Finance Theories Taxonomy 1

Finance Theories Taxonomy

Grace S. Thomson
 Finance Theories Taxonomy 2

Finance Theories Taxonomy

This document presents a taxonomy of selected finance theories developed in past 5

decades by academics, practitioners and scholars in the United States, Europe, Asia and Latin

America. A total of 14 theories and models are synthesized in this work, organized in five tables

with the same structure: Theories of capital structure; capital budgeting and cost of equity; asset

valuation, financial behavior and international finances.

Each table contains theories organized alphabetically with an indication of its germinal or

current character. The description of the theory is accompanied by current examples of empirical

research that updates or contradicts the theory and additional information about limitations,

scope and opportunities of research.

 Finance Theories Taxonomy 3

Table 1

Finance Theories Taxonomy: Theories of capital structure

Theory General description Current examples of the theory Other attributes

Modigliani and Miller Germinal theory of corporate finance A review of the theory by Criticism against flaws of M& M theory

Theory of investment proposed by Miller and Modigliani Miller himself, offers a new (Ball, 2001)

(1958) argues that “the value of a firm view about the so called ‘junk 1. Market perfection. M&M assumed

is independent of its capital structure” bonds’ which were considered information was complete and

(Miller, 2001) undesirable and non-tradable symmetric, when it was not

Dividends and capital structure are during the 60s when low-risk 2. Easy acceptance of firms with high

irrelevant in the determination of stock was the norm. levels of debt trading off for tax-

prices in the market. (Miller and Thirty years after the M&M deductible benefits

Modigliani, 1958; Chew, 2001); proposal, junk bonds seem to 3. Assumption that investment decisions

instead the market value of a firm is provide dynamism in the were not influenced by financial

based on the “earning power of the market and have helped decisions.

assets currently held and on the size develop the preference for (Ball, 2001)

and relative profitability of the Leveraged Buyouts LBOs not

 Finance Theories Taxonomy 4

Theory General description Current examples of the theory Other attributes

investment opportunities” (Miller & only in small firms but among This theory was revised in the 80s, and

Modigliani, 1958, p. 663) large firms (Miller, 2001) called "Tax-adjusted M&M". It

The valuation method of a firm is New characteristics in suggested that highly leveraged

based on the capitalization of corporate governance followed structures, which substitute deductible

operating earnings before interest and the LBOs of large firms. Miller interest payments for non-deductible

taxes, whereas Durand (1958) -one of cites “strip financing” as one dividends could push optimal capital

the first critics of the theory- proposed of them (Miller, 2001, p. 192) structure to 100% debt (Miller &

capitalization after interest and taxes, Modigliani, 1958)

accompanied by an adjustment for

leverage (Miller, 2001, p. 185)

Agency Cost Theory Germinal Theory proposed by Jensen Dogan and Smyth (2002) The desire for high rewards induces

and Meckling (1976) that analyzes the conducted a study of 223 managers to manipulate, overestimate or

conflict between shareholders and companies listed in the Kuala underestimate indicators to make them

managers - agents of shareholders. Lumpur Stock Exchange more achievable in detriment of the

KLSE using the agent theory value of the firm, e.g. low budgets,

Theory General description
Conflict arises because shareholders
require payouts for their investment,
reducing internal resources controlled
by managers (Jensen, 1986). Since
managers are compensated on the
basis of accounting profits, it increases
the incentives to manipulate
information and/or favor projects with
poor NPV if they provide immediate
profits (Dogan & Smyth, 2002). This
has negative consequences of potential
loss in value of public corporations
(Jensen & Meckling, 2001, p. 18).
Agency costs of Free Current theory proposed by Jensen
Current examples of the theory
to test relationships between
corporate performance,
performance criteria and
executive compensation.
Results showed that the
theoretically positive
relationship between board
remuneration and firm
performance was weaker in
Malaysia than in U.K. or U.S.
mostly explained by
concentration of ownership.
LBOs are another way to both
Finance Theories Taxonomy 5
Other attributes
inefficient debt targets.
Jensen & Meckling (1976) contend that
the agency costs of separating
ownership from control should not be
excessive provided that factors such as
competition, executive labor market,
and incentive plans are designed to
reduce the self-interest of managers.
This theory relates to the Free Cash
Flow theory proposed by Jensen in
1986.
The theory justifies the massive
 Finance Theories Taxonomy 6

