The University Journal Volume 1 Issue 2 2018 ISSN: 2519-0997 (Print)

Theories in Finance Discipline: A Critique of Literature Review

Beatrice N. Warue1, Ben Jackson M. Charles2 and Paul M. Mwania3
1
School of Business and Economics, Africa International University, Kenya; Email:
Warue.daea@gmail.com
2
School of Business and Economics, Kenya Methodist University, Kenya; Email:
michenibj@gmail.com
3
Lukenya University; Email: mwaniap74@gmail.com

Cite: Warue, B. N., Charles B. J. M., & Mwania, P. M. (2018). Theories in Finance
Discipline: A Critique of Literature Review. The University Journal, 1(2), 113-146.

Abstract
The purpose of this paper is to create awareness of a number of existing theories in Finance area
of specialization. The compilation and analyses on the theories will help scholars quickly identify
theories existing in finance and application of the theories in a scholarly manner. However the
theories analyzed are not exhaustive. Scholars are allowed to add to the list of analyses.
Keywords: Theories in Finance, Agency Theory, Portfolio Theory, Arbitrage Pricing
Theory, Divided Theory

Introduction
As a separate subject of discipline, finance is still in its infancy. It was only the latter half of
the twentieth century that witnessed most of major developments in finance with scientific
rigor (Miller, 2001). This means that the whole profession of finance had to digest a very
large amount of new theoretical developments in a relatively short time period. Educators,
scholars, and business people have been continuously introduced to new models, theories,
and empirical results thereof over the recent years and the trend continues (Markowitz, 1952).
Started out as largely a descriptive, institutional field of study, finance has quickly
transformed into a science full of theoretical thrusts. While few would dispute its origin as a
branch of applied microeconomics, finance now is as theoretical as its mother discipline.
The rapid changes in finance have had a profound implication for business education.
Especially, such extensive and rigorous theoretical developments over the recent past have
made finance teaching in college classrooms increasingly challenging (Miller, 1998).
Finance is one of the most quantified and theorized disciplines in business curriculum. The
dynamic and complex nature of finance requires continuous development of new theories. As
intellectual advances in finance continues in the form of more sophisticated theoretical
inquiries, the challenge of teaching finance theories will only grow bigger. Yet, finance is
somewhat unique in terms of the correspondence between theory and evidence. While
students are educated to make independent critical evaluations of the contending points of
views, many finance theories are still at their developmental stage and so they are highly
controversial, debatable, and subject to close scrutiny (Ball, 2001).

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Aim of the Paper

The aim of this paper is to review existing theories in finance discipline. Reviewing theories
in finance will help scholars quickly identify some of the existing theories in this area and
develop critical thinking by evaluating important issues both conceptually and logically. It is
such critical thinking ability that enables scholars to engage in “process learning,” which in
turn enables them to adapt to the changes occurring in financial world. It is almost inevitable
to utter a word or two about the assumptions of a theory in classroom discussion.
It is that all theories are based on a set of assumptions and they may be sometimes very
crucial and unrealistic. For example, students are taught that the Dividend Discount Model is
based on the assumption that the firm grows at a constant rate indefinitely. At this point,
many scholars and academicians become quite concerned about the justification of the
assumption. For instance much can be said about investment and stock market return
theories. Stock markets have grown considerably in developed and developing countries over
the last two decades. Several factors have aided in their growth, importantly, improved
macroeconomic fundamentals, such as monetary stability and higher economic growth.
General economic and capital market specific reforms, including privatization of state-owned
enterprises, financial liberalization, the establishment of stock exchanges and bond markets,
and an improved institutional framework for investors, have further encouraged capital
market development. Financial globalization has also advanced in the last two decades with
increased cross-border capital flows, tighter links among financial markets, and greater
commercial presence of foreign financial firms in countries around the world (Barber and
Odean, 2000).
An important element of the globalization trend has been the increase in the stock exchange
activities that take place abroad, most notably for emerging markets, but also for developed
countries. Many firms now cross-list on international exchanges, with depositary receipts
being a particularly popular instrument to access international markets. Going forward, many
expect these globalization trends to continue as access to information improves, standards
(concerning corporate governance, listing, accounting, and others) become more harmonized,
technology advances, and inter-market linkages further increase (Mishkin & Eakin, 2007).
In this regard the following are the exploration of existing theories in finance.

Modern Portfolio Theory (MPT)

Modern Portfolio Theory (MPT) is a sophisticated investment approach first developed by
Professor Harry Markowitz of the University of Chicago, in 1952. Markowitz (1952)
described how to combine assets into efficiently diversified portfolios. He demonstrated that
investors failed to account correctly for the high correlation among security returns. It was his
position that a portfolio’s risk could be reduced and the expected rate of return increased,
when assets with dissimilar price movements were combined. Holding securities that tend to
move in concert with each other does not lower your risk. Diversification, he concluded
“reduces risk only when assets are combined whose prices move inversely, or at different
times, in relation to each other.” Diversification reduces volatility more efficiently than most
people understand. The volatility of a diversified portfolio is less than the average of the
volatilities of its component parts. While the technical underpinnings of MPT are complex,
and drawn from financial economics, probability and statistical theory, its conclusion is

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simple and easy to understand. A diversified portfolio, of uncorrelated asset classes, can
provide the highest returns with the least amount of volatility (Markowitz, 1991).
MPT is the philosophical opposite of traditional asset picking. It is the creation of
economists, who try to understand the market as a whole, rather than looking for that which
makes each investment opportunity unique. The asset allocation problem is one of the
fundamental concerns of financial theory (Cohen & Natoli, 2003). Asset allocation and risk
are vital components in the MPT. Investments are described statistically, in terms of their
expected long-term return rate and their expected short-term volatility. The volatility is
equated with "risk", measuring how much worse than average an investment's bad years are
likely to be. The goal is to identify the acceptable level of risk tolerance, and then find a
portfolio with the maximum expected return for that level of risk (Elton & Gruber, 1997).

Arbitrage Pricing Theory (APT)

The literature on asset pricing models has taken on a new lease of life since the emergence of
the Arbitrage Pricing Theory (APT), formulated by Ross (1976), as an alternative theory to
the renowned Capital Asset Pricing Model (CAPM), proposed by Sharp (1964), Lintner
(1965) and Mossin (1966). The robustness of the APT, which specifies there exists a linear
relationship common across securities relating expected returns to a set of security specific
characteristics, relies heavily on the assumption of perfectly competitive and frictionless
markets with investors' homogeneous beliefs in k-factor return generating process. There are
hardly any markets that entirely qualify for these requirements. However, the advanced stock
markets are allegedly more superior to the emerging stock markets which are thin and suffer
severely from bubble effects and speculation attacks. As a result, most of the empirical works
to date have focused on examining the stock price behaviour of the advanced markets in the
Western world while neglecting the developing world. The literature gap provides us with a
fertile area to excavate.
The understanding of stock price behaviour in an emerging market such as Kenya’s Nairobi
Securities Exchange (NSE) is not less interesting and is, in fact, important for the following
reasons. First, it provides academic scholars with extra information on the application of the
APT under different conditions where the basic premises do not exist. Second, it grants
finance practitioners such as portfolio managers, investment advisors and security analysts a
decision making basis as to what extent they should rely on the validity of the APT in the
emerging stock markets and what factors most significantly affect the stock returns. Third, its
findings help authorities in the emerging stock markets with a way of thinking to facilitate the
growth of those markets and shorten the period before maturity. Furthermore, emerging stock
markets will finally become mature and that will be the time for initial research to be sought
out with a view to comparing the behavioural contrariety of stock pricing at different stages
of development of the security exchange.

Efficient Market Hypothesis (EMH)

Fama (1970) explains that in an efficient market stocks will always trade at their fair market
value in the securities exchange reflecting all available information, making it almost
impossible for investors to purchase undervalued shares or sell shares at inflated prices. In
reality individuals do not think rationally, they are instead led by emotions, subjective
thinking, and at times by the herd mentality (Shah & Oppenheimer, 2008). The EMH has
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steadily become deficient to explain market behaviour, subsequently leading to a shift in

thinking, with the understanding that the market consists of human beings whose behaviour
cannot be understood solely through mathematical or economic studies (Ozerol et al., 2011).
In making decisions to invest individuals’ behaviours will therefore be driven by personal
frames, including availability of financial information to guide their selection decision.
Behavioural theorists’ postulate that investment decisions are to some extent influenced by
personal prejudices and perceptions that fall short of the criteria of rationality as proposed in
the EMH. The contemporary capital markets are therefore being analyzed from a new
perspective of behavioural finance, a theoretical model applying the principles of psychology
and sociology to finance (Pompion, 2008).
The IPO pricing in Kenya is inconsistent with the EMH, as evidenced by the under and
overpricing phenomenon observed in Kenya. Kiplangat et al. (2009) examine determinants of
investor confidence in Kenya; the study revealed that price movements in the NSE are
significantly related to investor sentiment since the Equity Market Sentiment (EMS) Index
captured capital market related news and events. It is therefore probable that investors’
psychology is a potential explanation for stock activity movements. EMH has steadily
become deficient to provide explanation for the market behaviour, more dramatically
perhaps, the drastic drop in United States share prices by over 30 per cent during a two month
period that preceded the crash of October 1987 (Mosomi & Ghayekhloo, 2011).
Subsequently, there has been a shift in thinking, with the understanding that markets consists
of human beings whose behaviour cannot be understood solely through mathematical or
economic studies (Ozerol et al., 2011).

