Stock Markets, Investments and Corporate Behavior A Conceptual Framework of Understanding p1007hc_9781783266999_tp.indd 3/2/15 5:07 pm May 2, 2013 14:6 BC: 8831 - Probability and Statistical Theory This page intentionally left blank PST˙ws Stock Markets, Investments and Corporate Behavior A Conceptual Framework of Understanding Michael Dempsey RMIT University, Melbourne, Australia ICP p1007hc_9781783266999_tp.indd Imperial College Press 3/2/15 5:07 pm Published by Imperial College Press 57 Shelton Street Covent Garden London WC2H 9HE Distributed by World Scientific Publishing Co Pte Ltd Toh Tuck Link, Singapore 596224 USA office: 27 Warren Street, Suite 401-402, Hackensack, NJ 07601 UK office: 57 Shelton Street, Covent Garden, London WC2H 9HE Library of Congress Cataloging-in-Publication Data Dempsey, Michael (Michael J.) Stock markets, investments and corporate behavior : a conceptual framework of understanding / by Michael Dempsey pages cm Includes bibliographical references and index ISBN 978-1-78326-699-9 (alk paper) Corporations Finance Mathematical models Capital assets pricing model Stocks-Prices Corporations Valuation Capital market I Title HG4012.D46 2016 332.64'2 dc23 2015011284 British Library Cataloguing-in-Publication Data A catalogue record for this book is available from the British Library Copyright © 2016 by Imperial College Press All rights reserved This book, or parts thereof, may not be reproduced in any form or by any means, electronic or mechanical, including photocopying, recording or any information storage and retrieval system now known or to be invented, without written permission from the Publisher For photocopying of material in this volume, please pay a copying fee through the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, USA In this case permission to photocopy is not required from the publisher In-house Editors: Catharina Weijman/Dipasri Sardar Typeset by Stallion Press Email: enquiries@stallionpress.com Printed in Singapore Dipa - Stock Markets, Investments and Corporate Behavior.indd 22/9/2015 11:14:16 AM September 25, 2015 20:5 Stock Markets, Investments and Corporate Behavior - 9in x 6in b2083-fm The text is dedicated to Mary, Frank and children and their loved ones, the great Hugh Williams, who dictated the destiny of more than one of us, Tony Naughton, whom I remember with great affection, and the girls in Bangkok All of them have been good to me By three methods we may learn wisdom: First, by reflection, which is noblest; Second, by imitation, which is easiest; and third by experience, which is the bitterest Confucius All I ask is the chance to prove that money can’t make me happy Spike Milligan Mathematical finance can take us only so far The rest is economics and management There are many patterns in finance, but few immutable rules And the Sun comes up tomorrow It just doesn’t know she’s gone Gram Parsons –for Yokie– v page v May 2, 2013 14:6 BC: 8831 - Probability and Statistical Theory This page intentionally left blank PST˙ws September 25, 2015 20:5 Stock Markets, Investments and Corporate Behavior - 9in x 6in b2083-fm A Short Bio for the Author (Official Version) Michael Dempsey joined RMIT University as Professor and Head of the Finance Discipline in early 2013 Prior to this, he was an Associate Professor at Monash University, before which he was an Associate Professor with Griffith University, having previously been at Leeds University, UK He also has many years’ experience working for the petroleum exploration industry, in the Middle East, RMIT official photo: Spot Egypt, Aberdeen and London His teachthe rather forced smile aimed ing expertise includes corporate and at showing how enthusiastic investment finance, international finance, I am at my work, how happy derivatives and financial engineering He I am to be at RMIT, and how is an active researcher and research superI will say almost anything visor across financial markets, in which if it might give me a salary he has published over fifty articles that increase at my next perforhave appeared in leading international mance meeting journals, including Journal of Banking and Finance (2), Financial Analysts Journal (2), European Financial Management (1), Abacus (3), Journal of Investment Management (2), Australian Journal of Management (2), Journal of Business Finance and Accounting (3), Accounting and Business Research (3), Critical Perspectives on Accounting (3), Journal of Asset Management (1), and Accounting and Finance (1) He has a first degree in Mathematics and a PhD in Astrophysics, as well as an MBA and Masters degrees in Theoretical physics and Petroleum engineering vii page vii May 2, 2013 14:6 BC: 8831 - Probability and Statistical Theory This page intentionally left blank PST˙ws Cover design concept: Michael Dempsey; above photo by John Vaz b2083-fm Comment or suggestions on the text are welcomed at: Michael.Dempsey@rmit.edu.au Stock Markets, Investments and Corporate Behavior - 9in x 6in ix Unofficial photo: of myself (third from left) at one of our academic soirées in my Melbourne flat Where were you Riley and Larry? Yes, that’s Jimi Hendrix almost falling over in the background I tell my nieces that they must listen to Jimi at least once a month in their formative years And lots of Van Morrison (And early Bob Dylan.) 