A Historical Overview

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Moh Khoiruddin, S.E., M.Si.

Introduction

In the 1950s, fundamental changes in finance began to occur. The analytical methods and techniques traditional to economics began to be applied to problems in finance, and the resulting transformation has been significant. This evolution was accompanied by a change in the focus of the literature from normative questions such as
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 and analysis of corporate policy decisions.

02/05/2012

Moh Khoiruddin, S.E., M.Si.

...Introduction

The logical structure of decision-making implies that better answers to normative questions are likely to occur when the decision maker has a richer set of positive theories that provide a better understanding of the consequences of his or her choices.

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Moh Khoiruddin, S.E., M.Si.

The Major Theoretical Building Blocks of Financial Economics (Jensen & Smith, 1984)

Modern Theory of Finance

Efficient Market Theory

Portfolio Theory

Capital Asset Pricing Theory

Option Pricing Theory

Agency Theory

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Moh Khoiruddin, S.E., M.Si.

The Major Theoretical Building Blocks of Financial Economics (Megginson, 1997)

Financial Intermediation Theory Corporate Control Theory Market Microstructure Theory

Signalling Theory

Saving & Investment in Perfect Capital Market

Agency Theory

Portfolio Theory

Option Pricing Theory

Capital Structure Theory

Capital Market Efficiency Theory Asset Pricing Models

Dividend Policy Theory

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Moh Khoiruddin, S.E., M.Si.

Teori Keuangan & Tokohnya

Teori Saving & Investment in Perfect Capital Market Portfolio Theory Tokoh Irving Fisher Markowitz Lintner Sharp Mossin Modigliani & Miller Modigliani & Miller Tahun 1930 1952 1964 1964 1966 1958 1961 Keterangan Fisher Separation Theorem Embrio teori positif Teori positif

Capital Structure Theory Dividend Policy Theory

Nilai Ekonomi Asset Perusahaan Kebijakan Dividen tidak relevan

Asset Pricing Models

Sharp Black Brennan Merton Ross

Moh Khoiruddin, S.E., M.Si.

1964 1972 1970 1973 1976

CAPM Standar CAPM tanpa Rf After-Tax CAPM Intertemporal CAPM APT

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Teori Keuangan & Tokohnya

Teori Capital Market Efficiency Theory Option Pricing Theory Agency Theory Signalling Theory Tokoh Eugene Fama Black & Scholes Tahun 1970 1973 Keterangan Efficient Market Hypothesis Black & Scholes OPM Agency Problem Agency Cost Assymetric Information Nobel Prize

Jensen & Meckling 1976 1986 Ackerlof Spence Joseph Stiglitz Leland & Pyle 1977

Corporate Control Theory

Bradley Jensen & Ruback

1980 1983

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Moh Khoiruddin, S.E., M.Si.

Teori Keuangan & Tokohnya

Teori Financial Intermediation Theory Market Microstructure Theory Tokoh James Tahun 1987 Keterangan

Ho & Stoll Copeland & Galai Grassman & Stiglitz Kyle Admati & Pfeiderer Glosten Christie & Schultz

1981 1983 1983 1980 1985 1988 1994 1994

Spread model Price information model

Islamic Finance

02/05/2012

Moh Khoiruddin, S.E., M.Si.

Fundamental Building Blocks

The years since 1950 have witnessed the formulation of the major building blocks of the modern theory of financial economics: Efficient Market Theoryanalysis of equilibrium behavior of price changes through time in speculative markets. Portfolio Theoryanalysis of optimal security selection procedures for an investors entire portfolio of securities. Capital Asset Pricing Theoryanalysis of the determinants of asset prices under conditions of uncertainty. Option Pricing Theoryanalysis of the determinants of the prices of contingent claims such as call options and corporate bonds. Agency Theoryanalysis of the control of incentive conflicts in contractual relations.

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Moh Khoiruddin, S.E., M.Si.

Efficient Market Theory

The efficient market hypothesis holds that a market is efficient if it is impossible to make economic profits by trading on available information. This means that technical trading rules based on information 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 efficient markets hypothesis that unexpected price changes in a speculative market must behave as independent random drawings if the market is competitive and economic trading profits are zero.

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Moh Khoiruddin, S.E., M.Si.

...Efficient Market Theory

They argue that unexpected price changes reflect new information. Since new information by definition is information that cannot be deduced from previous information, new information must be independent over time. Therefore unexpected security price changes must be independent through time if expected economic profits are to be zero. In the economics literature, this hypothesis has been independently developed by Muth (1961). Termed the rational expectations hypothesis, it has had a dramatic impact on macroeconomic analysis.

