Formation of Corporate Finance - Essay Example

Order 177542; Topic: Corporate Finance Introduction: This paper seeks to respond to two ments by discussing their implication to corporate finance theory and practice. Question and Answers: Question 1: ‘When new technology is announced by a company director, the company’s share price will change accordingly. The share price will move up when favourable information is announced, and down with unfavorable information’. Discuss this statement. Answer to Question 1: The announce of new technology a company director is assumed to have an effect on the company’s share price, in that favourable information will make share prices of a corporation to move up while an unfavorable information will cause the reverse. The answer to the question is closely related and connected with the concept of whether Efficient Market Hypothesis is valid or not. Bergen (2004) noted about the important debate among stock market investors is whether the market is efficient. Market efficiency here means that all the information are made available to market participants at any given time. Hence the announcement of new technology by the company director in the above case as to the influence on stock prices has almost become immaterial. The efficient market hypothesis (EMH) theory forwards the idea that all stocks are perfectly priced according to their inherent investment properties, and that the knowledge for decision making are made available to all market participants possess equally. Ball, Ray (1995) made mentioned of deficiencies of the theory in citing the work made by Eugene Fama in the 1970’s which may give sense of truth to the statement of the company director above. What are the criticisms to the EMH theory? One argument against the theory is on its assumption as in the case of believing that that all investors perceive all available information in precisely the same manner. This could he hard to be believed because there are many methods for analyzing and valuing stocks and these may in a sense pose some problems for the validity of the model. If one person may see undervalued market opportunities, it is equally possible to have another person on the basis of growth potential. In other words, the availability of information may still means different things for difference people. Thus under the case, two investors may come to arrive at a different assessment of the stock’s estimated fair market value. Will this reality therefore not create variability in the result? (Bergen, J. 2004). If this argument is sustained it must also sustained that with or without the EMH theory, the differences in investor’s perception and attitude will still be there. Another criticism of the efficient market hypothesis is that, it implies that there is no single investor that will be ever able to get greater profitability than another with the same amount of invested funds. In other words, there is an assumed equal possession of information means that should make the investors necessarily achieve identical returns. One who would go deeply may forward a good counter argument for this criticism. How would one now explain the different rates earned and attained by the entire universe of investors, investment funds and so forth? To argue that no investor had any clear advantage over another, it would also be arguing that nobody will have more losses than the others. Such simply could not be sustained in reality. (Bergen, J. 2004). Another problem with the theory is under the efficient market hypothesis, there is also the implication that no single investor should ever be able to have a bigger profit than the market, or the annual returns that all investors may on the average by the use of the latter of their best efforts. Ball, Ray (1995) appears to offer one of the best evidence to contradict the assumption of the EMH where he mentioned Warren Buffett who was able to beat the averages year after year. How would the statement then be resolve? Is there a basis still to use the model? As seen from the exceptions, it would seem therefore logical to accept condition where theory should not be made applicable. An announcement of new technology by a company director and the expected effect of the company’s share price may still be relied still then in situations where the EMH apply. But it would be easier to have a general rule using the EHM as model with qualifications as to exceptions before venturing the believing the any announcement by the director would cause the desired effects that favourable information increases prices unfavorable information do the opposite. To balance the efficient market theory, Bergen, J. (2004) cited that Eugene Fama never imagined that his efficient market would be 100 per cent efficient all the time. Realizing that it is impossible for the market to achieve full efficiency all the time, as it takes time for stock prices to react to new information released into the investment community, the author still argues the model, does not give a strict definition of how much time prices need to revert to fair value. To allow for randomness, it is therefore now case of whether an allowance for random occurrences or environmental eventualities could be factored in the model. If this randomness that management may believe to be really applicable and that it could perceived as something really great and new to the rest of the investing the community as when the announcement of the new technology was really new in global sense, then there is reason to go for randomness, hence there is good reason to invoke in applicability of the model. One argument that would make the proponent of the model is present level of computer and communication technology where information could really be made available to wide array of decision makers. Would one not believe that there could be increasing market efficiency in the use of