Theory General description Current examples of the theory Other attributes

Cash Flow Theory (1986) and built upon the Jensen & reduce the agency costs of free substitution of debt for equity of the 80s,

Meckling’s theory of the agency cash flow and impose arguing that cash flow was going to pay

(2001), FCF is “the cash flow in discipline and efficiency interests and principal and not to

excess of that required to fund all (Stewart, 2001) however they “investment ratholes” (Miller, 2001, p.

projects that have positive net present increase the, agency costs of xix)

values when discounted at the relevant debt.

LBOs provide additional benefits to
cost of capital” (Jensen, 1986; Stewart
NABISCO was an example of reduce the agency costs of a firm: (1)
III, 2001).
a rich firm interested in Reallocation of resources, (2)

FCF is the sum of the cash flow to aggressive investment Squeezed out capital for growth ,

equity and cash flow to debtholders opportunities instead of paying however the media did not depict the

after interest-tax-shield (Shrieves & out dividends to stockholders real impact of LBOs as being beneficial

Wachovicz, 2001). (Stewart, 2001) (Chew, 2001, p. xxi)

The theory contends that by replacing

dividends for debt, managers will be

 Finance Theories Taxonomy 7

Theory General description Current examples of the theory Other attributes

forced to transfer excessive cash flows

`to investors and limit the allocation of

resources to low-return projects

(Miller, 2001).

Pecking-order theory of Current theory proposed by Myers and Brounen et al (2004) studied Typical issues observed in the

capital structure Mailuf (1984) based on the hypothesis firms in Europe and US to application of Pecking order theory are:

that financing follows hierarchy, and understand factors that a. Debt is encouraged when firm

that firms prefer internal over external determine their capital experience insufficient profits?

financing and debt over equity. structure. Financial flexibility b. Debt is encouraged when equity

The underlying factor is the was the factor that most is undervalued?

asymmetry of information: The more importantly drove capital When firms respond “yes” to these

asymmetry, the higher the costs of the structure, suggesting a questions, it is an indication of the

sources of financing (Brounen et al, “pecking order” model application of the theory. Brounen’s

2004). application (Brounen, et al, study rejected this hypothesis (Brounen

 Finance Theories Taxonomy 8

Theory General description Current examples of the theory Other attributes

2004, p. 94). et al, 2004, p. 94).

Static trade-off theory of Current theory that contends that firms In a study by Brounen et al Application of the trade off theory

capital structure trade off the costs and benefits of (2004) CFOs in Europe and requires a two step process

leverage associated with tax effects, US were asked about the 1. Define a target capital structure

bankruptcy and agency costs, in order importance of agency costs 2. Choose elements to include in

to generate a target capital structure and bankruptcy. Europeans the trade off: financial

for the firm (Brounen et al, 2004, p. considered bankruptcy costs as flexibility, credit rating,

93) the 4th more important after volatility of earnings, tax

Firms that respond to the static trade- financial flexibility, credit advantage, transaction cost, debt

off theory, have managers whose ratings and earnings volatility. level of other firms, potential

incentive to issue stock to keep the Their results prove that static- costs of bankruptcy) Brounen et

EPS dilution (Bancel & Mittoo, 2004, trade off theory reflects the al (2004), p. 96 (Brounen et al,

p.112). behaviors of corporate 2004, p. 96)

managers (Bancel & Mittoo,

2004; Brounen et al, 2004).

