MAR

24

THEORIES IN FINANCIAL MANAGEMENT

1. AGENCY THEORY
Agency theory suggests that the firm can be viewed as a nexus of contracts
(loosely defined) between resource holders. An agency relationship arises
whenever one or more individuals, called principals, hire one or more other
individuals, called agents, to perform some service and then delegate decision-
making authority to the agents. The primary agency relationships in business are
those (1) between stockholders and managers and (2) between debt-holders and
stockholders. These relationships are not necessarily harmonious; indeed, agency
theory is concerned with so-called agency conflicts, or conflicts of interest between
agents and principals. This has implications for, among other things, corporate
governance and business ethics. When agency occurs it also tends to give rise to
agency costs, which are expenses incurred in order to sustain an effective agency
relationship (e.g., offering management performance bonuses to encourage
managers to act in the shareholders' interests i.e., SWM). Accordingly, agency
theory has emerged as a dominant model in the financial economics literature, and
is widely discussed in business ethics texts.
CONFLICTS BETWEEN MANAGERS AND SHAREHOLDERS
Agency theory raises a fundamental problem in organizations—self-interested
behaviour. A corporation's managers may have personal goals that compete with
the owner's goal of maximization of shareholder wealth. Since the shareholders
authorize managers to administer the firm's assets, a potential conflict of interest
exists between the two groups.
SELF-INTERESTED BEHAVIOR
Agency theory suggests that, in imperfect labour and capital markets, managers
will seek to maximize their own utility at the expense of corporate shareholders.
Agents have the ability to operate in their own self-interest rather than in the best
interests of the firm because of asymmetric information (e.g., managers know
better than shareholders whether they are capable of meeting the shareholders'
objectives) and uncertainty (e.g., myriad factors contribute to final outcomes, and it
may not be evident whether the agent directly caused a given outcome, positive or
negative). Evidence of self-interested managerial behaviour includes the
consumption of some corporate resources in the form of perquisites and the
avoidance of optimal risk positions, whereby risk-averse managers bypass
profitable opportunities in which the firm's shareholders would prefer they invest.
Outside investors recognize that the firm will make decisions contrary to their best
interests. Accordingly, investors will discount the prices they are willing to pay for
the firm's securities.
A potential agency conflict arises whenever the manager of a firm owns less than
100 percent of the firm's common stock. If a firm is a sole proprietorship managed
by the owner, the owner-manager will undertake actions to maximize his or her
own welfare. The owner-manager will probably measure utility by personal
wealth, but may trade off other considerations, such as leisure and perquisites,
against personal wealth. If the owner-manager forgoes a portion of his or her
ownership by selling some of the firm's stock to outside investors, a potential
conflict of interest, called an agency conflict, arises. For example, the owner-
manager may prefer a more leisurely lifestyle and not work as vigorously to
maximize shareholder wealth, because less of the wealth will now accrue to the
owner-manager. In addition, the owner-manager may decide to consume more
perquisites, because some of the cost of the consumption of benefits will now be
borne by the outside shareholders.
In the majority of large publicly traded corporations, agency conflicts are
potentially quite significant because the firm's managers generally own only a
small percentage of the common stock. Therefore, shareholder wealth
maximization could be subordinated to an assortment of other managerial goals.
For instance, managers may have a fundamental objective of maximizing the size
of the firm. By creating a large, rapidly growing firm, executives increase their
own status, create more opportunities for lower- and middle-level managers and
salaries, and enhance their job security because an unfriendly takeover is less
likely. As a result, incumbent management may pursue diversification at the
expense of the shareholders who can easily diversify their individual portfolios
simply by buying shares in other companies.
Managers can be encouraged to act in the stockholders' best interests through
incentives, constraints, and punishments. These methods, however, are effective
 only if shareholders can observe all of the actions taken by managers. A moral
hazard problem, whereby agents take unobserved actions in their own self-
interests, originates because it is infeasible for shareholders to monitor all
managerial actions. To reduce the moral hazard problem, stockholders must incur
agency costs.
COSTS OF SHAREHOLDER-MANAGEMENT CONFLICT
Agency costs are defined as those costs borne by shareholders to encourage
managers to maximize shareholder wealth rather than behave in their own self-
interests. The notion of agency costs is perhaps most associated with a seminal
1976 Journal of Finance paper by Michael Jensen and William Meckling, who
suggested that corporate debt levels and management equity levels are both
influenced by a wish to contain agency costs. There are three major types of
agency costs:
1. Expenditures to monitor managerial activities, such as audit costs;
2. Expenditures to structure the organization in a way that will limit undesirable
managerial behaviour, such as appointing outside members to the board of
directors or restructuring the company's business units and management hierarchy;
and
3. Opportunity costs which are incurred when shareholder-imposed restrictions, such
as requirements for shareholder votes on specific issues, limit the ability of
managers to take actions that advance shareholder wealth.
In the absence of efforts by shareholders to alter managerial behaviour, there will
typically be some loss of shareholder wealth due to inappropriate managerial
actions. On the other hand, agency costs would be excessive if shareholders
attempted to ensure that every managerial action conformed to shareholder
interests. Therefore, the optimal amount of agency costs to be borne by
shareholders is determined in a cost-benefit context—agency costs should be
increased as long as each incremental dollar spent results in at least a dollar
increase in shareholder wealth.
MECHANISMS FOR DEALING WITH SHAREHOLDER-MANAGER
CONFLICTS
There are two polar positions for dealing with shareholder-manager agency
conflicts. At one extreme, the firm's managers are compensated entirely on the
basis of stock price changes. In this case, agency costs will be low because
managers have great incentives to maximize shareholder wealth. It would be
extremely difficult, however, to hire talented managers under these contractual
terms because the firm's earnings would be affected by economic events that are
not under managerial control. At the other extreme, stockholders could monitor
every managerial action, but this would be extremely costly and inefficient. The
optimal solution lies between the extremes, where executive compensation is tied
to performance, but some monitoring is also undertaken. In addition to monitoring,
the following mechanisms encourage managers to act in shareholders' interests: (1)
performance-based incentive plans, (2) direct intervention by shareholders, (3) the
threat of firing, and (4) the threat of takeover.
In the past, the likelihood of a large company's management being ousted by its
stockholders was so remote that it posed little threat. This was true because the
ownership of most firms was so widely distributed, and management's control over
the voting mechanism so strong, that it was almost impossible for dissident
stockholders to obtain the necessary votes required to remove the managers. In
recent years, however, the chief executive officers at American Express Co.,
General Motors Corp., IBM, and Kmart have all resigned in the midst of
institutional opposition and speculation that their departures were associated with
their companies' poor operating performance.
Hostile takeovers, which occur when management does not wish to sell the firm,
are most likely to develop when a firm's stock is undervalued relative to its
potential because of inadequate management. In a hostile takeover, the senior
managers of the acquired firm are typically dismissed, and those who are retained
lose the independence they had prior to the acquisition. The threat of a hostile
takeover disciplines managerial behaviour and induces managers to attempt to
maximize shareholder value.

