Financial Theories Overview

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  • Topic: Capital asset pricing model, Finance, Stock
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  • Published : August 26, 2010
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Financial Theories Overview
Velda Eaton
University of Phoenix – School of Advanced Studies

Financial Theories Overview
Theory| General Description| Current Examples| Significant Attributes| Efficiency Theory| The germinal theory proposed by Fama (1965) states An efficient market is where there are large numbers of rational profit-maximizers actively competing trying to predict future market values from new information on inherent values to be reflected immediately in actual prices. Market efficiency is the ability to allocate capital effectively, by pricing securities solely by economic considerations based on available information (Weaver-Weston, 2002).| The Information Highway: the World Wide Web and the Securities & Exchange Commission (SEC) provide information on large trading firms accessing and acting on stock transaction data before the merged trade data is published (Ross−Westerfield−Jaffe, 2008). | Information is feelessly incorporated into prices, it is impossible to profit from news as already priced into the stock (Ball, 2001), and high-speed traders have the advantage, which is estimated to account for two-thirds of all stock market volume (Ross−Westerfield−Jaffe, 2008). | Theory of Investment| This germinal theory depicts that dividends and capital structures are irrelevant in the determination of stock prices in the market. (Miller-Modigliani, 1958; Chew, 2001). Instead the market value of a firm is based on the earning power of the assets currently held and on the size and relative profitability of the investment opportunities, which is independent of its capital structure. (Miller-Modigliani, 1958| Junk bonds have provide vitality in the market and have aided in the development of the preference forLeveraged Buyouts (LBOs) (Chew, 2001). The new characteristics in corporate governance followed the LBOs of large firms. Chew (2001) states strip financing as one.| Miller-Modigliani (1958) assumed the market was perfect and the information was complete and symmetric, when it was not. There was a simple acceptance of firms with high-levels of debt trading off for tax deductible benefits with an assumption that investment decisions were not influenced by financial decisions.(Ball, 2001).| Agency Cost Theory| Germinal Theory proposed by Jensen-Meckling (1976) that analyzes the conflict between shareholders and managers- agents of shareholders. Since managers are compensated on the basis of accounting profits, it increases the incentives to influence information to be favorable or unfavorable with poor net present value if they provide immediate profits (Dogan & Smyth, 2002). | A study conducted by Dogan-Smyth (2002) of 223companies listed in the Kuala Lumpur Stock Exchange (KLSE) using this theory to test relationships among corporate performance, performance criteria and executive compensation. The results showed a positive rapport between board compensation and firm performance. The results were weaker in Malaysia than in U.K. or U.S. | The desire for high rewards persuades executives to manipulate, overrate, or underrate indicators to make them more attainable in loss of the value of the firm such as low budgets and inefficient debt targets. As evidenced by Jensen-Meckling (1976), 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 lessen management self-interest.| Agency Costs of Free Cash Flow Theory| Theory is considered to be current and built upon the Jensen-Meckling’s Agency Cost Theory (1976). The Free Cash Flow Theory (FCF) is the cash flow in surplus of what is required to fund all projects that have positive net present value when discounted at the relevant cost of capital (Stewart, 2001).| LBOs are another way to both lessen the agency costs of free cash flow and impose discipline and efficiency;...
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