Editing Financial economics (section)

===Corporate finance theory===
{{see also|Outline of corporate finance #Theory}}
[[Image:Manual decision tree.jpg|right|thumb|Project valuation via decision tree.]]
Mirroring the [[#Certainty|above]] developments, corporate finance valuations and decisioning no longer need assume "certainty".
[[Monte Carlo methods in finance]] allow financial analysts to construct "[[stochastic]]" or [[probabilistic]] corporate finance models, as opposed to the traditional static and [[deterministic]] models;<ref name="Damodaran_Risk"/> see {{section link|Corporate finance|Quantifying uncertainty}}. 
Relatedly, [[real options|Real Options theory]] allows for owner – i.e. managerial – actions that impact underlying value: by incorporating option pricing logic, these actions are then applied to a distribution of future outcomes, changing with time, which then determine the "project's" valuation today.<ref name="Damodaran"/> 
More traditionally, [[decision tree]]s – which are complementary – have been used to evaluate projects, by incorporating in the valuation (all) [[Event (probability theory)|possible events]] (or states) and consequent [[Decision making#Decision making in business and management|management decisions]];<ref>{{cite journal |title=Valuing Risky Projects: Option Pricing Theory and Decision Analysis |first1=James E. |last1=Smith |first2=Robert F. |last2=Nau |url=https://faculty.fuqua.duke.edu/~jes9/bio/Valuing_Risky_Projects.pdf |journal=Management Science |volume=41 |issue=5 |year=1995 |pages=795–816 |doi=10.1287/mnsc.41.5.795 |access-date=2017-08-17 |archive-url=https://web.archive.org/web/20100612170613/http://faculty.fuqua.duke.edu/%7Ejes9/bio/Valuing_Risky_Projects.pdf |archive-date=2010-06-12 |url-status=live }}</ref><ref name="Damodaran_Risk">[[Aswath Damodaran]] (2007). [http://www.stern.nyu.edu/~adamodar/pdfiles/papers/probabilistic.pdf "Probabilistic Approaches: Scenario Analysis, Decision Trees and Simulations"]. In ''Strategic Risk Taking: A Framework for Risk Management''. Prentice Hall. {{ISBN|0137043775}}</ref> the correct discount rate here reflecting each decision-point's "non-diversifiable risk looking forward."<ref name="Damodaran_Risk"/> 
{{NoteTag|
Simulation was first applied to (corporate) finance by [[David B. Hertz]] in 1964. 
Decision trees, a standard [[operations research]] tool, were applied to corporate finance also in the 1960s.<ref>See for example: {{cite journal |title= Decision Trees for Decision Making |first= John F. |url= https://hbr.org/1964/07/decision-trees-for-decision-making |last= Magee |journal= [[Harvard Business Review]] |volume= July 1964 |year= 1964 |pages= 795–816 |access-date= 2017-08-16 |archive-url= https://web.archive.org/web/20170816192517/https://hbr.org/1964/07/decision-trees-for-decision-making |archive-date= 2017-08-16 |url-status= live }}</ref>
Real options in corporate finance were first discussed by [[Stewart Myers]] in 1977.
}}

Related to this, is the treatment of forecasted cashflows in [[equity valuation]]. In many cases, following Williams [[#Certainty|above]], the average (or most likely) cash-flows were discounted,<ref name="Markowitz_interview">{{cite journal |last= Kritzman |first= Mark |title= An Interview with Nobel Laureate Harry M. Markowitz
 |journal=Financial Analysts Journal  |volume=73 |issue= 4|year= 2017|pages= 16–21|doi=10.2469/faj.v73.n4.3|s2cid= 158093964 }}</ref> as opposed to a theoretically correct state-by-state treatment under uncertainty; see comments under [[Financial modeling#Accounting|Financial modeling § Accounting]]. 
In more modern treatments, then, it is the ''expected'' cashflows (in the [[Expected value|mathematical sense]]: <math display=inline>\sum_{s}p_{s}X_{sj}</math>) combined into an overall value per forecast period which are discounted.
<ref name="Kruschwitz and Löffler"/>
<ref name="welch">[http://book.ivo-welch.info/read/chap13.pdf "Capital Budgeting Applications and Pitfalls"] {{Webarchive|url=https://web.archive.org/web/20170815234404/http://book.ivo-welch.info/read/chap13.pdf |date=2017-08-15 }}. Ch 13 in [[Ivo Welch]] (2017). ''Corporate Finance'': 4th Edition</ref>
<ref>George Chacko and Carolyn Evans (2014). ''Valuation: Methods and Models in Applied Corporate Finance''. FT Press. {{ISBN|0132905221}}</ref>
<ref name="Damodaran_Risk"/>
And using the CAPM – or extensions – the discounting here is at the risk-free rate plus a premium linked to the uncertainty of the entity or project cash flows
<ref name="Damodaran_Risk"/>
(essentially, <math>Y</math> and <math>r</math> combined).

