The Clute Institute International Academic Conference
Munich, Germany 2014
Foundations of Business Finance:
The Theoretical Triad
Judy Laux, Colorado College, USA
ABSTRACT
The current work represents the preface of a bigger work by the same title and presents the
rationale for infusing into the financial management course the three primary themes on which the
study of finance is based. Stockholder wealth maximization, the risk-return tradeoff, and agency
conflicts form the theoretical basis for much of managerial finance, and introductory courses that
do not pay appropriate tribute to these concepts fail both students and professors, as outlined in the
current work.
INTRODUCTION
“Foundations of Finance: The Theoretical Triad” is a ten-chapter work designed to accompany textbook
treatment of most topics covered in the introductory managerial finance course. 1 The current preface presents the
rationale for integrating into the financial management course the three primary themes on which the study of finance
is based—stockholder wealth maximization, the risk and return tradeoff, and agency conflicts—referred to as the
“theoretical triad” in the current work. In a nutshell, the three-fold rationale follows: Theory provides structure, a
thematic foundation for the study of finance that enhances students’ ability to internalize the mechanics of finance.
Understanding theory helps reveal the ethical traps financial managers face, an important aspect in today’s world.
Finally, theory provides the basis for most empirical investigations in any discipline. Therefore, students truly
benefit from exposure to this material at the introductory level; the case can also be made for benefits accruing to
professors, as well.
This supplemental material can engage students in the theoretical triad in a way that makes the mechanics of
financial management more understandable and compelling. Textbooks are inconsistent in their treatment of these
concepts, and rarely do authors provide any review of literature surrounding the various topics in the introductory
managerial finance course. It seems appropriate to include this coverage, as it serves both to broaden students’
understanding and better prepare them for later research of their own. Some students write senior theses in
economics, and some go on to graduate school, but even in the absence of such aspirations, students appreciate the
structure offered by this thematic approach, and it also affords the opportunity to address some of the ethical aspects of
financial management through this rubric. Professors, too, can benefit, because these theoretical constructs drive
home the mechanics around which finance revolves, and student interest also increases with this added dimension,
always a plus for the professor.
Ultimately, the chapters to follow offer the theoretical coverage outlined above. This preface first outlines
the rationale for a three-pronged theoretical approach to studying managerial finance, setting the tone for investigating
each major finance topic through this special lens. Then it explains in more detail the structure of this textbook
supplement.
1
An electronic draft for your review is available upon request to the author at jlaux@coloradocollege.edu. Or I would be happy to send interested
parties a more detailed table of contents upon email request. Also, I would like to extend a special thanks to the Clute Institute for publishing the
“Topics in Finance” series on which this supplement is based in the American Journal of Business Education, as this exposure provided much
valuable feedback and impetus for completing the larger work. The supplement is now under review at Cengage Learning for consideration.
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The Clute Institute
The Clute Institute International Academic Conference
Munich, Germany 2014
THEORY AS STRUCTURE
While theory might hold the reputation of being boring and difficult to learn, the current work makes the
argument that theory can be both helpful and enlightening in sorting through the myriad details of managerial finance.
In the words of Chang [2005, p. 40] and in the spirit of Martin et al. [1988]:
Facing an enormously complex real world, we have to have a device to capture the ‘essence’ of various
events, states, phenomena, processes, developments, behaviors, and decision-makings of our interest by abstracting
from reality via a theory.
Thus, the rapidly changing world in which financial managers must operate makes a theoretical foundation
imperative, as it helps them cope with the inevitably contradictory forces drawing on them as both decision makers
and human beings striving to make a living. Some textbooks present theoretical models as they apply to specific
topics. (Examples of this topical treatment include Modigliani and Miller’s famous propositions about capital
structure and dividend policy, the portfolio theory of Markowitz, and Black-Scholes options pricing theory.) Brealey
et al. [2008], Brigham and Houston [2012], Ross et al. [2012], and Brealey and Ehrhardt [2014] do a fine job with the
theory at this level. Most textbooks also pay a passing tribute, usually in the first ten pages, to the idea of stockholder
wealth maximization, but a quick review of the indices of those books reveals few further references. Similarly, the
risk-return tradeoff might appear in discussions of leverage, of valuation, and in working capital chapters, while
agency theory sometimes appears in brief sections on corporate governance. In other words, a shotgun approach to
the triad is pretty typical. What we are talking about here, however, is applying the broader theoretical constructs to
all individual topics, and the intent is to use these guiding theories to provide structure. In addition, from a
professorial viewpoint, we don’t believe teaching the mechanical parts of finance alone constitutes much more than
vocational training; that’s not really educating. To educate means to encourage students to look beyond those
mechanics and employ more abstract concepts as a way of thinking about problem-solving. Studying theory gives
one the opportunity to engage those mental exercises. Students: Fear not. You will learn equations (for those who
love them), but you will also learn the intuition behind those formulas, and that intuition, in large part, derives from the
theory. The logic and conceptual bases of finance keep us focused on the forest (rather than losing ourselves in the
trees).
