the theory of corporate finance
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A Historical Overview
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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.
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...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.
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The Major Theoretical Building Blocks ofFinancial Economics (Jensen & Smith,
1984)
ModernTheory ofFinance
EfficientMarketTheory
PortfolioTheory
Capital AssetPricingTheory
OptionPricingTheory
AgencyTheory
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The Major Theoretical Building Blocks of FinancialEconomics (Megginson, 1997)
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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
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Teori Keuangan & Tokohnya
02/05/2012 Moh Khoiruddin, S.E., M.Si.
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
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Teori Keuangan & Tokohnya
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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
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Teori Keuangan & Tokohnya
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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
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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.
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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.
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...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.
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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.
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...Efficient Market Theory
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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.
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...Efficient Market Theory
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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.
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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.)
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...Portfolio Theory
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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.
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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.
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...Capital Asset Pricing Theory
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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.
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...Capital Asset Pricing Theory
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...Capital Asset Pricing Theory
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.
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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.
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...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.
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...Option Pricing Theory
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.
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...Option Pricing Theory
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).
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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.
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...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.
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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).
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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
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The Major Areas of Corporate
Financial Policy
CorporateFinancial
Policy
Capital Budgeting CapitalStructure
Dividend Policy
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