AgendaAbout Finance & Corporate Finance Introduction to Overview of the Central Ideas of FinanceTime Line of the Introduction of New Concepts and Corporate FinanceIdeas in FinanceBuilding Blocks of Modern Finance TheoryThe Five Most Important Finance ConceptsSchool of Management, HUSTThe Top Achievements, Challenges, and Failures of Finance What We Do and Do Not Know about Finance1122Finance (1)Money and Capital MarketsDeals withFinancial Markets and InstitutionsAbout Finance & InvestmentsCorporate FinanceFocuses on the Decisions of Both Individual and Institutional Investors as They Choose Securities for their Investment PortfoliosFinancial ManagementBusiness Finance, Involves the Actual Management of Firms.(Eugene F. Brigham, Louis G. Gapenski, Financial Management: Theory and Practice (Eighth Edition), The Dryden Press, 1997. pp. 4-6)3344Finance (2)Finance (3)Corporate Finance(܄ඳҍༀ)Corporation Financeč܄ඳҍༀĎPersonal Financeč۱ದҍༀĎInvestmentsčሧ࿐ĎPublic Financečҍᆟ࿐ĎMacro financečޡܴҍༀĎInternational Financečݓ࠽ࣁವĎMultinational Financečॴݓ܄ඳҍༀĎ55661
®About Finance Corporate FinanceMacro-Finance: Public Finance (ҍᆟĎFinancial ManagementInvestment: Financial Markets & Institutions čࣁವĎManagerial FinanceBusiness FinanceCorporate Finance: Corporate Investment & Financing čҍༀĎPersonal Finance: Personal Investment & Financing čҍĎ7788The Balance-Sheet Model of Corporate Financethe FirmNet Working capitalCurrent liabilitiesCurrent liabilitiesCurrent assetsCurrent assetsRoss’s ViewThe Balance-Sheet Model of the FirmLong-term debtLong-term debtFixed assetsFixed assetsPie Model of the fixedShareholders’equityShareholders’equityassetsassets(Stephen A. Ross, Randolph W. Westerfield & Jeffrey F. Jaffe, Corporate Total value of the firmTotal value of assetsFinance(Sixth Edition), McGraw-Hill Irwin, 2002. pp. 3-5)to investors991010Pie Model of the FirmCorporate FinanceVan Horne’s View25% debtInvestment DecisionFinancing Decision50% debtquity50%75%e equityAssets Management DecisionCapital structure 2Capital structure 1(James C. Van Horne, John M. Wachowicz, Jr., “Fundamentals of Financial Management”(Eleventh Edition), Prentice-Hall International, Inc., 2001. pp. 2-3)111112122
Corporate FinanceCorporate FinanceBrealey’s ViewBrigham’s ViewInvestment, or Capital Budgeting, DecisionFinancial Managementis the broadest of Financing Decisionthe three areas (Money and Capital Markets, Investment and Financial Management).(Richard Brealey, Stewart Myers, Gordon Sick & Ronald Giammarino, (Eugene F. Brigham, Louis G. Gapenski, Financial Management: Theory Principles of Corporate Finance(Second Canadian Edition), and Practice(Eighth Edition), The Dryden Press, 1997. pp. 5)McGraw-Hill Ryerson, 1992. pp. 3)13131414®Capital BudgetingCorporate FinanceInvestment DecisionTime Value of Money (TVM)¾Capital BudgetingDiscounted Cash Flow (DCF) Approach¾(Securities) InvestmentFinancial Analysis in Feasibility StudyFinancing DecisionUncertainty Analysis(Scenario Analysis, ¾Long-Run Financing DecisionSensitivity Analysis, Decision Tree, Monte ¾Short-Run Financing DecisionCarlo Simulation, Break-Even Analysis)Special Areas in Corporate FinanceReal Option15151616(Micro) InvestmentLong-Run Financing DecisionTrade-Off of Expect Return and Risk Sources of Long-Term FinancingUtility TheoryCost of CapitalPortfolio TheoryFinancial Leverage &Capital StructureEfficient Market Hypothesis (EMH)Dividend PoliciesCapital Assets Pricing Model (CAPM)Capital Markets & Securities IssuingArbitrage Pricing Model (APM)Financial Leasing171718183
Special Areas in Short-Run Financing DecisionCorporate FinanceSources of Short-Term FinancingM & AScale of Short-Term FinancingInternational FinanceWorking Capital ManagementFinancial DistressCash ManagementMultinational Financial ManagementCredit Management (Accounts Receivable Financial Engineering in Corporate FinanceManagement)Risk ManagementInventory Management19192020Ten Axioms of FMTen Axioms of FMჰᄵ2ğࠊл֥ൈࡗࡎᆴ——ࣂ฿֥၂ჭఫбჰᄵ1ğڄག൬ၭ֥ಃޙ——ؓحຓ֥ڄགླေໃট֥၂ჭఫ۷ᆴఫbႵحຓ֥൬ၭࣉྛҀӊb1. The risk-return trade-off: We won’t take on 2. The time value of money: A dollar received additional risk unless we expect to be compensated today is worth more than a dollar received in the with additional return. The greater the risk, the future. A dollar received today is worth more than greater the dollar received tomorrow because a dollar received today can earn a day’s interest by čArthur J. Keown, David F. Scott, John D. Martin, Jay William Petty, ᇫtomorrow.བၲđགྷսҍༀܵࠎԤđКࣘğౢն࿐ԛϱഠđ1997୍bQQ Ď21212222Ten Axioms of FMTen Axioms of FMჰᄵ4ğᄹਈགྷࣁੀਈ——ᆺႵᄹਈ൞ཌྷܱ֥bჰᄵ3ğࡎᆴ֥ޙਈေॉ੮֥൞གྷࣁط҂4. Incremental cash flows: It’s only what changes that ൞০bcounts. Think incrementally. How will a decision changethe cash flow of the company?3. Cash-not profits-is king. Accounting profit or loss frequently does not coincide with the actual ჰᄵ5ğᄝࣩᆚ൧ӆഈીႵ০หљ֥ۚཛଢbtransfer of money. The first rule of running any 5. The curse of competitive markets: Why it’s hard to find business: Do not run out of profitable projects. Success attracts competition. Competition lowers
Ten Axioms of FMTen Axioms of FMჰᄵ6ğႵི֥ሧЧ൧ӆ——൧ӆ൞ਲૹ֥đࡎ۬൞ކ֥bჰᄵ8ğବඥ႕ཙြༀथҦb6. Efficient capital markets: The markets are quick and the 8. Taxes bias business decisions. Decisions using cash flows prices are right. Security prices adjust very quickly and must always use after-taxcash to new information.ჰᄵ9ğڄགٳູ҂֥োљ——Ⴕུॖၛ๙ݖٳ߄ཨԢđႵུᄵڎbჰᄵ7ğս໙ี——ܵದჴა෮Ⴕᆀ֥০ၭ҂၂ᇁb9. All risk is not equal. Some risk can be diversified away 7. The agency problem: Managers won’t work for owners and some cannot. Total risk is a combination of firm-unless it’s in their best interest. Most people will work harder specific risk, which can be diversified away, and market for themselves than they will for someone , which cannot be diversified away. (But see the futures markets.)25252626Ten Axioms of FMჰᄵ10ğ֣֡ྛູࣼ൞ေቓᆞಒ֥൙౦đطᄝࣁವြᇏԩԩթᄝሢ֣֡ࠈbOverview of the Central Ideas of Finance10. Ethical behavior is doing the right thing, and ethical dilemmas are everywhere in finance. Businesses that are not trusted by other businesses (J, Fred Weston, A Relatively Brief History of Finance or by customers will not maximize the wealth of Ideas, Financial Practice and Education, 1994,, pp. stockholders. Perhaps the primary goal of firms 7-26)should address stakeholders and not just DecisionsOverview of the Central Ideas of FinanceInvestment Decisions (Capital Budgeting)Fisher separation is the idea that investment decisions can be The Efficient Markets Hypothesis (EMH)separated from considerations about individual preferences. If capital markets are perfect, managers maximize owners' wealth Portfolio Decisions (Gains to Diversification)by investing until the rate of return is equal to the opportunity Risk and Return (Factor Models)cost of capital. Pricing Derivative Securities (Option Pricing Theory)Individuals can delegate investment decisions to the managers Capital Structure, Dividend Decisions, Optimal Contractual of firms, and the appropriate decision rule is the same, Choiceindependent of shareholders' time preferences for consumption. Valuation and Growth OpportunitiesThe investment rule is to undertake projects until the marginal International Financerate of return equals the market-determined discount rate (the opportunity cost of capital). Agency, Auctions, Games, Information, RecontractingGiven a perfectly competitive capital market, the important Takeovers, Governance, and ControlFisher separation concept applies as well to the full set of The Timing of Cash Inflows and Outflows (Short-Term traditional capital structure and related decisions Financial Management)292930305