20:5 Mike Dempsey has failed in many aspects of life He has failed to learn a second language despite (numerous) attempts, to ski with anything approaching style, or to hang-glide a significant distance cross-country He is also been mostly unsuccessful in his stock trading strategies (the reader of the text should bear this in mind∗ ) Nevertheless, his poker-playing skills are improving significantly He is currently working at RMIT University in Melbourne, Australia under the delusion that the royalties from the present text along with movie rights will make him immensely rich and famous September 25, 2015 Unofficial Bio The bull and bear on the front cover are in front of the Frankfurt Stock Exchange page ix ∗ Or, place it back on the shelf if you are one of those people who reads books at bookstores (go on, buy it!) September 25, 2015 20:5 Stock Markets, Investments and Corporate Behavior - 9in x 6in References b2083-ref page 297 297 Siegel, J.J (2005), “Perspectives on the Equity Risk Premium”, Financial Analysts Journal, 61, 61–71 Tversky, A and Kahneman, D (1992), “Advances in Prospect Theory: Cumulative Representation of Uncertainty”, Journal of Risk and Uncertainty, 5, 297–323 Weil, P (1989), “The Equity Premium Puzzle and the Risk-Free Rate Puzzle”, Journal of Monetary Economics, 24, 401–421 CHAPTER 12 Black, F and Scholes, M (1973), “The Pricing of Options and Corporate Liabilities”, Journal of Political Economy, 81, 637–654 Merton, R.C (1973), “Theory of Rational Option Pricing”, Bell Journal of Economics and Management Science, 4, 141–183 Merton, R.C (1990), Continuous-Time Finance (Basil Blackwell, Oxford) CHAPTER 13 Armitage, S., Hodgkinson L and Partington, G (2006), “The Market Value of UK Dividends from Shares with Differing Entitlements”, Journal of Business Finance and Accounting, 33, 220–244 Auerbach, A.J (1979), “Share Valuation and Corporate Equity Policy”, Journal of Public Economics, 11, 291–305 Boyd, J and Jagannathan, R (1994), “Ex-dividend Price Behavior of Common Stocks”, Review of Financial Studies, 7, 711–741 Cannavan, D., Finn, F and Gray, S (2004), “The Value of Dividend Imputation Tax Credits in Australia”, Journal of Financial Economics, 73, 167–197 Chu, H and Partington, G (2008), “The Market Valuation of Cash Dividends: The Case of the CRA Bonus Issue”, International Review of Finance, 8, 1–20 Clubb, C and Doran, P (1992), “On the Weighted Average Cost of Capital with Personal Taxes”, Accounting and Business Research, 23, 44–48 Cooper, I.A and Nyborg, K.G (2006), “The Value of Tax Shield Is Equal to the Present Value of Tax Shields”, Journal of Financial Economics, 81, 215–225 Cooper, I.A and Nyborg, K.G (2007), “Valuing the Debt Tax Shield”, Journal of Applied Corporate Finance, 19, 50–59 Dempsey, M (1996), “The Cost of Equity Capital at the Corporate and Investor Levels Allowing A Rational Expectations Model with Personal Taxations”, Journal of Business Finance and Accounting, 23, 1319–1331 Dempsey, M (1998), “The Impact of Personal Taxes on the Firm’s Weighted Average Cost of Capital and Investment Behaviour: A Simplified Approach September 25, 2015 298 20:5 Stock Markets, Investments and Corporate Behavior - 9in x 6in b2083-ref References using the Dempsey Discounted Dividends Model”, Journal of Business Finance and Accounting, 25, 747–763 Dempsey, M (1998), “Capital Gains Tax: Implications for the Firm’s Cost of Capital, Share Valuation and Investment Decision-Making”, Accounting and Business Research, 28, 91–96 Dempsey, M (2001a), “Valuation and Cost of Capital Formulae with Corporate and Personal Taxes: A Synthesis using the Dempsey Discounted Dividends Model”, Journal of Business Finance and Accounting, 28, 357–378 Dempsey, M (2001), “Investor Tax Rationality and the Relationship between DividendYield and Equity Returns:An Explanatory Note”, Journal of Banking and Finance, 25, 1681–1686 Dempsey, M (2008), “The Implications of Personal Taxes for Project Valuation”, working paper Dempsey, M and Partington, G (2008), “The Cost of Capital Equations under the Australian Imputation Tax System”, Accounting and Finance, 48, 439–460 Dempsey, M., McKenzie, M and Partington, G (2010), “The Problem of Pre-Tax Valuations: A Note”, Journal of Applied Research in Accounting and Finance, 5, 10–13 Dempsey, M (2013), “Consistent Cash Flow Valuation