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Contributions to Finance and Accounting

Umberto Sagliaschi
Roberto Savona

Dynamical
Corporate
Finance
An Equilibrium Approach
Contributions to Finance and Accounting
The book series ‘Contributions to Finance and Accounting’ features the latest
research from research areas like financial management, investment, capital markets,
financial institutions, FinTech and financial innovation, accounting methods and
standards, reporting, and corporate governance, among others. Books published in
this series are primarily monographs and edited volumes that present new research
results, both theoretical and empirical, on a clearly defined topic. All books are
published in print and digital formats and disseminated globally.

More information about this series at http://www.springer.com/series/16616

Umberto Sagliaschi • Roberto Savona

Dynamical Corporate
Finance
An Equilibrium Approach
Umberto Sagliaschi Roberto Savona
Quaestio Capital SGR SpA Department of Economics and Management
Milan, Italy University of Brescia
Brescia, Italy

ISSN 2730-6038 ISSN 2730-6046 (electronic)

Contributions to Finance and Accounting
ISBN 978-3-030-77852-1 ISBN 978-3-030-77853-8 (eBook)
https://doi.org/10.1007/978-3-030-77853-8

© The Editor(s) (if applicable) and The Author(s), under exclusive license to Springer Nature Switzerland
AG 2021
This work is subject to copyright. All rights are solely and exclusively licensed by the Publisher, whether
the whole or part of the material is concerned, specifically the rights of translation, reprinting, reuse
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The registered company address is: Gewerbestrasse 11, 6330 Cham, Switzerland
Contents

1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 1
1.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 1
1.2 The Realm of Corporate Finance .. . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 2
1.3 Equilibrium Approach, Market Structure
and Corporate Governance . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 3
1.3.1 Building on the Neoclassical Synthesis. . . .. . . . . . . . . . . . . . . . . . . . 6
1.3.2 Market Completeness, Pricing Kernel
and the Objective of the Firm . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 9
1.4 Roadmap . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 12
1.4.1 Plan of the Book . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 12
1.4.2 Prerequisites.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 14
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 15
2 The Value of the Firm and Its Securities . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 19
2.1 Notation and Basic Setting . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 20
2.1.1 Budget Constraints and Policies . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 22
2.1.2 Default and Bankruptcy Procedures . . . . . . .. . . . . . . . . . . . . . . . . . . . 25
2.2 The Modigliani and Miller Theorems .. . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 27
2.2.1 Irrelevance of Dividend Policy .. . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 27
2.2.2 The Irrelevance of Financing Policy . . . . . . .. . . . . . . . . . . . . . . . . . . . 29
2.2.3 Debt Tax Shield and Bankruptcy Costs . . . .. . . . . . . . . . . . . . . . . . . . 32
2.3 Capital Structure and Corporate Governance . . . . .. . . . . . . . . . . . . . . . . . . . 34
2.3.1 Investment Decisions and Agency Costs . .. . . . . . . . . . . . . . . . . . . . 34
2.3.2 Optimal Investments, Capital Budgeting
and Debt Overhang . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 35
2.3.3 The Value of Corporate Governance .. . . . . .. . . . . . . . . . . . . . . . . . . . 38
2.4 A General Expression for the Value of the Firm. . .. . . . . . . . . . . . . . . . . . . . 46
2.4.1 Abstract Securities . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 46
2.4.2 Restructuring, Renegotiation and Liquidation Procedures.. . . 48
2.4.3 The Value of the Firm . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 49
2.4.4 Dividends, Buybacks and Expected Equity Returns . . . . . . . . . . 51

v
vi Contents

2.5 Related Literature . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 53

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 54
3 Borrowing Constraints, Debt Dynamics and Investment
Decisions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 57
3.1 Collateral Constraints and Optimal Capital Structure .. . . . . . . . . . . . . . . . 58
3.1.1 Secured Debt and Flotation Costs. . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 58
3.1.2 Strict Individual Rationality and Absence of Default Risk . . . 60
3.1.3 The Value of the Firm, Optimal Capital Structure
and The Weighted Average Cost of Capital . . . . . . . . . . . . . . . . . . . 64
3.2 Perfect Product Market Competition and Optimal
investment-Financing Decisions . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 67
3.2.1 The Value of the Unlevered Firm . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 69
3.2.2 Optimal Investment and Financing Decisions .. . . . . . . . . . . . . . . . 72
3.3 Financial Returns and the Investment CAPM . . . . .. . . . . . . . . . . . . . . . . . . . 75
3.3.1 Fundamentals and Securities Returns .. . . . .. . . . . . . . . . . . . . . . . . . . 75
3.3.2 Capital Budgeting and WACC . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 77
3.3.3 The Hamada Equation .. . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 78
3.3.4 The Investment CAPM and the Cross-Section
of Equity Returns . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 78
3.4 Debt Agency Costs and the Trade-off Theory . . . . .. . . . . . . . . . . . . . . . . . . . 79
3.5 Related Literature . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 81
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 83
4 Imperfect Competition, Working Capital and Tobin’s Q.. . . . . . . . . . . . . . . 85
4.1 The Limits of Perfect Product Markets Competition .. . . . . . . . . . . . . . . . . 86
4.2 Monopolistic Competition and Market Power .. . . .. . . . . . . . . . . . . . . . . . . . 88
4.2.1 Timing of Decisions and Optimal Price Setting .. . . . . . . . . . . . . . 89
4.2.2 Optimal Investment and Financing Decisions .. . . . . . . . . . . . . . . . 92
4.2.3 Constant Price Elasticity of Demand and the Value
of the Firm . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 94
4.3 Imperfect Competition and the Cross-Section of Stock Returns.. . . . . 96
4.3.1 Tobin’s Q, Expected Stock Returns and Residual Income .. . . 96
4.3.2 Empirical Considerations.. . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 99
4.4 Equilibrium Models and Security Analysis . . . . . . . .. . . . . . . . . . . . . . . . . . . . 103
4.4.1 A Simple Quantitative Model . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 103
4.4.2 Expected Fundamentals . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 104
4.4.3 Stock Market Multiples and Valuation Models.. . . . . . . . . . . . . . . 106
4.5 Related Literature . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 109
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 110
5 Continuous Time Models, Unsecured Debt and Commitment .. . . . . . . . . 113
5.1 General Setting and Valuation .. . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 114
5.1.1 The Setting .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 114
5.1.2 The Value of the Firm and Its Securities. . .. . . . . . . . . . . . . . . . . . . . 116
Contents vii

5.2 The Hamilton–Jacobi–Bellman Approach .. . . . . . . .. . . . . . . . . . . . . . . . . . . . 118

5.2.1 Risk-Neutral Valuation . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 121
5.3 Commitment, Optimal Default and the Static Trade-off
Theory of Capital Structure.. . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 123
5.3.1 Option to Default and Expected Default Time . . . . . . . . . . . . . . . . 125
5.3.2 The Optimal Default Boundary . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 129
5.3.3 Optimal Static Capital Structure . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 130
5.3.4 Credit Spreads in the Leland Model . . . . . . .. . . . . . . . . . . . . . . . . . . . 131
5.4 Endogenous Investment and Agency Costs of Capital Structure . . . . . 133
5.4.1 Debt Overhang .. . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 133
5.4.2 Risk-Shifting .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 137
5.5 Related Literature . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 140
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 141
6 Dynamic Capital Structure without Commitment . . .. . . . . . . . . . . . . . . . . . . . 143
6.1 Commitment, Time Consistency and Debt Capacity .. . . . . . . . . . . . . . . . . 145
6.2 A Discrete Time Model .. . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 147
6.2.1 The Leverage Ratchet Effect . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 147
6.2.2 The Coase Conjecture . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 150
6.3 The Continuous Time Case . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 151
6.3.1 An Irrelevance Result . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 151
6.3.2 Global Optimality and the Leverage Ratchet Effect . . . . . . . . . . 153
6.3.3 The Value of the Firm . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 155
6.3.4 Leverage Dynamics .. . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 157
6.3.5 Positive Recovery Values .. . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 159
6.4 Endogenous Investment and The Cost of Capital .. . . . . . . . . . . . . . . . . . . . 162
6.4.1 Debt Overhang .. . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 162
6.4.2 Risk Shifting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 163
6.4.3 The Weighted Average Cost of Capital . . . .. . . . . . . . . . . . . . . . . . . . 165
6.5 Related Literature . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 168
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 169
7 Extensions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 171
7.1 A Quantitative Corporate Finance Model . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 172
7.1.1 Model Set-Up . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 172
7.1.2 Optimal Production and Pricing Decisions .. . . . . . . . . . . . . . . . . . . 175
7.1.3 Optimal Investment and Financing Decisions .. . . . . . . . . . . . . . . . 177
7.2 Borrowing Constraints .. . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 180
7.2.1 The Model.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 180
7.2.2 The Cross-Section of Stock Returns . . . . . .. . . . . . . . . . . . . . . . . . . . 183
7.3 An Introduction to Numerical Solution Methods
and Structural Econometrics.. . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 184
7.3.1 Discrete Dynamic Programming .. . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 184
7.3.2 The case of Defaultable Debt . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 188
7.3.3 The Generalized Method of Moments . . . . .. . . . . . . . . . . . . . . . . . . . 189
viii Contents

7.4 Non-Markov Perfect Equilibria . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 191

7.4.1 The Setting .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 192
7.4.2 Constant Leverage Policies. . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 193
7.4.3 Time-Consistent Constant Leverage Policies.. . . . . . . . . . . . . . . . . 195
7.4.4 Limits to Tax-Deductibility of Interest Expenses . . . . . . . . . . . . . 196
7.4.5 Final Considerations .. . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 197
Appendix . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 198
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 201
Chapter 1
Introduction

1.1 Introduction

The way in which leverage and its expected dynamics impact on firm valuation
is very different from the assumptions of the traditional static capital structure
framework. The purpose of this book is to re-characterize the firm’s valuation
process within a dynamical capital structure environment, by drawing on a vast body
of recent and more traditional theoretical insights and empirical findings on firm
evaluation, also including asset pricing literature. We offer a new setting in which
practitioners and researchers are provided with new tools to anticipate changes in
capital structure and setting prices for firm’s debt and equity accordingly.
We introduce the reader to selected theoretical models in corporate finance that
can be used to understand investment and financial decisions on the firms’ side,
their interdependence and related impacts on the value of corporate securities,
such as stocks and bonds. The book is then intended mostly for graduate/phd
students, researchers and financial professionals who are interested in modeling
asset prices and corporate strategy decisions. Our approach is sometimes referred
as “supply-side” or “investment-based” asset pricing, and it complements with the
more traditional approach deriving from the application of optimal portfolio theory.
The success of this approach (see Zhang 2017), is the possibility to leverage the
large availability of corporate data and partly overcome aggregation problems, as
opposed to demand side models, such as the Consumption Capital Asset Pricing
Model (e.g., Rubinstein 1976; Lucas 1978; Breeden 1979), which instead requires
to know investors’ preferences. To some extent, dynamic corporate finance is the
crossroads where equilibrium asset pricing meets the scope of firms’ production,
investment and financing decisions. In this regard, the book is also intended to
provide a guidance for an advanced practice of equity valuation. To make an
example, consider the practical problem of valuing the debt tax shield. At which
rate should we discount future tax benefits of debt, and how future financial leverage

© The Author(s), under exclusive license to Springer Nature Switzerland AG 2021 1

U. Sagliaschi, R. Savona, Dynamical Corporate Finance, Contributions
to Finance and Accounting, https://doi.org/10.1007/978-3-030-77853-8_1
2 1 Introduction

decisions should be factored in the same valuation process? This book is conceived
to give theoretical and pragmatical answers to questions such as these.
We have decided to keep the book intentionally synthetic, exploring in more
depth only those parts we believe to be relevant for both academics and practitioners.
While we do not cover the complete literature on dynamical capital structure, we
provide a large number of references for the readers wishing to understand in more
depth the technical details of the topics we deal with. However, some topics of
corporate finance theory have been intentionally excluded for reasons of scope and
space. The major exclusion is the field of security design, for which a huge literature
was developed in the last 20 years of the past century (see Hart 1995). In other
words, in all our models we take as given the contractual features of corporate
securities (e.g. common stocks have certain characteristics, such as shareholders’
limited liability). In this regard, we shall be clear from the beginning that the models
presented in the book can be applied only to non-financial corporations. This is an
intended consequence, motivated by three different reasons related to the nature of
financial corporations. Firstly, banks, insurance companies and asset managers are
delegated investors/financial intermediaries using their leverage in a very different
way relative to non-financial firms. Secondly, financial intermediaries are regulated.
Their capital structure decisions are constrained by tight capital adequacy rules,
that are primary intended to reduce their contribution to systemic risk. Thirdly, the
structure of their balance sheet is significantly different from that of non-financial
corporations, and therefore different accounting conventions must be taken into
account. For the interested reader, a synthetic introduction to the dynamic corporate
finance for banks and insurance companies can be found respectively in Chapters 4
and 5 of Moreno-Bromberg and Rochet (2018).

1.2 The Realm of Corporate Finance

At an abstract level, firms can be described in terms of production, investment

and financing decisions, which are interrelated one each other. To get an idea
of the underlying complexity of the corporate finance decision process, we may
start by observing that production depends on firm’s assets, which in turns are the
outcome of investment decisions. The optimal use of the production capacity is then
depending on the market competition, which affects the marginality of the firm,
and, consequently, financial resources available for new investments. For instance,
if inventories of intermediate inputs must be purchased before production eventually
becomes available for sales, the firm must be able to finance the working capital
required to achieve its production target. Likewise, investment decisions may be
affected by the level of indebtedness of the firm, with shareholders being little
motivated to invest in new projects when default is impending.
The example is enough to clarify why we need a theory of corporate finance,
which must be dynamic given the intertemporal nature of investment decisions.
1.3 Equilibrium Approach, Market Structure and Corporate Governance 3

Otherwise, a similar complexity could be never resolved by simply looking at data

in a unstructured fashion.
How do we build corporate finance models? First of all, it is necessary to establish
which questions are relevant, and in which order. Shareholders typically control the
firm and they try to maximize the value of their claims. The first task is therefore
that of putting in relation the cash flows that can be distributed to shareholders
with the equity value of the firm, which is a mere exercise of combining basic
accounting with the way in which stocks are priced as a function of their future
stream of dividends. After doing this, we must extend the analysis to the pricing of
any generic type of security that the firm may want to issue consistent with its budget
constraint. This process, in a sense, is equivalent to descriptive statistics in data
science. Given a set of available data, we learn how to present them in a consistent
fashion, which corresponds, in this case, to show how the budget constraint of the
firm affects the total value of the securities. In a nutshell, we will show that given
any (feasible) path for investment and financing decisions, the sum of the market
values of all the securities issued by the firm can be always traced back to the sum
of few components. Next, we can go back to the original problem of determining
which decisions are consistent with the shareholders optimizing behavior, exploring
which managerial conditions are needed to do this. We deal with such an extremely
complicated problem in Sect. 2.3.3, without entering into technical details, for which
the interested reader may refer to Tirole (2005). When presenting and discussing
the model in Chap. 3 through Chap. 7 we always assume that firms are effectively
managed in order to maximize shareholders value.
In sum, we are interested in shareholders optimal financing and investment
decisions, possibly conditional on the industrial organization setting of the firm.
As said, our interest is on the impact on firm value and its securities outstanding,
as well as the associated expected returns. Having clarified the corporate finance
perspective we assume, now we focus on the theoretical tools we need to build
consistent models.
We adopt an equilibrium approach and in the next section we provide the basic
elements for a correct understanding of all the models presented in the following
chapters, without entering too much into technical details in order to keep the
discussion self-contained.