2. EXPECTATION THEORY
The simplest of interest rate theories is the pure expectations theory which assumes
that the term structure of an interest contract only depends on the shorter term
segments for determining the pricing and interest rate of longer maturities. It
assumes that yields at higher maturities (such as that of 5, 10, or 30 year bonds),
correspond exactly to future realized rates, and are compounded from the yields on
shorter maturities. In other words, buying a ten year bond is equal to buying two
five year bonds in succession; you're as safe in a ten-year as in a five-year bond. At
a cursory consideration, this should indeed be the case. For instance, with the
government securities in the U.S. the only risk and rewards are born of the interest
rate return on the lent amount. There is no significant risk of default associated in
the transaction. Pure expectation theory also supposes that expectations of future
rates coincide exactly with future rates realized in time. The market is a perfect
predictor of future supply and demand. The pure expectations theory is in some
ways similar to the efficient market hypothesis, in that it assumes a perfect market
environment where expectations are just about the only determinant of future
prices.
From these basic assumptions, the pure expectations theory (PET) posits that
future interest rates on longer maturities depend only the rates of previous periods.
To calculate the yields on a 3-year bond, for example, all that you need to do is to
take the geometric mean of one-year yields on the first, second, and third years;
there's no external component independent of the yields that goes into the
calculation of the yield curve. The term structure is substitutable. A contract on a
three-year term serves exactly the same purpose as one on 3-months aside from the
difference in interest rates, and as such, it is valued as if made of successive
contracts combined to form the rate on the third year. You can either a buy a two-
year bond, or two one year bonds successively, the result will be the same with
respect to return.
The yield curve shows the various yields that are currently being
offered on bonds of different maturities. It enables investors at a quick glance to
compare the yields offered by short-term, medium-term and long-term bonds.
The yield curve can take three primary shapes. If short-term yields are lower than
long-term yields (the line is sloping upwards), then the curve is referred to a
positive (or "normal") yield curve. Below you will find an example of a normal
yield curve.

The expectation theory supports the upward sloping yield curve since investors
always expect the short-term rates to increase in the future. This implies that the
long-term rates will be higher than the short-term rates. But in the present value
terms, the return from investing in a long-term security will equal to the return
from investing in a series of a short-term security.
It is not hard to see that the pure expectations theory is similar to a pure intellectual
exercise. It is rare to achieve the perfect results of this theory where today's
predicted rates over different maturities exactly match future realized spot rates. In
addition, although the theory explains the simultaneous movement of rates, and
also the relationship between the long and short terms well, it does not say
anything about why the yield curve has an upward slope most of the time, that is,
why longer term maturities command a higher interest rate in comparison to the
short term. Since we noted that all maturities are equivalent in function, the slope
is equally likely to be upwards as downwards (in tune with the boom-bust cycle,
and rising and falling future rate expectations.), but this is not the case. Clearly,
investors attach a higher risk to longer maturities due to some intrinsic factor not
explained or predicted by the pure expectations theory.

3. LIQUIDITY PREFERENCE THEORY

The pure expectations theory is unable to explain why short-term yields are
typically lower than longer-term yields most of the time. Since PET assumes rates
across the maturity spectrum to be equivalent in quality and function, we'd expect a
homogenous distribution of both downward and upward sloping yield curves, but
we most of the time get the upward slope. The liquidity preference theory was
devised to explain this situation.
This theory introduces the concept of a risk or liquidity premium to the equation
for predicting future rates. It posits that, while the term structure (the mathematica;
formula defining the yield curve) of interest rate contracts are substitutable for the
most part for different maturities (i.e. a ten-year bond is partially a substitute for
two consecutive five-year bonds purchased), there is a risk factor that leads to the
yield curve to be upward sloping most of the time. Thus, even if the interest rate
expectations were the same across the entire spectrum of maturities, the yield curve
would still be sloping upwards due to the inherent risk of acquiring a debt
instrument at a longer maturity.
The risk premium is the result of lesser liquidity of long maturity interest rate
contracts, as well as the higher risk of default the more we delay the date the
repayment. In a two-way relationship, the lower marketability of long-term
instruments leads to their lower liquidity, and that also contributes to a higher
interest rate on a consistent basis.
Liquidity preference theory is essentially an improved version of the pure
expectations theory. It maintains the former's postulate that different maturities are
substitutable, but adds that they are only partially so. There is a small qualitative
difference between long and short term debt instruments, quantified in the risk
premium, which leads to the sloping upward curve, and the observed phenomenon
of higher rates at higher maturities most of the time.
The risk premium of the LPT assumes that all investors have similar preferences,
and for practical and easily understood reasons, choose to demand additional
compensation at higher maturities for higher risk. But what if different investors do
not equally value each segment of the maturity structure at the same degree? In
other words, what if there are inherent, qualitative differences between maturities
as perceived by investors, which leads to the conclusion that different maturities
are not substitutable to each other in terms of the role that they play in investor
portfolios? This supposition is the subject of the market segmentation theory.

