Tribute to Fischer Black

Fischer Black's Contributions to

Corporate Finance
Stewart C. Myers

Stewart C. Myers is the Billard Professor of Einance at the Massachusetts Institute of Technology.

• Fischer Black's impact on corporate finance is "... we might define an efficient market as one in
insufficiently noticed. He did not specialize in that which price . . . is more than half of value and less
subject, and the fame of "Black-Scholes" has drawn than twice value." (1986, p. 533)
attention from his broader contributions.
But Fischer was co-author of the most infiuential "In the real world of research, conventional tests of
early test of the capital asset pricing model (CAPM), [statistical] significance seem almost worthless."
now probably the most widely used tool for estimating (1993a, p. 9)
the opportunity cost of capital and valuing risky real
assets. The CAPM is not essential to the now- —were intended in part to jolt researchers into
accepted framework of corporate finance—any linear questioning conventional methodology or into working
asset pricing model works—but it made that framework on something new. So, in this review, I will emphasize
accessible and, at least in principle, implementable. some things we don't know about corporate finance
The Black-Scholes option pricing model provided and also known problems that are often conveniently
the tools to value the real options embedded in almost forgotten. The review is not a complete survey of
all corporate investments. It also revealed the true Fischer's work or of those parts of his work which may
structure of corporate liabilities. And there are great touch on corporate finance.
Black papers on dividend policy, the normative theory This review starts with the CAPM and its role in the
of corporate investment, the meaning of accounting standard framework of corporate finance. Used
income, and on taxes and pension management. normatively, this framework requires a way of valuing
Fischer had a gift for finding interesting ideas in real assets, and for that task, the CAPM, combined
unexplored or neglected territory. He rarely added twigs with discounted cash fiow (DCF), seems ideal. But of
to existing branches of the literature. Therefore, it pays course there are problems, and Fischer's work on real
to take an interest in what interested him. Some of his investment decisions suggests an alternative
more provocative statements—for example: approach, which I describe in Section II.
Section III considers real options and the
"... dividends that remain taxable will gradually applicability of valuation methods developed for
vanish." (1990, p. 5) traded options. The last section covers financing,
dividend policy, accounting, and tax issues.
"The objective of accounting is to use a set of rules
that makes the price-earnings ratio as constant as
possible." (1980b, p. 6) I. The CAPM and the Standard
Framework for Corporate Finance
This paper was presented at the Berkeley Program in Finance
conference "On Finance: In Honor of Fischer Black" and will
also be published in the conference festschrift. I thank John The standard framework for corporate finance starts
Cox for helpful comments. with a market-value balance sheet.

Financial Management, Voi. 25, No. 4, Winter 1996, pages 95 - 103

96 FiNANCiAL MANAGEMENT / WINTER 1996

PV = IPV. side of the balance sheet.^

PVGO E Thus the $64,000 question is: "How is project value
calculated?" The presumptive answer was discounted
V V cash flow:
» C
pv-Z — ^ (1)
where: ' 1=1 (1 +ri)'

PV ZPV. is the sum of the values of the where:

firm's projects—"projects" refers to C.,= the expected after-tax cash flow for project i
its real assets and existing in period t, extending to a horizon date H;
operations;
r.= the opportunity cost of capital, that is the
PVGO = the present value of future investment expected rate of return offered by securities
opportunities; or portfolios with risks matching project i.-*

D= ZD. = the market value of outstanding But this DCF formula immediately raises three further
securities, excepting equity; questions:

