A Synthesis of The Theory of Corporate Finance: Iwedi Marshal

Journal for Studies in Management and Planning e-ISSN: 2395-0463
Available at http://edupediapublications.org/journals/index.php/JSMaP/ Volume 02 Issue 2

February 2016
A Synthesis of the Theory of Corporate Finance

Iwedi Marshal
Department of Banking and Finance Rivers State University of Science and Technology
Nkpolu- Port Harcourt, Nigeria.
Iwedimarshal@yahoo.com
ABSTRACT
This paper synthesizes the theory of corporate finance. It highlights the equations, graphs
and models of corporate finance theory with particular reference to capital markets,
consumption and investments, investment decision under certainty and uncertainty
assumptions, capital budgeting decision under certainty, uncertainty and capital
rationing Conditions. There is also a down to earth explanations of the theory of choice,
objects of choice, market equilibrium, the theory of efficient capital markets, theories of
dividend policy, capital structure and cost of capital, security valuation, contingent
claims analysis and agency theory and analysis. This synthesis modeled eighty (80)
equations and twenty (20) graphs as it relates to corporate finance theory.
Keywords: Corporate Finance Theory, Equations, Graph and Model
Introduction
Over the years, the field of finance has remained dynamic and has received considerable
attention from academic researchers keen on understanding issues likes:
 How do individuals and society allocate scare resources?
 How do people make choices?
 How should capital budgeting decision be made?
 What dividend policy should the firm follow?
 How efficiently does capital market function?
 What is the cost of capital? How is it affected by project risk? and by project debt
capacity?
 How should financial assets be valued?
It is on this basis this synthesis is carried out to proffer answers to this questions thereby
reviewing some equations, graphs, theories and models relating to corporate finance and
it implication for corporate survival.
Available online: http://edupediapublications.org/journals/index.php/JSMaP/ P a g e | 186

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1. Capital Markets, Consumption and Investment

A. Consumption and Investment without Capital Markets
Assumption
 All outcomes from investment are known with certainty
 No transaction costs
 No taxes
 Two-period model
C1
C1a A
C1b B
Co
C0a C0b
Fig. 1 How Individuals Make Choices among Consumption Bundles

At point A, the decision maker has more consumption at end of the period but less
consumption at the beginning than point B decision maker does. The straight line tangent
at point B measures the rate of trade-off between C1 and C0. The trade-off is called the
marginal rate of substitution (MRS). It also reveals the individual subjective rate of time
preference r1 at point B. mathematically, it is defined as:
C1
MRS CC10  u  const  1  ri  - - - - - - 1
C0
Where C1 = Consumption at end of the period

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C0 = Consumption at the beginning of the period
Marginal rate
of return
r1 B
C
Investment
Fig. 2 Investment Schedule and Production Opportunity Set
The above shows a situation where productive opportunities abound, which allows a unit
of current savings/investment to be turned into more than one unit of future consumption.
At any given point an individual will make all investments which have rate of return
higher than his subjective rate of time preference.
C1
C B
1
1
Y1 A
C0 Y0 C0

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Fig.3 The Investment Opportunity Set

Note: The slope of a line tangent to curve ABC in Fig.3 demonstrate the rate at which a naira of
consumption forgone today is transformed into a naira of consumption tomorrow it is the marginal rate of
transformation offered by the investment opportunity set.
C1
MRS = MRT = - (1+r1)
Individual 2
Y1
Individual 1
Co
Y0
Fig. 4 Equilibrium in a Robinson Crusoe World
Individual 1 consumes more than individual 2 in period one since no capital market,
individuals with the same endowment and the same investment opportunity set may
choose completely differed investments because they have different indifference curve.
Consumption and Investment with Capital Market

Initial endowment A:
Y1
W0  Y0  (2)
1  r 
Where W0 = the present value of an individual initial endowment

Y0 = current income
Y1 (1+r) = the present value of his end of period income.

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C1
W1
*B
A U2
*
U1
Co
W0
Fig. 5 Capital market line
With capital market, an individual can move from A to B, reaching a higher utility. On
the capital market line, one’s wealth does not change but consumption differs. The slope
of the capital market line is given as:
C1*
W0  C 0*  - - - - - - - (3)
1 r
Equation 3 can be rewritten to give the CML equation as
C1*  W0 1  r   1  r  C0* - - - - - - (4)
and since W0 1  r   W1 , we have
C1*  W1  1  r C0* - - - - - - - (5)

w1 is the intercept, while (1 + r) is the slope of the capital market line.

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C1 POF
W1*
W1
P1
B*
C1 * *C
D* CML
Y1 *
A
P 0 C0 * Co
Y0 W0 W0*
Fig. 6 Joint effect of Production/Investment and Capital Market
Both POF and CML offer a high rate of return than his subjection time preference, but
production offers higher return, therefore, an agent chooses to invest and move along the
production frontier.
FISHER SEPARATION THEORY

“Given perfect and complete markets, the production is governed by an objective market
criterion without regard to individual’s subjective preferences that enter into their
consumption decision”. The separation of investment and consumption decisions is
known as the Fisher Separation Theorem.

