Running head: FINANCIAL THEORIES OVERVIEW

Financial Theories Overview Ivan F Rodriguez University of Phoenix

FINANCIAL THEORIES OVERVIEW Financial Theories Overview Finance is still in its infancy (Chang, 2005), there are several postulations and theories created to explain the interaction between investors and market variables and how they allocate their assets over time under specific conditions. Finance quickly has transformed into a science full of theoretical thrusts. Finance is one of the most quantified and theorized disciplines in business curriculum. The world in which humanity live, and the environment in which

organizations operate, are without precedent. Although the elements are the same; the pace and complexity of changes to new forms, ways of living, and values are of an order of magnitude never before experienced. This reality explains probably the dynamic and complex nature of finance that requires continuous development of new theories. This paper resumes 10 of several theories (as shown in Table 1), six of them were indicated by the instructor, Dr. Folino, the rest were selected based on their relevancy and applicability to prevailing financial reality in my perspective. It is clear that Finance is to some extent unique in terms of the correspondence between theory and evidence, this probably explains why several finance theories are still at their developmental stage and so they are highly controversial, debatable, and subject to close scrutiny as (Ball, 1994). Over the last several decades there has been an outcry that theory-oriented analytical subjects (Chang, 2005) such as finance, should make way for more important, newly emerging subjects such as leadership, communication, ethics, global management perspectives, technology, and other soft skills. Understanding these theories will help getting familiar with some variables affecting value definition and value perception, this should serve as a conceptual reference frame to maximize the value and the financial decision effectiveness.

Table 1

FINANCIAL THEORIES OVERVIEW Financial Theories a Comprehensive Review No. 1 Financial Theory Efficiency theory Acronym EMT Description It states that scant resources are distributed by the owner in an efficient manner. Owners choose the best outcome for their investment and regulate resources and products accordingly. The theory considers the fact that company resources are finite and can be used only once, with the result that using a quantity of a material for one purpose involves an opportunity cost, that is, it denies the company the chance to use the same material for another purpose. Last, this theory states that companies should structure their output to achieve the lowest cost per unit produced. Maximum allocative efficiency is achieved when the firm produces the optimal output level of a combination of goods or services to maximize the benefit to the company. The theory as applied to the stock market says that information of the market is fully reflected in the price of the stock and Examples Usually stock returns are compared to market returns. A mutual fund company will compare their returns to the general stock market return and state they are a certain percentage above or below the market standard returns. Most will try to say they have beaten the market average. This is true for most investing firms and, is used as a selling point for the company or mutual fund.

Significant Attributes If this theory was to be taken to the extreme one would have to say that it is impossible to beat the market average returns. This does not hold true in the real-world (Fama, 1970). There are funds and investments that do outperform the market. Generally this is true but specifically it is not. Lead steers, such as Warren Buffet consistently beat the market averages and continues to do so even today. It must be considered that there is some inefficiency in the market exploited for gain. According to Fama and his research there are outliers that can account for inefficiencies. Empirical research has shown that information has

FINANCIAL THEORIES OVERVIEW No. Financial Theory Acronym Description efficiently assimilated (Fama, 1970). Examples

4 Significant Attributes a cost and not everyone can get the same information at the same cost (Fama, 1970). Empirical evidence shows the balance sheet to attribute no value to a company. A number of research projects have concluded the value of a company is not determined by a companys debt (Toporowski, 2008). There has also been on evidence that stock market prices are affected by information contained in the balance sheet. The balance sheet was Minskys main focus in his research. The link between government policy and downturns in the business cycle are well founded (Toporowski, 2008).

