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.

ThesisFRANCO 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:

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.

ThesisHARRY 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.

ThesisWILLIAM 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:

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.

ThesisEUGENE 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:

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.

ThesisMICHAEL 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.

ThesisHAYNE 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.

ThesisSTEWART 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:

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.

ThesisROBERT 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.

ThesisJOEL 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:

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.

ThesisNICHOLAS 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: