Running head: FINANCIAL THEORIES OVERVIEW Financial Theories Overview Velda Eaton University of Phoenix – School of Advanced Studies Financial Theories Overview Theory| General Description| Current Examples| Significant Attributes| Efficiency Theory| The germinal theory proposed by Fama (1965) states An efficient market is where there are large numbers of rational profit-maximizers actively competing trying to predict future market values from new information on inherent values to be reflected immediately in actual prices.
Market efficiency is the ability to allocate capital effectively, by pricing securities solely by economic considerations based on available information (Weaver-Weston, 2002).
| The Information Highway: the World Wide Web and the Securities & Exchange Commission (SEC) provide information on large trading firms accessing and acting on stock transaction data before the merged trade data is published (Ross? Westerfield? Jaffe, 2008).
Information is feelessly incorporated into prices, it is impossible to profit from news as already priced into the stock (Ball, 2001), and high-speed traders have the advantage, which is estimated to account for two-thirds of all stock market volume (Ross? Westerfield? Jaffe, 2008). | Theory of Investment| This germinal theory depicts that dividends and capital structures are irrelevant in the determination of stock prices in the market. (Miller-Modigliani, 1958; Chew, 2001).
Instead the market value of a firm is based on the earning power of the assets currently held and on the size and relative profitability of the investment opportunities, which is independent of its capital structure. (Miller-Modigliani, 1958| Junk bonds have provide vitality in the market and have aided in the development of the preference forLeveraged Buyouts (LBOs) (Chew, 2001). The new characteristics in corporate governance followed the LBOs of large firms. Chew (2001) states strip financing as one. Miller-Modigliani (1958) assumed the market was perfect and the information was complete and symmetric, when it was not. There was a simple acceptance of firms with high-levels of debt trading off for tax deductible benefits with an assumption that investment decisions were not influenced by financial decisions. (Ball, 2001). | Agency Cost Theory| Germinal Theory proposed by Jensen-Meckling (1976) that analyzes the conflict between shareholders and managers- agents of shareholders.
Since managers are compensated on the basis of accounting profits, it increases the incentives to influence information to be favorable or unfavorable with poor net present value if they provide immediate profits (Dogan & Smyth, 2002). | A study conducted by Dogan-Smyth (2002) of 223companies listed in the Kuala Lumpur Stock Exchange (KLSE) using this theory to test relationships among corporate performance, performance criteria and executive compensation. The results showed a positive rapport between board compensation and firm performance.
The results were weaker in Malaysia than in U. K. or U. S. | The desire for high rewards persuades executives to manipulate, overrate, or underrate indicators to make them more attainable in loss of the value of the firm such as low budgets and inefficient debt targets. As evidenced by Jensen-Meckling (1976), agency costs of separating ownership from control should not be excessive provided that factors such as competition, executive labor market, and incentive plans are designed to lessen management self-interest. Agency Costs of Free Cash Flow Theory| Theory is considered to be current and built upon the Jensen-Meckling’s Agency Cost Theory (1976). The Free Cash Flow Theory (FCF) is the cash flow in surplus of what is required to fund all projects that have positive net present value when discounted at the relevant cost of capital (Stewart, 2001). | LBOs are another way to both lessen the agency costs of free cash flow and impose discipline and efficiency; however, will increase the agency costs of debt (Stewart, 2001).
NABISCO is an example of another rich firm interested in aggressive investment opportunities instead of paying out dividends to stockholders (Stewart, 2001). | The theory justifies the massive substitution of debt for equity arguing that cash flow was going to pay interests and principal and not to investor (Miller, 2001). An additional benefit is LBOs, which reduce the agency costs of a firm: (1) by redistributing resources and (2) by compressing capital for growth. This will allow a real impact by the LBOs that will be beneficial (Chew, 2001). Pecking-order Theory of Capital Structure| Theory is considered to be current and based on the hypothesis that financing follows hierarchy with firms preferring internal over external financing and debt over equity (Myers-Mailuf, 1984). The primary aspect is the irregularity of information. The more the irregularity, the higher the costs of the sources of financing (Brounen, et al, 2004). | A study of firms in Europe and US yielded factors that determine a firm’s capital structure, which include financial flexibility as a factor that most importantly drove capital structure (Brounen, et al, 2004). Typical issues observed within the theory are (1) debt is encouraged when firm experience insufficient profits and (2) debt is encouraged when equity is undervalued (Brounen et al, 2004). | Economic Value Added Theory| This is considered to be a current theory and is an integrated financial system used in decision-making and multiple corporate applications such as performance measurement, determining shareholder value, and equity valuation (Stewart, 2001). A study was performed to demonstrate the effect of capitalizing on R&D when outlays include new products when expensed R&D is worse than flows of outlays of a capitalized R&D across time. Firms reported to be active users of the theory are Bausch and Lomb, Coca Cola Company, and Georgia-Pacific Corporation (Hatfield, 2002). | This theory requires change in a firm’s culture and fiscal responsibility (Hatfield, 2002). This theory is not a new concept, is deemed highly flexible, and a concept of residual income. EVA is a financial imaginary premise inoperable unless markets are efficient (Chen-Dodd, 2002). Capital Asset Pricing Model (CAPM)| This is considered to be a germinal theory developed separately by William Sharpe in1964 and John Lintner in 1965. Capital Asset Pricing Model is to identify the adequate cost of capital in project valuation (Brounen et al, 2004), and is defined by Ball (2001) as a method of estimation expected returns which passive investors would otherwise have earned in the absence of the information being tested. CAPM is popular because there is no other accepted model to calculate anticipated returns (Chen-Dodd, 2002). A survey conducted by Brounen et al, (2004) reported CAPM was used by 64. 2 percent of U. S. firms and an average of 57 percent of European companies, with high occurrence in large and publicly traded firms whereCEOs have longevity regardless of educational background. | CAPM’s major weakness is in thedetermination of betas in efficient markets and the inability to explain the temporality of risk premiums and the amount of the expected changes in risk ratio. Fama-French (1996) critique CAPM flaws in recording anomalies of the market and expected returns.