Portfolio DecisionsThe Efficient Markets HypothesisEMH holds that current prices reflect all available no-arbitrage profit condition is also implied. Diversification eliminates nonsystematic risk. Only Any two securities or portfolios with the same state-contingent systematic risk is priced. payoff vectors must be priced identically. This is the single-price law of markets. On a mean-variance-efficient frontier, each investor If short selling is allowed, a second necessary condition for picks a point for a particular degree of risk aversion; market equilibrium is the absence of any risk-less arbitrage such portfolios will combine two assets: the risk-free opportunity. asset and the common risky portfolio, the market (M).Noise traders or uninformed investors are contrasted with informed investors who trade on information. Noise trading Two-fund separation still holds in the absence of a makes it possible for informed investors to earn a normal returnrisk-free asset by combining M with a zero beta on the investment in information gathering. portfolio.A second approximation to EMH adjusts for noise traders and the limited ability of arbitrage by rational investors to fully offset their and Return Risk and Return (Factor Models)(Factor Models)However, for more narrowly defined securities and The tradeoff between risk and return has been portfolios, less agreement is found on the identification of emphasized in recent generations of finance risk factors and other variables that appear to influence textbooks. This central proposition of financial security returns. economics is based on the proposition that risk-At the theoretical level, the law of one price, the arbitrage averse investors must be promised a higher condition, and the equilibrium condition all utilize linear nominal return to bear a higher risk. pricing relationships. For broad classes of securities, solid evidence is Security and portfolio expected returns are related to their consistent with this proposition, that is, historical sensitivities to pervasive factors, as formulated in factor returns on equities are higher than for straight models such as CAPA and APT. In empirical tests, a wide bonds. range of variables have been used to explain Derivative Securities Capital Structure, Dividend Decisions, Optimal Contractual Choice(Option Pricing Theory)Derivative securities are assets whose values are based on the values of other assets. Pricing derivatives is based on the The key aspects of corporate finance involve principle that close substitutes have the same price. Calls, puts, financial structure and dividend policy, for which swaps, futures, and forward contracts are examples of derivative securities whose payoffs are contingent on the valuesModiglianiand Miller (M&M) developed irrelevance of other assets. propositions. Derivative securities can be formed by the use of options such Departures from the M&M conditions give rise to as calls and puts or by combining short and long positions in options, in futures or forward contracts, or in combinations of many challenging corporate finance policy decision other assets with differing degrees of perceived risk. issues, including optimal contractual choice. Derivative securities provide opportunities for risk management (hedging) and spanning with new securities (financial engineering).353536366
Valuation and Growth Valuation and Growth OpportunitiesOpportunities (ctd.)Assets are valued by their appropriately discounted expected The relation between profitability rates and the cost of future cash flow distributions. capital defines growth opportunities and is central in If actions or decisions do not affect the probability models for estimating the intrinsic value of firms. distributions of the future cash flows, the capital structure and Some have suggested that capital structure issues should be dividend irrelevance propositions follow. combined with valuation. This should not be done since The related value additivityprinciple states that the value of valuation is more than simply relating expected cash flows the firm is equal to the sum of the values of its projects. to the relevant cost of capital. When the idealized assumptions of pure and perfect markets Much broader issues of organization strategic planning and are relaxed, capital structure and dividend policies can change policies are required for valuation analysisthe cost of capital and, therefore, the value of the firm. 37373838Agency, Auctions, Games, International FinanceInformations, RecontractingWhen activities in another region affect the index numbers When two or more firms are involved in decisions and/or actions,used to convert nominal expected cash flows into real divergent incentives and interests may develop. Managers may terms, the new perspective required is termed international take actions that are in their own interests but not those of other finance. Because investors may not use the same price stakeholders. index in deflating their expected monetary returns, the Asymmetric information may also influence actions by standard aggregation, separation, and asset pricing results stakeholders. Contracting (for example, bond covenants) and monitoring costs are transactions costs arising from agency of portfolio theory may be and asymmetric information. Unanticipated changes in the relative values of Contracting in a dynamic world inherently gives rise to pressures currencies create foreign exchange risk for international for recontractingas conditions and circumstances change. transactions. Such exchange rate movements represent When realizations diverge from the expectations upon which departures in some sense from the international parity contracts were based, individual parties may seek contract conditions of the international Fisher effect, interest rate revisions (., recontractingand reorganization following parity, and purchasing power distress).39394040The Timing of Cash Inflows and OutflowsTakeovers, Governance and Control(Short-Term Financial Management)Takeovers are one of the mechanisms for monitoring corporate The movements of inflows and outflows represent governance and control. another dimension of the analysis of cash flow behavior. Changes in the economic (globalization of competition) and Models in this area (historically called working capital political (deregulation) environment require adjustments by management) are important because short-term firms to align to their environments more effectively. Changes in financial management influences the liquidity, solvency, technology and in management methods also require adjustment. and value of organizations. Control changes may take place to accomplish the required changes. Short-term financial management decisions and Takeovers may result from opportunities for reorganizing the activities must be integrated with longer-term operations or activities of firms or changing their product-market investment and financing decisions. Advances in boundaries. models in this area contribute to firm value Divergent control incentives may also give rise to . . 414142427
Prior to 1900Time Line of the IntroductionDiminishing Marginal Utility and Risk Aversion: Bernoulli 1738of New Concepts and Ideas (Bernoulli, Daniel (1738): "Specimen Theoriaein FinanceNovae de Mensura Sortis," Commentarii Academiae Scientiarium Imperialis Petropolitanae, TomusV. translated and reprinted in Econometrica, vol. 22, no. 1 (January 1954). pp. 23-36.)43434444Bernoulli [1738]Prior to 1900Bernoulli [1738] wrote on diminishing Distribution of Stock Prices and marginal utility and risk aversion. Option valuation: Bachelier1900He proposed a problem commonly referred (Bachelier, Louis (1900): Theoriede la to as the St. Petersburg Paradox at a Speculation, Gauthier-Villars: Paris, reprinted in meeting of mathematicians. Cootner, Paul, ed. (1967): The Random Character This problem was concerned with why of Stock Market Prices, Massachusetts Institute of gamblers would pay only a finite sum for a Technology, Cambridge, Massachusetts, pp. 17-gamble with an infinite expected value. 78.)45454646Bachelier[1900]Bachelier[1900]His Brownian Motion derivation pre-dated the Bachelier[1900] wrote his doctoral dissertation at the much better known derivations of Brownian Sorbonne on the distribution of stock prices and option valuation. Motion by Albert Einstein. He provided a derivation for a probability density Unfortunately, his research was ignored until the function which was later to be known as a Weiner early 1950s when Leonard Savage and Paul Process (Brownian Motion Process with drift). Samuelson discussed the distribution of security The option valuation model based on this process was prices and when Sprenkle[1961] wrote his quite similar to the better known and more recently doctoral dissertation and other papers on option developed Black-Scholespricing model.
