Lesson 15: Theories and Approach

Question 1

also referred to as the efficient market theory, it is difficult to generate alpha consistently and share prices reflect all available information.

contends that since stocks always trade on exchanges at their fair value, investors are unable to buy cheap stocks or sell them for high prices.

Answer 1

Efficient Market Hypothesis (EMH)

Question 2

There have been both theoretical and empirical challenges to the EMH’s validity. Some investors, like ________, have outperformed the market. His method of concentrating on cheap stocks has generated billions of dollars in profits and served as a model for many others

Answer 2

Warren Buffett

Question 3

The relationship between expected return for assets, especially stocks, and systematic risk, or the general dangers of investing, is explained by the ________. This financial model shows that risk and the necessary return on an investment are linearly related.

Answer 3

capital asset pricing model (CAPM)

Question 4

________ states that the market value of a company is calculated as the present value of its future earnings and underlying assets, and is independent of its capital structure. Capital structure is the combination of debt and equity used to finance overall operations and growth.

Answer 4

Modigliani-Miller theorem (M&M)

Question 5

All investors agree on the market value of all cash flow streams.

_____: Contracts can be written and enforced without incurring any cost.

Answer 5

Efficient markets
Frictionless markets

Question 6

Taxes and government regulations do not affect capital structure.

Answer 6

No taxes or regulations

Question 7

Investors care only about the cash flow generated by an investment

Answer 7

Cash flow

Question 8

states that the optimal capital structure is a balancing act between reaping the marginal benefit of the interest tax shield and the risk of financial distress.

Answer 8

trade-off theory

Question 9

The borrowing of capital from lenders for a pre-determined period in exchange for the obligation to meet periodic interest payments and repay the original principal in full at maturity.

Answer 9

Debt Capital

Question 10

The issuance of shares that represent partial ownership in the company’s common equity.

Answer 10

Equity Capital

Question 11

relates to a company’s capital structure. Made popular by Stewart Myers and Nicolas Majluf in 1984, the theory states that managers follow a hierarchy when considering sources of financing

Answer 11

Pecking Order Model

Question 12

states that managers display the following preference of sources to fund investment opportunities: first, through the company’s retained earnings, followed by debt, and choosing equity financing as a last resort.

Answer 12

pecking order theory

Question 13

_____ is a concept used to explain the important relationships between principals and their relative agent. In the most basic sense, the ____ is someone who heavily relies on an agent to execute specific financial decisions and transactions that can result in fluctuating outcomes.

____ also often referred to as the “agency dilemma” or the “agency problem.”

Answer 13

Agency theory
principal
Agency theory

Question 14

to reduce the potential influx of agency problems, it is crucial for both the principal and the agent to be completely transparent with one another.

Answer 14

Transparency

Question 15

imposing restrictions or abolishing negative restrictions is a good way to significantly reduce the effect of agency loss.

Answer 15

Restrictions

Question 16

introducing and eradicating incentives and bonuses lessens the chances of a relationship that consists of conflicts and disagreements.

Answer 16

Bonuses