 Finance Theories Taxonomy 9

Table 2

Finance Theories Taxonomy: Theories of capital budgeting and cost of equity

Theory General description Current examples of the theory Other attributes

Economic Value Added Current theory of Economic Value In Research & Development, Application of EVA® requires change

Theory Added EVA ® was designed by Stern EVA is used to improve the in the organizational culture and fiscal

Stewart & Co (1982). treatment of outlays as responsibility (Hatfield, 2002)

It is an alternative model to CAPM investment given their value- EVA is not a new concept, it is deemed

used in capital budgeting because it creation character. “practical, highly flexible, a refinement

focuses on the ability of a firm to Hatfield (2002) prepared a of economists’ concept of residual

create wealth from the point of view study to demonstrate the effect income’ (Drucker as cited in Stewart &

of the economic model and not the of capitalizing R&D. Outlays Stern, 1996)

accounting model (Abate, Grant, and for new products when R&D is For other authors EVA is a financial

Stewart III, 2004, p. 62). expensed perform worse than fiction inoperable unless markets were

Strong competition of the Earning Per flows of outlays of a efficient (Chen & Dodd, 2002).

Share EPS model that prevailed in capitalized R&D across time. The formula to compute EVA is

America before the 90s (Stern, Firms reported by Stern & expressed (Hatfield, 2002)
 Finance Theories Taxonomy 10

Theory General description Current examples of the theory Other attributes

Stewart & Chew, 1996) and more real Stewart Co. as active users of EVA = NOPAT – CC (1)

than Return on Equity ROE, Free EVA include: Bausch and NOPAT= Net operating profit after

Cash Flow FCF and other methods Lomb, The Coca Cola Co., taxes

based in the Accounting model Georgia-Pacific Corp., CC= cost of capital x economic capital

(Hatfield, 2002). Monsanto, Rubbermaid Inc. Four steps are required : (1) Determine

It is an integrated financial system among others (Hatfield, 2002) the Net profit after taxes plus interest

used in decision making and different charges (2) Estimate market value of

corporate applications: Performance company’s equity (3) Calculate the

measurement, determination of opportunity cost of the capital and (4)

shareholder value, valuation of equity Compute EVA (Gonzalez, 2006)

(Hatfield, 2002; Stern, Stewart III and

Chew 1996).

The Sharpe-Lintner Germinal theory developed separately A survey conducted by Fama and French (1996) critique CAPM

Capital Asset Pricing by William Sharpe (1964) and John Brounen et al, (2004) reported flaws in recording anomalies of the

Lintner (1965) and used to identify the CAPM was used by 64.2% of
 Finance Theories Taxonomy 11

Theory General description Current examples of the theory Other attributes

Model (CAPM) adequate cost of capital in project U.S. firms and an average of market and expected returns (p. 1948).

valuation (Brounen et al, 2004). 57% of European companies,

CAPM’s major weakness is in the
with high occurrence in large
Ball (2001, p. 24) defines it as a determination of betas in efficient
and public firms across the
“method of estimation expected markets (Ball, 2001) and the inability to
data of 6,500 firms, where
returns which passive investors would explain the temporality of risk
CEOs have long tenures,
otherwise have earned in the absence premiums and the amount of the
regardless of their educational
of the information being tested” expected changes in that risk ratio.
background.
An equation for CAPM may look as Some theorists contend CAPM is not a

follows (Ball, p. 30): valid model to compute expected

returns, given the premise that dividends

E(R) = Rf + β (Rm – Rf) (1)
and earnings are non-fundamental to
Stock’s expected return E(R) is equal stock pricing determination. Its use in
to a riskless rate Rf plus a risk the computation of EVA® also has
premium compound by β and the
 Finance Theories Taxonomy 12

Theory General description Current examples of the theory Other attributes

amount a stock of average risk (Rm) is been challenged (Chen & Dodd, 2002).

expected to earn above the riskless

Divided opinions classify CAPM as a
rate (Rf).
result of the EMH (Efficient Market

CAPM is popular because there is no Theory) (Ball, 2001); others argue that

any other accepted model to compute the assumption that CAPM evaluates

expected returns (Chen & Dodd, 2002, only efficient portfolios does not imply

p. 509) that CAPM derives from Fama’s

Efficient Market Hypothesis (EMH).