with Tax-Deductible Debt: A Clarification”, European Financial Management, 19, 830–836 Elton, E.J and Gruber, M.J (1970), “Marginal Stockholder Tax Rates and the Clientele Effect”, The Review of Economics and Statistics, 52, 68–74 Fama, E and French, K (1997), “Industry costs of equity”, Journal of Financial Economics, 43, 153–193 Fenech, J.P., Skully, M and Xuguang, H (2014), “Franking Credits and Market Reactions: Evidence from the Australian Convertible Security Market”, Journal of International Financial Markets, Institutions & Money, 32, 1–19 Fernandez, P (2004), “The Value of Tax Shields is Not Equal to the Present Value of Tax Shields”, Journal of Financial Economics, 73, 145–165 Feuerherdt, C., Gray, S and Hall, J (2010), “The Value of Imputation Tax Credits on Australian Hybrid Securities”, International Review of Finance, 10, 365–401 Graham, J.R., Michaely, R and Roberts, M (2003), “Do Price Discreteness and Transactions Costs Affect Stock Returns? Comparing Ex-dividend Pricing before and after Decimalization”, Journal of Finance, 58, 2611–2637 Gray, S and Hall, J (2006), “Relationship between Franking Credits and the Market Risk Premium”, Accounting and Finance, 46, 405–428 page 298 September 25, 2015 20:5 Stock Markets, Investments and Corporate Behavior - 9in x 6in References b2083-ref page 299 299 Inselbag, I and Kaauford, H (1997), “Two DCF Approaches for Valuing Companies under Alternative Financing Strategies (and How to Choose Among Them)”, Journal of Applied Corporate Finance, 10, 114–122 Lally, M (2004), “The Fama and French Model, Leverage, and the ModiglianiMiller Propositions”, Journal of Financial Research, 27, 341–349 Lally, M and van Zijl, T (2003), “Capital Gains Tax and the Capital Asset Pricing Model”, Accounting and Finance, 43, 187–210 Massari, M., Roncaglio, F and Zanetti, L (2008), “On the Equivalence between the APV and the WACC Approach in a Growing Leveraged Firm”, European Financial Management, 14, 152–162 Modigliani, F and Miller, M (1963), “Corporate Income Taxes and the Cost of Capital: A Correction”, American Economic Review, 53, 433–443 Oded, J and Michel, A (2007), “Reconciling DCF Valuation Methodologies”, Journal of Applied Finance, 17, 21–32 Ruback, R.S (2002), “Capital Cash Flows: A Simple Approach to Valuing Risky Cash Flows”, Financial Management, 31, 85–103 Siau, K.-W., Sault, S and Warren, G (2013), “Are Imputation Credits Capitalised into Stock Prices?”, Accounting and Finance, 55, 241–277 Taggart, R.A (1991), “Consistent Valuation and Cost of Capital Expressions with Corporate and Personal Taxes”, Financial Management, 20, 8–20 Truong, G and Partington, G (2008), “Relation between Franking Credits and the Market Risk Premium: A Comment”, Accounting and Finance, 48, 153–158 Walker, S and Partington, G (1999), “The Value of Dividends: Evidence from Cum-dividend Trading in the Ex-dividend Period”, Accounting and Finance, 39, 275–296 CHAPTER 14 Ackoff, R.L (1970), A Concept of Corporate Planning (John Wiley & Sons, New York) Astley, W.G and Van de Ven, A.H (1983), “Central Perspectives and Debates in Organization Theory”, Administrative Science Quarterly, 28, 245–273 Bower, J.L (1972), Managing the Resource Allocation Process (Richard D Irwin, Homewood, IL) Bruner, R (2004), Applied Mergers and Acquisitions (John Wiley & Sons, New York) Bruner, R (2005), Deals from Hell: Lessons that Rise above the Ashes (John Wiley & Sons, New York) September 25, 2015 300 20:5 Stock Markets, Investments and Corporate Behavior - 9in x 6in b2083-ref References Butler, R., Davies, L., Pike, R and Sharp, J (1991), “Strategic investment decisionmaking: Complexities, politics and processes”, Journal of Management Studies, 28, 395–415 Carr, C., Tomkins, C and Bayliss, B (1994), Strategic Investment Decisions: A Comparison of UK and German Practices in the Motor Components Industry (Avebury Books, Avebury) Chami, R and Fullenkamp, C (2002), “Trust and Efficiency”, Journal of Banking and Finance, 26, 1785–1809 Dempsey, M (1996), “Corporate Financial Management: Time to Change the Cost of Capital Paradigm?”, Critical Perspectives on Accounting, 7, 617–639 Dempsey, M (2003), “A Multidisciplinary Perspective on the Evolution of Corporate Investment Decision Making”, Accounting, Accountability and Performance, 9, 1–33 Dempsey, M (2014), “The Modigliani and Miller (MM) Propositions: The History of a Failed Foundation for Corporate Finance?”, Abacus, 50, 279–295 Dent, J.F (1990), “Strategy, Organization and Control: Some Possibilities for Accounting Research”, Accounting, Organizations and Society, 15, 3–25 Duhaime, I.M and Thomas, H.W (1983), “Financial Analysis and Strategic Management”, Journal of Economics and Business, 35, 413–440 Durand, D (1989), “Afterthoughts on a Controversy with MM, Plus New Thoughts on Growth and the Cost of