Efficient Market Hypothesis - Impact on the Share Price of Friends Life and Aviva after Merger - Case Study Example

International Finance Impact on the share price of Friends Life and Aviva after Merger using the framework of Efficient Market Hypothesis (EMH) Student Registration: Module Leader: Workshop Tutor: Due Date: Table of Contents Introduction 2 Efficient Market Hypothesis 3 Valuation of Friends Life before Acquisition 6 Capital Structure and Weighted Average Cost of Capital (WACC) 7 The Required Rate of Return 8 Conclusion 9 References 10 Appendix 1 11 Appendix 2 13 Appendix 3 16 Introduction In the present challenging globalized business environment and demanding markets, companies must continually seek unorthodox ways to remain competitive, and those left to manage the firms must continually seek techniques that aid in corporate value creation, which translates to higher shareholder income, in terms of their dividend. Mergers and acquisitions are some of the techniques employed by these business outfits to match or even stay ahead of their competitors. It is a common occurrence in board room politics, and the announcement by the morning, and there after the admission by both parties on the truth of the matter was hardly surprising. There are a number of business advantages that accrue when two businesses merge and this can be in the form of higher economies of scale, as well as, increased market share. Be known to most professionals in the fields, mergers affect share prices, and other performances of their different shares on the bourse. However, the effects on share prices for any respective company involved in the merger shall be depended on a number of factors, and these include; efficient market hypothesis, behavioral finance theory and stock acquiring as method of payment. In all these factors, the outcomes cement the target stock’s prices react ad reassert better in the short term when the acquiring form has a better balance sheet. And this is not consistent with the efficient market theory, and it its weak form of efficiency, and behavioural theorists point out that most investors go for such stocks when either merger or acquisition is announced. This paper shall discuss the impact on the stocks of Friends Life and Aviva after a report appeared in a finance article speculating on their merger. Efficient Market Hypothesis This paper shall commence on a comprehensive discussion on the impact of merger and acquisition on the case analysis on the companies’ respective share prices within a stipulated then, and before then it is important to develop sufficient knowledge on the realms this discussion shall border. Since the realms of the discussion shall be the efficient market hypothesis this shall be borderline to which the entire discussion shall not pass. The efficient market hypothesis is based on the principle that stock prices must fully reflect available information, and in this theory, the information announced by the morning star on the impending acquisition of Friends Life counts as available information and it could share prices on the eve of the merger. Share prices normally responds to such news as the company’s owners that acquire the other firm shall achieve optimal outcomes as a result of the benefits that accrue from such deals. In general, it has always been observed that when there the merger or an acquisition comes to the public domain, the trading volume as well as the stock price of the target company rises in three days following the announcement particularly if they are acquired with the shares. Furthermore, when such an expectation is accomplished, the market may be declared efficient, as the information that was available in the market is completely replicated in the price on a timely as well as accurate manner. If investors feel that the new shares will be beneficial to their interest in their company, then the share price shall move corresponding to the available information. Such can take place in market that is synonymous with a large number