Credit Risk Theory

Although people have been facing credit risk ever since early ages, credit risk has not been
widely studied until recent 30 years. Early literature on credit uses traditional actuarial
methods of credit risk, whose major difficulty lies in their complete dependence on historical
data. Up to now, there are three quantitative approaches of analyzing credit risk: structural
approach, reduced form appraisal and incomplete information approach. Melton (1974)
introduced the credit risk theory otherwise called the structural theory which is said the
default event derives from a firm’s asset evolution modelled by a diffusion process with
constant parameters. Such models are commonly defined “structural model “and based on
variables related a specific issuer. An evolution of this category is represented by asset of
models where the loss conditional on default is exogenously specific. In these models, the
default can happen throughout all the life of a corporate bond and not only in maturity
(Longstaff & Schwartz, 1995).

Liquidity Theory of Credit

This theory, first suggested by Emery (1984), proposes that credit rationed firms use more
trade credit than those with normal access to financial institutions. The central point of this
idea is that when a firm is financially constrained the offer of trade credit can make up for the
reduction of the credit offer from financial institutions. In accordance with this view, those
firms presenting good liquidity or better access to capital markets can finance those that are
credit rationed.
Several approaches have tried to obtain empirical evidence in order to support this
assumption. For example, Nielsen (2002), using small firms as a proxy for credit rationed
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firms, finds that when there is a monetary contraction, small firms react by increasing the
amount of trade credit accepted. As financially unconstrained firms are less likely to demand
trade credit and more prone to offer it, a negative relation between a buyer’s access to other
sources of financing and trade credit use is expected. Petersen and Rajan (1997) obtained
evidence supporting this negative relation.

Portfolio Theory
Portfolio theory of investment which tries to maximize portfolio expected return for a given
amount of portfolio risk or equivalently minimize risk for a given level of expected return, by
carefully choosing the proportions of various assets. Although portfolio theory is widely used
in practice in the finance industry and several of its creators won a Nobel prize for the theory
,in recent years the basic portfolio theory have been widely challenged by fields such as
behavioural economics(Markowitz 1952).
Portfolio theory was developed in 1950s through the early 1970’s and was considered an
important advance in the mathematical modelling of finance. Since then, many theoretical
and practical criticisms have been developed against it. This include the fact that financial
returns do not follow a Gaussian distribution or indeed any symmetric distribution, and those
correlations between asset classes (Sproul, 1998).

Modigliani and Miller Theory of Investment

Germinal theory of corporate finance proposed by Miller and Modigliani (1958) argues that
“the value of a firm is independent of its capital structure” (Miller, 2001). Dividends and
capital structure are irrelevant in the determination of stock prices in the market (Miller &
Modigliani, 1958; Chew, 2001); instead the market value of a firm is based on the “earning
power of the assets currently held and on the size and relative profitability of the investment
opportunities” (Miller & Modigliani, 1958, p. 663)
The valuation method of a firm is based on the capitalization of operating earnings before
interest and taxes, whereas Durand (1959) - one of the first critics of the theory - proposed
capitalization after interest and taxes, accompanied by an adjustment for leverage (Miller,
2001, p. 185).
A review of the theory by Miller himself, offers a new view about the so called ‘junk bonds’
which were considered undesirable and non-tradable during the 60s when low-risk was the
norm. Thirty years after the M&M proposal, junk bonds seem to provide dynamism in the
market and have helped develop the preference for leveraged buyouts LBOs not only in small
firms but among large firms (Miller, 2001). New characteristics in corporate governance
followed the LBOs of large firms. Miller cites “strip financing” as one of them (Miller, 2001,
p. 192).

Criticism against Flaws of M&M Theory (Ball, 2001)

1. Market perfection. M&M assumed information was complete and symmetric, when it
was not
2. Easy acceptance of firms with high levels of debt trading off for tax deductible
benefits
3. Assumption that investment decisions were not influenced by financial decisions
(Ball, 2001).
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This theory was revised in the eighties, and called “Tax-adjusted M&M”. It suggested that
highly leveraged structures, which substitute deductible interest payments for non-deductible
dividends could push optimal capital structure to 100% debt (Miller & Modigliani, 1958).

Agency Cost Theory

Germinal Theory proposed by Jensen and Meckling (1976) that analyzes the conflict between
shareholders and managers - agents of shareholders. Conflict arises because shareholders
require payouts for their investment, reducing internal resources controlled by managers
(Jensen, 1986). Managers are compensated on the basis of accounting profits, it increases the
incentives to manipulate information and/or favor projects with poor NPV if they provide
immediate profits (Dogan & Smyth, 2002). This has negative consequences of potential loss
in value of public corporations (Jensen & Meckling, 2001, p. 18). Dogan and Smyth (2002)
conducted a study of 223 companies listed in the Kuala Lumpur Stock Exchange (KLSE)
using the agent theory to test relationships between corporate performance, performance
criteria and executive compensation. Results showed that the theoretically positive
relationship between board remuneration and firm performance was weaker in Malaysia than
in U.K. or U.S. mostly explained by concentration of ownership.
The desire for high rewards induces managers to manipulate, overestimate or underestimate
indicators to make them more achievable in detriment of the value of the firm, e.g. low
budgets, inefficient debt targets. Jensen & Meckling (1976) contend that the agency costs of
separating ownership from control should not be excessive provided that factors such as
competition, executive labour market, and incentive plans are designed to reduce the self-
interest of managers. This theory relates to the Free Cash Flow theory proposed by Jensen in
1986.

Agency Costs of Free Cash Flow Theory

Current theory proposed by Jensen (1986) and built upon the Jensen & Meckling’s theory of
the agency (2001), FCF is “the cash flow in excess of that required to fund all projects that
have positive net present values when discounted at the relevant cost of capital” (Jensen,
1986; Stewart, 1991). FCF is the sum of the cash flow to equity and cash flow to debtholders
after interest-tax-shield (Shrieves & Wachovicz, 2001). The theory contends that by replacing
dividends for debt, managers will be forced to transfer excessive cash flows `to investors and
limit the allocation of resources to low-return projects (Miller, 2001).
LBOs are another way to both reduce the agency costs of free cash flow and impose
discipline and efficiency (Stewart, 1991) however they increase the, agency costs of debt.
NABISCO was an example of a rich firm interested in aggressive investment opportunities
instead of paying out dividends to stockholders (Stewart, 1991). The theory justifies the
massive substitution of debt for equity of the 80s, arguing that cash flow was going to pay
interests and principal and not to “investment ratholes” (Miller, 2001, p. xix) LBOs provide
additional benefits to reduce the agency costs of a firm: (1) Reallocation of resources, (2)
Squeezed out capital for growth, however the media did not depict the real impact of LBOs
as being beneficial (Chew, 2001, p. xxi).

The Market Timing Theory

The market timing theory is based on the argument that firms time when to issue equity
stocks for subscription by the public. The theory argue that new stocks are only issued at such
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a time when they are perceived to be overvalued, and bought back when they are
undervalued. As a consequence, the perception about the stock price affects the capital
structure of the firm. There are two separate versions of market timing theory that have led to
dynamics in capital structure; first is the assumption that economic agents are rational (Myers
and Majluf, 1984). Companies issue equity directly after a positive information release which
reduces information asymmetry problem between the management of the firm and
stockholders. Then the reduction in asymmetry coincides with a rise in the stock price. This
triggers firms to create their own timing opportunities. The second theory assumes
irrationality of economic agents (Baker and Wurgler, 2002) which results into time varying
mispricing of a firms stock. Therefore managers make new equity issues when they perceive
their costs to be irrationally low and repurchase them when their costs are irrationally high.
Baker and Wurgler (2002) provide supportive evidence that equity market timing has a
persistent effect on the firm’s capital structure. Their study defines a measure for market
timing as a weighted average of external capital needs over a few past years, where the
weights used are market to book values of the firm. Their finding was that changes in
leverage are strongly and positively related to their market timing measure, so their
conclusion was that a firm’s capital structure was a cumulative outcome of attempts in the
past to time the equity market.

The ‘Irrelevance’ Theory

Modigliani and Miller (1963) demonstrated in their seminal paper ‘The cost of capital,
corporation finance, and the theory of investment’ that in the absence of taxes, bankruptcy
costs, transaction costs and asymmetric information and the same rate of interest of
borrowing by individuals and corporations, the value of a firm is independent of its financial
structure. It does not matter if the firm’s capital is raised by issuing or selling debt. It does not
matter what the firm’s dividend policy is. The model is based on a framework that starts with
assumptions of perfect competition in factor and product markets and no transaction costs.
Modigliani and Miller (1963) conclude that a firm cannot increase its value by using debt as
part of its permanent capital structure. This argument is based on perfect arbitrage such that
investors can assume personal debt to help financing the purchase of unlevered shares, if the
value of the levered shares is greater than the unlevered ones. With perfect arbitrage any
discrepancies in the value of the stocks of two hypothetical firms, one with levered shares
and the other with unlevered shares, will be eliminated. Capital structure is thus irrelevant to
firm value. Including tax deductibility of interest payments into their model, Modigliani and
Miller (1963) show that borrowing will only cause the value of the firm to rise by the amount
of the capitalized value of the tax subsidy. Relaxing assumptions in their original work and
introducing imperfect competition, bankruptcy costs, asymmetric information, and monopoly
power, financial structure appears to be an influencing factor on firm value. The introduction
of tax deductibility of interest payments has an implication on the choice of capital structure.
Profitability increases, non-debt tax shields reduce and liquidity increases.