Capital”, Financial Management, 18, 12–18 Fama, E and French, K (1997), “Industry Costs of Equity”, Journal of Financial Economics, 43, 153–193 Hopwood, A (1974), Accounting and Human Behaviour (Prentice Hall International, London) Hopwood, A (2009), “Exploring the Interface between Accounting and Finance”, Accounting, Organizations and Society, 34, 549–550 Keynes, J.M (1936), The General Theory of Employment, Interest and Money (Macmillan and Company, London) King, P (1975), “Is the Emphasis on Capital Budgeting Misplaced?”, Journal of Business Finance and Accounting, 2, 69–82 Mason, R.D and Mitroff, I.I (1981), Challenging Strategic Planning Assumptions (John Wiley & Sons, New York) Miller, D and Friesen, P.H (1980), “Momentum and Revolution in Organizational Adaptation”, Academy of Management Journal, 23, 591–614 Miller, D and Friesen, P.H (1984), Organizations: A Quantum View (Prentice Hall, Englewood Cliffs, NJ) Mintzberg, H (1978), “Patterns in Strategy Formulation”, Management Science, 24, 934–948 page 300 September 25, 2015 20:5 Stock Markets, Investments and Corporate Behavior - 9in x 6in References b2083-ref page 301 301 Mintzberg, H., Raisinghani, D and Theoret, A (1976), “The Structure of Unstructured Decision Processes”, Administrative Science Quarterly, 21, 246–275 Mitroff, I.I and Emshoff, J.R (1979), “On Strategic Assumption Making: A Dialectic Approach to Policy and Planning”, Academy of Management Review, 4, 1–12 Mukherjee, T.K and Henderson, G.V (1987), “The Capital Budgeting Process: Theory and Practice, Interfaces”, 17, 78–90 Mukherji, A and Nagarajan, N (1995), “Moral Hazard and Contractibility in Investment Decisions”, Journal of Economic Behaviour and Organization, 26, 413–430 Pettigrew, A (1985), The Awakening Giant, Continuity and Change in ICI (Blackwell, Oxford) Petty, J.W., Scott, D.F and Bird, M.M (1975), “The Capital Expenditure Decision-Making Process of Large Corporations”, Engineering Economist, 20, 159–171 Pfeffer, J and Salancik, G.R (1978), The External Control of Organizations: A Resource Dependence Perspective (Harper and Row, New York) Ross, M (1986), “Capital Budgeting Practices of Twelve Large Manufacturers”, Financial Management, 15, 15–22 Starbuck, W.H and Hedberg, B.L.T (1977), “Saving an Organization from a Stagnating Environment”, in Strategy + Structure = Performance (249–258), Thorelli, H.B (ed.) (Indiana University Press, Bloomington, IN) Tinsley, C.H., O’Connor, K.M and Sullivan, B.A (2002), “Tough Guys Finish Last: The Perils of a Distributive Reputation”, Organizational Behaviour and Human Decision Processes, 88, 621–645 CHAPTER 15 Bowie, N.E (1991), “Challenging the Egotistic Paradigm”, Business ethics Quarterly, 1, 1–16 Dempsey, M (2000), “Ethical Profit: An Agenda for Consolidation or for Radical Change”, Critical Perspectives on Accounting, 11, 531–548 Denhardt, R.B (1981), In the Shadow of Organization (Regents Press, Lawrence, KS) Dobson, J (1993), “The Role of ethics in Finance”, Financial Analysts Journal, 49, 57–61 Frank, R (1988), Passions Within Reason (W.W Norton & Co., New York) Foucault, M (1977), Madness and Civilization: A History of Insanity in the Age of Reason (Tavistock, London) September 25, 2015 20:5 Stock Markets, Investments and Corporate Behavior - 9in x 6in 302 b2083-ref References Lovell, A (1995), “Moral Reasoning and Moral Atmosphere in the Domain of Accounting”, Accounting, Auditing and Accountability, 8, 60–80 Mitchell, A., Puxty, T and Sikka, P (1994), “Ethical Statements as Smokescreens for Sectional Interests: The Case of the UK Accountancy Profession”, Journal of Business Ethics, 13, 39–51 Neimark, M.K (1995), “The Selling of Ethics: The Selling of Ethics Meets the Business of Ethics”, Accounting, Auditing and Accountability, 8, 81–96 Seedhouse, D (1988), Ethics: The Heart of Health Care (John Wiley & Sons, New York) CHAPTER 16 Ball, R (2009), “The Global Financial Crisis and the Efficient Market Hypothesis: What Have We Learned?”, Journal of Applied Corporate Finance, 21, 8–16 Bogle, J.C (2005a), “The Mutual Fund Industry 60 Years Later: For Better or for Worse?”, Financial Analysts Journal, 61, 15–24 Bogle, J.C (2005b), “The Relentless Rules of Humble Arithmetic”, Financial Analysts Journal, 61, 22–35 Bolton, P., Scheinkman, J and Xiong, W (2006), “Executive Compensation and Short-Termist Behaviour in Speculative Markets”, Review of Economic Studies, 73, 577–610 Cai, C.X., Clacher, I and Keasey, K (2013), “Consequences of the Capital Asset Pricing Model (CAPM) — A Critical and Broad Perspective”, Abacus, 49, 51–61 Coles, J.L., Hertzel, M and Kalpathy, S (2006), “Earnings Management Around Employee Stock Options Reissues”, Journal of Accounting and Economics, 41, 173–200 Conyon, M.J and Murphy, K.J (2000), “The Prince and the Pauper? CEO pay in the United States and United