Financial Theories Overview

Topics: Finance, Corporate finance, Free cash flow Pages: 7 (2523 words) Published: September 6, 2010
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...

References: Ball, R. (2001). The theory of stock market efficiency: Accomplishments and limitations. In D. H. Chew (Ed.), The New Corporate Finance: Where Theory Meets Practice (pp. 20-33). New York: McGraw-Hill Irwin.
Brounen, D., De Jong, A., & Koedijk, K. (2004). Corporate finance in Europe: Confronting theory and practice. Financial management (2000), 33(4), 71-101. Retrieved from
Chew, D. H. (Ed.). (2001). The new corporate finance: Where theory meets practice. New York: Irwin.
Fletcher, H., & Smith, D. (2004). Managing for value: Developing a performance measurement system integrating economic value added and the balanced scorecard in strategic planning. Journal of Business Strategies, 21(1), 1-17.  Retrieved from
Jensen, M. (2005). Agency costs of overvalued equity. Financial Management, 34(1), 5-19.  Retrieved from
Jensen, M. & Meckling, W. (2001). The nature of man. In Chew, D. H. (Ed.). (2001) The New Corporate Finance: Where Theory Meets Practice. pp. (4-19). New York: Irwin.
López-Gracia, J., & Sogorb-Mira, F. (2008). Testing trade-off and pecking order theories financing SMEs. Small Business Economics, 31(2), 117-136.  doi: 10.1007/s11187-007-9088-4
Miller, M. (2001). The Modgliani-Miller propostions after thirty years. In Chew, D. H. (Ed.), . 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
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).
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