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Chapter13: Corporate Financing Decisions and Efficient Capital Markets

Questions and Problems

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    CONCEPT 1 – 8
  1. Financing Decisions and Firm Value  What rule should a firm follow when making financing decisions? How can firms create valuable financing opportunities?

  2. Efficient Capital Markets  What are the three conditions under which markets may be efficient? Describe these in detail, and provide a practical example illustrating each condition in practice.

  3. Efficient Market Hypothesis  Explain what is meant by the efficient market hypothesis. Define the three forms of market efficiency, and explain why a characteristic of an efficient market is that investments in that market have zero NPVs.

  4. Efficient Market Hypothesis: The Evidence  A stock market analyst is able to identify mispriced equities by comparing the average price for the last 10 days with the average price for the last 60 days. If this is true, what do you know about the market?

  5. Behavioural Finance  In recent years a new interpretation of market behaviour has emerged. Explain this theory, and review what it says about Shleifer’s three conditions of market efficiency.

  6. Empirical Challenges to Market Efficiency  Discuss some of the anomalies to market efficiency that have been detected in academic research. Taken together, do these anomalies provide concrete evidence that the market is inefficient? Why or why not? Explain.

  7. Efficient Market Theory versus Behavioural Finance  Compare and contrast both theories. In your opinion, which is the most reflective of market behaviour? Explain.

  8. Implications for Corporate Finance  What do efficient market theory and behavioural finance imply for corporate decision-making? Provide three examples of how each theory may affect managerial behaviour.

    REGULAR 9 – 27
  9. Efficient Market Hypothesis  Which of the following statements are true about the efficient market hypothesis?

    1. It implies perfect forecasting ability.

    2. It implies that prices reflect all available information.

    3. It implies an irrational market.

    4. It implies that prices do not fluctuate.

    5. It results from keen competition among investors.

  10. Efficient Market Hypothesis  What are the implications of the efficient market hypo-thesis for investors who buy and sell shares in an attempt to ‘beat the market’?

  11. Efficient Market Hypothesis  Several celebrated investors have recorded huge returns on their investments over the past three decades. Does the success of these particular investors invalidate the EMH? Explain.

  12. Technical Analysis  What would a technical analyst say about market efficiency?

  13. Investor Sentiment  A technical analysis tool that is sometimes used to predict market movements is an investor sentiment index. Sentix, a German firm, publishes several investor sentiment indices. In the following table you will find the sentiment indices as at 8 September 2008, just prior to the weeks in which Lehman Brothers and Washington Mutual went bankrupt; HBOS was sold to Lloyds TSB; and AIG, Fortis Group and Bradford & Bingley were nationalized. The figures in parentheses are the previous month’s sentiment index values.

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    What is the investor sentiment index intended to capture? How might it be useful in technical analysis?

  14. Efficient Markets  A hundred years ago or so, companies did not compile annual reports. Even if you owned equity in a particular company, you were unlikely to be allowed to see the balance sheet or income statement for the company. Assuming the market is semi-strong form efficient, what does this say about market efficiency then compared with now?

  15. Efficient Market Hypothesis  Aerotech, a Chinese aerospace technology research firm, announced this morning that it has hired the world’s most knowledgeable and prolific space researchers. Before today, Aerotech’s equity had been selling for RMB100. Assume that no other information is received over the next week, and the Chinese stock market as a whole does not move.

    1. What do you expect will happen to Aerotech’s share price?

    2. Consider the following scenarios:

      1. The share price jumps to RMB118 on the day of the announcement. In subsequent days it floats up to RMB123, then falls back to RMB116.

      2. The share price jumps to RMB116 and remains at that level.

      3. The share price gradually climbs to RMB116 over the next week.

      Which scenario(s) indicate market efficiency? Which do not? Why?

  16. Efficient Market Hypothesis  When the 56-year-old founder of the Turkish firm Gulf Oil and Minerals died of a heart attack, the share price immediately jumped from 18.00 lira a share to 20.25 lira, a 12.5 per cent increase. This is evidence of market inefficiency, because an efficient stock market would have anticipated his death and adjusted the price beforehand. Assume that no other information is received, and the stock market as a whole does not move. Is this statement about market efficiency true or false? Explain.

  17. Efficient Market Hypothesis  Newtech GmbH is going to adopt a new chip-testing device that can greatly improve its production efficiency. Do you think the lead engineer can profit from purchasing the firm’s shares before the news release on the device? After reading the announcement in Speigel, should you be able to earn an abnormal return from purchasing the equity if the market is efficient?

