Building Blocks of Modern Finance Theory

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Introduction to Corporate Finance Building Blocks of Modern Finance Theory

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Building Blocks of Modern Finance Theory

Transcript of Building Blocks of Modern Finance Theory

Page 1: Building Blocks of Modern Finance Theory

Introduction to Corporate Finance

Building Blocks of Modern Finance Theory

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Savings and Investment in Perfect Capital Markets

Economist Irving Fisher (1930) showed 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.

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Savings and Investment in Perfect Capital Markets

Savers can earn a higher return by lending on the capital market than they could by seeking out individual borrowers, and borrowers can obtain more, lower-cost, financing than they could if forced to search for funding on their own.Total saving and total investment in an economy is therefore greater than it would be without capital markets.

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Savings and Investment in Perfect Capital Markets

Fisher developed an important theorem: The Fisher Separation Theorem.His theorem demonstrated that capital markets yield 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.

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Savings and Investment in Perfect Capital Markets

Without this separation of investment and financing decisions, firms would have to tailor their investment decisions to the preferences of individual investors, and the large modern corporation with its own legal identity and infinite time horizon could never have come into existence.

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Portfolio Theory

The next major advance in finance occurred when Harry Markowitz (1952) published the famous article laying our the basic principles of portfolio theory.The essence of rational portfolio allocation is captured in the phrase “don’t put all your eggs in one basket.”

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Portfolio TheoryMarkowitz shows that as you add assets to an investment portfolio the total risk of that portfolio – as measured by the variance of total return – declines continuously, but the expected return of the portfolio is the weighted average of the expected returns of the individual assets. In other words, by investing in portfolios rather than in individual assets, investors could lower the total risk of investing without sacrificing return.

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Portfolio Theory

The Markowitz portfolio selection rule is pick stocks with the highest return to risk ratios, and combine these stocks into efficient portfolios – where risk is minimized for any given level of expected return or, conversely, where return is maximized for any given level of risk.

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Portfolio Theory Standard Deviations of Annual Portfolio Returns (NYSE): # of Stocks in Average S.D. of Annual Portfolio Portfolio Returns

1 49.24% 10 23.93% 50 20.20% 100 19.69% 300 19.34% 500 19.27% 1,000 19.21%

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Portfolio Theory

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Capital Structure Theory

The Modigliani and Miller model (1958) states that the economic value of the bundle of assets owned by a firm is derived 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.

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Capital Structure TheoryM&M’s Proposition I states that 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&M’s Proposition II states that if the expected return on the firm’s assets is constant, then the required return on levered equity must increase directly and linearly as risk-free debt is added to the firm’s capital structure.

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Capital Structure Theory

Debt-equity ratio, D/E

Cost of capital

WACC = RA = REU

RD

REL = RA + (RA – RD ) x (D/E)

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Capital Structure Theory

Taken together, these two propositions establish that 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-equity ratio and the required return for firms of its risk class.After much debate in this area of study, we can offer no simple, unambiguous answer to the question, “Does capital structure matter?”

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Dividend PolicyMillar and Modigliani show that holding a firm’s 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.However, the real world does not have frictionless capital markets – it turns out that most “real” market frictions work against the payment of dividends.

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Dividend Policy

Examples of “real” market frictions include:

1. Firms must pay substantial fees to investment bankers to float a new share issue.

2. Investors pay higher marginal taxes on dividends than on capital gains; investors cannot control the timing of tax liabilities with dividends unlike capital gains.

3. The stock market response to the announcement of new equity issues is almost always negative.

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Dividend Policy

Given these “real” frictions, why than do American corporations pay out roughly half of their earnings as cash dividends?One possible answer is that the simple M&M dividend model did not allow either for agency problems between corporate managers and shareholders or asymmetric information between those same two groups.

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Dividend Policy

Dividend policy is also a byproduct of a firm’s life cycle – mature companies with few growth opportunities are more likely to pay dividends than growing companies.In conclusion, the state of dividend policy theory is in flux – important basic questions remain unanswered.

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Asset Pricing ModelsIt can be said that finance became a full-fledged discipline in 1964 when Sharpe published his paper deriving the Capital Asset Pricing Model (CAPM).For the first time, financial economists could describe and quantify what “risk” was in a capital market and specify how it was priced.CAPM assumes that investors hold well – diversified portfolios within which the unsystematic risk on individual assets is not important.

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Asset Pricing ModelsSharpe’s main contribution was to uniquely define systematic risk and to specify exactly how investors can trade 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 government treasury bills. Sharpe then pointed out, there is one unique risky asset portfolio that dominates all others, and he labeled this the market portfolio.

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Asset Pricing ModelsThis leads to the fundamental result – all investors will allocate their wealth into some combination of the risk-free asset and the market portfolio, and the slope of the line measuring this risk-return trade-off is called the capital market line.Sharpe’s final 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. He defined the covariance (standardized by dividing through the market variance) as beta.

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Asset Pricing Models

To be included in the market portfolio, every individual stock will sell at a price that yields investors the appropriate expected return, implied by its level of systematic risk and the current return on a risk-free asset.Mathematically, the CAPM can be expressed as:

E(Ri) = Rf + βi(Rm – Rf) where: (Rm – Rf) is called the market risk premium.

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Asset Pricing Models

Sharpe’s work touched off a torrent of academic research aimed at testing whether the CAPM accurately described objective market reality.Though “anomalies” exist with CAPM and other multi-factor models exist, CAPM has remained the dominant asset pricing model in finance – “you can’t beat someone with no one.”

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Efficient Capital Market Theory

Fama (1970) publishes one of the most important papers in economic history. He presents both a statistical and 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.