1.3 Equilibrium Approach, Market Structure and Corporate

Governance

The concept of equilibrium is of central importance in our book and needs to

be contextualized within our framework. To do this we rely on Kreps (1990),
Fudenberg and Tirole (1991), Osborne and Rubinstein (1994) and Gatcher (2013).
A theoretical model is an artificial economy where different agents, such as
investors and firms, interact with each other. As such, the role of an artificial
4 1 Introduction

economy is the same as the laboratories for natural scientists, namely perform-
ing controlled experiments assuming ideal conditions. An artificial, or “model”,
economy is always characterized by an institutional framework, which defines the
aggregate resource constraints and the way in which agents can interact with each
other. A situation is an outcome of the artificial economy. An equilibrium is a
situation in which each agent is doing as best as it can, given the institutional
framework and the behaviors of all other agents.1 The concept of equilibrium is
intended to be a composite principle to determine a plausible outcome for the model
economy, that is, a solution concept. The axiomatic explanation for this approach is
that an equilibrium defines a situation in which no agent has incentive to behave in
a different way given the behavior of other agents. In this regard, it is important to
observe that an equilibrium is always a property of the model, and not of the real
world. Hence, being the general definition of equilibrium a theoretical abstraction,
we may wonder why we should adopt an equilibrium approach in the first place. For
this reason, we adopt a set of more primitive principles, which jointly motivates the
use of equilibrium as solution concept for economic models.
There are two principles which are always assumed valid in economics, aggre-
gate consistency (e.g. Barro 2001) and optimization (e.g. Varian 2011). Aggregate
consistency requires that individual actions must conform with the institutional
constraints. For instance, the quantity purchased of an object cannot be different
from its quantity sold. Likewise, the total amount of securities within a market
must correspond to the total securities held by all investors. In this perspective,
we state that the actions of agents must be compatible with each other and with
the institutional framework. Optimization relates to the absence of unexploited
opportunities. This principle states that every agent select the best choice available
to her, depending on her informational set. This principle captures the basic idea that
we generally act in what we believe to be in our best interests. There is a key caveat
underlying the optimization principle to clarify. Indeed, in many circumstances,
the consequences of a certain decision may be affected by the behavior of other
individuals. As such, individual decisions may be driven by what each agent believes
about the simultaneous and subsequent behavior of others, depending on whether
individual act simultaneously or according to a a priori ordering. As a consequence,
without a principle describing how agents develop their conjectures about the
behaviors of other, we cannot characterize the outcome of the model as a whole.
The most common solution is to introduce the hypothesis of correct beliefs as a
third principle, which states that each agent takes as given the behaviors of others.
Since the assumption of correct beliefs is an important integrand part our models,
it is worth giving a little bit more of context. Essentially, the principle of correct

1 The “optimality” concept embedded in the definition of equilibrium is intended from an ex-

ante perspective, i.e. before the uncertain and random events materialize. To put the point into
perspective, consider, for e.g., an investor optimizing her portfolio, who then experiences a
considerable financial loss due to an adverse exogenous shock. Ex-ante, she formulates expectation
on key variables and takes her optimal asset allocation decision, while ex-post, due to a random
event which was not included in her decision process, she suffers a substantial loss.
1.3 Equilibrium Approach, Market Structure and Corporate Governance 5

beliefs translates into practice depending on what it is intended with the expressions
“doing” and “behaviors of others” in the definition of an equilibrium. Broadly
speaking, we can identify three situations. In simultaneous interactions with perfect
information, the principle of correct beliefs requires that each agent takes as given
the actions simultaneously played by others, which is the usual Nash requirement. A
trivial example is the one-shot prisoner’s dilemma, where the common knowledge
of rationality is enough for each prisoner to deduce that the other will confess
the crime. With imperfect information, this requirement is modified by imposing
that each agent takes as given the state-contingent actions of other agents, which
are commonly referred as strategies. To make an example, consider a sealed-bid
auction, in which the various participants submit their bids for a certain object
without knowing the reservation values of others, which are drawn from a common
probability distribution. In this case, the principle of correct beliefs requires that
each participant takes as given the functions (strategies) mapping the reservation
prices of other players’ into their corresponding bids. While a bit abstract at first,
the epistemic motivation for the assumption of correct beliefs in simultaneous
interactions is that the common knowledge of the optimization principle and the
institutional framework should guide each individual to deduce the simultaneous
behaviors of others (Aumann and Brandenburger 1995; Polak 1999). Likewise, in
sequential interactions, either with perfect or imperfect information, the principle
of correct beliefs requires the player moving first to correctly anticipate how her
decisions will affect those of the second movers.2 The reason for this assumption
is again that the common knowledge of optimizing behavior should allow the first
mover to correctly map its actions into those of second movers, which may be still
permeated by an element of uncertainty depending on the information structure
of the economy.3 In this regard, it is important to note that “sequentiality” needs
not be necessary intended in terms of passing time, but extends to decisions taking
place at a same instant albeit according to a predetermined “virtual” ordering. One
example is the basic model of monopolistic competition, in which the monopolist
maximizes its profits correctly anticipating the aggregate demand schedule deriving
from consumers’ optimizing behavior. This assumption is of extreme importance
for corporate finance models, in which at a certain point in time4 more events can
occur according to a virtual sequentiality (e.g. at time t ∈ N the firm produces a
certain amount of goods, collect revenues and then decide whether to default on its
debt obligations or not).
Taking together the principles of aggregate consistency, optimization and correct
beliefs we get an equilibrium approach in which every agent is doing as best as
it can, given the institutional framework and the behaviors of other agents. In the

2 In other words, when an agent is moving before others, she takes as given the function mapping

her decisions into the actions that second movers will play in response to her decision. In game
theory, this is the usual requirement of subgame perfection for Nash equilibria.
3 Or, more appropriately, the characteristics of the sequential game.
4 A point in time is a point on a subset of the real line (R).
6 1 Introduction

same way, the solution of any economic model based on aggregate consistency,
optimization ad correct beliefs principles is an equilibrium. While the definition
of equilibrium is potentially more general,5 this is how the equilibrium approach
is generally intended in applied economic theory. In this book, the principles of
aggregate consistency, optimization ad correct beliefs are always assumed valid to
build economic models, and, consequently, we are always considering equilibrium
behaviors. From a technical perspective, notice that, having assumed correct beliefs
for sequential interactions, we always consider subgame perfect equilibria. This
point is particularly relevant for Chap. 6, in which we analyze a dynamic game
between shareholders and bond holders of a given company.
It it important to observe that the equilibrium approach is intended to obtain eco-
nomic relations that, being valid in the model, should be tested empirically before
using by practitioners. For this reason, it is often convenient to focus on a subset of
agents, taking for granted the aggregate consistency of their equilibrium behavior
with the rest of the model economy. In this case, we refer to partial equilibrium
models. This is very common in corporate finance, and it is a characteristic of all
the models that are discussed in the next chapters. This simplification is motivated
by our primary interest to understand the equilibrium dynamics of firm’s decisions
for a given asset pricing kernel, the latter being a concept of utmost importance we
will discuss in Sect. 1.3.2.

1.3.1 Building on the Neoclassical Synthesis

The equilibrium approach is just a very general recipe to build economic models.
Consequently, it is important how economists translate it in practice, depending
on the context and the research questions that should be analyzed with the aid
of a specific model. Despite the vast array of different modeling choices, most of
corporate finance models are built on the neoclassical synthesis, which is based on
the following assumptions:
(1) perfectly rational individuals;
(2) rational expectations (RE).
By perfectly rational individuals, we intend that each agent is always able to
decide whether an action is preferred or not to another, according to a binary
preference relation satisfying the transitive property and the axiom of independence
of irrelevant alternatives. This ensures that the optimization principle can be cast
into a mathematical optimization problem, consisting in the maximization of an
expected utility function subject to the constraints faced by each decision maker in

5 An example is the assumption of self-confirming beliefs (Fudenberg and Levine 1993) instead of

correct beliefs, which is typical of the Nash tradition. Both assumptions lead to a situation where
the general definition of equilibrium is valid.
1.3 Equilibrium Approach, Market Structure and Corporate Governance 7

the model. The reader may refer to Mas-Colell et al. (2011) or Varian (1992) for
the more details. Expectations, in turn, depend on the probabilities that each agent
attributes to random events not yet realized at the time of its decision. In general,
the agents in the model may ignore the probabilistic structure of the exogenous
random variables, and have different priors in a Bayesian sense. In this regard, the
rational expectations (RE) hypothesis requires that individuals have common priors
for exogenous random variables, and that such a prior coincides with their objective
distribution. Additional references on this topic may be found in Ljungqvist and
Sargent (2018). Rational expectations are useful to introduce model discipline.
Indeed, without RE it would be very hard to obtain testable predictions, as we can
almost always find a set of heterogeneous priors to obtain a target outcome as the
equilibrium outcome of a given model. In fact, structural estimation and testing of
equilibrium models is possible only for rational expectations models (Hansen and
Singleton 1982).6
The neoclassical synthesis offers a plenty of potential modeling choices. Due
to the scope of our models, in our book we introduce few additional hypothesis
regarding the structure of financial markets and the informational set (i.e. the
institutional framework):
(1) perfect information;7
(2) Walrasian secondary financial markets;
(3) zero profits for intermediaries, which do not take risky positions on their own
as they do not trade directly in the firm’s securities (i.e. brokers rather than
dealers).
Perfect information is not a strict requirement, and a large body of literature in
corporate finance does not share this hypothesis. However, in our context it takes
the meaning of simplifying the set of equilibria that may be observed, particularly
in terms of how the price of corporate securities are determined on secondary
financial markets. By secondary financial markets we mean the trading venues in
which corporate securities are negotiated right after their issuance. The issuance of
new securities is generally intermediated by specific agents, such as coordinating
brokers, which could demand a fee in exchange of their services. Sometimes these
fees may be not negligible, although in recent years pure intermediation costs have
fallen significantly. The issuance process takes place on what we call primary,
or capital, markets. In all our models, this process takes place immediately and
translate into a corresponding listing of the newly issued securities on secondary
markets. We will come back at the end of this section on the role and potential
frictions of capital markets.

6 DeJong and Dave (2011) provides an excellent reference to structural estimation methods,

although pretty much focuses to macroeconomics applications. Strebulaev and Whited (2014) is a
concise and hands-on discussion of structural estimation in dynamic corporate finance models.
7 More formally, we say that all information is common knowledge, that is, at each date, the

information set of each agent is the same of any other.

8 1 Introduction

We assume that secondary markets are organized as Walrasian auctions. In a

Walrasian market, there is a single market price at which the participants can buy
and sell any amount of a certain object, for instance the stocks of a company. In
other words, investors face as only restriction their own budget constraints and do
not need to take into account the behavior of other traders. Aggregate consistency
is ensured by an anonymous auctioneer that sets beforehand a price at which the
resulting trades are mutually compatible (see Kreps 1990). Such a price is called
market-clearing price, and the resulting price and trades constitute a competitive
equilibrium.8 Real financial markets are not exactly consistent with the ideal setting
of the market-clearing model. However, for thick trading posts, a competitive
equilibrium is effectively a convenient approximation. The underlying idea is that,
when the number of investors is large, trading protocols9 should not be the driving
force behind corporate finance decisions.
Once we will add the hypothesis of market completeness (see Sect. 1.3.3),
corporate securities are always “correctly” evaluated, in the sense that we can rule
out the presence of bubbles, whether rational or not. This certainly precludes any
possibility to statistically profit from information frictions. Warusawitharana and
Whited (2015) is probably the only dynamic corporate finance model with equity
“misevaluation” due to imperfect information (e.g. Merton 1987; Grossman and
Stiglitz 1980) or heterogeneous beliefs (see Back 2017).
We now discuss in more details the role of primary, or capital, markets in our
models. As said, the issuance of new securities take place instantaneously on these
markets. However, financial intermediaries just coordinate the issuance of new
securities, without holding any of newly issued securities on their books. Effectively,
this setting is equivalent to the one in which newly issued securities are listed
immediately on the secondary financial market, and the issuer pay the associated
flotation costs, if any, to financial intermediaries as additional expenses that are not
included in the financial conditions of the securities issued. In all our models, we
shall rely implicitly on this equivalence.

8 The major drawback of the market-clearing model is that it doesn’t explain how the auctioneer

clears the market. At a theoretical level, the most convincing argument is that the auctioneer
knows the aggregate excess demand schedule and, right before the trades take place, sets a price
vector that ensures aggregate consistency of subsequent trades (Qin and Yang 2019). In this case,
sequential moves are taking place at a certain market instant, with the price being announced
before trades are executed. In a simultaneous moves setting, Arrow and Debreu (1954) shows that
a competitive equilibrium can be obtained if the auctioneer minimizes the net worth of aggregate
excess demand function (see also Villar 2000 and Tian 1992). However, a controversial assumption
is implicit in the Arrow and Debreu model. The auctioneer has “deep pockets”, and aggregate
consistency does not matter, in the sense that, out of equilibrium, the auctioneer can always satisfy
the aggregate excess demand using her own resources (Shapley and Shubik 1977). Despite the
difficulties in developing a convincing mechanism that implements a competitive equilibrium, the
market-clearing model remains a good proxy for real market in several circumstances.
9 Market microstructure is a very interesting field, and we invite the reader to explore this field.

Excellent references are Harris (2003) and De Jong and Rindi (2010).
1.3 Equilibrium Approach, Market Structure and Corporate Governance 9

The next question is therefore when transaction costs can be assumed equal to
zero. The answer is embedded in the assumption of zero profits for capital markets
intermediaries. When intermediation is costless, competition drive flotation costs
(intermediaries’ revenues) to zero. Whenever we believe reasonable to assume the
flotation of new securities as a costless process, we can set flotation costs equal to
zero. Clearly, this argument implicitly assumes absence of information asymmetries,
which is indeed one of our working hypothesis. There are however securities that
requires intermediaries (or sometimes the firm) to bear specific issuance costs.
A notable example is that of secured debt contracts, such as leveraged loans, in
which the firm pledges one or more assets as collateral. There are several legal and
monitoring activities involved in the lien process, which is usually delegated to one
or more intermediaries. As a result, capital markets intermediaries will charge a fee
to the firm in order to cover the related costs, unless the firm pay directly for this
expense. In both cases, we shall assume that the resulting flotation costs are not paid
within the terms of securities, but as direct costs charged to the firm. As a result, the
issuance price of a security will be always equal to its secondary market equilibrium
price. In other words, there will be no difference in our models between primary and
secondary listing prices.

1.3.2 Market Completeness, Pricing Kernel and the Objective

of the Firm

In our book, we assume markets to be complete, in the same spirit of Radner

(1972) model of sequential trading. Roughly speaking, completeness means that
investors can trade any form of state contingent contract. In other terms, the
market includes assets for every possible state of the world. Under the complete
markets assumption, also imposing perfect information and rational expectations,
the competitive equilibrium of secondary financial markets ensures the existence of
a unique strictly positive stochastic process {Mt }t ≥0 (M (t) in continuous time),
commonly known as stochastic discount factor (SDF) or asset pricing kernel, such
that the price (pt ) of a generic security must satisfy,
⎧⎧ ∞
⎪
⎪ ⎪
⎪  Mt +s
⎪
⎪⎨⎪
⎪ p = E yt +s
⎪
⎪
t t
Mt
⎪
⎪
⎪
⎪ 
s=0
 Discrete time models,
⎪⎪
⎪ ⎪
⎪
⎨⎪⎪ M T
⎩ lim Et pT nT +1 = 0
⎧ T →∞ Mt (1.3.1)
⎪
⎪ ⎪
∞ M
(s)
⎪
⎪ ⎪
⎪ p = E y (s) ds
⎪⎨
⎪ t t
⎪
⎪ 0 M (t)
⎪
⎪   Continuos time models,
⎪
⎪ ⎪
⎪⎪
⎩ ⎪ lim Et M (T ) p (T ) n (T ) = 0
⎩
T →∞ M (t)
10 1 Introduction

where {yt }t ≥0 (y (t) in continuous time) is the stochastic process characteriz-

ing the cash flows paid by one unity of the security to its holder, while nt +1
(n (t) in continuous time) is the amount in circulation at time t. In Sect. 2.1 we
clarify the reason why we set nt +1 instead of nt , although it is a matter of con-
venience in discrete time dynamic corporate finance applications.10 A competitive
equilibrium is always arbitrage free, in the sense that a) it prevents risk-free trading
opportunities with unbounded profits, and, b) all risk-free assets have the same rate
of return.
We recall that firms do not participate in secondary financial markets directly.
However, firms take as given the SDF. As each firm is the monopolist of its
own securities, it is natural to expect that its capital structure decisions will take
into account the related price impact (if any), just as the monopolist producer of
a certain good takes into account the pricing constraint induced by the demand
schedule for its products (see Sect. 4.2). The point is discussed in Chap. 6, in
which we study the dynamic game between shareholders and debt holders relative
to the optimal issuance of unsecured debt. In general, firms take the process Mt
(M (t) in continuous time) as given, while they might affect the distribution of
the cash flows of their securities through production, investment and financing
decisions. In other words, the firm, or who is in charge for its management, take
as given the way in which market-clearing prices are determined as a function of its
strategy.
We assume that shareholders do not invest in other liabilities issued by their
firm and agree unanimously with the maximization of the market value of the
firm’s equity. This is known as the shareholders value approach (Tirole 2001,
2005). As we discuss in the next chapters, equity value maximization does not
necessary correspond to maximization of the total value of the firm, which is by
definition the sum of the market values of the securities issued by the firm, net
of cash and other risk-free investments held as liquidity reserves. Nevertheless,
there might be situations in which shareholders may fail in their objective of
maximizing the value of equity. As firms are generally run by a group of managers,
equity value maximization requires a preemptive alignment of managerial incentives
with shareholders objectives. This is a type of principal-agent conflict, which may
be anything but easy to solve in practice. However, except for a few illustrative
examples, all the models we discuss from Chaps. 3–7 assume the existence of a
corporate governance mechanism that perfectly aligns the interests of shareholders
with that of managers. For the same reason, we move under the same hypothesis for
which the firm is directly managed by shareholders.
As introduced in this section, there is a fundamental difference between partial
and general equilibrium models. General equilibrium models consider closed-
ended environments, in which primitives such as individuals preferences and
production technologies are mapped into equilibrium prices and asset allocations.

10 In macroeconomics models this convention is instead more uncomfortable, and it is generally

used nt to denote the amount of securities outstanding at date t, instead of nt+1 as we do here.
1.3 Equilibrium Approach, Market Structure and Corporate Governance 11

Instead, partial equilibrium models are concerned with the behavior of one or more
individuals, holding everything else constant. Most of corporate finance models are
indeed partial equilibrium models, in which the main interest in deriving the firm’s
equilibrium relative to asset pricing kernel, which is assumed as given for each firm.
The models discussed in the book pertain to this group, as our objective is to fully
understand the effects of shareholders’ optimizing behavior in terms of production,
investment and financing decisions on market value of the firm as well as the value of
its securities, given a certain SDF. Hence, the implications and results proposed with
the models discussed throughout the book assume that each firm is small enough
relative to the market as a whole. This is a common assumption among practitioners
which is easy to verify empirically.
The extension within a general equilibrium models setting is not trivial, as aggre-
gating investors’ preferences could be problematic.11 To do this, the compromise
between partial and general equilibrium approaches is commonly proposed, which
consists in assuming a parametric form for the SDF, then computing find the values
for those parameters ensuring the aggregate consistency of the firms’ decisions.
This approach is nonetheless likely to have more success in empirical applications,
instead of deriving the SDF from a direct specification of investors preferences,
which is the crux of the equity premium and risk-free rate puzzles (Mehra and
Prescott 1985; Weil 1989). The reason is that aggregation problems across firms
tend to be less severe, making investment-based asset pricing a prominent direction
to obtain empirically robust pricing models (Lin and Zhang 2013). We discuss this
point in Chaps. 3 and 4, when introducing the Investment CAPM (Zhang 2017) as a
corollary of investment and financing decisions with risk-free debt.
A word of caution. Without complete markets, or in presence of externalities
or imperfect product market competition, the maximization of the equity value
may not be the best choice for all the shareholders (Grossman and Hart 1979;
Milne 1995; Carceles-Poveda and Coen-Pirani 2009; Hart and Zingales 2017). The
objective of the firm becomes the outcome of a voting problem, since depending on
the preferences of the majority of shareholders. Under some specific conditions,
shareholders may still agree on maximizing the equity market value (Sabarwal
2004). Despite that, asset prices may be sometimes disjoint from their fundamentals,
as there might be rational bubbles as in the case of sunspots equilibria (Maskin and
Tirole 1987).
Furthermore, with incomplete markets, there might be situations in which criteria
other than shareholders value maximization may be adopted, especially if the firm
generates externalities that cannot be hedged. In this regard, many are debating on
whether social and environmental impacts should be included in the objectives of

11 This is a consequence of the Sonnenschein-Mantel-Debreu (“anything goes”) theorem (Son-

nenschein 1972; Sonnenschein 1973; Debreu 1974; Mantel 1974; Andreu 1982; Chiappori and
Ekeland 1999).
12 1 Introduction

the firm (Hart and Zingales 2017). This may complicate the analysis for sure. Also,
growing discussion is focusing on the hypothesis that firms may increase their value
by paying more attention on environmental and social issues, which is a sort of
“doing good by doing better” concept. As is obvious, such assumption derives from
the idea that managers are not maximizing the value of the firm, and, therefore,
shareholders could improve their value by taking corrective measures, although
this implicitly requires that environmental and social performances can be correctly
measured by outsiders.12 If true, the ESG paradigm would resolve in the last letter of
its acronym: governance. To date, there is no clear consensus on this issue, and then
we have stick on the canonical assumption of equity value maximization, which is
a more robust theoretical framework when having conflicting objectives. After all,
maximizing the firm’s value is equivalent to agree to run the firm at an “average”
optimized risk-return profile.

