The Nature of the Firm #2

The capital theory of Austrian school economists focuses on the elements of time and entrepreneurship. While I thought much of it was informative, I found trying to tie the Hayekian Triangle to reality (to specific examples) very difficult. In my experience, Austrian school economics says very little about the organization of firms (other than existence of the division of labor) and finance (other than by banks and governments).

This book shed light on some of the missing, mostly the former. Large and durable capital investment is not the only issue. Other issues are (1) whether large and durable capital investments are re-deployable or not, and (2) if not, the need for and ease of adapting to changing market and technological circumstances.

This has ramifications for a firm borrowing as well. If everything goes well, the lender will be paid principle and interest as scheduled. In the event of default, however, how much lenders can recover depends on the degree to which assets are re-deployable. In the extreme case, of course, equity holders get nothing and lenders get what it can, which may be much less value than the loan. Since the value of a preemptive claim by the lender(s) declines as the degree of assets specificity increases, the terms of debt financing is adjusted adversely.

This triggered my own thoughts about what makes good collateral for obtaining a loan. For example, if a car dealer borrows to buy new cars to add to its inventory, the new cars are excellent collateral. Selling them provides the money to repay the loan and interest. Also, if the car dealer defaults on the loan, the lender can gain possession of the cars and sell them.

A firm’s accounts receivable is even better collateral for getting a (short-term) loan. This is money owed the firm by its customers/clients that comes due soon, e.g. in 90 days or often much less. A firm might so borrow to obtain cash, like meeting its payroll.