MODELLING SMALLER UK CORPORATIONS: A PORTFOLIO ANALYSIS
| Author | Donald A. Hay,Helen Louri |
| DOI | http://doi.org/10.1111/j.1468-0084.1991.mp53004005.x |
| Date | 01 November 1991 |
| Published date | 01 November 1991 |
OXFORD BULLETIN OF ECONOMICS AND STATISTICS, 53,4(1991)
0305-9049 S3.00
MODELLING SMALLER UK CORPORATIONS:
A PORTFOLIO ANALYSIS
Donald A. Hay and Helen Louri*
I. INTRODUCTION
The research reported in this paper has attempted to model the balance sheet
behaviour of smaller UK corporations. A mean-variance model was used after
extensive experimentation with other portfolio models and different samples.
In a previous paper, Hay and Louri (1989), we applied the mean-variance
framework to balance sheet items of a sample of unquoted UK firms. There
was clear evidence of interdependence between balance sheet items. The
success of this application encouraged us to try a similar framework for
quoted corporations, taking into account the differences between the two
types of firm, particularly the ability of quoted corporations to issue new
equity, and the separation of ownership and control.
Following the seminal contribution of Brainard and Tobin (1968), a
considerable literature has developed on the application of portfolio theory
to the balance sheets of financial institutions. Examples of this literature are
Parkin et aL (1970), Parkin (1970), Sharpe (1973), Courakis (1974, 1975 and
1980). Much of the earlier literature is critically surveyed by Courakis (1988).
The message of these studies is that, according to portfolio theory, assets and
liabilities are simultaneously determined in the balance sheets of financial
institutions, and that this simultaneity should be explicitly addressed in
econometric analyses. The three key assumptions of the theory are: the
decision taker seeks to maximize the expected utility of wealth at some termi-
nal date, the choice between alternative portfolios is determined solely by
expected return and risk (proxied by the mean and variance of returns), and
the decision takers are quantity setters taking as parametric the vector of sto-
chastic yields (costs) on different assets (liabilities).
Given the success of portfolio models of financial institutions, it is surpris-
ing that a similar approach has not generally been taken to the determinants
*We are grateful to Paul Horsnell for programming assistance, to A. Banerjee for econo-
metric advice, to A. Courakis for discussions, to anonymous referees for criticism and sugges-
tions on how to improve the paper, and to the Institute of Economics and Statistics, Oxford, for
research facilities. Helpful comments and suggestions were received from seminar audiences at
EUT, Florence and at Oxford. The research is supported by the SPES programme of the
European Community, Contract Number ERB SPES CT9 15000.
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of the balance sheets of firms. Exception are the papers by Dhrymes and
Kurz (1967), Hay and Morris (1984), and Mueller (1967), Grabowski and
Mueller (1972), which, however, use no formal portfolio model analysis.
Other studies (Bosworth, 1971; Taggart, 1977; Friedman, 1979; Chowdhury,
Green and Miles, 1986; Croasdale, 1988) have restricted their attention to
the financial variables (loans, trade debt and credit, working capital, new
equity issues) in firms balance sheets, presumably on the basis that decisions
about real variables (fixed capital, stocks and work in progress), are prior.
The firm decides on its investment and production plan first, and then seeks
an optimal financing package to enable it to put that plan into effect. With the
exceptions of Taggart and Chowdhury et al. these studies utilize aggregate
data for the whole corporate sector. Once again, there is no analysis of a
formal portfolio model.
The reluctance to pursue a full portfolio model of the balance sheets of
firms can be justified in two ways. Friedman (1979, p. 135) gives his judge-
ment that 'as yet there exists no satisfactory comprehensive theory of how the
firm jointly determines' all the different items in the balance sheet. It is
evident that he regards existing portfolio theory as being inadequate to the
task.Alternative justifications rely on the difficulty of matching the assumptions
of the theory to the reality of firms' experience. First, it is hard to justify the
use of period analysis in a situation where a firm may alter its holdings of
assets and liabilities continuously. One can appeal to the idea of a planning
period, and to the existence of adjustment costs preventing instantaneous
adjustment. But there is no reason to believe that either planning periods or
adjustment costs are the same across all balance sheet items. (Nor that the
planning period is one year, and that the terminal date coincides with the
annual balance sheet drawn up for accounting purposes: but we have to use
annual balance sheets in our empirical work.)
Secondly, the analysis is open to theoretical objection. The analysis arises,
in the case of the portfolio model we are considering, from the assumption
that the agents are risk averse, with preferences described by a negative
exponential utility function in wealth or profits. But the shareholders in a
quoted firm are likely to hold equity as part of a diversified portfolio of
wealth. They will be interested in the covariance risk of their holding, and
quite unconcerned about the variance risks implied in the balance sheet of the
firm. But for the managers of the firm, the variance risks may be very sig-
nificant. They are likely to have substantial human capital sunk in the firm,
and may have equity holdings or equity linked incentives which constitute a
significant part of their private wealth. In particular, where managerial effort
is not observable, a poor financial performance may be taken by the share-
holders as a signal of slack, even where it arises from shocks outside the
control of the managers. The danger for the managers is that shareholders
will be responsive to takeover bids, leading to their dismissal, with con-
sequent loss of their human capital in the firm. Managers are therefore likely
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