E = the market value of outstanding common 1) What assumptions about the expected cash
stock; and • flows C., are necessary for the formula to work?
2) How can the expected cash flows be estimated?
V - value of the firm 3) What determines r., the opportunity cost of
capital? Is it really likely to be independent of
Note that all entries are current market values. For the timing of cash flows?
example, PV. is the market value of project i if it were
separately traded. The assumed objective is The CAPM offered a possible answer to question 3:
maximization of E, the current value of shareholders'
wealth. r. = r^ + p,(r^-r^) (2)
This balance-sheet model of corporate finance is
more than definitions or an accounting identity. It where r^. is the risk-free interest rate, r^_ - r^ the expected
implicitly assumes that capital markets are tolerably market risk premium, and p. project i's beta. The formula
perfect, efficient, and complete. This assumption as written assumes these parameters are constant.
supports the objective of market-value maximization. The CAPM was potentially an enormous advance in
It also supports value additivity, the assertion that valuing real assets. Beta could, in principle, be
project values add up. The balance sheet says that the estimated from returns on stocks with risks similar to
value of the firm can be calculated by breaking its assets the project under consideration. Estimating the
and operations into discrete projects, valuing each one expected return on the market was harder, but not so
separately, and summing. tough as estimating expected returns on individual
This framework is used normatively as well as securities. Moreover, betas "added up." The CAPM
positively. It governs how much of corporate finance made it easy to see why present values add, and why
is taught. But finance teachers and textbook writers "portfolio effects" have no place in corporate
can't just describe the firm as a value-maximizing bundle investment decisions if shareholders have access to
of projects. Their audiences expect analytical methods perfect and complete capital markets."*
and advice. • • • ^Modigliani and Miller (1958) and Miller and Modigliani
Think of teaching finance in 1970. By then, it was (1961). The latter paper also distinguished PVGO from assets
clear that market-value maximization made sense. The in place.
value-additivity principle had been demonstrated for 'In practice, the opportunity cost of capital would be adjusted
(decreased) to reflect the value of interest tax shields on debt
perfect and (sufficiently) complete markets.' Modigliani supported by the project. The simplest device for this
and Miller's (MM's) papers had shown that financing adjustment is the weighted average cost of capital. See Brealey
and dividend policies ought to have only second-order and Myers (1996, ch. 19). Fischer Black did not consider tax-
effects: value added should come mostly from the left adjusted discount rates, so I bypass this issue in this paper.
•"The irrelevance of portfolio effects was not obvious pre-
CAPM. The analogy between portfolio selection for investors
'Myers (1967). in securities and a firm's choice of investment projects led
MYERS / FISCHER BLACK'S CONTRIBUTiONS TO COPORATE FINANCE 97

