Vous êtes sur la page 1sur 38

BUILDING BLOCKS OF MODERN

FINANCE THEORY
Corporate Finance Theory
William L. Megginson
1. Savings and Investment in
Perfect Capital Markets
Irving Fisher (1930) shows how capital markets
increase the utility both of economic agents with
surplus wealth (savers) and of agents with
investment opportunities that exceed their own
wealth (borrowers) by providing each party with a
low-cost means of achieving their goals.
The Fisher Separation Theorem demonstrates that
capital markets yields a single interest rate that
both borrowers and lenders can use in making
consumption and investment decisions, and this in
turn allows a separation between investment and
financing decisions.


2. Portfolio Theory
Harry Markowitz (1952): dont put all your eggs in
one basket.
Markowitz shows that as you add assets to an
investment portfolio the total risk of that portfolio
as measured by the variance (or standard
deviation) of total return decline continuously, but
the expected return of the portfolio is a weighted
average of the expected returns of the individual
assets. In other words, by investing in portfolio
rather than in individual assets, investors could
lower the total risk of investing without sacrificing
return.


2. Portfolio Theory
His primary theoretical contribution was to prove
that the unique, individual variability in an assets
return (unsystematic risk) shrinks to insignificance
as that assets weight in a portfolio declines, and in
a well-diversified portfolio the only risk that remains
is that which is common to all assets (systematic
risk). It is this covariance risk remaining after
diversification has washed out the effects of
individual asset risk that an investor must bear and
be compensated for, because there is no effective
method of eliminating it.

2. Portfolio Theory
Efficient Portfolio: risk is minimized for any given
level of expected return or, conversely, where
return is maximized for any given level of risk.
The theory, however, did not in and of itself
constitute a useful positive economic theory
describing how capital markets quantify and price
financial risk. That achievement would come a
decade later, when Sharpe (1964) would add two
critical pieces to the Markowitz efficient portfolio to
develop (with Lintner (1965) and Mosin (1966)) the
Capital Asset Pricing Model, or CAPM.

