Chapter 34: What We Know & Don’t Know About Finance

What We Know & Don’t Know About Finance systematically reviews the seven most important ideas in finance that define the modern financial manager's toolkit. The discussion begins with the Net Present Value (NPV) rule, the cornerstone concept that equates the value of an asset to the price of its future cash flows in open capital markets, discounted at the opportunity cost of capital. It reaffirms the utility of the Capital Asset Pricing Model (CAPM) for distinguishing between diversifiable risk and market risk (beta), and explores the theory of Efficient Capital Markets, which asserts that security prices rapidly reflect available information. The chapter also covers the Law of the Conservation of Value (value additivity), the Capital Structure theories of Modigliani and Miller which suggest financing decisions do not create value in perfect markets, and the critical insights provided by Option Theory and Agency Theory regarding strategic timing and stakeholder conflicts. The narrative then pivots to ten unsolved problems that represent the "known unknowns" of the field. This section critically examines the difficulty in estimating project betas and the origins of economic rents, as well as the statistical and theoretical gaps in risk-return models like the Fama-French three-factor model. It explores exceptions to market efficiency, such as behavioral finance anomalies, momentum, and speculative bubbles that defy rational pricing. The summary discusses the "off-balance-sheet liability" of management costs in relation to closed-end fund discounts, the unpredictable success of financial innovations, and the enduring payout controversy regarding dividends versus stock repurchases. Finally, it addresses the challenges of optimizing corporate risk-taking, the elusive valuation of liquidity, the behavioral cascades that drive merger waves, and the persistent fragility of financial systems that leads to recurring banking and sovereign debt crises.