Financial Theories Overview
Financial Theories Overview
This paper will include an overview of 10 financial theories incorporating both germinal and current research. In addition, each financial theory will include a general description, current examples, and significant attributes.
Table 1
Financial Theories Financial Theories | Description | Current Examples | Significant Attributes | 1. Efficiency Theory | Eugene Fama defined efficient markets as “a market where there are large numbers of rational profit-maximizers actively competing, with each trying to predict future market values of individuals securities, and where important current information is almost freely available to all participants” (Ball, 2001, p. 23). |
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10-11). John Roth, former chief executive officer (CEO) of Nortel, wrote off most acquisitions, when stock price crashed and closed down activities, which resulted in the destruction of not only the corporate value but also the social value of the company (Jensen, 2005). | Finance scholars found a reduction in conflict of interest between management and shareholders because of: (1) product market competition and a market for executive labor, (2) management incentive plans, and (3) an operating takeover market (Chew, 2001). | 4. Agency Costs of Free Cash Flow Theory | In 1986, Michael Jensen introduced the theory and defined it as follows: “Leveraged acquisitions, stock repurchases, and management buyouts of public companies were adding value to corporations by squeezing capital out of organizations that had few profitable growth opportunities” (Chew, 2001, p. xviii) | Chew explains before the hostile takeovers in the 1980s, corporate managers in mature industries reinvested excess capital, and in the worst-case scenario, diversified into unrelated businesses (2001).In addition, in the early 80s, oil companies that faced a massive free cash flow problem chose to reinvest excess capital and diversify into unrelated businesses (Chew, 2001). | Leverage is an option to reduce free cash flows and the agency costs associated
Capital markets provide a function which facilitates the buying and selling of long-term financial securities to increase liquidity and their value, Watson & Head (2013). Hence, the Efficient Market Hypothesis (EMH) explains the relationship that exists with the prices of the capital market securities, where no individual can beat the market by regularly buying securities at a lower price than it should be. This means that in order to be an efficient market prices of securities will have to fairly and fully reflect all available information, Fama (1970). Consequently, Watson & Head (2013) believe that market efficiency refers to the speed and quality of how share price adjusts to new information. Nevertheless, the testing of the efficient markets has led to the recognition of three different forms of efficiency in which explains how information available is used within the market. In this essay, the EMH will be analysed; testing of EMH will show that the model does provide strong evidence to explain share behaviour but also anomalies will be discussed that refutes the EMH. Therefore, a judgment will be made to see which structure explains the efficient market and whether there are some implications with the EMH, as a whole.
The basis of Efficient Market theory is considered to have a gap in theory and practice that
Managers and shareholders are the utmost contributors of these conflicts, hence affecting the entire structural organization of a company, its managerial system and eventually to the company's societal responsibility. A corporation is well organized with stipulated division of responsibilities among the arms of the organizational structure, shareholders, directors, managers and corporate officers. However, conflicts between managers in most firms and shareholders have brought about agency problems. Shares and their trade have seen many companies rise to big investments. Shareholders keep the companies running
This situation can lead to negative consequences for a business when its executives or management direct the organization to act in the best interest of themselves instead of the best interest of its owners or shareholders. Stockholders of the enterprise can keep this problem from arises by attempting to align the interest of management with that of themselves. This normally occurs through incentive pay, stock compensation, or other similar incentive packages that now cause the managers financial success to be tied to that of the company (Garcia, Rodriguez-Sanchez, & Fdez-Valdivia, 2015; Cui, Zhao, & Tang, 2007; Bruhl, 2003; Carols & Nicholas,
This was the case, for instance, with the leveraged buyouts of firms such as RJR Nabisco in the 1980s. Figure 26.1 summarizes the various transactions and the consequences for the target firm.
Once the goal of corporations became maximizing the value of the firm, they attracted wealthy “corporate raiders”, who used this new corporate philosophy to launch many takeover attempts on companies, with the intent on restructuring these companies, as to increase their stock prices, so that they can “refloat” them for a considerable profit. Most of these takeovers were financed with borrowed money, hence the term leveraged buyouts, or LBOs. As the article states, “In a typical LBO, the acquirer would buy out the public stockholders and run the company as a private concern, slashing costs and slimming it down. The ultimate aim was to refloat the company on the stock market at a higher valuation”. Initially this was seen as one of the best remedies for the agency issues that surfaced between shareholders and mangers. However as the economic climate changed, many realized that the LBO was not the answer. “When the economy went into a recession during the early nineteen nineties, many of the firms that had gone private, such as Macy’s and Revco, couldn’t keep up their interest
* An efficient market is a market in which all the available information is fully incorporated into
The efficient markets theory, according to NASDAQ (n.d.) is the, “Principle that all assets are correctly priced by the market, and that there are no bargains,” (para. 1). This theory implies that supply and demand dictate the reasonable market value for products. Without high demand, the supply will be greater and prices will be lower. Respectively, as demand increases so do the prices until the supply and demand are at equilibrium.
Efficient Market- Advertises in which security prices return all available information and adjust right away to any fresh information. If the safekeeping markets are truly well
Circon Corporation, a medical device maker was founded and led by Mr. Richard Auhll, who was also acting as the Chairman of the Circon Board.(p. 1) Mr. Auhll a aerospace engineer had rediscovered himself by pursuing his Harvard MBA to start his management journey in a technology company heading a small division Circon. By mid-1970, Mr. Auhll retransformed Circon into a successful medical device manufacturing company on the strong basis of innovative product line and superior quality. He acquired Circon for $1.1 million (p. 3) and eventually took it public in 1983. Circon saw the superior growth under the passionate leadership of Mr. Auhll. Mr. Auhll was
* A broader capital base gives the company more access to credit which gives the company an option to venture into new business opportunities
Efficient capital market “It was generally believed that securities markets were extremely efficient in reflecting information about the stock market as a whole” (Fama 1970). To extent that when there is new information about stock rise, the news was dispersed immediately and it affects the security 's price at that time.
The important implication of this is that investors cannot consistently outperform the market, and if they do it is purely through luck. With competition for information reaching new heights, professional managers face greater difficulties in attempting to outperform each other. If these professionals are unable to consistently beat the market, there remains little hope for the average investor.
Last but not least important, an efficient capital market is one in which stock prices fully reflect all available information. However, the paradox is that since information is reflected in security prices quickly, knowing information when it is released does an investor little good. Furthermore, it is impossible to create a portfolio which would earn extraordinary risk adjusted return. As a consequence, all the technical and fundamental analysis are useless, no one can consistently outperform the market, and new
“Corporate finance theory, teaching and the typically recommended practice at least in the US are all built on the premise that the primary goal of a corporation should be the maximization of shareholder value.”