Different Levels of Market Efficiency - Assignment Example

I. The testing of market efficiency has led to the recognition of three different levels or forms of market efficiency. A. Describe the three forms of market efficiency The levels of efficiency depends on the type of information that comes out in order for investors to take advantage and eliminate profit opportunities in the process. These levels of market efficiency includes weak-form efficiency, semi-strong form efficiency and strong form efficiency. Weak-form efficiency is describes the market all the historical information has already been incorporated in the prices of the stocks, all the information contained in the past prices. With semi-strong-form efficiency, the market does not only incorporate the past information in the prices of the stocks, but the prices also include all the publicly available information. This information includes earnings and dividends announcements, rights issues, technological breakthroughs, resignation of directors, and other public disclosure either the firm or the financial press makes. Strong-form efficiency refers to a market that includes all the pertinent information to the stocks, including those that are privately held and not revealed in the form of public disclosure. B. Discuss their respective implications With weak form efficiency, the past price movements are incorporated in the market. In the form of technical analysis, an investor can determine the past performance of the stock in terms of price movements. However, since the past information are already incorporated in the prices, in weak-form efficiency predicting the future based on the past price of the market, and the investor cannot make abnormal returns from the stock by basis of the historical prices alone. This is shown by the random walk in the stock market. With the semistrong-form efficiency, aside from the past movement of prices, all the available information are reflected in the price of the stocks. This is more common in fundamental analysis, where the basis of the stock valuations is the future profitability of the company. All the information available for the public that can impact the future profitability of the company in the eyes of the investor drives the supply and demand for the stocks which determines the prices. The major implication of this is that, the markets semi-strong efficiency would make it hard for an investor to make abnormal rates of returns because the prices have already absorbed the information. However, other incidents in the market can occur like stock market bubbles, and value investing which imply that the market is not fully efficient because there are other things beyond the publicly available information that influences the rationality of the market. With strong-form efficiency, all the available information even those that are not available in public are included in the price of the stock. Going back to the economists definition of an efficient market, which is defined as a market that incorporates almost all the information that should reflect the valuation of the good which is traded, the strong-form efficiency holds when insider knowledge, or information which is privately held is already incorporated in the stocks prices. This reflects the true status of the companys financial standing, which is pertinent to the valuation of its stocks. When an insider trades company shares depending on what it knows, the true valuation of the company as reflected by such information is reflected on the price. The major implication of this is that, even insiders when, this kind of information is already reflected on the price cannot expect to make abnormal returns from the stocks because asymmetry of information is almost nonexistent. II. With reference to the problem in question 1 section A: Explain to the finance director your recommendation with reference to the advantages and disadvantages of the above investment appraisal rules. Explain why your recommendation is justified by an investment appraisal approach that is thought to be superior to other approaches. Four appraisal methods are used to evaluate projects—with the net present value as the strongest of the methods as it incorporates the concept of the time value of money in the analysis, and uses the investors required rate of return as the hurdle rate as basis on what projects will be chosen. Therefore, project A should be chosen as the recommendation. Although project B is better in terms of the payback, discounted payback and IRR approach, NPV as a superior valuation tool, reflects the impact of the project on the companys capital budgeting decisions. The cash flows in project A and B are used along with the discount factor or 10% in order to derive the discounted cash flows for the NPV, IRR and discounted payback analysis. The tables shows that project A has a net present value of 24,588.50, while project B has a net present value of 13, 013.50. Using another method for capital budgeting, project A has a lower internal rate of return at 18% as compared to project Bs 21%. The table also shows that project B has a shorter payback period at 2 years, compared to project Bs 2.86 years. Using the discounted payback, project B still has the shorter payback period of 2.59 years, than project As 3.55 years. The internal rate of return is also a good method, however, it is less favoured than the NPV method because with this method, it is assumed that the returns are reinvested at the rate of the IRR instead of the required rate of return of investors, which is mostly not the case in the real world. The IRR is higher because of the compounding effect on the assumption of reinvestment using it, instead of using the required rate of return. Therefore, it is considered inferior to the net present value method. The weakest among the four methods is the payback period, which measures the length of time before the initial investment is recoup with the annual cash flows, without reference to the concept of time value of money. Because the payback method does not include the concept of the time