1.4 Roadmap

1.4.1 Plan of the Book

The remainder of the book is organized as follows.

Chapter 2 introduces the reader to the main concepts in corporate finance, and
to all other topics we deal with in the next chapters. We focus, in more depth,
on the value of the firm and its determinants, which is consistent with the book’s
philosophy. The natural starting point are the Modigliani and Miller theorems
(MM), which marked the birth of modern corporate finance in the 50’s. The ideal
conditions of the MM theorems are progressively abandoned in favor of richer
and more sophisticated environments. We briefly overview agency problems such
as debt overhang, the importance of efficient corporate governance mechanisms,
and illustrate how to describe in general terms bankruptcy procedures. A general
expression for the value of the firm is provided, which proves to be particularly
helpful in the following chapters.
Chapter 3 introduces debt dynamics and investment decisions. We assume
the presence of a collateral constraint that ensures that firms will never default.
These models are useful in several circumstances, especially once endogenous
investment decisions are introduced. In this regard, we analyze shareholders’
optimal investment and financing program in the case of perfect product market
competition, also introducing the presence of convex investment adjustment costs.

12 The quality of environmental (E) and social (S) performances may be subject to a strong infor-

mation gap between managers and shareholders. As externalities represent a tangible operational
and financial risk to shareholders, managers may be motivated to report E&S performances in the
most convenient way possible. Camodeca et al. (2018) formalizes this idea using different game
theoretical models of strategic information transmissions, with particular emphasis to the case of
partitioning equilibria as in the cheap talk model of Crawford and Sobel (1982).
1.4 Roadmap 13

The model is used to obtain a large number of useful insights on the firm’s leverage
dynamics and the relation between investment and stock markets returns.
The limits of the model are discussed in Chap. 3 and focus on the industrial
organization setting, since, except for some commodity producers, the majority of
firms have some degree of market power. Hence, in Chap. 4 we introduce the effects
of imperfect competition in the firm’s product market. The model also includes the
role of the working capital, in terms of inventories of intermediate inputs used in the
production process.The model offers a more realistic and insightful relation between
investment and stock returns. For this reason, we present a specific version of the
model in terms of stochastic processes for the exogenous variables, which can be
proficiently used in several applications, from empirical research in asset pricing to
equity valuation.
Until Chap. 4 all models are presented in discrete time. Continuous time methods
are introduced in Chap. 5, which is based on the Leland (1994) model. Differently
from the previous two chapters, the focus is on unsecured, unprotected and pari
passu (equal seniority) debt securities. Despite being a static representation of the
capital structure, this model turns out to be a very useful tool for more advanced
dynamic models. Besides, it helps to frame the economic intuition behind agency
problems such as strategic default, debt overhang and risk-shifting.
In Chap. 6 we extend the Leland model to the study of optimal dynamic capital
structure decisions, following the recent model developed by DeMarzo and He
(2020). The striking result of this framework is that, in a continuous time Markov
Perfect Equilibrium (MPE), the equity market value is the same as in the case that
shareholders commit to not issue additional debt in future. We analyze the impact
of this result to leverage dynamics and the firm’s cost of capital. We also provides
a discrete time version of the model, which helps to understanding the economic
mechanisms at work, and can be also used as a building block for quantitative
models.
Chapter 7 is the last chapter in which we are eventually able to introduce several
extensions that might be of particular relevance in practice. Firstly, we formulate
a model, both in discrete and continuous time, where the firm can issue either
secured risk-free debt or unsecured, unprotected, pari passu debt. The model is
an efficient combination of what is developed in the previous chapters, and can be
used for quantitative analysis. Indeed, it allows to model very heterogenous capital
structures, as a combination of risk-less secured debt and unsecured debt can be
used most of the time to represent also the case of risky secured debt. In any case,
the model has two limitations. First, it is based on Markov perfect strategies. Second,
it needs to be solved numerically. We discuss each of these points, and also provide
a brief introduction to structural econometric methods in finance.
14 1 Introduction

1.4.2 Prerequisites

In Sect. 1.3 we summarize some very important, synthetic, while incomplete,

prerequisites for the reader. We suggest the readers who are unfamiliar with those
concepts to refer on equilibrium asset pricing literature, such as Cochrane (2009),
Duffie (2010), Ma (2011), Dumas and Luciano (2017) or Back (2017). There are in
any case some other prerequisites that will help the reader to comfortably navigate
through the technical details of the book. First, a good understanding of static
optimization methods (linear and concave programming) in several variables is
more than essential, as well as an intermediate knowledge of stochastic processes,
both in discrete and continuous time. Hamilton (1994), Oksendal (2003) and Bjork
(2009) are very useful references for the theory of stochastic processes, while
De la Fuente (2009) and Simon and Blume (1994) provide a very good overview
of static optimization methods. As is natural, a complete understanding of the
theory of stochastic processes require a sound knowledge of probability theory
and mathematical statistics. Second, a basic knowledge of stochastic dynamic
programming (SDP) is absolutely necessary for a thorough comprehension of
dynamic corporate finance models. Miao (2020) and Stokey and Lucas (2004) are
excellent references for discrete time SDP. Dixit (1993), Dixit and Pindyck (1994),
Bjork (2009) and Stokey (2009) are useful references for continuous time dynamic
programming methods in finance. The basics of corporate finance are, of course,
the starting point to explore more advanced concepts. Berk and DeMarzo (2019) is
an excellent reference to this purpose. Although not essential, a prior knowledge
of more theoretical aspects of corporate finance are helpful. Amaro de Matos
(2001) and Tirole (2005) are strongly suggested readings. Tirole (1988) provides,
instead, a comprehensive overview of the theory of industrial organization, which
may be useful to have in mind the effects of product market competition. After
all, profitability drives investment and financing decisions, so it is quite relevant
to understand where it comes from. Finally, a basic knowledge of accounting is
essential.

Acknowledgments We are intellectually and personally indebted with many friends and col-
leagues who have provided us with invaluable comments and discussions regarding the topics
exposed in this book. We wish to thank Quaestio Capital Management, in particular Christian
Prinoth, Alessandro Potestà, Mario Baronci, Federico Valesi, Giacomo Saibene and Francesco
Ceci, as well as all the members and participants of the Investment Committee. We thank Luca
Bertazzi (University of Brescia), Renato Camodeca (University of Brescia) and all the PhD
program faculty in Analytics for Economics and Management, University of Brescia, Department
of Economics and Management. And finally, a special thank goes to our families, Elena with
Leonardo, and Marika with Luca and Nicolò.
References 15

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Chapter 2
The Value of the Firm and Its Securities

This chapter has the fundamental role to introduce the reader to the basics of
corporate finance. Broadly speaking, corporate finance is the branch of economic
science which deals with the financing and investment decisions of firms, and how
these decisions affect the value of corporate securities and their financial returns.
A security is a contingent claim liability issued by a company, which attributes
certain control rights to its holders. Control rights include, but are no restricted to,
receiving certain cash flow streams. For instance, common stocks attribute the right
to shareholders to receive dividends, as well as equal voting rights. Firms are not
directly tradable, while their liabilities are. The set of the outstanding securities
characterizes the ensemble of the control rights, and therefore the set of individuals
that are entitled to split the (free) cash flows generated by the firm. Accordingly, the
value of a firm is defined as the market value of its securities, net of cash and other
equivalent risk-free assets. Netting for liquidity allows to identify the going concern
value of the business, which is generally higher than the accounting book value of
invested capital (fixed assets plus trade working capital). Many motivations explain
such a underlying difference, which becomes more evident in the next chapters, in
particular in Chap. 3 and 4. In short, firms may extract valuable rents from their
operations, depending on the competitive landscape and the efficiency level of their
assets. Besides, firms may have valuable growth options, whose value cannot be
preemptively recognized in the balance sheet statement. In the end, what really
matters for the total value of the firm is the total cash flows that all security holders
can split between themselves. The purpose of this chapter is to clarify this point,
namely, how the value of a firm and its securities are related to the free cash flows
generating process.
The chapter is organized as follows. In Sect. 2.1 we introduce the main notations,
the concept of unlevered free cash flows and a very basic model of the firm’s
budget constraint. Section 2.2 presents the Miller and Modigliani (MM) theorems,
which state that, under certain conditions, financing decisions are irrelevant. As a
consequence, the only effect of financial leverage is to increase expected equity

© The Author(s), under exclusive license to Springer Nature Switzerland AG 2021 19

U. Sagliaschi, R. Savona, Dynamical Corporate Finance, Contributions
to Finance and Accounting, https://doi.org/10.1007/978-3-030-77853-8_2
20 2 The Value of the Firm and Its Securities

returns, consistent with the higher risk for shareholders, who are the residual claim
holders (i.e. the most junior) in the firm’s capital structure. The main assumptions
of the MM theorems are: (a) exogenous investment decisions, (b) absence of
transaction costs, (c) no tax benefits from the use of debt financing and (d) absence
of bankruptcy costs. In Sect. 2.2 we introduce tax effects of debt financing and
bankruptcy costs, and provide a general expression for the value of the firm.
Section 2.3 introduces a first analysis on the optimal investment decisions
and agency costs. A notable example is debt overhang, which is presented in
Sect. 2.3.1. We also provide specific examples of agency problems related to
corporate governance frictions, by limiting the discussion of these problems only
in this chapter. In Sect. 2.4 we provide a general formula for the value of the firm.
We introduce the concept of abstract security, and show that regardless the number
and the design of the securities actually issued, the value of the firm can be always
obtained as the sum of few distinct components. Sect. 2.4 concludes with practical
examples, which is a first attempt to estimate the expected stock returns based on
equilibrium corporate finance principles.
To summarize, with this chapter the reader should have a clear picture of which
elements affect the valuation of the firm and its securities, and how financing
and investment decisions can interact with each other. The topics covered in this
chapter are important prerequisites to fully understand more advanced discussions
and models we present throughout the book.

2.1 Notation and Basic Setting

Our analysis of corporate finance begins with a discrete time setting, in which all
agents interact with each other only at a countable set of decision instants, or dates,
t ∈ T ⊆ N. As anticipated in Sect. 1.3, this does not mean that at a generic time
t everything take place simultaneously. Rather, different events or actions may take
place sequentially, according to a predetermined ordering. However, as t is a point
on the real line, everything takes place instantaneously and the ordering has to be
intended as a virtual one. For the same reason, instants are also referred as periods,
although they are specific points in time. In the same way, when we consider a
variable at the end of period t, we intend its value after all the decisions in t took
place, which include all payments executed/received by the firm. Likewise, when we
observe the value of the firm’s securities at the beginning of time t, we must include
any cash flow that might be paid in the same period. Hence, we use the definition
cum cash flows or even, cum dividend market values. Instead, market values at the
end of the period are observed after all payments are made, and therefore they are ex
cash flows or ex dividend. This flexibility is very important to achieve consistency
with accounting data thereby representing the right timing of different decisions
within the model.
The natural starting point of our discussion is the firm’s budget constraint,
which relates the use of resources to the evolution of the firm’s liquidity balance.
2.1 Notation and Basic Setting 21

Table 2.1 Overview of recurrent notation

Symbol Description
Mt Stochastic discount factor (SDF)a
Mt+j
Mt,t+j := Mt The j -periods ahead pricing kernel at time t
Mt+j −1
rt+1 = Et Mt −1 The risk-free rate at time t
I Ct+1 The book value of the firm’s invested capital at end of
period t
Lt+1 The liquidity of the firm at the end of period t
Ft+1 The nominal amount of debt outstanding at the end of
period t
ebitt Earnings before Interests Expenses and Taxes (EbIT)
Ttc Taxation of EbIT
nopatt := ebitt − Ttc Net operating earnings after taxes (NoPAT)
xt = NOP aTt − (I Ct − I Ct−1 ) Unlevered free cash flows (UFCF)
πt Debt tax shield
Tt = Ttc + πt Total taxes paid in t
xt + πt Free cash flows to the firm
a See Sect. 1.3 for a quick reference

By liquidity, we mean callable deposits, term deposits or other equivalent risk-free

securities in which the firm invests its savings. Put in other terms, we assume that
the firm’s savings (if any), are invested at the risk-free rate, although we can also
include specific transaction costs (e.g. a tax on call deposits). Before presenting
the first model of the firm’s budget constraint, it is important to present a synthetic
overview of the relevant notation; see Table 2.1.
The risk-free rate at time t (rt +1 ) is equal to the coupon received in t + 1 for a
dollar invested at time t in a risk-free security. Except specific cases (e.g. taxes), the
difference between capital and lowercase letter serves to make distinction between
stock and flow variables, which is important from an accounting perspective.
Invested capital is the sum of firm’s fixed assets and trade working capital, which
is in turn equal to the book value of trade receivables plus that of inventories and
minus that of trade receivables. Unlevered free cash flows are the free cash flows
to the firm before any direct impact of debt financing. This does not means that
the financing policy will not affect them, as investment decisions may be indirectly
affected by capital structure decisions. In other words, for a given investment policy,
unlevered free cash flows corresponds to the dividends paid by an all-equity firm
which does not accumulate cash.
As anticipated in the previous chapter, the value of the firm is defined as the sum
of the market values of all its securities outstanding, net of liquidity (Lt +1 ). In this
regard, it is important to observe that we can consider cum-dividend or ex-dividend
valuations, although securities will be always traded at their ex-dividend price.
22 2 The Value of the Firm and Its Securities

Needless to say, the two cases are essentially equivalent, in that the former differs
from the latter only by the inclusion of the same period cash flows. Nevertheless,
as investment and financing decisions must be taken before dividends are paid, it
is the cum dividend value of equity that matters for their optimal decisions at each
date t. For this reason, the cum-dividend value of equity is also commonly referred
as shareholders value. These are important considerations that are valid in general.
To simplify the discussion, from here on out when we speak of value of the firm, or
that of a certain class of securities, we always intend ex-dividends values.
As for the probabilistic structure of discrete time
 models, we limit
 to say that the
economy is characterized by a probabilistic space , {Ft }t ≥0 , P spanned by a set
of exogenous source of randomness {zt }t ≥0 . The bold notation is intended to denote
a vector of real variables. The symbol  is the sample space of zt , while P is an
objective probability measure define over . The collection {Ft }t ≥0 is the natural
filtration generated by zt . All the other stochastic processes involved in our analysis
are assumed to be adapted to Ft , once the correct timing (and notation) conventions
are properly taken into account.

2.1.1 Budget Constraints and Policies

Our analysis of corporate finance decisions starts from a simple setting in which the
company can issue common stocks and a bond with one period maturity (i.e. bonds
issued in t expire in t + 1), and there are no transaction costs on capital markets.
At each date, the bonds issued are all of equal seniority, and pay a predetermined
coupon rate equal to ct +1 . The face value of each bond is equal to one unit of the
relevant numeraire, we name as dollar. Consequently, the number of bonds issued
in t is equal to Ft +1 . Hence, provided that the firm is solvent1 at date t, its budget
constraint is given by
⎡ ⎤
⎢ ⎥
st (nt+1 − nt ) + pt Ft+1 + yt − ⎣ d n + Ft (1 + ct ) ⎦ = Lt+1 − Lt (1 + rt ) ,
   t t  
Inflows from capital markets Outflows related to existing liabilities
(2.1.1)

where nt +1 is the number of shares outstanding at the end of period t, and dt is

the dividend per share paid to incumbent shareholders. Basically, the change in end
of period liquidity is the sum of the following components: (i) the free cash flows
to firm (yt ), (ii) the interest income on existing liquidity (rt Lt ) and (iii) the net
proceeds from financial markets st (nt +1 − nt )+pt Ft +1 −[dt nt + Ft (1 + ct )]. This
consideration holds in general, as we show in Sect. 1.4.1.

1 We use the term solvent as a synonym of a active (non-defaulted) firm at a generic time t.
2.1 Notation and Basic Setting 23

Notice that in the current example, bonds are unsecured.2 A debt instrument is
secured if, in case of the firm’s default, its holders can seize a specific asset of
the firm. Therefore, the recovery value of secured debt can never fall below the
net proceeds from the sales of the pledged asset. On the other hand, the recovery
value of unsecured debt instruments is tight to the going concern value of the firm
at default. We analyze in detail the difference between the two cases in the next
chapters, as the correlative borrowing mechanisms have different consequences.
From a technical perspective, the issuance of unsecured debt is known as borrowing
against cash flows, while we use the term borrowing against assets or collateral in
case of secured debt.
The value of the firm (Vt ), or enterprise value, is given by the following equation

Vt = VtE + pt Ft +1 − Lt +1 , (2.1.2)

where pt Ft +1 is the market value of debt, while VtE = ptE nt +1 is the market value
of equity. On this regard, nt +1 is the number of shares outstanding at the end of t,
i.e. after all payments for the same period are settled. Admittedly, the use of t + 1 in
spite of t may be misleading at first. However, as for the case of debt’s face value and
liquidity, this notation is convenient to set up the dynamic programs characterizing
shareholders optimizing behavior in the following chapters. In short, the number
of shares in circulation and the face value of debt at the end of each date are the
control variables for shareholders. On the contrary, the amount of debt and shares
inherited from the previous period are state variables. Rearranging Eq. (2.1.1), the
budget constraint of the firm can then be expressed as,

V + x + πt = (pt + dt ) nt + Ft (1 + ct ) − Lt (1 + rt ) , (2.1.3)
 t t 
Cumdividend value of the firm

which simply states that the cum-dividend value of the firm is equal to the sum of
cum-dividend value of incumbent security holders, net of the liquidity available at
the beginning of the period (1 + Lt rt ). This relation is of utmost importance, as it
suggests that, after all, the only thing that matters is the total amount of free cash
flows generated by the firm, which depends on production, investment and financing
decisions.
A policy is a state contingent rule which maps the set of measurable events at
each date in a specific decision. For ease of exposure, we often include production
decisions in the firm’s investment policy, although sometimes we need to be more
explicit, as in Chap. 4 and Sect. 7.1 of Chap. 7. For the moment, we assume that
both financing and investment decisions are exogenously given. In this case, we
can model a given investment policy in terms of the associated unlevered free cash
flows process {xt }t ≥0. Likewise, a financing policy is intended to be a multivariate

2 As a technical aside, notice that in this example there could be no role for debt covenants, as debt

is due at the same date at which new information is released.