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C1
W1
Individual 2
*
X
P1 B
Individual 1
Y
Co
P0 W0
Fig.7 Investment Decision is Independent of Individual Preferences
Without capital market opportunities, individual 1 would choose to produce at point Y,

which has lower utility, similarly, individual 2 would be worse off at point X. But with
good investment opportunities which rates of returns are higher the market than rate, the
individual can borrow (in case of wealth insufficient) funds and invest more than they
would without capital markets.

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2. Investment Decisions
A. Under the Certainty Assumption:
The following assumptions are made:
 The interest rate is known in all time periods
 All future payoffs from current investment decision are know
 There are no imperfections to capital markets.
C1
W1
Individual 1
P1
Individual 2
Co
P0 W0
Fig. 8 Separation of Shareholder Preferences from the Production Investment Decision
In the graph, P0, P1 maximizes the present value of the shareholders wealth Wo. The
separation principle implies that the maximization of the shareholders wealth is identical
to maximizing the present value of their life time consumption. Mathematically, this is
demonstrated as
C1
W0  C 0  (6)
1 r

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Where W0 = current wealth

Co = current consumption
C1 = end of period consumption (future)
B. Maximization of Shareholders Wealth

We can say that shareholders wealth is the discounted value of after tax cash flows paid
out by the firm which can be shown to be same as stream of dividends Dt, paid to
shareholder. The discounted value of the stream of dividend is

Dt
So =  1  k 
t 0
t
(7)
Where So = is the present value of shareholder wealth

K = is the market determined rate of interest.
Equation 7 can be rewritten for the present value of a growing annuity stream, we get
D1
S0 = (8)
kg
Where g= is the growth rate of the dividend stream and
K= the opportunity cost of investment.
Equation 7 and 8 is the discounted value of the stream of cash payments to shareholders
and is equivalent to the shareholders wealth.
C. Definition of Profit
To an economist profits mean cash flow. In making decision, the profits to be used are
the discounted stream of cash flows to shareholders (dividend) =
Dt = Rt – (W&S)t – It (9)
We can rewrite shareholders wealth as

Rt  W & S t  I t
S= 
t 0 1  k t
(10)
The accounting definition of profit is mathematically express as

At = Rt - (W&S)t – zt (11)

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Since At is different from Dt, it can be adjusted by subtracting net investment. This is
done in eq (12)

Rt  W & S t  Z t  I 1  Z t 
S= 
t 0 1  k t

At  N t
=  1 k 
t 0
t
(12)
D. Techniques for capital budgeting

The best capital budgeting techniques possess the following essential property.
- All cash flows should be considered
- The cash flows should be discounted at the opportunity cost of funds.
- The technique should select from a set of mutually exclusive projects the one
which maximizes shareholders wealth.
- Managers should be able to consider one project independently from all other
(This is known as The Value Additivity Principle)
The VAP implies that if we know the value of separate projects accepted by
management, then simply adding their values Vj will give us the value of the firm
V.
N
V  V j 1
j (13)
 There are five (5) widely used capital budgeting technique

1. The payback method: This method is defined as follows
Initial Investment Co
Payback =  (14)
Annual cash inf low C
2. The accounting rate of return (ARR)

Average after  tax income
ARR = or
Initial outlay
n 
 EBIT t 1  T  / n
ARR  
t 1
(15)
I 0  I n  / 2

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Where EBIT is earning before interest and tax as,

T = Tax rate,
I0 = book value of investment in the beginning
In = book value of investment at the end of n number of years.
3. Net Present Value (NPV)

NPV is mathematically defined as
N
NCFt
NPV =  1  k 
t 1
t
 I0 (16)
Where NCFt is the net cash flow in time period

I0 is the initial cash outlay
K is the firm’s cost of capital
N is the number of years in the project.
4. Internal Rate of Return (IRR): It is the rate which equates the present value of
the cash flows and inflows.
N
NCFt
NPV = 0 =  1  IRR 
t 1
t
 I0 (17)
5. Profitability Index (PI): This is the ratio of the present value of the cash flows to
the initial outlay. Mathematically we have
PV of annual cashflows
PI =
Initial investment
N
NCFt
PI =  1  k 
t 1
t
(18)
I0
3. Advanced Capital Budgeting Decision

