Understanding the Conjunction between Economy Efficiency and Equity - Coursework Example

Introduction Shareholders play a prominent role in a quoted company. It is the task f management of a company to put all organisation resources to maximise profits for shareholders who are the real owners of the company they manage. The performance of a corporate organisation has linkages with how solid its equity base is and well-structured corporate governance. Firms that are not guided with well protected guidelines for corporate governance that would lead to efficient performance may obstruct good returns to shareholders. In an unrestricted industry the increase in firms’ performances are positively skewed to their large numbers of shareholders. In a formalised capital society, price is the mechanism for allocation of resources. Hence, efficiency is obtained when this allocation of resources has the greatness proportion of minimising waste and high level of impact. This brings us to the definition of efficiency, which is the proportional level of inputs to outputs. When outputs surpass inputs we say, the activity or function is efficient. The more there is wider gap between the levels of outputs to inputs that indicate how efficiency is measured. Thus, in economy efficiency we can define it to be the level of which economic resources are employed to bring about minimal wastages and high level of output. Hence, economic efficiency comes about when there is adequate allocation of resources to bring about positive change in price that would affect positively on consumer of a particular product to increase their quantity of consumption. According to Dow & Gorton (1997), the equity or stock market has an informally price efficiency in the economy. This structure unlike in the case of economy efficiency, there is no direct pattern for allocation of share capital. In other words, managers of quoted companies have the discretion in controlling the level of their companies’ investment. This set the basis on whether there is a conjunction between economy efficiency and equity. Understanding the conjunction between economy efficiency and equity Investors in quoted companies buy shares with the expectation to accrue dividend at the end of a financial year. Thus, the level of a country’s economy development or positive national economic indices attained have direct impact on how successful a company would operate to maximise enough profit for equity dividends. However, it is argued that efficiency in equity or stock market efficiency does not transmit to mean that there is economic efficiency. Investors in the stock market increase when there is economic efficiency and economic development. The stock prices are seen as indirect guide to investors through the transfer of basic information on those available opportunities for investors in the market, and showcasing those past decisions that managers of quoted companies make which are germane to investors. In this view Dow & Gorton (1997) state that “stock market price does not value marginal investment; it is a secondary market price that vales the entire firm”. The reduction in investment resulting from stock speculation usually goes a long way in aggravating a country’s economy, especially one passing through financial crisis. In the case of Russian economy crisis in 1998, coupled with the Asian crisis in 1996-1997, Investors had nursed the fear that the Russian government would defaults on its debt payment. Thus, with this speculation investment began to drop. Following the argument of Medvedev (2001, pg 7) “International portfolio investors are typically more sensitive to external shocks and less sensitive to pure domestic shocks” it seen that the reverberating effects from the Asian stock crisis had a long impact and created fear on Investors in Russia, following the speculation of default in debt payment. This in no small way intensifies the currency crisis in Russia where, market stock took a plunge and economic recession sets in. Default in debt payment either locally or foreign means that a government is not fulfilling its obligation in implementing the terms of contracts payment either partially performed or fully completed. Here, government contractors’ capitals are tied with government. Hence, the implication is that this leads to low production activities. Thus, there would be increase in the rate of unemployment and little money in circulation pursuing few goods this would certainly lead to increase in the inflationary rate. Hence, it is deduced that during consistent increase in inflation rate currency crisis is bound to take place. This level of economy inefficiency has a direct impact on the price of equity in the stock market. In the diagram below, it is seen how the financial crisis of Russian government in 1998, coupled with government debt defaults led to a great fall in prices of shares in the country’s stock market. Russian Stock Market Chart (1997- 2008) Source: Stockcharts.com Excessive government regulations of stock market during currency crisis, especially for transition economies have a potential for hindering the growth of investment in the country. Thus, liberalization of transition economies capital market is advocated for economy growth and increase in investments from foreign investors. This in no small measure would increase GDP and safeguard it from currency crisis. In this view Henry (2003: 2) argues that liberalizing a country’s capital operations, especially for poor countries, would allow financial resources to flow from those countries with abundant capital. In this case, there would be a balancing of capital where expecting is low from countries with abundance to country with scarce capital where expectation is high. Where a country operates a liberalized capital market the flow of resources helps it reduce the cost of capital, thus, increasing investment and raising output (Fischer, 1998; Summers, 2000, cited in Henry 2003: 2). When a transition economy opens up its market, and its economy, thus liberalizing it to allow free foreign investments, it has being proven to allowing those resources from rich countries to be distributed to developing countries and those under economic transition. This goes