4. MARKET SEGMENTATION THEORY

The third approach to the valuation of bonds is radically different from the two
previous approaches. Both the liquidity preference theory, and the expectations
theory depend strongly on the presumption that debt instruments of different
maturities are only distinguished by their return, and that purchasing a two-year
bond is essentially equivalent to buying two one year bonds in succession, since
the market efficiently predicts future rates in the time horizon in question. Market
segmentation theory does away with this approximation (since we all know that
future rates as predicted by bonds and realized in the spot market do not exactly
match each other), and discusses each separate maturity term as being independent
of the others. In other words, we should not speak of a bond market, but rather of
two-year, five-year, ten-year bond markets, since the roles played by these
instruments are not equivalent in any way. Each maturity term is fulfilling a
different function, with a different investor profile, and thus is a unique product,
far from being a tool of convenience for those who would prefer to hold a single
contract instead of renewing each short term one in succession, as suggested by the
expectations theory.
MST posits that each borrower and lender have a particular timeframe in mind
when purchasing or selling a debt instrument. An investment bank may be buying
or selling a government bond in the short term in order to profit from interest rate
changes that could be announced by a central bank. A construction firm may desire
to sell ten-year bonds in order to repay them when the construction project is
finished and there is abundant liquidity to meet the demands of the creditor.
Similarly, a student would prefer to borrow on a long-term basis in order to meet
his obligations after graduation, when he'll have ample financial capability to pay
his debts.
The market segmentation theory allows us to incorporate the depth of the market
into our understanding of the term structure of debt instruments, and in a way,
takes the two-dimensional LPT or the expectations theories, and gives them the
third dimension of investor preferences. Thus, the risk premium discussed in the
context of the liquidity preference theory is not just something demanded by the
lender (supply side), but also eagerly provided by the borrower (the demand side)
due to his preference for longer term maturities which allow better returns on
investments as a result of the greater freedom enjoyed in business decisions and
planning (you can plan for the longer term since repayment is a long way away
from now). A greater number of lenders cluster around the short-side of the yield
curve due to lower risk and higher liquidity, leading to lower yields, while a
greater number of borrowers tend to group at longer maturities, due to the greater
flexibility that they enjoy while making use of the funds, which leads to greater
demand for borrowing, and higher rates, as a consequence. This supply demand
segmentation of the market leads to the observed slope of the yield curve where the
shorter term maturities are coupled to lower rates most of the time.
The advantage of this theory is that it succeeds where the other two theories fail. It
can easily explain while the yield curve slopes upwards most of the time, but does
not say anything about why rates move up or down simultaneously across the
maturity scale. Since each maturity term constitutes a separate market, we would
expect their interest rates to move independently up or down, with no obvious
relationship, but that, of course, contradicts the well-known and easily observed
relationships in the market.
To combine the market segmentation theory with the better aspects of the liquidity
preference theory, the preferred habitat theory was developed.
 5. PREFERRED HABITAT THEORY
Both the expectations theory and the market segmentation theory fail to explain
some observed phenomena in the market satisfactorily. The preferred habitat
theory is a combination, a synthesis of those two theories created in order to
explain the interest rate-maturity term relationship.
The preferred habitat theory posits that although investors prefer a certain segment
of the market in their transactions based on term structure (the yield-maturity plot
of the debt instrument showing which yield matches which maturity, another term
for the yield curve) and risk, they are often prepared to step out of this desired
segment if they are adequately compensated for the decision. But they will never
prefer a long term instrument over a short term contract with the same interest rate.
Thus, maturity structure does lead to some fundamental differences in investor
behaviour, but there is always a price at which all maturities will provide the same
attractiveness to a potential investor. In other words, a sufficiently high interest
rate will lead market actors to attach greater value to a less-preferred, unusual
maturity, leading to the usual upward sloping shape of the yield curve. The market
is segmented, but only partially so, interest rates do add up over longer maturities,
but once again, only in part.
The major conclusions of the preferred habitat theory are as follows:
1. If the yield curve slopes upward, investors do not expect any major changes in
interest rates. Rates may go higher, but they may also remain the same, with the
upward slope reflecting the risk premium. In other words, the prevailing conditions
are expected to continue (provided that the economy is growing).
2. If the yield curve is sloping downward, short interest rates are expected to fall.
Since at higher maturities we'd expect interest rates to be higher, but get them
lower in a downward slope, the only possible conclusion is that rates will fall so
much that they will be lower than today's rates even with the risk premium added.
3. If the yield curve is flat, the market is expecting future rates to come down
slightly. Interest rates must fall in the future, so that the yield curve may remain
flat even with the risk premium added on top of future prices.
The preferred habitat theory is the modern interest rate theory explaining the yield
curve. It was developed in the post-Nixon era to meet the difficulties arising in the
fiat currency systems, and remains a valid tool today.
6. MODERN PORTFOLIO THEORY
Modern portfolio theory (MPT) is a theory of investment which attempts to
maximize portfolio expected return for a given amount of portfolio risk, or
equivalently minimize risk for a given level of expected return, by carefully
choosing the proportions of various assets. Although MPT is widely used in
practice in the financial industry and several of its creators won a Nobel memorial
prize for the theory, in recent years the basic assumptions of MPT have been
widely challenged by fields such as behavioural economics.
MPT is a mathematical formulation of the concept of diversification in investing,
with the aim of selecting a collection of investment assets that has collectively
lower risk than any individual asset. That this is possible can be seen intuitively
because different types of assets often change in value in opposite ways. For
example, to the extent prices in the stock market move differently from prices in
the bond market, a collection of both types of assets can in theory face lower
overall risk than either individually. But diversification lowers risk even if assets'
returns are not negatively correlated—indeed, even if they are positively
correlated.
More technically, MPT models an asset's return as a normally distributed function
(or more generally as an elliptically distributed random variable), defines risk as
the standard deviation of return, and models a portfolio as a weighted combination
of assets so that the return of a portfolio is the weighted combination of the assets'
returns. By combining different assets whose returns are not perfectly positively
correlated, MPT seeks to reduce the total variance of the portfolio return. MPT also
assumes that investors are rational and markets are efficient.
MPT was developed in the 1950s through the early 1970s and was considered an
important advance in the mathematical modelling of finance. Since then, many
theoretical and practical criticisms have been levelled against it. These include the
fact that financial returns do not follow a Gaussian distribution or indeed any
symmetric distribution, and that correlations between asset classes are not fixed but
can vary depending on external events (especially in crises). Further, there is
growing evidence that investors are not rational and markets are not efficient.
CONCEPT
 The fundamental concept behind MPT is that the assets in an
investment portfolio should not be selected individually, each on their own merits.
Rather, it is important to consider how each asset changes in price relative to how
every other asset in the portfolio changes in price.
Investing is a trade-off between risk and expected return. In general, assets with
higher expected returns are riskier. For a given amount of risk, MPT describes how
to select a portfolio with the highest possible expected return. Or, for a given
expected return, MPT explains how to select a portfolio with the lowest possible
risk (the targeted expected return cannot be more than the highest-returning
available security, of course, unless negative holdings of assets are possible.)
MPT is therefore a form of diversification. Under certain assumptions and for
specific quantitative definitions of risk and return, MPT explains how to find the
best possible diversification strategy.
RISK AND EXPECTED RETURN
MPT assumes that investors are risk averse, meaning that given two portfolios that
offer the same expected return, investors will prefer the less risky one. Thus, an
investor will take on increased risk only if compensated by higher expected
returns. Conversely, an investor who wants higher expected returns must accept
more risk. The exact trade-off will be the same for all investors, but different
investors will evaluate the trade-off differently based on individual risk aversion
characteristics. The implication is that a rational investor will not invest in a
portfolio if a second portfolio exists with a more favourable risk-expected return
profile – i.e., if for that level of risk an alternative portfolio exists which has better
expected returns.
Note that the theory uses standard deviation of return as a proxy for risk, which is
valid if asset returns are jointly normally distributed or otherwise elliptically
distributed. There are problems with this, however.
Under the model:
 Portfolio return is the proportion-weighted combination of the constituent assets'
returns.
 Portfolio volatility is a function of the correlations ρij of the component assets, for
all asset pairs (i, j).
DIVERSIFICATION
 An investor can reduce portfolio risk simply by holding combinations of
instruments which are not perfectly positively correlated (correlation coefficient )).
In other words, investors can reduce their exposure to individual asset risk by
holding a diversified portfolio of assets. Diversification may allow for the same
portfolio expected return with reduced risk.
If all the asset pairs have correlations of 0—they are perfectly uncorrelated—the
portfolio's return variance is the sum over all assets of the square of the fraction
held in the asset times the asset's return variance (and the portfolio standard
deviation is the square root of this sum).
The MPT does not take its own effect on asset prices into account.
Diversification eliminates non-systematic risk, but at the cost of increasing
the systematic risk. Diversification forces the portfolio manager to invest in assets
without analyzing their fundamentals; solely for the benefit of eliminating the
portfolio’s non-systematic risk (the CAPM assumes investment in all available
assets). This artificially increased demand pushes up the price of assets that, when
analyzed individually, would be of little fundamental value. The result is that the
whole portfolio becomes more expensive and, as a result, the probability of a
positive return decreases (i.e. the risk of the portfolio increases).
Empirical evidence for this is the price hike that stocks typically experience once
they are included in major indices like the S&P 500.
WHY IS IT IMPORTANT?
So why do we care about modern portfolio theory, a dead economist named
Markowitz, or something called an efficient frontier? It is simply because that you
can use this approach to lower your risk (portfolio variance) while maintaining (or
increasing) your expected returns. Which of the following portfolios would you
prefer?
 A mix of stocks and bonds that returned an average of 7% per year, but varied by
as much as 10% per year (i.e., returns varied typically between -3% and +17%)
 A mix of stocks and bonds that returned an average of 7% per year, but varied by
only 2% per year (i.e., returns varied typically between 5% and 9%)
Although an annual return of 17% sounds good, keep in mind that it is also as
likely that you'll lose 3%! A less volatile return of between 5% and 9% may be
less exciting but will get you closer to your retirement goals faster.
7.ARBITRAGE PRICING THEORY
Arbitrage pricing theory (APT) in finance is a general theory of asset pricing that
holds that the expected return of a financial asset can be modeled as a linear
function of various macro-economic factors or theoretical market indices, where
sensitivity to changes in each factor is represented by a factor-specific beta
coefficient. The model-derived rate of return will then be used to price the asset
correctly - the asset price should equal the expected end of period
price discounted at the rate implied by the model. If the price
diverges, arbitrage should bring it back into line.
The theory was initiated by the economist Stephen Ross in the year 1976.
THE CONCEPT OF ARBITRAGE
Arbitrage is the practice of taking positive expected return from overvalued or
undervalued securities in the inefficient market without any incremental risk and
zero additional investments.
ARBITRAGE MECHANICS
In the APT context, arbitrage consists of trading in two assets – with at least one
being mis-priced. The arbitrageur sells the asset which is relatively too expensive
and uses the proceeds to buy one which is relatively too cheap.
Under the APT, an asset is mis-priced if its current price diverges from the price
predicted by the model. The asset price today should equal the sum of all future
cash flows discounted at the APT rate, where the expected return of the asset is a
linear function of various factors, and sensitivity to changes in each factor is
represented by a factor-specific beta coefficient.
A correctly priced asset here may be in fact a synthetic asset -
a portfolio consisting of other correctly priced assets. This portfolio has the same
exposure to each of the macroeconomic factors as the mis-priced asset. The
arbitrageur creates the portfolio by identifying x correctly priced assets (one per
factor plus one) and then weighting the assets such that portfolio beta per factor is
the same as for the mis-priced asset.
When the investor is long the asset and short the portfolio (or vice versa) he has
created a position which has a positive expected return (the difference between
asset return and portfolio return) and which has a net-zero exposure to any
macroeconomic factor and is therefore risk free (other than for firm specific risk).
The arbitrageur is thus in a position to make a risk-free profit:
Where today's price is too low:
 The implication is that at the end of the period the portfolio would have
appreciated at the rate implied by the APT, whereas the mis-priced asset would
have appreciated at more than this rate. The arbitrageur could therefore:
Today:
1. short sell the portfolio
2. buy the mis-priced asset with the proceeds.
At the end of the period:
1. sell the mis-priced asset
2. use the proceeds to buy back the portfolio
3. Pocket the difference.

