Here on our website, we've listed the chapter synopsis from the book's expanded Table of Contents. Thesis statements are then provided for the main source(s) discussed in each section of the chapter, along with a list of additional readings discussed in the section. Where possible, we've provided links to publicly available sources. To read our detailed synopsis, discussion, and thoughts about the practical application of the ideas presented in the sources listed below, buy the chapter by clicking on the cover image (or buy the entire book).
Chapter 7: Finance
Finance is the study of how investors allocate their assets over time under conditions of certainty and uncertainty, and typically examines the relationship between money, time, and risk.
Capital Structure
When two Chicago faculty were assigned to teach finance in the 1950s, they went to read existing material and found it so deficient they set out to derive consistent principles from scratch. This effort resulted in their foundational theory of capital structure.
FRANCO MODIGLIANI and MERTON MILLER. 1958. “The Cost of Capital, Corporate Finance and the Theory of Investment.” American Economic Review 48(3), 261–297.
Thesis: The value of a company is unaffected by how that firm is financed (in an efficient market absent taxes or bankruptcy costs).
Additional Readings:
- DeAngelo, Harry and Ronald Masulis. 1980. "Optimal Capital Structure under Corporate and Personal Taxation," Journal of Financial Economics 8, 3–29.
- Jensen, Michael and William Meckling. 1976. “Theory of the Firm: Managerial Behavior, Agency Costs, and Ownership Structure.” Journal of Financial Economics 3(4), 305–360.
- Kraus, Alan and Robert Litzenberger. 1973. “A State Preference Model of Optimal Financial Leverage,” Journal of Finance 28, 911–922.
- Miller, Merton. 1977. “Debt and Taxes.” Journal of Finance 32(2), 261–275.
- Modigliani, Franco and Merton Miller. 1963. "Corporate Income Taxes and the Cost of Capital: A Correction." American Economic Review 53(3), 433–443.
Capital Asset Pricing
The concept that investors seek to maximize return while minimizing risk was formalized in the 1950s, and let several authors to develop a formal model of how capital assets like stocks are priced in the market.
HARRY MARKOWITZ. 1952. “Portfolio Selection.” Journal of Finance 7(1), 77–91.
Thesis: Investor diversification can eliminate stock-specific risk so that only non-diversifiable market risk remains. Investment choice then becomes a matter of adding (a) a single riskless asset and (b) one combination of risky assets.
WILLIAM F. SHARPE. 1964. “Capital Asset Prices: A Theory of Market Equilibrium Under Conditions of Risk.” Journal of Finance 19(3), 425–442.
Thesis: Given a riskless rate and the expected return for the market, the capital asset pricing model (CAPM) provides a price for any security, based solely on how sensitive that security's return is to the market return.
Additional Readings:
- Chen, Nai-Fu, Richard Roll, and Stephen Ross. 1986. “Economic Forces and the Stock Market.” Journal of Business 59(3), 383–403.
- Dybvig, Philip and Stephen Ross. 1985. “Yes, the APT Is Testable.” Journal of Finance 40(4), 1173–1188.
- Fama, Eugene and Kenneth French. 1993. “Common Risk Factors in the Returns on Stocks and Bonds.” Journal of Financial Economics 33(1), 3–56.
- Roll, Richard. 1977. “A Critique of the Asset Pricing Theory's Tests.” Journal of Financial Economics 4(2), 129–176.
- Roll, Richard and Stephen Ross. 1980. “An Empirical Investigation of the Arbitrage Pricing Theory.” Journal of Finance 35(5), 1073–1104.
- Ross, Stephen. 1976. “The Arbitrage Theory of Capital Asset Pricing.” Journal of Economic Theory 13(3), 341–360.
- Shanken, Jay. 1982. “The Arbitrage Pricing Theory: Is It Testable?” Journal of Finance 37(5), 1129–1140.
Market Efficiency
One of the largest debates in modern finance over the past 50 years has concerned what types of information are (or are not) embedded in the prices of tradable assets. We explore the foundation of the theory of efficient markets.
EUGENE FAMA. 1970. “Efficient Capital Markets: A Review of Theory and Empirical Work.” Journal of Finance 25(2), 383–417.