of rational, profits optimizing and actively competing with one another, and each trying to forecast future values of these stocks, and that present information is freely available to all participants. In the efficient market, the real prices of stocks automatically show the influence of information that is based not only on events that have just happened and also events which shall happen in the future. In this case the present event is taken to be one on November 21st 2014, and all other dates after that represents the future, including the date when the deal will be actually closed. The closing price for Friends Life Prices on the eve of the M&A stood at £ 347.7, after an opening price of £ 344.1 on the same day (Appendix 1). On the 13th February 2015, the closing price for the Friends Life shares stood at £ 410.5 (Appendix 1). The rise in prices from the dates shown on the appendix represents a loose 18.06% increase in the company’s share prices, and the increase in price overtime, as a result of the announcement represents the forgone costs that those acquiring this company will fore-gore to enjoy the benefits if increased consolidation. Similarly, the closing price for Aviva’s shares on 21st November 2014 stood at 539p, but the company’s shares from an opening value of 533.5p (Appendix 2). Ironically, the share prices for this company took the spiral way tumbling from such high levels on 21st November 2014, to a low of 463.3p on January 7th 2015, and then again facing a turbulent movement in prices to settle at 541p on the closing day of 13 February 2015. In effect the following must seem precarious to this discussion: pre event announcement, earnings and announcement and long term effects of announcements. In short, the Efficient Market Hypothesis implies the price of the stock that is replicated in the information that is available in the market, and hence it serves as a good predictor of the intrinsic value of the security. Theoretically, efficiency is normally subdivided into three forms: the weak form, semi-strong and the strong form. The weak form is the situation where past market prices and data are reflected in the present prices of shares, while the semi-strong affirms that all publicly available information is completely shown in share prices, and finally, the strong form states that all information is fully reflected in the share prices. In an efficient bourse market, the acquisition of Friends Life by Aviva is immediately taken into the share prices, and the level of uncertainty regarding the acquisition shall be gradually reflected into the stock value as time goes by. In addition, the globalised nature of present transactions means that information released in London a second ago shall hit the pavements of Wall Street a minute later and overseas investor’s reactions to the merger shall be incorporated, albeit with a different degree of market efficiency. Valuation of Friends Life before Acquisition Valuation of a company might at times entail a lot of synergy and control, and move past mere valuation of the target firm, and this makes acquisition valuations very complex (Petitt, 2013). There are very many ways of company valuations, which include market capitalizations, volume of shares at a certain share price amongst other metrics’. The value of a company is determined through market capitalization available, and this is just the market value of each share by the number of ordinary shares that exists. On the LSE, Friends Life total number of shares is quoted at 11, 203536, and during this date, the company’s market price 366.2p, and it is this price that will be used in estimating the company’s market capitalization before its acquisition by Aviva, and after a peak on the company’s balance sheet the result becomes 4.223 sterling pounds. Enterprise value can also be used in estimating the value of a company, and the formula for establishing the enterprise value becomes: market cap plus debt, minority interest and preferred shares, then this value is subtracted