2 The Nature of Corporate Finance Law 2.1 Introduction (original) (raw)
This volume will focus on the most abstract principles of corporate finance law. This chapter will explain the definition of corporate finance law presented in the preface. The nature of corporate finance law can be explained on the premiss that the law of corporate finance is regarded as an autonomous discipline. The law of corporate finance has a distinctive character which is based on the unique nature of the tasks it undertakes. 2.2 Key Objectives of Corporate Finance Law For the firm, the law of corporate finance has one distinct objective separating it from other areas of law. The law of corporate finance should help the firm to make decisions regarding its finances in a rational way. 1 While corporate finance provides a framework that helps to make sense of the behaviour of all firms from an economic perspective, the law of corporate finance can help to make sense of the behaviour of all firms from a legal perspective. Perspective of the firm. In the law of corporate finance, the starting point should be the firm. The choice of the perspective of the firm helps to better explain corporate reality. This does not prevent investors from benefiting from corporate finance law in the same way as firms do. First, firms invest in all kinds of things themselves and can often act in the capacity of investors. Second, an investor-even a private person can be regarded as a " firm " when making investment decisions. All investors can thus use the information provided by corporate finance law when making their own investment decisions. The same can be said of funding and exit decisions. Context. The law of corporate finance is applied in the context of investments, funding, exit, and certain existential questions. All firms from small businesses to large multinational companies weigh up alternative investments and alternative ways to obtain funding. The firm will also study different exit alternatives either in 1 The rational choice theory is the prevailing theory of decision-making in microeconom-ics and much of the other social sciences that have been influenced by economics.
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At UCLA we use the text as a second course in finance for MBA students and as the first finance course for doctoral students. We found that requiring all finance majors to take a theory-of-finance course before proceeding to upperlevel courses eliminated a great deal of redundancy. For example, a portfolio theory course that uses the theory of finance as a prerequisite does not have to waste time with the fundamentals. Instead, after a brief review, most of the course can be devoted to more recent developments and applications.
Our purpose is to provide a review of the development of the modern theory of corporate finance. Through the early 1950s the finance literature consisted in large part of ad hoc theories. Dewing (1919; 1953) the major corporate finance textbook for a generation, contains much institutional detail but little systematic analysis. It starts with the birth of a corporation and follows it through various policy decisions to its death (bankruptcy). Corporate financial theory prior to the 1950s was riddled with logical inconsistencies and was almost totally prescriptive, that is, normatively oriented. The major concerns of the field were optimal investment, financing, and dividend policies, but little consideration was given to the effect on these policies of individual incentives, or to the nature of equilibrium in financial markets. The logical structure of decision-making implies that better answers to normative questions are likely to occur when the decision maker has a richer set of positive theories that provide a better understanding of the consequences of his or her choices. This important relation between normative and positive theories often goes unrecognized. Purposeful decisions cannot be made without the explicit or implicit use of positive theories. You cannot decide what action to take and expect to meet your objective if you have no idea about how alternative actions affect the desired outcome—and that is what is meant by a positive theory.1 For example, to choose among alternative financial structures, a manager wants to know how the choices affect expected net cash flows, their riskiness, and therefore how they affect firm value. Using incorrect positive theories leads to decisions that have unexpected and undesirable outcomes. In reviewing the development of the theory of corporative finance we begin in Section 2 with a brief summary of the major theoretical building blocks of financial economics. The major areas of corporate financial policy— capital budgeting, capital structure, and dividend policy—are discussed in Sections 3 through 5.
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