Business Finance in Less Developed Capital Markets

By Klaus P. Fischer; George J. Papaioannou | Go to book overview

14
Enterprise Governance and Growth: Notes on the Theory of the Firm in Less Developed Capital Markets

STAVROS B. THOMADAKIS

The received neoclassical theory of the firm assumes that there are markets for inputs and outputs in which each item is priced and from which the profit-maximizing firm derives optimal input and output decisions, given its technology. Competitive financial theory supplements the neoclassical paradigm with several elements. The three most critical ones are the following: First, the firm maximizes the market value of its invested capital by appropriately choosing its investments. Second, the value of the firm is reflected in the aggregate value of its outstanding securities, which, however, can be made up of different classes or categories (for example, debt or equity securities). Third, each type of security earns a rate of return commensurate to risk assumed by its holders, and the firm's cost of capital is some weighted average of these required returns. These three elements together constitute the foundation for a theory of the firm.

Market valuation is a linchpin in the competitive financial theory of the firm. It is a mechanism of allocation of resources, since capital is presumably invested in the highest-valued uses before being allocated to lower-valued ones. It is also a barometer of performance, since any errors or negligence in management's decisions will presumably be reflected in a reduction of the firm's value. This, in turn, will both make it more expensive to raise new capital and expose the firm to the threat of takeover and installation of better management policies. Thus, on one hand, market-value processes enable the optimal allocation of new capital to be realized. On the other hand, they also set down a discipline for the best utilization of capital already invested. It is clear that this theory of optimal firm behavior is grounded much more on what goes on outside the firm than on what goes on inside it. It is the capital market environment of the firm that supports the process of valuation and that gives rise to the benchmarks of optimal investment choice and competitive performance.

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