from the total cash and cash equivalents. In fact, analysts construe that the enterprise value is the hypothetical takeover price, and that in the event of a buyout, the acquirer would take both the debts of the company and its cash. The enterprise value = market cap + minority interest/preferred shares + debt –total cash and cash equivalents 4.233+0.88-0.09 = 5.023 billion sterling pounds This was the enterprise value before the firm was acquired by its rival life insurance competitor. Capital Structure and Weighted Average Cost of Capital (WACC) A simple peak into Friends Life balance sheet during the year ending 31st December 2013 reflects a prudential management of its debt as well as its equity levels. Shareholder’s equity during the same period stood at £ 5.549 billion, the debt level during the same period stood at £0. 88745billion.Such an impressive and healthy relationship between debt level and equity level pushed Aviva to claim a stake in their business rival. On the other hand, WACC reflects the alternative costs of investment into network components and related assets, in short, it is the return on investment, and its value is determined after taking into account the period in which the costs of such regulated services would be calculated (Pratt & Grabowski, 2008). In this paper, the nominal WACC value is arrived at with respect to 2013 data, and the method used is harmonized within the precincts for WACC calculations that is described within the basic WACC calculation guideline requirements within the United Kingdom. The weighted average cost of capital is arrived after considering the weighted price of both debt and equity, and WACC can be calculated with respect to the respect to the tax effect, it can also be irrespective of the tax effect. WACC is normally used by enterprises to substantiate their investment projects, hence the use with respect to the tax effect. Nonetheless, from a regulatory viewpoint, the WACC value before the tax effect is considered more effective and should instead be used. The reason for this viewpoint is that profit tax in BU-LRAIC model is not taken a cost, and hence the WACC value should be higher, and must show the cost of capital before taxation. Hence the mathematical formular for the WACC becomes: . The reason is that profit tax in the BU-LRAIC model is not considered as costs, thus WACC value should be higher and should reflect the cost of capital before taxation. Thus, the arithmetic WACC calculation formula is the following: WACC = Rd X Wd + Re X 1/1-t X We……………………………. (1) Wd = D/D+E……………………………………………………….. (2) We = E/D+E………………………………………………………... (3) Where: Rd – cost of debt in terms of percentage; Re – required return on investment (after taxation) in terms of percentage; We – share of equity in capital employed Wd – share of debt in capital employed; D – market value of debt; E – market value of equity; t – Effective profit tax rate. D= £5.549 E = £1.05 t=0.3631, t = earnings before tax-earnings after tax/earnings before tax. According to a reliable online computation of Friend Life’s WACC, the rate was quoted at 7.41%. The Required Rate of Return This is a part in a number of the metrics being used in corporate finance and equity valuation, and it moves ahead than just identification of returns of the investment, but considers the factors in risk as an important consideration to ascertaining the potential return. The required rate of return also sets the base return that an investor should agree to, provided that there are other options that exist and the existence of the capital structure of the company. To arrive at the required rate, one must consider at the factors such as the return of the whole market, the rate one can get if there was no risk, that is the risk-free rate of return, and the volatility of the stock or the overall cost of funding a given investment project. The use of the Capital Asset Pricing Model in arriving at the required rate of return hinges on the following; the risk free rate, the stocks beta and the expected market return. This is also the cost of equity, the formula hence becomes = risk free rate + beta asset*(Expected return of the market-risk free rate of return). This paper used the 10 year Treasury constant maturity rate as the risk free rate, and it is update on a daily basis, and the then prevailing rate was 2.03%, beta is the sensitivity of the expected excess asset returns to the expected excess market returns. Friends Life Group beta is 1.53, and the expected return of the market minus the risk free rate of return is also known as market premium, hence the market premium is 7. 