Kingdom”, The Economic Journal, 110, 640–671 Cowherd, D.M and Levine, D.I (1992), “Product Quality and Pay Equity between Lower-Level Employees and Top Management: An investigation of Distributive Justice Theory”, Administrative Science Quarterly, 37, 302–320 Dempsey, M and Jones, S (2015), “Financial Measurement and Financial Markets”, Ch 17 in Routledge Companion to Financial Accounting Theory, Jones, S (ed.) (Routledge, UK) Dodd, J.L and Johns, J (1999), “EVA Reconsidered”, Business and Economic Review, April–June, 13–18 Ellsworth, R.R (1983), “Capital Markets and Competitive Decline”, Harvard Business Review, September–October, 171–183 page 302 September 25, 2015 20:5 Stock Markets, Investments and Corporate Behavior - 9in x 6in References b2083-ref page 303 303 Ellsworth, R.R (2002), Leading with Purpose: The New Corporate Realities (Stanford University Press, Stanford) Ennis, R.M (2005), “Are Active Management Fees Too High?”, Financial Analysts Journal, 61, 44–51 Fox, J (2009), The Myth of the Rational Market (Harper Collins, New York) Froud, J., Johal, S., Leaver, A and Williams, K (2006), Financialization and Strategy: Narrative and Numbers (Routledge, London) Fuller, J and Jensen, M.C (2002), “Just Say No to Wall Street: Putting a Stop to the Earnings Game: Courageous CEOs are Putting a Stop to the Earnings Game and We Will All be Better Off for It”, Journal of Applied Corporate Finance, 14, 41–46 Graham, J.R., Harvey, C.R and Rajgopal, S (2005), “The Economic Implications of Corporate Financial Reporting”, Journal of Accounting and Economics, 40, 3–73 Jensen, M.C and Murphy, K.J (1990), “Performance Pay and Top-Management Incentives”, Journal of Political Economy, 98, 225–264 Jensen M.C and Zimmerman, J.L (1985), “Management Compensation and the Managerial Labor Market”, Journal of Accounting and Economics, 7, 3–9 Keasey, K and Hudson, R (2007), “Finance Theory: A House without Windows”, Critical Perspectives on Accounting, 18, 932–951 MacKenzie, D and Millo, Y (2003), “Constructing a Market, Performing Theory: The Historical Sociology of a Financial Derivatives Exchange”, American Journal of Sociology, 109, 107–145 Main, B.G.M., Bruce, A and Buck, T (1996), “Total Board Remuneration and Company performance”, The Economic Journal, 106, 1627–1644 McSweeney, B (2009), “The Roles of Financial Asset Market Failure Denial and the Economic Crisis: Reflections on Accounting and Financial Theories and Practices”, Accounting, Organizations and Society, 34, 834–848 Moosa, I.A (2013), “The Capital Asset Pricing Model (CAPM): The History of a Failed Revolutionary Idea in Finance? Comments and Extensions”, Abacus, 49, 62–68 Murphy, K.J (1985), “Corporate Performance and Managerial Remuneration: An Empirical Analysis”, Journal of Accounting and Economics, 7, 11–42 Murphy, K.J and Oyer, P (2001), “Discretion in Executive Incentive Contracts: Theory and Evidence”, Available at SSRN 294829, papers.ssrn.com Sanders, W.G and Carpenter, M.A (2003), “Strategic Satisficing? A BehavioralAgency Theory Perspective on Stock Repurchase Program Announcements”, Academy of Management Journal, 46, 160–178 September 25, 2015 304 20:5 Stock Markets, Investments and Corporate Behavior - 9in x 6in b2083-ref References Siegel, P.A and Hambrick, D.C (2005), “Pay Disparities within Top Management Groups: Evidence of Harmful Effects on Performance in High-Technology Firms”, Organization Science, 16, 259–274 Stinchcombe, A.L (2000), “Social Structure and Organizations: A Comment”, in Economics Meets Sociology in Strategic Management: Advances in Strategic Management, Baum, J and Dobbin, F (eds) (JAI Press, Greenwich, CT) Whitley, R.D (1984), The Intellectual and Social Organisation of the Sciences, (Clarendon Press, Oxford) Whitley, R.D (1986), “The Transformation of Business Finance into Financial Economics: The Roles of Academic Expansion and Changes in US Capital Markets”, Accounting, Organisations and Society, 11, 171–192 Yermack, D (1995), “Do Corporations Award CEO Stock Options Effectively?” Journal of Financial Economics, 39, 237–269 Zweig, J (2005) in Introduction to Where are the Customers’Yachts?, Schwed, F (1940, 2005 edition) (John Wiley & Sons, New York) page 304 September 25, 2015 20:5 Stock Markets, Investments and Corporate Behavior - 9in x 6in b2083-index Index academic, academic finance, 40, 43, 53, 69, 70, 275, 277–283 academic career, 282 accounting rate of return (ARR), 56, 256 add-on hypotheses, 35 adjusted present value (APV), 225–226, 236, 241 agency (theory), 59, 65, 152 altruism, 265 ambiguity, 200, 266 amortization, 232 anchoring, 67 anomaly(ies), 29, 30, 33–36, 39–42, 69 arbitrage pricing theory (APT), 34 Arnott Robert, 184 Asian tiger economies, 64 asset allocation, 173 asset clusters, 193 asset price formation, 121, 124 asset pricing, 41, 156, 171–172, 