Where today's price is too high:

The implication is that at the end of the period the portfolio would have
appreciated at the rate implied by the APT, whereas the mis-priced asset would
have appreciated at less than this rate. The arbitrageur could therefore:
Today:
1. short sell the mis-priced asset
2. Buy the portfolio with the proceeds.
At the end of the period:
1. sell the portfolio
2. use the proceeds to buy back the mis-priced asset
3. Pocket the difference.

8. CAPITAL ASSET PRICING MODEL

In finance, the capital asset pricing model (CAPM) is used to determine a
theoretically appropriate required rate of return of an asset, if that asset is to be
added to an already well-diversified portfolio, given that asset's non-
diversifiable risk. The model takes into account the asset's sensitivity to non-
diversifiable risk (also known as systematic risk or market risk), often represented
by the quantity beta (β) in the financial industry, as well as the expected return of
the market and the expected return of a theoretical risk-free asset.
The model was introduced by Jack Treynor (1961, 1962), William
Sharpe (1964), John Lintner (1965) and Jan Mossin (1966) independently, building
on the earlier work of Harry Markowitz on diversification and modern portfolio
 theory. Sharpe, Markowitz and Merton Miller jointly received the Nobel Memorial
Prize in Economics for this contribution to the field of financial economics.
THE FORMULA
The Security Market Line, seen here in a graph, describes a relation between the
beta and the asset's expected rate of return
The CAPM is a model for pricing an individual security or a portfolio. For
individual securities, we make use of the security market line (SML) and its
relation to expected return and systematic risk (beta) to show how the market must
price individual securities in relation to their security risk class. The SML enables
us to calculate the reward-to-risk ratio for any security in relation to that of the
overall market. Therefore, when the expected rate of return for any security is
deflated by its beta coefficient, the reward-to-risk ratio for any individual security
in the market is equal to the market reward-to-risk ratio, thus:
The market reward-to-risk ratio is effectively the market risk premium and by
rearranging the above equation and solving for E (Ri), we obtain the Capital Asset
Pricing Model (CAPM).
Where,
 is the expected return on the capital asset
 is the risk-free rate of interest such as interest arising from government bonds
 is the sensitivity of the expected excess asset returns to the expected excess
market returns, or also ,
 is the expected return of the market
 is sometimes known as the market premium(the difference between the expected
market rate of return and the risk-free rate of return).
 is also known as the risk premium
Restated, in terms of risk premium, we find that:
This states that the individual risk premium equals the market premium times β.
Note 1: the expected market rate of return is usually estimated by measuring
the Geometric Average of the historical returns on a market portfolio (e.g. S&P
500).
Note 2: the risk free rate of return used for determining the risk premium is usually
the arithmetic average of historical risk free rates of return and not the current risk
free rate of return.
RISK AND DIVERSIFICATION
 The risk of a portfolio comprises systematic risk, also known as undiversifiable
risk, and unsystematic risk which is also known as idiosyncratic risk or
diversifiable risk. Systematic risk refers to the risk common to all securities—
i.e. market risk. Unsystematic risk is the risk associated with individual assets.
Unsystematic risk can be diversified away to smaller levels by including a greater
number of assets in the portfolio (specific risks "average out"). The same is not
possible for systematic risk within one market. Depending on the market, a
portfolio of approximately 30-40 securities in developed markets such as UK or
US will render the portfolio sufficiently diversified such that risk exposure is
limited to systematic risk only. In developing markets a larger number is required,
due to the higher asset volatilities.
A rational investor should not take on any diversifiable risk, as only non-
diversifiable risks are rewarded within the scope of this model. Therefore, the
required return on an asset, that is, the return that compensates for risk taken, must
be linked to its riskiness in a portfolio context - i.e. its contribution to overall
portfolio riskiness - as opposed to its "stand alone riskiness." In the CAPM context,
portfolio risk is represented by higher variance i.e. less predictability. In other
words the beta of the portfolio is the defining factor in rewarding the systematic
exposure taken by an investor.
ASSUMPTIONS
All investors:
1. Aim to maximize economic utilities.
2. Are rational and risk-averse.
3. Are broadly diversified across a range of investments.
4. Are price takers, i.e., they cannot influence prices.
5. Can lend and borrow unlimited amounts under the risk free rate of interest.
6. Trade without transaction or taxation costs.
7. Deal with securities that are all highly divisible into small parcels.
8. Assume all information is available at the same time to all investors.
Further, the model assumes that standard deviation of past returns is a perfect
proxy for the future risk associated with a given security
PROBLEMS OF CAPM
 The model assumes that either asset returns are (jointly) normally
distributed random variables or that active or potential shareholders employ a
 quadratic form of utility. It is, however, frequently observed that returns in equity
and other markets are not normally distributed. As a result, large swings (3 to 6
standard deviations from the mean) occur in the market more frequently than the
normal distribution assumption would expect.
 The model assumes that the variance of returns is an adequate measurement of
risk. This might be justified under the assumption of normally distributed returns,
but for general return distributions other risk measures (like coherent risk
measures) will likely reflect the active and potential shareholders' preferences more
adequately. Indeed risk in financial investments is not variance in itself; rather it is
the probability of losing: it is asymmetric in nature.
 The model assumes that all active and potential shareholders have access to the
same information and agree about the risk and expected return of all assets
(homogeneous expectations assumption).
 The model assumes that the probability beliefs of active and potential shareholders
match the true distribution of returns. A different possibility is that active and
potential shareholders' expectations are biased, causing market prices to be
informationally inefficient. This possibility is studied in the field of behavioural
finance, which uses psychological assumptions to provide alternatives to the
CAPM such as the overconfidence-based asset pricing model of Kent
Daniel, David Hirshleifer, and Avanidhar Subrahmanyam (2001).
 The model does not appear to adequately explain the variation in stock returns.
Empirical studies show that low beta stocks may offer higher returns than the
model would predict. Some data to this effect was presented as early as a 1969
conference in Buffalo, New York in a paper by Fischer Black, Michael Jensen,
and Myron Scholes. Either that fact is itself rational (which saves the efficient-
market hypothesis but makes CAPM wrong), or it is irrational (which saves
CAPM, but makes the EMH wrong – indeed, this possibility makes volatility
arbitrage a strategy for reliably beating the market).
 The model assumes that given a certain expected return, active and potential
shareholders will prefer lower risk (lower variance) to higher risk and conversely
given a certain level of risk will prefer higher returns to lower ones. It does not
allow for active and potential shareholders who will accept lower returns for higher
risk. Casino gamblers pay to take on more risk, and it is possible that some stock
traders will pay for risk as well.
 The model assumes that there are no taxes or transaction costs, although this
assumption may be relaxed with more complicated versions of the model.
 The market portfolio consists of all assets in all markets, where each asset is
weighted by its market capitalization. This assumes no preference between markets
and assets for individual active and potential shareholders, and that active and
potential shareholders choose assets solely as a function of their risk-return profile.
It also assumes that all assets are infinitely divisible as to the amount which may be
held or transacted.
 The market portfolio should in theory include all types of assets that are held by
anyone as an investment (including works of art, real estate, human capital...). In
practice, such a market portfolio is unobservable and people usually substitute a
stock index as a proxy for the true market portfolio. Unfortunately, it has been
shown that this substitution is not innocuous and can lead to false inferences as to
the validity of the CAPM, and it has been said that due to the inobservability of the
true market portfolio, the CAPM might not be empirically testable. This was
presented in greater depth in a paper by Richard Roll in 1977, and is generally
referred to as Roll's critique.
 The model assumes just two dates, so that there is no opportunity to consume and
rebalance portfolios repeatedly over time. The basic insights of the model are
extended and generalized in the inter-temporal CAPM (ICAPM) of Robert Merton,
and the consumption CAPM (CCAPM) of Douglas Breeden and Mark Rubinstein.
 CAPM assumes that all active and potential shareholders will consider all of their
assets and optimize one portfolio. This is in sharp contradiction with portfolios that
are held by individual shareholders: humans tend to have fragmented portfolios or,
rather, multiple portfolios: for each goal one portfolio.

