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CHAPTER 1 - PROLOGUE

1.1 BACKGROUND -

A small incident would justify the rationale behind selecting the topic of study by the

researcher. In a typical Post graduate management degree class, at the time of ice breaking

session, researcher asked one of the students, reasons behind pursuing the Post Graduate

Degree program. Promptly the reply came was, to have demystification done with the help of

knowledge, to be gained while studying the syllabi of corporate finance.

This reply enthused the researcher, and researcher was eager to know, from the said

student, about the pertinent questions in the mind of the said student. The said student took a

brief pause… and replied as, “Well sir I am Mr. So and So, I have completed my graduation

in Engineering. I have many Questions in my mind like…How many paradigms a concept of

Profit has ? Whether Operating profit OR Gross profit OR Net profit be considered while

comparing the firm’s progress. How is it possible that even if a manufacturing firm incurs loss

in its Business endeavors and still shows Net profit? When a firm declares the dividend,

which is sharing the profit with share holders, why it has to borrow, at times, to pay the

dividend? Is profitability not linked with liquidity? So on and so forth….the list of questions

was exhaustive.

The researcher was anxious to know that these questions were never asked before by

anyone earlier. As a faculty member the researcher was bit annoyed as well. However the

Questions raised by the said students were all valid and fundamental. The researcher became

Curious.
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The session got over. But restlessness was experienced by the researcher, which prompted

him to think further. In fact this incidence was instrumental for initiating the study.

Researcher thought for a moment and asked a question to himself, Are we teaching what is

Preached by the real world. Is there any connect between the theoretical wisdom and the

Practitioner, or professional manager?

1.2 THE FINANCE PUZZLE -

The researcher, who happens to be a faculty, tried to stand in the shoes of the inquisitive

Student and then he realized that there are so many areas which are being discussed in

classroom But the real reasoning is different than what is being taught.

The array of questions was evident. Some of them are like…

How do companies decide the percentage of Debt and Equity in their total Capital?

When the dividend irrelevance model has been in the discussion since long, and payment of

Dividend is not mandatory, still why firms pay dividend to its shareholders?

The basic characteristics of any form of debt is periodic return to the investor and redemption

As per the agreed terms, then preferred stock has both the characteristics, still it is not

considered as debt.. Why?

Even the rational and logical thinking at students’ level has become a rarity still such

questions are raised by the students. Many a times the faculty members and over all academia

is not geared to redress all the queries such students.

One should not construe that the sample questions innocently raised by the studious

students of corporate finance are baseless and absurd. On the contrary these questions are
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challenging the basics of the theoretical domain and our understanding and belief of the

corporate finance theories.

The tendency of accepting the truth on face value is common and all pervasive in all

the areas of science. Such belief makes science static. Essence of dynamism is change,

progressive change. This is ongoing and never ending process. Probable this is also called as

progress.

If such approach is to be believed then what is the truth? What has been portrayed as

truth. And is being accepted as fact is really the factual thing? Management science is a social

Science. In Social Science the society and human social action is systematically studied.

One needs to have a holistic approach while studying any specific interrelated subject.

Social Science has many applied or interdisciplinary fields and management is one of them.

1.3 ANOMALIES -

Researchers in the field of Economics and finance have cited anomalies (Christopher L

Gilbert, 2011) cited that, Anomalies are the events that are apparently incompatible with

received scientific theory. Gilbert said Kuhn saw normal science as a puzzle solving activity.

Further he said puzzles are phenomena which are discrepant with received paradigm but

which the scientific community believes can be resolved by extending paradigmatic

exemplars.

Persistent failure of resolving a puzzle together with the available alternative paradigm which

offers prospect resolution transforms the puzzle into anomaly. Hence anomaly recognition is a

component of paradigm shift.

The discussion of anomalies in finance was introduced by Jensen(1978) and in Economics by

Kuhn(1987).

The Journal of Financial Economics devoted an issue in 1978 for discussing the deviations

from

Predictions of Efficient Market Hypothesis (EMH) as an editor of the said issue, Michael

Jensen wrote “ Yet in manner remarkably similar to that described by Thomas Kuhn in his

book ‘The Structure of Scientific Revolutions, we seem to be entering a stage where widely

scattered but as yet inconclusive evidence is arising which seem to be inconsistent with the

theory…”

Further Gilbert has referred to the anomalies as cited by Jensen (Finance) and Thaler

(Economics) as given below:

Jensen’s Anomaly Examples:

A. Announcement Effects (Abnormal Returns)

In intra-day market response to the announcement of new equity issues, it was observed by

Researchers that, for fifteen minutes following the announcement there is abnormally high

Volume and -1.3% average return. There is small but significant negative, average return in

the hour before the announcement.

