The Theory of Corporate Finance

The Theory of Corporate Finance
Jean Tirole
Princeton University Press
Princeton and Oxford

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Copyright © 2006 by Princeton University Press
Published by Princeton University Press,
41 William Street, Princeton, New Jersey 08540
In the United Kingdom: Princeton University Press,
3 Market Place, Woodstock, Oxfordshire OX20 1SY
All rights reserved
Library of Congress Cataloguing-in-Publication Data
Tirole, Jean.
The theory of corporate finance / Jean Tirole.
p. cm.
Includes bibliographical references and index.
ISBN-13: 978-0-691-12556-2 (cloth: alk. paper)
ISBN-10: 0-691-12556-2 (cloth: alk. paper)
1. Corporations—Finance. 2. Business enterprises—Finance.
3. Corporate governance. I. Title.
HG4011.T57 2006
338.4 3 001—dc22
2005052166
British Library Cataloguing-in-Publication Data
A catalogue record for this book is available from the British Library
This book has been composed in LucidaBright and
typeset by T&T Productions Ltd, London
Printed on acid-free paper ∞
www.pup.princeton.edu
Printed in the United States of America
1 2 3 4 5 6 7 8 9 10

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à Naïs, Margot, et Romain

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Contents
Acknowledgements
xi
2
Corporate Financing:
Introduction
1
Some Stylized Facts
75
Overview of the Field and
Coverage of the Book
1
2.1
Introduction
75
Approach
6
2.2
Modigliani–Miller and the Financial
Structure Puzzle
77
Prerequisites and Further Reading
7
2.3
Debt Instruments
80
Some Important Omissions
7
2.4
Equity Instruments
90
References
10
2.5
Financing Patterns
95
2.6
Conclusion
102
Appendixes
I
An Economic Overview of
Corporate Institutions
13
2.7
The Five Cs of Credit Analysis
103
2.8
Loan Covenants
103
References
106
1
Corporate Governance
15
1.1
Introduction: The Separation of
Ownership and Control
15
II
Corporate Financing and
1.2
Managerial Incentives: An Overview
20
Agency Costs
111
1.3
The Board of Directors
29
1.4
Investor Activism
36
1.5
Takeovers and Leveraged Buyouts
43
3
Outside Financing Capacity
113
1.6
Debt as a Governance Mechanism
51
1.7
International Comparisons of
3.1
Introduction
113
the Policy Environment
53
3.2
The Role of Net Worth: A Simple Model
1.8
Shareholder Value or Stakeholder
of Credit Rationing
115
Society?
56
3.3
Debt Overhang
125
Supplementary Section
3.4
Borrowing Capacity: The Equity
1.9
The Stakeholder Society: Incentives and
Multiplier
127
Control Issues
62
Supplementary Sections
Appendixes
3.5
Related Models of Credit Rationing:
1.10 Cadbury Report
65
Inside Equity and Outside Debt
130
1.11 Notes to Tables
67
3.6
Verifiable Income
132
References
68
3.7
Semiverifiable Income
138