Theory of Discounted Current theory of Discounted Cash Brounen et al (2004) surveyed In asset valuation, DCF compares the

Cash Flow Flow (DCF) used in capital budgeting 6,500 companies from the intrinsic value of a firm by discounting

or project valuation, asset valuation United Kingdom, Netherlands, the expected future free cash flows

(Myers, 2003; Shrieves & Wachovicz, France and Germany and U.S. (FCF) using a rate that reflects the cost

2001) and securities valuation to assess the behavior of of capital” (Stewart, 2001, p. 34).

financial officers regarding the


Theory General description
(Shrieves & Wachovicz, 2001).
DCF compares the future returns of
potential projects by discounting the
future cash flow at a rate that reflects
the yield of similar securities in the
market (Myers, 2003).
Internal Return rate (IRR), net present
value (NPV), adjusted present value
(APV) and discounted payback period
are DCF techniques (Brounen et al,
2004)
Myers (2001) highlights the
usefulness of NPV but cautions about
Finance Theories Taxonomy
Current examples of the theory
use of financial techniques
Results suggested that
European firms do not apply
DCF techniques as much as
they use payback criterion.
Authors argue that most
European firms are small and
private, and their CEOs do not
have MBA degrees which
could imply an increase use of
discounted techniques.
The study also found that those Flow (FCF) techniques and with EVA®
firms declaring that they
maximize shareholder value
13
Other attributes
Bias against long-lived projects is a
challenged result of DCF, reinforcing
the argument of management short-
sightedness in the 80s (Myers, 2001).
DCF main critiques derive from the use
of traditional financial reporting
(Shrieves & Wachovicz, 2001) and the
vulnerability to political forces within
the organization (Myers, 2001)
The multi-use of DCF is achieved
through a combination with Free Cash
for purposes of evaluation of managerial
performance (Shrieves & Wachovicz,
 Finance Theories Taxonomy 14

Theory General description Current examples of the theory Other attributes

the difficulties when defining discount use discounting techniques 2001; Stewart III, 2001).

rates, forecasting cash flows, most frequently (Brounen et al,

estimating time series and dealing 2004).

with the stringent accounting

principles (Shrieves & Wachovicz,

2001).

Table 3
Finance Theories Taxonomy: Theories of Asset Valuation
Theory General description
Theory of the stock Germinal theory discussed by Eugene
market efficiency Fama (1965) and French (1965) and
again by Ball and Brown (1968).
Eugene Fama (1965)
Efficient markets are characterized by
competition among “profit
maximizers” who attempt to estimate
the value of securities in the future
relying on the information they have
(Fama as cited by Ball, 2001).
Fama and French divided valuation
portfolios in two: Value Stock firms
(with high book to market) and growth
Finance Theories Taxonomy 15
Current examples of the theory Other attributes
Following the theory of market Limitations of the model include the
efficiency Anderson and unreal assumption that information is a
Garcia-Feijoo (2006) commodity and is costless.
conducted a study to test that
International applications of the Fama
firm valuation and valuation
and French model require a country-
ratios respond to optimal
specific study to observe particular
corporate investment
patterns of corporate investment activity
decisions.
(Anderson & Garcia-Feijoo, 2004, p.
The model tested consistently 192)
with the predictions of Fama
and French theory but also
concluded that pricing factors
 Finance Theories Taxonomy 16

Theory General description Current examples of the theory Other attributes

stock (with low book-to market value) resulting from size and book-

(Anderson & Garcia- Feijoo, 2006). to-market portfolios become

irrelevant when
Theory predicts that portfolio with low
macroeconomic conditions of
b/m value will have an increased
growth prevail (p. 175)
return before portfolio formation and

then would decrease. This return to Anderson and Garcia-Feijoo

equilibrium was a key element in the suggest including a fourth

model (Fama and French 1996). factor (investment-growth

factor) to the model of Fama

Fama and French (1992, 1993, 1996)
and French, in order to help
proposed a three-factor model that
explain the anomalous returns
describes variations in time that may
in portfolios (Anderson &
affect the measurement of stock
Garcia-Feijoo, 2004, p. 174,
return: Book-to market ratio, size and
191)
 Finance Theories Taxonomy 17

Theory General description Current examples of the theory Other attributes

excess market return.

