Name – Kanishk Pratap Singh

Roll No – 3404

Agency Theory
Agency theory deals with the problems that arise due to separation of ownership and
control. In corporations the shareholders are the principal and managers are the agent.
The differences between their interests and priorities leads to the principal-agent
problem. The shareholders depend on the managers of the firm to maximize their
market value of investments, but the managers might not be much inclined to do so.
The principal-agent problem can also exist between the managers and creditors. And
apart from corporations it can also exist between the brokers and investors, where the
brokers act on behalf of the investors. The principal-agent problem leads to agency
costs incurred when the agent doesn’t or might not act in the best interests of the
principal.
Hubris
It is the characteristic of excessive confidence or arrogance which leads a person to
believe that whatever he or she does turns out to be a successful endeavor. This is a
flaw in character often found in successful individuals (casually referred to as Midas
touch). It can cause short sighted, irrational, inconsiderate or harmful behavior.
Signaling
In corporate finance it refers to the information that is passed on, due to the actions a
corporation takes. For example when the company announces an increase in the
dividend payouts it sends a signal in the financial market that the company is
performing good. There can signals due to all kinds of actions like borrowing debt or
acquiring another company and it can lead to a positive or negative expectations among
investors.
Information Asymmetry
Information asymmetry exists where one party to an economic transaction possesses
greater knowledge on what is traded than the other party. For example during
insurance the person who is getting insured possesses more knowledge about the
present and future risks. Another example can be that of involving a second-hand car
sale, where the seller knows more about the car than the buyer.
Stock Split
It is a decision that a company takes to increase the number of its outstanding shares by
issuing more shares to its shareholders. When the number of shares are increased by
the way of splitting, the price decreases proportionately. Hence both the market
capitalization of the company and the value of shares that shareholder holds remains
the same (unless there is some price fluctuations in the market due to signaling).
Generally a stock split sends a positive message in the market signaling that the
company is doing well. Stock split is mostly done to help make shares more affordable
to smaller investors, it also increases the liquidity in the market.
Stock splits are done in ratios, like in 1:2 splits the number of outstanding shares
increases to twice the original number and the share price will be halved.

Stock Dividend
A stock dividend is a method used by the company to distribute wealth to its
shareholders, it is a dividend payment made in the form of shares rather than cash (also
known as bonus shares). The company takes this route when either it is low on cash or
have other uses for it. Like stock splits, stock dividend does not increase market
capitalization or shareholder’s wealth as the price per share decreases accordingly to
the percentage increase in outstanding shares this is because the value of the enterprise
has not changed. Stock dividend requires a Journal entry in the book of accounts of the
company. It gives tax benefit to the shareholders, as it is not taxed until the share is
sold.
Stock dividends are done in percentages. For example if the company declares to issue a
10% stock dividend it would mean that the number of shares would increase by 10% i.e.
1 for every 10 shares. But as the value of the company has not increased the share price
will decrease to compensate for the increase in the number of shares.

Trade-off theory
Trade-off theory is used for determining capital structure of the firm, it helps in deciding
how much to finance through debt and how much to finance through equity. There are
costs and benefits of choosing both debt and equity. Debt provides tax benefits and the
cost of raising funds through it is lower as compared with equity, but it also has its
demerits of paying regular interests payments and a possible cost of bankruptcy
(companies at early stages avoid it). With further increase in debt the marginal costs
increases as the lender expects more interest on further debts. Debt also reduces
agency costs as creditors monitor the firm and the decisions made by board of directors
& managers. Debt also helps in financial leverage hence shareholder’s value
maximization (EPS in a company with debt is more). But adding more debt makes it risky
for the firm as it might lead to liquidation. While coming to equity there is no obligation
to pay back to shareholders so it provides flexibility to the firm despite being costlier
than debt. With more debt equity also becomes costly as in case of liquidation most of
the loss is absorbed by shareholders. Hence there is a trade-off between choosing
between debt and equity. For most firms an optimal capital structure includes both debt
and equity such that cost of capital (WACC) is minimum.
Pecking order theory
According to pecking order theory the firms prefer internal financing over the external
financing. And even with external financing the preference is given to debt over equity.
The reason behind choosing debt over equity is that, with equity comes external
ownership also there is asymmetric information & signaling that plays a crucial role in
the preference. Debt signals the board’s confidence that the investment is profitable
and the current stock price is undervalued whereas issue of equity would signal a lack of
confidence in the board and they feel that share price is over-valued and can be
exploited. Due to information asymmetry the external investors always assume a higher
rate of return as they are not fully sure of the risk they are undertaking. The cost of
financing also increases in the order of retained earnings, debt and equity.
 Debt
 Borrowing money (may require collateral
or guarantees)
 Have to pay regular interest payments,
continuous claim on cash flows
 Faster & cheaper
 Reduces agency costs as creditors
monitor
 Financial leverage helps in RoE
 Impact future borrowing
 Interest rate is tax deductible
Preference Shares
 No voting rights
 More volatility
 Fixed dividend, & preference given
 At time of liquidation settled before common stock
Types of business
Sole Proprietorship
 Business owners involved in day to day
operations, autonomy & freedom
 Business is not a separate entity, sole
bearer of risk
 Size or growth is limited due to lack of
capital infusion easily at scale
 Going concern limited to health of owner
and succession after death
Partnership
 Contractual co-ownership by 2 or more
(max limited to 20)
 Unlimited liab
 Ceases when contract ends
 Mutual agency – every partner agent of
firm & other partners
Company
 Independent existence
 Limited liab
 Higher compliance cost
 Public vs private companies
Efficient Market Hypothesis
Equity
 Raising money by selling shares of the
company
 No obligation to pay dividends
 Dividends are appropriation of profit
 Long and costly process
 Dilution of control, voting rights of
shareholders
 Brings strategic benefit
 Stabilizes financial structure as cost of
borrowing reduces after issue of equity
Hindu Undivided Family
 Automatically formed by members of
family, members automatic co-owners by
birth
 The Karta (head) has unlimited liab but all
other members have limited liab
 Enjoys separate entity status
 Going concern, doesn’t lasts beyond few
generations due to family feuds
Limited Liability Partnership
 Liab of partners limited
 Separate legal entity & mandatory
incorporation (registration) under LLP Act
 Perpetual succession
 A little more compliances than
partnership
Cooperative
According to efficient market hypothesis, market efficiency is a condition in which
current prices reflect all the publicly available information about a security. The
competition drives the information into stock prices quickly due to which stocks always
tend to trade at their fair value. This makes it impossible for the investors to outperform
the overall market by stock selection or market timing. The only way higher returns can
be obtained is by purchasing riskier investments.
There are three versions of Efficient Market hypothesis depending on the information
available:
Weak form It states that current market prices reflect past price and
volume information.
Investors should not be able to outperform the market using
something that everybody else knows.
Semi-strong form It states that not only past prices but also publicly available
information like data reported by company in financial
statements, announcements & economic factors etc, are
incorporated into stock prices.
According to this financial statements are of no help in
forecasting future price movements as it is already reflected
into current market prices.
Strong form According to it private information or insider information
too is quickly incorporated in market prices, hence investors
can’t reap abnormal trading profits.
As private & public information is fully reflected in prices,
no long term gains are possible.

Efficient market hypothesis doesn’t give us the exact picture as human psychology
affects prices (biases, error in reasoning & information processing, over-reaction to new
information, etc). We have also seen low P/E stocks beating market, long term deviations
& economic bubbles that can’t be explained by efficient market hypothesis.