9. TRADE-OFF THEORY OF CAPITAL STRUCTURE

The Trade-Off Theory of Capital Structure refers to the idea that a company
chooses how much debt finance and how much equity finance to use by balancing
the costs and benefits. The classical version of the hypothesis goes back to Kraus
and Litzenberger who considered a balance between the dead-weight costs of
bankruptcy and the tax saving benefits of debt. Often agency costs are also
included in the balance. This theory is often set up as a competitor theory to
the Pecking Order Theory of Capital Structure. A review of the literature is
provided by Frank and Goyal.
An important purpose of the theory is to explain the fact that corporations usually
are financed partly with debt and partly with equity. It states that there is an
advantage to financing with debt, the tax benefits of debt and there is a cost of
financing with debt, the costs of financial distress including bankruptcy costs of
debt and non-bankruptcy costs (e.g. staff leaving, suppliers demanding
disadvantageous payment terms, bondholder/stockholder infighting, etc).
The marginal benefit of further increases in debt declines as debt increases, while
the marginal cost increases, so that a firm that is optimizing its overall value will
focus on this trade-off when choosing how much debt and equity to use for
financing.
As the Debt equity ratio (i.e. leverage) increases, there is a trade-off between the
interest tax shield and bankruptcy, causing an optimum capital structure, D/E*
The empirical relevance of the Trade-Off Theory has often been questioned.
Miller for example compared this balancing as akin to the balance between horse
and rabbit content in a stew of one horse and one rabbit. Taxes are large and they
are sure, while bankruptcy is rare and, according to Miller, it has low dead-weight
costs. Accordingly he suggested that if the Trade-Off Theory were true, then firms
ought to have much higher debt levels than we observe in reality. Myers was a
particularly fierce critic in his Presidential address to the American Finance
Association meetings in which he proposed what he called "The Pecking Order
Theory". Fama and French criticized both the Trade-Off Theory and the Pecking
Order Theory in different ways. Welch has argued that firms do not undo the
impact of stock price shocks as they should under the basic Trade-Off Theory and
so the mechanical change in asset prices that makes up for most of the variation in
capital structure
Despite such criticisms, the Trade-Off Theory remains the dominant theory of
corporate capital structure as taught in the main corporate finance textbooks.
Dynamic version of the model generally seem to offer enough flexibility in
matching the data so, contrary to Miller's verbal argument, dynamic trade-off
models are very hard to reject empirically.

10. PECKING ORDER THEORY

 In the theory of firm's capital structure and financing decisions, the Pecking Order
Theory or Pecking Order Model was first suggested by Donaldson in 1961 and it
was modified by Stewart C. Myers and Nicolas Majluf in 1984. It states that
companies prioritize their sources of financing (from internal financing to equity)
according to the Principle of least effort, or of least resistance, preferring to raise
equity as a financing means of last resort. Hence, internal funds are used first, and
when that is depleted, debt is issued, and when it is not sensible to issue any more
debt, equity is issued.
Pecking Order Theory starts with asymmetric information as managers know more
about their company’s prospects, risks and value than outside investors.
Asymmetric information affects the choice between internal and external financing
and between the issue of debt or equity. There therefore exists a pecking order for
the financing of new projects.
Asymmetric information favours the issue of debt over equity as the issue of debt
signals the board’s confidence that an investment is profitable and that the current
stock price is under-valued (if stock price was over-values the issue of equity
would be favoured). The issue of equity would signal a lack of confidence in the
board and that they feel the share price is overvalued. An issue of equity would
therefore lead to a drop in share price. This does not however apply to high-tech
industries where the issue of equity is preferable due to the high cost of debt issue
as assets are intangible.
Tests of the Pecking Order Theory have not been able to show that it is of first-
order importance in determining a firm's capital structure. However,
several authors have found that there are instances where it is a good
approximation of reality. On the one hand, Fama and French, and also Myers and
Shyam-Sunder find that some features of the data are better explained by the
Pecking Order than by the Trade. Goyal and Frank show, among other things, that
Pecking Order theory fails where it should hold, for small firms where information
asymmetry is presumably an important problem.
PROFITABILITY AND DEBT RATIOS
The Pecking Order Theory explains the inverse relationship between profitability
and debt ratios:
1. Firms prefer internal financing.
2. They adapt their target dividend payout ratios to their investment opportunities,
while trying to avoid sudden changes in dividends.
3. Sticky dividend policies, plus unpredictable fluctuations in profits and investment
opportunities, mean that internally generated cash flow is sometimes more than
capital expenditures and at other times less. If it is more, the firm pays off the debt
or invests in marketable securities. If it is less, the firm first draws down its cash
balance or sells its marketable securities, rather than reduce dividends.
4. If external financing is required, firms issue the safest security first. That is, they
start with debt, then possibly hybrid securities such as convertible bonds, then
perhaps equity as a last resort. In addition, issue costs are least for internal funds,
low for debt and highest for equity. There is also the negative signalling to the
stock market associated with issuing equity, positive signalling associated with
debt.

