The Theory of Corporate Finance

8/3/2019 The Theory of Corporate Finance

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A Historical Overview

02/05/2012 Moh Khoiruddin, S.E., M.Si.



Introduction

In the 1950s, fundamental changes in finance beganto occur. The analytical methods and techniquestraditional to economics began to be applied toproblems in finance, and the resulting transformationhas been significant.

This evolution was accompanied by a change in thefocus of the literature from normative questions suchas “What should investment, financing, or dividend policies

be?” to positive theories addressing questions such as“What are the effects of alternative investment, financing,

or dividend policies on the value of the firm?” This shift in research emphasis was necessary to

provide the scientific basis for the formation andanalysis of corporate policy decisions.




...Introduction

The logical structure of decision-makingimplies that better answers to normativequestions are likely to occur when the

decision maker has a richer set ofpositive theories that provide a betterunderstanding of the consequences of

his or her choices.




The Major Theoretical Building Blocks ofFinancial Economics (Jensen & Smith,

1984)

ModernTheory ofFinance

EfficientMarketTheory

PortfolioTheory

Capital AssetPricingTheory

OptionPricingTheory

AgencyTheory




The Major Theoretical Building Blocks of FinancialEconomics (Megginson, 1997)


FinancialIntermediation

TheoryMarket

MicrostructureTheory

Saving &Investment in

Perfect CapitalMarket

Portfolio Theory

CapitalStructureTheory

Dividend PolicyTheory

Asset PricingModels

Capital MarketEfficiency

Theory

Option PricingTheory

Agency Theory

SignallingTheory

CorporateControl Theory



Teori Keuangan & Tokohnya


Teori Tokoh Tahun KeteranganSaving & Investment inPerfect Capital Market

Irving Fisher 1930 Fisher SeparationTheorem

Portfolio Theory MarkowitzLintner

SharpMossin

19521964

19641966

Embrio teori positifTeori positif

Capital StructureTheory

Modigliani & Miller 1958 Nilai Ekonomi AssetPerusahaan

Dividend Policy Theory Modigliani & Miller 1961 Kebijakan Dividen

tidak relevanAsset Pricing Models Sharp

BlackBrennanMertonRoss

19641972197019731976

CAPM StandarCAPM tanpa RfAfter-Tax CAPMIntertemporal CAPMAPT





Teori Tokoh Tahun KeteranganCapital MarketEfficiency Theory

Eugene Fama 1970 Efficient MarketHypothesis

Option Pricing Theory Black & Scholes 1973 Black & Scholes OPM

Agency Theory Jensen & Meckling 19761986

Agency ProblemAgency Cost

Signalling Theory AckerlofSpenceJoseph Stiglitz

Leland & Pyle

1977 AssymetricInformationNobel Prize

Corporate ControlTheory

BradleyJensen & Ruback

19801983





Teori Tokoh Tahun KeteranganFinancialIntermediation Theory

James 1987

Market Microstructure

Theory

Ho & Stoll

Copeland & GalaiGrassman &StiglitzKyleAdmati & Pfeiderer

GlostenChristie & Schultz

1981

198319831980

19851988

19941994

Spread model

Price informationmodel

Islamic Finance



Fundamental Building Blocks

The years since 1950 have witnessed the formulation of themajor building blocks of the modern theory of financialeconomics:

Efficient Market Theory—analysis of equilibrium behavior ofprice changes through time in speculative markets.

Portfolio Theory—analysis of optimal security selectionprocedures for an investor’s entire portfolio of securities.

Capital Asset Pricing Theory—analysis of the determinants ofasset prices under conditions of uncertainty.

Option Pricing Theory—analysis of the determinants of the

prices of contingent claims such as call options and corporatebonds.

Agency Theory—analysis of the control of incentive conflictsin contractual relations.




Efficient Market Theory

The efficient market hypothesis holds that a marketis efficient if it is impossible to make economic profitsby trading on available information.

This means that technical trading rules based oninformation in the past price series cannot be

expected to make above-normal returns. Samuelson (1965) and Mandelbrot (1966) provide

the modern theoretical rationale behind the efficientmarkets hypothesis that unexpected price changesin a speculative market must behave as independent

random drawings if the market is competitive andeconomic trading profits are zero.