1930‘sFisher [1896], [1907] and [1930]Fisher [1896], [1907] and [1930] wrote Interest Rates and Investment Interest Rates and Investment important treatises on the theory of interest rates Decisions: Fisher 1930Decisions: Fisher 1930(Irving Fisher, The Theory of Interest: As and internal rate of return. (Irving Fisher, The Theory of Interest: As determined by the impatience to spend income determined by the impatience to spend income His 1896 paper set forth the Expectations and opportunity to invest it. , New York, NY, and opportunity to invest it. , New York, NY, The Macmillan Company, 1930.)Hypothesis of the term structure of interest rates. The Macmillan Company, 1930.)The well-known Fisher Separation Theorem Valuation Theory: Williams 1938demonstrates that the individual investment Valuation Theory: Williams 1938(J. B. Williams, The Theory of Investment Value, (J. B. Williams, The Theory of Investment decision can be made independently of Harvard University Press,1938.)Value, Harvard University Press,1938.)consumption preferences over time. 49495050Williams(1938)1940‘sJohn Burr Williams(1938) was among the first to challenge the "casino" view economists held of Financial Markets and Business financial markets and questions of asset :He argued that asset prices of financial assets reflected the "intrinsic value" of an asset, which can be Jacoby & Saulnier 1947measured by the discounted stream of future expected (Neil H. Jacoby and Raymond J. Saulnier, dividends from the Finance and Banking, New York, NY, National Bureau of Economic Research, This "fundamentalist" notion fit well with Irving 1947.)Fisher's (1907, 1930) theory, and the "value-investing" approach of practitioners such as Benjamin ‘s1950‘SCapital Budgeting: Dean 1951; Lorie and Savage 1955; Hershleifer1958; Baumoland QuandtWorking Capital Management: 1965(J. Dean, Managerial Economics, Englewood Cliffs, NJ, Prentice-Hall, Inc., Baumol1952;Miller & Orr 1966;1951)Stone 1972; Smith 1973; (Lorie, James and Leonard Savage (1955): "Three Problems in Rationing Capital," Journal of Business, vol. 28, pp. 229-239.)Kim & Atkins 1978; (Hershleifer, Jack (1958): "On the Theory of Optimal Investment Decision," Sartoris& Hill 1983; Journal of Political Economy, vol. 66, pp. 329-352.)(Baumol, William and 1988; (1965): "Investment and Discount Rates under Capital Rationing," Economic Journal, June 1965, pp. 317-329.)Kim & Srinivasan1988, 1991; Hill & Sartoris1988, 1993535354549
(William J. Baumol, "The Transactions Demand for Cash: An Inventory Theoretic Approach," Quarterl1950‘sy Journal of Economics 66 (November 1952), pp. 545-556.)(Merton H. Miller and Daniel Orr, "A Model of the Demand for Money by Firms," Quarterly Journal of Economics 80 (August 1966), pp. 413-435.)Merger Analysis: Weston 1953(B. K. Stone, "The Use of Forecasts and Smoothing in Control Limit Models for (J. Fred Weston, The Role of Mergers in the Cash Management," Financial Management (Spring 1972), pp. 72-84.)Growth of Large Firms, Berkeley, University (K. V. Smith, "State of the Art of Working Capital Management," Financial Management (Autumn 1973), pp. 50-55.)of California Press,1953.)(. Kim and J. C. Atkins, "Evaluating Investments in Accounts Receivable: A Wealth Maximization Framework," Journal of Finance (May 1978), pp. 403-412. )Dividend Growth Model: Gordon (W. L. Sartorisand N. C. Hill, "Evaluating Credit Policy Alternatives: A Present & Shapiro 1956 Value Framework," Journal of Financial Research (Spring 1981), pp. 81-89.)(Myron J. Gordon, and E. Shapiro, Capital (James A. Gentry, "State of the Art of Short-Run Financial Management," Financial Management 17 (Summer 1988), pp. 41-57.)Equipment Analysis: The Required Rate of (Yong H. Kim and Venkat Srinivasan, eds., Advances in Working Capital Profit, Management Science 3 (October 1956), Management, Greenwich, CT, JAI Press, Vol. 1, 1988. )-110.)(Ned C. Hill and William L. Sartoris, Short-Term Financial Management, New York, NY, Macmillan, 1988, 1993.)555556561950‘s1950‘sAuctions, Games, Information:Luce & Raiffa1957; Capital Structure:Vickrey1961Durand 1952;(R. Duncan Luce and Howard Raiffa, Games and Decisions, New York, NY, Dover Publications, Modigliani& Miller 1958;Inc., 1957.)Miller 1977;(William Vickrey, "Counterspeculation, Auctions, Myers 1977, 1984;and Competitive Sealed Tenders," Journal of Finance 16 (March 1961), pp. 8-37.)Myers & Majluf1984;Titman198457575858(David Durand, Conference on Research and Business Finance, New York, NY, 1950‘sNational Bureau of Economic Research, 1952.)(F. Modiglianiand M. Miller, "The Cost of Capital, Corporation Finance and the Theory of Investment," American Economic Review (June 1958),pp. 261-297. )Portfolio Theory: (Merton H. Miller, "Debt and Taxes," Journal of Finance 32 (May1977), pp. 261-275.)Markowize1952, 1959(Stewart C. Myers, "Determinants of Corporate Borrowing," Journal of (. Markowitz, "Portfolio Selection," Journal of Financial Economics 5 (November 1977), pp. 147-175.)Finance 7 (March 1952), pp. 77-91. )(Stewart C. Myers, "The Capital Structure Puzzle," Journal of Finance 39 (July 1984), pp. 575-592. )(. Markowit, Portfolio Selection: Efficient (Stewart C. Myers and Nicholas S. Majluf, "Corporate Financing and Diversification of Investments New York, NY, Investment Decisions When Firms Have Information That Investors Do Not John Wiley & Sons, Inc., 1959.)Have," Journal of Financial Economics 13 (1984), pp. 187-221.)(S. Titman, "The Effect of Capital Structure on a Firm's Liquidation Decision," Journal of Financial Economics (March 1984), pp. 137-151.)5959606010
1960‘s1960‘sCAPM: Sharpe 1964; Lintner1965; Dividend Policy:Mayers1972; Merton 1973Miller & Modigliani 1961;(William F. Sharpe, "Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk," Journal of Finance 19 (1964), pp. 425-442.)Gordon 1962(John Lintner, "The Valuation of Risk Assets and the Selection of Risky (Merton H. Miller and F. Modigliani, "Dividend Policy, Investments in Stock Portfolios and Capital Budgets," Review of Growth, and the Valuation of Shares," Journal of Economics and Statistics 47 (1965), pp. 13-37.)Business (October 1961), pp. 411-433.)(D. Mayers, "Non-Marketable Assets and the Capital Market Equilibrium under Uncertainty," in Jensen, ed., Studies in the Theory of Capital Markets, (Myron J. Gordon, The Investment. Financing and New York, NY, Praeger, 1972, pp. 223-248.)Valuation of the Corporation, Homewood, IL, Richard D. (Robert C. Merton, "An IntertemporalCapital Asset Pricing Model," Irwin, 1962. )Econometrica(September 1973), pp. 867-888.)616162621960‘s1960‘sFinancial Distress:Event Analysis: Altman 1968; Warner 1977Fama, Fisher, Jensen & Roll 1969; (Edward I. Altman, "Financial Ratios, DiscriminantAnalysis and the Prediction of Corporate Brown & Warner 1980Bankruptcy," Journal of Finance 23 (September (Eugene F. Fama, Lawrence Fisher, Michael C. Jensen, and 1968), pp. 589-609.)Richard Roll, "The Adjustment of Stock Prices to New (J. B. Warner, "Bankruptcy Costs: Some Evidence," Information," International Economic Review 10 (1969), Journal of Finance 32 (May 1977), pp. 337-347.)pp. 1-21.)(S. Brown and J. Warner, "Measuring Security Price Performance," Journal of Financial Economics 8 (1980), pp. 205-258.)636364641970‘s1970‘sAgency Theory:Akerlof1970; Efficient Capital Markets:Jenson & Meckling 1976Fama1970, 1991(Akerlof, . (1970): "The Market for `Lemons': (Eugene F. Fama, "Efficient Capital Markets: A Quality Uncertainty and the Market Mechanism," Review of Theory and Empirical Work," Quarterly Journal of Economics, pp. 488-500.)Journal of Finance 25 (1970), pp. 383-417. )(. Jensen and W. Meckling, "Theory of the Firm: (Eugene F. Fama, "Efficient Capital Markets: II," Managerial Behavior, Agency Costs and Journal of Finance 46 (December 1991), pp. Ownership Structure," Journal of Financial 1575-1617.)Economics (October 1976), pp. 305-360.)6565666611
