Financial Theories Overview Financial Theories Overview This paper will include an overview of 10 financial theories incorporating both germinal and current research. In addition, each financial theory will include a general description, current examples, and significant attributes. Table 1 Financial Theories Financial Theories| Description| Current Examples| Significant Attributes| 1.
Efficiency Theory | Eugene Fama defined efficient markets as “a market where there are large numbers of rational profit-maximizers actively competing, with each trying to predict future market values of individuals securities, and where important current information is almost freely available to all participants” (Ball, 2001, p. 23). | Publicly available information is accessible to all investors at zero cost while earnings reports are costly to firms to produce (Ball, 2001).
Once these reports are public in databases or corporate websites, they are nearly costless to obtain but may have a cost associated to interpret the information (Ball, 2001). Another example is to use a coupon to obtain a free item. The item is free, but the opportunity cost is not free. In addition, there is a cost associated with the resources used to print the coupon for the potential customer. | According to Ball (2001), this theory has limitations because it neglects the role of information costs and assumes price includes all costs. Theory uses event time to isolate market reactions to stock prices (Ball, 2001).
A notable factor contributing to success was Center for Research in Securities Prices (CRSP), which provided comprehensive NYSE data dated from 1926 (Ball, 2001). The following anomalies exist in this theory: price overreactions, excel volatility, price under reactions to earnings, the failure of CAPM to explain returns, the explanatory power of non-CAPM factions, and seasonal patterns (Ball, 2001). The following problems exist when testing the theory: changes in riskless rates and risk premiums, trends in real rates and market risk premiums, changes in betas, and seasonal patterns in betas (Ball, 2001). 2. Theory of Investment| Proposed by Miller and Modgliani in 1958, this theory states the capital structure of a firm is irrelevant to its value (Miller, 2001). The dividend policy and capital structure are independent to market stock prices (Miller, 2001). In 1952, David Durand criticized the theory and saw “two polar approaches to valuing shares, that investors might ignore the firm’s then-existing capital structure and first price the whole firm by capitalizing its operating earnings before interest and tax” (Miller, 2001, p. 185). Durand later rejected his criticism. In recent years, high debt ratios installed by outside initiated LBOs that fended hostile takeovers and emphasized tax benefits (Miller, 2001). The surge of leveraged buy-outs (LBOs) showed the feasibility of high-leverage capital structures for reducing corporate income taxes and suggested shareholder gains accompanied by recapitalization (Miller, 2001). | The propositions imply “weighted average of these costs of capital to a firm would remain the same no matter what combination of financing sources the firm actually chose” (Miller, 2001, p. 185).
The dividend proposition overcomes objection to leverage proof. | 3. Agency Cost Theory| Michael Jensen and William Meckling define agency costs as the costs associated with cooperative effort by human beings, which arises when the principal hires an agent to carry out duties (Jensen, 2005). Conflicts of interest between management and shareholders are inevitable and can cause a potential loss in value of public corporations (Chew, 2001). For example, shareholders may want management to increase shareholder value, but management may grow the business to increase personal power and wealth (Chew, 2001). Enron’s company was worth $30 billion and senior managers’ tried to defend a $40 billion of excess valuation. Ultimately Enron executives destroyed the company “by trying to fool the markets through accounting manipulations, hiding debt through off-balance sheet partnerships, and over hyped new ventures such as their broadband futures effort” (Jensen, 2005, pp. 10-11). John Roth, former chief executive officer (CEO) of Nortel, wrote off most acquisitions, when stock price crashed and closed down activities, which resulted in the destruction of not only the corporate value but also the social value of the company (Jensen, 2005). Finance scholars found a reduction in conflict of interest between management and shareholders because of: (1) product market competition and a market for executive labor, (2) management incentive plans, and (3) an operating takeover market (Chew, 2001). | 4. Agency Costs of Free Cash Flow Theory| In 1986, Michael Jensen introduced the theory and defined it as follows: “Leveraged acquisitions, stock repurchases, and management buyouts of public companies were adding value to corporations by squeezing capital out of organizations that had few profitable growth opportunities” (Chew, 2001, p. viii)| Chew explains before the hostile takeovers in the 1980s, corporate managers in mature industries reinvested excess capital, and in the worst-case scenario, diversified into unrelated businesses (2001). In addition, in the early 80s, oil companies that faced a massive free cash flow problem chose to reinvest excess capital and diversify into unrelated businesses (Chew, 2001). | Leverage is an option to reduce free cash flows and the agency costs associated with potential over-investment or wasting excess cash (Ruland ; Zhou, 2005).