Signalling Theory and Capital Structure

This model asserts that financial decisions made by the firm are signals to potential investors
meant to compensate for information asymmetry. These signals are therefore intended to
enable investors to make informed decisions concerning company investment. Ross (1977)
linked the notion of signalling to capital structure theory and argue that since the
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management have information on the correct distribution of the firm’s returns while outsiders
don’t, the firm is likely to benefit if the firms securities are overvalued and the converse is
true. They also argue that managers can use higher financial leverage to signal optimistic
future for the company since debt capital involves a contractual commitment to pay back
both principal and interests and failure to do so could result into bankruptcy which may
further result into job losses. Hence, additional debt in the firm’s capital structure may be
interpreted as a positive signal about a firm’s future.

Pecking-Order Theory of Capital Structure

Current theory proposed by Myers and Mailuf (1984) based on the hypothesis that financing
follows hierarchy, and that firms prefer internal over external financing and debt over equity.
The underlying factor is the asymmetry of information: The more asymmetry, the higher the
costs of the sources of financing (Brounen et al., 2004). Brounen et al. (2004) studied firms
in Europe and US to understand factors that determine their capital structure. Financial
flexibility was the factor that most importantly drove capital structure, suggesting a “pecking
order” model application (Brounen et al., 2004, p. 94).
Typical issues observed in the application of Pecking order theory are: (a) Debt is encouraged
when firm experience insufficient profits? (b) Debt is encouraged when equity is
undervalued? When firms respond “yes” to these questions, it is an indication of the
application of the theory. Brounen’s study rejected this hypothesis (Brounen et al., 2004, p.
94). Current theory that contends that firm’s trade off the costs and benefits of leverage
associated with tax effects, bankruptcy and agency costs, in order to generate a target capital
structure for the firm (Brounen et al., 2004, p. 93). Firms that respond to the static tradeoff
theory, have managers whose incentive to issue stock to keep the EPS dilution (Bancel &
Mittoo, 2004, p.112).

Static Trade-Off Theory of Capital Structure

Current theory that contends that firm’s trade off the costs and benefits of leverage associated
with tax effects, bankruptcy and agency costs, in order to generate a target capital structure
for the firm (Brounen et al., 2004, p. 93). Firms that respond to the static tradeoff theory,
have managers whose incentive to issue stock to keep the EPS dilution (Bancel & Mittoo,
2004, p.112).
In a study by Brounen et al. (2004) CFOs in Europe and US were asked about the importance
of agency costs and bankruptcy. Europeans considered bankruptcy costs as the 4th more
important after financial flexibility, credit ratings and earnings volatility. Their results prove
that static trade off theory reflects the behaviours of corporate managers (Bancel & Mittoo,
2004; Brounen et al., 2004). Application of the tradeoff theory requires a two-step process:
(1)Define a target capital structure (2)Choose elements to include in the trade off: financial
flexibility, credit rating, volatility of earnings, tax advantage, transaction cost, debt level of
other firms, potential costs of bankruptcy (Brounen et al., 2004; Brounen et al., 2004).

Economic Value Added Theory

Current theory of Economic Value Added EVA was designed by Stern, Stewart & Chew
(1995). It is an alternative model to CAPM used in capital budgeting because it focuses on
the ability of a firm to create wealth from the point of view of the economic model and not
the accounting model (Abate, Grant & Stewart, 2004, p. 62). Strong competition of the
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Earning Per Share EPS model that prevailed in America before the 90s (Stern, Stewart &
Chew, 1995) and more real than Return on Equity ROE, Free Cash Flow FCF and other
methods based in the Accounting model (Hatfield, 2002).
It is an integrated financial system used in decision making and different corporate
applications: Performance measurement, determination of shareholder value, valuation of
equity (Hatfield, 2002; Stern, Stewart & Chew, 1995).
In Research & Development, EVA is used to improve the treatment of outlays as investment
given their value creation character. Hatfield (2002) prepared a study to demonstrate the
effect of capitalizing R&D. Outlays for new products when R&D is expensed perform worse
than flows of outlays of a capitalized R&D across time. Firms reported by Stern & Stewart
Co. (n.d) as active users of EVA include: Bausch and Lomb, The Coca Cola Co., Georgia-
Pacific Corp., Monsanto, Rubbermaid Inc. among others (Hatfield, 2002). Application of
EVA requires change in the organizational culture and fiscal responsibility (Hatfield, 2002).
EVA is not a new concept, it is deemed “practical, highly flexible, a refinement of
economists’ concept of residual income’ (Drucker as cited in Stewart, 1991). For other
authors EVA is a financial fiction inoperable unless markets were efficient (Chen & Dodd,
2002). The formula to compute EVA is expressed (Hatfield, 2002).
EVA = NOPAT – CC (1)
NOPAT= Net operating profit after taxes
CC= cost of capital x economic capital
Four steps are required : (1) Determine the Net profit after taxes plus interest charges (2)
Estimate market value of company’s equity (3) Calculate the opportunity cost of the capital
and (4) Compute EVA (Gonzalez, 2006).

The Sharpe-Lintner Capital Asset Pricing Model (CAPM)

Germinal theory developed separately by Sharpe (1964) and Lintner (1965) and used to
identify the adequate cost of capital in project valuation (Brounen et al., 2004). Ball (2001, p.
24) defines it as a “method of estimation expected returns which passive investors would
otherwise have earned in the absence of the information being tested” An equation for CAPM
may look as follows (Ball, 2001, p. 30): E(R) = Rf + β (Rm – Rf) (1)
Stock’s expected return E(R) is equal to a riskless rate Rf plus a risk premium compound by
β and the expected to earn above the riskless rate (Rf). CAPM is popular because there is no
any other accepted model to compute expected returns (Chen & Dodd, 2002, p. 509).
A survey conducted by Brounen et al. (2004) reported CAPM was used by 64.2% of U.S.
firms and an average of 57% of European companies, with high occurrence in large and
public firms across the data of 6,500 firms, where CEOs have long tenures, regardless of their
educational background. Fama and French (1996) critique CAPM flaws in recording
anomalies of the market and expected returns (p. 1948). CAPM’s major weakness is in the
determination of betas in efficient markets (Ball, 2001) and the inability to explain the
temporality of risk premiums and the amount of the expected changes in that risk ratio. Some
theorists contend CAPM is not a valid model to compute expected returns, given the premise
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that dividends and earnings are non-fundamental to stock pricing determination. Its use in the
computation of EVA also has been challenged (Chen & Dodd, 2002).
Divided opinions classify CAPM as a result of the EMH (Efficient Market Theory) (Ball,
2001); others argue that the assumption that CAPM evaluates only efficient portfolios does
not imply that CAPM derives from Fama’s Efficient Market Hypothesis (EMH).

Current Theory of Discounted Cash

Flow (DCF) used in capital budgeting or project valuation, asset valuation (Myers, 2001;
Shrieves & Wachovicz, 2001) and securities valuation (Shrieves & Wachovicz, 2001). DCF
compares the future returns of potential projects by discounting the future cash flow at a rate
that reflects the yield of similar securities in the market (Myers, 2001). Internal return rate
(IRR), net present value (NPV), adjusted present value (APV) and discounted payback period
are DCF techniques (Brounen et al., 2004). Myers (2001) highlights the usefulness of NPV
but cautions about the difficulties when defining discount rates, forecasting cash flows,
estimating time series and dealing the stringent accounting principles (Shrieves &
Wachovicz, 2001).
Brounen et al (2004) surveyed 6,500 companies from the United Kingdom, Netherlands,
France and Germany and U.S. to assess the behavior of financial officers regarding the use of
financial techniques Results suggested that European firms do not apply DCF techniques as
much as they use payback criterion. Authors argue that most European firms are small and
private, and their CEOs do not have MBA degrees which could imply an increase use of
discounted techniques.
The study also found that those firms declaring that they maximize shareholder value use
discounting techniques most frequently (Brounen et al., 2004). In asset valuation, DCF
compares the intrinsic value of a firm by discounting the expected future free cash flows
(FCF) using a rate that reflects the cost of capital” (Stewart, 1991, p. 34). Bias against long-
lived projects is a challenged result of DCF, reinforcing the argument of management
shortsightedness in the 80s (Myers, 2001).
DCF main critiques derive from the use of traditional financial reporting (Shrieves &
Wachovicz, 2001) and the vulnerability to political forces within the organization (Myers,
2001). The multi-use of DCF is achieved through a combination with Free Cash Flow (FCF)
techniques and with EVA® for purposes of evaluation of managerial performance (Shrieves
& Wachovicz, 2001; Stewart, 1991).