But could the CAPM be trusted? By 1970, its theory as well as empirical tests. In the meantime, those
theoretical importance was well understood, but its involved in applied corporate finance will often end
empirical relevance was unknown. Thus, the stage was up using the CAPM, because it is consistent with the
set for Black, Jensen, and Scholes (1972). That paper's balance-sheet model and most of the time seems to
econometric setup, carefully designed to avoid bias give sensible answers. When better asset-pricing
and reduce measurement errors, inspired confidence. models are finally fit for use, the CAPM will depart,
And the paper showed that betas mattered. There was but the balance-sheet model will stay. That model
a significant positive relationship between average seems second-nature today because the CAPM helped
returns and beta from 1931 to 1965, though returns on us understand it.
low-beta portfolios were too high—higher than But Fischer would give a final, contrarian twist to
predicted by the CAPM—and returns on high-beta this story. The balance-sheet model may seem second-
portfolios were too low.' nature to most, but he didn't fully trust it. For example,
In other words, the relationship between return and he offers "irrational pricing" as a partial explanation
beta was too flat—but that could be accommodated in for the CAPM's empirical shortcomings (1993a, p. 10).
generalized versions of the CAPM in which beta plays The balance sheet model assumes rational investors.
its customary role. For example. Black (1972) showed He also disagrees with MM's leverage irrelevance
how the CAPM changes when there is no truly risk- proposition, arguing that corporations should borrow
free asset or when investors face restrictions on, or to take advantage of the too-flat security market line,
extra costs of, borrowing. He offered this generalized thereby substituting corporate for personal leverage.
model as a possible explanation of the too-flat slope I wish he were here to debate this.'^
of the empirical security market line. By the 1990s, he
regarded this model as the most likely explanation.* II. Fischer Black on Corporate
The Black-Jensen-Scholes paper, with Investment Decisions
contemporaneous work by Miller and Scholes (1972)
and others,' gave researchers, teachers, and ultimately
Financial managers, consultants, and textbook
financial managers confidence in the CAPM and
writers now seem comfortable with DCF, but a devil's
therefore a relatively easy way of thinking about risk advocate can easily paint Equation (1) as simple-
and the cost of capital.* The CAPM fit easily into the minded. Here are three common problems:
balance-sheet model of corporate finance and
eventually made that model seem no more than common
1) Estimates of expected cash flows several years
sense.
away are vaporous or biased or maybe both.
Today, that early confidence in the CAPM may seem
2) Even if the CAPM is OK, some betas can't be
misplaced. The positive relationship between beta and
estimated with acceptable accuracy, and there is
average return seems to have disappeared post 1965,
no assurance that future betas approximate past
and other factors, such as size and market-to-book
betas. Estimates of the market risk premium are
ratios, seem much more powerful in explaining
frequently controversial.
differences in average returns.
3) In order to use a constant (not time-varying)
Black (1993a) gives a critical review of much of this
discount rate, detrended cash flows must follow
work and a strong defense of beta and the CAPM.
a geometric random walk with constant
With Fischer Black on its side, the CAPM can't be
proportional variance.'"This implies lognormally
completely dead. The CAPM won't disappear until a
replacement is found—a replacement with support from
'If the security market line has been too flat, then corporations
have had a strong incentive to borrow more, and the supply of
John Lintner. the CAPM's co-inventor, to write that "the corporate debt should have expanded to the point where the
problem of determining the best capital budget of any given effects of any restrictions on investors' borrowing are
size is formally identical to the solution of a security portfolio eliminated and leverage irrelevance holds at the margin. Why
analysis" (1965, p. 65). Several adaptations of portfolio has this not happened? Black (1993a, p. 17) suggests that
selection techniques to corporate investment decisions were corporate managers may be irrationally averse to leverage,
published, including Van Home (1966) and Weingartner (1966). perhaps "carry[ing] over the investor psychology that makes
'A companion paper, Black and Scholes (1974). showed that individuals reluctant to borrow."
the too-flat slope was not attributable to the higher dividend '"In order for r. to be constant (independent of t), beta must
yields of low-beta stocks. be constant from periods I to t. Thus the eovariance of the
'Black (1993a). unexpected change in PV(C|) with the market return must be
'Much of this work appeared in Jensen (1972). constant, and PV(C|) must follow a geometric random walk.
"The CAPM also made it easy to see the risk-return tradeoffs Thus PV,(C,) is lognormal. Since PV|(C, ) = C, , the cash flow
implied by MM's proposition II relating the expected rate of C| must be lognormal too. See Myers and Turnbull (1977),
return on equity to financial leverage. See Hamada (1969). Fama (1977, 1996). and Black and Treynor (1976).
98 FINANCIAL MANAGEMENT/WINTER 1996

distributed cash flows, and rules out negative more periods. Suppose the cash flow is to be received
future cash flows if the expected cash flow is at date 2:
positive." (Managers would love to find projects
with guaranteed positive cash returns. C, =
Unfortunately .. .'^) Mean reversion, as might be
predicted from competitive responses to where e^ captures the noise between dates 0 and 2.
unexpectedly high or low cash flow realizations, The present value of b(l + r^|)(l -i- r^^^), which
is likewise ruled out." corresponds to b dollars invested in the market for
two periods, is again b, and
Black (1988) presents "a simple discounting rule"
that may alleviate some of these problems.
His idea can be put as follows. Suppose that a cash
flow to be received one period hence is linearly related
to the return on the market portfolio: (4a)