174–175 and following, 191–192, 202, 251, 282 beta, 5, 12, 17, 19, 21, 32, 66, 106, 112, 242 binomial model, distribution, operator, outcome, process, representation, 74, 117–121, 132, 157, 205 Black Fischer, 12, 13, 41, 204, 277 Black’s CAPM, 12, 22, 26 Black–Scholes model, 203 and following Blackjack, 200 Bogle John, 281 bonds, 1, 164 bonuses, 45, 279–281 book-to-market (B/M), 33–35, 41, 185–190, 245, 276 BP Oil Company, 197 British Gas, 281 Brown Cedric, 281 Brownian motion, 137 bubbles, 44, 63–64, 125, 278–279 Buffet Warren, 270 bull (market), 8, 154 B/M ratio, see, book-to-market (B/M) backward induction, 200–201 balance sheet(s), 278–279 bankrupt, bankruptcy costs, 59, 279 banks, 4, 278–279 Barclays, bear (market), 8, 154 Bear Stearns, 279 behavioral (context, considerations), 44, 50 behavioral finance, 50, 68 Bernstein Peter, 138 Cadbury, 281 Call option, 203 and following capital asset pricing model (CAPM), 5–7, 11 and following, 32 and following, 37, 39, 40, 44–45, 66, 68, 156, 161–162, 167–168, 172, 185–186, 225, 242, 246, 249, 251, 275–276 capital budgeting, 56 capital cash flow (CCF), 223, 225, 238, 242 cash flow to equity (CFE), 225, 237, 241 capital gain(s), 68, 152, 224, 226, 247–248 305 page 305 September 25, 2015 20:5 Stock Markets, Investments and Corporate Behavior - 9in x 6in 306 capital growth, 228 capital market line (CML), 142–145, 156, 162, 165, 169, 172–173, 192 capital structure, 7, 55–58, 68–70 capital-weighted index, 176 capital-weighted indexation (CWI), 185–188, 190 capitalization factor, 225, 246–247, 251 Carhart 1997 model, 39 case study approach, 70 cash flow (see also free cash flow, cash flow to equity), 61 cash flow to equity (CFE), 233 central bank, 63 central limit theorem, 115–117, 125 centrally planned, 200 Chartered Financial Analyst (CFA) Institute, Institute’s Code of Ethics, 262, 271 churning, 281 Citigroup, 4, 279 Cochrane John, 41, 194, 276 cognitive (biases) psychological experiments, 66, 68 collateralized debt obligations, 63, 278 Combined Code, 281 commercial bank, commitment and trust relationships, 255, 258–259, 270, 277 complete market, 173 compounding, 75 conceptual framework, 30, 65, 262 Confucius, 264 Conrad John, 266 conscience, 265 constant relative risk aversion, 137–138 consumption, 192, 194–198, 202, 276 consumption capital asset pricing model (CCAPM), 194–195, 197, 276 contagion, 279 continuously compounding, 77 and following, 130 corporate bonds, 155 corporate ethics, 263 b2083-index Index corporate finance, financial decision making (management), 50–51, 55, 61, 66–67, 69, 254, 257, 275 corporate governance, 70, 281 corporate investment decisions, 52, 68 corporate strategy, 50 corporate tax shield, 229 corporate tax, 58, 231, 248 correlation, 106, 113 cost of (financial) capital, 2, 56, 60–62, 69, 225, 228, 258–259, 277 cost of equity, 30, 57, 227, 237, 241, 245 covariance, 106, 108 credit default swap instruments, 278 cross-section regression, 21 crowd psychology, 44 CRSP database, 43 cycles of economic growth, 65 data mining, 36, 40–41, 43, 45, 282 debt (see also leverage), 1, 63–65, 253 decision making under uncertainty, 276 decreasing absolute risk aversion, 138 decreasing returns with expansion, 51 deep out-of-the-money, 219 deep-in-the-money, 219 depreciation, 232 depression, 148, 151 Descartes Réne, 124 Dewing Arthur, 51 dimensional consistency, 228 direction of causality, 17 discounting (factor), 45, 52, 75 discounting cash flows (methods), 75, 223 and following, 250 discrete returns, 75 dividend, 58–59, 152, 154, 226–228, 250–251, 276 dividend clientele(s), 65, 152 dividend decision (payments, policy), 7, 51, 56, 58, 65, 68–69, 132, 152, 253 dividend signalling, 65 dividend yield, 216 divisional performance, 54 page 306 September 25, 2015 20:5 Stock Markets, Investments and Corporate Behavior - 9in x 6in b2083-index Index drop-off ratio, 248 duration, 277 earnings per share (EPS), 62 EBIT (earnings before interest and tax), 232 economic cycle(s), 8, 17, 63, 173, 276, 282 economic issues, 43 efficient frontier, 192–193 efficient market, theory, hypothesis, 13, 14, 28, 44, 55, 66, 68, 278, 280 efficient portfolio, 165–167 egotism, 265 Ennis Richard, 281 Ennis, Knupp & Associates, 281 entrepreneurial, 51 equal-weighted (weighting) portfolio, 176, 182 equilibrium, 28, 51, 54, 146, 149 equity finance, equity markets, 155 and following equity risk, premium (see also market risk premium), 170, 174, 195–197 equity (value), 164, 228, 241 ethics, 261 and following ethical behavior, 8, 65, 276–277 European Call, 204 ex-dividend, studies, 228, 248 executive (pay, remuneration), 278, 280–281 exercise of option, 203 expectation of return, 2, 6, 15, 33, 60, 106, 228 expected periodic return, 128–129, 140 expected wealth outcome, 158 expiration of option, 203 exponential growth, 80, 121, 125–126, 130–131, 