1970‘s1970‘sConglomerate Performance:Critical of CAPM:Weston & Mansinghka 1971;Merton 1972;Weston, Smith & Shrieves 1972Roll 1977(J. Fred Weston and SurendraK. Mansinghka, "Tests of the (Robert C. Merton, "An Analytic Derivation of the Efficient Efficiency of Conglomerate Firms," Journal of Finance 26 Portfolio Frontier," Journal of Financial and Quantitative (September 1971), pp. 919-936.)Analysis (September 1972), pp. 1851-1872.)(J. Fred Weston, Keith V. Smith, and Ronald E. Shrieves, (Richard Roll, "A Critique of the Asset Pricing Theory's "Conglomerate Performance Using the Capital Asset Tests' Part I: On Past and Potential Testability of the Pricing Model," Review of Economics and Statistics 54 Theory," Journal of Financial Economics 4 (1977), pp. (November 1972), pp. 357-363.)129-176.)676768681970‘s1970‘sOption Pricing: Black & Scholes 1973; International Finance:Merton 1973; Rubinstein 1976Solnik 1974;(Fischer Black, and Myron Scholes, "The Pricing of Adler & Dumas 1982;Options and Corporate Liabilities," Journal of Political Economy 81 (May-June 1973), pp. 637-659.)Levi 1983;(Robert C. Merton, "Theory of Rational Option Pricing," Bell Journal of Economics and Management Science 4 Solnik 1991(Spring 1973a), pp. 141-183.)(Mark Rubinstein, "The Valuation of Uncertain Income Streams and the Pricing of Options," Bell Journal of Economics 7 (Autumn 1976), pp. 407-425. )696970701970‘s(B. H. Solnik, "An Equilibrium Model of the International Capital Market," Journal of Economic Theory 8 (August 1974), pp. 500-524.)Contingent Claims Analysis:(Michael Adler and Bernard Dumas, "International Portfolio ChoiceBrennan & Schwartz 1978 and Corporation Finance: A Synthesis," Journal of Finance 38 (June 1983), pp. 925-984.)(Michael J. Brennan and Eduardo S. Schwartz, (Maurice Levi, International Finance: Financial Management "Finite Difference Methods and Jump Processes and the International Economy, New York, NY, McGraw-Arising in the Pricing of Contingent Claims: A Hill Book Company, 1983.)Synthesis," Journal of Financial and Quantitative Analysis 13 (September 1978), pp. 461-474.)(B. H. Solnik, International Investments, 2nd ed., Reading, MA, Addison-Wesley Publishing Company, 1991.)7171727212
1970‘s1970‘sBOP: Sharpe 1978; Cox, Ross & Rubinstein 1979; APT: Rendleman & Bartter 1979Ross 1976; (William F. Sharpe, Investments, Englewood Cliffs, NJ, Prentice-Hall, Inc., 1sted., 1978. )Roll & Ross 1980; (John C. Cox, Stephen A. Ross, and Mark Rubinstein, Bower, Bower & Logue 1984; "Option Pricing: A Simplified Approach," Journal of Financial Economics 7 (September 1979), pp. 229-263.)Chen, Roll & Ross 1986(Richard J. Rendleman, Jr. and Brit J. Bartter, "Two-State Option Pricing," Journal of Finance 34 (December 1979), pp. 1093-1110. )737374741970‘s(Stephen A. Ross, "The Arbitrage Theory of Capital Asset Pricing," Journal of Economic Theory 13 (1976), pp. 341-Financial Contracting: 360.)Smith & Warner 1979;(Richard Roll and Stephen A. Ross, "An Empirical Investigation of the Arbitrage Pricing Theory," Journal of Emery & Finnerty 1992Finance 35 (1980), pp. 1073-1103. )(Clifford W. Smith, Jr. and J. B. Warner, "On Financial (Dorothy H. Bower, Richard S. Bower, and Dennis E. Logue, Contracting: An Analysis of Bond Covenants," Journal of "Arbitrage Pricing Theory and Utility Stock Returns," Financial Economics 7 (1979), pp. 117-161.)Journal of Finance 39 (September 1984), pp. 1041-1054.)(Douglas R. Emery and John D. Finnerty, "A Review of (Nai-fu Chen, Richard Roll, and Stephen A. Ross, "Economic Recent Research Concerning Corporate Debt Provisions," Forces and the Stock Market," Journal of Business 56 in New York University Salomon Center, Financial (1986), pp. 383-403.)Markets, Institutions & 1 (1992), pp. 23-39.)757576761970‘s1970‘sIPOIbbotson1975;Ritter1984 1991; Beatty & Ritter 1986;Ritter & Welch 2002(Roger G. Ibbotson. 1975. Price Performance Of Common Stock Prospect theory:New Issues. Journal of Financial Economics2:3, 235-272. )Kahneman & Tversky(Jay R. Ritter. April 1984. The Hot Issue Market of 1980. 1979Journal of Business57:2, 215-240.)(Kahneman, D. & Tversky, A. (1979): (Beatty R. and J. Ritter (1986): "Investment Banking, Reputation, Prospect Theory: An analysis of decision and the Underpricingof Initial Public Offerings," Journal of Financial Economics, 15, 213-232.)under risk. Econometrica, 263-291.)(Ritter, Jay R.; 1991, The Long Run Performance Of Initial Public Offerings, Journal of Finance 46-1,3-28.)(Jay R. Ritter, IvoWelch. August 2002. A Review of IPO Activity, Pricing, and Allocations. The Journal of Fanance57:4, 1795-1828. )7777787813
(Grossman, Sanford and Joseph Stiglitz(1976): "Information and 1970‘sCompetitive Price Systems," American Economic Review, vol. 66, pp. 246-253.)(Leland, H. and D. Pyle (1977): "Information Asymmetries, Financial Structure, and Financial Intermediation," Journal of Finance, pp. Information:371-387.)(Spence, Michael (1974): Market Signalling. Cambridge, Mass.: Grossman & Stiglitz[1976];Harvard University Press. )Leland & Pyle [1977];(Ross, Stephen A. (1977): "The Determination of Financial Structure: The Incentive-SignallingApproach," Bell Journal of Economics and Spence [1974]Management Science, pp. 23-60.)(Dann, Larry (1981): "Common Stock Repurchases: An Analysis of Ross [1977]Returns to Bondholders and Stockholders," Journal of FinancialDann[1981]Economics, vol. 9, pp. 113-138.)(Vermaelen, Theo (1981): "Common Stock Repurchases and Market Vermaelen[1981]Signalling," Journal of Financial Economics, vol. 9, pp. 139-183.)797980801980‘s1980‘sCorporate Control and Restructure:Jensen & Ruback 1983; Weston & Chung Financial Strategy:1983; Chung & Weston 1982Myers 1984(. Jensen and R. S. Ruback, "The Market for Corporate Control: The Scientific Evidence," Journal of Financial (Stewart C. Myers, "Finance Theory and Economics 11 (April 1983), pp. 5-50.)Financial Strategy," Interfaces 14 (J. Fred Weston and K. S. Chung, "Some Aspects of Merger Theor(January-February 1984), pp. 126-137.)y," Midwest Finance Journal 12 (1983), pp. 1-38.)(. Chung and J. Fred Weston, "Diversification and Mergersin a Strategic Long-Range-Planning Framework," Chapter 13 in Mergers and Acquisitions, M. Keenan and L. J. White, eds., Lexington, MA, D. C. Heath, 1982, pp. 315-347.)818182821980‘s1980‘sHubris Hypothesis:Synthetic Securities:Roll 1986Cox & Rubinstein 1985(RollđR.đ“The Hubris Hypothesis of (John C. Cox and Mark Rubinstein, Corporate Takeovers”đJournal of Options Markets, Englewood Cliffs, NJ, Businessđ1986đ59č2Ďğ197-216. )Prentice-Hall, Inc., 1985.)8383848414
1980‘s1980‘sFinancial Engineering:Finnerty1988;Portfolio Insurance:Smith & Smithson 1990Rubinstein & Leland 1981(John D. Finnerty, "Financial Engineering in (Mark Rubinsteinand HayneE. Leland, Corporate Finance: An Overview," Financial "Replicating Options with Positions in Management (Winter 1988), pp. 14-33.)Stock and Cash," Financial Analysts (Clifford W. Smith, Jr. and Charles W. Smithson, Journal 37 (July-August 1981), pp. 63-72.)The Handbook of Financial Engineering: New Financial Product Innovations, Applications, and Analyses, New York, NY, Harper Business, 1990.)858586861980‘s1990‘sReal Options:Mason & Merton 1985;Bailey 1991; Quigg1993; Graham & Harvey 2001; Risk Management:Copeland,Weston & Shastri2004(Mason, Scott and Robert Merton (1985): "The Role of Contingent Claims Smith, Smithson & Wilford 1990Analysis in Corporate Finance," Recent Advances in Corporate Finance, (Clifford W. Smith, Jr. and Charles W. Smithson, edited by Edward Altman and Marti Subrahmanyam, Homewood Illinois: Irwin, pp. 7-54.)The Handbook of Financial Egineering: New (Bailey, W. (1991): “Valuing Agriculture Firms,”Journal of Economic Financial Product Innovations,Appilication, and Dynamics and Control, 15, pp. 771-791.)Analysis, New York, NY, Harper Business,1990.)(Quigg, L. (1993): Empirical Testing of Real Option Pricing Models,”Journal of Finance(Clifford W. Smith, Jr. and D. Sykes Wilford, , 48, 2, pp. 621-640.)(Graham, John R. and Campbell R. Harvey (2001): “The Theory and Practice of Managing Financial Risk, NY, Harper & Row, Corporate Finance: Evidence from the Field,”Journal of Financial Economics, Publishers,1990.)60, pp. 187-243.)(Copeland, Thomas, J. Fred Weston and Kuldeep Shastri(2004): Financial Theory and Corporate Policy, 4th ed., Addison-Wesley, New York.)878788881990‘s1990‘sControlling Shareholders:Three-Factor Model:Shleifer& . Vishny1997Fama& French 1992a1993(A Survey of Corporate Governance, Andrei (Eugene F. Famaand Kenneth R. French, Cross-Shleifer&. Vishny, Journal of Finance, June, Section of Expected Stock Returns, Journal of 1997. ) Finance47 (June 1992), 427-465.)La Porta, De-Silanes & Shleifer 1999(Eugene F. Famaand Kenneth R. French, ( Porta, F. Lopez-De-SilanesandCommon Risk Factors in the Returns on Stocks Andrei Shleifer, Corporate Ownership Around the and Bonds, Journal of Financial Economics33 World, The Journal. of Finance, Vol. LIV , (February 1993), 3-56.)April 1999.)8989909015