Theory of the stock Germinal theory is based on Fama In the mid 60s Ball and Brown Limitations of the theory are analyzed

market efficiency (1965) definition of efficiency. performed a study to evaluate by Ball (2001) himself and divided in 3

how stock market reacted to categories: Empirical anomalies, defects

Ray Ball and Phillip Brown (1978, p.17) defines efficient
announcements of annual as a model of stock market and
Brown (1968) capital markets as “one in which it is
earnings. problems in testing the efficiency of the
impossible to earn an abnormal return
model.
by trading on the basis of publicly They analyzed 2300 annual

available information”. earnings reports of 300 NYSE Empirical anomalies include problems

companies, between 1956- in fitting the theory to the data because

Fama (1965) and Brown (1968)
1964 of seasonal patterns.
definitions have a common element:

the assumption of available Ball and Brown found an Defects in efficiency as a model of stock

information about the earnings of a upward movement in stock market comprise not incorporating

firm, traditionally expressed by price after announcement of information costs, transaction costs,

Theory General description
Earning per share (EPS).
Ball and Brown (1968) tried to explain
the behavior of the stock market
which was not of main interest by
economists but statisticians. After
The Market efficiency concept was the
base for other theories such as: Miller
and Modigliani Theory of corporate
finance policy; Sharpe-Lintner Capital
Asset Pricing Model (CAPM) and
Black-Scholes option pricing model.
The Black-Scholes option Germinal theory proposed by Black
pricing model and Scholes (1973) and developed
Finance Theories Taxonomy
Current examples of the theory
increase in earnings, and slight
downwards after
announcement of decreases in
earnings. In a period of six
months afterwards net earnings
were close to 0.
The conclusion was that stock
prices did reflect the
information announced
annually (p.21)
New studies have included
variables that make the model
18
Other attributes
oversimplifying academic analysis and
ignoring market microstructure effects
(Ball, p. 25)
Market microstructure effect explains
“how investors’ latent or hidden
demands are ultimately translated into
prices and volumes” (Madhavan, 2002)
Problems in the model relate to
definition of risk-less rates, market risk
premium, individual betas and the
volatility of the stock prices.
In a simple definition the model is
written (Versluis & Hillegers, 2006) as a

Theory General description
along with Merton’s Theory of
Rational Option Pricing (1973).
Based on a portfolio of stocks and
options on the stocks which valuation
is based on the assumptions of short-
term horizon, fixed interest rates,
prices for the underlying assets, no
dividend payments, no selling or
buying options and abilities to borrow
and short sell (Versluis & Hillegers,
2006)
Its main characteristic is its
satisfactory fit to market data, but its
two more criticized flaws are
Finance Theories Taxonomy 19
Current examples of the theory Other attributes
more adaptive to reality. function with 4 variables:
Versluis and Hillegers (2006) Π = Qt=t S – c
proposed a modification to the
Π = value of portfolio
model to include the effect of
re-financing at the end of the Qt=t = fraction of stocks
short-term interval.
S = price of underlying asset
Versluis & Hillegers (2006)
c = value of European call option on the
add a parameter that accounts
underlying asset
for the drift of the stock price
This model has been improved to
process which applied to a
include other variables e.g.
study of seven Dutch stocks
“distributions of dividends, interest rate
and showed better fit than the
changes, trading cost, taxes and
original model.
(…)stochastic volatility” (Versluis &
 Finance Theories Taxonomy 20

Theory General description Current examples of the theory Other attributes

“moneyness (or volatility smile) and The Chicago Board Options Hillegers, 2006, p. 261) and

time to maturity” (Blyinski & Fasruk, Exchange (SBOE) was the first

2006, p. 47; Versluis & Hillegers, one in using the Black and

2006, p. 261). Scholes model in 1973 and

continues to use the newly

developed neural models and

implied volatility variables.


