Corporate finance

Assignment submitted to : Dr Faid Gul

Submitted by: Ayesha Samdani

Due date :9-04-2019

Submittion date:16-04-2019

Reg no:509-bba-fms-f15

Batch :BBA 34
What is capital market theory:

Capital market theory extends portfolio theory and develops a model for pricing all risky assets.

Capital asset pricing model will allow you to determine the required rate of return for any risky
asset.Valuation of assets or investments is the subject matter of security analysis. In considering
the portfolio,not only returns are to be considered but also their risks also.In aggression of risks
two plus two will not make four.This is shown by famous aurthor Markowits.The objective of
investor is to maximize the return with minimizing the risk for a given return.

Capital market theory deals with that subject.

Following are the theories of capital market theory which are as follows:

1. M.M theory

The Modigliani-Miller theorem (M&M) states that the market value of a company is calculated
using its earning power and the risk of its underlying assets and is independent of the way it
finances investments or distributes dividends.

There are three methods a firm can choose to finance:

 Borrowing
 Spending profits (versus handing them out to shareholders in the form of dividends)
 Straight issuance of shares.

While complicated, the theorem in its simplest form is based on the idea that with certain
assumptions in place, there is no difference between a firm financing itself with debt or equity.

2. Tax Shield theory

A tax shield is a reduction in taxable income for an individual or corporation achieved through
claiming allowable deductions such as mortgage interest, medical expenses, charitable
donations, amortization and depreciation. These deductions reduce a taxpayer's taxable income
for a given year or defer income taxes into future years. Tax shields lower the overall amount of
taxes owed by an individual taxpayer or a business.

3. Market timing theory

Market timing is a type of investment or trading strategy. It is the act of moving in and out of a
financial market or switching between asset classes based on predictive methods. These
predictive tools include following technical indicators or economic data, to gauge how the
market is going to move.
Many investors, academics, and financial professionals believe it is impossible to time the
market. Other investors, notably active traders, believe strongly in it. Thus, whether market
timing is possible is a matter of opinion. What can be said with certainty is it is very difficult to
time the market consistently over the long run successfully.

Market timing is the opposite of a buy-and-hold investment strategy.

4. Trade off theory

The trade-off theory states that the optimal capital structure is a trade-off between interest
tax shields and cost of financial distress.

The trade-off theory of capital structure is the idea that a company chooses how much debt
finance and how much equity finance to use by balancing the costs and benefits.

An important purpose of the theory is to explain the fact that corporations usually are financed
partly with debt and partly with equity. It states that there is an advantage to financing with debt,
the tax benefits of debt and there is a cost of financing with debt, the costs of financial distress
including bankruptcy costs of debt and non-bankruptcy costs.

5. Bankruptcy theory

A legal proceeding involving a person or business that is unable to repay outstandings debts.

All of the debtors assets are measured and evauated where upon the assets are used to repay a
portion of outstanding debts.

Bankruptcy is due to:

 Market conditions
 Financing
 Poor decision making
 Other causes.

Bankruptcy is overcome by cut costs,contact customers and suppliers,contact

creditors,consolidate loans.

6. Pecking order theory

The pecking order theory of the capital structure is a theory in corporate finance.The theories
tries to explain why companies prefer to use one type of financing.

The pecking order theory assumes that there is no target capital structure. Due to adverse
selection, firms prefer internal to external finance. When outside funds are necessary, firms
prefer debt to equity because of lower information costs associated with debt issues.The theory
maintains that business adhere to a hierarchy of financing sources and prefer internal sourcing
when available when debt is preferred over equity if external financing is required.Thus the form
of debt a firm choses can act as a signal of its need for external finance