Key Concepts in Finance: From Friedman to CAPM
Key Financial Concepts
Friedman’s Social Responsibility: Businesses’ sole purpose is to generate profit for shareholders. Companies adopting a social responsibility attitude face more constraints and become less competitive.
Present Value: We rely on present value since many investment decisions must be made without good information about market value. 1/(1+r) … 1/(1+r)^t
Transition Costs: These are expenses incurred when buying or selling a good or service, such as real estate title fees or brokers’ charges.
Agency Costs: Agency costs typically arise from inefficiencies, dissatisfactions, and disruptions, such as conflicts of interest between shareholders and management.
Gordon Growth Model: This model determines the intrinsic value of a stock based on a future series of dividends that grow at a constant rate. PV = c(next yr’s dividend)/(r-g)
Double Fallacies
IRR: The higher the Internal Rate of Return (IRR), the more desirable it is to undertake a project.
Cost of Capital: Represents a hurdle rate that a company must overcome before it can generate value. Only invest in projects that provide returns exceeding the cost of capital.
Miller Dividend Policy (M&M 1961)
Investors do not prioritize a company’s dividend history; thus, dividends are irrelevant in calculating the valuation of a company.
The only factor impacting a company’s valuation is its earnings, which directly result from the company’s investment policy and future prospects.
Assumptions:
- Perfect Capital Market: Rational people with access to information (which does not exist).
- No Taxes: Dividends and capital gains are taxed at the same rate (taxes exist).
- Fixed Investment Policy: No change in the existing investment policy.
Black Dividend Puzzle
The dividend puzzle is a concept in finance where companies that pay dividends are rewarded by investors with higher valuations, even though, according to many economists, it should not matter to investors whether a firm pays dividends or not.
M&M 1958 Cost of Capital
Firms can be divided into “equivalent return” classes such that the return on shares issued by any firm in a given class is proportional to the return on shares issued by any other firm in the same class. Within a class, firms are homogenous; the only differences are in scale.
Proposition 1: The value of the firm is independent of its capital structure.
Proposition II: The expected yield on a share of stock equals the appropriate capitalization rate (k) for a pure equity stream in the class, plus a premium related to the financial risk equal to the debt-to-equity ratio times the spread between k and r.
Debt and Tax – Miller Debt and Taxes 1977
Miller argues that a company’s market value is independent of its capital structure. The theorem was developed by economists Franco Modigliani and Merton Miller in 1958. The main idea of the M&M theory is that the capital structure of a company does not affect its overall value.
Perfect Market:
- M&M Proposition 1: The company’s capital structure does not impact its value; the value of a company is calculated as the present value of future cash flows.
- M&M2: The company’s cost of equity is directly proportional to the company’s leverage level. Increased leverage induces a higher default probability.
Real World:
- M&M 1: Tax shields from tax-deductible interest payments make the value of a levered company higher than the value of an unlevered company.
- M&M 2: The cost of equity has a directly proportional relationship with the leverage level. However, tax shields make the cost of equity less sensitive to the leverage level.
Efficient Market Hypothesis (EMH)
EMH is an investment theory where share prices reflect all information, and consistent alpha generation is impossible. Theoretically, neither technical nor fundamental analysis can produce risk-adjusted excess returns consistently. Only inside information can result in outsized risk-adjusted returns. All investments should be put into index funds, and investors should reduce expenses and increase returns.
- (FAMA I 1970) Weak Form: Stock prices reflect all current information, but anomalies may be found by researching companies’ financial statements. Past price movements, volume, and earnings data do not affect a stock’s price and cannot be used to predict its future direction.
- Semi-Strong Form: All information in the public domain is used in the calculation of a stock’s current price. It is impossible for investors to identify undervalued securities and generate higher returns by using either technical or fundamental analysis.
- Strong Form: No information, public or inside, will benefit an investor because even inside information is reflected in the current stock price. All information in a market, whether public or private, is accounted for in a stock’s price.
(FAMA) Joint Hypothesis Test: To determine how fully the asset market reflects available information, one must compare the expected return of an asset to the asset’s risk.
FAMA II: A weaker version of the efficiency hypothesis states that prices reflect information to the point where the marginal benefits of acting on information do not exceed the marginal costs.
If stock prices follow a random walk, there will be no correlation. There was a positive correlation between the dividend-to-stock price ratio and long-term expected returns – EMH anomalies (FAMA II 1991).
FAMA II Weak Form: Includes tests of forecasting returns with variables like dividend yields and interest rates. Also, cross-section tests like size effect and January effect. All EMH tests are joint tests of the equilibrium model of risk and expected return plus market efficiency.
Semi-Strong Form: Adjustment of prices to public information – “Event Studies.” Announcements of new stock issues are bad for stock prices. Merger announcements are good news for the company. For EMH, the speed of adjustment to new information is key.
Long-Horizon Tests: Tests show both overreactions and underreactions to information.
Strong Form: Tests for private information. This has always been an outer boundary for tests of EMH.
EMH may lead to the rejection of CAPM. “Value stocks”—those whose share prices appear low relative to the book value of equity—and small-company stocks are riskier and, thus, earn higher returns.
Fundamental Concepts
- The risk of a security only matters in the context of a larger portfolio.
- Expected Utility
- Investors choose portfolios based on Expected Returns and Standard Deviation.
A portfolio that includes a variety of securities so that the weight of any security is small. The risk of a well-diversified portfolio closely approximates the systematic risk of the overall market, and the unsystematic risk of each security has been diversified out of the portfolio.
Efficient Portfolio:
- No other portfolio exists with a greater expected return and the same standard deviation.
- No other portfolio exists with a lower standard deviation and the same expected return.
Investor’s Choice: Point of tangency: where the efficient set is tangent to the highest attainable indifference curve.
Portfolio managers can rank stocks by expected performance.
Sharpe’s Insight
CAPM: Sharpe found a relationship between expected return for every asset and risk in the portfolio context. For rho = 1, we have std = 0 for our two assets.