2000‘s2000‘sTunneling:Market Timing:Johnson, LaPorta, Lopez-de-Baker and Wurgler 2002Silanes,Shleifer2000 (BakerđM.đandWurglerđJ.đ“Market Timing and Capital Structure”đ(“Tunelling”, American Economic Journal of Financeđ2002đ57č1ĎğReviewVol. 90, pp. 22-27. ) 1-32. ) 91919292Savings and Investment in Perfect Capital MarketsEconomist Irving Fisher (1930) showed how capital markets increase the utility both of Building Blocks of Modern economic agents with surplus wealth (savers) Finance Theoryand of agents with investment opportunities that exceed their own wealth (borrowers) by providing each party with a low-cost means of achieving their and Investment in Perfect Savings and Investment in Perfect Capital MarketsCapital MarketsSavers can earn a higher return by lending on the Fisher developed an important theorem: capital market than they could by seeking out The Fisher Separation borrowers, and borrowers can obtain His theorem demonstrated that capital more, lower-cost, financing than they could if markets yield a single interest rate that both forced to search for funding on their and lenders can use in making Total saving and total investment in an economy is consumption and investment decisions, and therefore greater than it would be without capital in turn allows a separation between investment and financing
Savings and Investment in Perfect Portfolio TheoryCapital MarketsThe next major advance in finance occurred Without this separation of investment and when Harry Markowitz (1952) published the financing decisions, firms would have to tailor famous article laying our the basic principles of their investment decisions to the preferences of portfolio investors, and the large modern The essence of rational portfolio allocation is corporation with its own legal identity and infinite captured in the phrase “don’t put all your eggs in time horizon could never have come into basket.”97979898Portfolio TheoryPortfolio TheoryMarkowitz shows that as you add assets to an The Markowitz portfolio selection rule is pick investment portfolio the total risk of that portfolio stocks with the highest return to risk ratios, and –as measured by the variance of total return –combine these stocks into efficient portfolios –declines continuously, but the expected return of where risk is minimized for any given level of the portfolio is the weighted average of the expected return or, conversely, where return is expected returns of the individual assets. maximized for any given level of risk.In other words, by investing in portfolios rather than in individual assets, investors could lower the total risk of investing without sacrificing TheoryPortfolio TheoryStandard Deviations of Annual Portfolio Returns (NYSE):# of Stocks in Average . of AnnualPortfolio Portfolio Returns %% % % % % 1,% 10110110210217
Capital Structure TheoryCapital Structure TheoryThe Modiglianiand Miller model (1958) states M&M’s Proposition I states that the market value that the economic value of the bundle of assets of any firm is independent of its capital structure owned by a firm is derived solely from the and is given by capitalizing its expected return at stream of operating cash flows those assets the rate appropriate to its risk ; it is the stream of operating cash flows M&M’s Proposition II states that if the expected (profits) expected to be generated by those assets return on the firm’s assets is constant, then the that creates value. required return on levered equity must increase directly and linearly as risk-free debt is added to the firm’s capital Structure TheoryCapital Structure TheoryLCost of R= R+ (R–R) x (D/E)EAADTaken together, these two propositions establish capitalthat capital structure is irrelevant in a perfect capital market and the required return on a given firm’s equity is computed directly from its debt-to-UWACC = R= Requity ratio and the required return for firms of its AErisk After much debate in this area of study, we can offer no simple, unambiguous answer to the question, “Does capital structure matter?”Debt-equity ratio,D/E105105106106Dividend PolicyDividend PolicyMillar and Modiglianishow that holding a firm’s Examples of “real”market frictions include:investment policy fixed, the payment of cash must pay substantial fees to investment bankers to float a new share cannot affect firm value in a frictionless pay higher marginal taxes on dividends than arket because whatever the firm pays out in on capital gains; investors cannot control the timing dividends it must make up by selling new tax liabilities with dividends unlike capital gains.However, the real world does not have frictionless stock market response to the announcement of capital markets –it turns out that most “real”new equity issues is almost always frictions work against the payment of
Dividend PolicyDividend PolicyGiven these “real”frictions, why than do Dividend policy is also a byproduct of a firm’s life American corporations pay out roughly half of cycle –mature companies with few growth their earnings as cash dividends?opportunities are more likely to pay dividends than growing companies.One possible answer is that the simple M&M dividend model did not allow either for agency In conclusion, the state of dividend policy theory problems between corporate managers and is in flux –important basic questions remain shareholders or asymmetric information between same two Pricing ModelsAsset Pricing ModelsIt can be said that finance became a full-fledged Sharpe’s main contribution was to uniquely define discipline in 1964 when Sharpe published his systematic risk and to specify exactly how paper deriving the Capital Asset Pricing Model investors can trade risk and return –he did this by (CAPM).assuming investors can either invest in risky assets, For the first time, financial economists could such as common stocks, or in a risk-free asset, describe and quantify what “risk”was in a capital such as government treasury bills. market and specify how it was priced.Sharpe then pointed out, there is one unique risky CAPM assumes that investors hold well –diversified portfolios within which the asset portfolio that dominates all others, and he unsystematic risk on individual assets is not labeled this the market portfolio. Pricing ModelsAsset Pricing ModelsThis leads to the fundamental result –all investors To be included in the market portfolio, every will allocate their wealth into some combination of the individual stock will sell at a price that yields risk-free asset and the market portfolio, and the slope of the line measuring this risk-return trade-off is called investors the appropriate expected return, implied the capital market its level of systematic risk and the current Sharpe’s final contribution was to point out that, in return on a risk-free , every asset must offer an expected return Mathematically, the CAPM can be expressed as:that is linearly related to the covariance of its return with expected return on the market portfolio. He defined the covariance (standardized by dividing E(Ri) = Rf+ Ȧi(Rm–Rf) where: through the market variance) as beta. (Rm–Rf) is called the market risk
Asset Pricing ModelsEfficient Capital Market TheorySharpe’s work touched off a torrent of academic Fama (1970) publishes one of the most research aimed at testing whether the CAPM important papers in economic history. accurately described objective market reality.He presents both a statistical and conceptual Though “anomalies”exist with CAPM and other definition of an efficient capital market –multi-factor models exist, CAPM has remained where efficiency is defined in terms of the the dominant asset pricing model in finance –speed and completeness with which capital “you can’t beat someone with no one.”markets incorporate relevant information into security Capital Market TheoryEfficient Capital Market TheoryFama’s Efficiency Market Hypothesis has Fama provides three definitions of efficiency:revolutionized our view of how financial markets form –security prices incorporate all relevant information.How? Because competition among traders -strong form –security prices reflect all relevant, ensures that security prices accurately reflect all publicly-available information, market prices can be form –security prices reflect all relevant “trusted.”information, private and public.Investors can rely on efficient markets to ensure that they willnot Strong form efficiency does not generally hold in the real-be taken advantage of by better-informed financial markets.Corporations can assume that they will be able to issue new securities without having to fear that these will be “irrationally” Capital Market TheoryOption Pricing TheoryBlack and Scholes (1973) published an article However, don’t misunderstand the efficient-describing the model for pricing stock options that market idea. It doesn’t say that there are no still bears their or costs; it doesn’t say that there aren’t The Black-Scholes Option Pricing Model (OPM) some cleaver people and some stupid ones. was a genuine breakthrough because it provided a closed-form solution for pricing put and call It merely implies that competition in capital options that relies solely on five observable (or markets is very tough –there are no money calculable) variables:machines, and security prices reflect true The exercise price of the option, the current price of the firm’s stock, the time to maturity of the option, the variance of the stock’s underlying values of assets. return, and the risk-free rate of