By committing a bit of time to learning what stockholder wealth maximization is (and isn’t), you will see how
everyday decisions financial managers must make can further or impede the welfare of the principals they are
allegedly representing—the stockholders. Furthermore, the effort to add value for those stockholders requires
managers to understand how risk and return relationships are represented in the valuation of financial instruments,
such as stock prices. Finally, human behavior does not always coincide with what theory would recommend, the
ethical dimension we investigate under the rubric of agency theory. Together, these three constructs provide a
skeletal structure for the study of finance. That is, when we think of the common decisions financial managers must
make, such as how much cash to hold, whether to invest in a particular machine, or if the company should pay
dividends, and so forth, we can think in terms of these three dimensions and better judge the decision actually made.
Sometimes managers will decide to expose the firm to more risk in exchange for a higher return or decrease risk and
accept a lower return. What we DON’T want to find them doing is taking on more risk for no more (or even lower)
return or reducing risk and forfeiting too much return, because either of those decisions will reduce the value of the
firm. The theoretical triad helps us to think in those terms and envision scenarios where managers misbehave as
agents of the stockholders in favor of their own individual welfare. The ethical dimension is profiled in the next
section.
THEORY AS AN ETHICS BAROMETER
The world of business always has been plagued by concerns about ethical behavior. One need only look to
the scandalous headlines of the last few decades to find evidence that managers do not always act in the best interests
of investors and creditors. For students taking that first finance course, the bulk of time and effort is devoted to
financial statements, equations, and mathematical relationships; very little attention is paid to how the decisions driven
by those numbers might be misguided, sometimes intentionally. Rest assured that the theories covered in the
following chapters affect the professional behavior of financial managers. As Chang [2005, p. 41] suggests:
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Munich, Germany 2014
Professional education should place sufficient emphasis on the application and practicality of the relevant knowledge.
However, practitioners should also be properly educated to transfer new developments from ivory tower to corporate
briefing room. It is sad, therefore, to see many academic journals in finance being turned away by corporate
America. Part of the reason lies in the unpreparedness on the part of practitioners to receive new theories.
One of the greatest challenges facing both future financial managers and future academics is to fortify those
bridges that span the gaps between the everyday experience of managers and the empirical investigations of
academics. After all:
The ultimate motivation to study any subject is the desire to improve our world. Unfortunately, the world is
enormously complex in its every aspect. So, the first step toward our goal is to understand this complexity. But to be
able to explain why companies and financial managers behave the way they do, we need a device to capture the
essence of their behaviors. [Chang, 2005, p. 41]
Perhaps society needs future managers who have thought from the very beginning about the temptations
faced by the stewards of investment dollars, how information asymmetry can affect judgment, how valuation can be
compromised. The Sarbanes-Oxley Act demanded more disclosure on the accounting front and more shared
responsibility on the part of managers, and a good dose of theory about principal-agent relationships can build a
foundation for discussing the ethical dilemmas common to financial management, as well. In the absence of a look at
the behavioral aspects, finance can seem much more sterile, less interesting, and overly mathematical. Studying
agency theory and envisioning decisions that might go contrary to those recommended by finance models and
equations adds a valuable dimension. After all, finance isn’t just about applying the right models; it’s about ensuring
the best behavior. Much empirical literature attempts to discover whether financial managers do, in fact, follow the
“decision rules” as outlined in textbooks or instead exercise subjective judgments, the final reason for studying the
theory.
THEORY TESTED EMPIRICALLY
While theories present abstract models along with their assumptions, empirical studies set out to discover
whether or not the real world emulates those expectations—whether real managers in real settings behave as expected.
As we investigate reality through empirical studies, we attempt to shed light on the inadequacies of the theories, and
we try to improve those theories. Through this process we challenge our minds to dig deeper, to think critically, to
analyze fully, and to recognize the inadequacies in our field and ourselves.