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viii
Contents
3.8
Nonverifiable Income
141
6.2
Implications of the Lemons Problem
3.9
Exercises
144
and of Market Breakdown
241
6.3
Dissipative Signals
249
References
154
Supplementary Section
6.4
Contract Design by an Informed Party:
4
Some Determinants of
An Introduction
264
Borrowing Capacity
157
Appendixes
4.1
Introduction: The Quest for
6.5
Optimal Contracting in the
Pledgeable Income
157
Privately-Known-Prospects Model
269
4.2
Boosting the Ability to Borrow:
6.6
The Debt Bias with a Continuum of
Diversification and Its Limits
158
Possible Incomes
270
4.3
Boosting the Ability to Borrow:
6.7
Signaling through Costly Collateral
271
The Costs and Benefits of
Collateralization
164
6.8
Short Maturities as a Signaling Device
271
4.4
The Liquidity–Accountability Tradeoff
171
6.9
Formal Analysis of the Underpricing
4.5
Restraining the Ability to Borrow:
Problem
272
Inalienability of Human Capital
177
6.10 Exercises
273
Supplementary Sections
References
280
4.6
Group Lending and Microfinance
180
4.7
Sequential Projects
183
4.8
Exercises
188
7
Topics: Product Markets and
References
195
Earnings Manipulations
283
7.1
Corporate Finance and Product Markets
283
7.2
Creative Accounting and Other
5
Liquidity and Risk Management, Free
Earnings Manipulations
299
Cash Flow, and Long-Term Finance
199
Supplementary Section
5.1
Introduction
199
7.3
Brander and Lewis’s Cournot Analysis
318
5.2
The Maturity of Liabilities
201
7.4
Exercises
322
5.3
The Liquidity–Scale Tradeoff
207
5.4
Corporate Risk Management
213
References
327
5.5
Endogenous Liquidity Needs, the
Sensitivity of Investment to Cash Flow,
and the Soft Budget Constraint
220
III
Exit and Voice: Passive and
5.6
Free Cash Flow
225
Active Monitoring
331
5.7
Exercises
229
References
235
8
Investors of Passage: Entry, Exit, and
Speculation
333
6
Corporate Financing under
8.1
General Introduction to Monitoring in
Asymmetric Information
237
Corporate Finance
333
8.2
Performance Measurement and the
6.1
Introduction
237
Value of Speculative Information
338

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Contents
ix
8.3
Market Monitoring
345
11
Takeovers
425
8.4
Monitoring on the Debt Side:
Liquidity-Draining versus
11.1 Introduction
425
Liquidity-Neutral Runs
350
8.5
Exercises
353
11.2 The Pure Theory of Takeovers:
A Framework
425
References
353
11.3 Extracting the Raider’s Surplus:
Takeover Defenses as Monopoly Pricing
426
11.4 Takeovers and Managerial Incentives
429
9
Lending Relationships and
Investor Activism
355
11.5 Positive Theory of Takeovers:
Single-Bidder Case
431
9.1
Introduction
355
11.6 Value-Decreasing Raider and the
9.2
Basics of Investor Activism
356
One-Share–One-Vote Result
438
9.3
The Emergence of Share Concentration
366
11.7 Positive Theory of Takeovers:
9.4
Learning by Lending
369
Multiple Bidders
440
9.5
Liquidity Needs of Large Investors and
11.8 Managerial Resistance
441
Short-Termism
374
11.9 Exercise
441
9.6
Exercises
379
References
442
References
382
V
Security Design:
IV
Security Design:
The Demand Side View
445
The Control Right View
385
12
Consumer Liquidity Demand
447
10
Control Rights and Corporate
Governance
387
12.1 Introduction
447
10.1 Introduction
387
12.2 Consumer Liquidity Demand:
The Diamond–Dybvig Model and
10.2 Pledgeable Income and the Allocation
the Term Structure of Interest Rates
447
of Control Rights between Insiders and
Outsiders
389
12.3 Runs
454
10.3 Corporate Governance and Real Control
398
12.4 Heterogenous Consumer Horizons and
the Diversity of Securities
457
10.4 Allocation of Control Rights among
Securityholders
404
Supplementary Sections
Supplementary Sections
12.5 Aggregate Uncertainty and Risk Sharing
461
10.5 Internal Capital Markets
411
12.6 Private Signals and Uniqueness in
10.6 Active Monitoring and Initiative
415
Bank Run Models
463
10.7 Exercises
418
12.7 Exercises
466
References
422
References
467

