Professional Documents
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Grace S. Thomson
Finance Theories Taxonomy 2
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
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,
Table 1
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
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)
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 &
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,
Finance Theories Taxonomy 5
Conflict arises because shareholders to test relationships between inefficient debt targets.
Agency costs of Free Current theory proposed by Jensen LBOs are another way to both The theory justifies the massive
Finance Theories Taxonomy 6
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)
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
(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
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,
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,
Table 2
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
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
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
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
Model (CAPM) adequate cost of capital in project U.S. firms and an average of market and expected returns (p. 1948).
amount a stock of average risk (Rm) is been challenged (Chen & Dodd, 2002).
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
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).
(Shrieves & Wachovicz, 2001). use of financial techniques Bias against long-lived projects is a
the yield of similar securities in the they use payback criterion. DCF main critiques derive from the use
market (Myers, 2003). Authors argue that most of traditional financial reporting
European firms are small and (Shrieves & Wachovicz, 2001) and the
Internal Return rate (IRR), net present
private, and their CEOs do not vulnerability to political forces within
value (NPV), adjusted present value
have MBA degrees which the organization (Myers, 2001)
(APV) and discounted payback period
could imply an increase use of
are DCF techniques (Brounen et al, The multi-use of DCF is achieved
discounted techniques.
2004) through a combination with Free Cash
The study also found that those Flow (FCF) techniques and with EVA®
Myers (2001) highlights the
firms declaring that they for purposes of evaluation of managerial
usefulness of NPV but cautions about
maximize shareholder value performance (Shrieves & Wachovicz,
Finance Theories Taxonomy 14
the difficulties when defining discount use discounting techniques 2001; Stewart III, 2001).
2001).
Finance Theories Taxonomy 15
Table 3
Theory of the stock Germinal theory discussed by Eugene Following the theory of market Limitations of the model include the
market efficiency Fama (1965) and French (1965) and efficiency Anderson and unreal assumption that information is a
again by Ball and Brown (1968). Garcia-Feijoo (2006) commodity and is costless.
Eugene Fama (1965)
conducted a study to test that
Efficient markets are characterized by International applications of the Fama
firm valuation and valuation
competition among “profit and French model require a country-
ratios respond to optimal
maximizers” who attempt to estimate specific study to observe particular
corporate investment
the value of securities in the future patterns of corporate investment activity
decisions.
relying on the information they have (Anderson & Garcia-Feijoo, 2004, p.
stock (with low book-to market value) resulting from size and book-
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
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
available information”. earnings reports of 300 NYSE Empirical anomalies include problems
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,
Finance Theories Taxonomy 18
Earning per share (EPS). increase in earnings, and slight oversimplifying academic analysis and
base for other theories such as: Miller The conclusion was that stock prices and volumes” (Madhavan, 2002)
The Black-Scholes option Germinal theory proposed by Black New studies have included In a simple definition the model is
pricing model and Scholes (1973) and developed variables that make the model written (Versluis & Hillegers, 2006) as a
Finance Theories Taxonomy 19
along with Merton’s Theory of more adaptive to reality. function with 4 variables:
is based on the assumptions of short- re-financing at the end of the Qt=t = fraction of stocks
“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
Table 4
REMM Theory of Current theory proposed by Meckling Most economists are REMM Corruption in financial markets is
Human Behavior (1976) addresses the concept of “man” individuals who believe that addressed by Brunner and Meckling
(Resourceful, Evaluative, as unit of analysis in economics. It price system is a self- (1977) and explained from the REMM
Maximizing Model) explains man’s behaviors as a result of regulatory mechanism that perspective as the result of corrupted
interactions with value systems and responds to needs and wants. government agencies rather than private
Meckling, 1977)
Table 5
Financial liberalization Current theory originated in the The application of the Liberalization theory was based on
theory of IMF separate work of McKinnon (1973) liberalization theory resulted in strong classical assumptions about the
and Shaw (1973). The hypothesis chaos and crises in developing role of the interest rate. Shaw (1973)
supporting this theory proposed that countries. In 1989 considered interest rates as a signal of
financial development and economic Venezuela’s banking system opportunities of investments, and
growth were strongly attached. The broke and 60% of their assets therefore an increase in economic
systems, the more growth in economic high interest rates would increase
In Mexico, in the late 90s
development. Arestis, Nissanke & savings flows and decrease any excess
government intervention to
Stein (2005). of demands (Arestis, Nissanke & Stein,
solve financial crisis
p. 247).
The liberalization theory was applied represented costs of 17% of the
Finance Theories Taxonomy 24
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).
Finance Theories Taxonomy 25
financial conglomerates,
“Norms, incentives, regulations,
transparency and
capacities and organizations” are five
accountability (p. 22)
institutions of any financial system
have to be socialized.
Finance Theories Taxonomy 26
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