B. Stock Splits and Dividend announcements

The literature supports the significant positive abnormal returns for firms around the stock
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Split announcements (Ajit Jain and Mohammad Robbani). McNichlos and Dravid (1990)

observed this phenomenon and noted that stock split is a way to signal superior performance

in future. The information theory proposed by Fama, Fisher, Jensen and Roll

(1969) and Grinblatt, Masulis and Titman(1984)pointed out that managers convey positive

information about firms performance. Whereas liquidity theory proposed by Baker and

Gallagher(1980) and Lakonishok and Lev(1987) asserted that stock split Improves the

liquidity of the stock which results in reduction in stock price.

C. Close end Mutual Funds (Existence of Profitable Trading Rules)

Researchers’ observed that closed ended mutual funds usually trade at substantial discounts

relative to their net asset value. Over the period 1965-1985 researchers noted that in U S

The discount was 10.1 percent.

D. Stock and Cash Dividend (Valuation Differences)

Researchers observed that, returns on the stock portfolio were superior then the cash portfolio.

And positive returns on stock portfolio (Stock dividend) were more prominent when holding

period was more.

E. Stock and Options Prices (Small violations of Arbitrage conditions)

The researchers Efendi et al., (Jap Efendi, Anup Srivastava and Edward P Swanson, 2007)

noted when CEO’s have sizeable holdings of stock option ‘in-the-money’(i.e. stock price

above the exercise price) then misstatement of financial information was noted.

F. Informational Content of Option Prices (Implied Volatilities contain Information)

Implied volatility has been widely believed to be informationally superior to historical

volatility, because it is the markets forecast of future volatility. But S & P 100 index options

Are most traded contracts in US, researchers found implied volatility is a poor forecast of

Subsequent realized volatility.

Thaler’s anomalies

G. Market Efficiency- January Effect (Existence of Profitable Trading Rules)

The overall stock prices rise in the month of January. This happens more in case of Small

Cap stocks than large cap stocks.

H. Seasonality in Securities Prices

Well document seasonal effects on stock prices have been noted. Markets give strong positive

results at the turn of the year. (As narrated above). The summer months usually give positive

Returns, however September is traditionally a down month.

I. Mean Reversion of Stock Prices Foreign Exchange

Mean Reversion is a mathematical methodology. When used in stock investing, it tries to find

the average price using the analytical techniques. It helps to find out the trading range for a

particular stock. When the current market price is less than the average price then, the stock is

considered as a ‘buy’.

J. Endowment effect (Selling Prices exceed Buying Prices)

In behavioral economics it is also known as divestiture aversion. This means people would

ascribe more value to things because they own them. People would tend to pay more to retain
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something they own than to obtain something owned by someone else- even when there is no

cause for attachment.

K. Equity Premium Puzzle

This is a phenomenon where anomalously higher returns of stocks over the bonds. Equity

premium is equity returns less bond returns. These returns have been observed around 6%

over the past century. This reflects the relative risk of stock as compared with risk free bonds.

Puzzle arises because of unexpectedly large percentage implies a suspiciously high level of

risk aversion among investors.

L. Risk Aversion

As it indicates, an investor when offered two investment proposals yielding similar expected

return but having different risks, then the investor selects the proposal having lower risk

attached.

M. Saving out of windfall income

Har R Arkes et al.,(1994) observed that windfall gain are spent more readily than other types

of assets.

N. Inter-industry wage differentials

Working performing similar or same duties in similar industries are paid differently. This

anomalous phenomenon has been observed by many researchers however no specific solution

has been offered by any one as yet. The difference in emoluments could be substantial. For

example, in India the salary paid to an employee in government sector job is much lower than

the salary paid to private sector employee performing similar job, and having similar skill set

and acumen.
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Above mentioned are some of the anomalies, these are the representative anomalies.

The little looser interpretation of Efficient Market Hypothesis allows that there may be

profitable trading rules but states that once rule becomes known, it will cease to be profitable.

In line with this Schwert(2003,p.947) has stated “ week-end effect seem to have disappeared

or at least substantially attenuated, since it was first documented in 1980”. He has summarized

his Review on anomalies and said “ All of these findings raise the possibility that anomalies

are more apparent than real….”