Other developments here include<ref>See Jensen and Smith under "External links", as well as Rubinstein under "Bibliography".</ref> [[agency theory]], which analyses the difficulties in motivating corporate management (the "agent"; in a different sense to the above) to act in the best interests of shareholders (the "principal"), rather than in their own interests; here emphasizing the issues interrelated with capital structure.
<ref>{{cite journal|title=Theory of the firm: Managerial behavior, agency costs and ownership structure|last1=Jensen|first1=Michael |last2=Meckling|first2=William|journal=Journal of Financial Economics |year=1976|volume=3|issue=4|pages=305–360|doi=10.1016/0304-405X(76)90026-X|doi-access=free}}</ref> 
[[Clean surplus accounting]] and the related [[residual income valuation]] provide a model that returns price as a function of earnings, expected returns, and change in [[book value]], as opposed to dividends. This approach, to some extent, arises due to the implicit contradiction of seeing value as a function of dividends, while also holding that dividend policy cannot influence value per Modigliani and Miller's "[[Irrelevance principle]]"; see {{section link|Dividend policy|Relevance of dividend policy}}.

"Corporate finance" as a discipline more generally, building on Fisher [[#Certainty|above]], relates to the long term objective of maximizing the [[Enterprise value|value of the firm]] - and its [[Total shareholder return|return to shareholders]] - and thus also incorporates the areas of [[capital structure]] and [[dividend policy]]. 
<ref>[http://pages.stern.nyu.edu/~adamodar/New_Home_Page/AppldCF/other/Image2.gif Corporate Finance: First Principles], from [[Aswath Damodaran]] (2022). ''Applied Corporate Finance: A User's Manual''. Wiley. {{ISBN|978-1118808931}}</ref>
Extensions of the theory here then also consider these latter, as follows:
(i) [[Corporate finance#Capitalization structure|optimization re capitalization structure]], and theories here as to corporate choices and behavior: [[Capital structure substitution theory]], [[Pecking order theory]], [[Market timing hypothesis]], [[Trade-off theory of capital structure|Trade-off theory]];
(ii) [[Corporate finance#Dividend policy|considerations and analysis re dividend policy]], additional to - and sometimes contrasting with - Modigliani-Miller, include: 
the [[Dividend policy#Walter's model|Walter model]], [[John Lintner#Lintner's dividend policy model|Lintner model]], [[Dividend policy#Residuals theory of dividends|Residuals theory]] and [[Dividend policy#Dividend signaling hypothesis|signaling hypothesis]], as well as discussion re the observed [[clientele effect]] and [[dividend puzzle]].

As described, the typical application of real options is to [[capital budgeting]] type problems. 
However, here, they are [[Corporate finance#Corporate governance|also applied]] to problems of capital structure and dividend policy, and to the related design of corporate securities;
<ref name="Garbade">Kenneth D. Garbade (2001). ''Pricing Corporate Securities as Contingent Claims.'' [[MIT Press]]. {{ISBN|9780262072236}}</ref>  
and since stockholder and bondholders have different objective functions, in the analysis of the [[Corporate finance#Corporate governance|related agency problems]].
<ref name="Damodaran">{{cite journal|last=Damodaran|first=Aswath|author-link=Aswath Damodaran|title=The Promise and Peril of Real Options|journal=NYU Working Paper|issue=S-DRP-05-02|year=2005|url=http://stern.nyu.edu/~adamodar/pdfiles/papers/realopt.pdf|access-date=2016-12-14|archive-url=https://web.archive.org/web/20010613082802/http://www.stern.nyu.edu/~adamodar/pdfiles/papers/realopt.pdf|archive-date=2001-06-13|url-status=live}}</ref> 
In all of these cases, state-prices can provide the market-implied information relating to the corporate, [[#State prices|as above]], which is then applied to the analysis. For example, [[convertible bond]]s can (must) be priced consistent with the (recovered) state-prices of the corporate's equity.<ref name="corp fin state prices"/><ref name="Kruschwitz and Löffler">See Kruschwitz and Löffler under Bibliography.</ref>