Free Cash Flow Theory

The free cash flow theory was advanced and researched by (Jensen, 1986) in a bid to explain
the relationship between free cash flows and the role of debt in organizations, impact of
diversification programs and factors influencing takeovers. Jensen (1986) argued that
conflicts of interest between shareholders and managers over payout policies are especially
severe when the organization generates substantial free cash flow as corporate management is
for firm growth and against dividend payout as they reduce resources under their control.
Brush et al. (2000) found that sales growth was most beneficial to firms lacking free cash
flows. Free cash flows are associated with increases in managers’ compensation because
changes in compensation are positively related to the growth in sales (Murphy, 1985). To
motivate managers to disgorge the cash rather than investing it at below the cost of capital or
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wasting it on organization inefficiencies (Jensen, 1986) proposed increased dividend

payments to shareholders, share repurchases and use of debt to promote organizational
efficiency and deal with the agency conflict. The use of debt was found more suitable for
firms with large free cash flows and few growth prospects than growing firms with highly
profitable investments and no free cash flows. Debt was also argued to be a substitute
dividend as managers are bound by debt whose holders have legal recourse on non-payment
of unlike dividend. Free cash flow theory also attempted to explain previously puzzling
results on the effects of financial restructuring (Jensen, 1986). Free cash flow theory predicts
that except for firms with profitable unfunded investment projects, prices will rise with
unexpected increases in payouts to shareholders, and prices will fall with reductions in
payments or new requests for funds. The theory argues that share price declines on the sale of
debt and preferred share arises because these sales bring new cash under the control of
managers. According to FCF theory most leverage-increasing transactions, including stock
repurchases and exchange of debt or preferred stock for common stock, debt for preferred
stock, and income bonds for preferred stock results in significant positive increases in
common stock prices. On the other hand most leverage-reducing transactions such as the sale
of common stock, exchange of common stock for debt or preferred stock, or preferred stock
for debt as well as the call of convertible bonds or convertible preferred forcing conversion
into common results in significant decreases in stock prices. Rubin (1990) stated that
managers in firms with high free cash flows prefer investing them in projects with negative
net value over paying them to shareholders as dividends and in order to obscure these
investments engage in earnings management. Jensen (1986) argued that diversification
programs were likely to be undertaken by managers with large free cash flows resulting in
low benefit or even value destroying mergers. Shleifer and Vishny (1991) attributed hostile
takeovers in the 1980s to reversed over-investment by managers who undertook unrelated
diversification programs due to large free cash flows in the 1960s. FCF theory proposed that
debt creation in takeovers in organizations with large cash flows but few high-return
investment projects increases efficiency and helps prevent from wasting resources on low-
return projects. Jensen (1986) further predicts that takeovers financed with cash and debt will
generate larger benefits than those accomplished through exchange of stock as debt and cash
are associated with growth opportunities and a shortage of free cash flow.

Modern Portfolio Theory

According to Findlay and Hamilton (1979), modern Portfolio Theory (MPT) approaches
investing by examining the entire market and the whole economy. The theory is an
alternative to the older method of analyzing each investment’s individual merits. Investors
look at each investment’s individual merits, they are analyzing one investment without
worrying about the way different investments will perform relative to each other. On the
other hand, MPT places a large emphasis on the correlation between investments. Markowitz
(1952) developed a basic portfolio model that demonstrated how risk could be reduced within
a portfolio by combining assets whose returns demonstrate less than perfect positive
correlation. The Markowitz theory exploited the low correlation between two assets and
demonstrates that as long as the correlation between the two assets is low, the risk component
of a portfolio would be less than the average of the risk of the individual assets (Goslings &
Petri, 1991).

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Portfolio could be reduced by spreading the amount of funds available for investments into a
variety of opportunities, each in a different risk class. Institutional investors have over the
years achieved portfolio diversification using property and equity as their prime investments
(Reddy, 2001).
The proponents of MPT argued Property′s high relative management costs are increased by a
globally-scattered portfolio where no scale efficiencies can be obtained; there are additional
costs in monitoring the local managing agents. Gordon (1991), as a result, the tendency
would be to concentrate holdings on a small number of markets (and on larger units) thus
sacrificing potential diversification gains. Market access may be problematic; particularly
where the market capitalization is small in relation to the size of fund there may simply be no
appropriately sized buildings available. Liquidity problems make it difficult to implement
and actively manage a portfolio strategy (Brown, 1991). Markets with low correlations to the
global portfolio are often those with least research and most restrictive market practices.
Information may be difficult and costly to obtain; it is rare that data will be of good quality
and with a long time-series. Furthermore, there may be comparability problems caused by
differences in ownership and legal structures, valuation methodologies and terminology. In
individual asset selection, local factors may dominate, placing the overseas investor without a
local partner at a relative disadvantage (Ennis & Burik, 1991).

The Modigliani and Miller Theory

The initial theory relating to Dividend policy was developed in 1958 by economists Franco
Modigliani and Merton Miller known as MM Theory. The Modigliani and Miller (1963) and
Miller (1977) result that firm value is independent of dividend policy has also been examined
extensively. Bhattacharya (1979) and others show that firm dividend policy can be a costly
device to signal a firm’s state, and hence relevant, in a class of models, firstly, asymmetric
information about stochastic firm earnings, secondly, shareholder liquidity (a need to sell
makes firm valuation relevant), and thirdly deadweight costs (to pay dividends, refinance
cash flow shocks or cover under-investment). In a separating equilibrium, only firms with
high anticipated earning pay high dividends, thus signalling their prospects to the stock
market. As in other costly signalling models, why a firm would use financial decisions to
reveal information, rather than direct disclosure, must be addressed. As previously, taxes are
another important friction which affects dividend policy Modigliani and Miller (1963),
hereafter referred to as MM, put forward the irrelevance theorems, more commonly known as
the MM theorems and these form the foundation of modern corporate finance theory. The
two main conclusions that are drawn from the MM theorems are that firm value is dependent
on its current and future free cash flow. Secondly, the level of dividends (or dividend policy)
does not affect firm value given that firms maximize their value through investment. Whilst
investment increases the value of future cash flows. The difference between equity issued and
payouts of the firm is equal to its free cash flow. Hence, dividend policy is irrelevant when it
comes to affecting firm value. Regarding the impact of dividend policy decision on
investment, it is understood that firms should take all projects with a positive Net Present
Value (NPV). However, the issue is that if management put more emphasis on dividend
policy to such an extent that it eventually dominates investment policy decisions, it could be
argued that NPV projects or projects creating firm value be cancelled or delayed for a later
time. By cancelling or delaying positive NPV projects, this will obviously have an adverse
effect on the future expected profits of the company. Although Fama (1974) carried out a
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research on the relationship between investment decisions and dividend decisions. His
findings revealed that investment decisions and dividend decisions are not correlated; that
these two types of decision making do not affect each other.

Market Efficiency Theory

Theory of the stock market efficiency Fama (1965) Germinal theory discussed by Fama
(1965) and again by Ball and Brown (1968). Efficient markets are characterized by
competition among “profit maximizers” who attempt to estimate the value of securities in the
future relying on the information they have (Fama as cited by Ball, 2001). Fama and French
divided valuation portfolios in two: Value Stock firms (with high book to market) and growth
stock (with low book-to market value) (Anderson & Garcia-Feijoo, 2006).
Theory predicts that portfolio with low b/m value will have an increased return before
portfolio formation and then would decrease. This return to equilibrium was a key element in
the model (Fama & French, 1996). Fama and French (1993, 1996) proposed a three-factor
model that describes variations in time that may affect the measurement of stock return:
Book-to market ratio, size and excess market return. Following the theory of market
efficiency Anderson and Garcia-Feijoo (2006) conducted a study to test that firm valuation
and valuation ratios respond to optimal corporate investment decisions.
The model tested consistently with the predictions of Fama and French theory but also
concluded that pricing factors resulting from size and bookto-market portfolios become
irrelevant when macroeconomic conditions of growth prevail. Anderson and Garcia-Feijoo
suggest including a fourth factor (investment-growth factor) to the model of Fama and
French, in order to help explain the anomalous returns in portfolios (Anderson & Garcia-
Feijoo, 2006, p. 174, 191).
Limitations of the model include the unreal assumption that information is a commodity and
is costless. International applications of the Fama and French model require a countryspecific
study to observe particular patterns of corporate investment activity (Anderson & Garcia-
Feijoo, 2006, p. 192).
Theory of the Stock Market Efficiency
Germinal theory is based on Fama (1965) definition of efficiency. Brown (1978, p.17)
defines efficient capital markets as “one in which it is impossible to earn an abnormal return
by trading on the basis of publicly available information”. Fama (1965) and Brown (1978)
definitions have a common element: the assumption of available information about the
earnings of a firm, traditionally expressed by Earning per share (EPS). Ball and Brown
(1968) tried to explain the behaviour of the stock market which was not of main interest by
economists but statisticians.
Miller and Modigliani Theory of corporate finance policy; Sharpe-Lintner Capital Asset
Pricing Model (CAPM) and Black-Scholes option pricing model. In the mid-60s Ball and
Brown performed a study to evaluate how stock market reacted to announcements of annual
earnings. They analyzed 2300 annual earnings reports of 300 NYSE companies between
1956-1964. Ball and Brown found an upward movement in stock price after announcement
of increase in earnings, and slight downwards after announcement of decreases in earnings.
In a period of six months afterwards net earnings were close to 0. The conclusion was that
stock prices did reflect the information announced annually (p.21).
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Limitations of the theory are analyzed by Ball (2001) himself and divided in 3 categories:
Empirical anomalies, defects as a model of stock market and problems in testing the
efficiency of the model. Empirical anomalies include problems in fitting the theory to the
data because of seasonal patterns. Defects in efficiency as a model of stock market comprise
not incorporating information costs, transaction costs, oversimplifying academic analysis
and ignoring market microstructure effects (Ball & Brown, 1968 p. 25) Market
microstructure effect explains “how investors’ latent or hidden demands are ultimately
translated into prices and volumes” (Madhavan, 2002). Problems in the model relate to
definition of risk-less rates, market risk premium, individual betas and the volatility of the
stock prices.

The Black-Scholes Option Pricing Model

Germinal theory proposed by Black and Scholes (1973) and developed along with Merton’s
Theory of Rational Option Pricing (1973). Based on a portfolio of stocks and options on the
stocks which valuation is based on the assumptions of short term horizon, fixed interest rates,
prices for the underlying assets, no dividend payments, no selling or buying options and
abilities to borrow and short sell (Versluis & Hillegers, 2006). Its main characteristic is its
satisfactory fit to market data, but its two more criticized flaws are “moneyness (or volatility
smile) and time to maturity” (Blyinski & Faseruk, 2006, p. 47; Versluis & Hillegers, 2006,
p. 261).
New studies have included variables that make the model more adaptive to reality. Versluis
and Hillegers (2006) proposed a modification to the model to include the effect of re-
financing at the end of the short-term interval. Versluis & Hillegers (2006) add a parameter
that accounts for the drift of the stock price process which applied to a study of seven Dutch
stocks and showed better fit than the original model. The Chicago Board Options Exchange
(SBOE) was the first one in using the Black and Scholes model in 1973 and continues to use
the newly developed neural models and implied volatility variables.