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Efficient Capital Market Theory

Fama provides three definitions of efficiency:

1. Weak form – security prices incorporate all relevant historical information.

2. Semi-strong form – security prices reflect all relevant, publicly-available information.

3. Strong form – security prices reflect all relevant information, private and public.

Strong form efficiency does not generally hold in the real-world financial markets.

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Efficient Capital Market TheoryFama’s Efficiency Market Hypothesis has revolutionized our view of how financial markets work.How? Because competition among traders ensures that security prices accurately reflect all relevant information, market prices can be “trusted.”

Investors can rely on efficient markets to ensure that they will not be taken advantage of by better-informed traders.Corporations can assume that they will be able to issue new securities without having to fear that these will be “irrationally” priced.

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Efficient Capital Market Theory

However, don’t misunderstand the efficient-market idea. It doesn’t say that there are no taxes or costs; it doesn’t say that there aren’t some cleaver people and some stupid ones. It merely implies that competition in capital markets is very tough – there are no money machines, and security prices reflect true underlying values of assets.

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Option Pricing TheoryBlack and Scholes (1973) published an article describing the model for pricing stock options that still bears their names.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 calculable) variables:

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 return, and the risk-free rate of interest.

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Option Pricing Theory

The basic BS OPM was developed for European options and assumes that stocks do not pay dividends. 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 options.

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Option Pricing Theory

However, in spite of these limitations and biases, the OPM (and its later derivations) has proven itself to be amazingly robust and accurate model for pricing options of all types of financial assets.

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Agency Theory

Prior to 1976, finance theorists used the standard economic model of the firm to describe corporate behavior – the model viewed the firm as a “black box” that processed inputs into usable outputs and that responded rationally to economic incentives managers would always act in the best interests of their shareholders.

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Agency TheoryThe agency cost model of the firm, put forth by Jensen and Meckling (1976), incorporates human nature into a cohesive model of corporate behavior – 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.

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Agency TheoryIn other words, it is a model that relies on rational behavior by self-interested economic agents who understand the incentives of all the other contracting parties, and who take steps to protect themselves from predictable exploitation by other parties.Given this theory, we may now view the relationship between managers and owners as an agency problem which results in agency costs – management “perks”, monitoring costs, and lost economic opportunities.

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Agency TheoryThis agency problem has lead to further research into compensation policy where compensation can help align the goals and objectives of managers and shareholder. The classic problem in this area is that managers – who have all their “eggs in one basket” – typically will prefer a far less risky investment strategy than will investors, who can diversify their wealth among many financial assets.

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Agency Theory

A management compensation scheme that ties the payoffs to managers to the payoff received by shareholders can partially overcome this problem, and stock-option based executive compensation packages have indeed become almost universal in large American corporations.

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Signaling Theory

Signaling theory was developed to explicitly account for the fact that corporate insiders 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-equality firms.

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Signaling TheoryBecause of this asymmetric information problem, investors will assign a low average quality valuation to the shares of all firms.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.As such, how do managers convey this information to investors in a way that cannot be duplicated by the managers of lower quality firms?

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Signaling TheoryOne method 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 – for example, the payment of dividends.Other “positive” signals used by corporate insiders may include:

Retaining a large-ownership stake in high-intrinsic value projects, andBy employing more debt financing in its capital structure.

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The Modern Theory of Corporate Control

Motivated by the merger and acquisition activity of the 1980s, academic researchers were provided with a wealth of data and practical examples to base their corporate control research on.

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The Modern Theory of Corporate Control

The first major exposition of a truly modern theory of corporate control was presented by Bradley (1980), who documents:

1. Shares increase in value by approximately 30% immediately after a tender offer is announced,

2. And then stays at about that same level until either the acquisition is either completed or canceled,

3. And that those shares which are not purchased in a successful takeover drop in price back towards their initial value immediately after the takeover is completed.

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The Modern Theory of Corporate Control

Bradley’s 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.

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The Modern Theory of Corporate Control

In Bradley’s model rival management teams compete for the right to control corporate assets. Inefficient management teams are replaced by more capable ones, and the control of corporate resources naturally flows towards those people able to put the resources to their highest and best use – shareholders are the impartial referees in this allocation process.

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The Modern Theory of Corporate Control

Therefore, a vibrant takeover market is good for the economy because it weeds out inefficiencies and concentrates corporate control in the most capable hands.This competition means that rival management teams have to offer target firm shareholders most of the profit that is expected to accrue from improved post-acquisition performance in the form of a high tender offer premium.

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The Theory of Financial Intermediation

Within the past decade it has become clear that capital market financing is often a much more costly and economically wasteful method of funding routine corporate activities than is financing via banks and other financial intermediaries.Commercial banks seem to have a clear competitive advantage over capital markets for all but the very largest types of corporate fundings.

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The Theory of Financial IntermediationLargely because of their competitive advantages, commercial banks tend to dominate corporate finance in almost all developed and developing countries of the world except the United States.The reason for this odd state of affairs is bad public policy:

The McFadden Act (1927) prevented interstate banking and, as such, the U.S. has produced no banks with a nation-wide reach.The Glass-Steagall Act (1934) legally separated commercial and investment banks which placed U.S. commercial banks in a global competitive disadvantage.

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The Theory of Financial Intermediation

Researchers have documented positive returns to corporate shareholders following the announcement that a firm has obtained a loan from a commercial bank and negative or insignificant returns associated with other corporate financing announcements.

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The Theory of Financial Intermediation

Since a bank presumably has direct access to a company’s accounts and intimate contact with a company’s executives, stock market participants 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 party.