A. Capital budgeting decision under inflation

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Firms are always concerned about the impact of inflation on the project’s profitability.
The capital budgeting results will be biased if the impact of inflation is not correctly
factored in the analysis. Since the opportunity cost of capital or the discount rate is a
combination of the real rate (say K) and the expected inflation rate (call it alpha  ). This
relationship, long ago recognized in the financial economic theory is called the Fisher’s
Effect. It may be stated as follows.
Nominal discount rate = (1 + Real discount rate) x (1+ inflation rate) – 1
K  1  K  1     1 (19)
The NPV formula can be written as follows when cash flows and discount rates are
expressed in normal terms.
NCFt 1   
n t
NPV =  1  k  1   
t 1
t t
 I0 (20)
When K is the real discount rate,

 is the expected inflation rate.
B. Asset Replacement Problem

The choice between projects with unequal lives should be made by comparing their real
annual equivalent values (AEVs) AEV is the NPV of an investment divided by the
annuity factor given its life and host-free discount rate.
NPV
AEV = (21)
Annuuity factor
1
Where PVFA =
1  K n
AEV for perpetuities
When we assume that projects can be replicated at constant scale indefinitely, we imply
that an annuity is paid at the end of every n years starting from the first period. This can
be written as
NPV n NPV n
NPV   NPV n   ..... (22)
1  k  n
1  k 2n
Solving this series, we get

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 1  k n 
NPV   NPV n    (23)
 1  k  1
n
Where
NPV  is the present value of the investment indefinitely
NPVn is the present value of the investment for original life.
n and k is the opportunity cost of capital.
NOTE: The procedure of comparing AEVs can be followed while replacing an existing asset by new asset.
The NPV rule also proves handy in resolving the timing problem of an investment.
C. Capital Rationing
Capital rationing occurs because of either the external or internal constrain on the supply
of funds. In capital rationing situation, the firm cannot accept all profitable projects.
Therefore, the firm will aim at maximizing NPV subject to the funds constraint.
 In simple one-period capital rationing situations, the profitability index (PI) rule
can be used. PI rule breaks in the case of multi-period funds constraints and
project indivisibility. The PI under capital rationing situation is as
n
Ct
 1 K 
t 1
t
PI = (24)
I0
i.e. the ratio of the present value of cashflows to the initial outlay.
 A more sophisticated approach either linear programming or integer programming
can be used to select investment under capital rationing. However, two factors
limit the use of these approaches in practice. First, they are costly and second they
assume investment opportunities as known.
4. THE THEORY OF CHOICE (UTILITY THEORY)

A. The Axioms of Cardinal Utility

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 Comparability: Here, an individual can say either that outcome X is preferred to

outcome Y (X>Y) or Y is preferred to X (Y>X) or the individual is indifferent as
to X and Y (X~Y)2.
 Consistency: If an individual prefers X to Y and Y to Z, then X is preferred to Z
(if X > Y and Y> Z, then X> Z). If an individual is indifferent as to X and Y and
is also indifferent as to Y and Z, then he is indifferent as to X and Z. (if X ~ Y and
Y ~ Z, then X ~ Z).
 Strong Independence: assume a gamble where an individual has a probability 
of receiving outcome X and a probability (1-  ) of a receiving outcome Z. this
can be written a G(X,Z:  ). The third axioms says that if the individual is
indifferent as to X and Y, then he will also be indifferent as to a first gamble, set
up between X with probability  and mutually exclusive outcomes Z, and a
second gamble, set up between Y with probability  and the same mutually
exclusive outcome, Z.
If X ~ Y, then G (X, z:  ) ~ G (Y,Z:  )
 Measurability: If outcome Y is preferred less than X but more than Z, then there
is a unique  (a probability) such that the individual will be indifferent between
Y and a gamble X with probability  and Z with probability 1-  3. If X>Y > Z
or X >Y>Z, then there exists a unique  , such that Y ~ G (X,Z:  )
 Ranking: If alternatives Y and U both lie somewhere between X and Z and we
can establish gambles such that an individual is indifferent between Y and a
gamble between X (with probability  1 ) and Z, while he is also indifferent
between U and a second gamble, this time between X (with probability  2 ) and Z,
then if  1 is greater than  2 , Y is preferred to U. If X>Y>Z and X>U, then if Y-
G(X, Z:  1 ) and U-G (X, Z:  2 ), it follows that if  1 >  2 then Y >U or if  1 =  2
then Y-U.
However, given the five axioms of rational investor behavior and the additional
assumption that all investors always prefer more wealth to less, we can say that investors
will always seek to maximize their expected utility of wealth.
In general, we can express the expected utility of wealth as

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MAX E[U(W)] = ∑PiU(WI) (25)

Equation (25) is exactly what we mean by the theory of choice.
We have graphed three utility functions with positive marginal utility:
Risk lover = If U[E(W)] < E[U(W)] we have risk aversion.
Risk neutral = If U[E(W)] = E[U(W)] we have risk neutrality
Risk averter = If U[E(W)] > E[U(W)] we have risk loving
U(w) U(w)
U(b) U(b)
U(a)
U(a)
w w
a b a b
Fig 9 Risk lover Fig10 Risk Neutral
U(w)
U(b)
U(a)
a w
b
Fig 11 Risk averter

Note: If an individual’s utility function is strictly conceive he will be risk averse, if it is liner, he will be risk
neutral and if it is convex, he will be a risk lover.