3. Capital Structure Theory
Modigliani and Miller (1958)
The central point of the M&M model is that the
economic value of the bundle of assets owned by
a firm derives solely from the stream of operating
cash flows those assets produce. It is the stream
of operating cash flows (profits) expected to be
generated by those assets that creates value
market participants will forecast the average level
of those flows and then compute a present value
based on the perceived riskiness of the cash
flows.
3. Capital Structure Theory
M&Ms Proposition I:the market value of any firm
is independent of its capital structure and is given
by capitalizing its expected return at the rate
appropriate to its risk class.
M&Ms Proposition II: If the expected return on
the firms assets is the constant , then the
required return on levered equity must increase
directly and linearly as risk-free debt is added to
the firms capital structure.
3. Capital Structure Theory
Taken together, the two propositions establish that
capital structure is irrelevant in a perfect capital
market and the required return on a given firms
equity is computed directly from its debt-to-equity
ratio and the required return for firms of its risk
class.
Since 1958, finance theorists have examined how
relaxing first one and then another assumption
affects the capital structure irrelevance results. The
model held up well until corporate taxes, personal
taxes, and deadweight bankruptcy costs were
included these all change the models
implications, but in predictable ways.
3. Capital Structure Theory
The development of agency cost and asymmetric
information models in the 1970s also led to a
modification of the basic M&M model, but even
today after almost five decades of intensive
theoretical and empirical research we can offer
no simple, unambiguous answer to the question,
does capital structure matter?
4. Dividend Policy
Miller and Modigliani (1961)
M&M shows that holding a firms investment
policy fixed, the payment of cash dividends
cannot affect firm value in a frictionless market
because whatever the firm pays out in dividends it
must make up by selling new equity.
Cash flow identity: total cash inflows must equal
total cash outflows, that drives the M&M dividend
irrelevance model.
5. Asset Pricing Models
Finance became a full-fledged scientific discipline
in 1964 when Sharpe published his paper
deriving CAPM.
The CAPM assumes that investors hold well-
diversified portfolio within which the unsystematic
risk of individual assets is unimportant.
Systematic risk, o.t.o.h., refers to an assets (or
portfolios) sensitivity to economy wide factors
such as interest and exchange rates, inflation,
and business cycle fluctuation.
5. Asset Pricing Models
Sharpes main contribution was to uniquely define
systematic risk and to specify exactly how
investors can trade off risk and return. He did this
by assuming investors can either invest in risky
assets, such as common stocks, or in a risk-free
asset, such as T-bill.
Sharpes other contribution was to point out that,
in equilibrium, every asset must offer an expected
return that is linearly related to the covariance of
its return with expected return on the market
portfolio. Mathematically, the CAPM can be
expressed as:
E(R
j
) = R
f
+
j
(R
m
- R
f
)
5. Asset Pricing Models
Rosss (1976) Arbitrage Pricing Theory (APT)
holds that the expected return on a given asset is
based on that assets sensitivity to one or more
systematic factors.
The sensitivities of an assets return to each
factors realization were called factor loading, and
preliminary research suggested that most
common stocks were significantly influenced by
between three and five factors.
A major problem with the APT, which is still not
solved, is that there is no prior specification of
exactly what economic variables the factors
represent.
6. Efficient Capital Market Theory
Fama (1970) presents both a statistical and a
conceptual definition of an efficient capital
market, where efficiency is defined in terms of the
speed and completeness with which capital
markets incorporate relevant information into
security prices.
In a weak form efficient market, security prices
incorporate all relevant historical information. In
other words, there is nothing to be gained by
studying past trends in security prices because
there is no prediction that can be drawn from
them about the future course of prices changes.
6. Efficient Capital Market Theory
Research has unambiguously supported weak
form efficiency in almost all major U.S. financial
markets.
In a semi-strong-form efficient market, security
prices reflect all relevant, publicly-available
information. This is stronger than weak form
efficiency, in that it predicts that security prices
will always reflect relevant historical
information, and will react fully and
instantaneously whenever new information is
revealed in a public medium such as television,
newspapers, government documents, or a wire
service report.
6. Efficient Capital Market Theory
In a strong-form efficient market, security
prices incorporate all relevant information
public and private.
7. Option Pricing Theory
Black and Scholes (1973) published an article
describing the model for pricing stock options.
The Black-Scholes Option Pricing Model (OPM)
was a genuine breakthrough because it
provided a closed-form solution for pricing put
and call options that relies solely on five
observable (or at least readily calculable)
variables; the exercise price of the option, the
current price of the firms stock, the time to
maturity of the option, the variance of the
stocks return, and the risk-free rate of interest.
7. Option Pricing Theory
Very quickly it was discovered that a variety of
systematic biases were present in the pricing
model, particularly when it was used to price
deep in-the-money and out-of-the-money
options (where the current stock price was,
respectively, much greater than or much less
than the exercise price of the option.
The basic OPM assumes that stocks do not pay
dividends, and can yield significant pricing
errors if applied to stocks making large nominal
dividend payments.
7. Option Pricing Theory
The OPM was developed for European options
which can only be exercised on the day the
option expires but virtually all real options
traded are American options that can be
exercised at any time prior to and including the
expiration date.
Since an option gives the owner the right, but
not the obligation, to exercise a trade, it is an
ideal tool to use for many hedging activities
(protecting company costs or revenues from
adverse price movements).
8. Agency Theory
The fundamental contribution of the agency
cost model of the firm put forth by Jensen and
Meckling (1976) is that it incorporates human
nature into a cohesive model of corporate
behavior. In the Jensen and Meckling model,
the firm is a legal fiction that serves merely as
a nexus of contracts for agreements between
managers, shareholders, suppliers, customers
and other parties. All the parties are consenting
adults who act in their own self-interest, and
fully expect all other parties to act in theirs.
8. Agency Theory
It is a model that relies on rational behavior by
self-ineterested economic agents who
understand the incentives of all the other
contracting parties, and who take steps to protect
themselves from predictable exploitation by these
parties.
Residual loss, the dollar value of the total agency
costs remaining after the monitoring and bonding
expenditure, is the irreducible cost of separating
ownership and control in large modern
corporations.


8. Agency Theory
Jensen and Meckling fleshed out their model by
demonstrating both how issuing outside debt
can help overcome the agency costs of issuing
equity, and how the presence of too much debt
can generate an entirely different set of agency
problems. This helped convert their work into a
full-fledged model of corporate capital structure,
as well as one of corporate governance; and
this theory also helps explain why investors
demand and corporations are willing to pay
regular cash dividens.
8. Agency Theory
Perhaps the most important application of the
agency cost model is in explaining the
corporate control contests that burst on the
scene so dramatically during the 1980s. By
viewing the takeover battles of this period as
contests between rival management teams for
control of corporate resources, it is easy to
understand (1) why firms might be undervalued
in the first place (because they are controlled by
inefficient but entrenched managers);
8. Agency Theory
(2) why potential acquirers might be willing and
able to pay such a high price for the targets
shares (investors value the target to reflect the
poor performance of incumbent management
and would value the firm more positively with a
more competent management team in place);
and (3) why target firm managers often resist
takeover bids so vehemently (since they stand
to lose both the financial and personal benefits
that come with controlling a large corporation).
8. Agency Theory
Several aspects of the takeover battles of the
1980s, especially the frequency with which target
firm managers and directors adopted value-
reducing defenses such as poison pills and
other shark repellents, can only be explained
with an agency cost model that explicitly
recognizes the conflict of interest between
corporate managers and shareholders.
Another very important vein of academic
research concerning agency costs has examined
the potential of compensation policy to
overcome agency problems between corporate
investors and managers.
9. Signaling Theory
Signaling theory was developed in both the
economics and finance literature to explicitly
account for the fact that corporate insiders
(officers and directors) generally are much
better informed about the current workings and
future prospects of a firm than are outside
investors. In the presence of this asymmetry of
information, it is very difficult for investors to
objectively discriminate between high-quality
and low-quality firms. Statements by corporate
managers convey no useful information.
9. Signaling Theory
Because of the asymmetric information problem,
investors will assign a low average quality
valuation to the shares of all firms. In the
language of signaling theory, this is referred as a
pooling equilibrium since both high and low
quality firms are relegated to the same valuation
pool.
Obviously, high-quality firm managers have an
incentive to somehow convince investors that
their firm should be assigned a higher valuation
based on what the managers know to be superior
prospects for the company. One way to do this
would be for high-quality firm managers to
employ a signal that would be costly, but
affordable, for their firms but which would be
prohibitively expensive for low-quality firms to
mimic (e.g. large cash dividends).
9. Signaling Theory
When investors understand the incentives, they
would assign high values to firms that paid high
dividends and would assign low valuations to
firms that either paid low dividends or paid none
at all. This result is referred to as a separating
equilibrium because investors are able to assign
separate, and economically rational, valuation to
high- and low-quality firms. It is also a stable
equilibrium, in spite of its deadweight cost in
terms of foregone investment, because high-
quality firms are able to achieve the higher
valuation they desire and deserve, low-quality
firms receive the valuation they deserve (but do
not desire), and investors are able to confidently
invest in firms with the most promising prospects.