...Efficient Market Theory

They argue that unexpected price changesreflect new information. Since new informationby definition is information that cannot bededuced from previous information, newinformation must be independent over time.Therefore unexpected security price changesmust be independent through time if expectedeconomic profits are to be zero.

In the economics literature, this hypothesis

has been independently developed by Muth(1961). Termed the rational expectationshypothesis, it has had a dramatic impact onmacroeconomic analysis.




The efficient markets hypothesis is perhaps the mostextensively tested hypothesis in all the social sciences.

If capital markets are efficient, then the market value ofthe firm reflects the present value of the firm’s expectedfuture net cash flows, including cash flows from future

investment opportunities. Thus the efficient markets hypothesis has several

important implications for corporate finance. First, there is no ambiguity about the firm’s objective function:

managers should maximize the current market value of thefirm.3 Hence management does not have to choose betweenmaximizing the firm’s current value or its future value, and there

is no reason for management to have a time horizon that is tooshort.





Second, there is no benefit to manipulating earnings per share.Management decisions that increase earnings but do not affectcash flows represent wasted effort.

Third, if new securities are issued at market prices which reflectan unbiased assessment of future payoffs, then concern aboutdilution or the sharing of positive net present value projects with

new security holders is eliminated. Fourth, security returns are meaningful measures of firmperformance. This allows scholars to use security returns toestimate the effects of various corporate policies and events onthe market value of the corporation.

Beginning with the Fama, Fisher, Jensen and Roll (1969)analysis of the effect of stock splits on the value of the

firm’s shares, this empirical research has produced a richarray of evidence to augment positive theories incorporate finance.





Portfolio Theory

Prior to Markowitz (1952; 1959), little attention was givento portfolio selection.

Security analysis focused on picking undervaluedsecurities; a portfolio was generally taken to be just anaccumulation of these securities.

Markowitz points out that if risk is an undesirable attributefor investors, merely accumulating predicted “winners” isa poor portfolio selection procedure because it ignores theeffect of portfolio diversification on risk.

He analyzes the normative portfolio question: how to pickportfolios that maximize the expected utility of investors

under conditions where investors choose amongportfolios on the basis of expected portfolio return andportfolio risk measured by the variance of portfolio return.




He defines the efficient set of portfolios as those whichprovide both maximum expected return for a givenvariance and minimum variance for a given expectedreturn. His mean-variance analysis provides formalcontent to the meaning of diversification, a measure of thecontribution of the covariance among security returns tothe riskiness of a portfolio, and rules for the constructionof an efficient portfolio.

Portfolio theory implies that the firm should evaluateprojects in the same way that investors evaluatesecurities. For example, there are no rewards or penaltiesper se associated with corporate diversification. (Ofcourse, diversification could affect value by affectingexpected bankruptcy costs and thus net cash flows.)


...Portfolio Theory



Capital Asset Pricing Theory

Treynor (1961), Sharpe (1964), and Lintner (1965) applythe normative analysis of Markowitz to create a positivetheory of the determination of asset prices. Given investordemands for securities implied by the Markowitz mean-variance portfolio selection model and assuming fixedsupplies of assets, they solve for equilibrium securityprices in a single-period world with no taxes.

Although total risk is measured by the variance of portfolioreturns, Treynor, Sharpe, and Lintner demonstrate that inequilibrium an individual security is priced to reflect itscontribution to total risk, which is measured by thecovariance of its return with the return on the marketportfolio of all assets. This risk measure is commonlycalled an assets “systematic” risk.




The simplest form of the capital asset pricing modelyields the following expression for the equilibriumexpected returns, E Rj ( ), on asset j:

E (Rj)= RF + [E (RM)- RF ]β j

where RF is the riskless rate of interest; E (RM) is theexpected return on the market portfolio of all assets;and β j = cov (Rj, RM)/ σ2 (RM), the covariance between

the return on asset j and the, market return divided bythe variance of the market return, is the measure ofsystemic risk of asset j.


...Capital Asset Pricing Theory



Asset-pricing theory defines the opportunitycost of capital for the firm’s capital budgetingdecisions.

Much research has been devoted to

extensions and empirical tests of the model. Jensen (1972) provides a survey of much of

the literature, Roll (1977) offers criticisms oftests of the capital asset pricing model, andSchwert (1983) provides a survey of size-

related deviations of average returns fromthose predicted by the capital asset pricingmodel.






