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Financial Management

The document discusses several theories related to financial management including modern portfolio theory, arbitrage pricing theory, capital asset pricing model, trade-off theory of capital structure, and pecking order theory. It provides details on each theory including their key aspects and implications.

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Julz Rosary
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44 views27 pages

Financial Management

The document discusses several theories related to financial management including modern portfolio theory, arbitrage pricing theory, capital asset pricing model, trade-off theory of capital structure, and pecking order theory. It provides details on each theory including their key aspects and implications.

Uploaded by

Julz Rosary
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
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THEORIES IN

Financial Management Theory


- deals with the usage of money in a business,
including all acquisitions, sales and expenditure. Its
effectively taking financial management theory and
applying it to practice applicable to your organization.
Sometimes we just call it finance management and
return on investment.
Modern Portfolio
Theory
MODERN PORTFOLIO THEORY
• Harry Max Markowitz born in August 24, 1927 , an American
Economist , and the father of Modern Portfolio Theory (MPT) because he
is the first person who gave a mathematical model for portfolio optimization
and diversification.

• Modern Portfolio Theory (MPT) is a theory of finance that attempts to


maximize portfolio expected return for a given amount of risk, or minimize
the risk for a given level of expected return.

• Markowitz theory` advise investors to invest in multiple securities rather


than pulling all eggs in one basket.
MODERN PORTFOLIO THEORY
Essence of Markowitz Theory:
- An investor has a certain amount of capital he wants to invest over a
single time.

- He can choose between different investment instruments like stocks ,


bonds, options, currency or portfolio. The investment decision
depends on the future risk and return.

- The decision also depends on if he or she wants to either maximize


the yield or maximize the risk.
MODERN PORTFOLIO THEORY
The fundamental concept behind MPT is that the assets in an
investment portfolio should not be selected individually, each on their own
merits. Rather, it is important to consider how each asset changes in price
relative to how every other asset in the portfolio changes in price.

Investing is a trade-off between risk and expected return. In general, assets


with higher expected returns are riskier. For a given amount of risk, MPT
describes how to select a portfolio with the highest possible expected return.
Or, for a given expected return, MPT explains how to select a portfolio with
the lowest possible risk. 
MODERN PORTFOLIO THEORY
Diversification
- An investor can reduce portfolio risk simply by holding of instruments
which are not perfectly positively correlated. It also allow for the same
portfolio expected return with reduced risk by using quantitative method.

So why do we care about modern portfolio theory?

- Simply because you can use this approach to lower your risk in
investing while maintaining your expected returns.
Arbitrage Pricing
Theory
ARBITRAGE PRICING THEORY
• Arbitrage pricing theory (APT) was developed by the
economist Stephen Ross in 1976.

• It is a multi-factor asset pricing model based on the idea that an


asset's returns can be predicted using the linear relationship
between the asset's expected return and a number of
macroeconomic variables that capture systematic risk.

• The theory aims to pinpoint the fair market price of a security that
may be temporarily mispriced.
ARBITRAGE PRICING THEORY

• The practice of arbitrage will ensure prices in competitive


markets will be very close. If there is perfect information
and low transaction costs, you would expect only normal
profit from engaging in arbitrage. However, if an investor
can take advantage of better information or delays in the
dissemination of prices, then they can make more profit.
ARBITRAGE PRICING THEORY
The theory does follow three underlying assumptions:

• Asset returns are explained by systematic factors.

• Investors can build a portfolio of assets where specific risk is


eliminated through diversification.

• No arbitrage opportunity exists among well-diversified portfolios.


Capital Asset
Pricing Model
Capital Asset Pricing Model
• The model was introduced by Jack Treynor (1961,1962), William Sharpe (1964),
John Lintner(1965) and Jan Mossin (1966).

• The model describes the relationship between risk and expected return that is
used in the pricing of risky securities.

• It assumes that all active and potential shareholders will consider all of their
assets and optimize one portfolio.

• The general idea behind CAPM is that investors need to be compensated in two
ways: time value of money and risk.
Capital Asset Pricing Model
ASSUMPTIONS
All investors:
1. Aim to maximize economic utilities.
2. Are rational and risk-averse.
3. Are broadly diversified across a range of investments.
4. Are price takers
5. Can lend and borrow unlimited amounts under the risk free rate
of interest.
6. Trade without transaction or taxation costs.
7. Deal with securities that are all highly divisible in small parcels.
8. Assume all information is available at the same time to all
investors.
Implications and Relevance of CAPM
• Investors will always combine a risk free asset with a market portfolio
of risky assets. Investors will invest in risky assets in proportion to
their market value.

• Investors can expect returns from their investment according to the


risk. This implies a liner relationship between the asset`s expected
return.

• Investors will be compensated only for that risk which they cannot
diversify. This is the market related risk.
How CAPM used in real life?

• Investors used CAPM when they want to assess the fair value
of stock. So when the level of risk changes, or other factors in
the market make an investment riskier, they will use the
formula to help re-determine pricing and forecasting for
expected returns.
How CAPM used in real life?

• Investors used CAPM when they want to assess the fair value
of stock. So when the level of risk changes, or other factors in
the market make an investment riskier, they will use the
formula to help re-determine pricing and forecasting for
expected returns.
Trade-Off Theory
of
Capital Structure
Trade-Off Theory of Capital Structure
• The trade-off theory of capital structure refers to the idea that a
company chooses how much debt finance and how much equity
finance to use by balancing the costs and benefits.

• Optimal level of leverage is achieved by balancing the benefits from


interest payments and costs of issuing debt.

• Firm maximize value by increasing debts and reducing weighted


average cost.
Why balance between Cost and Benefits
BENEFITS OF DEBT

• TAX SHIELD BENEFIT


- Interest experiences are tax deductible but in equity dividend
are not.

• ADDED DISCIPLINE
- Manager to think more about the investment decision more
carefully and reduce bad investment.
Why balance between Cost and Benefits
COST OF DEBT

• BANKRUPTCY COST
- Firms with a greater risk of experiencing financial distress tend to borrow less
than
Firms having lower financial distress risk.

• AGENCY COST
- Conflict between shareholder and management.
- Conflict between shareholder and creditor.

• LOSS OF FLEXIBILITY
- Using available debt capacity today , you cannot draw on it in the future.
Pecking Order
Theory
Pecking Order Theory
• Pecking Order Theory or Pecking Order Model was first suggested by
Donaldson in 1961 and it was modified by Stewart C. Myers and Nicolas
Majluf in 1984.

• It states that companies should prioritize to finance itself first internally


through retained earnings. If this source of financing is unavailable, a
company should then finance itself through debt.

• This pecking order theory is important because it signals to the


public how the company is performing.
Pecking Order Theory
Implication:
- the highly profitable firms that generate high
earnings are expected to use less debt capital than
those that are not very profitable.

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