9. Signaling Theory
Signaling models, however, have not fared well in
empirical testing because they typically predict
exactly the opposite of what is actually observed
corporate behavior. For example, signaling models
typically predict that the most promising (in terms of
growth prospects) firms will also pay the highest
dividends and will have the highest debt-to-equity
ratios. In actual practice, however, rapidly-growing
technology companies tend not to pay any
dividends at all while mature companies in stable
industries usually pay out most of their earnings as
dividends. The same is true for capital structure
observed debt ratios tend to be inversely related to
both profitability and industry growth rates.
10. The Modern Theory of
Corporate Control
Motivated by M&A in the 1980s
The first major exposition of a truly modern theory
of corporate control was presented by Bradley
(1980), who studies the stock price performance
of companies that are the targets of takeover bids.
Bradley documents that these shares increase in
value by approximately 30% immediately after a
tender offer (a publicly announced offer to buy
shares at a fixed price from anyone who tenders
their shares) is announced, and then stays at
about that same level until the acquisition is either
completed or canceled.
10. The Modern Theory of
Corporate Control
Bradley also documents that those shares which
are not purchased in a successful takeover, as
will always occur if a bidder only purchases, say,
51% of the targets shares, drop in price back
towards their initial value immediately after the
takeover is completed.
Prior to Bradleys work, most observers assumed
that bidding firms acquired majority stakes in
target firms either to loot the assets of the target
company or to profit from an appreciation of the
target firms shares after the takeover is
announced.
10. The Modern Theory of
Corporate Control
Bradleys results are inconsistent with either of
these explanations. Since unpurchased shares
remain above their pre-bid price even after a
takeover is completed, it is clear that successful
bidders are not looting their acquired companies
because this would have caused the price of
unpurchased shares to fall far below their pre-bid
price. On the other hand, since the price of
unpurchased shares falls below the tender offer
price once the takeover is completed, it is obvious
that bidders are suffering a capital loss on the
shares they purchased rather than a gain.
10. The Modern Theory of
Corporate Control
Bradleys theoretical model assumes that bidding
firm managers will launch a tender offer primarily
in order to gain control over the assets and
operations of a target firm that is currently being
run in a sub-optimal manner. Once the bidder
gains control of the target, a new, higher valued
operating strategy will be implemented and the
bidding firm will earn a profit from operating the
target more effectively.
11. The Theory of Financial
Intermediation
Financing through capital markets maybe costly
and using financial intermediation maybe the
alternatives.
In academic circles, an early description of the
informational advantage of financial intermediation
was provided in the article by Leland and Pyle
(1977). Several other articles that document large,
negative returns to shareholders following the
announcement of new security issues (particularly
equity issues) by corporations reinforce the idea
that capital market financing is inherently costly and
disruptive.
11. The Theory of Financial
Intermediation
James (1987) provides an important contribution
to this literature by documenting positive returns
to corporate shareholders following the
announcement that a firm has obtained a loan
from a commercial bank.
12. Market Microstructure
Theory
Market microstructure is the study of how
securities markets set prices, compensate market
makers, and incorporate private information into
equilibrium price level.
Microstructure research can be classified into two
separable, though related, streams of analysis.
(1) Market structure/spread models which study
the relative merits of different market structure
(monopoly specialist versus multiple dealer
markets, electronic order book versus human
dealer markets, etc.)
12. Market Microstructure
Theory
(2) Price formation models analyze how private
information is incorporated into securities prices,
and study how trade size, aggregate trading
volume, and price levels are related.
Motivating articles: Ho and Stoll (1981), Demsetz
(1968), Tinic (1972), Branch and Freed (1977).
SEVERAL BASIC PRINCIPLES
In pricing financial assets, only
systematic risk matters.
Emphasize investment rather than
financing.
Emphasize cash flows rather than
accounting profits.
Remember that finance is now a global
game.
Remember that finance is a quantitative
discipline.