11. DIVIDEND DECISION – WALTER MODEL

The term dividend refers to that part of after-tax profit which is distributed to the
owners (shareholders) of the company. The undistributed part of the profit is
known as Retained earnings. Higher the dividend payout, lower will be retained
earnings.
The dividend policy of a company refers to the views and policies of the
management with respect of distribution of dividends. The dividend policy of a
company should aim at shareholder-wealth maximization.
The essence of dividend policy is:
If the company is confident of generating more than market returns then only it
should retain higher profits and pay less as dividends (or pay no dividends at all),
as the shareholders can expect higher share prices based on higher RoI of the
company. However, if the company is not confident of generating more than
market returns, it should pay out more dividends (or 100% dividends). This is done
for two reasons. One, the shareholders prefer early receipt of cash (liquidity
preference theory) and second, the shareholders can invest this cash to generate
more returns (since market returns are expected to be higher than returns generated
by the company).
Over the years, various models have been developed that establish the relationship
between dividends and stock prices. The most important of them is Walter Model:
 WALTER MODEL
Prof James E. Walter devised an easy and simple formula to show how dividend
can be used to maximize the wealth position of shareholders. He considers
dividend as one of the important factors determining the market valuation.
According to Walter, in the long run, share prices reflect the present value of future
stream of dividends. Retained earnings influence stock prices only through their
effect on further dividends.
ASSUMPTIONS:
 The Company is a going concern with perpetual life span.
 The only source of finance is retained earnings. i.e. no other alternative means of
financing.
 The cost of capital and return on investment are constant throughout the life of the
company.
According to Walter Model,
P = [D + (E - D) x ROI / Kc] / Kc
P= Market price per share E= Earnings per share
D = Dividend per share Kc= Cost of Capital (Capitalisation rate)
ROI = Return on Investment (also called return on internal retention)
The model considers internal rate of return (IRR), market Capitalisation rate (Kc)
and dividend payout ratio in determination of share prices. However, it ignores
various other factors determining the share prices. It fails to appropriately calculate
prices of companies that resort to external sources of finance. Further, the
assumption of constant cost of capital and constant return are unrealistic.
If the internal rate of return from retained earnings (RoI) is higher than the market
capitalization rate, the value of ordinary shares would be high even if the dividends
are low. However, if the RoI within the business is lower than what market
expects, the value of shares would be low. In such cases, the shareholders would
expect a higher dividend.
If RoI > Kc, Price would be high even if Dividends are low
Walter model explains why market prices of shares of growth companies are high
even if dividend payout is low. It also explains why the market prices of shares of
certain companies which pay higher dividend and retain low profits are high.
Example:
A Ltd. paid a dividend of Rs 5 per share for 2009-10. The company follows a fixed
dividend payout ratio of 30% and earns a return of 18% on its investments. Cost of
capital is 12%. The expected price of the shares of A Ltd. using Walter Model
would be calculated as follows
EPS = Dividend / payout Ratio = 5 / 0.30 = Rs.16.67
According to Walter Model,
P = [D + (E - D) x ROI / Kc] / Kc
P = [5 + 16.67 - 5.00) x 0.18 / 0.12] / 0.12
P = 187.50

12. GORDON MODEL

It is a model for determining the intrinsic value of a stock, based on a future series
of dividends that grow at a constant rate. Given a dividend per share that is payable
in one year, and the assumption that the dividend grows at a constant rate in
perpetuity, the model solves for the present value of the infinite series of
future dividends.

The Gordon model assumes a constant growth rate for infinity.

The value of the stock is given by:
V=D1/ (Re – g)
Where,
D1 = Expected dividend at the end of the year
Re = required rate of return on equity
g = Expected growth rate for a long period of time (mathematically, infinite
period)
For example, A Ltd. Reported earnings per share (EPS) of Rs 15 last year and paid
out 52% of its earnings as dividend. The earnings and dividends are expected to
grow at the rate of 8% in the long term as in the past. If the required rate of return
on equity shares of A Ltd. is 12%, the value of the security is calculated as follows;
EPS = Rs 15
The Current dividend per share is given by the payout ratio times the EPS.
Dividend per share (D0) = 15 x 0.52 = Rs. 7.8
So the expected dividend would be given by multiplying the current dividend with
the expected growth rate.
 Dividend per share (D1) = 7.8 x 1.08 = Rs. 8.42
Expected growth rate = 8%
required rate of return = 12%
V = 8.42 / (0.12 – 0.08) = 210.50
LIMITATIONS
There are two major limitations of this model:
 This model is used only when the growth rate is constant.
 This model does not function when the growth rate is equal to or exceeds the
required rate of return. Try and calculate the value of the security in the above
example assuming the growth rate is 13%! The price would be negative Rs. 842.
Equity shares cannot have negative value. More so, if the growth rate is equal to
the required rate of return, the value of the security approaches infinity.

13. BAUMOL MODEL OF CASH MANAGEMENT

Baumol model of cash management helps in determining a firm's optimum cash
balance under certainty. It is extensively used and highly useful for the purpose of
cash management. As per the model, cash and inventory management problems are
one and the same.
William J. Baumol developed a model (The transactions Demand for Cash: An
Inventory Theoretic Approach) which is usually used in Inventory management &
cash management. Baumol model of cash management trades off between
opportunity cost or carrying cost or holding cost & the transaction cost. As such
firm attempts to minimize the sum of the holding cash & the cost of converting
marketable securities to cash.
Relevance
At present many companies make an effort to reduce the costs incurred by owning
cash. They also strive to spend less money on changing marketable securities to
cash. The Baumol model of cash management is useful in this regard.
Use of Baumol Model
The Baumol model enables companies to find out their desirable level of cash
balance under certainty. The Baumol model of cash management theory relies on
the trade off between the liquidity provided by holding money (the ability to carry
out transactions) and the interest foregone by holding one's assets in the form of
non-interest bearing money. The key variables of the demand for money are then
 the nominal interest rate, the level of real income which corresponds to the amount
of desired transactions and to a fixed cost of transferring one's wealth between
liquid money and interest bearing assets.
ASSUMPTIONS OF THE MODEL
The firm is able to forecast its cash requirements with certainty and receive a
specific amount at regular intervals.
1. The firm’s cash payments occur uniformly over a period of time i.e. a steady rate
of cash outflows.
2. The opportunity cost of holding cash is known and does not change over time.
Cash holdings incur an opportunity cost in the form of opportunity foregone.
3. The firm will incur the same transaction cost whenever it converts securities to
cash. Each transaction incurs a fixed and variable cost.
For example, let us assume that the firm sells securities and starts with a cash
balance of C rupees. When the firm spends cash, its cash balance starts decreasing
and reaches zero. The firm again gets back its money by selling marketable
securities. As the cash balance decreases gradually, the average cash balance will
be: C/2.

The firm incurs a cost known as holding cost for maintaining the cash balance. It is
known as opportunity cost, the return inevitable on the marketable securities.
Equational Representations in Baumol Model of Cash Management:
 Holding Cost = k(C/2)
 Transaction Cost = F(T/C)
 Total Cost = k(C/2) + F(T/C)
C = target cash balance
F = Fixed cost of a transaction
T = total amount of cash needed over a year
k = opportunity cost of holding cash (annual rate)
Optimum level of cash balance
As the demand for cash, ‘C’ increases, the holding cost will also increase and the
transaction cost will reduce because of a decline in the number of transactions.
Hence, it can be said that there is a relationship between the holding cost and the
transaction cost.
The optimum cash balance, C* is obtained when the total cost is minimum.
The optimal level of cash is determined using the following formula:
Optimal level of cash = √ (2FT / k)
With the increase in the cost per transaction and total funds required, the optimum
cash balance will increase. However, with an increase in the opportunity cost, it
will decrease.
LIMITATIONS OF THE BAUMOL MODEL
1. It does not allow cash flows to fluctuate.
2. Overdraft is not considered.
3. There are uncertainties in the pattern of future cash flows.