Table 4
Finance Theories Taxonomy: Theories of Financial Behavior
Theory General description
REMM Theory of Current theory proposed by Meckling
Human Behavior (1976) addresses the concept of “man” individuals who believe that
(Resourceful, Evaluative, as unit of analysis in economics. It
Maximizing Model) explains man’s behaviors as a result of regulatory mechanism that
interactions with value systems and
constraints” (Brunner & Meckling,
1977).
REMM individuals are able to make
trade-offs to overcome a constraint,
and therefore theoretically have “no
needs”, they have wants and desires
Finance Theories Taxonomy
Current examples of the theory
Most economists are REMM
price system is a self-
responds to needs and wants.
Trade-off in the costs of
leverage to avoid the costs of
bankruptcy is an example of a
REMM action (Brounen et al,
2004)
21
Other attributes
Corruption in financial markets is
addressed by Brunner and Meckling
(1977) and explained from the REMM
perspective as the result of corrupted
government agencies rather than private
firms.
Limitations of the theory:
REMM does not describe behavior of
particular individuals and might appear
too biased towards the role of
government agencies as controlling
 Finance Theories Taxonomy 22

Theory General description Current examples of the theory Other attributes

which help them focus on alternatives, entities of corporate governance (Jensen

substitutes and costs and reduce their & Meckling, 2001)

exposure to hidden agendas of

politicians or media (Brunner &

Meckling, 1977)

In general markets are always in

equilibrium because REMM

individuals adapt to their opportunity

set and make demand and supply

better off, by balancing cost/benefit

(Jensen & Meckling, 2001)


Table 5
Finance Theories Taxonomy: Theory of International Finances
Theory General description
Financial liberalization Current theory originated in the
theory of IMF separate work of McKinnon (1973)
and Shaw (1973). The hypothesis
supporting this theory proposed that
financial development and economic
growth were strongly attached. The
more liberalization of financial
systems, the more growth in economic
development. Arestis, Nissanke &
Stein (2005).
The liberalization theory was applied
Finance Theories Taxonomy 23
Current examples of the theory Other attributes
The application of the Liberalization theory was based on
liberalization theory resulted in strong classical assumptions about the
chaos and crises in developing role of the interest rate. Shaw (1973)
countries. In 1989 considered interest rates as a signal of
Venezuela’s banking system opportunities of investments, and
broke and 60% of their assets therefore an increase in economic
were lost. development. For McKinnon (1973)
high interest rates would increase
In Mexico, in the late 90s
savings flows and decrease any excess
government intervention to
of demands (Arestis, Nissanke & Stein,
solve financial crisis
p. 247).
represented costs of 17% of the
 Finance Theories Taxonomy 24

Theory General description Current examples of the theory Other attributes

during the 90s in developing countries Gross domestic product. Flaws of the liberalization model

based on the idea that financial resided in forgetting that markets are not
Sahoo, Geethanjali and
institutions would benefit from foreign sophisticated and that markets are
Kmaiah (2001) studied real
capital inflows and competition imperfect (Arestis et al, p. 249)
savings and real GDP statistics
among banks and financial institutions
from 1950-1999 and found that
would foster efficiency (Glen &
the relationship was growth-to-
Singh, 2005); however the inflow
savings and not savings-to-
increased the instability of these
growth.
countries (Shaw, 1973).

Institutional-centric Current theory proposed by Arestis, Empirical studies have found A banking system that connects

theory of finances Nissanke and Stein, 2005 as an that in reality the transition of investment and production in a

alternative to the flawed financial economies to an institutional symmetric manner, with common

liberalization theory that increased the centered model is not guidelines will attract investment and

instability of developing countries happening, instead takeovers accumulation (Glen and Sing, 2005).

Theory General description
during the 90s.
Based on the theory of imperfect
markets, it acknowledges the existence
of imperfect information and informal
and formal institutions, which
efficiency is the engine of
development (Arestis et al, 2005;
Dornbusch & Reynoso, 2003)
“Norms, incentives, regulations,
capacities and organizations” are five
institutions of any financial system
(Arestis et al, 2005, p. 257) who risks
have to be socialized.
Finance Theories Taxonomy 25
Current examples of the theory Other attributes
by foreign commercial banks An integration of financial supervision
are common (Arestis et al, was proposed by Demaestri and
2005). Guerrero (2003) and theoretically
suggests that effectiveness and efficacy
The study by Demaestri and
are achieved when regulatory
Guerrero (2003) show
institutions are integrated in one.
empirical evidence that
financial regulation overcome
issues of moral hazard,
financial conglomerates,
transparency and
accountability (p. 22)
 Finance Theories Taxonomy 26

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