The Role of Theory
Normative versus Positive Theory
Major
building blocks of the theory of financial economics:
Efficient
Markets Theory
Bottom Line:
- It is impossible to make economic profits by trading
on available information.
- The market value of the firm is the present value of
the firm's expected future cash flows.
Implications:
- managers should maximize shareholder wealth (i.e. current
share price)
- manipulating accounting earnings is of no value (it's
cash flows that matter)
- concerns about delusive effects of new issues unfounded
(new issue fairly priced)
- security returns are meaningful measures of firm performance
(thus, the motivation for "event studies")
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Portfolio
Theory
"Picking winners" versus
optimal portfolio selection
Bottom Line:
- defined "diversification"
- showed how covariance with portfolio assets affects portfolio
risk
- defined investor's objective function
- for a given level of risk, maximize expected return,
or
- for a given level of expected return, minimize risk
Implications:
- firms should evaluate projects in the same way individuals
do
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Capital
Asset Pricing Theory
Equilibrium model employing portfolio
theory and assuming a fixed supply of assets that solves for asset prices.
Bottom Line:
- only "systematic risk" is relevant
Implication:
- the opportunity cost of capital of a firms project is
determined by the systematic risk of the project
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Option
Pricing Theory
Used to value assets whose value
is contingent on the future value of another asset.
Bottom Line:
- if cash flows fixed, option pricing theory can be used
to value contingent claims such as equity and debt
Implication:
- the factors that affect option values also affect the
value of claims like equity and debt
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Agency
Theory
Analyses of conflicts of interest
between contracting parties as well as the contracting measures (and their
associated costs) they take to overcome those conflicts.
Bottom Line:
- conflicts of interest (different incentives) are associated
with real costs
- monitoring costs
- bonding costs
- residual loss
Implication:
- contracting parties can benefit from devising more effective
ways of overcoming these conflicts of interest
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Economic
Darwinism
Firms that can supply a demanded
product for the lowest price while covering costs will survive (i.e., not
fail).
Bottom Line:
- "efficient" firms survive
Implication:
- when we examine systematic differences in financial policies
across firms, we assume that the systematic differences exist as a function
of the underlying nature of the firm and its contracting environment.
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