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5. Objects of Choice: Mean Variance Uncertainty

A. Measure of location
The mean is most often used measure of location. It is defined as
E X  
N
P X
i 1
i i (26)
Where Pi is the probability of a random event

Xi is the total number of possible events
The expected or mean return is the expected prices less the current price divided by the
current price.
E P  P0
E R   (27)
P0
B. Measures of Dispersion
There are five measures of dispersion which we could use the range, the semi-
interquartile range, the variance, the semi-variance and the absolute mean deviation.
Each of these has slightly different implications for risk
 The range is defined as the difference between the highest and lowest outcomes.
 The semi-interquartile range is the difference between the observation of the 78th
percentile, X75, and the 25th percentile, X25 divided by 2.
X 75  X 25
Semi-interquartile range = (28)
2
 The variance is the statistic most frequently used to measure the dispersion of a
distribution and it will be used as a measure of investment risk. It is defined as
the expected squared difference from the mean.

VAR X   E X 1  E X 
2
 (29a)
Recalling the definition of the mean as the sum of the probabilities of events times the
value of the events the variance can be rewritten as
VAR X    P X  E X 
N
2
i i (29b)
i 1
 The standard deviation which is the square root of the variance, is often used to
express dispersion and his given as

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 P   VAR P  (30)
C. Measuring Portfolio Risk and Return

Investors measure the expected utility of choices among risky assets by looking at the
mean and variance provided by combination of those assets. For a portfolio manager, the
risk and return are the mean and variance of the weighted average of the assets in his
portfolio.
The mean return is the expected outcome and is given as
E( RP   aE X   bE Y  (31)
The portfolio mean return is the weighted average of returns of individual securities,
where the weights are the percentage invested in those securities.
 The portfolio variance is the sum of the variance of the individual securities
multiplied by the square of their weights plus a third term, which is called the co
variance, Cov X , Y 
VAR RP   a 2 VAR x  b 2 VAR Y  2ab CoV x, Y  (32)

Cov X , Y   E X  EX  Y  EY  
D. The Correlation Coefficient
The correlation rxy, between two random variables is defined as the covariance divided by
the product of the standard deviations.
CoV  X , Y 
Vx, y  (33)
x y
Fig. 12 Correlation Coefficient Graph

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This graph shows independent returns of two assets. A situation where the covariance is
zero, the correlation between them is also zero.
An opposite situation occurs when the returns are perfectly correlated. Here the
returns of the assets fall on a strength line, perfect correlation will result in a correlation
coefficient which is equal to 1
6. Market Equilibrium
Means Variance Uncertainty and Asset Valuation
In order to determine the market price for risk and the appropriate measure of risk for a
single asset, the economic model of the Capital Asset Pricing Model (CAPM) is used to
solve this problem.
Recall that the slope of the capital market line is
E  Rm   R f
(34)
m
Equating this with the slope of the opportunity set we have
E Rm   R f E Ri   E Rm 
 (35)
m  
 im   m2 / 6m
This relationship can be rearranged to solve for E(R1) as follows:
 
E Ri   R f  E Rm   R f  i (36)
Equation 7.3 is known as the capital asset pricing model and it is shown graphically
below
E(Ri)
SML
E(Rm)
Rf
 im
Pm i 
 m2

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FIG. 13 The Capital Asset Pricing Model
Note: The required rate of return on any asset, E(Ri) in eq. 36 is equal to the risk-free rate of return plus a
risk premium. The risk premium is the price of risk multiplied by the quantity of risk. In CAPM, the price of
the risk is the slope of the line, the difference between the expected rate of return on the market portfolio
and the risk-free rate of return. The quantity of risk is often called beta, i it is the covariance.
 im CoV Ri , Rm 
i   (37)
 m2 VAR R m 
Between returns on the risky asset; I, and market portfolio, M divided by the variance of
the market portfolio. The risk-free asset has a beta of zero because its covariance with the
market of portfolio is zero. The market portfolio has a beta of one because the covariance
of the market portfolio with itself is identical to the variance of the market portfolio:
CoV Rm, Rm  VAR Rm 

m   1 (38)
VAR R m  VAR Rm 
B. Use of the CAPM for valuation: Single-Period Models, Uncertainty


The CAPM is an extremely useful tool for valuing risky asset. Our risky return, R j is

 Pe  P0
Rj  (39)
P0

Where R j is risky return

Pe is risky payoff
P0 is the price we pay today
The CAPM can be used to determine what the current value of the asset, Po should be.
The CAPM is
E R j   R f   Cov R j , Rm , (40)
E  Rm   R f
Where  
VAR Rm 

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Note that  can be described as the market price per unit risk. We can equate the
expected return Eq. (39) with the expected return in Eq (40):
E Pe   Po
 R f   CoV R j Rm  (41)
Po
We can now interpret Po as the equilibrium price of the risk asset. Rearranging the above
expression, we get
E Pe 
Po  (42)
1  R f  CoV R j , Rm 
Equation (42) is often referred to as the risk-adjusted rate of return valuation formula.
The numerator is the expected end of period price for the risky asset and the denominator
can be thought of as a discount rate.
The certainty – equivalent valuation formula is given
Po 
 