These are some of the anomalies acknowledged by the eminent researchers in the field of

Finance and Economics.

The researchers are trying to explore the reasons and are in the constant search of solutions for

all the above referred anomalies. There are some Hypotheses; some explanations offered by

the researchers however these explanations are incapable arriving at the factual thing. Hence

overall experience is, there is very little connect between the industry and academia. Some of

the pertinent questions are why consistently superior returns cannot be earned by the

investors? The efficient market hypothesis has three variants weak form of EMH says prices

efficiently reflect all the information in the past series of stock prices. The semi strong form of

EMH says prices reflect all published information. The strong form of EMH says stock prices

impound all the available information. As an investor which form of EMH is to be believed?

The general academic text discusses the theoretical aspects in more detail, rarely questioning

the Existence of a theory. Specific questions are raised by Brealey et al., in their book on

Corporate Finance (Richard A Brealey, Stewert C Myers and Alan J Marcus). Nine pertinent

questions are raised by the authors.

1. What Determines project risk and present value? The basic question asked is why

some of the firms earn superior returns and other cannot. When are superior returns

mere windfall gains? For how long firms enjoy such gains? Can such gains be

anticipated?

2. While citing the risk-return, these authors have said CAPM is hard to prove or

disprove conclusively. CAPM is incomplete but extremely useful way of linking risk

and return.

3. Further they ask are there any important exceptions for the Efficient Market Theory?

Why asset prices go out of line is not understood by the theory.

4. They have observed that managers and employees co invest with stockholders and

creditors human capital from insiders and financial capital from outside investors, very

little is known about this co investment.

5. They feel that still coherent and accepted theory for capital structure is not available.

6. Why firms pay dividends is not fully understood as yet.

7. The wave of merger was observed in 2004. Till 2002 firms were not keen for mergers

and all of a sudden the financial fashion of merger was experienced. This is not fully

understood by the researchers.

8. What is the value of Liquidity? When firms maintain cash as a precautionary measure

the cash is considered as liquidity. This cash has value which is seldom considered.

9. Why financial Systems are are prone to crisis? The situation of crisis is never

satisfactorily explained by the academic literature.

Besides this, anomalies in the financial performance analysis are experienced.

In the analytical tool like Ratio Analysis, There are benchmarks like Debt : Equity ratio is

preferred to be 2:1. This ratio of 2:1 is very subjective and cannot be taken as target ratio.
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There is a strong possibility where 4:1 or even 6:1 ratio could be observed and tolerated

without any problem.

While studying working capital, when the statement showing changes in working capital is

prepared , whether provisions be considered as current liabilities or not, is a gray area.

Whether unsecured loans be considered while calculating the working capital as current

liabilities?

When profitability of a firm is assessed then whether EBIT/ Operating Profit should be

considered? Or PAT should be considered?

1.4 SOME RESOLUTIONS IN FINANCE -

Even though there are certain anomalies and unanswered questions, there are definite answers

for quite a few concepts, as elaborated in various text books on Corporate Finance. However,

the researcher found that Brely and Myers (Richard A Brealey, Stewert C Myers and Alan J

Marcus) have summarized the same in a lucid manner.

What we know about finance- the seven most important ideas in finance

1. Net Present Value (NPV)- this is most valuable concept in finance and is the only way

of evaluating the assets. All the corporate finance managers strive for increment in

NPV.

2. Capital Asset Pricing Model (C A P M )- Provides thinking about Risk and Return.

This model tells us that assets have two kinds of risks diversifiable and

undiversifiable. Only the non-diversifiable or market risks count. So Assets return is a

function of market risk and risk premiums are calculated as direct function of market

risk measure, beta.

3. Efficient Capital Markets- believes that security prices reflect information accurately.

The three forms viz. Strong, Semi strong and Weak form give us the degree of

efficiency. It is good to observe that capital markets are by and large efficient.

4. Value Additivity and Law of Conservation of value- states value as a whole is given

by the sum of its parts. Its implications on mergers and acquisitions states that value is

not added unless combined firm produces better cash flows than either firm produced

when it was independent.

5. Capital Structure Theory- Miller and Modigliani stated that in perfect market, changes

in capital structure do not change the value of the firm.

6. Options Theory-In finance options means more than alternatives, it means opportunity

to trade or not to trade, in future, on terms that are fixed today.