In the following chapters, we explore some of the best, most compelling, and most understandable research
of the last two decades for each of the topics. Occasionally, the original or “seminal” works also appear to help
enlighten the reader about just how far more current investigations have come (or how closely that original researcher
came to what, even today, we believe best explains real world phenomena). While the chapters summarize the
investigations, the reader is encouraged to access the original works to get a deeper understanding of what was asked,
how the question was investigated, and what other avenues exist for further investigation. Perhaps these
springboards for further research will inspire students and professors to leap into that sector of the world of
scholarship.
Graduate students and researching professors devote much time and energy to designing studies to test
whether managers behave as suggested in the textbooks. In many cases, these empirical investigations are looking to
see if the theoretical triad ideas hold up to close scrutiny. That is, if managers behave contrary to our expectations,
chances are pretty good that there are wealth (valuation), risk and return, and agency implications. Why, then, do we
not study these theories early in financial management? Surely students can ask good questions, look to see if those
questions have been studied by others, and add meaningful dimensions to the investigative literature. Even if they,
themselves, never pursue the investigative research, professors and future researchers should benefit from the innate
curiosity and contagious enthusiasm newbies to the field can offer. So, exposure to some of the best empirical works
sets the stage for developing an inquisitive state of mind. Finally, graduate students will enter that stage of their
career much better prepared if the theoretical discussions commence sooner in their finance adventure.
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THE CURRENT TEXT
In exploring the following presentation of the theoretical triad, professors and students should expect to
devote an extra half-hour per topic—five to six hours over the course of a semester if reading all chapters. However,
you also may select among the chapters, rather than using the entire supplement. The order is relatively unimportant,
with the following exceptions. The first chapter is required reading for all those to follow, as it describes the triad in
more detail, relates it to the overall structure of managerial finance, and introduces some of the stockholder wealth
maximization literature. Chapters 5 (Capital Structure), 6 (Capital Budgeting), and 7 (Dividend Policy) should
probably be read in sequence, although Chapter 7 can also stand alone. Chapter 8 (Mergers and Acquisitions) relies a
little on Chapter 7 but can also stand alone or be used much later in the course. Finally, I cover working capital
management (Chapter 9) relatively late in the course, but it can be treated much earlier, if that is the structure of the
accompanying textbook. In other words, the supplement offers much flexibility, and students and professors can
explore it in a variety of ways.
As a quick look at the table of contents reveals, after the introductory chapter (which sets the basis for the
triad), each subsequent chapter offers a brief introduction to the topic at hand, followed by a summary of the essential
mechanics related to the topic, an encapsulated look at what the textbooks usually present. Then a conceptual section
ties the topic to our theoretical triad. After a review of some of the key literature applicable to the topic, the chapter
ends with words of advice to financial managers—a set of questions to help them discover if they have applied the
triad appropriately in their decisions related to the specific topic. The purpose is to provide a forum for discussing the
elements of finance from a thematic perspective.
To the extent one wants to look more closely at the literature covered in each chapter, a complete references
section at the end of the supplement should easily serve that purpose, and of course this would require an added time
commitment. If readers want to pursue actual research, the references should offer a solid foundation for that
endeavor. This might be particularly important to professors, to undergraduates planning to write a senior thesis, or
to graduate students in finance. One of the desired learning outcomes is to immerse yourself in some of the theory
and supporting literature while staying true to the path taken by textbooks. Pick and choose as you like—the world of
the theoretical triad awaits you…
REFERENCES
1.
2.
3.
4.
5.
6.
7.
Brealey, Richard, Stewart Myers, and Franklin Allen. 2008. Principles of Corporate Finance, 9th edition.
New York: McGraw-Hill.
Brigham, Eugene F. and Michael Ehrhardt. 2014. Financial Management: Theory & Practice, 14th edition.
Mason, Ohio: Cengage Learning.
Brigham, Eugene F. and Joel F. Houston. 2012. Fundamentals of Financial Management, 13th edition.
Mason, Ohio: Cengage Learning.
Chang, S.J. 2005. “A Theoretical Discussion on Financial Theory: What Should We Teach and How?”
Journal of Economics and Finance Education, Vol. 4, No. 2: 39-48.
Laux, Judith A. 2010-2013, various publication dates. “Topics in Finance” series. American Journal of
Business Education. Clute Institute; available online.
Martin, J., S. Cox, and R. MacMinn. 1988. The Theory of Finance. New York: Dryden Press.
Ross, Stephen A., Randolph Westerfield, and Jeffrey Jaffe. 2012. Principles of Corporate Finance, 10th
edition. New York: McGraw-Hill.
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