Thesis: Asset prices reflect all information contained in the history of past prices, and also reflect all publicly available information. Prices may even reflect much non-public information (except the detailed information held by stock exchange specialists and corporate insiders).
Additional Readings:
- Banz, Rolf. 1981. “The Relationship between Return and Market Value of Common Stock,” Journal of Financial Economics 9, 3–18.
- Basu, Sanjoy. 1977. “Investment Performance of Common Stocks in Relation to Their Price-Earnings Ratios: A Test of the Efficient Markets Hypothesis.” Journal of Finance 32(3), 663–682.
- Basu, Sanjoy. 1983. “The Relationship between Earnings' Yield, Market Value and Return for NYSE Common Stocks: Further Evidence.” Journal of Financial Economics 12(1), 129–156.
- Fama, Eugene and Kenneth French. 1992. “The Cross-Section of Expected Stock Returns,” Journal of Finance 47(2), 427–465.
- Fama, Eugene and Kenneth French. 1993. “Common Risk Factors in the Returns on Stocks and Bonds.” Journal of Financial Economics 33(1), 3–56.
- Keim, Donald. 1983. “Size-Related Anomalies and Stock Return Seasonality: Further Empirical Evidence.” Journal of Financial Economics 12(1), 13–32.
- Jegadeesh, Narasimhan and Sheridan Titman. 1993. “Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency,” Journal of Finance 48, 65–92.
- Lakonishok, Josef, Andrei Shleifer, and Robert Vishny. 1994. “Contrarian Investment, Extrapolations, and Risk,” Journal of Finance 49(5), 1541–1578.
- Rosenberg, Barr, Kenneth Reid, and Ronald Lanstein, 1985. “Persuasive Evidence of Market Inefficiency.” Journal of Portfolio Management 11(3), 9–17.
- Reinganum, Marc. 1981. “A Misspecification of Capital Asset Pricing: Empirical Anomalies Based on Earnings Yields and Market Values,” Journal of Financial Economics 9, 19–46.
- Schwert, William. 1983. “Size and Stock Returns, and Other Empirical Regularities,” Journal of Financial Economics 12(1), 3–12.
- Stattman Dennis. 1980. Book values and stock returns. The Chicago MBA: A Journal of Selected Papers 4, 25–45.
Agency Theory
Before the 1970s, most research treated companies as individual agents with one primary objective. We look at research which investigates what happens when organizations contain multiple agents with conflicting objectives.
MICHAEL JENSEN and WILLIAM MECKLING. 1976. “Theory of the Firm: Managerial Behavior, Agency Costs, and Ownership Structure.” Journal of Financial Economics 3(4), 305–360.
Thesis: When one group (managers) performs on behalf of another group (owners), the interests of the two groups can diverge. Contracts can minimize the differing incentives, and it can be in the best interest of managers to contractually restrict their own behavior.
Additional Readings:
- Milgrom, Paul and John Roberts. 1992. Economics, Organization and Management, Prentice-Hall: Englewood Cliffs.
- Williamson, Oliver. 1996. “The Economics of Organization: A Primer.” California Management Review 38(2), 131–146.
Imperfect Information
In addition to the potential for having different objectives, research has examined what happens when agents have different information sets. The models make many predictions which appear consistent with how companies and markets operate.
HAYNE LELAND and DAVID PYLE. 1977. “Informational Asymmetries, Financial Structure, and Financial Intermediation.” Journal of Finance 32(2), 371–387.
Thesis: When entrepreneurs have inside information about their project quality, the value of the firm will increase with the share held by that entrepreneur. Financing does matter.
STEWART MYERS and NICHOLAS MAJLUF. 1984. “Corporate Financing and Investment Decisions When Firms Have Information that Investors Do Not Have.” Journal of Financial Economics 13(2), 187–221.
Thesis: Knowing that management has inside information, investors will interpret any issuance of equity as evidence that the company is overvalued. This will cause firms with limited debt capacity to pass up.
Additional Reading:
- Allen, Franklin and Gerald Faulhaber. 1989. “Signaling by Underpricing in the IPO Market, Journal of Financial Economics 23(2), 303–323.
- Fama, Eugene and Kenneth French. 2002. “Testing Tradeoff and Pecking Order: Predictions About Dividends and Debt,” Review of Financial Studies 15(1), 1–37.