205 exponential return, 158 factor model(s), 39–42, 276 factors, 33, 36 fair value accounting (FVA), 278–279 falsification, 29 page 307 307 Fama and French three-factor (FF-3F) model, 31 and following, 39–40, 45, 123, 130, 175 and following, 185–187, 190, 225, 243, 245–246, 251, 276 Fama Eugene, 31, 44, 64, 276 fat tails, 154 fear factor, 154 FF-3F model, see Fama and French three-factor (FF-3F) model financial crisis, 44 financial distress, 34, 59 financial management, see corporate finance financial markets, 275 financial performance, 280 financing (capital structure) decision (see also debt and leverage), 6, 51, 68 firm size (see also small firm size effect), 35, 190, 245 Fisher Irving, 52 Foucault Michael, 266, 277 Fox Justin, 16, 28 Frank Robert, 264 free cash flow (FCF), 225, 232, 239–241 free market economies, 200 French Kenneth, 31, 276 frontier of portfolio possibilities, 192 funds managers, management, 28, 45, 281–282 fundamental value, 66, 278–279 fundamental indexation (FI), valuation, 176 and following, 184 and following garbage, 197–198 gearing (see also leverage), 62 global financial crisis (GFC), 2, 5, 50, 63–64, 70, 151, 198, 203, 257, 269–270, 278, 281, 283 Goldman Sachs, Greenbury, 281 Greenspan Alan, 16 growing perpetuity, 77 growth firm, 33 growth stocks, 36 September 25, 2015 20:5 Stock Markets, Investments and Corporate Behavior - 9in x 6in 308 Hampel report, 281 Hansen Lars Peter, 44, 64 Hardy Godfrey, 49 hedge, 203 human attributes, human enterprise, humanity of business, 51, 68, 254, 276 hypocrisy, 265 idiosyncratic (non-market) volatility, 11–12, 25, 36, 129–130 immunizing, 184–185 implied volatility, 217, 219 imputation tax credits, 225–226, 246–250 in-the-money, 204 incomplete markets, 196 individual tax liabilities, 224 induction, 199 institutional imperatives, 28 institutional, institutions, 28, 50, 146, 262, 267–268, 271, 279, 282 insurance, 200, 202 insured liabilities, 63 integration, 93 and following inter-temporal CAPM (ICAPM), 34 internal rate of return (IRR), 256 intrinsic value (see also fundamental value), 176 intuition, 257 investment bank (ers), 4, 279 investment counter, 61, 279 investment, decision making, 6, 51–52, 55, 62, 137, 197–199, 201–202, 255, 258–259, 277 investment horizon, 199, 201–202 investment portfolio, 154 investment profession, 262 investor sentiment, 173 Jensen Michael, 12 job paper, 282 John Lintner, 275 JP Morgan Chase, Kahneman Daniel, 66 Keynes John Maynard, 44, 53, 67, 138 b2083-index Index Krugman Paul, 64 Kuhn Thomas, 29, 35 law of large numbers, 117 Lehman Brothers, 279 leptokurtosis, 125 leverage (see also debt), ratio(s), 57, 62, 63, 225, 229, 230, 237, 241, 245, 276, 279 levered firm’s cost of equity, 230 life insurance, 197 limited liability, Lintner John, liquidity, 36, 42, 63 loadings, 33 log-wealth utility, 131, 153, 155 and following, 197, 276 logarithms, 81 and following long term, long haul, 192, 198, 277, 279–280 long-term bond, 155 lottery tickets, 200 Malkiel Burton, 42 management, literature, 66, 254, 276, 282 mark-to-market, 249, 251, 278–279 market efficiency, 282 market equilibrium, 146, 218 market frictions, 196 market growth model, 132 and following market portfolio, 18, 162–163, 165–169, 192 market risk, 12, 36, 155, 192, 194 market risk premium (see also equity risk, premium), 5, 6, 14, 30, 35, 131–132, 149, 153–154 market value, 56, 228–229 market volatility, 153–154, 276 market-capital weighted, 182 Markowitz portfolio theory, 130 Markowitz Harry, 5, 7, 276 MBA, 257, 259 Merton Robert, 204, 219 micro-finance, 42 Miller Merton, 5–7, 50, 59, 275 page 308 September 25, 2015 20:5 Stock Markets, Investments and Corporate Behavior - 9in x 6in Index Minsky Hyman, 63 Minsky moment, 64 mispricing, 8, 36, 175 and following, 185, 201, 276–277 mispricing (operator), 175–177, 189–190 Modigliani and Miller (MM) propositions, 6–7, 45, 49 and following, 52, 56–57, 63, 69, 225–226, 230–232, 238, 242–246, 251, 253, 275–276 Modigliani Franco, 6, 7, 50, 59, 275 momentum, 36, 39, 40 Morgan Stanley, Mossin Jan, 5, 275 natural selection, 200, 265, 271 net present value (NPV), 52, 56, 58, 61–62, 256–257, 259, 277 Nietzsche, 264 Nobel Prize in Economics, 5, 7, 44, 59, 64, 67, 199, 204 non-diversifiable risk, see idiosyncratic volatility non market-capital weighted portfolio, 176, 184, 190 non-model hypothesis, 25–26 normal distribution(s), 74, 85–103, 111, 121, 123, 125, 154, 205 normally distributed, 103, 126, 130, 170, 172, 201, 206, 276 normal science, 35–36 normative rules, 54 norms of society, 261 operating free cash flow (FCF), 226 optimal allocation portfolio, 165 option premium, 204 options, 203 organic growth, process, 123–124, 131 organization(s), 3, 8, 255, 263, 267, 271 organizational behavior, structure, 254, 258, 282 Orwell George, 266 out-of-the-money, 204 b2083-index page 