value of money in its computation, the price of money or the opportunity cost in the form of interest rate is not included. Therefore, from the financial management perspective, it is the weakest form of investment appraisal method. Discounted payback, in contrast to traditional payback, uses discounted cash flows and takes note of the cash flow’s timing and its implications on the time value of money. By using a discount rate that incorporates the additional risk on the investment, the recovery of the initial outlay is measured by the present value of the cash flows in contrast to the undiscounted value which is used by traditional payback method. By bringing back the cash flows to their current value using a discount rate, the discounted payback takes note of the timing of the cash flows and financial implications, but is not enough as it only covers the length of payback of the investment. The table shows that in terms of IRR, payback and discounted payback methods, project B is more advantageous to pursue. The higher rate of return, the shorter payback and discounted payback shows favourable numbers. However, the weaknesses of each of these methods make them inferior to the net present value method. Under the net present value method, project A has a higher value, thus the superior project between the two. Project A is to be chosen as the major recommendation. III. Critically discuss the use of dividend model in share valuations. The logic behind the use of the dividend model in share valuations is in line with the financial concept of time value of money. The value of the stocks which is dependent on the future profitability of the company and ability to create value, is measured by the cash flows to investors. The time value of money states that there is an opportunity cost to holding money in the form of interests when investors place their money in the bank for a risk-free investment. Therefore, the cash flows derived from every investment, both in the present and in the future must be considered. Future cash flows, because of the time value of money, should be discounted in order to assess their net present values. Only with this, can the value of the investment be determined. These cash flows to investors come in the form of dividends. The dividends are then discounted depending on the required rate of return of investors. Because the cash flow that the investors would get from the stocks comes in the form of dividends, how much they expect the stocks to perform, at the least expectable level of return for them would determine the present value of the stocks. Therefore, the dividend growth model is a measure of the net present value of the companys stocks. IV. Explain what is defined as synergy in a merger situation? A. Discuss the source of synergy in mergers and how they might contribute to the increase in value of the combined firm; and, When companies merge and their competitive advantages complement each other, the value they create when they are merged is bigger than the value they hold when they stand alone. This synergy results in the companies ability to utilise the technical know-hows of each other, thus resulting either in higher earning capability due to higher profits, or huge saving potential. These factors contribute to the creation of value due to synergy. Companies usually merge in order to take advantage of the technical know-hows of the other organisation, which the acquirer currently lacks. With the merger, not only the resources are merged, but also the intangibles of the organisation which is represented by goodwill, such as the targets business system, customers, infrastructure that can be valuable to the acquirer. This may come in the form of huge saving potential for the acquirer, or a strategic move to further expand the business. This increase in the earning potential of both organisations drive the prices of the stocks of the company because of the prospect of synergy, thus increasing the shareholder value. Since market value is dependent on a companys earning potential, the impact of mergers to the operations of the two companies, from a fundamental perspective creates value in the form of incorporation of benefits to the prices; with the efficient market theory, it is assumed that investors are rational and incorporate the future benefit of such a move in the form of higher prices in the market. B. Discuss the possible reasons why many mergers and acquisitions cannot achieve their initial expectations. Many M&As fail to achieve their initial expectations because they fail to look at most of the non-financial factors that are also crucial to the future operations of the combined entity. Non-financial factors are also important to the success of a merger.. These include factors such as the role of the target in the larger strategic plan of the acquirer, the alignment of corporate values, and factors like organisational culture and strategies. In order for a merger to be successful, it has to be strategic. Usually, mergers are done in order for a company to grow inorganically, thus resorting into acquiring its competitors to increase its share in the market.. In other instances, competitors merge in order to consolidate their strategic capabilities and thus dominate the market with their effort. Or, if companies merge with other companies that are not their competitors, their usual reason is to take advantage of the strategic capability of the target which is valuable to the acquirer, either to increase revenues or decrease costs, and increase overall earnings. If the merger is strategic, factors in line with the internal systems are the usual issues. For example, how the target fits the perception of the acquirers brand is an important consideration. Also, in order for two companies to work harmoniously, there should not be a clash of values. The two organisations, when merged should be able to create a culture that would consolidate them in order to take advantage of their capabilities. Culture clashes are detrimental to the two organisations and are the usual causes for mergers to fail. Read More