Financial Management: Modern Concepts and Theories, Slides of Financial Management

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FINANCIAL MANAGEMENT

MODERN FINANCE THEORY

(Modified from Megginson, 1997) FINANCE INVESTMENT CORPORATE FINANCE PORTFOLIO CAPM EMH OPTION PRICING MODEL CAPITAL STRUCTURE DIVIDEND POLICY AGENCY THEORY SIGNALING THEORY CORPORATE CONTROL FINANCIAL INTERMEDIATION FINANCIAL INSTITUTION BANKING MIS MARKET MICROSTRUCTURE Insurance

Portfolio Theory

• Professor Harry Markowitz (1952): “Don’t put all your eggs in one basket”.
• Base concept: unsystematic risk and systematic risk efficient portfolio
• Technique and measuring correlation, covariance, standard deviation, and total variation in portfolio setting.

Capital Asset Pricing Model (CAPM)

• Sharpe (1964), Lintner (1965), and Mossin (1966)
• Contributions:
  1. Trade off risk and return: capital market line
  2. Beta (β)
• Ross (1976): Arbitrage Pricing Theory (APT) with more than one factor that influence the expected return of asset such as economic variables.

Option Pricing Theory

(Black-Scholes Option Pricing Model)

• Black and Scholes (1973)
• 8 Assumptions:
  1. Market are friction
  2. Short sales are allow
  3. No dividend payment or other distribution
  4. Market on going (continue)
  5. Stock prices random walk
  6. Constant variance rate of return
  7. The option can be exercised only at maturity
  8. The risk less interest rate is known and constant

Market Microstructure

• First modern market microstructure study was Ho and Stol (1981) base on Demsetz (1968) and Tinic (1972)
• Market crashed in American capital market in 1987
• Two basic model: spread model and price formation model

Corporate Finance

• The major study of corporate finance are capital budgeting, capital structure, dividend policy and merger and acquisition to maximize shareholder’s wealth.

Capital Structure

• Modigliani and Miller (1958): M&M irrelevant propositions, called proposition I and proposition II
• Link of the study is asymmetric information such as signaling model, pecking order hypothesis, agency cost/tax shield trade-off model

Agency Theory

• Jensen and Meckling (1976)
• Contributions:
  1. Agency cost model of the firm
  2. Compensation policy

Signaling Theory

• Arkelof (1970) and Spence (1973): the original economics papers on signaling. Leland and Pyle (1977) was the first major financial application of signaling theory.
• Corporate insiders better informed than outside investor

Financial Intermediation

• Financial Institution: reksadana
• Banking: investment vs commercial banking
• Banking: national banking vs Universal banking
• Insurance: life, investment, pension, education, etc

Management Information System

• Base idea: unite disparate financial function into a single, integrated system that provide complete visibility into financial system
• MIS functions:
  1. as a management tool: support of management change
  2. provide a wide range of financial and non financial information
  3. as a system: connect, accumulate, process, and then provide information to all parties in the budget system on a continuous basis

Summary

• In pricing assets, only systematic risk matter
• Emphasize investment rather than financing
• Emphasize cash flow rather than accounting profits
• Remember that finance is now a global game
• Remember that finance is a quantitative discipline
• All theories are based on the principles of informationally efficient capital markets populated by rational, utility-of- wealth-maximizing investors who can costlessly diversify unsystematic risk and are thus concerned only with pervasive, economy-wide forces. So, where is the behavior finance stand?

Good luck