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x
Contents
15.2 Moving Wealth across States of Nature:
VI
Macroeconomic Implications and
When Is Inside Liquidity Sufficient?
518
the Political Economy of
15.3 Aggregate Liquidity Shortages and
Corporate Finance
469
Liquidity Asset Pricing
523
15.4 Moving Wealth across Time:
The Case of the Corporate
13
Credit Rationing and
Sector as a Net Lender
527
Economic Activity
471
15.5 Exercises
530
13.1 Introduction
471
References
532
13.2 Capital Squeezes and Economic Activity:
The Balance-Sheet Channel
471
13.3 Loanable Funds and the Credit Crunch:
16
Institutions, Public Policy, and
The Lending Channel
478
the Political Economy of Finance
535
13.4 Dynamic Complementarities:
16.1 Introduction
535
Net Worth Effects, Poverty Traps,
and the Financial Accelerator
484
16.2 Contracting Institutions
537
13.5 Dynamic Substitutabilities:
16.3 Property Rights Institutions
544
The Deflationary Impact
16.4 Political Alliances
551
of Past Investment
489
Supplementary Sections
13.6 Exercises
493
16.5 Contracting Institutions,
References
495
Financial Structure, and
Attitudes toward Reform
555
16.6 Property Rights Institutions:
14
Mergers and Acquisitions, and
Are Privately Optimal Maturity
the Equilibrium Determination
Structures Socially Optimal?
560
of Asset Values
497
16.7 Exercises
563
14.1 Introduction
497
References
567
14.2 Valuing Specialized Assets
499
14.3 General Equilibrium Determination of
Asset Values, Borrowing Capacities,
VII
Answers to Selected Exercises,
and Economic Activity:
and Review Problems
569
The Kiyotaki–Moore Model
509
14.4 Exercises
515
Answers to Selected Exercises
571
References
516
Review Problems
625
Answers to Selected Review Problems
633
15
Aggregate Liquidity Shortages and
Liquidity Asset Pricing
517
15.1 Introduction
517
Index
641

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Acknowledgements
While bearing my name as sole author, this book is
I am, of course, entirely responsible for any re-
largely a collective undertaking and would not exist
maining errors and omissions. Needless to say, I will
without the talent and generosity of a large number
be grateful to have these pointed out; comments on
of people.
this book can be either communicated to me directly
First of all, this book owes much to my collabora-
or uploaded on the following website:
tion with Bengt Holmström. Many chapters indeed
http://www.pupress.princeton.edu/titles/8123.html
borrow unrestrainedly from joint work and discus-
Note that this website also contains exercises, an-
sions with him.
swers, and some lecture transparencies which are
This book benefited substantially from the input
available for lecturers to download and adapt for
of researchers and students who helped fashion
their own use, with appropriate acknowledgement.
its form and its content. I am grateful to Philippe
Pierrette Vaissade, my assistant, deserves very
Aghion, Arnoud Boot, Philip Bond, Giacinta Cestone,
special thanks for her high standards and remark-
Gilles Chemla, Jing-Yuang Chiou, Roberta Dessi,
able skills. Her patience with the many revisions dur-
Mathias Dewatripont, Emmanuel Farhi, Antoine
ing the decade over which this book was elaborated
Faure-Grimaud, Daniel Gottlieb, Denis Gromb, Bruno
was matched only by her ever cheerful mood. She
Jullien, Dominique Olié Lauga, Josh Lerner, Marco
just did a wonderful job. I am also grateful to Emily
Pagano, Parag Pathak, Alessandro Pavan, Marek
Gallagher for always making my visits to MIT run
Pycia, Patrick Rey, Jean-Charles Rochet, Bernard
smoothly.
Salanié, Yossi Spiegel, Anton Souvorov, David Sraer,
At Princeton University Press, Richard Baggaley,
Jeremy Stein, Olga Shurchkov, David Thesmar, Flavio
my editor, and Peter Dougherty, its director, pro-
Toxvaerd, Harald Uhlig, Michael Weisbach, and sev-
vided very useful advice and encouragement at var-
eral anonymous reviewers for very helpful com-
ious stages of the production. Jon Wainwright, with
ments.
the help of Sam Clark, at T&T Productions Ltd did a
Jing-Yuang Chiou, Emmanuel Farhi, Denis Gromb,
truly superb job at editing the manuscript and type-
Antoine Faure-Grimaud, Josh Lerner, and Marco
setting the book, and always kept good spirits de-
Pagano in particular were extremely generous with
spite long hours, a tight schedule, and my incessant
their time and gave extremely detailed comments
changes and requests.
on the penultimate draft. They deserve very spe-
I also benefited from very special research en-
cial thanks. Catherine Bobtcheff and Aggey Semenov
vironments and colleagues: foremost, the Institut
provided excellent research assistance on the last
d’Economie Industrielle (IDEI), founded within the
draft.
University of Toulouse 1 by Jean-Jacques Laffont,
Drafts of this book were taught at the Ecole
for its congenial and stimulating environment; and
Polytechnique, the University of Toulouse, the Mas-
also the economics department at MIT and the Ecole
sachusetts Institute of Technology (MIT), Gerzensee,
Nationale des Ponts et Chaussées (CERAS, now part
the University of Lausanne, and Wuhan University;
of Paris Sciences Economiques). The friendly encour-
I am grateful to the students in these institutions
agement of my colleagues in those institutions was
for their comments and suggestions.
invaluable.