C,, = (3) The extension to a long-lived stream of cash flows, as

in the DCF formula given as Equation (1), is
where a is a constant and e^ is independent noise with straightforward.
a mean of zero. The present value of b(l +r^,), which Could this rule help the financial manager? It depends
corresponds to b dollars invested in the market, is just on whether the manager can come up with a conditional
b. The present value of the diversifiable error term e^ forecast of future cash flows. Once such a forecast is
is zero. The present value of the constant a is found in hand, the manager does not need to know the
by discounting at the risk-free rate.'"* Therefore the expected market risk premium r_^ - r^. The manager does
value of a cash flow to be received at date 1 is: not need to know beta or the opportunity cost of
capital. Time-varying or uncertain betas or risk
premiums cause no problems. The manager does not
even have to worry whether the security market line is
too flat. The discount rate for the conditional (certainty
(4) equivalent) cash flow forecast is just the spot Treasury
rate for the date at which the cash flow is to be received.
In other words, the certainty equivalent of C.| is a + But if the manager starts with an unconditional
b(l + r^), the expectation of the cash flow conditional forecast, Black's discounting rule is of much less help.
on r^i = r^. . Black's discounting rule replaces the Such a forecast could, of course, be written down from
unconditional expected cash flow with a the unconditional expectation a H- b(l + r^^) to its
"conservative" forecast which assumes that investors certainty equivalent a -i- b(l -t- r^), but this writedown
in the market end up earning no risk premium. This would require knowledge of b (equivalent to knowing
seems natural: in practice one rarely observes financial beta) and of the difference between r^ and r^ (the
managers varying discount rates project by project, expected market risk premium). In this case, why not
but they do dial in different degrees of conservatism use the conventional DCF formula directly? The only
in forecasting projects' cash flows. disadvantage of doing so is relying explicitly on the
The discounting rule is easily extended to two or CAPM. (Once the conditional, certainty equivalent
"See Fama (1996). cash flow is obtained, the CAPM is discarded.
'^DCF can accommodate negative cash flows if fixed costs are However, the choice of the market portfolio as the
split out and valued separately, so that PV = PV(revenues less traded valuation benchmark may implicitly assume that
variable costs) - PV(fixed costs). Revenues net of variable model. More on this later.)
costs are more likely to be lognormal and strictly positive.
However, this approach requires two discount rates. Fixed costs Fischer claimed that conditional forecasts are, for
are relatively safe and deserve a low discount rate. Net revenues most people, easier than unconditional ones. I think
are also safer than overall project cash flows because he's correct, if the right questions are posed to the
discounting fixed costs separately eliminates operating
forecaster.
leverage.
"The geometric random walk is a natural first description of Suppose the question is put this way: "Assume that
asset values in an information-efficient market. But there is next year's return to investors in the stock market is
no economic reason why a time series of (detrended) cash only the one-year Treasury rate. Then what is next
flows should behave in the same way.
'"Actually, the after-tax risk-free rate, i.e., rj(l - T^), where T^
year's expected cash flow for the proposed expansion
is the marginal corporate rate. See Myers and Ruback (1992). of our refinery?" This question is almost impossible
Here, I have left out taxes for simplicity. to respond to directly, because the manager is given
iVIYERS / FiSCHER BLACK'S CONTRiBUTiONS TO COPORATE FiNANCE 99

