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The Firm as a Nexus of Contracts

People always are asking why Finance is fun.  This is it.  This is one of the many reasons why I love Finance.  No matter what we (I?) say when teaching derivatives, etc Finance is still an art.  No where is that more true than in Corporate Finance. 

To look at any one aspect of a company in isolation is inherently incorrect. Similarly, a "holistic" view of the corporation is needed before finance can be investigated.  To get this understanding we need to start at the very beginning (a very good place to start!--apologies to the Sound of Music). 

If this is Corporate Finance (or even investments) we need to know what a corporation is.  We probably remember from our introductory financial classes that a corporation is a legal entity.  Its owners have limited liability, and their shares can be traded. But that is legal talk.  Make it simpler

What is a corporation?  Can you hit it?  Of course not.  A corporation is merely a group of people.  To make things more difficult lets call of the the people-- stakeholders.  Thus whenever you hear stakeholders, think all of the people who have an interest in the corporation.

So a corporation is a group of stakeholders.  Who are these stakeholders?  Oh,  just about anyone you can name.  CEOs, Employees, Bondholders, Vendors, Customers, and most importantly Stockholders.  These stakeholders all have a stake in the firm. (hence the name--pretty imaginative, huh?)   Another way of saying that is to say they have a contract with someone else who is also a stakeholder.  These contracts may be implicit (not written or stated) or explicit.  As everyone has these contracts we have a Nexus of contracts.  (and you thought this was going to be hard! 

So if stekholders are people, what are people?  Here the old DePeche Mode song probably comes closest to the truth: People are people.  Unfortunately that is not very helpful.  So we turn to more academic definitions of mankind. 

Michael Jensen and William Meckling have what many believe to be the best theory of human behavior.  Their view was developed in the 1970s and became the instant classic in the field since.  They categorize Humans as REMMs.

Remms is a model of human nature that maintains humans are Resourceful, Evalautive, and Maximizers.  This means that people are rational, they can make comaprisions, adapt to their environment, and are out to be as well off as possible.  The next section has some notes on their theories as well as a link to the the summary of the Jensen-Meckling paper (which will be online soon). Many of these notes are indirectly from their work. 

However before we go onto to their notes, I must acknowledge that not everyone thinks that their rationality assumption is correct.  There are other models of human nature as well.  In their work in Chew's book Jensen and Meckling discuss many of these views and what was wrong with them.  However, for a contrasting viewpoint one can read the summary of a very interesting speech by Brannen discussing why we can not always assume rationality.

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Teaching notes: When I teach this it comes at the beginning of semester (classes 2-5).  It is a building block that we continually come back to throughout the semester when dealing with issuing securities, executive compensation, and just about everything else.

Additionally my PowerPoint slides for FIN488 at JMU might be beneficial.   We covered the notes in the second through fifth classes of a regular semester and on days two and three of my summer class. (Note JMU classes are 75 minutes long.)