Option Pricing TheoryOption Pricing TheoryHowever, in spite of these limitations and biases, The basic BS OPM was developed for the OPM (and its later derivations) has proven European options and assumes that stocks itself to be amazingly robust and accurate model do not pay dividends. for pricing options of all types of financial assets.Shortly after the models introduction, 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 TheoryAgency TheoryPrior to 1976, finance theorists used the standard The agency cost model of the firm, put forth by economic model of the firm to describe corporate Jensen and Meckling (1976), incorporates human behavior –the model viewed the firm as a “black nature into a cohesive model of corporate behavior box”that processed inputs into usable outputs and –the “firm”is a legal fiction that serves merely as that responded rationally to economic incentives a nexus of contracts for agreements between managers would always act in the best interests of managers, shareholders, suppliers, customers, and their parties. All the parties are consenting adults who act in their own self-interest, and fully expect all other parties to act in TheoryAgency TheoryIn other words, it is a model that relies on rational This agency problem has lead to further research behavior by self-interested economic agents who into compensation policy where compensation can understand the incentives of all the other help align the goals and objectives of managers contracting parties, and who take steps to protect and shareholder. themselves from predictable exploitation by other The classic problem in this area is that managers – have all their “eggs in one basket”–typically Given this theory, we may now view the will prefer a far less risky investment strategy than relationship between managers and owners as an will investors, who can diversify their wealth agency problem which results in agency costs –managementamong many financial assets. “perks”, monitoring costs, and lost economic
Agency TheorySignaling TheoryA management compensation scheme that ties the Signaling theory was developed to explicitly payoffs to managers to the payoff received by account for the fact that corporate insiders shareholders can partially overcome this problem, generally are much better informed about the and stock-option based executive compensation current workings and future prospects of a firm packages have indeed become almost universal in than are outside investors. In the presence of this large American of information, it is very difficult for investors to objectively discriminate between high-quality and low-equality TheorySignaling TheoryBecause of this asymmetric information problem, One method would be for high-quality firm investors will assign a low average quality managers to employ a signal that would be costly, valuation to the shares of affordable, for their firms but which would be Obviously, high-quality firm managers have an prohibitively expensive for low-quality firms to incentive to somehow convince investors that their mimic –for example, the payment of should be assigned a higher valuation based Other “positive”signals used by corporate insiders on what the managers know to be superior may include:prospects for the company.Retaining a large-ownership stake in high-intrinsic value projects, andAs such, how do managers convey this By employing more debt financing in its capital information to investors in a way that cannot be by the managers of lower quality firms?129129130130The Modern Theory of Corporate ControlThe Modern Theory of Corporate ControlThe first major exposition of a truly modern Motivated by the merger and acquisition activity theory of corporate control was presented by of the 1980s, academic researchers were provided Bradley (1980), who documents:with a wealth of data and practical examples to increase in value by approximately 30% base their corporate control research after a tender offer is announced, then stays at about that same level until either the acquisition is either completed or canceled, that those shares which are not purchased in a successful takeover drop in price back towards their initial value immediately after the takeover is
The Modern Theory of Corporate ControlThe Modern Theory of Corporate ControlBradley’s theoretical model assumes that bidding In Bradley’s model rival management teams firm managers will launch a tender offer primarily compete for the right to control corporate in order to gain control over the assets and assets. Inefficient management teams are operations of a target firm that is currently being replaced by more capable ones, and the run in a sub-optimal manner. Once the bidder control of corporate resources naturally gains control of the target, a new higher valued flows towards those people able to put the operating strategy will be implemented and the resources to their highest and best use –bidding firm will earn a profit from operating the shareholders are the impartial referees in target more effectively. this allocation process. 133133134134The Modern Theory of Corporate ControlThe Theory of Financial IntermediationTherefore, a vibrant takeover market is good for Within the past decade it has become clear that the economy because it weeds out inefficiencies capital market financing is often a much more and concentrates corporate control in the most costly and economically wasteful method of capable routine corporate activities than is financing via banks and other financial This competition means that rival management have to offer target firm shareholders most of the profit that is expected to accrue from Commercial banks seem to have a clear improved post-acquisition performance in the competitive advantage over capital markets for all form of a high tender offer premium. but the very largest types of corporate fundings. 135135136136The Theory of Financial IntermediationThe Theory of Financial IntermediationLargely because of their competitive advantages, Researchers have documented positive returns to commercial banks tend to dominate corporate finance in almost all developed and developing countries of corporate shareholders following the the world except the United that a firm has obtained a loan from The reason for this odd state of affairs is bad public a commercial bank and negative or insignificant policy:returns associated with other corporate financing The McFadden Act (1927) prevented interstate banking , as such, the . has produced no banks with a nation-wide reach.The Glass-Steagall Act (1934) legally separated commercial and investment banks which placed . commercial banks in a global competitive
The Theory of Financial IntermediationSince a bank presumably has direct access to a The Five Most Important company’s accounts and intimate contact with a company’s executives, stock market participants Finance Concepts clearly interpret the announcement that a bank will grant a firm credit as an important vote of confidence in that firm’s prospects by an informed (Benton E. Gup, The Five Most Important Finance : A Summary, Financial Practice and Education, 1994,, pp. 106-109)139139140140The Five Most Important Present ValueFinance Concepts Three panelists chose present value. Brigham stated that financial asset values are determined by the present values of their expected cash flow streams, and therefore the single most Present Valueimportant concept is the time value of money, including the Cost of Capital/CAPMbasic DCF valuation model.Myers pointed out that DCF is a tool, not a tool box. Managers Cash Flow and Financial Statementstend to treat DCF project analysis as a computational exercise, Risk –Returnlike closing the books every quarter, not as a valuation exercise. Sometimes they use DCF when market values can be observed Capital Marketsin closely comparable transactions. Often they report back positive net present values when there is no business or economic reason to expect a superior of Capital/CAPMCost of Capital/CAPMGordon, Myers, and Weaver listed the cost of capital as one of the most important concepts. However, each of the three focused Myers was concerned about the opportunity cost of on different aspects of the concept. Gordon examined the capital. He explained that the cost of capital is theoretical underpinnings of the cost of capital. He found that determined by the use of funds, not by the source of the neoclassical model of the cost of equity capital is not valid in funds. In other words, a project hurdle rate depends the presence of the numerous market imperfections that exist. not on the source of cash for the investment but on Moreover, the neoclassical model imposes on the corporation the expected rate of return in other, equivalent-risk the objective of maximizing share price today regardless of the uses. Other uses include uses in the company, in the probability of bankruptcy tomorrow. He went on to argue that financial markets, and in the world economy. the Gordon dividend growth model can be useful in determining Weaver discussed required rates of return, including the cost of equity capital and that corporations should maximizethe cost of capital and risk-adjusted hurdle probability of long-run survival, not current share