REMM Theory of Human Behaviour (Resourceful, Evaluative, Maximizing Model)

Current theory proposed by Meckling (1976) addresses the concept of “man” as unit of
analysis in economics. It explains man’s behaviours as a result of interactions with value
systems and constraints” (Brunner & Meckling, 1977). REMM individuals are able to make
trade-offs to overcome a constraint, and therefore theoretically have “no needs”, they have
wants and desires which help them focus on alternatives, substitutes and costs and reduce
their exposure to hidden agendas of politicians or media (Brunner & Meckling, 1977).
In general markets are always in equilibrium because REMM individuals adapt to their
opportunity set and make demand and supply better off, by balancing cost/benefit (Jensen &
Meckling, 2001) which help them focus on alternatives, substitutes and costs and reduce their
exposure to hidden agendas of politicians or media (Brunner & Meckling, 1977). In general
markets are always in equilibrium because REMM individuals adapt to their opportunity set
and make demand and supply better off, by balancing cost/benefit (Jensen & Meckling,
2001).
Most economists are REMM individuals who believe that price system is a self-regulatory
mechanism that responds to needs and wants. Trade-off in the costs of leverage to avoid the
costs of bankruptcy is an example of a REMM action (Brounen et al., 2004). Most

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economists are REMM individuals who believe that price system is a self-regulatory
mechanism that responds to needs and wants. Trade-off in the costs of leverage to avoid the
costs of bankruptcy is an example of a REMM action (Brounen et al., 2004).
Corruption in financial markets is addressed by Brunner and Meckling (1977) and explained
from the REMM perspective as the result of corrupt government agencies rather than private
firms. The limitations of the theory are that; REMM does not describe behaviour of particular
individuals and might appear too biased towards the role of government agencies as
controlling entities of corporate governance (Jensen & Meckling, 2001).

Financial Liberalization Theory of IMF

Current theory originated in the separate work of McKinnon (1973) and Shaw (1973). The
hypothesis supporting this theory proposed that financial development and economic growth
were strongly attached. The more liberalization of financial systems, the more growth in
economic development. Arestis, Nissanke & Stein (2005). The liberalization theory was
applied during the 90s in developing countries based on the idea that financial institutions
would benefit from foreign capital inflows and competition among banks and financial
institutions would foster efficiency (Glen & Singh, 2005); however the inflow increased the
instability of these countries (Shaw, 1973).
The application of the liberalization theory resulted in chaos and crises in developing
countries. In 1989 Venezuela’s banking system broke and 60% of their assets were lost. In
Mexico, in the late 90s government intervention to solve financial crisis represented costs of
17% of the Gross domestic product. Sahoo, Nataraj and Kmaiah (2001) studied real savings
and real GDP statistics from 1950-1999 and found that the relationship was growth-to
savings and not savings-to growth.
Liberalization theory was based on strong classical assumptions about the role of the interest
rate. Shaw (1973) considered interest rates as a signal of opportunities of investments, and
therefore an increase in economic development. For McKinnon (1973) high interest rates
would increase savings flows and decrease any excess of demands (Arestis, Nissanke &
Stein, 2005 p. 247). Flaws of the liberalization model resided in forgetting that markets are
not sophisticated and that markets are imperfect (Arestis et al., p. 249).

Institutional-Centric Theory of Finances

Current theory proposed by Arestis, Nissanke and Stein (2005) as an alternative to the flawed
financial liberalization theory that increased the instability of developing countries during the
90s. Based on the theory of imperfect markets, it acknowledges the existence of imperfect
information and informal and formal institutions, which efficiency is the engine of
development (Arestis et al., 2005).
“Norms, incentives, regulations, capacities and organizations” are five institutions of any
financial system (Arestis et al., 2005, p. 257) who risks have to be socialized. Empirical
studies have found that in reality the transition of economies to an institutional centered
model is not happening, instead takeovers by foreign commercial banks are common (Arestis
et al., 2005).
The study by DeMaestri and Guerrero (2003) show empirical evidence that financial
regulation overcome issues of moral hazard, financial conglomerates, transparency and
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accountability. A banking system that connects investment and production in a symmetric

manner, with common guidelines will attract investment and accumulation (Glen and Sing,
2005). An integration of financial supervision was proposed by DeMaestri and Guerrero
(2003) and theoretically suggests that effectiveness and efficacy are achieved when
regulatory institutions are integrated in one.

Deflation Theory
The concept of debt deflation theory was pioneered by Fisher (1930) following the Wall
Street Crash of 1929 and the ensuing great depression. Debt deflation is a theory of economic
cycles, which holds that recessions and depressions are due to the overall level of debt
shrinking (deflating). Fisher stated that, credit cycle is the cause of the economic cycle.
Fisher developed debt deflation theory by taking hypothetical case by assuming that, at some
point of time, a state of over-indebtedness exists, this would tend to lead to liquidation,
through the alarm either of debtors or creditors or both. In Fisher's formulation of debt
deflation, he states that, when the debt bubble bursts the following sequence of events occurs;
(1) debt liquidation leads to distress selling and to (2) contraction of deposit currency, as
bank loans are paid off, and to a slowing down of velocity of circulation. This contraction of
deposits and of their velocity, precipitated by distress selling, causes (3) a fall in the level of
prices, in other words, a swelling of the dollar. Assuming, as above stated, that this fall of
prices is not interfered with by reflation or otherwise, there must be (4) a still greater fall in
the net worth of business, precipitating bankruptcies and (5) a like fall in profits, which in a
"capitalistic," that is, a private-profit society, leads the concerns which are running at a loss to
make (6) a reduction in output, in trade and in employment of labour. These losses,
bankruptcies and unemployment, lead to (7) pessimism and loss of confidence, which in turn
lead to (8) hoarding and slowing down still more the velocity of circulation. The afore eight
changes cause (9) complicated disturbances in the rates of interest, in particular, a fall in the
nominal, or money, rates and a rise in the real, or commodity, rates of interest.

Financial Theory
Minsky (1974) pioneered financial theory (commonly known as financial instability
hypothesis) and attempted to provide an understanding and explanation of the characteristics
of financial crises. Minsky proposed theories linking financial market fragility, in the normal
life cycle of an economy, with speculative investment bubbles endogenous to financial
markets. Minsky claimed that in prosperous times, when corporate cash flow rises beyond
what is needed to pay off debt, a speculative euphoria develops, and soon thereafter debts
exceed what borrowers can pay off from their incoming revenues, which in turn produces a
financial crisis. As a result of such speculative borrowing bubbles, banks and lenders tighten
credit availability, even to companies that can afford loans, and the economy subsequently
contracts.
Minsky's model of the credit system, which he dubbed the "financial instability hypothesis"
(FIH), incorporated many ideas. He states that, a fundamental characteristic of an economy is
that the financial system swings between robustness and fragility and these swings are an
integral part of the process that generates business cycles. Disagreeing with many mainstream
economists of the day, he argued that these swings, and the booms and busts that can
accompany them, are inevitable in a so-called free market economy – unless government
steps in to control them, through regulation, central bank action and other tools.
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Hyman Minsky's theories about debt accumulation received revived attention in the media
during the subprime mortgage crisis of the late 2000s. Minsky argued that a key mechanism
that pushes an economy towards a crisis is the accumulation of debt. He identified three types
of borrowers that contribute to the accumulation of insolvent debt: hedge borrowers,
speculative borrowers, and Ponzi borrowers. The "hedge borrower" can make debt payments
(covering interest and principal) from current cash flows from investments. For the
"speculative borrower", the cash flow from investments can service the debt, i.e., cover the
interest due, but the borrower must regularly roll over, or re-borrow, the principal. The
"Ponzi borrower" borrows based on the belief that the appreciation of the value of the asset
will be sufficient to refinance the debt but could not make sufficient payments on interest or
principal with the cash flow from investments; only the appreciating asset value can keep the
Ponzi borrower afloat. Because of the unlikelihood of most investments' capital gains being
enough to pay interest and principal, much of this type of finance is fraudulent.
If the use of Ponzi finance is general enough in the financial system, then the inevitable
disillusionment of the Ponzi borrower can cause the system to seize up: when the bubble
pops, i.e., when the asset prices stop increasing, the speculative borrower can no longer
refinance (roll over) the principal even if able to cover interest payments. He further states
that, collapse of the speculative borrowers can then bring down even hedge borrowers, who
are unable to find loans despite the apparent soundness of the underlying investments.
Minsky stated his theories verbally, and did not build mathematical models based on them.
Consequently, his theories have not been incorporated into mainstream economic models,
which do not include private debt as a factor. Minsky's theories, which emphasize the
macroeconomic dangers of speculative bubbles in asset prices, have also not been
incorporated into central bank policy. However, in the wake of the financial crisis of 2007–
2010 there has been increased interest in policy implications of his theories, with some
central bankers advocating that central bank policy include a Minsky factor.