24 2 The Value of the Firm and Its Securities

stochastic process {dt +1 , nt +1 Ft +1 , ct +1 , Lt +1 }t ≥0 for the firm’s capital structure.

We define the firm’s synthetic dividend (Dt ) as,

Dt := dt nt + pt (nt +1 − nt ) , (2.1.4)

which is the sum of actual dividends paid plus cash flows related to share buybacks
(minus, if shares are issued). As is clear, for a given investment policy, we can
consider only feasible financing policies, in the sense that Eq. (2.1.1) must be valid
at each date in which the firm is solvent.
While it should be immediate to conclude that the firm can adopt only feasible
financing policies, it is less obvious whether we should consider any restriction on
{xt }t ≥0 . If we were taking explicitly into account shareholders optimizing behavior,
the answer would be certainly negative, as shareholders have always the option to
shut down the firm if there is no way to make it profitable. However, when the
investment policy is exogenously given, as if it was written in the corporate bylaws
rather than being dynamically optimized in the best interests of shareholders, it is
convenient to restrict our attention only to policies with a positive net present value
(NPV), that is,
∞
 Mt +j
Et xt +j ≥ 0. (2.1.5)
Mt
j =0

A policy that satisfies Eq. (2.1.5) is individually rational. To understand the meaning
of this condition, consider the case of an all-equity firm without liquidity, i.e. xt =
Dt . It is easy to show that the left hand side (LHS) of Eq. (2.1.4) is the cum-dividend
equity value of the firm V̂tE = dt nt + VtE . The proof comes from rearranging
Eq. (1.3.1) and Eq. (2.1.3) (see Sect. 2.2.1), from which we obtain
 
Mt +1
VtE = st nt +1 = Et VtE+1 + xt +1 . (2.1.6)
Mt

Solving forward the previous expression, under the transversality condition

limT →∞ Et M T
Mt sT nT +1 deriving from Eq. (1.3.1), we eventually obtain,

∞

V̂tE = Et Mt,t +j xt +j . (2.1.7)
j =0

A policy that is not individual rational will be never adopted by the shareholders
of the firm, as it is equivalent to a collection of projects with strictly negative NPV.
Therefore, it is quite natural to rule out this case while we are working under the
hypothesis of an exogenously given investment policy.
2.1 Notation and Basic Setting 25

Notice that, in order to obtain the previous result, we made use of the transversal-
ity condition from Eq. (1.3.1), limT →∞ Et M T
Mt sT nT +1 . Similarly, another impor-
tant constraint must be always imposed when financing decisions are exogenously
given, that is,
 
MT
lim Et LT +1 = 0. (2.1.8)
T →∞ Mt

As liquidity reserves are invested in risk-free assets, limT →∞ Et M T

Mt LT +1 > 0
would be equivalent to allow for the existence of a Ponzi scheme in the supply-
side of risk-free assets. In equilibrium, this eventuality is ruled out by the dynamics
of the risk-free rate. Consequently, the value of the firm satisfies the transversality
condition,
 
MT
lim Et VT = 0. (2.1.9)
T →∞ Mt

Notably, the effect of Eq. (2.1.9) is that of restricting further the set of admissible
financing policies, by requiring that the growth of cash balances is bounded above
by the risk-free rate process {rt +1 }t ≥0.

2.1.2 Default and Bankruptcy Procedures

The remainder of the section is dedicated to discuss what happens if the firm renege
on its debts. This is a very important part of every corporate finance model, as it
shapes the conflict of interests between share and debt holders. First of all, recall
that equity holders are protected by limited liability, which means that in the worst
case they get nothing out of a bankruptcy procedure. Holding the investment policy
fixed to the one exogenously given, shareholders always opt for default if there exists
no feasible financing policy t = {Fs+1 , Ls+1 }s≥t such that V̂tE (t ) ≥ 0. However,
the assumption of an exogenous investment policy is just a way to initially separate
investment from financing decisions. When production and investment decisions
are explicitly modeled, it is customary to impose that default always occurs after
production takes place. This hypothesis serves to rule out indirect asset sales before
trading becomes possible at a certain date. This is a very technical point which we
clarify further in the next chapter.
The first type of bankruptcy procedure which we examine is inspired by
the Chapter 11 of the United States Bankruptcy code. Basically, we consider a
26 2 The Value of the Firm and Its Securities

restructuring of the firm’s liabilities through a debt-for-equity swap. Let td be the

default date; then, the process goes as follows:
(1) the firm, on behalf of its shareholders, declares the intention to renege on its
debts;3
(2) investment, financing decisions are temporary suspended, and all the outstand-
ing securities are converted in a new class of ordinary shares;
(3) the incumbent share and debt holders split between themselves, according
to some allocation mechanism, the cum-dividend value of the new shares,
obtaining respectively a non-negative payoff equal to to RtEd and RtBd ;
(4) the
 legal
 and administrative expenses related to the balance sheet restructuring
bctd are paid;
(5) investment and financing decision for date td are taken.
Based on the timing of these events, we can formulate the following equation in td ,
 
RtEd + RtBd = xtd − bctd + 1 + rtd −1,td Ltd + Vtd (2.1.10)

which reflects the fact that sum of the recovery values, net of the available liquidity,
is equal to the cum-dividend value of the firm. As there are no interest payments
at td , compared to the case in which the firm is solvent, dividends are lowered
by direct bankruptcy
 costs bc t d and the loss of tax shield on current interests
expenses πtd = 0 . The debt-for-equity swap is essentially a procedure in which
the firm continues to operate, but there is a change in its ownership. The fact that
shareholders may retain a positive recovery value, therefore violating the absolute
priority of debt holders, may depend on the strategic design (see Section 6.3.5), as
in Mella-Barral and Perraudin (1997).Notice that a debt-for-equity swap is feasible
if and only if 0 ≤ bctd ≤ Vtd + xtd + 1 + rtd −1,td Ltd , as a result of shareholders’
limited liability.
Instead, on the other side we have Chap. 7-like procedures, which entail the
liquidation of the firm. The general schematic description of a liquidation is the
following:
(1) an event of default takes place (e.g. coupon payments are skipped);
(2) the firm’s assets are seized and grouped into different lots;
(3) a contract is written with an agent in charge of maximizing the proceeds from
the assets sale;
(4) depending on their priority, the incumbent security holders obtain a non-
negative recovery value;
(5) the firm ceases to exist and its securities are written off.
The total proceeds from assets sales are equal to the sum of the recovery values of
debt and equity holders, where the latter will typically obtain nothing in this case. It
is convenient to represent the sum of recovery values introducing a random variable

3 In the legal jargon, the firm fills for bankruptcy protection.

2.2 The Modigliani and Miller Theorems 27

bctd defined as,

∞
 Mtd +j
bctd := Etd xt +j − RtEd + RtBd , (2.1.11)
Mtd
j =0

which can be interpreted as the difference between the NPV of the cash flows that
could be extracted from the firm’s assets and their liquidation value. Typically, we
should expect to see this difference to be positive, which means that liquidation
is costly. Shleifer and Vishny (1992) provides a general equilibrium explanation
for the presence of liquidation costs, which could be useful to understand how
macroeconomic conditions influence the outcome of bankruptcy procedures. With
these notions, we are ready to present the Modigliani and Miller (MM) theorems,
which marked the birth of modern corporate finance theory.

2.2 The Modigliani and Miller Theorems

The MM theorems are valid under specific conditions, which are often labelled as
“ideal” to give a sense of how far they are from reality. And it is indeed for this
reason that the propositions are of fundamental importance, as we can understand
when and why capital structure and dividend policy decisions may affect the value of
firms when relaxing the MM assumptions. We illustrate the theorems by considering
the simple capital structure described above. Nevertheless, a more sophisticated
capital structures is possible, and it is actually a specific result of the general case we
discuss in Sect. 1.4.1. The MM theorems divide in a statement about the irrelevance
of dividend policy, and one about the irrelevance of the financing policy as a whole.
While we could present just the latter result, it is useful to proceed step by step,
as the methodology developed in this section will prove to be a very useful tool in
more general circumstances.

2.2.1 Irrelevance of Dividend Policy

Consider a firm which makes no use of debt and does not hold cash reserves.
By Eq. (2.1.1), unlevered free cash flows are paid out as dividends plus share
buybacks(shares offerings, if negative), and the value of the firm is equal to
Vt = Et ∞ s=1 Mt,t +s xt +s , consistent with Eq. (2.1.7). Suppose that either taxation
is null or interest income is tax-free (πt = 0). We now allow the firm to hold cash
reserves. Absent debt, the firm dividend policy {dt ≥ 0, nt +1 ≥ 0, Lt +1 }t ≥0 must be
consistent with the budget constraint,

st (nt +1 − nt ) + xt = dt nt + Lt +1 − Lt (1 + rt ) , (2.2.1)
28 2 The Value of the Firm and Its Securities

as well as with Eq. (2.1.8). As a result, the budget constraint can be written as Vt +1 +
xt +1 = nt +1 (pt +1 + dt +1 ) + Lt +2 − Lt +1 (1 + rt +1 ), where Vt = pt nt +1 − Lt +1 .
Financial markets equilibrium requires that,
 
pt nt +1 = Vt + Lt +1 = Et Mt,t +1 (pt +1 + dt +1 ) nt +1 =

Mt +1
Et [Vt +1 + xt +1 + Lt +1 (1 + rt +1 )] =
Mt
   
Mt +1 Mt +1
= Et (Vt +1 + xt +1 ) + Lt +1 Et (1 + rt +1 )
Mt Mt
 
Mt +1
= Et (Vt +1 + xt +1 ) + Lt +1 . (2.2.2)
Mt

Hence, we can write the value of the firm as,

 
Mt +1
Vt = Et (Vt +1 + xt +1 ) . (2.2.3)
Mt

To solve this equation we can then use Eq. (2.1.9), thereby obtaining the following
expression for the value of the firm.
∞
 Mt +j
Vt = Et xt +j . (2.2.4)
Mt
j =1

Thus, we have the following result.

Proposition 2.1 Suppose the firm’s capital structure includes only common stocks,
and the investment policy {xt }t ≥0 is exogenously given. If there are no transaction
costs, and no taxes on liquidity reserves, then the value of the firm is independent
from its dividend-liquidity policy and shareholders gain nothing regardless the
policy assumed by the firm.
Proof The first part of the proposition has been shown above. To prove that
shareholders value is independent from the dividend-liquidity policy adopted, it is

sufficient to observe that V̂tE = xt + Lt (1 + rt ) + Et ∞
Mt+j
! j =1 Mt "xt +j , which is
independent from the continuation policy dj ≥ 0, s j +1 ≥ 0, Lj +1 j ≥t . Since the
same argument holds for all t ≥ 0, we conclude that shareholders value is unaffected
by dividend-liquidity decisions. 
As a corollary to the proposition, since Lt is taken as given at time t, the only driver
for the value the shareholders can focus on is the investment policy of the firm.
2.2 The Modigliani and Miller Theorems 29

2.2.2 The Irrelevance of Financing Policy

The result we obtained in the previous section can be generalized by including

debt financing. If this result was actually true, the theory of capital structure would
probably end up in this section. This is not the case, as several hypothesis, such
as the absence of tax effects of debt financing, are counterfactual. However, the
importance of the irrelevance result contained in Proposition 2.2 is twofold. On
one hand, it shows under which ideal conditions we should not be caring about
financing decisions, which may be a useful approximation in several cases. On the
other, it suggests that investment decisions will be a primary driver of the value for
shareholders, which is a generally accepted result, both in theory and practice.
We give a formal statement for the capital structure described in Sect. 2.1, and
provide a formal proof in the case that an event of default is resolved with a debt-
for-equity swap, in which bond holders have absolute priority. The alternatives
of liquidation and multiple debt securities can be obtained as special cases of the
general analysis presented in Sect. 1.4.1.
Proposition 2.2 Suppose the investment policy {xt }t ≥0 is exogenously given, inde-
pendently from the financing policy, and that {πt = bct = 0}t ≥0 . If the absolute
priority rule is satisfied in case of default, RtB+1 = min {Ft +1 (1 + ct +1 ) , xt +1
+Lt +1 (1 + rt +1 ) + Vt +1 − bct +1 }, the value of the firm (Vt = st nt +1 + pt Ft +1
−Lt +1 ) is independent from  its financial policy {dt +1 , nt +1 Ft +1 , ct +1 , Lt +1 }t ≥0
and it is equal to Vt = Et ∞ j =i Mt,t +j xt +j . Moreover, shareholders value is
independent from financing decisions.
Proof Let δt be an indicator function that is equal to 1 if bankruptcy occurs at date
t, or zero otherwise. At each point in time, the asset pricing equations for bonds and
shares are,
# $ %&
Mt +1 RtB+1
pt = Et (1 + ct +1 ) · (1 − δt +1 ) + δt +1 (2.2.5)
Mt bt
# $ %&
Mt +1 RtE+1
st = Et (st +1 + dt +1 ) · (1 − δt +1 ) + δt +1 (2.2.6)
Mt nt

Let Ct +1 ⊆ Ft +1 the set of events for which default does not take place in t + 1. If
we let Pt the conditional probability measure at time t, the value of the firm can be
written as,

Vt = st nt +1 + pt Ft +1 − Lt +1 =
Mt +1
[(st +1 + dt +1) nt +1 + (1 + ct +1 ) Ft +1 ] dPt (ω) +
ω∈Ct+1 Mt (2.2.7)

Mt,t +1 RtE+1 + RtB+1 dPt (ω) − Lt +1 .

ω∈C t+1
30 2 The Value of the Firm and Its Securities

Furthermore, ∀ω ∈ Ct +1 the firm’s one-period ahead budget constraint is equal to,

(pt +1 + dt +1 ) nt + (1 + ct +1 ) bt = Vt +1 + xt +1 + (1 + rt +1 ) Lt +1 (2.2.8)

while for ∀ω ∈ C t +1 , the following expression holds valid,

RtE+1 + RtB+1 = Vt +1 + xt +1 + (1 + rt +1 ) Lt +1 . (2.2.9)

Therefore,

Mt +1   
Vt = Vt +1 + xt +1 + Lt 1 + rt,t +1 dPt − Lt +1 =
ω∈Ft+1 Mt
  (2.2.10)
Mt +1
Et (xt +1 + Vt +1 ) .
Mt

Mt+s
Recall the transversality condition lims→∞ Et Mt Vt +s = 0. Solving
Eq. (2.2.10) we obtain,
∞

Vt = Et Mt,t +j xt +j , (2.2.11)
j =1

To prove the second part of the proposition we can proceed as in the proof of
Proposition 2.1. Since the absolute priority rule holds, shareholders will default only
if their recovery value is null. In fact, in order to obtain a positive recovery value, we

must have SHt := xt +Lt (1 + rt )+Et ∞
Mt+j
j =1 Mt xt +j −Ft (1 + ct ) > 0, which is
equivalent to having positive shareholders value and conditional upon the decision
to repay debt and coupon. Hence, shareholders ! value is equal to max {0, SH"t }, which
is independent from the continuation policy dj +1 , nj +1 Fj +1 , cj +1 , Lj +1 j ≥t . 
Proposition 2.2 asserts that, if (i) there are no bankruptcy costs, (ii) the are no
transaction costs associated to issuing new securities, (iii) taxation is unaffected
by financing choices, and (iv) the firm’s investment policy is independent from
financing choices, then both the value of the firm and shareholders value are not
affected by financing choices. The intuition is trivial. We can imagine debt and
equity as different slices of a pie, where the pie is the market value of the firm. By
non-arbitrage, although the firm’s unlevered cash flows are not directly traded, there
exists always a portfolio of securities that replicates its dynamics. Such a portfolio
is indeed composed by the firm’s financial liabilities, that are freely tradable on the
market. Hence, if the financial liabilities mix has no effects on the free cash flows
stream of the firm, the size of the pie remains unchanged, and the total market value
of the firm depends only on {xt }t ≥0 .
At this point, we may wonder what is the effect of financial leverage, as it is
eventually irrelevant for shareholder value. Suppose that ct +1 is such that pt +1 = 1
2.2 The Modigliani and Miller Theorems 31

always, that is, debt is issued at par value. Intuitively, higher debt makes future
dividends riskier for shareholders. As such, after time t dividends are paid, we
should expect the ex-dividend equity value to be lower the higher the leverage
ratio FVt+1
E is. Equivalently, the stocks of more levered firm, ceteris paribus, should
t
be associated to higher expected returns. Similarly, higher liquidity levels should
reduce expected returns, as they dilute the weight of cash flows risk. However,
since the value of the firm is unchanged, we should not expect the weighted
average of stocks and bonds to be affected by the financing mix. This result is
actually a corollary of Proposition 2.2, which comes from Hamada (1972) for the
case of risk-free debt (see Sect. 3.3). Two considerations appears useful from a
practitioner’s perspective, at least assuming that Proposition 2.2 can thought as a
good approximation of what happen in the real market. First, financial leverage can
be used to shift the risk-return profile of a stock. Hence, holding everything else
constant, investing in stocks with higher leverage should generate higher expected
returns on average, but, at the same time, it should also be associated to higher
portfolio volatility. Second, if we wish to neutralize the effect of leverage, but still
get exposure to the firm’s free cash flows, we should invest both in stocks and bonds,
in the same proportion of their relative market capitalizations.
Proposition 2.3 Assume that ct +1 is such that pt = 1 for all t. Let χ := {x}t ≥0
χ VE
the firm’s investment policy, and rt +1 := Vtt rtE+1 + FVt+1 t
rtB+1 − LVt+1
t
rt +1 , rtE+1 :=
(dt+1 +st+1 )(1−δt+1 )+Rt+1
E δ
and rtB+1 = (1 + ct +1 ) (1 − δt +1 ) + RtB+1 δt +1 the total
t+1
st
χ
returns firm, stocks and bonds at time t + 1, respectively. Then, rt +1 is independent
 E  F
from the firm’s financing policy. Furthermore, Et rt +1 is increasing in Vt+1 E and
t
Lt+1
decreasing in VtE
.

