w Corporate Behavior A Conceptual Framework of Understanding
Michael Dempsey RMIT University, Melbourne, Australia
Contents
A Short Biofor the Author (Official Version) Unofficial Bio
Prologue
Chapter 1. Introduction: Stock Markets, Investments and Corporate Financial Decision Making
Part A — Foundations of Stock Pricing: A Critical Assessment Chapter 2. The Capital Asset Pricing Model
2.1. Introduction
2.2. Background to the CAPM 2.3. A Test for the CAPM 2.4. The Black Model
2.5. A Test of the Irrelevancy of Beta
2.6. Time for Reflection: What Have We Löarned? Chapter 3. The Fama and French Three-Factor Model 3.1. Introduction
3.2. The Fama and French Three-Factor Model
3.3. Critique of the Fama and French Three-Factor Model 3.4. Time for Reflection: What Have We Learned?
vii ix xi 1 9 11 11 13 16 22 25 27 31 31 32 34 36 xiii
Chapter 4. Beyond the Fama and French Three-Factor Model
4.1. Introduction
4.2. Asset Pricing Research
4.3. Asset Pricing and Data Mining
4.4. Implications of Abandoning the CAPM 4.5. Time for Reflection: What Have We Learned?
Part B — Foundations of Corporate Financial Activity: A Critical Assessment
Chapter 5. The Modigliani and Miller Propositions and the Foundations of Corporate Finance 5.1. Introduction
5.2. Corporate Financial Management prior to MM 5.3. Corporate Finance and the Paradigm of the MM
Propositions
5.4. A Critique of the MM Propositions
5.5. Recent Developments in Corporate Finance 5.6. Time for Reflection: What Have We Learned?
39 39 40 42 44 45 47 49 49 51 55 60 66 69
Contents xv Part C — Stock Markets and Investment Choices:
71 Growth, Asset Pricing and Portfolio Construction
Chapter 6. Mathematics of Growth 73
6.1. Introduction 73
6.2. The Important Power Laws 74
6.3. Discrete Returns, Compounding, and Discounting 75 6.4. Continuously Compounding Growth Rates 77
6.5. Application of Logarithms 81
6.6. The Normal Distribution 85
6.7. The Normal Distribution and Asset Pricing 91 6.8. Rates of Change between Variables and their Implied
Direct Relation: The Calculus 93
6.9. The Calculus of the Normal Probability Function 103 6.10. Portfolio Formation: Expected Returns, Standard
Deviations (Variance), Covariance, Beta,
and Correlation Coefficients 106
6.10.1. Expected return 106
6.10.2. Variance and Standard deviation 107
6.10.3. Covariance 108
6.10.4. Variance of portfolio returns 110 6.10.5. An example with normal distribution tables 111
6.10.6. Beta 112
6.10.7. Correlation 113
6.11. The Central Limit Theorem 115
6.12. The Binomial Representation Distributed
Exponential Growth Rates 117
6.13. Time to Reflect: What Have We Learned? 121 Chapter 7. The Statistical Growth of Asset Portfolios 123
7.1. Introduction 123
7.2. Normally Distributed Growth Rates as a Foundation
for Asset Price Formation 124
7.3. The Mathematics of Normally Distributed
7.4. The Outcome of Normally Distributed Growth Rates 128 7.5. Normally Distributed Growth Rates and the Small Firm
Size Effect in the FF-3F Model 129
7.6. Time for Reflection: What Have We Learned? 130 Chapter 8. The Fundamentals of Growth, Asset
Pricing, and Portfolio Allocation 131
8.1. Introduction 131
8.2. Portfolio Formation with One Risky Asset and One
Risk-Free Asset 132
8.3. The Log-Wealth Utility Function 137
8.4. Optimal Portfolio Selection 141
8.5. Portfolio Allocation and the Market Risk Premium 146
8.6. The Case for Stahle Dividends 152
8.7. Time for Reflection: What Have We Learned? 153 Chapter 9. A Model of Asset Pricing and Portfolio Allocation 155