Firms with larger cash flows, and fewer investments, such as diversified firms, have a higher potential for leverage to reduce agency costs (Ruland ; Zhou, 2005). | 5. Pecking-order Theory of Capital Structure| This theory is a result of asymmetric information, which is also present in financial markets (Lopez-Gracia ; Sogorb-Mira, 2008). “Corporate managers often have better information about the health and prospects of their companies than outside investors” (Lopez-Gracia ; Sogorb-Mira, p. 122, 2008, para 2).
Changes in debt level are not motivated by the need for external financial when exhausting one internal resource and opportunities for profitable investment exist (Lopez-Gracia ; Sogorb-Mira, 2008). | Lopez-Gracia and Sogorb-Mira (2008) recommended testing a firm by examining financial decisions made after short-term changes in profits and investmentAnother way to test this theory is “by regressing a firm’s debt over the main factors that summarize the essential financial behavior” (Lopez-Gracia ; Sogorb-Mira, p. 122, 2008).
Lopez-Gracia and Sogorb-Mira (2008) tested the theory using Small and Medium-Sized Enterprises (SMEs) over a 10-year period dating from 1995 – 2004. “SMEs can be affected by asymmetric information problems like adverse selection and moral hazard” (Lopez-Gracia ; Sogorb-Mira, p. 122, 2008), which results in short-term debt financing. The transaction costs ofexternal sources of financing is higher because SMEs have less organizational and management power in credit markets (Lopez-Gracia ; Sogorb-Mira, 2008). | As a result of information asymmetries, ndervalue of new securities occur when issued in financial markets (Lopez-Gracia ; Sogorb-Mira, 2008)Provided cash flow has not run out, firms will increase leverage by boosting investment opportunities (Lopez-Gracia ; Sogorb-Mira, 2008)This theory assumes that older firms retain more earnings over time and require less debt (Lopez-Gracia ; Sogorb-Mira, 2008)| 6. Economic Value Added Theory (EVA)| Developed by Stern Stewart ; Co. , EVA measures the financial performance of the firm (Fletcher ; Smith, 2004).
EVA “estimates a company’s worth as the sum of all future expected operating cash flows, net of required new investment and discounted at a cost of capital that reflects risk and investors’ alternative investment opportunities” (Chew, 2001, p. 2). This is used to reduce conflicts between managers and shareholders (Chew, 2001). According to Stern, Stewart, and Chew (2001), EVA incorporates tools to make corporate financial decisions. The EVA financial management system includes an incentive compensation package (Stern, Stewart, ; Chew, 2001). Stern Stewart identified more than 120 shortcomings in conventional GAAP accounting and its inability to handle R;D and other corporate investments (Stern, Stewart, ; Chew, 2001). Fred Stratton of Briggs ; Stratton attributed the company’s 70% stock increase from a previous year and the 40% outperformance of the S;P 500 after adopting EVA (Stern, Stewart, ; Chew, 2001). | EVA can increase shareholder value by increasing the return derived from assets, invest additional capital and lower average return, discontinuing investments that do not yield high returns (Stern, Stewart, ; Chew (2001).
EVA discourages corporate overinvestment and addresses underinvestment problems (Chew, 2001). EVA focuses on value creation (Fletcher ; Smith, 2004). The most sophisticated, influential investors use EVA to price corporate securities (Chew, 2001). Fletcher and Smith (2004) found limitations for EVA because it relies heavily “on historical, financial measures such as profit margin, asset turnover, cost of money and level of capital invested in the firm” (p. 3), when leading drivers are often non-financial.