VE pF L x +V
Proof The first part is trivial. Simply, Vtt rtE+1 + t Vt+1
t
rtB+1 − Vt+1
t
rt +1 = t+1Vt t+1
χ
from the application of the firm’s budget constraint. Hence, rt +1 does not depend
on the firm’s financing policy. The second part, instead, is more complicated. To see
why, consider that the effect of leverage is ambiguous in principle. On one hand,
higher leverage increases the risk for shareholders to see their dividends slashed in
the following period, if they decide to repay debt. On the other, higher leverage
increases the option value of default, that is, the possibility for shareholders to
rationally renege on the firm’s debt.  
E
∂Et rt+1
Formally, our goal is to show that ∂Ft+1 ≥ 0. In order to do so, the first
step is to recognize the expression of time t + 1 shareholders value V̂tE+1 the
V̂ E
numerator of rtE+1 , so that we can write rtE+1 = Vt+1E . From Proposition 2.2, we have
' 
t (
∞ M
V̂tE = max 0, xt + Lt (1 + rt ) + Et j =1 Mt xt +j − Ft (1 + ct ) , which can be
t+j
32 2 The Value of the Firm and Its Securities

used to obtain the following expression for equity returns,

1
1 + rtE+1 = max {0, xt +1 + Vt +1 + Lt +1 (1 + rt +1 ) − Ft +1 (1 + ct +1 )} ,
VtE
(2.2.12)

Consider the scenarios in which the firm is not defaulted, δt +1 = 0. Then, debt
χ VtE E pt Ft+1 Lt+1
holders are paid back in full, rt +1 = Vt rt +1 + ct +1 − Vt rt +1 and we can
VtE
write Eq. (2.2.12) as,
  
Lt +1  χ  Ft +1  χ 
rtE+1 = max rt +1 + 1 − E rt +1 − rt +1 + E rt +1 − ct +1 , −1 .
Vt Vt
(2.2.13)

χ Lt+1  χ  Ft+1  χ 
Let ut +1 := rt +1 − VtE
rt +1 − rt +1 + VtE
rt +1 − ct +1 . Since the investment
χ
policy is individually rational, rt +1 ≥ −1 and, consequently, Prt {ut +1 > 1 + α} >
Prt {ut +1 > 1 −!α} for every" α > 0. The resulting positive skew implies that
Et rtE+1 = Et [ut +1 , −1]+ is increasing in the variance of ut +1 . Since the latter
 E 
is increasing in Ft+1
E and decreasing in
Lt+1
E , we conclude that Et rt +1 is increasing
Vt Vt
Ft+1 Lt+1
in and decreasing in as we claim. 
VtE VtE

2.2.3 Debt Tax Shield and Bankruptcy Costs

Most of countries adopted fiscal legislations that allows for tax effects of financial
income and expenses. For instance, the interest income earned on liquidity reserves
is often taxed at the same rate applied for operating earnings. Likewise, interests
expenses are often tax deductible, although sometimes with limitations. At a very
general level, we can say that a certain financing policy results in a net tax shield
πt which increases or reduces taxation in period t depending on the interests paid
on debt and those earned on liquidity. To make a specific example, suppose that
the corporate tax rate (τ ) is constant4 and it is applied to the firm’s net income. In
this case, we would have Tt = (ebitt − ct Ft + rt Lt ) τ , and, consequently, πt =
ct Ft − rt Lt .
In the remainder of the section our interest is to understand the effects of
introducing taxable financial income and bankruptcy costs in the MM framework. A
debt-for-equity swap procedure remains the working hypothesis in case of default.

4 A constant tax rate implies that the firm receives a net transfer from the government when its net

income is negative. It is sometimes a good approximation in situations in which the loss carry-
forwards can be quickly used.
2.2 The Modigliani and Miller Theorems 33

As a result, in case of default the firm will loose its ability to deduce interests
expenses from taxes in the same period that default takes place, as all bonds are
converted in shares before coupons are paid. Although not essential, it may be con-
venient in this case to represent the debt tax shield as πt = dtst (rt Lt , (1 − δt ) ct Ft ).
We can then show that the following value of the firm is always valid,
∞

Vt = Et Mt,t +j xt +j + DT St − BCt (2.2.14)
j =1


where DT St := Et ∞ j =i Mt,t +j dtst (rt Lt , (1 − δt ) ct Ft ) is the net present
value
 of the tax benefits from a given financing policy. The term BCt :=
Et ∞ j =i Mt,t +j bc t +j δ t +j is instead the NPV of all bankruptcy costs that the
firm will experience in case of one or more default episodes.
The proof of Eq. (2.2.14) derives again from the firm’s budget constraint. Starting
from the asset pricing equation for the price of shares and debt, Eq. (2.2.5–2.2.6)
respectively, we can write the value of the firm as,

Mt+1
Vt = st nt+1 + pt Ft+1 − Lt+1 = [(st+1 + dt+1 ) nt+1 + (1 + ct+1 ) Ft+1 ]
ω∈Ct+1 Mt

× (1 − δt+1 ) dPt (ω)

Mt+1
+ E
Rt+1 + Rt+1
B
δt+1 dPt (ω) − Lt+1 .
ω∈C t+1 Mt
(2.2.15)

Substituting Eq. (2.1.1) and Eq. (2.1.10) into the first and second integral of
Eq. (2.2.15), respectively, the following difference equation is obtained,
! "
Vt = Et Mt,t +1 [xt +1 + Vt +1 + πt +1 − δt +1 bct +1] , (2.2.16)

which admits the solution,

∞
 ∞

Mt +j Mt +j    
Vt = Et xt +j + Et dtst rt +j Lt +j , 1 − δt +j ct +j Ft +j
Mt Mt
j =1 j =1
∞
 Mt +j
− Et bct +j δt +j . (2.2.17)
Mt
j =1

Differently from the MM world, the value of the firm is now affected by the
firm’s financing policy. As a result, shareholders value may depend on capital
structure decisions. The irrelevance of the firm’s financing policy is now broken,
and understanding the effects of dynamical capital structure decisions is of central
importance.
34 2 The Value of the Firm and Its Securities

2.3 Capital Structure and Corporate Governance

We have seen that introducing tax effects of debt financing and bankruptcy costs,
the MM irrelevance results are no longer valid. However, one point we consider as
unsatisfactory is about the investment and financing decisions which are assumed
as exogenously given. In other words, while we could always formulate Eq. (2.2.17)
for a given investment and financing pattern, a more robust theoretical framework is
need to determine which patterns will be chosen. This will be actually the purpose
of all the following chapters, but it is important to introduce from the beginning few
very important concepts in relation to investment decisions and in which interests
we should expect a firm to be managed.

2.3.1 Investment Decisions and Agency Costs

Let Υ be the set of all unlevered free cash flows processes χ = {xt }t ≥0, which
depends on the firm’s investment policy. To simplify our discussion, and without
loss of generality, Υ can be assumed as the set of all available investment policies.
Note that we are not imposing the individual
! " rationality condition.
 Let assume that
there exists an element χ ∗ ∈ Υ , χ ∗ = xt∗ t ≥0 , such that Et ∞ j =0 M t,t +j x ∗
t +j ≥
∞ ∗
Et j =0 Mt,t +j xt +j for every χ ∈ Υ . By definition, χ maximizes shareholders
value for an all-equity firm that does not hold liquidity reserves. This lead us to
following definition. A firm is said unlevered if these conditions hold: (i) the capital
structure includes only common stocks, (ii) no cash reserves exist and (iii) the
investment policy adopted is χ ∗ . In other words, the unlevered firm is an-all equity
firm whose value, Vtu , cannot be improved by any other investment strategy,

∞

Vtu = Et Mt,t +j xt∗+j . (2.3.1)
j =0

The unlevered firm is an important benchmark, which can be used to gauge the
real effects of dynamic capital structure decisions. To put the point into perspective,
assume that, in order to the best interest of the controlling stakeholder, the firm is
running
 under an ∗investmentpolicy χ ∈ Υ : χ = χ ∗ . The difference between
Et ∞ M x
j =1 t,t +j t +j and Et
∞
j =1 t,t +j xt +j is called agency costs (ACt ),
M

∞
 ∞

ACt := Et Mt,t +j xt∗+j − Et Mt,t +j xt +j (2.3.2)
j =1 j =1

and it is a deadweight loss for the firm. It should be noticed that the notion of
controlling stakeholder denotes the agent effectively in control of the firm’s decision
making process. While in general we conjecture that markets are complete and
2.3 Capital Structure and Corporate Governance 35

a representative shareholder is in control, there might situations in which this

hypothesis is not appropriate. In Sect. 2.3.3 we briefly overview this important
feature, which motivates the indispensable role of corporate governance. Still, even
when a representative shareholder can be thought to be in control, there might be
reasons for her to deviate from χ ∗ . Writing Eq. (2.2.17) equivalently as,

Vt = Vtu + DT St − (ACt + BCt ) , (2.3.3)

we can guess that, in equilibrium, shareholders are trading-off the tax benefits
of debt financing with the resulting agency and bankruptcy costs. Actually, this
is the common trait of all the models we present in the following chapters, and
well summarizes the kind of topics that are commonly considered part of dynamic
corporate finance theory.

2.3.2 Optimal Investments, Capital Budgeting

and Debt Overhang

Debt overhang is a notable example of agency costs, we briefly discuss in this

section. Chapters 5, 6 and 7 explore in more depth the technical details and come up
with more accurate quantitative predictions. Myers (1977) is the first to formalize
the idea that shareholders may become reluctant to invest when indebtedness
becomes very high relative to the firm’s fundamentals. The model we present in
this section is useful also to introduce the concept of growth options and assets in
place.
Suppose there are neither taxes nor bankruptcy costs. The firm is endowed with
capital stock K0 , which is assumed for simplicity not to depreciate over time. The
optimal use of this capital stock allows shareholders to extract in each future time
t > 0 an amount of operating cash flows equal to At K0 , where {At > 0}t ≥0 is a
strictly positive exogenous stochastic process. Let assume also that the firm’s capital
stock cannot be increased, but in each period the firm has the option to invest a
dollars amount equal to It ∈ [0, I ] in a new project. Each project becomes available
at a specific time t, and the firm can invest in it only at the same date. In other words,
there is no option to delay the investment in the growth option becoming available at
a given point in time. Likewise, investment in each project ' is irreversible.
( A generic
5 (t )
project t generates a non-negative cash flows streams yt +j It > 0 , where It is
j >0
the amount of dollar invested in the project. In addition, investment in each project is
irreversible, meaning that the firm cannot divest from any of its earlier implemented
projects.

5 Projects are indexed by the date in which they are available, which corresponds to the time index

of the economy.
36 2 The Value of the Firm and Its Securities

If we let Kt be the firm’s total invested capital,


t
Kt = K0 + It , (2.3.4)
j =1

it easily turns out that unlevered free cash flows can be expressed as,

t −1
 (j )
xt = At K0 + It yt − It . (2.3.5)
j =1

The firm is endowed with a certain amount of debt, say F0 ≥ 0, which consists of a
perpetual bond with coupon rate c > 0. The amount of the outstanding debt cannot
be adjusted over time, and the firm does not hold or accumulate cash. A default event
results in the firm liquidation and shareholders are assumed to lose everything. On
this regard, the hypothesis is that the option to invest in future projects is lost in
the bankruptcy process, as only the assets in place of the firm can be liquidated.
Hence, the key question is whether shareholders will adopt the same investment
policy {It }t ≥0 independently from F0 .
Consider first the case of an all-equity firm, that is, F0 = 0. In all discrete
time models we discuss, investment decisions at time t are always taken before
dividends are paid. Hence, shareholders maximize their cum-dividend equity value,
then obtaining the cum-dividend unlevered firm value V̂tu = Vtu + xt∗ . Thus, the
unlevered firm’s shareholders solve the following dynamic problem,
⎧ ⎫
⎨  
Mt +1 u ⎬
t −1
 (j )
V̂tu = max At K0 + Ij yt − It + Et V̂ , (2.3.6)
It ∈[0,I ] ⎩ Mt t ⎭
j =1

as Vtu = Et MMt+1t
V̂tu . The solution of the problem can be obtained by using a
standard dynamic programming approach. However, in this specific case we can use
a more direct approach, after having represented the LHS of Eq. (2.3.6) equivalently
as,
⎧ ⎡ ⎤⎫
⎨ 
t ∞
 Mt+s 
t+s−1 ⎬
max At K0 +
(t−s)
It−s yt − It + Et ⎣At+s K0 + (t+s)
I j yt ∗ ⎦
− It+s ,
It ∈[0,I ] ⎩ Mt ⎭
s=0 s=1 j =1
(2.3.7)
where It∗+s
is the optimal investment decision in period t ± s, s = 0. Notice that
past and future investment decisions have no effect on the decision about investing
in the currently available project. As a result, the optimal investment level in each
2.3 Capital Structure and Corporate Governance 37

period can be obtained as the solution of a static problem, namely,

#$ ∞
% &
 Mt +s
It∗
(t )
= argmaxIt ∈[0,I ] −1 + Et yt +s It . (2.3.8)
Mt
s=1


:= −1 + Et ∞
(t ) (t )
The expression NP Vt s=1 Mt,t +s yt +s is the NPV per dollar
invested in the project t at the same date, which is constant and independent from the
(t )
amount of dollars invested. As long as NP Vt > 0, it is optimal for shareholders
to invest as much as possible in project t. Hence, the equilibrium investment policy
for an all-equity firm is,
, ∞
-
 Mt +s
It∗ = I I Et
(t )
yt +s ≥1 (2.3.9)
Mt
s=1

This result is a restatement of the positive NPV rule,6 which is a direct

consequence of shareholders inability to postpone the investment decisions. Hence,
the recursive application of Eq. (2.3.9) generates the maximum NPV for {xt }t ≥0.
At this point, we need to understand whether introducing F0 > 0
should motivate shareholders to deviate from the first-best policy It∗ =

I I Et ∞
(t )
s=1 Mt,t +s yt +s ≥ 1 for the NPV of unlevered free cash flows. To answer
the question, we formulate the problem of the levered firms, which consists in
maximizing shareholders value. However, differently from the unlevered case, we
must take into account the effects of the option to default. Since the option to invest
at time t project is lost in case of default, the levered firm’s shareholders solve,
⎧ ⎧ ⎫ ⎫
⎨ ⎨  
Mt +1 E ⎬ ⎬
t −1
 (j )
V̂tE = max max At K0 + Ij yt − It − cF0 + Et V̂ ,0 .
⎩It ∈[0,I ] ⎩ Mt t ⎭ ⎭
j =1
(2.3.10)

First, we observe that for high levels of debt,

' relative to the current fun-

damentals, the continuation value maxIt ∈[0,I ] At K0 + tj−1
(j )
=1 Ij yt − It − cF0
(
+Et MMt+1 t
V̂tE could be negative. As such, shareholders prefer the default instead
of paying coupons and continue to invest in positive NPV projects. Let δt be an
indicator function of this occurrence. Then, it is straightforward to reformulate

6 Usually assumed as benchmark rule in optimal capital budgeting.

38 2 The Value of the Firm and Its Securities

shareholders problem as,

⎧ ⎧
⎨ ⎨ t −1
 (j )
V̂tE = max max At K0 + Ij yt − It − cF0 +
⎩It ∈[0,I ] ⎩
j =1
⎡ ⎤ ⎫ ⎫
∞
 Mt +s
t +s−1
 ⎬ ⎬
⎣At +s K0 + (t +s)
Et Ij yt − It +s − cF0 ⎦ (1 − δt +s ) , 0 .
Mt ⎭ ⎭
s=1 j =1
(2.3.11)
' 
maxIt ∈[0,I ] At K0 + tj−1
(j )
Suppose at time t =1 Ij yt − It − cF0 + Et
(
Mt+1 E
Mt V̂t > 0. Then, δt = 0, and, since current investment decisions are
not depending on the future, the levered firm investment policy is obtained as the
solution of the following static program,
#$ ∞
% &
 Mt +s (t )
argmaxIt ∈[0,I ] −1 + Et yt +s (1 − δt +s ) It . (2.3.12)
Mt
s=1

By anticipating future default decisions, the NPV from investing in date t project
is lower than the unlevered case. As a consequence, we may frequently encounter
projects with a positive NPV for the unlevered firm, but with negative NPV for
shareholders in presence of leverage. Notably, the higher is debt relative to xt , the
higher is the chance that default will take place in the future. Hence, the effect of

higher debt levels is that of increasing the threshold for Et ∞ Mt+s (t )
s=1 Mt yt +s which
makes convenient for shareholders to invest in project t. Thus, the presence of
debt may depress investments, especially when default is likely to occur in the
near future. This effect is known as debt overhang, and it is frequently observed
in distressed firms. Put differently, we observe a decoupling between the NPV of a

project t cash flows, −1 + Et ∞ Mt+s (t )
s=1 Mt yt +s It , and the NPV of the same project

for shareholders, −1 + Et ∞ Mt+s (t )
s=1 Mt yt +s (1 − δt +s ) It . As long as shareholders
are in control of the firm, it is the latter that drives investment decisions.

