The guarantee of the nation-state was better protection than the personal promise of the sovereign.
These markets needed to offer a way for investors to have condence in the valuation of securities. Initially, equity investors were often required to contribute additional funds after their initial purchase. Promoters had to screen out potential investors who might not be able to deliver more funds if needed. This impeded the growth of broad markets for common shares. Markets also still struggled with information problems, especially the asymmetry of information between management and investor/owners. Management often manipulated the nancial press for its own gain. Poor knowledge increased the perception of risk, in turn threatening to frustrate the development of nance. Investors preferred debt securities, because they seemed less risky. Preferred stock, with its xedincome guaranteed dividend, addressed this concern and became the most popular vehicle for railroad nance. Preferred stock introduced the lasting idea that stock should provide a xed dividend. This idea actually leads to the accumulation of more corporate debt, under the pecking order hypothesis, which says that because investors poorly understand nancial structures, corporations can retain investor condence by establishing a steady, rising trend of dividends as the base of their nancial policies. In some cases, this means that rms take on debt when they need more capital, rather than issue more equity shares. Managerial capitalism and common stock nance rose from 1900 to 1940. Professional managers, who typically owned only a small percentage of their companies, became the primary decision-makers for large corporations, supplanting founding families. Large corporations could achieve economies of scale through vertical integration, lowering transaction costs by controlling their vital services and supplies, and maintaining demand by controlling marketing. Corporations widened the scope of their businesses and achieved economies through research and development. The management structures inherited from railroads helped create economies of scale in these complex corporations, but new, more decentralized management structures arose to exploit economies of scope. Investors only gradually came to accept and embrace common-share investing. Markets still struggled to set values for shares. Attempts to price shares according to the value of investment in the corporation proved unreliable. Investors were so much more accustomed to bonds (not shares) that dividends were expressed as a percentage of the par value, as if the stock were a bond. Investors sought calculations of par value returns, not capital gains. The public frowned on undistributed prots, feeling that reported earnings should be paid. More and more corporations began to issue common stock. At rst investors were attracted because stocks seemed to share the properties of debt instruments. With better nancial reporting, greater nancial disclosure and improved accounting practices, investors began to look at book value and other methods of stock valuation instead of dividend patterns. In the 1920s, the public realized that equity shares were the best tools for sharing the gains earned by managerial capitalism. The crash of 1929 and the ensuing depression shook investor condence but led to reforms that further improved disclosure and transparency.
The ordering of corporate affairs was made more effective by modern professional management techniques that were perfected in the railroad industry beginning in the 1860s.
Unlike the small, family-controlled rms characteristic of the preindustrial economy, there was a high degree of separation of ownership and control in the modern corporation.
The lack of a clear body of accounting standards encouraged manipulative nancial reporting, and this enhanced the perception of the riskiness of equity investment.
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Center rms were able to achieve dramatic cost savings by establishing organizations that made possible more effective coordination and control of many interdependent operational elements.
Transition to the Contemporary Era Three leading classes of enterprise dominate contemporary nance: the center rm, the conglomerate and the leveraged-buyout partnership. Center rms diversify across many areas of production, expanding into complimentary areas. Ideally, this diversity creates reduced risk and increased return. The huge industrial capacity of center rms fueled the growth of national economies. Center rms have been leaders in research and development, product innovation and the production of capital goods; this has given them great dynamism.
After World War II, markets were bolstered by more and better nancial information. Accounting principles were standardized and more specialized periodicals appeared, sharpening investors knowledge of business affairs. New electronic media spread more information, and spread it faster, helping the markets price-searching function. Conglomerates created vast, diversied companies based upon portfolio theory. Rather than the center rms economies of scale and scope, conglomerates sought economies of nancial transacting. Aided by loose accounting practices, they hedged risk and tried to balance cash ow by investing in unrelated enterprises. The goal was to create synergies, or efciencies, by applying advanced management techniques. In theory, this was bolstered by advancements in management science, computer technology and data processing. High corporate tax rates encouraged the acquisition of rms with net operating losses. In time, though, conglomerates proved unsuccessful. Their thin central management proved inadequate to maximize returns from their diverse divisions and the promised efciencies did not materialize. Leveraged buyouts (LBOs) arose from the belief that managers were acting primarily in their own interests, not in the interest of the shareholders. The partnerships took on large amounts of debt and concentrated ownership among a few general partners, limiting outside investors to the role of creditors.
The enhancement of managerial capacities through improved communications also made possible the concentration of great amounts of nancial capital in business enterprises of great scale and scope.
About The Author
Barron Baskin held degrees from the University of Chicago, Columbia University and Harvard University. From 1985 until his death in 1989, he was associate professor of Finance at Baruch College. Paul J. Miranti holds degrees from Johns Hopkins University and New York University. He is the associate dean in the faculty of management at Rutgers University.
Buzz-Words
Bubbles / Center rm / Colleganza / Compagnia / Conglomerate / Joint-stock company / Leveraged-buyout partnership / Limited liability / Managerial capitalism / Preferred stock / Societas / Vertical integration
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