E Pe    CoV Pe , , Rm  (43)
1  Rf
Note: That the risk-adjusted rate of return and the certainty equivalent approaches are equivalent for one-
period valuation models.
C. Applications of the CAPM for Corporate Policy

Assuming that the firm has no debt and that there are no corporate taxes. The cost of
equity capital for a firm is given directly by the CAPM, which is use to determine the
required rate of return on equity and is given as
 
E R j   R f  E Rm   R f  j (44)
If it is possible to estimate the systematic risk of a company’s equity as well ask the
market rate of return then E(Rj) is the required rate of return on equity i.e. the cost of
equity for the firm. If we designate the cost of equity as Ke then
E(Rj) = Ke (45)

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Graphically it is represented as
E R 
E K k 
Rk *K
K  E R j 
L
Rf
j k 
Fig 14 The Cost of Equity using the CAPM
The expected rate of return on project K is higher than the cost of equity for the firm. But
the project also is riskier than the firm because it has greater systematic risk.
E R p 
E(Rm) M
*
E(Rz) B A
* *
m  R p 
Fig 15 The Capital Market Line with No Risk-Free Rate
The above graph shows the capital market line with no risk-free rate. Portfolio M is
identified by all investors as the market portfolio which has on the efficient set. Portfolio

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A and B are both uncorrelated with the market portfolio M and have the same expected
return, E(Rz). However, only one of them, portfolio B lies in the opportunity set.
7. Theory of Efficient Capital Markets

Capital markets may be efficient in weak, semi-strong and strong form as defined by
Fama (1970, 1976).
A. Weak-Form Efficiency
The security prices reflect all past information about the price movements in the weak
form of efficiency. It is therefore, not possible for an investor to predict future security by
analysis historical prices, and achieve a return better than the stock market index.
In an efficient capital market, there should not exist a significant correlation between the
security prices overtime, as share prices behave randomly. Hence the weak form of
efficiency is referred to as the random walk hypothesis.
B. Semi-Strong Form Efficiency
Here security prices reflect all publicly available information. This implies that an
investor will not be able to outperform the market by analyzing the existing company-
related or other relevant information available in, say the annual accounts, or financial
dailies/magazines.
C. Strong Form of Efficiency
In the strong form of efficiency, the prices reflect all published and unpublished public
and private information. No investor can earn excess returns using information whether
publicly available or not.
D. The Theory of efficient markets
 Expected Return or “Fair Game” Models – the fair-game model is based on the
behavior of average returns (not on the entire probability distribution. Its
mathematical expression is
Pj , t 1  Pjt E Pj t 1 / nt   Pj t
E j , t 1   (46)
Pjt Pj t
Pj , t  1  E Pj t 1 / nt 
=
Pj t

February 2016
Where:
Pjt + 1 = the actual price of security j next period
E(Pjt + 1/nt) = the predicted end-of-period price of security j givens the current
information structure.
Ej, t+1 = the difference between actual and predicted returns
Note that equation 46 is written in returns form. If we let the one-period return be defined
as
Pj , t 1  Pjt
r j , t 1  (47)
Pjt
Then equation 46 may be rewritten as

Ej,t + 1 = rj,t+1 – E(rj,t + 1/nt) and
E(Ej,t +1) = E(rjt +1 – E (rj,t + 1/nt) = 0 (48)
Therefore, a fair game means that, on average, across a large number of samples, the
expected return on an asset equals its actual return.
 The Submartingale or The Martingale Model
The submartingale is a fair game where tomorrow’s price is expected to be greater than
today’s price. Mathematically, the submartingale model is
E(Pjt+1/nt) > Pjt (49)
In returns form this implies that expected returns are positive. This may be written as
follows:
E Pj t 1 / nt   Pj t
 E r j t , 1 / nt   0 - - - - (50)
Pj t
The martingale model is also a fair game, however, with a martingale tomorrows price is
expected to be the same as today’s price. Mathematically, this is
E Pj t , 1 / nt   Pj t (51)
In returns form, it is written as

E Pj t 1 / nt   Pj t
 E r j t , 1 / nt   0 (52)
Pj t
 The random walk model

February 2016
The random walk model says that there is no difference between the distribution of
returns conditional on a given information structure and the unconditional distribution of
returns.
 
f Plt ,......... .. Pnt / ntm  1  f Plt ,......... .. Pnt / nt  1 (53)
Equation 53 is a random walk in prices while equation 54 is a random walk in returns:
f rl , 1...., rn.t 1  f rl , 1...., rn.t 1 / nt  (54)
Random walks are much stronger conditions than fair games or martingales because they
require all the parameter of a distribution (like the mean, variance, skewness and
kurtosis) to be same (identical) if returns follow a random walk, then the mean of the
underlying distribution does not charge over time, and a fair game will result.
8. Dividend Policy of the Firm