Ownership Structure Theory

Ownership structure theory pioneered by Jensen (1976) integrated the elements of theory of
property rights, the theory of agency (Ross, 1973; Mitnick, 1974) and the theory of finance
(Minsky, 1974). The theory explains why highly regulated industries such as public utilities
or banks have higher debt-equity ratios for equivalent levels of risk than the average
nonregulated firm. Jensen argues that “ownership structure” rather than “capital structure”
are the crucial variables to be determined, not just the relative amounts of debt and equity but
also the fraction of the equity held by the manager.
The theory posits that, if there are other individuals in the economy who have sufficiently
large amounts of personal capital to finance the entire firm, capital constrained owner can
realize the full capital value of his current and prospective projects and avoid the agency
costs by simply selling the firm (i.e., the right to take these projects) to one of these
individuals. The owner would then avoid the wealth losses associated with the agency costs
caused by the sale of debt or outside equity. If no such individuals exist, it will pay him (and
society) to obtain the additional capital in the debt market. One can argue that it is the project
which bears the costs since, if it is not sufficiently profitable to cover all the costs (including
the agency costs).

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Credit Scorecards Theory

Credit scorecards theory (Altman, 1968) provides a quantitative measurement of the
likelihood that a customer will display a defined behaviour (e.g. loan default) with respect to
their current or proposed credit position with a lender. The theory uses observations or data
from clients who defaulted on their loans plus observations on a large number of clients who
have not defaulted. Statistical techniques such logistic regression or probit model of analysis
are used to create estimates of the probability of default for observations based on this
historical data. Credit scoring model can be used to predict probability of default for new
clients using the same observation characteristics (e.g. age, income, house owner). The
default probabilities are then scaled to a "credit score." This score ranks clients by riskiness
without explicitly identifying their probability of default. Z-score estimation formula
(Altman, 1968) is commonly used as a credit scoring technique. “As I first wrote in 1968, and
it seems even truer in the late 1990s, academicians seem to be moving toward the elimination
of ratio analysis as an analytical technique in assessing the performance of the business
enterprise” (Altman, 2000).

Theory of the Firm

The theory of the firm was traditionally one branch of Microeconomics which studied the
supply of goods by profit-maximising agents. In this theory, production costs played a crucial
role. Coase (1937) was one of the first pointing out that in addition to production costs of the
usual sort, one must also consider transaction costs in explaining institutions like the firm. He
focused on the comparative transaction costs of alternative organizational structures, such as
firms and markets. This theory was later extended by Oliver Williamson and became widely
known as transaction-cost economics (Williamson, 1985) or more broadly the economics of
organization. Transaction costs are costs (e.g. in terms of money or time) incurred when
making an economic exchange. If we extend this term, transaction costs do not only include
bilateral transactions but subsume contractual relationships between individuals. In general,
transaction costs symbolise “friction losses”, i.e. the lost resources for the involved parties,
but which are inevitable to reach certain goals. In firms, transaction costs may include the
costs of organising business activity over time, planning the future and limiting as well as
allocating risks which may arise in the future. It therefore includes the elements of
uncertainty and opportunism, which are both indispensable for debates in corporate
governance.
Coase argued in his 1937 article that transaction costs explain both the existence of firms and
their optimal size. In “The Nature of the Firm” he identified certain transactions which are
prohibitively costly if the parties involved could only deal with instant market transactions. In
order to carry out a market transaction it is necessary to identify the party one wishes to deal
with, establishing terms and conditions, conducting negotiations and concluding a contract.
After the conclusion of the contract monitoring is needed to make sure that all terms and
conditions are fulfilled. If slight changes are wished, the whole transaction process needs to
be initiated again. Or, to put it in other words, Coase emphasised that making contracts and
purchasing assets and other property in markets incurred costs that were not accounted for by
the “price mechanism”. Individuals would therefore organise firms and maintain them when
the organisational entity provided implicit savings in terms of assembling resources, assets,
and labour internally. This describes situations in which market transactions would show
their relative inflexibility to re-contracting when changes in the existing relationship arise.
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Regularly recurring transactions and long-term transactions might be good examples. In such
situations longer, incomplete contracts, which are typical for firms, provide much more
flexibility for the parties in a world of uncertainty. These contracts can be left open to be
flexible in case of a changing environment. On the other hand dissimilarities of transactions,
the probability of changes in the market prices for the relevant resources as well as the spatial
distribution of the relevant resources and transactions highlight factors which increase the
costs of using a firm. One might argue in this context that transaction costs would be
minimised in a world without transactions. This could be achieved if rights and duties would
initially be assigned in the “right” way.
Based on this idea Armen Alchian and Harold Demsetz built their theory of property rights.
Property can be tangible (e.g. equipment in a firm) and intangible (intellectual property), and
property rights theory argues that the ownership, which includes residual rights to the
benefits of ownership, of productive assets provides a foundation for explaining firms.
According to Oliver Hart, one of the leading scholars in this area, a firm without property is
just a phantom (Hart, 1995). In situations where ordinary contractual relationships fail, firms
arise and the ownership of capital assets puts (collection of) persons in the position to
organise production through the purchase of economic factors, including labour (Hart, 1995).
Applied to corporate governance, this theory provides a supplement to contract theories. The
theory claims that legal systems should assign and secure property rights and additionally
explains that those who invest in or own productive property and capital of the firm, have a
privileged position as legal agents to bargain with other parties such as directors, employees,
suppliers, and other constituencies. Coase, in his theory of the firm, built a connection
between the above discussed property rights and transaction costs. In a world without the
latter, the initial assignment of property rights would be irrelevant as each “error” in the
assignment of these rights could easily be rescinded by additional transactions. This is the
idea of the Coase Theorem for property rights. The applicability of the Coase Theorem to
companies is questionable as the idea rests on the assumptions that there are no legal,
strategic and informational barriers to bargaining. But in modern firms all these barriers
normally exist and make transactions more expensive, i.e. incur transaction costs.

Agency Theory
The 1976 article Theory of the Firm: Managerial Behaviour, Agency Costs and Ownership
Structure by Jensen and Meckling helped establish Agency Theory as the dominant
theoretical framework of the CG literature, and position shareholders as the main
stakeholder (Lee et al., 2010, Daily et al., 2003).
The adoption of the agency logic increased during the 1980s as companies started replacing
the hitherto corporate logic of managerial capitalism with the perception of managers as
agents of the shareholders (Zajac et al., 2004). The subsequent stream of literature would
break with the tradition of largely treating the firm as a black box and the assumption that the
firm always sought to maximize value (Jensen 1 994).
AT addressed what had become a growing concern, that management engaged in empire
building and possessed a general disregard for shareholder interest, what Jensen called “the
systematic fleecing of shareholders and bondholders” (1989, p. 64), through providing
prescriptions as to how the principal should control the agent to curb managerial opportunism
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and self-interest (Perrow, 1986; Daily et al., 2003). As the market reacted positively to this
change in logic, with time the agency approach became institutionalized in the practice of
Corporate Governance, within business education, research and media (Zajac et al., 2004;
Shapiro, 2005).

Loan Pricing Theory

This theory explains why it is not prudent for financial institutions such as SACCOs to set
very high interest rates to optimize profit from loan sales. If financial Institutions set up very
high interest rates, they could induce the problem of adverse selection and moral hazard by
attracting borrowers with very risky projects into their portfolio. The high interest rates
would later act as an incentive for the risky borrowers to consider adding more risk to their
investment portfolio due to high affinity for high returns (Chodechai, 2004).
Financial institutions cannot always set high interest rates, e.g. trying to earn maximum
interest income. Finacial institutions should consider the problems of adverse selection and
moral hazard since it is very difficult to forecast the borrower type at the start of the banking
relationship (Stiglitz, 1981). If SACCOs set interest rates too high, they may induce adverse
selection problems because high-risk borrowers are willing to accept these high rates. Once
these borrowers receive the loans, they may develop moral hazard behaviour or so called
borrower moral hazard since they are likely to take on highly risky projects or investments
(Chodecai, 2004). From the reasoning of Stiglitz, it is usual that in some cases we may not
find that the interest rate set by SACCOs is commensurate with the risk of the borrowers.

Institutional Theory
Institutional theorists assert that the institutional environment can strongly influence the
development of formal structures in an organization, often more profoundly than market
pressures. Innovative structures that improve technical efficiency in early-adopting
organizations are legitimized in the environment. Ultimately these innovations reach a level
of legitimization where failure to adopt them is seen as "irrational and negligent" (or they
become legal mandates). At this point new and existing organizations will adopt the
structural form even if the form doesn't improve efficiency. Meyer and Rowan (1977) argue
that often these "institutional myths" are merely accepted ceremoniously in order for the
organization to gain or maintain legitimacy in the institutional environment. Organizations
adopt the "vocabularies of structure" prevalent in their environment such as specific job titles,
procedures, and organizational roles. The adoption and prominent display of these
institutionally-acceptable "trappings of legitimacy" help preserve an aura of organizational
action based on "good faith". Legitimacy in the institutional environment helps ensure
organizational survival. However, these formal structures of legitimacy can reduce efficiency
and hinder the organization's competitive position in their technical environment. To reduce
this negative effect, organizations often will decouple their technical core from these
legitimizing structures. Organizations will minimize or ceremonialize evaluation and neglect
program implementation to maintain external (and internal) confidence in formal structures
while reducing their efficiency impact.
Tolbert and Zucker (1996) confirmed the hypothesis that while early organizations adopt the
new form to improve efficiency, later organizations adopt the structural form to maintain
legitimacy. The theory is relevant to the deposit taking SACCOs as it depicts the
environments the SACCOs operate in. Deposit taking SACCOs are regulated by the SACCO
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act though SASRA. The regulations keep changing and SACCOs have to adhere with the
directives. SASRA is a body that influences the operations of the deposit taking. It seeks to
harmonize some operations by issuing some directives that SACCOs are meant to adhere to.
Example of indirect regulations includes the compliance requirements.

