BUILDING BLOCKS OF MODERN FINANCE THEORYCorporate Finance Theory William L. Megginson

1. Savings and Investment in Perfect Capital MarketsIrving 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 TheoryHarry 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 TheoryHis 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 TheoryEfficient 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 TheoryModigliani 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 TheoryM&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 TheoryTaken 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 TheoryThe 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 PolicyMiller 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 ModelsFinance 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 ModelsSharpes 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(Rj) = Rf + j (Rm - Rf)

5. Asset Pricing ModelsRosss (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 TheoryFama (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 TheoryResearch 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 TheoryIn a strong-form efficient market, security prices incorporate all relevant information public and private.

7. Option Pricing TheoryBlack 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 TheoryVery 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 TheoryThe 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 TheoryThe 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 TheoryIt 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 TheoryJensen 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 TheoryPerhaps 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 TheorySeveral 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 TheorySignaling 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 TheoryBecause 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 TheoryWhen 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 TheorySignaling 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 ControlMotivated by M&A in the 1980sThe 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 ControlBradley 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 ControlBradleys 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 ControlBradleys 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 IntermediationFinancing 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 IntermediationJames (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 TheoryMarket 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 PRINCIPLESIn 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.