Financial Theories Overview

Financial Theories Overview

University of Phoenix

D’Ainsley Smith


November 24, 2014

Professor Allen








Financial Theories Overview

There are various theories that explain various tenets of finance. In this respect, researchers and scholars have come up with theories that explain capital structure, capital budgeting, asset valuation, and the cost of equity. This paper is deemed to bring the overview of these theories to a clear stance, and provides a keen look at the proposition. The theories are described, explored, criticized, and explained.

The overview is organized in tables where the theories are categorized into sections such as; international finance theories, financial behavior theories, capital structure theories, and capital budgeting theories. The theories are arranged systematically in each section, and provide a clear indication of whether it is a current or a germinal theory is provided.

                                           Financial Theories of Capital Structure Overview
 Financial TheoryDescriptionCurrent Example(s)Significant Attributes
1The Theory of InvestmentThe Theory of Investment is a terminal theory proposed by Miller and Modigliani (1958). The theory states the capital structure of the firm does not affect the value of the firm. Investment theory proposes valuation of the firm should be determined by capitalizing earnings before interest, and taxes. The earning power and the profit margin the market value of the firm, and not the dividend or the capital structure. (Lucarelli, 2011).Investment Theory brought change in the perception of the low risk non tradable bonds. This theory created dynamics in the market by developing the predilection of debt buy out in small and large firms.There has been criticism on the various assumptions brought forward by the theory of investment.

A fact of investment theory is it provides information symmetry. Financial decisions do not affect investment decisions.

The theory has been modified to incorporate the adjustment of taxes.

2Agency Cost Theory


Agent Cost Theory is a germinal theory supported by Meckling and Jensen (1976).

The agency cost theory states there is usually a potential conflict of interest between shareholders of a firm, and the managers are agents of the shareholders. The shareholders need maximization of pay out which reduces funds controlled by managers. Managers want to increase profits because this will measure their performance in the organization.

A recent research study of thirty-three firms listed in the NASDAQ shows high performing managers always have higher remuneration while reducing the dividend payout.The financial thirst for higher rewards makes managers practice creative accounting. This practice does not depict the true financial position of the firm.
3Agency Costs of Free Cash Flow Theory


Agency Costs of Free Cash is a current theory developed by Jensen (2001). The free cash flow means cash flow emanating from equity and debt, excluding tax and interest. The theory proposes “as manager’s exercise the buyback option of restructuring capital structure, more funds will given to the investors and hence less funds will available to invest in ventures with low returns” (Quiry et al, 2011).


The Woodside Company buyback deal to reduce shares worth 78.3 million.  The amount reduced equity and increased the firm’s leverage, and the increased interest was paid to investors who financed the buyout. This also reduces the amount of money invested.The theory accentuated immense changeover of liability of equity in the 1980’s.

The money flow reimbursed interest, and initial investments.

4Pecking-order Theory of Capital Structure


Pecking-order Theory of Capital is a current theory proposed by Mailuf and Mayers (1984). The theory states various firms possess stratified preface to acquisition of finance. Organizations prefer to finance activities from internal sources. Companies prefer to use debt capital rather than equity capital, based on “higher information symmetry, the lower the cost of capital and vice versa is true” (Lucarelli, 2011).Brounen et al, (2004), researched organizations in Europe, and the United States to establish factors that influence investment structure. Financial elasticity was found to be a feature that escalated capital structure and this is substantial proves to support the theory.Two things that are clearly brought out in this theory are: debt is often encouraged when equity of the firm is undervalued and also when realized profits are low.
5Static Trade-off Theory of

Capital Structure

Static Trade-off Theory of Capital Structure is a current theory which stated there is always a tradeoff between benefits and costs, and in line with agency costs, bankruptcy costs, and taxation costs. “All theories should be examined when coming up with a formidable capital structure” (Toporowski, 2005).Recent research performed by The Wall Street Journal questioned sixty firms regarding the significance of agency cost to their organization. 85% of the firms responded that agency cost is a fundamental cost and would be compared with credit rating, financial volatility and earnings volatility.The theory is affected in two steps which include; defining desired capital structure, and carefully choosing the best elements to include.
6Economic Value Added TheoryEconomic Value Added Theory is a current theory upheld by Mamun et al, (2012).

This is a model used in the “capital budgeting process and focuses on the creation of wealth based on perception of the economic model moving away from the perception of the accounting theory and model” (Aghnides, 1916).


Hatfield (2002) carried out research to exhibit the outcome of capitalization of the R&D. Investments in original products at the time when R&D is worse than outflows across the entire time.


