The best known empirical failures of consumption-based asset pricing models are the equity premium puzzle and the risk-free rate puzzle. Mehra and Prescott (1985) investigate U.S. data from 1889 to 1978 and find that the mean annual premium of equity return over the riskless rate was around 6% which is too large to be justified by the standard Arrow-Debreu model with a plausible degree of risk aversion. In other words, stocks are not sufficiently riskier than Treasury bills to explain the spread in their returns.
Since Modigliani and Miller (1958), financial economists have devoted much effort to understanding firms' financing policies. While most of the early literature analyzes financing decisions within qualitative models, recent research tries to provide quantitative guidance as well. This is typically done in contingent claims models in which the firm's investment policy is fixed and the value0maximizing debt level results from a trade off between tax benefits and costs of financial distress. When applied to capital structure decisions, contingent claims models generally suffer from two major limitations. First, these models generate leverage ratios that exceed observed leverage ratios. Second, they cannot reproduce the cross sectional variation in capital structures. One potential explanation for these limitations is that these models have overlooked some determinants of debt policy in particular the impact of agency conflicts on firms' financing decisions.
The notion that agency conflicts affect firms' investment and financing decisions is now widely accepted. While agency conflicts can take a variety of forms, the literature analyzing corporate securities as contingent claims has more narrowly focused on share holders' incentives to increase investment risk the asset substitution problem or to reject positive NPV projects the underinvestment problem. Because the costs associated with these conflicts typically increase with the firm's leverage and with the number of growth options available to the firm, it has been argued that these conflicts could explain both observed debt levels and the cross0sectional variation in capital structures [see e.g. Smith and Watts (1992)]. However, recent work by Leland (1998) or Parrino and Weisbach (1999) has shown that distortions arising from stockholder bondholder conflicts are typically too small to explain firms' capital structure decisions.
Since opening its first store in 1962 in Rogers, Arkansas, Wal-Mart has grown to be the world’s largest company. It reported a net income of $9 billion on net worldwide sales of over $256 billion for the fiscal year ending January 31, 2004 (Wal-Mart Stores 2004).
In 2002, Wal-Mart sales accounted for an astonishing 2.3 percent of U.S. GNP (Sperling 2003). It is also the world’s largest private employer, with over 1.4 million employees, nearly 1 million of them in the U.S. (Ghemawat, Mark and Bradley 2004). Wal-Mart has a dominating presence the U.S. retail sector: in 2002; fully 82 percent of U.S. households made at least one purchase at Wal-Mart (Bianco and Zellner 2003). It is already the largest food retailer in the nation, as well as the third largest pharmacy (Dube and Jacobs 2004), and continues to expand at a rapid rate (Upbin 2004) – planning an additional 200-250 new stores in the 2006 fiscal year.