no way of translating the assumed market return into expected returns and to choose a benchmark. But if a
assumptions about the business conditions relevant benchmark can be found, and if cash flow forecasts
to refining. can be made conditional on the benchmark return equal
Thus, Fischer's discounting rule seems to call for a to the risk-free rate, then knowing the parameters of
two-step forecast. First construct scenarios for the the asset pricing model is no longer necessary.
business variables corresponding to the Could Fischer's valuation procedure substantially
macroeconomic conditions implied by a market return improve capital investment practice? I think it's worth
equal to the risk-free rate. Then, ask the manager to trying. At least the attempt might wake up casual users
forecast cash flow for these scenarios.'^ If everything of DCF plus CAPM to the assumptions they have been
is done consistently, the result should be the making.
conditional forecast Fischer calls for.
Better still, replace the market with a stock or
III. Real Options
portfolio that's closer to the project under
consideration. For example, the refinery-expansion Fischer's discounting rule works only for project
project's cash flows could be forecasted on the cash fiows that can be expressed as linear functions
assumption that an oil industry portfolio will earn only of security or portfolio returns. In other words, it does
the risk-free rate. Black's reasoning works for any not work for real options or for assets with option-like
benchmark security or portfolio that's priced in an characteristics. In this respect, it is no better than
efficient and competitive market. conventional DCF. To keep things simple, I will set the
Fischer's discounting rule does not require the rule aside and concentrate on the deficiencies of DCF
CAPM, only that the cash fiow can be linked to the when options are important.
traded benchmark by an equation like (3). Suppose How important are real options in corporate
that asset prices conform to a two-factor arbitrage investment decisions? Judging from practice, where
pricing model; for the benchmark portfolio B, explicit real options analyses are very rare, one might
conclude that DCF solves, say, 95% of the investment
valuation problem, leaving option pricing methods as
a possible 5% refinement. In fact, options are at the
where the b's are the benchmark's "betas" on the factor heart of the valuation problem in all but the most
returns, and r, , - r, and r, , - r, the expected pedestrian corporate investments. If I am right in this,
' factor I f factor 2 f "
factor risk premiums. Fischer's discounting rule the option-pricing methods first developed by Black
requires that the project cash fiow depend linearly on and Scholes (1973) are a first-order contribution to
the benchmark's return, and that no factor shows up in corporate finance.
the noise variable e. For the first cash flow at date 1, It's hard to think of an investment project that does
not include important real options:
Cji = a-i-b(l +rg,)-He, (3a)
1) When a new project is undertaken, no one knows
This works only if the project cash flows also depend how long it will last. There is no predetermined
on factors 1 and 2 and have the same relative factor economic life. Successful projects are extended,
weights as the benchmark portfolio. Otherwise the failures cut short. If one views each project as
"surprises" in r^ will show up in the noise term e, and potentially long-lived, then there is a put option
we can no longer assert that the present value of e is to abandon. The exercise price is the value of the
zero even if it has a zero mean. If the present value of project's assets in their next-best use."' This
e is not zero, then Fischer's rule does not apply. abandonment value put is encountered in all
In short, you can't apply Fischer's discounting rule projects, excepting a few with contractually
without choosing an asset pricing model. You need to determined lives. Myers and Majd (1990) have
specify a model to know what factors determine shown the put's importance numerically.
"Construction of the scenarios would start with values for 2) Some investment decisions are "go or no go," now
macroeconomic variables consistent with a stock market rate or never. But when delay is possible, the firm holds
of return equal to the risk-free rate. The macroeconomic a call option to invest. The call is not exercised
variables would in turn imply conditional forecasts for the unless the project's NPV is sufficiently far in the
relevant industry and company variables. Of course there would
be a large number of possible scenarios consistent with r,. = r^, money to justify cutting the call's life short. The