5%. As a result, the required rate of return through the use of capital asset pricing model becomes 13.505%. Conclusion The results above show that RRR and WACC, and other financial results of Friends of Life imply healthy and financial sound institution, a general reflection of the insurance industry in United Kingdom. As a matter of fact most professional s in the Insurance industry concedes that the insurance industry in the United Kingdom is the most vibrant one across Europe. Buoyed by this results, even Aviva should move to acquire the company, but the price quoted by the Aviva is 399p, yet the announcement triggered a rise in the price of Friends of life shares, whose price rose to 372.6p, which is far below the rate the company is offering to acquire its rival shares, yet in the meantime the share did rise to 410.5p at the close on February 13, 2015. An 11p set back on their evaluations of the purchase price. As an industry analysts, it would vital to predict a price of 400p to be the final offer that Aviva shall lay to Friends life shareholders so that they may take a controlling stake in that company, and assist them in offsetting their own negative profit balances that have accumulated over the past few years. References Petitt, B. S. P., & Ferris, K. R. 2013. Valuation for mergers and acquisitions. Pratt, S. P., & Grabowski, R. J. 2008. Cost of capital applications and examples. Hoboken, N.J., John Wiley & Sons. Appendix 1 Data on Friends Life Prices between November 21 2014 and February 2015 Date Open High Low Close Volume Adj Close 13-02-15 411.5 413.5 408.3 410.5 3194900 386.44 12-02-15 404 412.7 404 411.2 3067000 387.09 11-02-15 408.8 410.2 404.7 406 3646100 382.2 10-02-15 402.7 410.6 402.7 410.6 3931900 386.53 09-02-15 405 405.8 400.9 403 2006800 379.37 06-02-15 403 407.7 398.5 405.6 6721500 381.82 05-02-15 397.4 399.4 396.33 398.9 6960000 375.52 04-02-15 401.5 402.6 395.2 397.6 10592000 374.29 03-02-15 398.6 404.6 398.1 401.8 9558700 378.25 02-02-15 399.2 401.8 396.2 398.6 7194600 375.23 30-01-15 404.4 407.6 398.4 398.4 6785900 375.04 29-01-15 400.2 405.4 398.7 404.4 10668000 380.69 28-01-15 407.2 407.3 399 401.1 10134200 377.59 27-01-15 409.6 410.39 401.4 404 4352300 380.32 26-01-15 405.8 413.5 403.68 409.5 3561900 385.49 23-01-15 407.5 413.62 404.5 407 5816500 383.14 22-01-15 398.6 409.2 398.28 406.8 4770900 382.95 21-01-15 390.5 400.2 390.5 399.9 6192100 376.46 20-01-15 389.6 391.2 385.4 390.2 8065900 367.33 19-01-15 381.3 388.24 381.3 386 10745800 363.37 16-01-15 379.1 382.8 376.94 381.5 8483700 359.14 15-01-15 373.2 382.6 369.1 382.5 9242000 360.08 14-01-15 366.5 374.2 366.5 371.2 7156300 349.44 13-01-15 362.9 372.5 362.4 371.2 4660000 349.44 12-01-15 371.3 376.4 363.2 365 4368800 343.6 09-01-15 363.4 375.2 363.4 371.7 6524600 349.91 08-01-15 354.5 367.6 352.5 365.1 5940000 343.7 07-01-15 353.7 355.2 349.8 351 5538100 330.42 06-01-15 356.3 358.54 352.3 352.6 4590000 331.93 05-01-15 363.3 366.4 356.4 357.5 3264800 336.54 02-01-15 369.3 369.9 363.7 365 2119200 343.6 01-01-15 366.2 366.2 366.2 366.2 0 344.73 31-12-14 368.2 369.4 364.9 366.2 437700 344.73 30-12-14 367.1 370.4 365.2 366.4 1488200 344.92 29-12-14 375.5 376.5 367.2 370.7 2000300 348.97 26-12-14 371.6 371.6 371.6 371.6 0 349.82 25-12-14 371.6 371.6 371.6 371.6 0 349.82 24-12-14 367.4 374.4 367.4 371.6 411400 349.82 23-12-14 373.2 375.1 369.7 371.4 2868500 349.63 22-12-14 373.8 375.3 370.3 371.3 1990700 349.53 19-12-14 364.1 