Innovation Diffusions Theory

This theory explains how new ideas and Innovations are spread and adopted by new cultures.
The theory seeks to examine critical factors in diffusion of innovations. They are what
qualities make an innovation spread, the importance of peer-peer conversations and peer
networks. Diffusion of Innovations takes a radically different approach to most other
theories of change. Instead of focusing on persuading individuals to change, it sees change as
being primarily about the evolution or “reinvention” of products and behaviours so they
become better fits for the needs of individuals and groups. In Diffusion of Innovations it is
not people who change, but the innovations themselves. The theory gives reasons why certain
innovations spread more than others and others fail.
These reasons include the Relative advantage of the innovation in comparison to the others,
the innovations compatibility with existing values and practices; Simplicity and ease of use;
Trial ability and Observable results.
The theory is relevant to this study as it can make a valuable checklist to frame focus group
discussions or project evaluations. They can help identify weaknesses to be addressed when
improving products or behaviours. Success of SACCO products and services rests on
continuous improvement. It also highlights the importance of inter-personal marketing
through peer–peer conversations which financial institutions today call word of mouth from
satisfied customers. The theory emphasis on the importance of understanding the needs of
different users of SACCO products.

Fisher Theory
Fisher (1930) hypothesized that the ex-ante nominal interest rate should fully anticipate
movements in expected inflation, in order to yield the equilibrium real interest rate. The
expected real interest rate is determined by real factors such as the productivity of capital and
time preference of consumers, and is independent of the expected inflation rate. In principle,
the Fisher hypothesis could be extended to any asset, such as real estate, common stock, and
other risky securities. The empirical relationship between inflation and common stocks was
first investigated by Jaffe and Mandelker (1976), Bodie (1976) and Nelson (1976). Although
employing different empirical approaches, these authors all concluded for a significant
negative relationship between the proxies of inflation and stock returns. Following these
pioneering studies, Fama and Schwert (1977) investigate the inflation effect on asset returns
in a number of assets. They concluded that, similar to previous studies, common stocks seem
to perform poorly as hedge against both expected and unexpected inflation. Since these
earlier studies, the empirical literature on the Fisher hypothesis has been prolific, and the
findings have been largely similar (e.g. Gertler and Grinols (1982), Buono (1989), Park
(1997)). The early studies on the Fisher hypothesis mentioned above were mainly concerned
with documenting and describing the nature of the relationship between stock returns and
inflation, and not with any explanation of the results. Several alternative explanations have
emerged. The Tax-Effect Hypothesis proposed by Feldstein (1980) argues that inflation
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generates artificial capital gains due to the valuation of depreciation and inventories (usually
nominally fixed) subject to taxation. This increase corporate tax liabilities and thus reduces
real after-tax earnings. Rational investors would take into account this effect of inflation by
reducing common stock valuation. In this sense, inflation “causes” movement in stock prices.

Fama’s Proxy Hypothesis

The theory revealed that the anomalous relationship observed between real stock returns and
inflation was a consequence of a spurious relationship: the negative relationship between
stock returns and inflation are induced by the positive correlation between stock returns and
real activity and the negative correlation between inflation and real activity. The argument
hinges on the money demand behaviour of rational agents who perceive a fall in economic
activity and therefore a decrease in money demand. This causes an excess money stock and
therefore inflation. In this sense, measures of real activity should dominate measures of
inflation when both are used as explanatory variables for real stock returns in testing the
Fisher Hypothesis.
Benderly and Zwick (1985) and Lee (1992) supported the proxy hypothesis while Ram and
Spencer (1983) failed to support the theory as they felt that his explanation calls into question
the conventional theories of the Phillips curve, in which a positive rather than a negative
relationship between inflation and real activity is suggested. They find consistent evidence of
a positive relationship between real activity and inflation and a negative relationship between
real activity and stock returns.

Inflation and Money Illusion Theory

Modigliani and Cohn (1979), theory states that the real effect of inflation is caused by money
illusion. Inflation illusion suggests that when there is a rise in expected inflation, bond yields
rise, but because equity investors incorrectly discount real cash flows using nominal rates, the
increase in nominal yields leads to under pricing of equities (Baekaert & Engstrom, 2009).
Stock market investors fail to understand the effect of inflation on nominal dividend growth
rates and extrapolate historical nominal growth rates even in periods of changing inflation.
Thus when inflation increases, bond market participants increase nominal interest rates which
are used by stock market participants to discount unchanged expectations of future nominal
dividends. The dividend-price ratio moves with the nominal bond yield because stock market
investors irrationally fail to adjust the nominal growth rate to match the nominal discount
rate. This implies that stock prices are undervalued when inflation is high and may become
overvalued when inflation falls. The dividend yield that emerges from the interaction of
rational and irrational investors is positively correlated with inflation and the long term
nominal interest rate.

Keynesian Economic Theory

Keynes (1930), in his Treatise on Money, argued for the importance of the banking sector in
economic growth. He suggested that bank credit "is the pavement along which production
travels, and the bankers if they knew their duty, would provide the transport facilities to just
the extent that is required in order that the productive powers of the community can be
employed at their full capacity". Keynesian economics focuses on immediate results in
economic theories. Policies focus on the short-term needs and how economic policies can
make instant corrections to a nation’s economy. Also, the government is seen as the only

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force to end financial and economic downturns through monetary or fiscal policies, and
providing aggregate demand to increase the level of economic output, facilitated through a
stable financial system that can spur continued economic stability. Keynes later in 1930s
supported an alternative structure that includes direct government control of investment and
advanced that financial deepening can occur due to an expansion in government expenditure.
Since higher interest rates lower private investment, an increase in government expenditure
promotes investments and reduces private investments concurrently.

McKinnon and Shaw Theory

McKinnon (1973) and Shaw (1973) argued that if real interest rates are kept below the
market equilibrium, this could increase the demand for investment but not the actual
investment. Low interest rates are insufficient to generate savings; it can even reduce savings
especially if substitution effects dominate the income effect for households. On the other
hand, low rates raise the expected profitability of investment projects by raising the net
present value of future earnings from the project. The theory rests on the assumptions that
saving is an increasing function of real rate of interest on deposits and real rate of growth in
output and that investment is a decreasing function of the real loan rate of interest and an
increasing function of the growth rate. The theory posits that the nominal interest rate should
be administratively fixed. They advance that emerging economies are fragmented; hence
there is a greater likelihood of having investments that are less productive. Capital
accumulation is discouraged by the fact that for a high inflation rate, nominal interest rates
are set too low and thus real interest rates could be negative. As capital supply of banking
sector is limited and banks have only specialized credit activities, people have to finance their
investment projects by themselves or have to go to the informal sector where interest rates are
often usurious.

The Signalling Hypothesis

A signalling model for stock splits was first proposed by Brennan and Copeland (1988).
According to the signalling theory, splits acted as a means of passing information from
managers to stockholders. The signalling model of stock splits showed that stock splits
served as costly signals of managers’ private information because trading costs increased as
stock prices decreased. They built up the hypothesis from Fama et al. (1969), who suggested
that by announcing splits, a company could reduce any information asymmetries that might
have existed between stockholders and management. The stock price reduction resulting from
a split then conveyed management’s conviction of rising future earnings. Since a stock split
usually required a significant cash outlay, and because sending a false signal would punish
the company with an unusually low stock price, a stock split was often seen as a more
credible form of information diffusion than road shows or press releases. Benartzi et al.
(2005) argued that management split their stocks only if it considered the current level of
stock price and earnings to be permanent. Brennan and Copeland (1988) saw the essence of
signalling argument as being that managers only split their stock if they were optimistic that
the future share prices would increase, or at the very least not decrease. If a manager believed
that the future share prices would decrease, they would not be willing to split stock due to the
increased cost of trading lower priced stocks. McNichols and Dravid (1990) noted that
managers did not explicitly intend for the split to be a positive signal about future prospects
of the firm, but the split could still convey information to the market.
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Agreeing with the signalling hypothesis theory, Conroy et al. (1999) found excess returns
after stock splits were considerably higher when shareholders were surprised by a larger-
than-expected split. Financial analysts were also found to increase their earnings forecast
notably when the split factor was greater than expected. Excess returns earned by market
participants then tended to be significantly higher when a company’s management decided on
a split factor that the stock price would fall below an expected level.

The Optimal Tick Size Hypothesis/ Market-Maker Hypothesis

Angel (1997) came up with the market-maker hypothesis, which suggested that companies
strived for an optimal tick size. The tick size was the minimum change in share prices. They
noted that if there was a constant absolute tick size, the management of a company could
influence the relative tick size through a stock split, that being the tick size in relation to the
stock price. Recently, academics paid attention to the role of tick size on the decision of stock
distributions. Most equity markets had rules on tick size; the minimum price variation.
Therefore, the primary difference between equity markets was whether they used a single
absolute tick size that applied to most stocks, or a tick size set that was a function of stock
prices. Angel (1997) noted that the minimum price variation rules determined the minimum
bid-ask spread that could be quoted. No quoted spread could then be less than the minimum
price variation. Larger tick sizes were found to make trading expensive, especially for smaller
traders. Admanti and Pfleiderer (1989) also noted that the relative tick size was more
influential on trading decisions and could even affect stock variation. Schultz (2000) agreed
with the optimal tick size hypothesis, and suggested that if there was an absolute constant tick
size on the stock exchange, a company’s management could influence the relative tick size
relative to the stock price through a split. The tick size was then important in that a high tick
size was conducive for market making, and it made it more profitable.