because various combinations of macro variables could yield decision rule, "Invest if NPV is positive," is no
that market performance. A small number of easy-to-interpret
scenarios would have to be chosen. For consistency, each would "The same project could be modeled as short-lived, but could
have to fit in equations like (3) without bias, that is, with the include a call option to reinvest. The exercise price is the
expectation of the noise term e equal to zero. same.
100 FINANCiAL iUIANAGEiViENT / WiNTER 1996

longer right.''' I attribute the lag in applications to two things. First

3)The design of production facilities has to trade is simply lack of understanding. Most financial
off specialization versus fiexibility. Flexibility managers are not comfortable with option pricing
generally costs more, either in investment or methods. They do not fully trust the valuation methods
production costs, but keeps the facilities useful if or grasp the meaning of assumptions and inputs. Thus
the intended product doesn't sell."* the numerical packages usually required look like black
4) Most "strategic" investments involve outlays boxes. Moreover, the language of options is not widely
today undertaken to open up further investment understood. Remember, DCF is not just a tool for
opportunities (i.e., options to invest) tomorrow." valuing projects, it is a way of talking about projects,
Thus a company may enter a new market not to that is, a framework for assembling information and
earn immediate high returns, but to aquire debating projects' prospects. Unless real options can
technology or an established base of customers, or be talked about, calculations of real option values will
to "get down the learning curve" to lower costs not be trusted.
faster than later-entering competitors. These The second, deeper problem is thefuzziness of many
advantages then give the option for follow-on real options. Their terms are not contractual but part
investment. There need be no certainty of positive and parcel of the business. So they have to be identified
NPV for these investments, only the possibility. and modeled before inputs can be estimated and
In fact, the more uncertainty the better, other things valuations calculated. In some cases this is not a big
equal, because options on volatile assets are hurdle. The abandonment put, for example, is easily
always worth more than options on safe ones. recognized, and its exercise price is the "salvage" or
5) Investments in R&D, though neglected in the terminal value used in conventional DCF. But in other
finance literature, are similar to strategic cases, for example, strategic investments or outlays
investments—made not in expectation of for R&D, the real option may be easy to see intuitively
immediate profit, but in hopes of generating follow- but very hard to write down. The option may be too
on investments with positive NPV. compex, or its boundaries not crisply defined.
That may be discouraging for quantitative, normative
My point is that real options are nearly ubiquitous. finance. If the object is positive, that is, to explain
They account for PVGO, the present value of growth corporate investment behavior, option pricing theory
opportunities in the balance-sheet model, and they clearly helps. Managers who have never heard of Black
are embodied in, or attached to, virtually every real and Scholes respond to real options by judgment and
asset or investment project. Thanks to Black and common sense. For example, they make strategic
Scholes (1973), and the financial engineering investments and commit to R&D even when
techniques built on the Black-Scholes theory, these conventional DCF would advise otherwise. So
real options can be valued. I think this is Fischer's financial economists may be able to understand
biggest single contribution to corporate finance. financial managers' actions even though we can't tell
But why are practical valuations of real options so them what to do.
scarce? The most common types of real options have
been identified (and listed earlier) and solution
techniques laid out. Two comprehensive books on the
IV. Financing, Dividend Policy,
analysis of real options have just been publisbed.^" Pensions, and Accounting
The problem is not that option-pricing methods are
untested, or that they require unusual or arbitrary So far, I have concentrated on the biggest general
assumptions. The methods are routinely used in issue in corporate finance, the valuation of real assets
financial markets worldwide. The assumptions required and options. But Fischer Black had important things
to apply the methods to real options are no more to say on many other topics. I will briefly cover four of
stringent than the assumptions required to apply them.