2.3.3 The Value of Corporate Governance

In this section we depart from the general assumption that firms maximize share-
holders value. The purpose of the discussion is to shed lights on some important
factors explaining the value-oriented behaviors. Since we are not interested in the
effects of debt financing, we let common stocks be the only class of securities in the
firm’s capital structure. In addition, the firm holds no cash on its balance sheet, and
2.3 Capital Structure and Corporate Governance 39

there are no transaction costs on financial markets. While the firm’s technology is
the same as in the previous section, we assume now that it is managed by a group of
managers.
Suppose that shareholders can write a contract, that, other than being perfectly
enforceable, it can specify the investment policy that must be followed by managers.
If that was possible, shareholders would simply write their optimal investment
policy in the corporate bylaws to obtain the unlevered firm value. However, real
contracts are typically incomplete, as writing in a legally binding piece of paper
the state-contingent prescriptions of an optimal dynamic program in not possible.
For this reason, shareholders need to set up alternative governance mechanism that,
hopefully, will align their interests with those of the managers in charge to manage
the firm on their behalf, which is an example of principal-agent problem.
When contracts are incomplete, markets are also incomplete. While an equilib-
rium stochastic discount factor continues to exist for the purpose of valuing the
firm and its securities consistently with Eq. (1.3.1), shareholders may no longer
agree upon the objective of maximizing the value of the firm (see Sect. 1.3.2). This
creates a second problem, as the controlling shareholder may be not interested
in maximizing the cum-dividend value of equity. We exemplify the point in
Sect. 2.3.3.2.
In Sect. 2.3.3.1, we consider a firm with a perfectly dispersed ownership. Since
no one is in control and there are no externalities, we assume that each shareholder’s
utility function is monotone increasing in the cum-dividend market value of equity.
As a consequence, shareholders would agree on proposing to the management
a contract which requires them to maximize total shareholders value. However,
because no one is in control, the private cost of monitoring managers will be
generally too high, an argument we extend to shareholders meetings, in which
a poor performing management could be replaced. Generally speaking, managers
may be not acting in the best interest of shareholders. In the model, this possibility
is introduced by assuming that investing in new projects requires managers to
put additional effort in their jobs at the firm. This is not infrequent in the real
world, which may be due to the lack of organizational capital, in the sense that top
managers are typically time-constrained and may need to work several extra hours to
complete a new project. In this regard, we denote by D the dollars equivalent value
of the private detriment in which managers incur if working on a new investment
project. As a result, if managers have a remuneration scheme independent from the
firm’s performance, and there is no threat of replacement, they will be always better-
off by choosing to not invest in new projects. The relevant question is thus whether
a raider, intended as a candidate controlling shareholders, may be successful to take
control of the firm and replace the incumbent management team. Under a perfectly
dispersed ownership, we show that this is not an easy task, despite the welfare loss
caused by leaving on the ground valuable investment opportunities.
Instead, in Sect. 2.3.3.2 we assume the presence of a majority shareholder
who is in the direct control of the firm. However, its objectives collides with the
40 2 The Value of the Firm and Its Securities

maximization of the total firm’s value. In particular, minority shareholders will be

harmed by the conflictual presence of the large shareholder. This applies for both the
institutional and the private controlling shareholders, who can represent an holding
company and an entrepreneur, respectively.
The models we present in this section are intentionally extreme. However,
they provide food for thought. The message is that corporate governance and
ownership structure are of utmost importance. Without a governance code able to
ensure the total shareholders value maximization, firms may be managed in a very
different fashion, and a corporate raid could be just a wishful thinking. Although
in the remainder of the book we assume that firms are managed as to maximize
shareholders value, we should keep in mind that this condition should be not always
taken for granted.

2.3.3.1 Dispersed Ownership, Take-overs and Threat of Replacement

The model we introduce in this section is an adaptation of Grossman and Hart

(1980). Specifically, we impose the following hypotheses:
(1) the firm is managed by its Board of Directors (BoD);
(2) the members of the BoD, or directors, are homogeneous and remunerated by a
constant wage;
(3) all members have the same preferences and are all involved in the investment
selection process for new projects;
(4) investing in a new project results in a private detriment D > 0 to each director;
(5) the BoD can be changed at the end of each date t with a majority vote at a
shareholders meeting;
(6) the firm’s ownership structure is perfectly dispersed (i.e. each shareholder is
infinitesimal);
(7) replacing the BoD requires the payment of a search cost C > 0;
(8) a raider can bid a price to acquire the shares of the company, however incurring
in legal and transaction costs equal to c ≥ 0.
A perfectly dispersed ownership means that each shareholder holds an infinitesimal
stake in the firm. While this is of course an abstraction, it aims at describing a
situation in which the cost of each individual shareholder to participate actively
in the firm’s governance will exceed the corresponding benefits. To simplify the
discussion, we use the terms tender and takeover interchangeably. Moreover, we
move having in mind the equilibrium property for which the agents taking actions
first are assumed to correctly anticipate the strategies of agents moving second (see
also Sect. 1.3).
At each time t, the first mover is the BoD, as it is up to its member the decision
to invest in the project t. Since the members of the BoD are homogeneous, they can
be seen as a single individual, we simply define the manager. The second movers
are in order the raider, and the incumbent shareholders. The virtual timing of events
at each time t is thus the following.
2.3 Capital Structure and Corporate Governance 41

(1) First, the manager decides whether to invest or not in project t.

(2) Second, the raider, once dividends are paid, decides whether to bid for the
control of the company. In this regard, the raider will bid a price that ensures a
non-negative NPV from the deal.
(3) Third, incumbent shareholders decide whether to participate to the tender-offer,
or to remain within the firm.
(4) Fourth, if at least 50% of the shares outstanding are tendered to the raider, the
takeover is completed and the raider gets in control of the firm.
(5) Fifth, shareholders convene at their period meeting and decide whether to
replace the management or not. If a controlling shareholder exists within the
ownership structure, she becomes automatically the new manager at no cost.
As a result, there are three possible outcome: (i) the manager remains in charge,
(ii) the manager is replaced by the incumbent shareholders, (iii) the manager is
replaced by a raider that acquires the control of the firm with a tender offer.
We can then obtain the unique equilibrium of such a game with some logical
observations. Suppose the incumbent manager predicts that she will be not replaced,
regardless of her performance, which is the value creation from investing in positive
NPV projects. If the threat of replacement is not credible, the manager will prefer
not to invest in any project, independently from the NPV. In this way, she will
not experience the private detriment related to the additional effort related to each
project execution. Being unsatisfactory for this behavior, shareholders will be very
much in the mood to fire the lazy manager, at the same time introducing a new
remuneration policy to motivate the new management team to invest in projects
with positive NPV.
We claim that there is no equilibrium in which a perfectly dispersed ownership
is successful to remove the incumbent manager. The proof is as follows. In order
to replace the incumbent manager, a coalition of shareholders must bear the search
cost c to find a new management team and draft a bullet-proof contract for the
newly hired. As is obvious, in case drafting a contract that aligns the incentive
of managers to those of shareholders is not possible, there will be no reason for
shareholders to bear the cost c and replace the manager. Consider now the alternative
in which it is possible to align the incentives between the two stakeholders. Suppose
that this is indeed the case. Since each shareholder is infinitesimal in the coalition,
her incentive is that of abandoning the coalition and free ride the ending result.
Since this argument holds for every member of the coalition, it follows that no
coalition can be organized in the first place. It is the tragedy of the commons.
Although replacing the incumbent manager would be collectively valuable, a perfect
ownership dispersion generates such an extreme free-rider problem which prevents
shareholders to coordinate with each other to improve the corporate governance of
the firm.
Unless a change in the firm’s ownership structure is possible, the manager would
be right to conjecture that, regardless her behavior, she will remain in charge. In this
regard, the striking implication of a perfectly dispersed ownership is that a tender-
offer will never actually take place if c > 0. A a result, the incumbent manager will
42 2 The Value of the Firm and Its Securities

stay in power despite her poor performance, and there will be a net welfare loss for
shareholders. To show this result, let VtE be the value of the firm’s equity assuming
a perfectly dispersed ownership. In this case, the BoD never invests in new projects
and, consequently,
∞

VtE = K0 Et Mt,t +j At +j . (2.3.13)
j =1

In other words, with a dispersed ownership the value of growth opportunities is

zero.7 Now consider a raider that engages in a takeover bid. If the raider ’s bid
is accepted, she would get in control of the firm and become the new manager.
Differently from incumbent shareholders, the raider does not incur in the search
cost C, as she will manage the firm directly in her best interest.
Suppose that the investment projects that become available to the firm are not
sources of externalities for the raider.8 Then, the raider’s choice to invest in projects
with a negative NPV is suboptimal. However, since the new projects still require
to put effort in the firm, the raider will directly experience the private detriment D.
While minority shareholders would benefit from positive NPV projects, at the same
time they will not share the costs of raider’s effort in managing the firm. For this
reason, we should expect that the raider will invest only in those projects that are
worth the effort. Let θ be the raider stake in the firm, which we assume to remain
constant in time.9 As the raider keeps for itself only a fraction θ of the increase in
the firm’s value, she will put effort only in projects with an NPV at least equal to
1
θ D > 0. Hence, if the tender offer will be successful, the value of equity will be
improved with Vt > VtE ,
$ ∞  %
∞ I j =1 Mt,t +j yt +j λt + Et ∞
(t )
 i=1 Mt,t +i
Vt = K0 Et Mt,t +j At +j + ∞ (t +i) ,
j =1
× j =1 Mt +i,t +i+j yt +i+j − 1 λt +i
     
Value of Assets in Place Value of Growth Opportunities
(2.3.14)


where λt := I θ Et ∞
(t )
s=1 Mt,t +s yt +s ≥ D is an indicator function that denotes at
which conditions it will be optimal for the rider to invest in new projects. While the
presence of the raider does not entirely resolve the underinvestment problem, still it
can improve total shareholders value, and the incumbent shareholders would benefit
from its presence.

7 Although the underlying economic mechanism is different, this result is not infrequent with this

“kind” of investment opportunities. An example is the industry equilibrium is in Leahy (1993).

8 An example is an individual investing in a factory right in front of her home. If engaging in a new

project increases pollution, there is a negative externality for her.

9 This is a very important assumption which we discuss at the end of Sect. 2.3.3.2.
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„Ah … ’k heb hem ook in de gaten … Die slimmerd. Hij blijft ook liever
boven ’t lage land. Hij ontwijkt ’t Rhöngebergte.”

„Da’s toch zoo hoog niet?”

„’n Kleine duizend meter.”

„Niet meer inloopen,” riep Dolf. „Hoe ver schat je, dat ie ons voor is?”

„Nou, ’n kilometer of vijf hoogstens.”

„Is dàt vijf kilometer? ’t Lijkt zoo’n klein eindje … Waar zou ie heen gaan.”

„’k Weet er niks van hoor.”

„Waar gaan we op aan?”

„’k Weet ’t niet precies … Jongens we verliezen op hem … Hij zet er de

sokken in.”

„Hou keep!” riep Dolf. „Houdt ’m vast!”

„Die ontkomt me niet,” lachte Jan Drie.

Ze zwegen weer ’n poos. Alleen de motor gaf geluid. Verder was ’t stil.
Maar toen ze de Main voor zich hadden met de stad Schweinfurt, riep Dolf
alweer:

„’n Stad! Kijk hij vliegt er vlak boven.”

Met dezelfde snelheid vlogen de twee monoplaans achter elkaar voort, uren
lang. ’t Ging over de Tauber, de Jagst, de Neckar. Bij Heilbron week de
voorste monoplaan hoe langer hoe meer van de Zuidelijke richting af en om
zes uur waren ze boven Karlsruhe. Ze hadden drie honderd vijftig
kilometers afgelegd en waren drie uur in de lucht. Jan Drie had al lang ’n
greep gedaan in de vliegtabletten van m’nheer Vliegenthert en hij en Dolf
knabbelden als n paar hongerige konijnen. Weer maakte inspecteur Punt ’n
nieuwe wending naar ’t Zuiden en volgde de Rijn. ’n Half uur later waren
ze boven Straatsburg en om acht uur hadden ze Bazel in Zwitserland
bereikt.

„Ik begrijp niet waar die man heen wil,” zei Jan Drie. „Hij schijnt er niet
over te denken om neer te dalen. Maar ik zal toch ’n beetje opletten, als ie
soms nog naar beneden gaat, dat ie ons niet in de gaten krijgt.”

„Geen nood Jan, hij vliegt door, zoolang z’n hond aanslaat, al was ’t tot aan
’t eindje van de wereld.”

„Wat drommel, wat voert ie nou in z’n schild … ’k Heb niet veel trek hem
dáár te volgen hoor.”

„Ben je gek, waar hij heen kan, kan jij zeker heen. Ik vind ’t eenig leuk.”

„Ja maar Dolf weet je wel waar hij heen vliegt op ’t oogenblik? Als we zoo
nog ’n uur door vliegen, zitten we midden in ’t Berner Oberland.”

„Nou wat zou dat … Ik vind ’t prachtig.”

„Ja maar ik heb het niet op die bergen … Ginds zie je de kleintjes … maar
dan komen de kokkerds. Noem jij ’t maar prettig, ’k heb ’t nou al koel.”

„O ben je kouwelijk … Ik dacht dat je bang was voor die bonken steen.”

„In dat mooie monoplaantje van m’nheer Vliegenthert, Dolf?! Belachelijk!”

smaalde Jan Drie. „Tenminste als ’t er om te doen is óver de Alpen te
komen. Als ’n zwaluw schieten we over de hoogste heen.”

„Dat was vroeger anders hè” zei Dolf. „Die leuke leeraar in de aviatiek,
vertelde hoe in 1910 de aviateur Weyman met ’n passagier ’s morgens uit
St. Cloud vertrok om de top van de Puy de Dôme te bereiken. ’k Weet niet
meer hoe hoog dat ding is, maar in ieder geval is ’t ’n snertberg.”

„1465 meter geloof ik,” zei Jan.

„Nou kijk es aan. Tien kilometer voor de top bleef hij steken. In datzelfde
jaar werd ook de eerste wedstrijd voor ’n bergvlucht uitgeschreven, over de
Simplonpas nog wel. Gemakkelijker kon ’t al niet en ze mochten nog
neerdalen onder weg ook.”

„En hoe liep dat af?”

„’k Weet al niet meer. Je kan niet alles onthouden, wat ze je van die
geschiedenis der aviatiek vertellen. Maar de voornaamste aviateurs uit die
tijd hadden mee ingeschreven, Tyck, Latham, De Lesseps, Chavez, Aubrun,
Legangneux, Cattaneo, Morisant, Parisot en nog meer van die
vliegpioniers … Chavez kwam er over, dat weet ik nog wel, en toen hij er
over was braken z’n vleugels en hij zelf stierf een paar dagen later.”

„Als hij maar niet ergens op zoo’n bergtop dalen wil … Dat doe ik ’m in
geen geval na.”

„Over wie heb je ’t nou,” vroeg Dolf.

„Wel over inspecteur Punt … Die vliegt regelrecht de bergen in … en dat

nou ’t donker begint te worden.”

„We hebben maan van avond …”

„Dat is tenminste iets …” zei Jan … „Maar ’n neveltje kan alles bederven …
D’r hangen om die hooge bergtoppen soms van die dikke wolkbrokken …
Daar moet ik niks van hebben … Daar ga ik boven uit hoor, al raak ik de
heele inspecteur kwijt … Inspecteur Punt stijgt al … Die is ook niet van plan
met z’n neus tegen de keien te vliegen.”
 ACHTSTE HOOFDSTUK.

Waarin inspecteur Punt op ’n hooge berg ’n dame met blond haar aantreft, die
evenwel door Jan Drie en z’n vriend Dolf gered wordt.

„’n Mooie pan,” riep Jan ’n poosje later lachend. „Als ’t ’n beetje wil zijn
we morgen allemaal bevroren … Hoe hoog vliegen we nou?… Duizend
meter?”

„’t Scheelt niet veel, twaalf honderd … Kijk eens daar ginder, recht
vooruit … wat is dat?”

„Alpengloeien … Allemaal witte sneeuw, die de zon rood, oranje en goud

verft … Dat zijn de kokkerds al …”

„Prachtig!”

Dolf werd stil van bewondering, maar na ’n poos zei hij toch:

„En dat zijn nou volgens onze aardrijkskunde leeraar, de botten van Europa,
die door de huid heensteken, meer dan drie duizend meter hoog in de lucht.
Kale dorre knokken, met geen grasje er op. Niets dan sta-in-de-wegs,
waarvoor den menschen netjes ’n omweg hadden te maken.”

„Tot ze zich er door heen boorden met dynamiet …” zei Jan, „en er eindelijk
over heen vlogen. Vroeger waren de bergen ons de baas … Hoeveel moeite
hebben de menschen niet gedaan om die hooge toppen te beklimmen en
hoeveel werden ’t slachtoffer van de bergsport … Nu hebben de menschen
ook die reuzen overwonnen, met luchtschepen en aeroplaans.”

„’t Wordt hoe langer hoe prachtiger!” riep Dolf opgetogen.

„Geen wonder … we vliegen er met ’n honderd-kilometer-gangentje naar

toe. Inspecteur Punt stijgt nog steeds … Hoe hoog?”
„Zestien honderd zoo wat.”

Zoo vlogen de twee aeroplaans maar steeds achter elkaar voort, steeds
hooger klimmend in de fijne blauwe lucht. Want de bergen werden hooger
hoe meer ze ’t hartje van Zwitserland naderden. Aan alle kanten verrezen de
hooge toppen met scherpe kanten en stijle rotshellingen, en vlak voor zich
hadden ze de wit gepruikte oude reuzen van ’t Berner Oberland, die met
gloeiende koppen hen aanstaarden … Die waren allemaal meer dan 3000
meter hoog.

Beneden werden de Zwitsersche bergdorpen in de dalen en de huizen op de

groene almen met lichtjes bespikkeld, maar daarboven scheen nog de zon
ofschoon blauwe en paarsche schaduwen langs de ruwe ruggen langzaam
hooger en hooger opstegen. Op de bergen daalde de nacht niet neer maar
klom uit de dalen omhoog.

Inspecteur Punt had reeds z’n zoeklicht ontstoken, doch Jan Drie was slim
genoeg ’t maar zonder lantaarns te doen. Op die manier had hij de meeste
kans, dat inspecteur Punt onkundig zou blijven omtrent de nabijheid van z’n
twee nieuwsgierige vervolgers.