On the relationship between dividend policy and the value of the firm, different theories
and models have been advanced as follows.
A. Relevance Theory
The proponents of these theories are Professor J.E. Walter called the Walters model and
Myron Gordon with the popular Gordon’s dividend-capitalization model.
Dividend Relevance Assumption
 All-equity firm
 No external financing
 Constant return and cost of capital
 100 percent payout or retention
Walter’s model to determine the market price per share is given below.
DIV ( EPS  DIV ) / K
P r (55)
K K
Equation 55 shows that the market price per share is the sum of the present value of two
sources of income:

February 2016
 The present value of the infinite stream of constant dividends, DIV and
K
 The present value of the infinite stream of capital gains, r ( EPS  DIV ) / K  / K
This equation (55) can be rewritten as follows:
DIV  (r / K )(EPS  DIV )
P (56)
K
Gordon’s Model
According to his model, the market value of a share is equal to the present value of an
infinite stream of dividends received by shareholders which is given as:

DIV1 DIV 2 DIV  DIVt
P0  
(1  K ) (1  K ) 2
 ...... 
(1  K ) 
 
t 1 1  K )
t
(57)
Note: That the dividend per share is expected to grow when earnings are retained. Hence when we
incorporate growth in earnings dividends, resulting from the retained earnings in the model, the present
value of a share is determined as follows:

DIV (1  g ) t
P0   (58)
t 1 (1  K ) t
When equation (58) is solve it becomes
DIV1
P0  (59)
kg
Substituting Eps1 (1-b) or DIV1 and br for g, equation 59 can be rewritten as:
EPS1 (1  b)
P0  (60)
k  br
Equation 60 is particularly useful for studying the effects of dividend policy on the value
of the share.
B. The case of a normal firm where r = k

Under this situation equation (60) may be expressed as follows
EPS 1 (1  b) rA(1  b)
P0   (61)
k  br k  br
(Since EPS =Ra, A = assets per share)

February 2016
EPS 1 (1  b) rA(1  b) EPS rA

If r = k1 then P0     A (62)
k  br k  br K r
Equation (62) shows that regardless of the firm’s earnings per share, EPS, or risk the
firm’s value is not affected by dividend policy and is equal to the book value of asset per
share.
C. Case of the declining firm where r <k
Equation (62) indicates that, if the retention ratio, b is zero or payout ratio (1-b) is
100 percent the value of the share is equal to:
rA
P0  (b  0) (63)
k
If r  k then r 1 and from eq (63) it follows that P0 is smaller than the firms
k
investment per share in assets A.
D. Dividend Irrelevance: Miller-Modigliani (MM) Hypothesis

MM’s hypothesis of irrelevance is based on the following assumption
 Perfect capital market
 No taxes
 The firm has a fixed investment policy
 No risk
MM’s derive their valuation model as follows
DIV1  ( P1  P0 )
r (64)
P0
DIV1  P1 DIV1  P1
P0   (65)
(1  r ) (1  K )
Where P0 = is the market price per share at time 0
P1 = is the market price per share at time 1
DIV1= is the dividend per share at time 1
r = is the firms rate of retain

r=k
k = is the firms cost of capital

February 2016
Since r = k in the assumed world of certainty and perfect markets. Both sides of equation
H can be multiplied by the number of shares outstanding, n, we obtain the total value of
firms if no new financing exist.
n( DIV1  P1 )
V  nP0  (66)
(1  K )
Thus, there does not seem to be a consensus on whether dividend matter or not. In
practice, a number of factors will have to be considered before deciding about the
appropriate dividend policy of the firm.
9. Capital Structure and Cost of Capital

There exist conflicting theories on the relationship between capital structure and the value
of a firm.
A. Relevance of Capital Structure
The traditionalists believe that capital structure affects the firm’s value. One earlier
version of the view that capital structure is relevant is the NET INCOME (NI)
APPROACH. Here NI approach classify firm’s into 1 levered firm (equity and debt), 2
unlevered firm (only equity but no debt)
Value of equity = discounted value of net income
Net Income NI
VE   (67)
Cost of equity ke
Similarly the value of a firm’s debt is the discounted value of debt-holders interest
income.
Interest INT
VD   (68)
Cost of debt Kd
So, therefore the value of firm is the sum of the value of equity and the value of debt
V f  VE  VD (69)
Net operating income

The firm’s overall cost of capital is =
Value of the firm

February 2016
No 1
Kc  (70)
Vf
The firm’s overall cost of capital is the weighted average cost of capital (WACC).
Alternately it can be calculated as;
WACC = cost of equity x equity weight cost of debt x debt weight
VE VD
K C  Ke   Kd  (71)
Vf Vf
Rearranging equation (5), we get
 V  V
WACC  K C  Ke  1 D   Kd  D
 V  Vf
 f 
V
WACC  K C Ke  ( Ke  Kd ) D (72)
Vf
B. IRRELEVANCE OF CAPITAL STRUCTURE: MM HYPOTHESIS WITHOUT

TAXES
Modigliani and Miller (MM) argue that, in perfect capital markets without taxes and
transaction cost, a firm’s market value and the cost of capital remain invariant to be
capital structure changes. The value of the firm depends on the earnings and risk of its
assets rather than the way in which assets have been financed. Financing only changes
the way in which the net operating income is distributed between equity holders and debt-
holders.
MM’s proposition 1: Firms in same risk class.