computers. Bergen, J. (2004). Cited the case of the rise of computerized systems to analyze stock investments, trades and corporations. The author sees the realities where investments are becoming increasingly automated on the basis of strict mathematical or fundamental analytical methods, so that given the right power and speed; some computers can immediately process any and all available information, and even translate such analysis into an immediate trade execution (Bergen, J. 2004). On this point it is not hard to agree with the author but again one would find the counter argument that there are still information that may not be properly processed and conveyed by the computers. Moreover, the analysis that may be have by the increasing use of computers may not be the same as the decision-making that is still the controlling factor and is done by human beings, Now one could but find also the great possibility of human error. Thus Bergen, J. (2004) observed that even at an institutional level, the use of analytical machines is anything but universal and that while the success of stock market investing is based mostly on the skill of individual or institutional investors, the author pointed out that people will continually search for the surefire method of achieving greater returns than the market averages. Bergen, J. (2004) therefore concluded that it safe to say the market is not going to achieve perfect efficiency anytime soon. He declared that for greater efficiency to occur, the following criteria must be met: (1) universal access to high-speed and advanced systems of pricing analysis, (2) a universally accepted analysis system of pricing stocks, (3) an absolute absence of human emotion in investment decision-making, (4) the willingness of all investors to accept that their returns or losses will be exactly identical to all other market participants. It is hard to imagine even one of these criteria of market efficiency being met. (Bergen, J. 2004). • Explain the imperfections/limitations There are imperfections/ limitations of the theory. Ball, Ray (1995), mentioned the case of empirical anomalies to include price overreactions, where he was showed evidence that prices of individual stocks overreact to information and undergo corrections, thus the author saw opportunities to ‘contrarian’ trading strategies by creating opportunities for profit. Another anomaly, found on research is price under-reactions to earnings, where he found a lending support or earnings momentum strategies. Seasonal patters where researches have found evidence variability patterns which could be hours, daily or monthly (Ball, 1995). • Conclusion The director making the announce of the new technology has all the reason to expect higher prices of stocks if the person is convinced that the efficient market theory will not apply, There is ground to invoke the conditions for the applications of the theory such as the universal access to high-speed and advanced systems of pricing analysis, a universally accepted analysis system of pricing stocks, an absolute absence of human emotion in investment decision-making, the willingness of all investors to accept that their returns or losses will be exactly identical to all other market participants. It is hard to imagine even one of these criteria of market efficiency being met (Bergen, J. 2004). Absent the above condition the director should not in give much credit to new technology as creating new values for the company. Question 2: ‘Discussion of dividend policy is a waste of time because dividend policy has no effect on shareholders wealth’. Discuss this statement. The statement implies that management need not adopt any dividend policy because it has connection with the purpose of effecting increase on stockholders’ wealth. It also the gives the meaning that dividends will not increase the wealth of the stockholders. The implication generates much meaning since an independent observer might ask: “Are not dividends the fruit of investments of stockholders of the corporations and the therefore that should make the stockholders richer. • Explain why dividends are different than wealth Dividends may be given periodically to stockholders but it does not be necessarily makes the stockholder richer because using the dividends for the corporation could make the stockholder wealthier if there are lost opportunity cost if higher when the declaration to given dividends was made. Dividends are not wealth because they just represent a part of the earnings that are distributed by wealth connotes permanency which includes both the earnings and the capitalization or the equity. • Explain how dividends derive, for example: profits can be allocated to the following options: dividends repurchase stocks and reinvestments Dividends are derived from accumulated earnings of the corporation hence they cannot come from the investment of the stockholders unless the corporation is under liquidation. The retained earnings are however may allocated to dividends, repurchase of stocks and reinvestments. Dividends may the take the form of stock and non-stock dividends. Non stock dividends may take the form of cash and property dividends which are actually given to the stockholders. In stock dividends however, the stockholders only received a proportionate increase in their stockholdings but the assets of the corporation were not decreased. In other words, the decrease in retained earnings was transferred to capital stock; hence what happened was recapitalization of earnings or increase capitalization of the corporation which may be used for expansion and other business program. What happens therefore in stock dividends is reinvestment the earnings the corporation to more investment opportunities of the corporation for better wealth opportunities of the stockholders. • Describe the types of dividends Dividends may be in form of stock and non-stock dividends. As