02/05/2012

Moh Khoiruddin, S.E., M.Si.

...Efficient Market Theory

The efficient markets hypothesis is perhaps the most extensively tested hypothesis in all the social sciences. If capital markets are efficient, then the market value of the firm reflects the present value of the firms expected future 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 firms objective function:

managers should maximize the current market value of the firm.3 Hence management does not have to choose between maximizing the firms current value or its future value, and there is no reason for management to have a time horizon that is too short.

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Moh Khoiruddin, S.E., M.Si.

...Efficient Market Theory

Second, there is no benefit to manipulating earnings per share.

Management decisions that increase earnings but do not affect cash flows represent wasted effort. Third, if new securities are issued at market prices which reflect an unbiased assessment of future payoffs, then concern about dilution or the sharing of positive net present value projects with new security holders is eliminated. Fourth, security returns are meaningful measures of firm performance. This allows scholars to use security returns to estimate the effects of various corporate policies and events on the 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 firms shares, this empirical research has produced a rich array of evidence to augment positive theories in corporate finance.

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Moh Khoiruddin, S.E., M.Si.

Portfolio Theory
Prior to Markowitz (1952; 1959), little attention was given to portfolio selection. Security analysis focused on picking undervalued securities; a portfolio was generally taken to be just an accumulation of these securities. Markowitz points out that if risk is an undesirable attribute for investors, merely accumulating predicted winners is a poor portfolio selection procedure because it ignores the effect of portfolio diversification on risk. He analyzes the normative portfolio question: how to pick portfolios that maximize the expected utility of investors under conditions where investors choose among portfolios on the basis of expected portfolio return and portfolio risk measured by the variance of portfolio return.

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Moh Khoiruddin, S.E., M.Si.

...Portfolio Theory
He defines the efficient set of portfolios as those which provide both maximum expected return for a given variance and minimum variance for a given expected return. His mean-variance analysis provides formal content to the meaning of diversification, a measure of the contribution of the covariance among security returns to the riskiness of a portfolio, and rules for the construction of an efficient portfolio. Portfolio theory implies that the firm should evaluate projects in the same way that investors evaluate securities. For example, there are no rewards or penalties per se associated with corporate diversification. (Of course, diversification could affect value by affecting expected bankruptcy costs and thus net cash flows.)

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Moh Khoiruddin, S.E., M.Si.

Capital Asset Pricing Theory

Treynor (1961), Sharpe (1964), and Lintner (1965) apply the normative analysis of Markowitz to create a positive theory of the determination of asset prices. Given investor demands for securities implied by the Markowitz meanvariance portfolio selection model and assuming fixed supplies of assets, they solve for equilibrium security prices in a single-period world with no taxes. Although total risk is measured by the variance of portfolio returns, Treynor, Sharpe, and Lintner demonstrate that in equilibrium an individual security is priced to reflect its contribution to total risk, which is measured by the covariance of its return with the return on the market portfolio of all assets. This risk measure is commonly called an assets systematic risk.

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Moh Khoiruddin, S.E., M.Si.

...Capital Asset Pricing Theory

The simplest form of the capital asset pricing model yields the following expression for the equilibrium expected returns, E Rj ( ), on asset j:

E (Rj)= RF + [E (RM)- RF ]j where RF is the riskless rate of interest; E (RM) is the expected return on the market portfolio of all assets; and j = cov (Rj, RM)/2 (RM), the covariance between the return on asset j and the, market return divided by the variance of the market return, is the measure of systemic risk of asset j.

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Moh Khoiruddin, S.E., M.Si.

...Capital Asset Pricing Theory

Asset-pricing theory defines the opportunity cost of capital for the firms capital budgeting decisions. 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 of tests of the capital asset pricing model, and Schwert (1983) provides a survey of sizerelated deviations of average returns from those predicted by the capital asset pricing model.

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Moh Khoiruddin, S.E., M.Si.

...Capital Asset Pricing Theory

Alternative valuation models such as the arbitrage pricing model suggested by Ross (1976) or the consumption-based asset pricing model suggested by Breeden (1979) may eventually lead to a better understanding of the structure of security prices and overcome limitations of the capital asset pricing model. However, at this time, each of these models implies that expected returns are related to the contribution of a security to a particular measure of total risk.

02/05/2012 Moh Khoiruddin, S.E., M.Si.