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xii
Acknowledgements
My wife, Nathalie, and our children, Naïs, Mar-
the memory of our innumerable discussions, over
got, and Romain, provided much understanding,
the twenty-three years of our collaboration, on the
support, and love during the long period that was
topics of this book, economics more generally, his
needed to bring this book to fruition.
many projects and dreams, and life. He was, for me
Finally, may this book be a (modest) tribute
as for many others, a role model, a mentor, and a
to Jean-Jacques Laffont. Jean-Jacques prematurely
dear friend.
passed away on May 1, 2004. I will always cherish

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Introduction
This introduction has a dual purpose: it explains
risk among investors and the pricing of redundant
the book’s approach and the organization of the
claims by arbitrage.
chapters; and it points up some important topics
Relatedly, Modigliani and Miller in two papers in
that receive insufficient attention in the book (and
1958 and 1963 proved the rather remarkable result
provides an inexhaustive list of references for ad-
that under some conditions a firm’s financial struc-
ditional reading). This introduction will be of most
ture, for example, its choice of leverage or of divi-
use to teachers and graduate students. Anyone with-
dend policy, is irrelevant. The simplest set of such
out a strong economics background who is finding
conditions is the Arrow–Debreu environment (com-
it tough going on a first reading should turn straight
plete markets, no transaction costs, no taxes, no
to Chapter 1.
bankruptcy costs).1 The value of a financial claim is
then equal to the value of the random return of this
Overview of the Field and
claim computed at the Arrow–Debreu prices (that
Coverage of the Book
is, the prices of state-contingent securities, where a
state-contingent security is a security delivering one
The field of corporate finance has undergone a
unit of numéraire in a given state of nature). The to-
tremendous mutation in the past twenty years. A
tal value of a firm, equal to the sum of the values of
substantial and important body of empirical work
the claims it issues, is thus equal to the value of the
has provided a clearer picture of patterns of corpo-
random return of the firm computed at the Arrow–
rate financing and governance, and of their impact
Debreu prices. In other words, the size of the pie is
for firm behavior and macroeconomic activity. On
unaffected by the way it is carved.
the theoretical front, the 1970s came to the view
Because we have little to say about firms’ finan-
that the dominant Arrow–Debreu general equilib-
cial choices and governance in a world in which the
rium model of frictionless markets (presumed per-
Modigliani–Miller Theorem applies, the latter acted
fectly competitive and complete, and unhampered
as a detonator for the theory of corporate finance,
by taxes, transaction costs, and informational asym-
a benchmark whose assumptions needed to be re-
metries) could prove to be a powerful tool for an-
laxed in order to investigate the determinants of
alyzing the pricing of claims in financial markets,
financial structures. In particular, the assumption
but said little about the firms’ financial choices and
that the size of the pie is unaffected by how this pie
about their governance. To the extent that financial
is distributed had to be discarded. Following the lead
claims’ returns depend on some choices such as in-
of a few influential papers written in the 1970s (in
vestments, these choices, in the complete market
particular, Jensen and Meckling 1976; Myers 1977;
paradigm of Arrow and Debreu, are assumed to be
Ross 1977), the principal direction of inquiry since
contractible and therefore are not affected by moral
the 1980s has been to introduce agency problems at
hazard. Furthermore, investors agree on the distri-
various levels of the corporate structure (managerial
bution of a claim’s returns; that is, financial markets
team, specific claimholders).
are not plagued by problems of asymmetric infor-
mation. Viewed through the Arrow–Debreu lens, the
1. For more general conditions, see, for example, Stiglitz (1969,
key issue for financial economists is the allocation of
1973, 1974) and Duffie (1992).

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