9.1. Introduction 155
9.2. A Generalized Utility Function 156
9.3. Portfolio Optimization 160
9.4. The CAPM 161
9.5. Repeated Investment Periods 162
9.6. A Worked Example 162
9.6.1. Investors Risk Aversion and Required Equity
Return 162
9.6.2. TheCML 165
9.6.3. The CAPM and Roll's Critique 167
9.7. Can We Retain Log-Wealth Utility? 170
9.8. Generalization of the Equations of Portfolio Choice 171 9.9. Time to Reflect: What Have We Learned? 172
Chapter 10. Stock Mispricing 175
10.1. Introduction 175
10.2. The Model 176
Contents xvii 10.4. The Model for Mispricing and Portfolio Valuation 180
10.5. Equal Weighting of Assets 181
10.6. Exploiting Mispricing by Avoidance of Capital Weighting 183 10.7. Fundamental Indexation and the FF-3F Model: Models of
Risk Assimilation or Stock Mispricing? 184 10.8. Time for Reflection: What Have We Learned? 190 Chapter 11. Practitioner Client Portfolios, the Risk
Premium, and Time Diversification 191
11.1. Introduction 191
11.2. The Mutual Fund Separation Theorem 192
11.3. Consumption-Based Models 194
11.4. Time Diversification 198
11.5. Time to Reflect: What Have We Learned? 202 Chapter 12. Option Pricing: The Black-Scholes Model 203
12.1. Introduction 203
12.2. The Principle of Risk Neutrality 206 12.3. Derivation of the Black-Scholes Formula 210 12.3.1. The Probability That the Call is in the Money 211 12.3.2. The Probability-Weighted Summation Over All
In-the-money Outcome Prices 212
12.3.3. A Closed Expression for the Price
of a Call Option 214
12.4. Options on the Index with Dividends 216
12.5. Testing the Black-Scholes Model 217
12.6. Time for Reflection: What Have We Learned? 219
Part D — Corporate Financial Decision Making 221 Chapter 13. Valuation of the Firm's Cash Flows
13.1. Introduction 223
13.2. Complicating Issues in Discounting 225 13.3. Towards Coherence in Discounting 227
13.3.1. A Discount Model for Cash Flows Subject
to Taxes (Proposition 1) 227
13.3.2. The Cost of Equity and Leverage
(Proposition 2) 229
13.4. The Market Valuation of the Firm's Component
Cash Flows 232
13.4.1. Free Cash Flow (FCF) 232
13.4.2. Cash Flow to Equity and to Debt (CFD) 233
13.4.3. Capital Cash Flow 233
13.5. The Discounting Methods 234
13.6. Choice of Discount Method 241
13.7. Consistency of the CAPM with the Principle of Additivity of Investors' Risk-Return Exposures (as Proposition 2,
Eq. (13.6)) 242
13.8. In-consistency of the FF-3F Model with the Principle of Additivity of Investors' Risk-Return Exposures
as MM's proposition 2 (and Proposition 2, Eq. (13.6)) 243 13.9. The Capitalization Factors, qE and qo 246 13.10. Valuation of Imputation Tax Credits 249 13.11. Time for Reflection: What Have We Learned? 250 Chapter 14. Corporate Finance in a Strategie/
Behavioral Context 253
14.1. Introduction 253
14.2. Corporate Finance and the Management Literature 254 14.3. Towards a Corporate Management Context
for Corporate Finance 257
14.4. Time for Reflection: What Have We Learned? 259
Chapter 15. Ethics 261
15.1. Introduction 261
15.2. The Nature of Ethics 263
15.3. The Institutionalization of Ethics 266
15.4. Corporate Ethics 269
15.5. Ethics and the Individual 270
Contents
Final Chapter 273
Chapter 16. Academic Finance: Responsable Enquiry or
Stamp Collecting? 275
16.1. Summary of the Text 275
16.2. Finance Theory as Performative 277
16.3. Academic Finance: Responsible Enquiry
or Stamp Collecting? 282
References 285