7. Agency Theory-Helps us to explain why complex contracts and arrangements are

needed in many corporate transactions. An organization comprises of many men,

women, lenders, borrowers, shareholders, customers. The conflicts cannot be

eliminated completely but understanding them can help us get the best working results.

For these theories the explanation of the relevance and usefulness has been established. In

facts because of the same theses are considered the theories of corporate finance.

1.5 THE RESEARCH CONCEPT -

Besides the above theories there are large number of Theories / Concepts / Approaches in the

domain of corporate finance. The theory is efficient when it explains or answers the relevant

concepts. An effort is made to know whether select corporate finance theories are relevant in

present time or not? By the researcher. so to understand the efficacy of the theory researcher

attempted to review the research papers and articles, in detail, relevant to the specific Theory/

Concept / Approach.
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The broad classification of select corporate finance theories has been done as

A. The Financing Decisions

B. The Investing Decisions

C. The Dividend Decisions

D. Other Decisions

Further the relevant theories / concepts / approaches were considered as per the individual

decision.

1.6 – THE CHAPTER SCHEME -

The research work carried out by the researcher has been elaborated in Seven chapters as

elaborated below -:

1. Prologue

The rationale of this study has been explained in the chapter-1, Prologue. The researcher

experiences several anomalies and confusions while practicing the as a faculty in the business

management School as well as in professional life. What is a theory? What is a concept? How

an approach is different than theory and concept? If there is a difference then why the

thinkers and researchers in the field of corporate finance use these words interchangeably?

Were the questions in the mind of the researcher. Can clarity of thought be achieved? Can

some demystification be made possible? Was thought by the researcher.

In this chapter what we know of corporate finance? And what we do not know about

the corporate finance has been briefly discussed. As stated earlier four broad aspects viz. the

financing decisions, the investing decisions, the dividend decisions and the areas which are

relevant but cannot be classified in these classes are considered in other decisions.
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2. Research Methodology

The various types of research, the discussion about qualitative and quantitative research

including the comparison have been discussed in this Chapter-2 of Research Methodology. In

the domain of the quantitative research, which specific type of research is suitable for this

study has been discussed. The methods of Qualitative data analysis have been elaborated in

research methodology. The theoretical concepts / beliefs are considered as normative

statements for each relevant theory, the exhaustive list of such normative statements has been

provided in research methodology. The process of analyzing the data and arriving at the

inference with the help of descriptive statistics has been elaborated.

3. The Financing Decisions

In Chapter-3, the crucial function of making the financial resources available for the enterprise

is studied in the financing decisions. The relevant theories /Concepts / Approaches are

considered and an effort has been made to study the relevance of these, for the same. The

relevant research papers / research articles were studied in detail and congruence or rejection

or indifference was noted and analyzed.

4. The Investing Decisions

The Investment aspect and financing are interlinked. In Chapter-4 largely the capital

budgeting related decisions are considered in investment decisions. As mentioned above, in

chapter-3, the relevant theories/ concepts / approaches related with the investment decisions

were studied and the researchers’ views on these theories / concepts / approaches were

analyzed.

5. The Dividend decisions

In Chapter-5 Dividend theories are studied. The relevant theories /concepts / approaches with

respect to dividend decisions are considered. The specific theories like bird-in-hand theory,

clientele effect are the dividend decision specific theories, discussed in this chapter. The

researchers findings/ conclusions and the relevance of the same with the existing select

dividend theories / concepts / approaches were analyzed to find out the usefulness of such

theories in present context.

6. Other Decisions

Corporate finance theories which cannot be classified in Financing, Investing and Dividend

decisions are classified in other decisions. In Chapter-6 such theories / concepts / approaches

are considered. Concepts like Average Rate of Return (ARR), Behavioral Finance, Cash

Flow, Corporate Governance, E V A , Tobin’s Q, Profit Maximization , Prospect Theory,

Tunneling effect are considered in this chapter. The relevance of these theories / concepts /

approaches in the light of researchers’ conclusions were analyzed.

7. Epilogue

In Chapter-8, Epilogue, the review of the study of all four selected broad categories of

corporate finance theories has been taken. The present status of these theories/ concepts /

approaches on the basis of the analysis done by the researcher is explained. Besides this

further more areas which are largely remaining un-answered till date have been enlisted.

Though researchers are trying to find logical solutions since long, no conclusive answer in

seen in the vicinity.

8. Bibliography

The detailed references and bibliography has been enlisted in this concluding section of the

chronicler.