The Optimal Price Range Hypothesis

Copeland (1979) came up with the notion that a stock split changed stock prices to a more
optimal price, which in turn increased demand for the stock. Their hypothesis of the optimal
price range stated that there was a price range within which trading was most liquid for
stocks of a company. Firms were found to split their stock to keep prices within an optimal
trading range. Baker and Powell (1993) revealed that the main motivation for the executives
to split stock was for improved liquidity. High-priced stocks were found to be illiquid due to
the psychological reasons and transaction costs. Therefore, when the prices climbed up to a
certain level, the executive split the stock to lower prices which facilitated trading, hence they
enhanced liquidity. Conroy, Harris and Benet (1999) agreed with the optimal price range
hypothesis and noted that when a stock became too expensive, a split brought it back to the
optimal price range. Lakonishok and Lev (1987) argued that there existed benchmark values
regarding stock prices and managers were guided by these comparative figures.
Lamoureux and Poon (1987) also in agreement with this hypothesis noted that the managers’
expected stocks trading at lower prices to be generally more liquid and to attract a larger pool
of potential investors. Managers were then found to make use of splits to extend their
shareholder base, since the lower stock prices were more attractive to minority shareholders.

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The Neoclassical Theory: The Exogenous Growth Theory

The neoclassical exogenous growth theory is also called the Solow-Swan growth model and
is built upon the basic neoclassical frameworks of long run economic growth. This
framework explains economic growth using four main components namely, productivity,
capital accumulation, population growth and technological progress. This theory states that
the long run economic growth is exogenously determined, that is, economic growth is
determined by factors outside the basic model specifications. The basic building block of this
theory is the production function which has constant labor (L) and capital (K) which are
reproducible. Therefore the equation is Output (Y) being a function of Capital (K). The
crucial aspect of the production function is the assumption of diminishing returns of capital
accumulation. This means giving labor more capital goods without technological inventions
will result in redundant investment of the new capital at a certain point. Another basic
premise of the neoclassical growth model is that there tends to be a convergence to a steady
state in the long run depending on the technological progress and rate of labor force growth.
It states that a country that has higher savings than other will tend to growth faster than those
with low savings. In the very long run the role of capital accumulation plays a smaller role in
this model than technological progress as nations move to the steady state. The neoclassical
growth model emphasizes mostly on the importance of technological innovation in the long
run growth to offset the effects of diminishing returns that affect both capital accumulation
and labor increases in the economy (Aghion and Howitt, 1998).

The Endogenous Growth Theory

In the endogenous growth theory, economic growth is seen to be as a result of internal and
not external forces, this means that households, investing in human capital and innovation
play a significant role in the growth of an economy. This theory focuses on the positive
externalities and spillover effects of a knowledge based economy which ultimately leads to
economic development. It is in contrast to the exogenous growth model that emphasizes the
role of technological processes as a scientific exogenous process that is not determined by
economic forces. The main feature of the endogenous growth model is that the broad
definition of capital stock is not subject to diminishing returns as with the exogenous growth
model (Fry, 1997). This therefore means that growth is a positive function of the investment
ratio. It states that in the long run, economic growth will depend on the policy measures that
are taken by different governments. This implies that policies that embrace openness,
competition and innovation will promote growth (Aghion & Howitt, 1998).

Intermediation Theory
Financial intermediation involves matching lenders with excess funds (savings) with
borrowers who need the money and this is done by a third party agent such as a bank. The
intermediation theory is built on models of resource allocation that are based on perfect and
complete markets. The basis of complete perfect markets which this theory is based on comes
from the basic assumptions of the neoclassical model that include lack of competitive
advantages and little or no transaction costs in getting information as it is freely available to
all participants in the market. These assumptions are however not realized in the real world
due to various market imperfections such as asymmetric information which increases
transaction costs and result in other having a competitive edge over others. Financial
Intermediaries therefore exist to remove these imperfections and they do it in many ways.
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Intermediaries remove transaction costs by sharing or diversifying the evaluation of assets

fixed costs, something individuals find difficult to do. This means that business is diversified
by financial intermediaries such as banks and with that costs are able to be reduced through
economies of scale. Asymmetric information is removed through intermediaries as they act as
delegated monitors for the lenders through collecting information on the borrower and also
doing a number of screenings (for banks they look at credit worthiness of borrowers).
Financial intermediaries also signal an informed position by investing in the assets they have
particular knowledge of as they do extensive research about the market that some individuals
can not readily and actively do. Intermediaries like banks also provide commitments to long
term relationships with customers and thereby creating a relationship with the customer,
removing the problem of adverse selection and moral hazard (Gwilym, 2008). The
intermediation theory however only recognizes the importance of financial intermediaries in
the economy for the role of removing transaction costs and asymmetric information.

Clientele Effect Theory

According to Botha (1985), the tax induced clientele argument is based on shareholders‟
different tax status, which causes shareholders to have preference in respect to returns from
investments. This argument implies that there are three major groups of shareholders,
namely, those seeking immediate dividend income, those seeking capital appreciation and
those who are indifference to both dividends and capital appreciation. A firm is thus not only
faced with one clientele but with different clienteles, with preference from one dividend
policy to another. Investors who want current investment income such as retirees will own
shares in high dividend paying firms while investors who do not require dividends
distributions owns shares in low dividend paying firms. Thus different dividend clienteles
would probably be found in the following life cycles of companies, namely, maturity phase
for high dividend payout companies, the growth phase for low dividend payout companies
and the expansion phase for indifference between dividend income and capital growth. Allen,
Bernardo and Welch (2000) suggest that clienteles such as institutional investors tend to be
attracted to invest in dividend-paying stocks because they have relative tax advantages over
individual investors. The purpose of this theory is to predict the decisions of investors. This
will then affect the financial decisions of the firm.

Stewardship Theory
Stewardship theory has its roots from psychology and sociology and is defined by Davis et
al., (1997) as “a steward protects and maximizes shareholders wealth through firm
performance, 14 because by so doing, the steward’s utility functions are maximized”. In this
perspective, stewards are bank executives and managers working for the shareholders,
protects and make profits for the shareholders. Unlike agency theory, stewardship theory
stresses not on the perspective of individualism Donaldson and Davis, (1991), but rather on
the role of top management being as stewards, integrating their goals as part of the
organization. The stewardship perspective suggests that stewards are satisfied and motivated
when organizational success is attained. Agyris (1973) argues agency theory looks at an
employee or people as an economic being, which suppresses an individual’s own aspirations.
However, stewardship theory recognizes the importance of structures that empower the
steward and offers maximum autonomy built on trust Donaldson and Davis, (1991). It
stresses on the position of employees or executives to act more autonomously so that the
shareholders’ returns are maximized. Indeed, this can minimize the costs aimed at monitoring
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and controlling behaviors Daviset al., (1997). On the other end, Daily et al. (2003) argued
that in order to protect their reputations as decision makers in organizations, executives and
directors are inclined to operate the firm to maximize financial performance as well as
shareholders’ profits. In this sense, it is believed that the firm’s performance can directly
impact perceptions of their individual performance. Indeed, Fama (1980) contend that
executives and directors are also managing their careers in order to be seen as effective
stewards of their organization, whilst, Shleifer and Vishny (1997) insists that managers return
finance to investors to establish a good reputation so that they can re-enter the market for
future finance. Stewardship model can have linking or resemblance in countries like Japan,
where the Japanese worker assumes the role of stewards and takes ownership of their jobs
and work at them diligently. Moreover, stewardship theory suggests unifying the role of the
CEO and the chairman so as to reduce agency costs and to have greater role as stewards in
the organization. It was evident that there would be better safeguarding of the interest of the
shareholders. It was empirically found that the returns improved by having both these
theories combined rather than separated (Donaldson & Davis, 1991).

Stakeholder Theory
Stakeholder theory can be defined as “any group or individual who can affect or is affected
by the achievement of the organization’s objectives”. Unlike agency theory in which the
managers are working and serving for the stakeholders, stakeholder theorists suggest that
managers in organizations have a network of relationships to serve – this include the
suppliers, employees and business partners. This group of network is important other than
owner-manager-employee relationship as in agency theory Freeman, (1999). On the other
end, Sundaram and Inkpen (2004) contend that stakeholder theory attempts to address the
group of stakeholder deserving and requiring management’s attention. Whilst, Donaldson and
Preston (1995) claimed that all groups participate in a business to obtain benefits.
Nevertheless, Clarkson (1995) suggested that the firm is a system, where there are
stakeholders and the purpose of the organization is to create wealth for its stakeholders.
Freeman (1984) contends that the network of relationships with many groups can affect
decision making processes as stakeholder theory is concerned with the nature of these
relationships in terms of both processes and outcomes for the firm and its stakeholders.
Donaldson and Preston (1995) argued that this theory focuses on managerial decision making
and interests of all stakeholders have intrinsic value, and no sets of interests are assumed to
dominate the others.

Conclusions
Despite major advances in the theories used in finance, there has been scant impact on their
use in relation to strategic financial management. Researchers need to strategically and
accurately apply theories of finance correctly. The theories of finance have been extended in
order to reconcile financial and strategic analysis. It can be summarized by asking how the
present gaps between finance theory and strategic planning might be bridged. Strategic
planning needs finance. Present value calculations are needed as a check on strategic analysis
and vice versa. However, the standard discounted cash flow techniques will tend to
understate the option value attached to growing, profitable lines of business. Financial
management theories require extension to deal with real options. Therefore, to bridge the gap
researchers need to: Apply existing theories correctly; extend the theories. It is evident that
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Theories in Finance Discipline: A Critique of Literature Review [Warue et al.]

the most promising line of research is to try to use option of theories to model the time-series
interactions between investments. Both sides could make a conscious effort to reconcile
financial and strategic analysis. Although complete reconciliation will rarely be possible, the
attempt should uncover hidden assumptions and bring a generally deeper understanding of
strategic choices.

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