Chen-Dodd (2002) challenge that CAPM is not a valid model to calculate anticipated returns, given the premise that dividends and earnings are non-fundamental to stock pricing determination; however, many firms still use the model. | Arbitrage Pricing Theory (APT)| This theory is considered to be germinal and is an asset pricing model based an asset’s returns can be predicted using the relationship between that same asset and many common risk factors. This theory predicts a relationship between the returns of a portfolio and the returns of a single asset through a linear combination of many independent macro-economic variables (Ross, 1976). Arbitrageurs use the APT model to profit by taking advantage of mispriced securities. Brokerage firms, publicly traded firms with large IPOs and LBOs use this model (Weaver-Weston, 2002). | APT is assumed that the factors considered are sensitive to changes, and that is represented by a factor-specific beta coefficient. CAPM formula requires the market’s anticipated return, APT uses the risky asset’s anticipated return and the risk premium of a number of macro-economic factors (Weaver-Weston, 2002). REMM Theory ofHuman Behavior(Resourceful, Evaluative,Maximizing Model)| This is considered to be a current theory that addresses the concept of man as a unit of analysis in economics and explains man’s behaviors as a result ofinteractions with value systems andconstraints, which are able to maketrade-offs to overcome a constraint; therefore, having no needs, but wants and desires, which help them focus on alternatives, substitutes, and costs that reduce their exposure to hidden agendas (Brunner-Meckling, 1977). | Most economists are REMM individuals who believe price systems are self-regulatory mechanisms that respond to needs and wants.
Trade-off in the costs ofleverage to avoid the costs of bankruptcy is an example of a REMM action (Brounen et al, 2004)| Corruption in financial markets is explained from the REMM viewpoint as the result of corrupted government agencies rather than private firms. There are limitations to the theory as it does not describe behavior of any particular individual with the appearance of being too biased towards any controlling entity of corporate governance (Jensen-Meckling, 2001). | Black-Scholes Model| This theory is considered to be germinal.
The theory is proposed by Black-Scholes in 1973. The theory is based on a portfolio of stocks andoptions on the stocks with valuation based on the assumptions of short-termhorizon, fixed interest rates, prices for the underlying assets, no dividend payments, no selling or buying options, and abilities to borrow and short sell (Versluis-Hillegers, 2006). | New studies have included variables that make the model more adaptive to reality, which proposed a modification to the model to include the effect of re-financing at the end of the short-term interval.
The Chicago Board Options Exchange (SBOE) was the first one in using the Black-Scholes model in 1973 and continues to use the newly developed neural models and implied volatility variables (Versluis-Hillegers, 2006). | Black-Scholes model attributes to the volatility smile-all the parameters in the model other than the volatility are observed without ambiguity. Valuing bond options-because of the pull-to-par problem, Black-Scholes can never be applied directly to bond securities.
Interest rate curve-as they vary with tenor, an interest rate curve is obtained that helps to pick the appropriate rate to use in the Black-Scholes. Short stock rate-a short stock position is not free. Often a long stock position is lent at a low cost. In both the cases, this is considered as continuous dividend while evaluating Black-Scholes (Versluis-Hillegers, 2006). | References Ball, R. (2001). The theory of stock market efficiency: accomplishments and limitations. In Chew, D. H. (Ed. ). (2001) The New Corporate Finance: Where Theory Meets Practice, p. 0-33. New York: Irwin Brounen, D. , De Jong, ; Koedijk, K. (2004). Corporate finance in Europe: Confronting theory and practice. Financial management (2000), 33(4), 71-101. Retrieved May 27, 2010 from EBSCOHost database Brunner, K. ; Meckling, W. (1977). The perception of man and the conception of government. Journal of Money, Credit and Banking, 9(1), 70-85. Retrieved May 28, 2010 from EBSCOHost database Chen, Sh. ; Dodd, J. (2002). Market efficiency, CAPM, and value-relevance of earnings and EVA: A reply to the comment by professor Paulo.
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W. , Jaffe, J. (2004). Corporate finance —7th ed. McGraw-Hill/Irwin: New York, NY. Stewart, B. (2001). Market Myths. In Chew, D. H. (Ed. ). (2001) The New Corporate Finance: Where Theory Meets Practice, p. 35-50. New York: Irwin Versluis, C. ; Hillegers, T. (2006). The impact of portfolio re-financing on Black-Scholes call option valuation. Applied Financial Economics Letters, 2, 261-263. Retrieved May 28, 2010 from ProQuest database Weaver, S. C. , ; Westin, J. F. (2002). Finance and accounting for nonfinancial managers. McGraw-Hill: New York, NY.
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