De politieinspecteur had den heelen middag en avond zonder omzien

doorgevlogen, steeds maar luisterend naar ’t aanslaan van Spits en scherp
uitkijkend naar de roodachtige aeroplaan van m’nheer Vliegenthert.
Onwillekeurig had de inspecteur de gemakkelijkste weg gevolgd, wat
natuurlijk iedere luchtvaarder doet en zoo was hij er toe gekomen om niet
recht toe recht aan over bergen en dalen te vliegen, maar de laagte te
houden en eindelijk langs de Rijn tot Bazel te vliegen. Waarschijnlijk zou
hij nog wel verder ’t Rijndal gevolgd hebben, als ’n kleine wending boven
Bazel, toen hij meende ’n roode aeroplaan met ’n vrouw er in te bespeuren,
hem niet in ’n meer Zuidelijke richting gebracht had. Spits bleef aanslaan
en dus was de nieuwe richting de goede. De arme hond hielp den inspecteur
leelijk op ’n dwaalweg, maar ’t stomme dier kon er ook niemendal aan
doen. Hij rook aanhoudend vóór zich dezelfde geur, die men hem bevolen
had te volgen, want inspecteur Punt had z’n vliegjas aan, en als ’n trouwe
speurhond riep hij dus voortdurend: „Waf.” De rest ging hem niemendal
aan.

Hierdoor kwam ’t dat inspecteur Punt van Bazel af regelrecht op ’t meer

van Thun en ’t meer van Brienz aanvloog. Twee waterketels van ’n paar
honderd meter diepte, die daar omsloten door hooge bergen van alle kanten
watervallen en bergstroomen in zich opnemen en waaruit bij Thun de Aare
wegstroomt met vloeibaar voedsel voor de Rijn. Tusschen deze twee
meeren ’t eene donker en ’t andere lichtgroen, ligt de stad Interlaken.

Inspecteur Punt was al hooger en hooger gestegen en toen hij nog ’n

kilometer of tien van ’t meer af was had hij de respectabele hoogte van ruim
twee duizend meter bereikt, wat wel noodig was, daar hij nu nog maar net
over de top van de Gemmenalphorn heenkwam, ten Noorden van ’t
Thunermeer, die 2064 meter hoog is. De Beatenberg, die met z’n voet in ’t
meer staat, is weer veel lager en inspecteur Punt zag toen hij daarover heen
was de lichten van Interlaken diep onder zich en aan alle zijden de
electrische lantaarns van de dorpen aan de oevers der twee meren. Doch de
inspecteur daalde niet in Interlaken. Met ’n sprongetje was hij over ’t meer
heen, van de eene berg op de ander en daar aan de overkant zagen de
jongens plotseling de vlieger van inspecteur Punt naar beneden gaan.

„Hij daalt” riep Dolf.

„Boven op de berg,” zei Jan Drie.

„Zien waar hij blijft hoor.”

„Stil maar …. Ik zal wat langzamer vliegen … en ’n rondje maken boven z’n
hoofd als ’t noodig is … Zie jij ’m?”

„Kan je niet ’n beetje lager gaan?”

„Jawel, maar dan hoort ie ons misschien.”

„We moeten ’t er op wagen. Wat zou die eigenlijk op die berg zoeken?”
„Wel,” lachte Jan, „hij is ook niet gek … Als ie zoo doorgevlogen had, was
ie binnen ’t kwartier met z’n vlieger tegen die lui aan de overkant gevlogen.
Daar staan de Eiger en de Mönch en de Jungfrau … Of hij had nog ’n paar
duizend meters hooger moeten gaan.

„Daar zit ie, als ’n wesp achter die rots.”

„Let nou is op Dolf … ik zal je eens laten zien, wat je met zoo’n
aeroplaantje als dit, doen kan… Pas op, daar gaat ie!”
Hij verzette ’t hoogtestuur. De aeroplaan dook en plotseling stond de motor
stop. Als ’n duif met uitgespreide vleugels zeilde de aeroplaan omlaag en
kwam terecht midden in de alpenrozen op ’n bijna vlak stuk alpenweide,
aan de andere kant van de rots.

„Prachtig, prachtig,” riep Dolf. „Kerel je ben ’n eerste klas aviateur hoor. Ik
zou ’t niet klaar gespeeld hebben.”

Jan Drie was er al uit.

„’k Ben blij, dat ik m’n beenen eens verzetten kan. ’t Werd taai hoor, zoo
ver boven de wolken.”

„Boven de wolken?”

„Denk je dan dat de wolken de gewoonte hebben zoo hoog te zeilen, als wij
nu gedaan hebben. Kan je begrijpen. Maar van wolken gesproken. Kijk
eens even naar de overkant. Die besuikerde top met die bocht er in is de
Jungfrau en die hier op aan is de Mönch en die waar die blauwe wolk tegen
aan hangt is de Eiger. ’k Heb ze verleden jaar netjes van buiten geleerd hè
toen ik met vader en m’n broer hier in de buurt was … Als die wolk nou
maar daar blijft is ’t niet erg …. maar als dat ding hier heen komt zijn we
bestolen.”

„Hè?”

„Ja, meen je, dat ik gek genoeg zou zijn hier op te stijgen in ’n wolk, met al
die lieve harde steenklompen om je heen? Ik zou je danken. Dan blijf ik
hier bivakeeren.”

„Wat ’n prachtig schouwspel zijn die bergen daar aan de overkant … Je zou
ze zoo grijpen.”

„Jawel, als je ’n arm had van twintig kilometer lang. Daar ligt ’t heele
Grinderwalddal nog tusschen in met ’t Lauterbrunnendal en ’n paar bergen
van twee duizend meter hoogte … waar we nu maar overheen kijken.”
„En wat is dat voor ’n spits, die we daar tusschen zien?”

„O, dat is de Finsteraarhorn. Die is maar ’n goeie vierduizend meter hoog

en ligt nog heel wat kilometertjes verder. Achter de Breithorn en de
Jungfrau en de Mönch en de Eiger en de Schreckhorn en de Wetterhorn
krijg je eerst nog wat gletschers en eeuwige sneeuwvelden en dan komen
eerst die allerhoogste oomes. Kijk daar links tusschen de Wetterhorn en de
Schreckhorn kan je een van de twee Grindelwald-gletschers zien …”

„Goeie help,” zei Dolf, „je zou er met pleizier den heelen inspecteur Punt
voor vergeten.”

„Dat doen we toch niet. Nu we hem eenmaal tot bij de sneeuw, die nooit
smelt, hebben gevolgd, wil ik ook weten wat ie uitvoert.”

„Ik denk dat ie hier kampeert. Laten we maar eens gaan kijken.”

„Pas op Dolf, de bergen zijn verraderlijk. Laat mij maar voor gaan en trek je
vliegjas uit.”

„Wat is dat nog ’n eind weg,” zuchtte Dolf na ’n poosje. „Ik dacht dat we
vlak bij hem waren.”

„Kan je begrijpen. De dingen lijken hier maar zoo dichtbij … We zijn

minstens nog tien minuten van ’m verwijderd … Maar ’t kan ook nog wel
meer zijn.”

„’t Loopt hier lastig ook, tusschen die alpenrozen. Die zijn nog erger dan de
hei thuis. Als ’t pikkedonker was, wandelde ik hier liever niet.”

„St … daar zie ik licht … daar in de laagte daar staat de vlieger … en … e …

nóg ’n vlieger … en ’n juffrouw.”

„Hè??… Waarempel … Bukken Dolf … Op de grond gaan liggen, anders

krijgt ie ons óók nog in de gaten, hij staat juist met z’n neus naar ons toe.
En ’t is hier zoo licht.”
„Och, we zijn toch in de schaduw.”

„En de maan dan?”

„Da’s waar ook … die staat daar ginds achter die berg … zoometeen komt ie
er boven uit.”

„Hou je mond nou es Dolf … dan kunnen we misschien hooren wat ie zegt.”

„Ik lig hier niet erg lekker in die harde dingen.”

„Zwijg nou toch … Nee … maar!”

Die uitroep van verbazing werd veroorzaakt door inspecteur Punt, die vlak
onder Jan en Dolf ’n kleine vijftig meter lager, met ’n dame stond te praten.

Toen inspecteur Punt over het dal waar Interlaken ligt was gevlogen en de
tweeduizend meter hooge bergen aan de overkant bereikt had, zag hij op
eens hel verlicht door z’n zoeklicht boven op de berg ’n vlieger staan met ’n
dame er naast, die zoodra ’t scherpe licht van de politievlieger zichtbaar
werd hevig aan ’t wuiven was gegaan met ’n groote witte sluier. Inspecteur
Punt daalde onmiddelijk in de nabijheid, waar ruimte genoeg was en de
helling niet te schuin. Hij was toen uit de aeroplaan gestapt met Spits en
snel naar de dame toegeloopen. Deze kwam hem echter met nog meer haast
te gemoet.

„O m’nheer wat ben ik blij, dat u mij hebt opgemerkt. Ik zit hier al meer
dan ’n uur angstig uit te kijken of er niets tot redding op kwam dagen, want
ik heb geen vliegolie meer … en nu weet ik niet waar hier op de berg ’n
depôt is. Ik heb wel ’t groen- en roode depôtlicht verder beneden gezien,
maar daar durfde ik niet heen. ’t Pad was zoo steil.”

„Zoo …” zei inspecteur Punt, terwijl hij scherp de dame aankeek, die blond
haar had, terwijl haar vlieger, die op eenigen afstand stond, rood was …
„Zoo,” herhaalde hij … en toen z’n notitieboekje uit z’n zak halend. „U
weet dat ik van de politie ben?”

„Ja m’nheer … dat zie ik immers aan uw lichten.”…

„Goed … Ik ben inspecteur Punt uit Den Haag …. Nu zal u er wel alles van
begrijpen hè?… Vertel u me nu eerst maar eens, hoe komt u aan die
aeroplaan?”

„Wat blief?”

„Meegenomen hè … uit Den Haag … gisteren avond … U ziet, ik weet

alles … Ontkennen baat niet …”
„Wat beteekent dat m’nheer?” zei de dame met groote verwondering. „U
houd mij toch niet voor ’n dievegge?… ’t Is mijn eigen vlieger m’nheer ….
en als ik niet door gebrek aan vliegolie hier op die akelige berg was blijven
steken …”

„Had ik u niet hier aangetroffen” zei inspecteur Punt … „Daar twijfel ik

geen oogenblik aan … Dan was u misschien al over die hooge toppen daar.”

„Maar m’nheer …” riep de dame … „ik wou naar Luzern, daar woon ik en
daar kunt u alles omtrent mij vernemen …”

„Ja ja … dat liedje kennen we … we zullen er geen woord meer over

verspillen … Deze politiehond heeft uw spoor gevolgd tot hiertoe … U is
mijn arrestant …”

Deze laatste woorden die inspecteur Punt zeer nadrukkelijk gezegd had
waren ook daarboven verstaan en hadden aan Jan Drie de verbaasde uitroep
ontlokt, en de rest van ’t gesprek dat veel luider gevoerd werd dan ’t begin
konden ze ook bijna heelemaal verstaan.

„Ik begrijp er niets van,” zei de dame … „geef me toch in ’s hemelsnaam

wat vliegolie m’nheer de inspecteur, dan ga ik dadelijk met u mee en dan is
alles zóó opgehelderd.”

„Dat zou ik ook ’t liefst willen,” hernam inspecteur Punt, „maar ik heb zelf
niet veel meer … Ik zal u nog een poosje in de eenzaamheid moeten laten.
Ik kom spoedig weer terug … met vliegolie natuurlijk en ’n paar man van
de politie uit Interlaken … U moet ’t u maar zoo gezellig mogelijk maken
tot zoolang. En bang hoeft u niet te zijn, want ik laat de hond hier om op te
passen.”

„O … ik ben zoo bang voor honden!” riep de dame … „Neem dat beest
mee … neem asjeblieft dat beest mee …”

„Nee …” zei inspecteur Punt, „die blijft hier om u te bewaken en om op de

vlieger te passen, die hij de heele dag gevolgd heeft …”
„Maar m’nheer … dat is ’n leugen … die hond kan me niet gevolgd zijn …
ik kom regelrecht uit Luzern …

„Vertel u de rest later maar voor den rechter.” zei inspecteur Punt. „Spits
opgepast hoor!”

Inspecteur Punt stapte weer in z’n vlieger en zette de motor aan. ’n

Oogenblik later vloog hij op en verdween al spoedig achter ’n bergrand.

Spits keek den inspecteur na, snuffelde eens aan de vliegjas van de dame,
maar aangezien hij niets bekends daaraan rook, begreep Spits dat ie daar
niets mee te maken had, vervolgens ging hij de monoplaan beruiken en wijl
die ook volkomen onbekend rook, zette hij zich ’t heele geval uit z’n kop en
trok zich van geschiedenis verder niemendal aan. Hij ging liggen slapen.

Jan en Dolf, die van het gesprek wel niet alles maar toch genoeg verstaan
hadden, keken elkaar eens aan.

„Da’s mooi” zei Jan Drie verschrikt, „nou gaat ie die dame gevangen
nemen, omdat wij er met de aeroplaan van m’nheer Vliegenthert vandoor
zijn.”

„Nou,” zei Dolf … „is dat nou zoo erg?… Ze kan op geen gemakkelijker
manier van den berg afkomen. Ze heeft geen vliegolie en ze wil tòch naar
beneden … waaraan ze gelijk heeft hoor … ’t Is hier knapjes koel om er de
heelen nacht te blijven tenminste.”

„Ja maar … ze wordt gevangen genomen.”

„Och … wat zou dat nou … Ze laten haar wel weer los … als ze bemerken,
dat ’t de verkeerde aeroplaan is …”

„Nee”… zei Jan Drie, „dàt mag niet … Ik zou me schamen als die vrouw
door de politie meegenomen werd door mijn toedoen … Gauw naar de
vlieger er is nog ’n reserveblik in. Die dame moet weg zijn vóór inspecteur
Punt terugkomt. Gauw, ga je mee?”
„Als je met alle geweld dat mensch hiervandaan wil hebben, vooruit dan
maar … ’t Begon anders net zoo lollig te worden.”

„Hoor eens Dolf … ik houd wel van ’n avontuurtje, maar niet als ’n ander er
voor in angst moet zitten en die dame zit zeker in angst … Kijk maar eens.”

„Da’s waar …” bekende Dolf … „zoover heb ik nog niet eens gedacht …
Kom vooruit … Dan maar voortmaken …”

Maar ’t ging niet zoo gemakkelijk … Met de bus vliegolie moesten ze nog
’n heel eind naar beneden klauteren langs ’n tamelijk ongebaand pad … ’n
Beetje steil was ’t soms wel doch ze waren stevige turners allebei en vlug
als katten, en ze kwamen heelhuids op de alm waar de dame bij haar vlieger
stond.
„Zie je wel,” zei Jan Drie, „ze staat te schreien.”

„Dat houdt gauw genoeg weer op, als ze de bus vliegolie in de gaten krijgt”
meende Dolf.

De dame hoorde de jongens pas toen ze tamelijk dicht bij waren en ze keek
vreemd op.

„Ze denkt zeker, dat we ook van de politie zijn” fluisterde Dolf.
„Maak nou geen gekheid,” bromde Jan Drie en toen riep hij hardop:
„Mevrouw hier brengen we u vliegolie … Asjeblieft … ’n heel blik …
Wacht, ik zal ’t wel even voor u aan de motor bevestigen …”

En terwijl hij daarmee bezig was, zei Dolf tot de verbaasde dame
„Mevrouw, we zaten daarboven, en we hoorden, dat die inspecteur u
gevangen wou nemen … en dat wou m’n vriend Jan niet hebben … ziet
u …”

„Dank je wel jongens … maar nu kan ik toch niet weg … want die hond
vliegt me zeker aan, als ik instap. Hij moet op me passen.”

„Wel mevrouw”, zei Jan, „’t is te probeeren. En doet u ’t maar gauw … Stap
u maar vlug in, dan kunnen we zien, wat die hond van plan is … Op ’t
oogenblik slaapt ie geloof ik …”

„Maar gaan jullie dan asjeblieft vóór de hond staan hè.”

„Met plezier,” zei Dolf …

Nu stapte de dame in en Spits trok er zich geen steek van aan.

„Ziet u wel,” hernam Dolf … „’t Gaat heel goed … Vlieg u maar gerust
weg.”

„Ik durf niet goed,” zei de dame … „Kijk eens er komt ’n nevel omhoog.”

„Mevrouw,” riep Jan, „u moet toch vooruit en gauw en wij ook … Als die
nevel ons bereikt, durf ik zelf ook niet meer weg … en dan moeten we de
heele nacht misschien hier blijven … en dan vangt inspecteur Punt ons
allemaal nog … Gauw Dolf mee naar de aeroplaan.”

„O …” riep de dame angstig … „ik durf haast niet.”

„Weet je wat Dolf,” zei Jan, „ga jij in deze vlieger, die heeft maar één zit …
ik haal gauw de onze … en neem mevrouw mee … Vlieg jij dan maar achter
ons aan.”
„Best,” zei Dolf, terwijl Jan Drie wegholde en reeds weer ’t steile pad langs
de rots beklom. „Jakkes wat komt die mist op … kijk eens ’t is of ze ’m
tegen de berg oprollen …”

Jan Drie had dat ook in de gaten en hij haastte zich zooveel hij kon. Hij
deed z’n handen en z’n kniëen soms leelijk zeer, maar hij kwam toch bij z’n
vlieger. Vlug zat hij er in Rrrrt … daar vloog hij al in ’n kring naar omlaag
en kwam ’n oogenblik later bij de wachtenden neer. Dolf zat al in de andere
aeroplaan.

„Ziezoo,… mevrouw stap nu maar gauw in … Dolf jouw motor is toch in

orde hè?”

„’k Heb er niet naar gekeken,” riep Dolf terug.

„O, die motor is uitstekend,” zei de dame … „Je vriend kan er op

vertrouwen.”

„Nu dan vooruit.”