309 309 over- (under-) priced, valued, 179–180, 184 overconfidence, 67, 68 ownership structure, 253 paradigm(s), 29, 30, 35, 60, 66, 68–70, 255–256, 275, 282 payback, 56, 256 pension funds, schemes, 198, 226 perfect (capital) markets, 55, 60, 69 performative, 277 periodic return, 128 personal taxes (see also tax), 224, 226, 231, 234, 247–248, 250, 277 physics, 29 pillars of corporate finance, 6, 62, 65 Popper Karl, 29, 50 portfolio allocation(s), 132 and following, 156 and following portfolio optimization, 156, 160, 165 positive science, theory, 50, 55, 61 power laws, 74 practice is primary, 29 Pratt’s measure of relative risk aversion, 156 prescriptive, 54 present value of the tax savings (PVTS), 225, 229, 236 present value, 76 prestige, 63 price-to-earnings ratio (P/E), 28 primary market, principle of additivity, 225 probability-weighted outcomes, 18, 53 processes, 53 professional (investors), 28, 263, 268, 271 prospect theory, 68, 138, 196 proxies for risk, 36 psychological (idiosyncrasies, factors), 8, 44–45, 50, 52, 62, 66, 68 psychology of markets, 67, 276 Put option, 204, 208, 210 put-call parity, 208 Putnam Hilary, 29, 65 September 25, 2015 20:5 Stock Markets, Investments and Corporate Behavior - 9in x 6in 310 qualitative judgments, 255 qualitative research, 69 quantitative research, 70 rate of change (differentiation), 93 and following rational behavior (investor, expectations), 28, 66, 68, 196 real estate boom, 63 receivership, 279 regulated commodity, industries, 45, 223–224 regulatory authorities, 278–279 relative risk aversion, 174 repatriation (dividend) decision, representative agent, 194 reputation(s), 59, 61, 63, 65, 256, 258–259, 270 reputation(s) based on past performance, 255, 258–259, 270, 277 required return (capital growth), 34, 228 Research Affiliates, 184 retirement needs, 197, 202 return-risk efficient, 18 risk (factor, measure) and return, 32, 40–42, 44, 53, 155 and following, 202, 276 risky market, 132 and following risk aversion, 4, 12, 163, 165, 170, 174, 192–193, 196, 200, 277 risk neutrality, 206, 209–211, 215 risk premium(s), 12, 15–16, 27, 33, 36, 131, 153, 170, 196 risk(less)-free asset (rate), 5, 155, 209, 215, 131 and following, 153, 191–192 Roll’s critique, 18, 167–168, 172–173 Royal Bank of Scotland (RBS), 4, 279 Samuelson Paul, 199, 277 Scholes Myron, 12, 204, 277 science, scientific method, 50 scientific management, 61 secondary market, securitization, 278 share options, 280 b2083-index Index shareholder wealth, 257 shareholders’ required expectation of return (see cost of equity), 227 Sharpe William, 5, Shiller Robert, 43, 64 short-term performance, 279–281 signaling, 59, 152 small (big) firm size (effect), 33–34, 41, 43, 123, 130, 185–187, 189, 276 social-strategic dynamic (construct), 66, 69, 276 socialization of decision making, 51, 68 Socrates, 263 speculative investment, 63–64 standard deviation, 86, 106, 108 static asset pricing model, 194 stock market, stock options, 279 strategy, strategic (management), 50, 54, 61–62, 65, 68, 254–255, 258–259, 282 strike price, 203 swapped obligations, 63 synergies, 54 target leverage, 241 tax (see also personal taxes), 58–59, 65, 152, 226–227, 229, 245 testable predictions, 20 Texas Hold’em poker, 199 time diversification, 192, 201 time horizon, 192 time invariant, 198 time-series regression(s), 20–21, 33 Tobin’s q, 229 transaction costs, 59 Treynor Jack, 5, 275 trust, 65, 258–259, 270 Tversky Amos, 66 uncertainty, 52–53, 61, 200 underlying, 203 underpriced (undervalued) (see also mispricing), 179, 184 unit normal distribution, 86 unlevered cash flow, 225–226 page 310 September 25, 2015 20:5 Stock Markets, Investments and Corporate Behavior - 9in x 6in Index unlevered cost of equity, 225–226, 236 US Treasury bonds, 22 utility, 137, 143–144, 155 and following, 172, 194, 196, 201 valuation, 277 value of the firm, 33, 55 value stocks (see also B/M ratio), 36, 42, 186 Vanguard Group, 281 variance (volatility) of returns, 86, 106, 107, 110, 133 and following b2083-index page 311 311 VIX, 219 Von Neumann and Morgenstern theorem, 139 Wall Street, 282 Weber–Fecher law, 137 weighted average cost of capital (WACC), 56, 226, 232, 239–241 William Sharpe, 275 wisdom, 259 working capital, 232 ... including Journal of Banking and Finance (2), Financial Analysts Journal (2), European Financial Management (1), Abacus (3), Journal of Investment Management (2), Australian Journal of Management (2),... theory of corporate finance” September 25, 2015 20:4 Stock Markets, Investments and Corporate Behavior - 9in x 6in b2083-ch01 Stock Markets, Investments and Corporate Behavior how markets react and. .. and the psychology of markets Part D advances a framework for corporate financial decision making that complements the mathematics of cash flow valuation (Chapter 13) with a framework that captures