The market establishes a company’s value by capitalizing its current earnings (Fletcher ; Smith, 2004). | 7. The Sociological (or Social Victim) Model| Proposed by Meckling in 1976, this model is one of the five alternative models of human behavior that state individuals are a product of their cultural environment such as taboos, customs, mores, and traditions sometimes referred to social victims, which determine attitudes and actions (Jensen ; Meckling, 2001). To Marxist politicians, this model is the “foundation for the centralization of power” (Jensen ; Mecklin, 2001, p. 13). Meckling and Jensen (2001) use the example of social scientists looking to change morals and social attitudes to explain increases in sexuality and declines in birth rates. IBM’s decision to abandon its policy of lifetime employment, which was a social expectation. Increased global competition, as a result of corporate restructuring in the United States, lifetime employment is no longer an expectation (Meckling ; Jensen, 2001). Japanese and European companies are rethinking their policy while finding solutions for issues of chronic industrial overcapacity and inefficiencies (Meckling ; Jensen, 2001). Cultural practices must adapt to opportunity costs and benefits for group or organization to prosper (Jensen ; Meckling, 2001). Other attributes of this theory are: * Cultural factors determine human behavior. * Social conflict occurs when underlying costs and benefits change. * Cultural environment determines success or failure| 8. Trade-off Theory| The firm’s goal is to obtain capital structure and leverage the costs and benefits of an additional monetary unit of debt (Lopez-Gracia ; Sogorb-Mira, 2008).
This theory “predicts that firms trade off the costs and benefits of leverage associated with tax effects, bankruptcy, and agency costs” (Brounen, De Jong, ; Koedijk, 2004, p. 93)| Brounen, De Jong, and Koedijk (2004) found that European and American CFOs considered the tax advantages of interest. From the study, the authors also discovered that CFOs in the UK and the Netherlands strove to maximize shareholder’s wealth, whereas German and French firms attached a low priority to this goal (Brounen, De Jong, & Koedijk, 2004, p. 3). | Firms adopting the trade-off theory first set a target capital structure, then chose factors to obtain the optimal capital structure (Brounen, De Jong, & Koedijk, 2004). The advantages include using interest payments and non-debt tax shields (NDTS) to reduce tax and using debt to reduce free cash (Lopez-Gracia & Sogorb-Mira, 2008). Default risk offsets debt financing to protect firms from bankruptcy (Lopez-Gracia & Sogorb-Mira, 2008). The disadvantages include the potential cost of inancialdistress and agency costs arising between owners and financialcreditors (Lopez-Gracia & Sogorb-Mira, 2008). | 9. Capital Asset Pricing Model (CAPM)| Developed by William Sharpe in 1964 and John Lintner in 1965, this model was used by institutional and industrial corporations to estimate investor’s expected returns (Ball, 2001). | In a study conducted by Brounen, De Jong, and Koedijk (2004), European CFOs with maximum tenure in public firms determined cost of capital using the capital asset pricing model (CAPM). Mostly by large firms with high leverage use this theory (Brounen, De Jong, & Koedijk, 2004). “High-beta stocks do not earn higher returns than low-beta stocks” (Ball, 2001, p. 26). | 10. The Resourceful, Evaluative, Maximizing Model (REMM) Model| Proposed by Meckling in 1976, this model is one of the five alternative models of human behavior that states individuals care, have unlimited wants, maximizes opportunities, and is resourceful (Jensen & Meckling, 2001). Jensen and Meckling (2001) use an example of driving the speed limit imposition of 55-mile-per-hour to conserve gasoline. Opponents of the speed limit argued that time is lost when drove at a slower rate of speed, which created inefficiencies, and drivers responded by violating the speed limit, reduced travel, bought radio detectors to avoid speeding tickets (Jensen & Meckling, 2001). Another example of this model is discovering loopholes to avoid paying income tax (Jensen & Meckling, 2001). This model implies there are wants, desires, and demands because the individual is always willing to make trade-offs when constraints arise (Jensen & Meckling, 2001). REMM might appear too biased toward government agencies as controlling entities (Jensen & Meckling, 2001). Individuals may sacrifice morality and reputation to obtain wants, which can result in corruption or disaster and may require governmental intervention (Jensen & Meckling, 2001). | References Ball, R. (2001). The theory of stock market efficiency: Accomplishments and limitations.
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The New Corporate Finance: Where Theory Meets Practice pp. (184-196). New York: Irwin. Ruland, W. , & Zhou, P. (2005). Debt, diversification, and valuation. Review of Quantitative Finance and Accounting, 25(3), 277-291. Retrieved from http://proquest. umi. com. ezproxy. apollolibrary. com/pqdweb? did=895897291&sid=2&Fmt=6&clientId=13118&RQT=309&VName=PQD Stern, J. M. , Stewart, G. B. , & Chew, D. H. (2001). The EVA financial management system. In D. H. Chew (Ed. ), The New Corporate Finance: Where Theory Meets Practice (pp. 132-146).