Theory of investment

TOI

There are a number of investment theories out. The one addressed here was developed by Hyman Minsky in the late 50s in his doctoral dissertation. This theory was not well received during his life, but after his death in 1996 and during the housing crash of 2006 his work has received more attention (Toporowski, 2008). Minsky suggests that the balance sheet and a companys investment process attribute to the business cycle. How a company obtains investment capital, either internally or externally, and the movements of business investments have an aggregate attribution to macroeconomic fluctuations. Minsky contributed the 1930s depression to policy mistakes buy government officials. This is the reason for the renewed recent

As stated above the renewed interest in this theory is the housing crash of 2006. There are many economists that are attributing this recession to government policy and the effect it has on business finance. Another part of Minskys theory is debt recession in which a debt is not paid and the financers debt is also not paid and creates a snow ball effect that causes a macroeconomic recession or depression as is seen today. Minsky was adamant that this was the cause of the long-term depression of the 1930s (Toporowski, 2008).

FINANCIAL THEORIES OVERVIEW No. Financial Theory Acronym Description interest in his theory (Toporowski, 2008). 3 Agency cost theory ACT Managerial mischief is the word associated with this theory. The theory is that when management and shareholder do not agree, management will pursue their own self-interest. There is research that discredits this theory. Alignment of management pay and incentives to ownership priorities is still an important issue. The research refers to this as CEO incentive alignment constructs (Nyberg, Fulmer, Gerhart, & Carpenter, 2010). Agency theory suggests the lack of alignment of goals will reduce the value of the company and a good alignment of the goals will increase the value of a company. It makes sense that a good alignment of these goals should enhance the performance of the company but this same alignment many not enhance the value of a company (Nyberg et al., 2010). This theory involves Recent news reports of CEO misbehaviors have caused a rise in interest for this theory. Although widely studied, there has been no affinitive connection between alignment of goals and company value. There is some interest by the government to intervene in CEO compensation with the idea that restricting pay incentives will help to align goals. There is no evidence that this will be successful (Nyberg et al., 2010). Individual selfinterest will always win out over government regulation. Examples

5 Significant Attributes

The idea is that financial compensation will motivate strongly management to link goals to incentives. The idea is to link financial compensation to the goals and to encourage company ownership through stock purchases giving the CEO more incentives for taking the company in the right direction (Nyberg et al., 2010). There are recent news stories that tend to conclude that these financial incentives do not work all the time.

Agency

ACF

Some recent

The theory is an

FINANCIAL THEORIES OVERVIEW No. Financial Theory cost of free cash flow theory Acronym Description management and the payout of stock dividends. This is another area of agency cost, and the conflict between management and shareholders. Money is power and managers who have cash flow also have power. This power is not always easy to give away in the form of dividends. Another conflict is internal financing of capital expenditures is cheaper than external financing (Jensen, 1986). This is a matter of how much power the manager will wield. Growing the company is also a power struggle between management and payout of dividends (Jensen, 1986). The theory suggests managers will hoard the cash rather than pay it out in dividends. The theory explains several things. The theory explains benefits of debt reduction and its substitution for payouts, why diversification generates losses, takeovers in diverse industries are similar, and why bidders and Examples examples would be Disney World and the conflict that took place a few years ago over dividend payout and the replacement of the CEO at a stockholders meeting. The shareholders voted to find a new CEO after the payout on the stock was not performing as desired by the shareholders.

6 Significant Attributes attempt to explain some of the reasons for corporate financial decisions. There are those who believe corporate heads tend to prefer internal financing even though the cost of external financing is cheaper. It is an attempt to explain some type of leveraged buyouts and takeovers. The theory is consistent with data in takeovers and acquisitions that have in the past gone unexplained.

FINANCIAL THEORIES OVERVIEW No. Financial Theory Acronym Description targets become more successful prior to a takeover (Jensen, 1986). 5 Peckingorder theory of capital structure POT The pecking-order theory of capital structure states that companies prefer internal financing over external financing. There are two competing theories. The static theory states companies have a debt to value ratio they pursue. The POT suggests companies tend to move toward a decision that benefits long-term investors. The static theory did not reconcile the economic model and the debt ratios of companies in similar industries. The POT suggests there is no optimal ratio, and there is a dollar for dollar tradeoff between the increase in financial debt and the firms leverage. The data confirmed strong evidence of this dollar for dollar tradeoff (Ni & Yo, 2008). Economic valueadded theory is a trade mark of Stern Steward & Company The article gives a number of Chinese firms that this theory was applied to (157 to be exact). As stated above the evidence was strong that a Pecking-Order was evident in the financing decisions of these companies (Ni & Yo, 2008). This makes sense to the average person. If a company has a shareholder that has been with the company a long time, and they own a bank would be logical to obtain the needed financing through networking, the longtime shareholder. Examples