14. MILLER AND ORR MODEL OF CASH

MANAGEMENT
Overview of Miller and Orr Model of Cash Management
The Miller and Orr model of cash management is one of the various cash
management models in operation. It is an important cash management model as
well. It helps the present day companies to manage their cash while taking into
consideration the fluctuations in daily cash flow.
Description of the Miller and Orr Model of Cash Management
As per the Miller and Orr model of cash management the companies let their cash
balance move within two limits - the upper limit and the lower limit. The
companies buy or sell the marketable securities only if the cash balance is equal to
any one of these.
When the cash balances of a company touches the upper limit it purchases a certain
number of saleable securities that helps them to come back to the desired level. If
the cash balance of the company reaches the lower level then the company trades
its saleable securities and gathers enough cash to fix the problem.
It is normally assumed in such cases that the average value of the distribution of
net cash flows is zero. It is also understood that the distribution of net cash flows
has a standard deviation. The Miller and Orr model of cash management also
assumes that distribution of cash flows is normal.
Equational Representations in Miller and Orr model of cash management:
Target cash balance (Z):
Where,
 TC = transaction cost of buying or selling securities
V = variance of daily cash flows
r = daily return on short-term investments
L = minimum cash requirement
The upper limit for the cash account (H) is determined by the equation:
H = 3Z - 2L
Application of Miller-Orr model of cash management
The Miller and Orr model of cash management is widely used by most business
entities. However, in order for it applied properly the financial managers need to
make sure that the following procedures are followed:
 Finding out the approximate prices at which the saleable securities could be sold
or brought
 Deciding the minimum possible levels of desired cash balance
 Checking the rate of interest
 Calculating the Standard Deviation of regular cash flows

15. NET INCOME (NI) APPROACH

Net Income theory was introduced by David Durand. According to this approach,
the capital structure decision is relevant to the valuation of the firm. This means
that a change in the financial leverage will automatically lead to a corresponding
change in the overall cost of capital as well as the total value of the
firm. According to NI approach, if the financial leverage increases, the weighted
average cost of capital decreases and the value of the firm and the market price of
the equity shares increases. Similarly, if the financial leverage decreases, the
weighted average cost of capital increases and the value of the firm and the market
price of the equity shares decreases.
ASSUMPTIONS OF NI APPROACH:
1. There are no taxes
2. The cost of debt is less than the cost of equity.
3. The use of debt does not change the risk perception of the investors
Example
A company expects its annual EBIT to be $50,000. The company has $200,000 in
10% bonds and the cost of equity (Ke) is 12.5%.
Calculation of the Value of the firm:
EBIT $50,000
Less: Interest cost (10% on $200,000) $20,000
EBT (EAT also as taxes assumed to be 0) $30,000
Earnings available to equity shareholders $30,000
Cost of equity 12.5%
Therefore, market value of equity (A) = NI/Ke
= $30,000/12.5% =$240,000
Market value of debt (given as) (B) $200,000
Total value of firm (V=A+B) $440,000
Overall cost of capital = (EBIT/V) *100
= $50,000/$440,000 *100 = 11.36%
EFFECTS OF CHANGE IN THE CAPITAL STRUCTURE: (INCREASE IN
DEBT CAPITAL)
Let us assume that the firm decides to retire $100,000 worth of equity by using the
proceeds of new debt issue worth the same amount. The cost of debt and equity
would remain the same as per the assumptions of the NI approach. This is because
one of the assumptions is that the use of debt does not change the risk perception
of the investors.
Calculation of new value of the Firm
EBIT $50,000
Less: Interest cost (10% on $300,000) $30,000
EBT (EAT also as taxes assumed to be 0) $20,000
Earnings available to equity shareholders $20,000
Cost of equity 12.5%
Therefore, market value of equity (A) = NI/Ke
= $20,000/12.5% =$160,000
Market value of debt (given as) (B) $300,000
Total value of firm (V=A+B) $460,000
Overall cost of capital = (EBIT/V) *100
 = $50,000/$460,000 *100 = 10.87%

This proves that the use of additional financial leverage (debt) causes the value of
the firm to increase and the overall cost of capital to decrease.

16. NET OPERATING INCOME APPROACH

Net Operating Income Approach was also suggested by Durand. This approach is
of the opposite view of Net Income approach. This approach suggests that the
capital structure decision of a firm is irrelevant and that any change in the leverage
or debt will not result in a change in the total value of the firm as well as the
market price of its shares. This approach also says that the overall cost of capital is
independent of the degree of leverage.
FEATURES OF NOI APPROACH:
1. At all degrees of leverage (debt), the overall capitalization rate would remain
constant. For a given level of Earnings before Interest and Taxes (EBIT), the value
of a firm would be equal to EBIT/overall capitalization rate.
2. The value of equity of a firm can be determined by subtracting the value of debt
from the total value of the firm. This can be denoted as follows:
Value of Equity = Total value of the firm - Value of debt
3. Cost of equity increases with every increase in debt and the weighted average cost
of capital (WACC) remain constant. When the debt content in the capital structure
increases, it increases the risk of the firm as well as its shareholders. To
compensate for the higher risk involved in investing in highly levered company,
equity holders naturally expect higher returns which in turn increases the cost of
equity capital.
Example:
Let us assume that a firm has an EBIT level of $50,000, cost of debt 10%, the total
value of debt $200,000 and the WACC is 12.5%. Let us find out the total value of
the firm and the cost of equity capital (the equity capitalization rate).
Solution:
EBIT = $50,000
WACC (overall capitalization rate) = 12.5%
Therefore, total market value of the firm =
EBIT/Ko ⇒ $50,000/12.5% ⇒ $400,000
Total value of debt =$200,000
Therefore, total value of equity = Total market value - Value of debt

⇒ $400,000-$200,000 ⇒ $200,000

Cost of equity capital = Earnings available to equity holders/Total market value of

equity shares
Earnings available to equity holders = EBIT - Interest on debt

⇒ $50,000 - (10% on $200,000) ⇒ $30,000

Therefore, cost of equity capital = $30,000/$200,000 ⇒ 15%

Verification of WACC:
10% x ($200,000/$400,000) + 15% x ($200,000/$400,000) ⇒ 12.5%

EFFECT OF CHANGE IN CAPITAL STRUCTURE (TO PROVE

IRRELEVANCE)
Let us now assume that the leverage increases from $200,000 to $300,000 in the
firm's capital structure. The firm also uses the proceeds to re-purchase its equity
stock so that the market value of the firm remains the same at $400,000.
EBIT = $50,000
WACC = 12.5% (overall capitalization rate)
Total market value of the firm = $50,000/12.5% ⇒ $400,000
Less: Total market value of debt ⇒ $300,000
Therefore, market value of equity = $400,000 - $300,000 ⇒ $100,000
Equity-capitalization rate = ($50,000 - [10% on $300,000)/$100,000 ⇒ 20%
Overall cost of capital = 10% x $300,000/$400,000 + 20% x
$100,000/$400,000 ⇒ 12.5%
The above example proves that a change in the leverage does not affect the total
value of the firm, the market price of the shares as well as the overall cost of
capital.