of the project assuming it will last a very long time and (2) the
"See McDonald and Siegel (1986), Ross (1995), and Ingersoll abandonment put. If financial markets are sufficiently
and Ross (1992). complete to justify value maximization as the firm's objective
'"See Triantis and Hodder (1990). and DCF valuation of the underlying asset, then they are also
"See Myers (1984) and Brealey and Myers (1996, ch. 21). complete with respect to options contingent on that asset's
™Dixit and Pindyck (1994) and Trigeorgis (1996). future value. In other words, if investment in the project does
^'Real option applications require identification of an underlying not expand the investors' opportunity set, acquisition of an
asset, usually valued by DCF. For example, the present value option on the project will not expand it either. See also Mason
of a project with uncertain life is the sum of (1) the DCF value and Merton (1985, pp. 38-39).
MYERS / FISCHER BLACK'S CONTRIBUTIONS TO COPORATE FINANCE 101

A. Financing "Why do firms pay dividends? I think investors

simply like dividends. They believe that dividends
Black and Scholes (1973) is doubly famous. It showed enhance stock value . . . and they regard dividends
how to price options and it explained the structure of as a more ready source of wealth because they feel
corporate liabilities. uncomfortable spending out of capital."
Common shares are call options, options to take (or
retain) the firm's assets by paying off its debt. By put-
The information content of dividends now is
call parity, we can also say that the value of debt is
dismissed and the tax disadvantages of dividends
marked down by the value of a default put:
emphasized:
stockholders can put the assets of the firm to its
creditors and walk away without further liability. The
"Changing dividends seems a poor way to tell about
exercise price of the put is the face value of the debt.
a firm's prospects. I think dividends that remain
From this insight, it was clear how the relative taxable will gradually vanish."
prices" of the firm's liabilities are determined. Effects
that might have seemed odd (for example, equity value There is no model or analysis to back these
goes up when the volatility of asset returns increases) statements up, but Fischer's line of thought can be
were obvious. The conflicts of interest between seen pretty clearly. First is the admissability of irrational
stockholders and creditors were easy to see.^^ Thus investors or managers. It's not that people are
the Black-Scholes paper accelerated the development generally stupid. Noise makes it hard to know when
of agency theories of capital structure. our behavior is rational and when it is not. See Black
The value of a debt guarantee equals the value of (1986). Second is the recognition of taxes as a first-
shareholders' default put. An extensive literature on order effect. The tax burden on cash distributed as
debt guarantees, especially deposit insurance, dividends (vs. share repurchases) couldn't be clearer.
therefore started up shortly after Black-Scholes. The What offsetting benefits do cash dividends provide?
moral hazard problems created by deposit insurance Black says investors "like" dividends. He may be right.
were worked out in theory in the 1970s.^'' They were But I think dividends won't be fully understood until
worked out in practice in the savings and loan we have a formal, general agency theory of corporate
industry's subsequent debacle. finance.
Of course, we now use Black-Scholes methods
routinely to price all sorts of corporate securities— C. Pensions
convertibles, warrants, stock options, debt issues
subject to call, etc. Black and Cox (1976), which Speaking of tax effects, how about tax arbitrage?
investigated how bond indenture provisions affected Black (1980a) and Black and Dewhurst (1981) identify
default puts and bond values, was especially influential. an arbitrage opportunity in corporate pension funding.
Suppose a corporation has a defined benefit pension
B. Dividend Policy obligation that it can fund. That is, the Internal
Revenue Service will allow the firm to contribute, say,
Fischer's main contribution to dividend policy was $100 million more to its pension fund. So the firm
to remind us that we don't understand it. In "The borrows $100 million, puts this amount in the pension
Dividend Puzzle," he concluded (1976b, p. 8): and invests in corporate bonds similar to the
corporation's own debt. The new debt liability and
"What should the individual investor do about pension asset exactly offset, except that interest paid
dividends in his portfolio? We don't know." on the corporation's new debt is tax-deductable and
the interest earned in the pension fund is tax-free. For
"What should the corporation do about dividend long-lived pension liabilities and asets, the present
policy? We don't know." value gained is roughly equal to the marginal corporate
tax rate times the amount invested, at today's tax rate
By 1990, he had much more definite opinions:" about $35 million in this example.^*
^^ Nothing in option-pricing theory upsets the Modigliani- So the rule for blue-chip, tax-paying corporations
Miller theorem that the total value of the firm does not depend ought to be, "Borrow and fund the maximum the IRS
on the nature of securities issued against its assets.
" Jensen and Meckling (1976) stressed the temptation to will allow. Put the pension assets in corporate debt."
increase asset ri.sk once debt was issued. Myers (1977) relied
on option valuation theory to show the underinvestment ^' The pension contribution is tax-deductible regardless of
problem, that is, shareholders' reluctance to invest when the whether the pension is funded now or later. This tax shield has
firm has risky debt outstanding. nothing to do with pension funding policy. However, the tax
" Mefton (1978) is an early example. arbitrage argument does ignore the possibility of default on
« Black (1990, p. 5). pension obligations.
102 FINANCIAL MANAGEMENT / WINTER 1996

That's Fischer's advice. He's right: you can't argue "The objective of accounting is to use a set of rules
with arbitrage. I don't understand why his advice isn't that makes the price-earnings ratio as constant as
more widely followed.^' possible." (1980b, p. 6)

D. Accounting This is a testable statement. It implies that price-

earnings ratios vary less cross-sectionally than, say,
I close with one of Fischer's most important and
market-to-book ratios, and that price-earnings ratios
interesting insights, namely the correct definition of
are more stable over time than price, earnings or other
accounting earnings.
common measures such as free cash flow. Fischer's
Economists are trained to think of earnings as
results (in 1993c) seem to confirm this hypothesis..
economic income, that is, cash flow plus change in
value. For stocks, income is obviously dividends plus Accounting is the language of practical finance and
capital gains or losses. Thus we tend to assume that accounting numbers one of the most important sources
accounting income should equal economic income. of information about firms. Yet financial economists
Accountants may say they are shooting for economic have not paid much attention to the "should" and
income, and in some special cases they may even try "why" of accounting. Academic accountants research
to measure it. But as Black (1980b, 1993c) shows, the "why" but rarely the "should."
economic income can't be the true, general objective As Fischer said (1993c, p. 1),
of accounting rules. If it were, the rules would attempt
to measure changes in the value of the firm or its assets, "I am fascinated by the 'should' of accounting
and they clearly do not. rules. We must pick some rules. How should we
What then is accounting income supposed to go about it?"
measure? As far as I know, the accounting literature V. No Conclusions
does not say. Fischer's answer is the only one that
makes sense: all the users of accounting reports What were Fischer's contributions to corporate
finance? We don't know yet. He left us with too many
"... want the same kind of earnings figure. They all open questions and unabsorbed ideas. It's wrong to
want earnings to be a measure of value, not a measure presume to wrap up Fischer's research. So I offer no
of the change in value." (t980b, p. 3) conclusions. •

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