- Frank, Murray and Vidhan Goyal. 2003. “Testing the Pecking Order Theory of Capital Structure,” Journal of Financial Economics 67(2), 217–248.
- Myers, Stewart. 1984. “The Capital Structure Puzzle,” Journal of Finance 39(3), 575–592.
- Ritter, Jay. 2003. “Introduction.” In J. Ritter (editor), Recent Developments in Corporate Finance. Northampton, MA, Edward Elgar Publishers. 1–13.
Business Measurement
Managers need more than accounting statements to make informed decisions. We review and evaluate frameworks for collecting the information that can enable management to make internal decisions.
ROBERT KAPLAN and DAVID NORTON. 1996. The Balanced Scorecard: Translating Strategy into Action. Cambridge, Harvard Business Review Press.
Thesis: Executives can only manage what is measured. The financial statements prepared for investors are an inadequate source of information for managerial decision-making; companies need to identify which metrics best capture their performance, and build a link from this scorecard to ongoing executive action.
JOEL STERN, BENNETT STEWART, and DON CHEW. 1995. “The EVA Financial Management System.” Journal of Applied Corporate Finance 8(2), 32–46.
Thesis: Companies can better manage for shareholder value if they use an economic measure of value-added rather than an accounting measure that ignores investment. A value-added measure is straightforward to compute and has a higher correlation with changes in market value.
Additional Readings:
- Chermushkin, Sergei. 2008. “What's Wrong with the Economic Value Added?” Mordovian State University Working Paper.
- Damodaran, Aswath. 2009. “Valuation: Closing Thoughts.” Damodaran Online Lectures, New York University.
- Dodd, James and Shimin Chen. 1996. “EVA: A New Panacea?” Business and Economic Review 42(July–September), 26–28.
- Jensen, Michael. 2001. “Value Maximisation, Stakeholder Theory, and the Corporate Objective Function,” European Financial Management 7(2), 97–317.
- Kurtzman Joel. 1997. “Is Your Company Off Course? Now You Can Find Out Why.” Fortune 17 February, 128–130.
- Malina, Mary and Frank Selto. 2001. “Communicating and Controlling Strategy: An Empirical Study of the Effectiveness of the Balanced Scorecard, Journal of Management Accounting Research 13(1), 47–90.
- Stangeland, David. 2006. “Using the EVA Financial Management System to Make the Wrong Decision,” Journal of Business & Economics Research 4(11), 43–56.
- Stern, Joel, Bennett Stewart, and Don Chew, 1995. “The EVA Financial Management System,” Journal of Applied Corporate Finance 8(2), 32–46.
- Stewart, G. Bennett. 1990. The Quest for Value: The EVATM Management Guide. New York, HarperBusiness.
Behavioral Finance
There is a young but growing field of research which suggests that individuals do not rationally maximize outcomes. Part of that literature focuses on documented irrationalities in finance and investing.
NICHOLAS BARBERIS and RICHARD THALER. 2003. “A Survey of Behavioral Finance.” In G. M. Constantinides, M. Harris, and R. Stulz (editors), The Handbook of the Economics of Finance. New York, Elsevier Science B.V. pp. 1052–1121.
Thesis: Agents are not rational, and markets are not efficient. People exhibit persistent and significant cognitive biases in how they process information, assess risk, and make investment decisions. These risks are consistent enough across people to be predictable.
Additional Readings:
- Ball, Eric, Hsin-Hui Chiu, and Richard Smith. 2011. “Can VCs Time the Market? An Analysis of Exit Choice for Venture-Backed Firms,” Review of Financial Studies 24(9), 3105–3138.
- Fama, Eugene. 1998. “Market Efficiency, Long-Term Returns and Behavioral Finance,” Journal of Financial Economics 49(3), 283–306.
- Fama, Eugene. 2009. “Q&A: Is Market Efficiency the Culprit?” Fama/French Forum, 4 November.
- Fama, Eugene and Kenneth French. 2010. “Q&A: The Limits of Arbitrage.” Fama/French Forum, 14 July.
- Mitchell, Mark and Todd Pulvino. 2011. “Arbitrage Crashes and the Speed of Capital,” SSRN working paper.
- Ritter, Jay. 2003. “Behavioral Finance,” Pacific-Basin Finance Journal 11(4), 429–437.