Cash Flow and Financial Cost of Capital/CAPMStatementsBrigham observed that students in introductory finance courses Both Brigham and Peters considered the CAPM an are presumed to have had a course in financial accounting. important concept, but they did not mention the cost However, they cannot be presumed to understand clearly the of capital as such. According to Brigham, the CAPM difference between accounting profits and cash flows. They also need to understand that financial statements are used to assess is a useful way to quantify the effect of risk on the risk of a firm as well as to predict future cash flows, by discount rates. He also stated that it is a problem to investors and by clear to students that the CAPM in the real "Cash is king," according to Myers. Students must understand world does not produce neat, precise answers, accounting from the financial viewpoint, which requires a tieback to cash and market values. The finance point of view without at the same time making them wonder why looks at cash, not earnings. A corollary is to look at market we teach not book Flow and Financial Risk -ReturnStatementsValues are fundamentally dependent on discount rates, and Weaver stated that finance is a middle ground between discount rates depend on relative risks. accounting and economics. Finance requires dealing with accounting information and applying it to business decisions. Therefore, Brigham asserted that the measurement of risk is a Thus, it is especially important to understand financial ratios,critically important concept to cover in the introductory flow, and pro forma accounting systems. On separate Risk is different from DCF in that we have precise formulas for occasions, a practicing corporate finance professional may be DCF, but financial risk is more subjective. Except in certain dealing with the real world as portrayed by ratio analysis and arbitrage situations, the basic data entered in risk analysis are industry studies or be dealing with theories related to the subjective. Even when we examine past data to develop optimum capital structure, to international finance, or to market "objective" probability distributions, subjectivity still entersefficiency. Many managers of small business concerns do not because we must infer the future from past data in a dynamic know their firms' net incomes, but they do know the balances their bank accounts. Larger firms, however, tend to lose sight of the importance of cash MarketsRisk -ReturnStudents should know something about financial markets and how rates are set in these markets, "We don't know how to measure risk," said Weaver, according to Brigham. A certain amount of descriptive "but it is very real." The concept of risk and return has material is involved, and it is best presented using much broader applications than simply to financial economic concepts of the market. These concepts decisions. It is embodied in our expectations: we may include supply and demand for funds and the resulting have the expectations that a lump of coal will turn into prices (interest rates) that arise in the financial markets. a diamond or that it may stay a piece of coal. Risk, The students should be made aware of increased return, and expectations are everywhere in everything globalization and how it is affecting both firms and individuals, although introductory students do not need that we do. Peters noted that higher risks must be to know the technical details of by higher returns. 14914915015025
Capital MarketsCapital MarketsMyers pointed out that buying financial services starts with zero net present values (NPV). For example, when a trader is pushing a fancy swap, the corporate financial manager must recognize that, absent inefficiencies, the swap has a zero NPV minus the Peters focused on the treasury function of a firm. It trader's profit; any benefit to the company must be specificallyis very important that students understand what the identified. Similarly, when an investment banker pushes a diversifying merger, the corporate manager should ask "Where's treasury does and such basic information as what a the value added? What makes the firms worth more together than common stock, a preferred stock, and a debenture apart?" To deal with such situations, we should teach the theoryare, for example. of efficient markets, Modigliani and Miller's dividend and leverage propositions, and the importance of nondiversifiablerisk (compared to the unimportance of diversifiable risk). These concepts should be taught, not because they are invariably the but because they are the right place to start when making actual Achievements of Finance1. No Arbitrage2. Efficient Markets (EM)The Top Achievements, 3. Net Present Value (NPV)Challenges, and Failures of 4. Derivatives Valuation TechniquesFinance5. Mean Variance Analysis6. Capital Structure and Dividend Irrelevance(Yale ICF Working Paper No. 00-67, Social Science Research Network Electronic Paper Collection:7. Capital Asset Pricing Model (CAPM) Novemb8. Understanding of Yield Curve and Fixed er 2001.)Income Instruments 153153154154The Achievements of Arbitrage9. Event StudiesThe idea that there is no risk-free way to get rich 10. Factor Pricing Models (APT, ICAPM, quick, and that this has implications for the prices of CCAPM)assets. This is similar to the "law of one price": if your neighbor sells gas for $2 a gallon, you will not 11. Corporate Structure Information be able to sell it for $3. The absence of arbitrage was Imperfectionsfirst prominently used by Modigliani-Miller (1958, 12. "Anomalies" 1961) in their famous capital structure propositions. Later, and with equal force, it lay the basis for Ross' 13. Long-Term Market Timing (1976) APT and for the pricing of derivatives.14. Certain Modeling Setups15. CRSP15515515615626
Present Value (NPV) Markets (EM)The idea that one can compute a today's equivalent for future payoffs based on The idea that the market uses all available expected cash flows in the numerator and a risk/time adjustment in the denominator. information in its setting of an asset's price This allows corporations and individuals to perform "capital budgeting," the (according to some tradeoff between risk and process of comparing dissimilar projects on a "profitability" metric to decide returns). where to deploy capital. Although practically everything can be valued using NPV, its purest application Bachelier(1900) and Cootner(1964, 1961, 1960) may be the valuation of bonds. A second noteworthy application of NPV may have pioneered EM, but it was probably Eugene principles is the Gordon (dividend) growth model, which is a special of NPV. A third noteworthy application is "EVA" (Economic Value Added) andits variants, Fama's (1970) article that sorted it all out and heavily promoted by corporate consultants. sparked the revolution in the asset-pricing The contributions to the development of NPV may go back a long time, but component of modern Finance. Irving Fisher (1908) and Jack Hirshleifer(1964) put the subject on sounder empirical footing than it was before, and explained the relationand differences As well, it sparked the invention of IRR(Internal Rate of Return) and Valuation Variance AnalysisA derivative is a financial instrument whose payoff will depend on yet another Mean variance analysis maps the attainable tradeoff financial instrument in a specified manner. Naturally, the valueof the base and between expected future returns and their standard derivative asset should be related, and this relations has become the perhaps deviation (risk), which has many surprising and most successful branch of knowledge (prediction) in the social sciences. Derivatives valuation started with techniques to value equity options. Black and parsimonious properties. Scholes(1973) and Merton (1973), and perhaps Harrison-Kreps(1979), are