The Theory of Corporate Finance: A Historical Overview

Michael C. Jensen, Clifford W. Smith, Jr., THE MODERN THEORY OF CORPORATE FINANCE, New York: McGraw-Hill Inc., pp. 2-20, 1984

30 Pages Posted: 29 Sep 2000  

Michael C. Jensen

SSRN; Harvard Business School; National Bureau of Economic Research (NBER); European Corporate Governance Institute (ECGI); Harvard University - Accounting & Control Unit

Clifford W. Smith Jr.

Simon Graduate School of Business, University of Rochester

Abstract

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. 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.

Suggested Citation

Jensen, Michael C. and Smith, Clifford W., The Theory of Corporate Finance: A Historical Overview. Michael C. Jensen, Clifford W. Smith, Jr., THE MODERN THEORY OF CORPORATE FINANCE, New York: McGraw-Hill Inc., pp. 2-20, 1984. Available at SSRN: https://ssrn.com/abstract=244161 or http://dx.doi.org/10.2139/ssrn.244161

Michael C. Jensen (Contact Author)

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Harvard University - Accounting & Control Unit ( email )

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Clifford W. Smith Jr.

Simon Graduate School of Business, University of Rochester ( email )

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