Alternative valuation models such as thearbitrage pricing model suggested by Ross(1976) or the consumption-based assetpricing model suggested by Breeden

(1979) may eventually lead to a betterunderstanding of the structure of securityprices and overcome limitations of thecapital asset pricing model.

However, at this time, each of thesemodels implies that expected returns arerelated to the contribution of a security to aparticular measure of total risk.




Option Pricing Theory

Many important corporate policyproblems require knowledge of thevaluation of assets which, like call

options, have payoffs that are contingenton the value of another asset.

Black and Scholes (1973) provide a key

to this problem in their solution to thecall option valuation problem.




...Option Pricing Theory

An American call option gives the holder theright to buy a stock at a specific exercise priceat any time prior to a specified exercise date.

They note that a risk-free position can be

maintained by a hedge between an option andits stock when the hedge can be adjustedcontinuously through time.

To avoid opportunities for riskless arbitrage

profits, the return to the hedge must equal themarket risk-free rate; this condition yields anexpression for the equilibrium call price.





Black/Scholes note that if the firm’s cash flowdistribution is fixed, the option pricing analysis canbe used to value other contingent claims such as theequity and debt of a levered firm.

In this view the equity of a levered firm is a call

option on the total value of the firm’s assets with anexercise price equal to the face value of the debt andan expiration date equal to the maturity date of thedebt. The Black/Scholes analysis yields a valuationmodel for the firm’s equity and debt.

An increase in the value of the firm’s assetsincreases the expected payoffs to the equity andincreases the coverage on the debt, increasing thecurrent value of both.





An increase in the face value of the debt increases thedebtholder’s claim on the firm’s assets, thus increasing the

value of the debt, and since the stockholders are residualclaimants, reduces the current value of the equity;

An increase in the time to repayment of the debt or in theriskless rate lowers the present value of the debt andincreases the market value of the equity.

An increase in the variance rate or in the time to maturityincreases the dispersion of possible values of the firm at thematurity date of the debt.

Since the debtholders have a maximum payment which theycan receive, an increase in dispersion increases theprobability of default, lowering the value of the debt andincreasing the value of the equity. For a review of thisliterature, see Smith (1976; 1979) and Cox and Ross (1976).




Agency Theory

Narrowly defined, an agency relationship is a contract in which

one or more persons [the principal(s)] engage another person[the agent] to perform some service on their behalf whichinvolves delegating some decision-making authority.

Jensen and Meckling define agency costs as the sum of thecosts of structuring contracts (formal and informal): monitoring

expenditures by the principal, bonding expenditures by the agent,and the residual loss. The residual loss is the opportunity costassociated with the change in real activities that occurs becauseit does not pay to enforce all contracts perfectly.

They argue that the parties to the contracts make rational

forecasts of the activities to be accomplished and structurecontracts to facilitate those activities. At the time the contracts arenegotiated, the actions motivated by the incentives establishedthrough the contracts are anticipated and reflected in thecontracts’ prices and terms.




...Agency Theory

Hence, the agency costs of anyrelationship are born by the parties to thecontracting relationship. This means that

some individuals) can always benefit bydevising more effective ways of reducingthem.

Jensen and Meckling use the agency

framework to analyze the resolution ofconflicts of interest between stockholders,managers, and bondholders of the firm.




In his 1951 book, Capital Budgeting,Dean recommends that the firm makeinvestment decisions by looking to the

capital markets for the firm’s cost of capital, accepting each project with aninternal rate of return that exceeds thismarket-determined cost of capital. (The

internal rate of return is the discount rateat which the present value of the netcash flows equals zero).




Capital Structure Policy

The Irrelevance Proposition In 1958, Modigliani/Miller laid an important foundation for

a positive theory of financial structure by developing theimplications of market equilibrium for optimal debt policy.They demonstrated that given the firm’s investment policyand ignoring taxes and contracting costs, the firm’s choice

of financing policy does not affect the current market valueof the firm.

Their capital structure irrelevance propositiondemonstrates that the firm’s choice of financing policycannot affect the value of the firm so long as it does notaffect the probability distribution of the total cash flows to

the firm. The Modigliani/Miller irrelevance proposition is a special

case of the more general




The Major Areas of Corporate

Financial Policy

CorporateFinancial

Policy

Capital Budgeting CapitalStructure

Dividend Policy


The Theory of Corporate Finance

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