For example, a security’s covariance with other usually cited here. But I personally believe that the Sharpe (1978) and Cox, Ross, and Rubinstein(1979) binomial approach was as important, because it helped securities is typically more important than its own even MBA students understand the basic insights behind derivatives valuation variance risk. Invented by Tobin (1958) and Markowitzand opened up a large venue of simulation methods for all sorts of complex (1952), this is still the foundation of all investor choice instruments. The vast majority of research departments' proprietary trading on Wall Street analysis problems, and the basis for the CAPM (see #7 was made possible by the wide teaching and understanding of derivative below). methods, usually based on binomial trees. Finally, applications of derivatives techniques have migrated into Corporate This is the basis for the ubiquitous concept of Finance, where "real options" are giving us new insights into the value of such diversification and perhaps for the growth of the mutual concepts as flexibility and Structure and Asset Pricing Model Dividend Irrelevance(CAPM)The deservedly famous Nobel-prize winning insights by Built on mean variance analysis (see #5 above), the Modiglianiand Miller (1958, 1961; often abbreviated as CAPM was the first modern model of appropriate "MM") that capital structure and dividend policy do not security pricing in equilibrium (. how much expected matter if markets are perfect. return is a reasonable tradeoff for a given risk profile). It was an early pioneer in the use of Perfect Markets as a Credit Lintner(1965), Mossin(1966), Sharpe (1964), concept for analysis. The MM propositions are often and Black (1972) for the development, and Roll (1977) misinterpreted: capital structure and dividend policy is for helping us better understand its limitations. indeed relevant (., see capital market imperfections below); MM explained to us why and when. Still the most widely used model to obtain "discount There may be an interesting predecessor: John Burr rates" (see #3 above), even though it suffers from many Williams, "The Theory of Investment Value," 1938, empirical a page of text with similar
of Yield Curve Studiesand Fixed Income InstrumentsEvent studies assume a (reasonably) efficient capital market, and ask the question of how the market reacts to the release of new information. This reaction provides a good measure of the value Unlike many of the other ideas in this list, our impact of the (unanticipated) news. understanding of how bonds are priced has The event study was originally invented by Fama, Fisher, Jensen come gradually and from many different and Roll (1969) and improved by Ball and Brown (1968). The power and simplicity of event study techniques is enormous. (To contributors. illustrate its flexibility, note that it has even been used to measure such phenomena as the impact of political pressure on the South-Noteworthy are Fisher's (1908) work on interest African apartheid regime.) rates, the Macaulay(1938) duration measure, Event studies have suffered some academic disdain in recent and the Vasicek(1977) and Cox, Ingersoll, and years, primarily because it is too easy to run an event study without putting much thought into it. In my view, this is not a Ross (1985) equilibrium valuation of the technique, but a sign of its Pricing Models (APT, Structure ICAPM, CCAPM)Information ImperfectionsWe do not live in an Modiglianiand Miller world. We should Breeden (1979), Merton (1973), and Ross (1976) give Holmstrom(1979) and Meckling-Jensen (1976) credit for deserve credit for methods different from the analyzing the role of agency problems, and Ross (1977) and CAPM that allow pricing securities. Leland and Pyle (1977) credit for analyzing the role of information (signaling) problems. Unfortunately, they suffer from poor empirical Despite constant claims to the contrary in many an empirical results or poor factor identification. Still, this paper, practically by definition, neither of these issues lend gave us an insight into how rational pricing themselves to easy empirical , and papers by Roll and Ross (1980), That is, by definition, most of these effects are hidden (or they Chen, Roll and Ross (1986) and Hansen-would not be effects). Thus, and perhaps necessarily, this is anSingleton area in which the empirical relevance remains difficult to assess, (1982) gave us a first set of only quantitatively but also -Term Market Timing12."Anomalies"Can we predict what the overall stock market return Are there financial instruments that offer much will be over the next year or over the next decade? higher returns than appropriate for their risk Shiller(1981) and Campbell and Shiller's (1988) path profile (contribution)? Although Graham and breaking work was significantly extended and perhaps Dodd (1934) started "value-investing“as early as transformed by Famaand French (1988) in the early 1934(!), a rigorous search for such "alien life" with Banz(1981), Keim(1983), There is an ongoing debate about the validity and Reinganum(1981), Roll (1983), DeBondtand significance of the long-term timing findings, but forecasting the equity premium is such an important Thaler(1985), and others, in the early eighties. and ubiquitous issue in all sectors of Finance, that it just These anomaly studies all pointed to various had to be included. At the very least, these papers factors that seem to offer higher returns in opened up a whole new strand for
Modeling In some sense, everything from algebra to Bayestheorem qualifies as important tools used in finance. However, as a unique way of The first major ongoing stock pricing building models in finance, it is worthwhile to mention at leasttwo modeling setups that are very common in finance and rather database for research use, and still the gold uncommon elsewhere: First, there is the "exponential standard for historical pricing data. Prior to utility+normal-distribution“modeling technique, used in a whole class of mathematical models. This technique was first brought to CRSP, Cowles (at Yale) was the prime Finance by Diamond and Verrecchia(1981), solving a famous source for financial pointed out by Grossman (1977), and Kyle (1985) in different contexts. (PS: Hellwigwrote a similar paper in economics contemporaneously.) Kyle's application created an entirely new field, the analysis of market microstructure. The second is Merton's (1969)stochastic calculus technique, which was used to address many problems in derivatives (mentioned in #4 above).169169170170The Challenges of FinanceThe Challenges of FinanceMeaningful Behavioral FinanceInfluenceThe Equity PremiumEmployeesTransaction Costs(Global) Capital FlowsLiquidityCapital Markets and Economic Well BeingCrashesEvolutionary Competition(Anonymous Uncoordinated) FrenziesCloser Theory-Empirics Linkage (or Factor Identification and Stability"Empirical Optimality in Policy")TaxesEmpirical Herding/Cascades171171172172The Failures of FinanceSolutionMy own suggested solution for the last two The Empirical Applicability of the CCAPMissues is a journal that has the same 3 editors first Mathematical Sophistication with Lack of Testsdecide by majority vote whether they believe a Out of Sample Predictionparticular submission will have impact. Fixation on Statistical Rather than Economic If the answer is affirmative, the paper is sent onto Significancea referee, whose sole job is to make sure there Academic Rewards For IQ Instead of Relevanceare not obvious errors. Journal Publication TestsAfter 1 or 2 years, different editors replace the A Consistent Journal Refereeing Processeditors. Revolution Rewards Rather Than Evolution RewardsNot all journals should be run this way, but one journal in finance should be!17317317417429
The Seven Most Important Ideas in FinanceNet Present Value(NPV)The Capital Asset Pricing Model (CAPM)What We Do andEfficient Capital MarketsDo Not Know about FinanceValue Additivityand The Law of Conservation of Value (Richard A. Brealey& Stewart C. Myers, Capital Structure TheoryPrinciples of Corporate Finance (Sixth Edition) Option Theory , McGraw-Hill, 2000)Agency Theory175175176176The 10 Unsolved Problems in The 10 Unsolved Problems in FinanceFinanceHow Are Major Financial Decisions Made?How Can We Explain the Success of New -What Determines Project Risk and Net Securities and New Markets?Present Value? The Controversy About Dividend PolicyRisk and Return -What Have We Missed? -What Risks Should A Firm Take? How Important Are the Exceptions to -What Is the Value of Liquidity? Efficient Market Theory?-How Can We Explain Merger Waves?-Is Management an Off-Balance-Sheet Liability? 17717717817830