Value of the debt-equity firm = value of equity firm
Net of operating income
Value of the firm V1  Vu
firm' s operating cos t of capital
No 1
V f  V1  Vu  (73)
Ka
In the case of debt-equity firm, WACC = k0 or K1 thus
NOI
K 0  K1  (74)
VI
While the unlevered firm’s WACC or Ku we have

February 2016
NOI
Ku  (75)
Vu
The MM Hypothesis under Corporate Taxes:
In reality, corporate income taxes exist and interest paid to debt-holder is treated as a
deductible expenses. Thus, interest payable by firms save taxes. This makes debt
financing advantageous.
Interest tax shield = Corporate Tax rate x Interest
INTS = T x INT = T x KdD (76)
10. Valuation of Corporate Securities

A. Contingent Claims Analysis
Contingent claims analysis (CCA) is a techniques to determine the following:
 The price of a security whose payoff depend upon the price of one or more other
securities.
 The value of a convertible bond in terms of the price of the underlying stock into
which the bond can be converted.
 The value of the flexibility associated with a multi-purpose production facility.
B. Corporate Liabilities as Options
The most fundamental options are
 Calls options
 Puts option
P
C
Value of
put option
Value of on
X
call option expiration
on date
expiration
date
C=0 P=0 S
C=0 S X
X Stock price on expiration date
Stock price on expiration date

February 2016
Fig. 16: Calls option Fig. 17 Puts options

The graph above depicts the value of the call and put options as it depends on the stock
price on the expiration date. The value of the call and put options are
C (S, O X) = Max (S- X, 0) (77)
P (S, O, X) = Max (X - S, 0) (78)
C. Value of the Firm on the Maturity
Fig. 18 and 19 depict the value of equity and risky debt as they depend on the value of the
firm on the maturity date of the debt. If on the debt’s maturity date, the value of the firm
is greater than the promised principal V > B, then the debt will be paid off, D = B and the
equity will be worth V - B. However, if the value of the firm is less than the promised
principal, V<B, then the equity will be worthless E = O. Thus, on the maturity date of the
debt, the value of equity can be represented as
E (V, O, B) = Max (V - B, 0) (79)
While the value of risky debt is
D (V,O,B) = Min (V, B) (80)
Equation (80) says that the value of the risky debt on its maturity date, T = O, is the
minimum of V and B.
D
E
D=B
B
E=0 B V
B V Fig. 19 Value of firm on
Fig. 18 Value of firm on maturity date maturity date
But, since the value of the firm is the sum of the value of the equity and the value of the
debt which is given as

February 2016
V=E+D
11. Agency Theory and Analysis
Agency relationship is a contract in which one or more persons (the principals) engage
another person (the agent) to take action on behalf of the principal(s) which involves the
delegation of some decision-making authority to the agent.
A. The Agency Problem

 Principal - Agent problems emanates from the conflict of interest (Mekling 1976).
 In most cases, Agent (managers) does not always act in the best interest of the
shareholder (principal) and this is the agency problem.
 The agent acts in order to fulfill their own goals at the expense of the principal
(owners).
B. The Agency Theory

In developing a theory of agency two approaches have been advanced, which are:
 The Positive Theory of Agency
 The Principal – Agent literature
The positive agency literature is generally non mathematical and empirical
oriented where as the principal-agent literature is generally mathematical and non-
empirically oriented. Both literatures address the contracting problem among self-
interested individuals and assume that in any contracting relationship total agency costs
are minimized. The principal-agent literature has concentrated more on analysis of the
effects of preference and asymmetric information and les on the effects of the technology
of contracting and control.
C. Agency Cost
 Jensen and Meckling (1976) defined agency costs as the sum of the out-of-pocket
costs of structuring, administering and enforcing contracts (both formal and
informal) plus the residual loss.