Option Pricing Theory

Many important corporate policy problems require knowledge of the valuation of assets which, like call options, have payoffs that are contingent on the value of another asset. Black and Scholes (1973) provide a key to this problem in their solution to the call option valuation problem.

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Moh Khoiruddin, S.E., M.Si.

...Option Pricing Theory

An American call option gives the holder the right to buy a stock at a specific exercise price at any time prior to a specified exercise date. They note that a risk-free position can be maintained by a hedge between an option and its stock when the hedge can be adjusted continuously through time. To avoid opportunities for riskless arbitrage profits, the return to the hedge must equal the market risk-free rate; this condition yields an expression for the equilibrium call price.

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Moh Khoiruddin, S.E., M.Si.

...Option Pricing Theory

Black/Scholes note that if the firms cash flow distribution is fixed, the option pricing analysis can be used to value other contingent claims such as the equity 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 firms assets with an exercise price equal to the face value of the debt and an expiration date equal to the maturity date of the debt. The Black/Scholes analysis yields a valuation model for the firms equity and debt. An increase in the value of the firms assets increases the expected payoffs to the equity and increases the coverage on the debt, increasing the current value of both.

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Moh Khoiruddin, S.E., M.Si.

...Option Pricing Theory

An increase in the face value of the debt increases the debtholders claim on the firms assets, thus increasing the value of the debt, and since the stockholders are residual claimants, reduces the current value of the equity; An increase in the time to repayment of the debt or in the riskless rate lowers the present value of the debt and increases the market value of the equity. An increase in the variance rate or in the time to maturity increases the dispersion of possible values of the firm at the maturity date of the debt. Since the debtholders have a maximum payment which they can receive, an increase in dispersion increases the probability of default, lowering the value of the debt and increasing the value of the equity. For a review of this literature, see Smith (1976; 1979) and Cox and Ross (1976).
Moh Khoiruddin, S.E., M.Si.

02/05/2012

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 which involves delegating some decision-making authority. Jensen and Meckling define agency costs as the sum of the costs 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 cost associated with the change in real activities that occurs because it 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 structure contracts to facilitate those activities. At the time the contracts are negotiated, the actions motivated by the incentives established through the contracts are anticipated and reflected in the contracts prices and terms.
Moh Khoiruddin, S.E., M.Si.

02/05/2012

...Agency Theory
Hence, the agency costs of any relationship are born by the parties to the contracting relationship. This means that some individuals) can always benefit by devising more effective ways of reducing them. Jensen and Meckling use the agency framework to analyze the resolution of conflicts of interest between stockholders, managers, and bondholders of the firm.

02/05/2012 Moh Khoiruddin, S.E., M.Si.

In his 1951 book, Capital Budgeting, Dean recommends that the firm make investment decisions by looking to the capital markets for the firms cost of capital, accepting each project with an internal rate of return that exceeds this market-determined cost of capital. (The internal rate of return is the discount rate at which the present value of the net cash flows equals zero).
Moh Khoiruddin, S.E., M.Si.

02/05/2012

Capital Structure Policy

The Irrelevance Proposition

In 1958, Modigliani/Miller laid an important foundation for

a positive theory of financial structure by developing the implications of market equilibrium for optimal debt policy. They demonstrated that given the firms investment policy and ignoring taxes and contracting costs, the firms choice of financing policy does not affect the current market value of the firm. Their capital structure irrelevance proposition demonstrates that the firms choice of financing policy cannot affect the value of the firm so long as it does not affect 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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Moh Khoiruddin, S.E., M.Si.

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Moh Khoiruddin, S.E., M.Si.

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Moh Khoiruddin, S.E., M.Si.

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Moh Khoiruddin, S.E., M.Si.

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Moh Khoiruddin, S.E., M.Si.

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Moh Khoiruddin, S.E., M.Si.

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Moh Khoiruddin, S.E., M.Si.

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Moh Khoiruddin, S.E., M.Si.

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Moh Khoiruddin, S.E., M.Si.

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Moh Khoiruddin, S.E., M.Si.

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Moh Khoiruddin, S.E., M.Si.

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Moh Khoiruddin, S.E., M.Si.

The Major Areas of Corporate Financial Policy

Corporate Financial Policy

Capital Budgeting

Capital Structure

Dividend Policy

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Moh Khoiruddin, S.E., M.Si.

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Moh Khoiruddin, S.E., M.Si.

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Moh Khoiruddin, S.E., M.Si.

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Moh Khoiruddin, S.E., M.Si.

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Moh Khoiruddin, S.E., M.Si.