7 Significant Attributes

The empirical studies show only large firms use the PeckingOrder decision model. Small and mid-size firms do not. It is expected that small firms would be the main followers of this theory. This study was done in China and therefore must conclude that small and medium businesses in China do not apply to the theory. The theory was developed in the United States, and the opposite is true here (Ni & Yo, 2008).

Economic value added theory

EVAT

An example given in the article is Cokea-cola. The

The valueadded is not an accounting tool but has some

FINANCIAL THEORIES OVERVIEW No. Financial Theory Acronym Description that developed the tool. Essentially the theory is to take the net present value of future cash flows from the companys investments. The tool takes the net operation profit after taxes (NOPAT) less the dollar cost of capital required to create that profit (Ray, 2001). Examples company experienced a stock increase from three dollars a share to 60 dollars a share after implementing the EVA.

8 Significant Attributes basis in accounting. The EVA tool has 164 variations at present depending on what firm or industry it is applied to and causes a problem with consistency. The tool also has variances from generally accepted accounting principles that include capitalizing R&D research and advertising (Ray, 2001). The theory predicts the United States should have moved in a direction that would allow the free market to take control and adjust the economy and solve the crisis. This, of course, did not happen. The government did the opposite, which seems to contradict the theory. This contradiction is not explained by

Legal Origins theory

LOT

The legal origins theory places countries in one of two categories. Common law, which comes from a history associated with Great Britain, and civil law that comes from an association with France. The main idea is that countries will act or react in predictable ways during a crisis depending on which school of thought dominates the society. The common law history tends to act in a manner that allows the free market to

The example used it the United States and the housing bubble burst of 2006. The article details much of the financial collapse that took place between 2006 and 2009.

FINANCIAL THEORIES OVERVIEW No. Financial Theory Acronym Description correct the crisis where civil law history tends to use courts and government takeover to solve the problem. The theory links the historic origins to financial development. This key part of the theory makes it a predictor of financial market reactions to national crises. The article is specifically geared to the United States and how the country has responded to the present financial crises (Fairfax, 2009). Examples

9 Significant Attributes the theory. Supporters of the theory suggest the depth and extent of the crisis led the country to rely more heavily on legislation. The theory still works well in less problematic situations, and that the response still reflects the legal origin of the country even with the extreme response that was needed (Fairfax, 2009). The DSGE model is not accurate. It is simply a model to give approximations or predictions (Schorfheide, 2008). The model cannot predict catastrophic events in the economy. Generally it is applicable and helpful to normal distributions. It also varies, depending on the parameters

Dynamic Stochastic General Equilibrium (Global theory)

DSGE

It is a measure of macroeconomics used by the Federal Reserve Bank. The model is based on the New Keynesian Phillips curve (NKPC). The model generates predictions about price changes measure by microeconomic data. It is a measure of inflation that policy makers use to predict future inflation rates (Schorfheide, 2008).

This model has been used by central banks around the world. It was developed by the U.S. federal reserve and has been widely used and quoted in numerous magazine articles nationwide (Schorfheide, 2008).

FINANCIAL THEORIES OVERVIEW No. Financial Theory Acronym Description Examples

10 Significant Attributes of the input information. It has already been suggested that a new model be developed where the inputs are more precisely defined (Schorfheide, 2008). The model uses production index, wholesale prices, and dollar rate over a three month and six month intervals and compares them to the selected stock returns (Singh, 2008).

Capital asset pricing model

CAPM

It is an accepted model for evaluating assets. CAPM is an equilibrium theory for quantifying risk. The theory gives a beta displayed by the stock exchange. This article was written and researched in India but is also applicable to other stock exchanges. The model gives a relationship between risk and return (Singh, 2008).