Rrrrrt … Jan Drie schoot de lucht in, net vroeg genoeg, want de nevel had
bijna de plek bereikt, waar ze stonden … Dolf snorde hen snel achterna. Jan
keek naar beneden om ’t meer van Brienz in ’t oog te krijgen, dat hij volgen
moest om naar ’t Vierwaldstädtermeer te komen, waaraan Luzern ligt. Doch
’t was niets dan nevel onder hen …

„Dan maar op ’t kompas,” zei Jan … „Noord-Oost … Een ding is gelukkig

mevrouw … de nevel belet inspecteur Punt ons te zien.”

Toen ze ’n eind gevlogen hadden, waren ze boven de wolk vandaan. Ze

konden weer naar beneden zien. Jan bleef echter op dezelfde hoogte vliegen
want er waren aan weerskanten hooge toppen. Vlak bij ’t meer van Brienz
was om te beginnen aan de linkerzijde de Rothhorn met z’n 2300 meter en
Jan was blij dat hij eindelijk ’t Sarnermeer onder zich zag. Nu kon hij ’n
eind dalen want van Sarnau af was de bodem niet meer dan vijfhonderd
meter boven de zeespiegel … Daar stroomde de Aa. Jan was blij dat hij laag
kon vliegen, want voor hen uit in de richting van ’t groote meer dreven
alweer wolken. Hij kon er nu onder blijven. De dame wist hier goed de
weg, ze noemde Jan de plaatsen waar over ze heen vlogen.

„Ha,” riep Jan …. „’t Vierwaldstädtermeer … daar links is de Pilatus, niet

waar mevrouw?”

„Ja jongeheer … en daar rechtuit dat licht … is Stansstadt en links

Hergiswil. Stuur daar maar tusschen door, dan kom je vlak boven ’t meer …
Juist … en nu linksaf … over Luzern … en dan daarginds weer ’n beetje
links waar die lichten branden, daar op de helling van de Sonnenberg …
woon ik …”

„Wijs u mij ’t huis maar,” zei Jan.

„Daar is ’t al… neen … die witte villa … juist … ’n beetje rechts …”

Jan zwaaide in ’n kring om ’t aangeduide huis, dat alleen stond en daalde …

De aeroplaan van m’nheer Vliegenthert ging langzamer en langzamer … de
motor stopte … en landde op ’t hel verlichte dak, waar ’n deftige m’nheer
met ’n uitroep van vreugde de dame verwelkomde, die vlug uit de aeroplaan
stapte.

’n Oogenblik later landde Dolf ook.

 NEGENDE HOOFDSTUK.

Waarin Jan Drie en Dolf Brandsma kennis maken met m’nheer Przlwitz en ze met
hun allen de luchtadvertentie lezen.

„Hoe heb ik ’t nu,” vroeg de heer aan de dame, „kom je in ’n vreemde

vlieger thuis en breng je gasten mee? Waar ben je zoo lang geweest … Ik zat
al in ongerustheid over je.”

„Ach …,” zei mevrouw, „dat is ’n heele geschiedenis, maar laat ik je eerst
m’n twee dappere redders voorstellen … Jongens, dat is mijn man, m’nheer
Przlwitz—’n vreemde naam hè, maar daar zij we ook Russen voor … en dit
is Jan Drie uit Den Haag en dat is … ja jou naam ken ik nog niet …”

„Ik heet Dolf Brandsma, mevrouw … ook uit Den Haag …”

„Wel jongens,” zei m’nheer Przlwitz terwijl hij hen beide ’n hand gaf,
„welkom hier op de Sonnenberg … Maar vertel me nu eerst eens vrouw, wat
er eigenlijk gebeurd is met je … je sprak van redders … Ik brand van
nieuwsgierigheid.”

„Laten we eerst maar naar beneden gaan …. Die jongens willen misschien
wat eten.”

„Asjeblieft drinken mevrouw”… zei Dolf. „Ik versmacht.”

„Hadden jullie dan geen drinken bij je?”

„Vergeten mevrouw … we gingen in zoo’n vreeselijke haast weg.”

„Laten we dan maar eerst de vliegers in de hangar brengen,” stelde m’nheer

Przlwitz voor … „Kom jongens help ’n handje.”

Mevrouw Przlwitz ging naar beneden en m’nheer bracht met de jongens de

vliegers onderdak.

„n Prachtig monoplaantje heb jullie daar,” merkte m’nheer Przlwitz op.

„Fijn hoor … ’t nieuwste systeem ook nog. Die slaande vleugels hebben aan
de vliegtechnikers heel wat hoofdbrekens gekost.”
„Toch nam Adhémar de la Hault op ’n veld in Casteau er honderd jaar
geleden al proeven mee,” zei Jan Drie.

„Ei, ei,… je ben goed op de hoogte jongeheer … Daar wist ik niemendal

van … Hoe heette die uitvinder zeg je?”

„Adhémar de la Hault, m’nheer.”

„Ja m’nheer,” zei Dolf, „als u wat over de vliegkunst wil weten, moet u Jan
Drie maar vragen. Hij wil luchtingenieur worden.”

„’n Mooi vak,” zei m’nheer Przlwitz. „Hoe oud ben je Jan?”

„Vijftien m’nheer …”

„Verbazend … en heb jij je vliegbewijs dan al?”

„Nee,” zei Dolf … „hij zit pas in vier … Ik heb ’t maar Jan Drie kwam ’t
beter toe dan mij …”

„Zoo?” zei Jan … „Ik weet nog niemendal van de weerkunde …”

„O, dat snertvak,” smaalde Dolf … „Dat heb jij in ’n paar maanden onder de
knie.”

„Nou, nou … „lachte m’nheer Przlwitz, „je hoeft niet zoo laag neer te zien
op de weerkunde. Dat is ’n wetenschap, die de vliegmenschen niet missen
kunnen. Waar zouden we aankomen, als we geen verstand hadden van
luchtstroomingen, en als we niet uit de stand van onze weerinstrumenten
konden voorspellen wat er in de eerstvolgende dagen in ons element zou
veranderen?”

„Wel,” lachte Dolf „dat lees ik in de krant …”

„Niet voldoende,” meende m’nheer Przlwitz. „Je moet op je zelf kunnen

vertrouwen. Wat jij Jan?”
„Ik vind dat u gelijk hebt m’nheer … en ik zal er mijn best op doen in dit
jaar …”

„Jij liever dan ik,” zei Dolf … „ik viel er altijd bijna bij in slaap.”

„Is die aeroplaan van jou Dolf?” vroeg m’nheer Przlwitz …

„Ik wou dat ’t waar was m’nheer … Hij is van oom Dokie.”

„Zoo … laten we nu dan maar naar beneden gaan … Kijk hij eens … Is de
dorst zoo groot?”

Dolf dronk uit z’n hand onder de kraan van de waterleiding in de hangar.

„Hè, hè … dat smaakt …”

M’nheer Przlwitz en Jan waren al naar de lift gegaan, en Dolf ging hen
gauw achterop, onder ’t loopen z’n handen met z’n zakdoek afdrogend.

M’nheer Prlzwitz wees de jongens ieder ’n kamer waar ze zich ’n beetje

konden opfrisschen met zeep en water en waar ze die nacht zouden slapen,
want mevrouw Przlwitz wilde in ieder geval, dat haar redders zouden
blijven logeeren, iets waar Jan Drie en Dolf niemendal op tegen hadden.
M’nheer Przlwitz ging intusschen naar mevrouw om zich alles te laten
vertellen en toen de jongens klaar waren met hun toilet vonden ze m’nheer
en mevrouw al in ’n gezellige kamer bij de tafel zitten, waarop ’n heele boel
lekkere dingen en heerlijke vruchten stonden en natuurlijk ook de Russische
theemachine, de samovar, waaruit mevrouw de geurige warme drank in
fijne glazen schonk, die in zilveren glashouders met mooie blinkende ooren
gevat waren. Terwijl ze aten en dronken zei m’nheer: „jongens, ik moet
jullie nog bedanken voor de hulp die je mijn vrouw verleend hebt … Ze
heeft mij ’t heele ongeval verhaald … Ik begrijp niet goed hoe de Haagsche
inspecteur er toe komen kon mijn vrouw zoo maar voor ’n aeroplaandief
aan te zien … ’t Is wel heel toevallig, dat jullie ook uit Den Haag komt …
Kennen jullie dien m’nheer?”
„Jawel..” zei Dolf, „ik ken inspecteur Punt wel, en ’t was geen toeval, dat
we daar op die berg waren.”

„Wat, geen toeval?”

„Nee m’nheer,” ging Dolf voort. „We zijn inspecteur Punt achterna
gegaan.”

Hij hield plotseling op, want Jan Drie gaf ’m onder de tafel ’n venijnige trap
op z’n voet …

„Nu ga voort” zei m’nheer Przlwitz.

Dolf wist eerst niet goed wat te doen. Hij begreep, dat Jan liever had, dat ie
niets meer losliet. Maar hij kon nu toch niet z’n mond blijven houden, of
zeggen, dat ie er niets meer van wist. Dat was toch te gek … Wat gaf ’t
bovendien ook, dacht ie en hij keek Jan Drie even lachend aan toen hij
vervolgde:

„We zijn inspecteur Punt achterna gegaan van Nordhausen af, waar we
vanmiddag om drie uur opgevlogen zijn … Die inspecteur beweerde, dat ie
door z’n hond Spits ’t spoor gevolgd was van ’n gestolen aeroplaan tot op ’t
dak van ’t Automatische hotel waar wij logeerden. Vader, moeder, de zussen
en ik … Maar daar raakte hij ’t kwijt en vond ’t later weer terug … en toen
zijn wij ’m snel nagevlogen uit nieuwsgierigheid hoe ’t zou afloopen.”

„Ah zit dat zoo in elkaar … Maar jullie waren zoo dadelijk bereid m’n
vrouw te helpen … en dat had je toch niet mogen doen als ze eens werkelijk
de dievegge geweest was …”

„Hè man, hoe kan je dat nu zeggen …” zei mevrouw Przlwitz … „Ik vond ’t
heel aardig van jullie hoor jongens … en m’n man ook.”

„Natuurlijk … natuurlijk …” zei m’nheer, „maar hoe konden die jongens

nou weten, dat jij geen dief was … Die inspecteur en z’n hond hebben zich
vergist, dat is buiten twijfel … maar dat wisten zij toch óók niet.”
„O,” zei Dolf lachend …. „dat wisten we heel sekuur.”

„Was jij er ook zoo zeker van?” vroeg m’nheer Przlwitz lachend aan Jan
Drie.

Jan kreeg ’n kleur doch zei niets en Dolf riep:

„Hij begon er ’t eerst over … die wou met alle geweld mevrouw redden.”

„Ik vind ’t echt van jullie hoor,” betuigde mevrouw „en ik ben jullie zeer
dankbaar. Verbeeld je man, zonder die jongens, had ik daar nu nog heel
alleen op die nare berg gezeten, want die inspecteur zal ’t ook wel niet
aangedurfd hebben er weer heen te vliegen toen die nevel om de berg hing.
Neen hoor ik ben wat blij, dat ze niet eerst alles zoo voorzichtig overwogen
hebben of ’t wel goed was of niet … Hier, nemen jullie nog wat van die
druiven … en zoo’n groote appel …. Die zal je ook wel lusten.”

Mevrouw Przlwitz laadde Jan’s bord en dat van Dolf vol vruchten en
m’nheer lachte maar. Hij vond ’t toch bij slot van rekening maar goed, dat
die jongens zoo zonder nadere overwegingen gehandeld hadden, want hij
zou ’t ook niet aangenaam gevonden hebben voor z’n vrouw, als ze ’n heele
nacht op zoo’n gure berg tusschen de alpenroozen had moeten doorbrengen,
of wat misschien nog erger was—in de gevangenis. Maar toch, heelemaal
goedkeuren wat die jongens gedaan hadden wou hij ook niet.

„Ik begrijp toch niet hoe die inspecteur met z’n hond juist daar kwam.” zei
m’nheer na ’n poos … „’t Is ’n wonderlijke geschiedenis.”

„Er moet zeker ’n vergissing gebeurd zijn met die hond,” beweerde Dolf.
„’t Is de beste politiehond die ze in Den Haag hebben.”

„Juist daarom” hernam m’nheer Przlwitz. „Zoo’n hond vergist zich niet.
Doch, wat denk je vrouw, zouden we niet nog ’n poosje op ’t dak gaan
zitten. ’t Is zulk heerlijk weer … we kunnen ook in de tuin gaan, maar ik
vind ’t op ’t dak aardiger. Daar hebben we ’n veel beter gezicht op de stad
en op ’t meer. We zullen van avond niet veel van de bergen kunnen zien …
want de lucht is betrokken … Anders zijn die bergen om ’t meer heen, van
de Rigi tot aan de Pilatus in maanlicht wel de moeite waard.”

„De jongens mogen ’t zeggen,” zei mevrouw. „Waar hou jij ’t meest van
Jan?”

„Mevrouw ik zit ’t liefst op ’t dak.”

„Geen wonder …” riep Dolf … „Daar zit ie thuis ook altijd. Jan is ’n
luchtjongen. Die zou wel willen eten, drinken en slapen in ’n aeroplaan.”

„Kom dan maar. Vrouw je zorgt zeker wel voor wat limonade hè?”

„Laat dat maar aan mij over, m’n twee dappere redders zullen ’t goed bij
mij hebben.”

Op ’t dak gingen ze op gemakkelijke stoelen zitten en keken uit over

Luzern met al z’n lichten en over ’t meer, dat nu onder de donkere
wolkenhemel alleen maar blonk van lichtjes op schuitjes en van de
lantaarns en de verlichte vensters aan de oevers. Van de bergen zagen ze
niemendal. Die zaten met hun koppen in ’n wolkenmuts.

„Je kan hier anders de lichten van Rigi-Kulm zien,” zei m’nheer, „maar dat
treffen jullie slecht. ’t Lijkt wel of we ’n donderbui krijgen. De lucht is
zwart.”

„Jammer”, vond Jan. „Ik zie graag de sterren en de witte bergtoppen.”

„Dat is ’n heerlijk gezicht,” meende ook m’nheer Przlwitz. „Vooral de

sterren, de eenige dingen die we verplicht zijn van onder te bekijken.. hoe
hoog we ook boven de bergen uitvliegen. Dààr kunnen we in geen geval
bij.”

„Och,” zei Dolf, „de menschen kunnen zooveel, misschien brengen ze ’t

ook nog nog wel eens zóóver.”
„Je ben ’n grappenmaker Dolf … Ik geloof dat we de grens bereikt hebben,
wat de afstand betreft. Alleen kunnen we misschien onze vliegapparaten
nog wat verbeteren. Ik vind altijd nog maar, dat ’n vogel heel wat beter af is
dan wij. Er is te veel omhaal bij, als wij vliegen willen.”

„O,” riep Dolf … „U wil vleugels hebben.”

„Dat heb je goed geraden. Ik wou ’n gemakkelijker vliegtoestel, iets dat we

net als vroeger de fiets in ’n klein hoekje konden opbergen, en waar we
geen motor, geen schroef en geen staart bij noodig hadden. Misschien komt
Jan Drie naderhand wel eens met zoo iets voor de dag, als ie vliegingenieur
is.”

„En dat we zelf in beweging kunnen brengen?” vroeg Jan.

„Nee … mechanische beweegkracht. Vliegen in heel mooi, maar je moet je

er niet moe bij behoeven te werken. Wij hebben onze krachten wel noodig
voor andere arbeid … Ah, nou beginnen ze met de luchtadvertenties … Die
hebben we in geen maand hier gehad … Steeds mooi weer.”

„Bij ons is ’t zelden ’n maand lang mooi weer,” zei Jan … „en als we ’n
paar dagen zonder luchtadvertenties zitten is ’t al mooi.”

„Ik vind die annonces in de lucht wel aardig,” merkte mevrouw op. „’t Zou
zonde wezen als ze die letters tusschen de sterren konden zetten. Maar op
zoo’n donkere wolk mag ik ’t wel, als je toch niets te bewonderen hebt
daarboven.”

„Jan!” riep Dolf opeens en allen keken ’n oogenblik zwijgend naar de lucht
boven ’t meer. Daar stond met groote lichte letters in de wereldtaal:

500 GULDEN BELOONING!

voor diegene, die inlichtingen geeft omtrent een
GESTOLEN CACAOKLEURIGE MONOPLAAN
met S L A A N D E V L E U G E L S ,
van den heer V L I E G E N T H E R T
 TE
DEN HAAG.

En welke er toe leiden den dief of de dieven in handen te krijgen.

M’nheer Przlwitz las halfluid en zeer langzaam: ca-cao-kleu-ri-ge-mo-no-

plaan-met-slaan-de-vleu-gels. „Hé Dolf, dat lijkt wel ’n beetje op de
monoplaan van oom Dokie hè?”

„Wel … ’n b … beetje …” stotterde Dolf bleek van schrik en Jan Drie zat
met open mond die duivelsche advertentie in de lucht aan te staren, die
maar niet weg scheen te willen. Maar eindelijk verdween ze toch en Jan
was er zóó van opgelucht dat hij plotseling uitriep in ’t Hollandsch: „Hé
afgeloopen!”

En Dolf zei zacht in dezelfde taal:

„Net iets voor oom Dokie … Alles vergeet ie, maar dàt niet.”

Mevrouw en m’nheer Przlwitz verstonden natuurlijk geen Hollandsch maar

keken Dolf en Jan er des te verbaasder om aan.

„Vrouw wat denk je van die twee jongens?” vroeg m’nheer in ’t Russisch.
„’t Is niet in orde geloof ik. Hun monoplaan lijkt me wat al te veel op die
gestolen vlieger … Zouen ’t ’n paar jeugdige gaudieven zijn? Kan haast niet
hè?”

„Nee,” antwoordde mevrouw met overtuiging terwijl ze beurtelings Jan

Drie en Dolf Brandsma aankeek die wel beetje uit ’t veld geslagen leken, „’t
Zijn vast en zeker eerlijke flinke jongens .. Bovendien, dan zouden ze toch
niet àchter dien inspecteur aangevlogen zijn?”

„Ja maar wie bewijst je, dat ze er achter aangevlogen zijn? Als ze er nu eens
vóór den inspecteur op de berg waren geweest … en die hond was hén
gevolgd?”

Mevrouw dacht ’n poosje na en toen zei ze: „Nee man dat kan onmogelijk.
’t Was nog helder dag toen ik op de berg aankwam en ik heb voortdurend
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