on to bridging the inequalities between the rich nations and the not too rich nations. In this view, “ greater openness to external trade will have very different effects on inequality depending on the level of economic development; this will lead to increase in inequality for rich countries and would reduce it in poor ones” ( Wood 1994, cited by Ravallion 2001:19). However, using the data generated by Squire & Zou (1998) (as cited in Ravallion 2001, pg 19) in a survey test carried out across 50 countries, with 100 observations to find out the effect of openness of countries investment environment on inequality Ravallion asserts that no significant effect of exports on the countries GDP. The controls include those on financial sector developments. Schools, urbanization and black-market premium. The study found out that there is a strong negative interaction effect with early GDP for countries with openness of its investment economic sector. Thus, the study suggests, “openness is associated with higher inequality in poor countries” (Ravallion 2001, pg 19, 20). Investors’ wealth and Share prices The prices of shares are a direct pointer to the wealth of investors in the stock market. When prices are high the investors’ wealth in the market would be high. And the reverse is the case when they are falling or low. For instance, the last global economic depression greatly affected many shareholders investment in the stock market, as prices fall drastically. This resulted in lost of huge fund. Many investors were bankrupted as some funded their investment through loans they sourced from banks and other financial institutions. Many investors are yet to recover from the nightmare that came with the fall in prices of shares due to the economic meltdown. In addition, the equity prices in stock market may not be a direct indicator as a pointer to determine a country’s economy efficiency, but it has valuable facts that are fundamental to investment decisions. The information contains in equity prices in stock market are indirectly useful as they portray information on potential investment projects and cash flows. In this view it is seen that the information embedded in stock market has production and monitoring roles (ibid). To calculate the impact of economy on equity dividends or returns to shareholders fund, the economic value added (EVA) invented by Stern Stewart and Co in 1989 is germane here. The calculation for EVA is done where operating profit after taxes are deducted from a dollar cost for the equity capital employed by the firm. Furthermore, the dollar cost of equity capital employed by the firm is equal to the firm’s equity capital – as stated in its balance sheet- multiplied by a percentage return on the required firm’s shareholders on investment. The equation below sums this up: EVA = NOPAT – (EC x % Cost of EC) Where: NOPAT = Net Operating Profit After Taxes, EC = Equity Capital. The interpretation for EVA is that when negative number is produced it indicates that there is diminishing values of returns from the company to its shareholders, while a positive result indicates that the values to shareholders by company is increasing (Fraker 2006). It suffice to say when there is economic boom in a country the level of investment by investors goes up and these empowers consumers to buy, and profitability maximisations of firms increase. Hence, equity returns to investors would be positively affected. Apart from this above calculation to show economy efficiency on equity, the return on assets (ROA) return on equity (ROE) and efficiency ratio are good tools of measurement. The level of demand and supply for a particular share would determine the price of the equity in the quoted stock market. Hence, just like any other goods, when the level of demands for a particular share is on the increase the quoted price for that share will rise, and the reverse is the case when the demand is low. The graph above illustrates the inelastic supply of shares at the short run. The original price is OP. The quantity supplied is represented by M, M1, and M2. Demand increases from D to D1. The Supply of shares for this particular company in the short run is inelastic, for the company can only exceed the authorised share capital in its memorandum of association, at this period. The quantity of shares supply to investors would be the same at the level. Therefore, at this period price of the equity will increase to OP1. However, in the long period, more amendments and authorised shares would have been given to the firm, hence; the volume of shares would increase. Thus, supply at this period will be elastic, and this is represented by the line S1. The long-run price of the shares will then fall to OP2. However, it is germane to note that the price of a company’s share is determined by that the level of performance by the quoted firm, and the level of competition in the industry it operates. Also, economic development, and operating an economic efficiency where there is balance distribution of resources to argument economic growth would usually affect positively the price of shares in the stock market. Conclusion Economy efficiency may not be directly linked to the position of equity prices of a company. Managers’ decisions may impact positively or negatively despite a very good efficient economy regime practiced by government. However, share prices are good indicators that give information to investor and also portray indirectly how efficient a country is. Also, the prices of shares in the stock market portrays the wealth of investors, when they fall like experienced during the last global depression investors wealth crashes. References Dow, J. & Gorton G. (1997) “Stock Market Efficiency and Economic Efficiency: Is There a Connection?” The Journal of Finance, Vol. 52, No. 3 Fraker, T. Gregory (2006) “Using Economic Value added (EVA) to Measure and improve bank Performance” Paper Writing contest RMA, Arizona Henry, Peter B. (2003) “Capital Account Liberalization, The Cost Of Capital, And Economic Growth” National Bureau of Economic Research Working Paper No 9488 Ravallion, Martin (2001) “Growth, Inequality and Poverty: Looking Beyond Averages” Development Research Group, World Bank June. Read More