The theory will hold efficiently when the market is efficient, and the information asymmetry problem is a big impediment to this theory.
7Capital Asset PricingCapital Asset Pricing is a germinal theory brought forward by Fama and French (2004).

The theory states “the method of estimating returns on investment for reflexive investors which they would have earned in the event the information is not tested. The following formula is used; E(r) = Rf+b(Rm-Rf” (Quiry et al, (2011).

A survey done by, Brounen et al (2004) stated 66 % of the firms in the United States used the CAMP model to investigate returns on investment portfolios. Companies relied on this model because it encompassed various risks shown in the market.CAPM’s major drawback is in the calculation of company betas in well-organized markets and the incapability to explicate volatility of risk qualities and quantity of anticipated variation in risk ratio.
8Efficiency TheoryEfficient Theory is a germinal theory that advocates efficient capital market. The theory states there is no participant in the market earning abnormal profit because of information asymmetry in trading of public stock. The theory outlines “if all the information about the market trends are explicitly made available to the public, then it wills a strong form of a market structure” (Toporowski, 2005).A research study done by NASDAQ showed various companies based their investment plans on the basis of information brought out in the stock market. Their prediction in most cases is determined by what they get from the stock exchange market information.The limitations of the theory are: Empirical inconsistencies entail problems in correcting the theory of statistics because of recurring patterns. Problems in efficiency as a form of stock market entails not incorporating costs of information, costs of transactions, oversimplifying analysis in academics and abandoning market micro-structure influences.
9Financial Liberalization

Theory of IMF

Financial Liberalization Theory of IMF is a current theory proposed by Shaw (1973). The theory advocates that more international monetary fund get liberalized the more global economic growth is realized” (Sercu, 2009)The theory was applied in 1990’s in developing nations based on the design that financial organizations would profit from foreign funds, and rivalry among financial institutions would promote efficiency.


This theory fails to address the issue on information asymmetry in the international stance, and ignores market imperfections.
10REMM Theory of Human BehaviorREMM is a current theory supported by Jensen and Meckling (1976). The theory views man as a unit for analysis in terms of economics. The behavior of people as a result of interaction with various economic systems is brought forward in this theory. The theory also states “markets are constantly in

equilibrium since REMM individuals adapt to various opportunity frontiers and make supply and demand superior, by harmonizing benefits and costs” (Sercu, 2009).

Most researchers and economists are REMM supporters who believe price structure is a self adjusting mechanism which acts in response to wants and needs.The limitation of the theory is it does not invariably describe the behavior of a specific individual and may be perceived as biased on the role of the agencies of government in their stature of controlling corporate entities.


Modigliani, F. and Miller, M. H. (1958). The Cost of Capital, Corporate Finance and the Theory   of Investment. American Economic Review, 48, 261-97.

Lucarelli, B. (2011). The economics of financial turbulence: Alternative theories of money and       finance. Cheltenham, UK: Edward Elgar

Jensen, M. and Meckling, W. (1976). Theory of the firm: Managerial Behavior, Agency Costs        and Ownership Structure. University of Rochester: New York.

Quiry, P. and Vernimmen, P. (2011). Corporate finance: Theory and practice. Chicester, West      Sussex, U.K: Wiley.

Majluf, N. S. and Myers, S. C. (1984). Corporate Financing and Investment Decisions when         Firms have Information that Investors do not have. Journal of Financial Economics 13,  187-221. North-Holland.

Brounen, D., Jong, A. and Koedijk, K. (2004). Corporate Finance in Europe: Confronting            Theory with Practice. The Netherlands: Rotterdam School of Management.

Toporowski, J. (2005). Theories of Financial Disturbance: An Examination of Critical Theories     of Finance from Adam Smith to the Present Day. Cheltenham: Edward Elgar Pub.

Mamun, A., Entebang, H. and Mansor, A. (2012). EVA as Superior Performance Measurement    Tool. Modern Economy, Vol. 3 No. 3, pp. 310-318.

Aghnides, N. (1916). Mohammedan theories of finance. New York: Columbia University.

Hatfield, G. (2002). R&D in an EVA World: As a Valuable Financial Metric, Economic Value     Added Reinforces the Role of R&D as an Investment in the Future of the Corporation.           Research-Technology Management, Vol. 45, No. 1

Fama, E. and French, K. (2004). The Capital Asset Pricing Model: Theory and Evidence.  Journal of Economic Perspectives. Volume 18, Number 3. pp. 25–46

Shaw, E. 1973. Financial Deepening in Economic Development. New York: Oxford University   Press.

Sercu, P. (2009). International finance: Theory into practice. Princeton, N.J: Princeton       University Press.


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