  18. Efficient Market Hypothesis  In 2005 all companies in the European Union adopted IFRS (International Financial Reporting Standards). TransTrust NV changed how it accounts for inventory. Taxes are unaffected, although the resulting earnings report released once IFRS had been adopted is 20 per cent higher than what it would have been under the old accounting system. There is no other surprise in the earnings report, and the change in the accounting treatment was publicly announced. If the market is efficient, will the share price be higher when the market learns that the reported earnings are higher?

  19. Efficient Market Hypothesis  The Durkin Investing Agency has been the best stock picker in the country for the past two years. Before this rise to fame occurred, the Durkin newsletter had 200 subscribers. Those subscribers beat the market consistently, earning substantially higher returns after adjustment for risk and transaction costs. Subscriptions have skyrocketed to 10,000. Now, when the Durkin Investing Agency recommends an equity, the price instantly rises several points. The subscribers currently earn only a normal return when they buy recommended shares, because the price rises before anybody can act on the information. Briefly explain this phenomenon. Is Durkin’s ability to pick winners consistent with market efficiency?

  20. Efficient Market Hypothesis  Your broker commented that well-managed firms are better investments than poorly managed firms. As evidence your broker cited a recent study examining 100 small manufacturing firms that eight years earlier had been listed in an industry magazine as the best-managed small manufacturers in the country. In the ensuing eight years the 100 firms listed have not earned more than the normal market return. Your broker continued to say that if the firms were well managed, they should have produced better-than-average returns. If the market is efficient, do you agree with your broker?

  21. Efficient Market Hypothesis  A famous economist just announced in the Financial Times his findings that the recession is over and the economy is again entering an expansion. Assume market efficiency. Can you profit from investing in the stock market after you read this announcement?

  22. Efficient Market Hypothesis  Suppose the market is semi-strong form efficient. Can you expect to earn excess returns if you make trades based on

    1. Your broker’s information about record earnings for a company?

    2. Rumours about a merger of a firm?

    3. Yesterday’s announcement of a successful new product test?

  23. Efficient Market Hypothesis  Imagine that a particular macroeconomic variable that influ-ences your firm’s net earnings is positively serially correlated. Assume market efficiency. Would you expect price changes in your shares to be serially correlated? Why or why not?

  24. Efficient Market Hypothesis  The efficient market hypothesis implies that all mutual funds should obtain the same expected risk-adjusted returns. Therefore, we can simply pick mutual funds at random. Is this statement true or false? Explain.

  25. Efficient Market Hypothesis  Assume that markets are efficient. During a trading day, British Golf plc announces that it has lost a contract for a large golfing project that, prior to the news, it was widely believed to have secured. If the market is efficient, how should the share price react to this information if no additional information is released?

  26. Efficient Market Hypothesis  Prospectors plc is a publicly traded gold prospecting company with operations in Northern Tanzania. Although the firm’s searches for gold usually fail, the prospectors occasionally find a rich vein of ore. What pattern would you expect to observe for Prospectors’ cumulative abnormal returns if the market is efficient?

  27. Evidence on Market Efficiency  Some people argue that the efficient market hypothesis cannot explain the 1987 market crash or the high price-to-earnings ratio of European shares in 2005 and 2006. What alternative hypothesis is currently used for these two phenomena?

    CHALLENGE 28 – 31
  28. Cumulative Abnormal Returns  Iberia Airlines, Air France-KLM and Lufthansa announced purchases of planes on 18 July (18/7), 12 February (12/2) and 7 October (7/10), respectively. Given the following information, calculate the cumulative abnormal return (CAR) for these equities as a group. Graph the result and provide an explanation. All of the stocks have a beta of 1, and no other announcements are made.

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  29. Cumulative Abnormal Returns  The following diagram shows the cumulative abnormal returns (CAR) for 386 oil exploration companies announcing oil discoveries between 1950 and 1980. Month 0 in the diagram is the announcement month. Assume that no other information is received and the equity market as a whole does not move. Is the diagram consistent with market efficiency? Why or why not?

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  30. Cumulative Abnormal Returns  The following figures present the results of four cumulative abnormal returns (CAR) studies. Indicate whether the results of each study support, reject, or are inconclusive about the semi-strong form of the efficient market hypothesis. In each figure time 0 is the date of an event.

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  31. Cumulative Abnormal Returns  A study analysed the behaviour of the equity prices of firms that had lost monopoly cases. Included in the diagram are all firms that lost the initial court decision, even if the decision was later overturned on appeal. The event at time 0 is the initial, pre-appeal court decision. Assume no other information was released, aside from that disclosed in the initial trial. The stock prices all have a beta of 1. Is the diagram consistent with market efficiency? Why or why not?

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