375.1 363.9 372.6 4643900 350.76 18-12-14 355.5 363.7 354.2 363.5 6158700 342.19 17-12-14 348.3 352.4 344.07 350 8198300 329.48 16-12-14 350.4 351.99 345.95 351.9 10842700 331.27 15-12-14 354.1 361.1 349.8 349.8 6550700 329.29 12-12-14 364.8 366.8 355.1 355.1 5437800 334.28 11-12-14 370.5 371.9 365.1 367.3 6106600 345.77 10-12-14 372.6 374.3 369.74 372.1 4209600 350.29 09-12-14 379.6 381.4 371.52 371.9 9503800 350.1 08-12-14 380 382.9 378.4 381.8 4583000 359.42 05-12-14 379.5 382.3 377.65 380.5 8527000 358.19 04-12-14 380.3 383.4 376 376 7681300 353.96 03-12-14 373.8 382.4 372.32 379.3 10158700 357.06 02-12-14 367.8 386.5 363.2 375.1 26483400 353.11 01-12-14 367 372.49 360.5 366.2 5465000 344.73 28-11-14 366.2 370.07 365.49 369.2 6906800 347.56 27-11-14 367.8 369.4 366.5 367.2 3331300 345.67 26-11-14 368 368.8 366 367.2 6157900 345.67 25-11-14 367.8 370.7 366 367.7 12377500 346.14 24-11-14 367 376.3 361.76 368.2 28544300 346.61 21-11-14 344.1 350.6 343.9 347.7 7021800 327.32 Adapted from Yahoo Finance Appendix 2 Data on Aviva Prices between November 21 2014 and February 2015 Date Open High Low Close Volume Adj Close 13-02-15 540 543.31 539 541 5330400 504.18 12-02-15 532 541.5 530.01 540 6200200 503.25 11-02-15 539 539.5 530.5 532 4606900 495.79 10-02-15 534 539.5 531.67 538 5452500 501.39 09-02-15 535.5 536 529.5 532 5023300 495.79 06-02-15 530.5 539.61 527.5 537 7445000 500.45 05-02-15 525.5 529.5 523.8 529.5 6285200 493.46 04-02-15 534 534 523.5 528 9725400 492.07 03-02-15 529.5 536.5 527.05 533 10522100 496.73 02-02-15 531.5 531.5 522.5 529 13400900 493 30-01-15 536.5 538.5 527 528 7267100 492.07 29-01-15 528.5 536.11 526.5 536 9834800 499.52 28-01-15 537 537 524.5 531.5 11835300 495.33 27-01-15 541.5 541.5 529 532 18190500 495.79 26-01-15 534 546.61 532 540.5 8324800 503.72 23-01-15 540 548 533.5 536.5 10876100 499.99 22-01-15 529.5 539 525.5 538.5 9887700 501.85 21-01-15 519 529 516 529 11495200 493 20-01-15 513.5 517.15 509.5 517 16422800 481.82 19-01-15 509 512.5 489.12 511 7609200 476.22 16-01-15 503.5 507.5 491.1 506.5 14216300 472.03 15-01-15 494 507 488.9 507 18807600 472.5 14-01-15 487 494.7 486.1 491.4 12186800 457.96 13-01-15 481.7 491.6 479.84 490.8 12456400 457.4 12-01-15 492 495.5 481 484.1 9823800 451.15 09-01-15 480.4 496.6 479.7 490.4 16814300 457.03 08-01-15 468 485.2 465.4 483.2 14593200 450.32 07-01-15 465.8 468.9 462.35 463.3 10824300 431.77 06-01-15 471.1 473.58 464 464 10188800 432.42 05-01-15 482.6 485.6 469.8 470.8 7352000 438.76 02-01-15 488.6 489.1 482.5 484.4 5047100 451.43 01-01-15 484.5 484.5 484.5 484.5 0 451.53 31-12-14 485.7 488.24 482.27 484.5 1224900 451.53 30-12-14 489.2 492 483.6 485.6 3338100 452.55 29-12-14 496.8 497.14 487.2 492.8 3915100 459.26 26-12-14 494.8 494.8 494.8 494.8 0 461.13 25-12-14 494.8 494.8 494.8 494.8 0 461.13 24-12-14 488 497.59 488 494.8 1035900 461.13 23-12-14 494.6 499.07 491.44 493.1 3363200 459.54 22-12-14 495.5 497.2 491 492.3 4283300 458.8 19-12-14 485.5 498.7 483.89 495 21473000 461.31 18-12-14 474.1 482.1 471.1 480.6 11945400 447.89 17-12-14 466 469.3 461.6 467.9 9512300 436.06 16-12-14 464.6 470.1 458.2 470.1 15135200 438.11 15-12-14 483.8 483.8 463.9 463.9 13929800 432.33 12-12-14 481.9 485.3 467.4 468 10590500 436.15 11-12-14 490 493 485 487.1 10681200 453.95 10-12-14 493.9 496.53 491.5 493.5 9666800 459.91 09-12-14 503 504 491.5 492.6 14474600 459.08 08-12-14 506 509.52 504.5 507 12940000 472.5 05-12-14 503 506.5 502.5 506 13424600 471.56 04-12-14 506.5 511 501 501 11643800 466.9 03-12-14 498.2 509.5 498.2 505 21588500 470.63 02-12-14 508 515.9 496.7 500 20585500 465.97 01-12-14 505.5 507.18 497.9 499.4 8011100 465.41 28-11-14 506.5 511 506.35 508 6252600 473.43 27-11-14 506.5 510.4 505 508 5918800 473.43 26-11-14 506 510.03 506 507 14635700 472.5 25-11-14 513.5 515 507.5 508 21080800 473.43 24-11-14 522 524 508.5 510 24275600 475.29 21-11-14 533.5 540 533 539 5975700 502.32 Adapted from Yahoo Finance Appendix 3 Table showing the volume of Friends Life shares Volume 11,203,536 Avg Vol (3m): 5,488,430 Read More