17. THE MODIGLIANI–MILLER THEOREM

The Modigliani–Miller theorem (of Franco Modigliani, Merton Miller) forms the
basis for modern thinking on capital structure. This approach is similar to the Net
operating income approach. The MM approach favours the Net operating income
approach and agrees with the fact that the cost of capital is independent of the
degree of leverage and at any mix of debt-equity proportions. The significance of
this MM approach is that it provides operational or behavioural justification for
constant cost of capital at any degree of leverage. Whereas, the net operating
income approach does not provide operational justification for independence of the
company's cost of capital. The basic theorem states that, under a certain market
price process (the classical random walk), in the absence of taxes, agency costs,
bankruptcy costs, and asymmetric information, and in an efficient market, the
value of a firm is unaffected by how that firm is financed. It does not matter if the
firm's capital is raised by issuing stock or selling debt. It does not matter what the
firm's dividend policy is. Therefore, the Modigliani–Miller theorem is also often
called the capital structure irrelevance principle.
Modigliani was awarded the 1985 Nobel Prize in Economics for this and other
contributions. Miller was a professor at the University of Chicago when he was
awarded the 1990 Nobel Prize in Economics, along with Harry
Markowitz and William Sharpe, for their "work in the theory of financial
economics," with Miller specifically cited for "fundamental contributions to the
theory of corporate finance."
ARBITRAGE PROCESS
Arbitrage process is the operational justification for the Modigliani-Miller
hypothesis. Arbitrage is the process of purchasing a security in a market where the
price is low and selling it in a market where the price is higher. This results in
restoration of equilibrium in the market price of a security asset. This process is a
balancing operation which implies that a security cannot sell at different prices.
The MM hypothesis states that the total value of homogeneous firms that differ
only in leverage will not be different due to the arbitrage operation. Generally,
 investors will buy the shares of the firm that's price is lower and sell the shares of
the firm that's price is higher. This process or this behaviour of the investors will
have the effect of increasing the price of the shares that is being purchased and
decreasing the price of the shares that is being sold. This process will continue till
the market prices of these two firms become equal or identical. Thus the arbitrage
process drives the value of two homogeneous companies to equality that differs
only in leverage.
BASIC PROPOSITIONS OF MM APPROACH:
1. At any degree of leverage, the company's overall cost of capital (ko) and the Value
of the firm (V) remains constant. This means that it is independent of the capital
structure. The total value can be obtained by capitalizing the operating earnings
stream that is expected in future, discounted at an appropriate discount rate suitable
for the risk undertaken.
2. The cost of capital (Ke) equals the capitalization rate of a pure equity stream and a
premium for financial risk. This is equal to the difference between the pure equity
capitalization rate and ki times the debt-equity ratio.
3. The minimum cut-off rate for the purpose of capital investments is fully
independent of the way in which a project is financed.
The theorem was originally proven under the assumption of no taxes. It is made up
of two propositions which can also be extended to a situation with taxes.
Consider two firms which are identical except for their financial structures. The
first (Firm U) is unlevered: that is, it is financed by equity only. The other (Firm L)
is levered: it is financed partly by equity, and partly by debt. The Modigliani–
Miller theorem states that the value of the two firms is the same.
Without taxes:
Proposition I: where VU is the value of an unlevered firm = price of buying a
firm composed only of equity, and VL is the value of a levered firm = price of
buying a firm that is composed of some mix of debt and equity. Another word for
levered is geared, which has the same meaning.
To see why this should be true, suppose an investor is considering buying one of
the two firms U or L. Instead of purchasing the shares of the levered firm L, he
could purchase the shares of firm U and borrow the same amount of money B that
firm L does. The eventual returns to either of these investments would be the same.
 Therefore the price of L must be the same as the price of U minus the money
borrowed B, which is the value of L's debt.
This discussion also clarifies the role of some of the theorem's assumptions. We
have implicitly assumed that the investor's cost of borrowing money is the same as
that of the firm, which need not be true in the presence of asymmetric information,
in the absence of efficient markets, or if the investor has a different risk profile to
the firm.
Proposition II:
Proposition II is with risky debt. As leverage (D/E) increases, the WACC (k0)
stays constant.
 ke is the required rate of return on equity, or cost of equity.
 k0 is the company unlevered cost of capital (ie assume no leverage).
 kd is the required rate of return on borrowings, or cost of debt.
 is the debt-to-equity ratio.
A higher debt-to-equity ratio leads to a higher required return on equity, because of
the higher risk involved for equity-holders in a company with debt. The formula is
derived from the theory of weighted average cost of capital (WACC).
These propositions are true assuming the following assumptions:
 no taxes exist,
 no transaction costs exist, and
 Individuals and corporations borrow at the same rates.
These results might seem irrelevant (after all, none of the conditions are met in the
real world), but the theorem is still taught and studied because it tells something
very important. That is, capital structure matters precisely because one or more of
these assumptions is violated. It tells where to look for determinants of optimal
capital structure and how those factors might affect optimal capital structure.
With taxes:
Proposition I:
Where,
 VL is the value of a levered firm.
 VU is the value of an unlevered firm.
 TCD is the tax rate (TC) x the value of debt (D)
 the term TCD assumes debt is perpetual
 This means that there are advantages for firms to be levered, since corporations can
deduct interest payments. Therefore leverage
lowers tax payments. Dividend payments are non-deductible.
Proposition II:
Where,
 rE is the required rate of return on equity, or cost of levered equity = unlevered
equity + financing premium.
 r0 is the company cost of equity capital with no leverage (unlevered cost of equity,
or return on assets with D/E = 0).
 rD is the required rate of return on borrowings, or cost of debt.
 D / E is the debt-to-equity ratio.
 Tc is the tax rate.
The same relationship as earlier described stating that the cost of equity rises with
leverage, because the risk to equity rises, still holds. The formula however has
implications for the difference with the WACC. Their second attempt on capital
structure included taxes has identified that as the level of gearing increases by
replacing equity with cheap debt the level of the WACC drops and an optimal
capital structure does indeed exist at a point where debt is 100%
The following assumptions are made in the propositions with taxes:
 corporations are taxed at the rate TC on earnings after interest,
 no transaction costs exist, and
 individuals and corporations borrow at the same rate
Miller and Modigliani published a number of follow-up papers discussing some of
these issues.
ECONOMIC CONSEQUENCES
While it is difficult to determine the exact extent to which the Modigliani–Miller
theorem has impacted the capital markets, the argument can be made that it has
been used to promote and expand the use of leverage.
When misinterpreted in practice, the theorem can be used to justify near
limitless financial leverage while not properly accounting for the increased risk,
especially bankruptcy risk that excessive leverage ratios bring. Since the value of
the theorem primarily lies in understanding the violation of the assumptions in
practice, rather than the result itself, its application should be focused on
understanding the implications that the relaxation of those assumptions bring.
 CRITICISMS
The main problem with the Modigliani and Miller (1958) is that they assume
shareholders are the owners of the public corporations. This assumption has been
refuted by legal scholars since Berle and Means (1932). Shareholders are neither
the owners, residual claimants (i.e. owners of the profit), or the investors as 99.9%
are in the secondary market.
The formula's use of EBIT / Cost of Capital to calculate a company's value is
extremely limiting. It also uses the weighted average cost of capital formula, which
calculates the value based on E + D, where E = the value of equity and D = the
value of debt. Modigliani and Miller are equating two different formulas to arrive
at a number which maximizes a firm's value. It is inappropriate to say that a firm's
value is maximized when these two different formulas cross each other because of
their striking differences. The formula essentially says a firm's value is maximized
when a company has earnings * the discount rate multiple = book value.
Modigliani and Miller equate E + D = EBIT / Cost of Capital. This seems to over-
simplify the firm's valuation.
LIMITATIONS OF MM HYPOTHESIS:
1. Investors would find the personal leverage inconvenient.
2. The risk perception of corporate and personal leverage may be different.
3. Arbitrage process cannot be smooth due the institutional restrictions.
4. Arbitrage process would also be affected by the transaction costs.
5. The corporate leverage and personal leverage are not perfect substitutes.

REFERENCE
Financial Management by I. M. Pandey
Financial Management by Prasanna Chandra
Financial Management by M.Y.Khan and P.K.Jain
www.books.google.co.in
www.google.com
www.wikipedia.com
www.investopedia.com
www.moneychimp.com

Posted 24th March 2013 by Namitha K Cheriyan