stated stock dividends may take the form of cash and property dividends which are actually given to the stockholders and therefore increase their personal assets but decreases those of the corporation. On the other hand, notice that in stock dividends, there is no distribution of assets to the stockholders as the latter only received a proportionate increase in their stockholdings. As to taxability the non stock are taxable while the latter are not taxable. • Define the Modigliani-Miller II Theory and its assumptions The Modigliani-Miller theorem is believed to be the basis for contemporary thinking on capital structure. The theorem argues that, in the absence of given factors particularly of taxes, bankruptcy costs, and asymmetric information under an efficient market, the firm’s stock value is unmoved by how that firm is financed. (Van Horne, 1992). There is therefore no difference if the firms capital is financed by issuing stock or selling debt which in effect the concept of firm’s dividend policy as non-issue for the company, thus there is basis to what the other author’s statement that the Modigliani-Miller theorem is a capital structure irrelevance principle. The theorem was reported to be originally confirmed or demonstrated under the assumption of no taxes and at present writers consider it to be made up of two propositions which can now be extended to a situation where taxes are given factors for decision making. To apply the concept one must need to consider two firms to be indistinguishable except for their financial structures. With the first firm to be unlevered (U), that is, it should be solely financed by equity while the other is levered (L) is levered is financed partly by equity, and partly by debt. The theorem states that the value of the two firms is the indistinguishable whether one borrows or not. Under the first proposition: this paper assigns VU the value of an unlevered firm to be equivalent to the price of buying a firm composed only of equity, and VL is the value of a levered firm to be equal to the price of buying a firm financed by a mix of debt and equity. This could be understood by supposing an investor is considering buying one of the two firms U or L. Instead of purchasing the shares of the levered firm L, the investor could purchase the shares of firm U and borrow the same amount of money X that company L present has. Under the theorem the final returns to either of these investments would not differ thus, it could be argued that the price of L must be the same as the price of U minus the money borrowed X, which can be observed to the same value of company Ls liability. The analysis now points out obviously the role of some of the principles, assumptions, and that includes the investor’s cost of borrowing money. Note that cost of barrowing and expect profit was implicitly assumed to be the same. Many finance people would agree with this assumption as this need not be necessarily true if asymmetric information is present or if efficient markets theory is not working. One would also find that there a difference between borrowing and declaring merely dividends, since the first is tax deductible while the second is not. The second proposition posits that as financial leverage as expressed in Debt to Equity ratio increases, the (weighted average cost of capital) WACC remains constant. It states that the cost of equity has a direct relation with the firms debt to equity ratio, this it argues that a higher debt-to-equity ratio will produce a higher required return on equity, or the higher risk involved for equity-holders in a company with debt the higher will be the return from investments. With the formula being derived from the theory of WACC, it has the following assumptions: There no taxes that exist, there are no transaction costs exist, and that individuals and corporations borrow at the same cost of money. (Modigliani and Miller, 1958) • What happens if assumptions are not valid? If the assumptions are not valid, the following will happen, the model is not applicable and therefore there is such a thing as capital structure which requires a certain level of debt in relation to equity in order to ensure the risk level that is acceptable by the company. • What happens in practice? As to what happens in practice, it could be argued that companies are mindful of their debt to equity ratios in relation to the industry. Creditors of the firms require certain level of debt to equity. • Conclusion This paper has demonstrated that there is perfect market theory which requires the operation of certain conditions that may not be easily disregarded. There is basis no complete basis to disregard the statement implying that management need not adopt any dividend policy because it has no connection with the purpose of effecting increase on stockholders’ wealth. If the theorem is not applicable that is assumptions are not true then dividend policy is important It is logical however to say that that dividends will not increase the wealth of the stockholders as the two are different. The question that “Are not dividends the fruit of investments of stockholders of the corporations and the therefore that should make the stockholders richer?” is therefore explained by the difference of the concepts. Reference: 1. Bergen, J. (2004) Working Through The Efficient Market Hypothesis, {www document} URL http://www.investopedia.com/articles/basics/04/022004.asp 2. Ball, Ray (1995), "The Theory of Stock Market Efficiency: Accomplishments and Limitations." Journal of Corporate Finance. 3. Fama, E F., (May, 1970) "Efficient Capital Markets: a Review of Theory and Empirical Work." Journal of Finance 4. F. Modigliani and M. Miller, (June 1958)"The Cost of Capital, Corporation Finance and the Theory of Investment," American Economic Review 5. Van Horne (1992) Financial Management and Policy, Prentice Hall, International, Inc, US Read More