The article gives the Indian stock exchange as an example. The BSE 200 is used for the article research. The article illustrates the CAPM model and the APT model and suggests the CAPM model is slightly more accurate for the sample stock returns that were researched. The example is the same BSE 200 of the Indian stock exchange. The two models are compared side by side showing the CAPM model to be superior (Singh, 2008).

10

Arbitrage pricing theory

APT

The APT or Arbitrage pricing theory is a completive theory to the CAPM model. The article written by Singh compared the two theories for accuracy against one another. The APT gives an alternative to the CAPM, APT says that proper asset

The model is influenced by long-term trends such as interest rates, growth rates, and inflation. The model suggests dividends are immediate detriments to

FINANCIAL THEORIES OVERVIEW No. Financial Theory Acronym Description pricing is required for proper pricing of shares. The two theories are very similar and both evaluate risk and return. Both models give a beta value that has a linear relationship to expected returns. The beta for APT is factor specific. The APT suggests stocks have sensitivities to certain factors not defined. If expected returns are not seen the arbitrage opportunities will cause elimination (Singh, 2008). Examples

11 Significant Attributes stock prices. The model also suggests that only 50% of stock prices are reflected in the model.

Note: The Efficient Market Theory (EMT) is critically opposed by, among others, a group of finance scholars known as behavioralists. Although largely refuting this criticism, Ball (1994) admits that the theory has obvious limitations. He further notes that with a limited tradition the much of the evidence on stock price behavior cannot reliably address the issue of efficiency. On the other hand, Miller (1998) recognizes the EMT as one of the major works that have contributed to the development of finance but which has so far not received the much deserved attention from the Nobel Committee.

Conclusion Based on this task it resulted clear that considering the complexity of the financial variables, complexity driven that the interdependency of quantitative and qualitative variables, it is the critical thinking by evaluating important issues conceptually and logically what will provide the best outcome concerning to making decisions that involve financial information. It is such critical thinking ability that enables to adapt to the changes occurring in financial world. It is my learned experience that the validity of a theory must be judged on empirical tests and that explanatory power and prediction ability is what a theory is all about.

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References Ball, R. (1994). On the development, accomplishments, and limitations of the theory of stock market efficiency. Managerial Finance, 20(2), 3-48. Chang, S.J. (2005). A theoretical discussion on financial theory: What should we teach and how?. Journal of economics and finance educations. 4(2), 39-48. Fairfax, L. M. (2009). The legal origins theory in crisis. Brigham Young University Law Review, 3(6), 1571-1617. Fama, E. F. (1970). Efficient capital markets: A review of theory and empirical work. Journal of Finance, 25(2), 383-417. Fama, E. F. (1976). Foundations of Finance. New York, NY: Basic Books. Jensen, M. C. (1986, May). Agency costs of free cash flow, corporate finance, and takeovers. American Economic review, 76(2), 323. Miller, M. H. (1998). The history of finance: An eyewitness account. In the revolution in corporate finance. New York, NY: Blackwell Publishing. Ni, J., & Yo, M. (2008, February). Testing the Pecking-Order theory. The Chinese Economy, 41(1), 97-113. Nyberg, A. J., Fulmer, I. S., Gerhart, B., & Carpenter, M. A. (2010). Agency Theory Revisited: CEO return and shareholder interest alignment. Academy of Management Journal, 53, 1029-1049. Ray, R. (2001). Economic Value Added: Theory and evidence, a missing link. Review of Business, 66, 5-9. Schorfheide, F. (2008). DSGE Model-based estimation of the new Keynesian Phillips curve. Economic Quarterly, 94(4), 379-433.

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Singh, R. (2008). CAPM vs. APT with macro economic variables: evidence from the Indian stock market. Asia-Pacific business review, 76. Toporowski, J. (2008, September). Minskys induced investment and business cycles. Journal of Economics, 32(5), 725-737.