February 2016
 Agency cost include all costs frequently referred to as contracting costs,

transactions costs, moral hazard costs and information costs.
D. Conflicts of Interest and Agency Problem

Basically, two conflict of interest exist, they are;
 The conflict of interest between managers and stock holder in the corporations.
This conflicts generate agency problems between managers and residual
claimants when risk bearing is separated from management i.e. when ownership is
separated from control (Berle and Means 1932). Such agency cost can be reduced
by the multitude of control procedures outlined in the accounting and control
literature. Fama and Jensen (1983) recommended that imposing restrictions on
residual claims is one of the ways of controlling the agency cost.
 The conflict of interest between bondholder and stockholders. Some corporate
decisions increase the wealth of stockholders while reducing the wealth of
bondholders and in cases where the wealth transfers are large enough, stock prices
can rise from decisions that reduce the value of the firm.
Smith and Warner identify four major sources of conflict between bondholder and
stockholders to include:
 Dividend payout
 Claim dilution
 Asset substitution
 Under investment
REFERENCES
[1] Bierman, H.J. and Smidt, S., (1975). The Capital Budgeting Decision. 4th ed
Macmillan, New York.
[2] Bodenhorn, D., (1964). A Cashflow Concept of Profit. The Journal of Finance.
3:(16-31).
[3] Cooley, P.L., Roenfeldt, R.L. and Chew, I.K.,(1975). Capital Budgeting
Procedure under Inflation Financial Management Winter (18-27).

February 2016
[4] Ezra, S., (1963). The Theory of Financial Management Colombia University
Press.
[5] Fama, E.F. (1965), Random Walks in Stock Market Prices. Financial Analyst
Journal Oct (55-59).
[6] Fama, E.F. (1970). Efficient Capital Markets: A Review of Theory and Empirical
Work. Journal of Finance. 5 :( 383-417).
[7] Fama, E.F., and Miller, M.H., (1972). The Theory of Finance, Holt, Rinehart and
Winston, New York.
[8] Fisher, I., (1930). The Theory of Interest. Macmillan, New York.
[9] Friedman, M., and Savage, L.J., (1948). The Utility Analysis of Choices
involving Risk. The Journal of Political Economy. 8 :( 279-308).
[10] Gordon, M.J., (1962). The Investment, Financing and Valuation of Corporation,
Richard D .Irwin.
[11] Hirshleifer, J., (1970). Investment, interest and capital. Prentice-Hall Englewood
Cliffs, N.J.
[12] Jensen, M.C. and Meckling, W.H.,(1976). Theory of the Firm: Managerial
Behavior Agency Costs and Ownership Structure. Journal of Financial Economics.
3:(60-305).
[13] Linter, J., (1965). The valuation of Risk Assets and the Selection of Risky
Investments in Stock Portfolios and Capital Budget. The Review of Economics and
Statistic. 2:(13-37).
[14] Modigliani, H and Miller, M.H., (1958). The Cost of Capital, Corporation Finance
and the Theory of Investment, American Economic Review. 48:(97-261)
[15] Pandey, I.M., (2005). Financial Management. 9th ed, Vikas Publishing House
PVT Ltd New Delhi.
[16] Ross, S. (1973). The Economic Theory of Agency: The Principal’s Problem.
American Economic Review. 63:(39-134).
[17] Sharpe, W.F., (1970). Portfolio Theory and Capital Markets, Chapter 10, State
Preference Theory. (202-222) McGraw-Hill New York.
[18] Walter, J.E. (1963). Dividend Policy: Its influence on the Value of the Enterprise.
Journal of Finance, May (91-280).

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Journal for Studies in Management and Planning e-ISSN: 2395-0463

Available at http://edupediapublications.org/journals/index.php/JSMaP/ Volume 02 Issue 2

A Synthesis of the Theory of Corporate Finance

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1. Capital Markets, Consumption and Investment

Fig. 1 How Individuals Make Choices among Consumption Bundles

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C0 = Consumption at the beginning of the period

Fig. 2 Investment Schedule and Production Opportunity Set

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Fig.3 The Investment Opportunity Set

Consumption and Investment with Capital Market

Where W0 = the present value of an individual initial endowment

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and since W0 1  r   W1 , we have

C1*  W1  1  r C0* - - - - - - - (5)

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FISHER SEPARATION THEORY

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Without capital market opportunities, individual 1 would choose to produce at point Y,

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Where W0 = current wealth

B. Maximization of Shareholders Wealth

Where So = is the present value of shareholder wealth

The accounting definition of profit is mathematically express as

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D. Techniques for capital budgeting

 There are five (5) widely used capital budgeting technique

2. The accounting rate of return (ARR)

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Where EBIT is earning before interest and tax as,

3. Net Present Value (NPV)

Where NCFt is the net cash flow in time period

3. Advanced Capital Budgeting Decision

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When K is the real discount rate,

B. Asset Replacement Problem

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NPVn is the present value of the investment for original life.

n and k is the opportunity cost of capital.

4. THE THEORY OF CHOICE (UTILITY THEORY)

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 Comparability: Here, an individual can say either that outcome X is preferred to

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MAX E[U(W)] = ∑PiU(WI) (25)

Fig 11 Risk averter

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5. Objects of Choice: Mean Variance Uncertainty

Where Pi is the probability of a random event

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C. Measuring Portfolio Risk and Return

VAR RP   a 2 VAR x  b 2 VAR Y  2ab CoV x, Y  (32)

Fig. 12 Correlation Coefficient Graph

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FIG. 13 The Capital Asset Pricing Model

CoV Rm, Rm  VAR Rm 

B. Use of the CAPM for valuation: Single-Period Models, Uncertainty