Q1. Evaluate the assumptions, validity and relevance of the efficient markets hypothesis {EMH} what does the {EMH} imply for individual investors? How is the EMH tested? Is the EMH past its ‘sell by’ date? Should it be abandoned in favor of other market theories; if so, which?
The efficient market hypothesis (EMH) implies and states that individual investors are unable to outperform the market on a consistent basis. The theory contends that security pricing reflects all known information, which is obtained quickly and enables a company’s stock prices to adjust rapidly. (2000 ) Efficient markets are based on the premise that technical and fundamental analysis cannot consistently provide a higher-than-normal rate of return because of transaction costs which implies that the next price change of a randomly moving stock is unrelated to past price behavior. If prices move randomly, then repeating price patterns have no predictive ability. Efficient markets are based on several assumptions includes a large number of competing participants who are analyzing securities, new information arriving in the market in a random way, investors adjusting to new information rapidly not necessarily correctly, just in an unbiased way and expected returns implicitly include risk. (2000)
The EMH is divided into three forms: weak, semi-strong and strong – this process should not be abandoned in replacement of other market theories even though EMH has its weak form, which assumes that stock prices fully reflect all available market information, (1998 ) believes that security returns are independent of each other and correlation between stock prices over time is virtually nothing. ( 1996) This is in direct contrast to technical analysis, which attempts to predict future pricing based upon the study of past pricing and volume patterns. The weak form, which can be explained by the random walk theory states that historical price behavior or technical indicators cannot produce superior returns, and that information utilized by technical analysis has no predictive value. (1970 ) However, the weak form does state that using good research may produce superior returns, which would support the notion that fundamental analysis has some value. The semi-strong states that stock prices fully reflect all public information, including a company’s history and information learned from studying financial statements, the industry and the economic environment. (1998) Therefore, the client cannot expect to achieve superior returns using fundamental analysis. The semi-strong form does not assume that the client can’t achieve superior returns, only that superior returns should not be expected. The strong form holds that stock prices fully reflect all public and private information.
Therefore, not even access to inside information can produce superior returns. Again, this does not assume that the client can’t achieve success only that success should not be expected. In testing EMH, this indicates that if investors in general have success using inside information in one situation, they most likely will fail in other situations. In the end, they are not expected to produce superior results using inside information. (1998) Moreover, clients who accept both the semi-strong and strong forms of the EMH will avoid active managers since superior returns cannot be expected. Market anomalies can conflict with the EMH, because by definition a market anomaly is something that would not be expected to happen if the EMH held true. Market anomalies fall into categories: time series, cross-sectional, Value Line and overreaction. The focus of the test is to determine if there is any public information that produces superior returns in the short and long term. (1998) These tests show that there is minimal success in predicting short-term returns. However, predicting long-term returns can be successful. Studies show that dividend yield, default spread and term structure spread can be used to determine the returns on stocks and bonds. This implies that investors anticipating the purchase of a stock should not purchase it on Friday but rather wait for Monday, whereas investors anticipating the sale of a stock should sell on Friday. This anomaly should be erased if investors’ short-sell on Friday and buy back their positions on Monday. (1998)
Therefore, the return of a firm diminishes as its market capitalization gets bigger. The neglected-firm effect states that a firm which has a small number of analysts following it tends to produce higher returns than those firms covered by many analysts. Finally, stocks with high book-to-price ratios have a higher risk-adjusted return, representing evidence against the EMH. Using the efficient market hypothesis suggests that individual investors are lining up at the starting gate equal. (
1990) In addition, it means that these investors are using all information thrown at them to make their investment decisions from any one of the EMH theories. (1989) Unfortunately, investors enter the starting gate at different levels. Not all your clients will listen to all your suggestions, follow all your data leads and incorporate technical or fundamental analysis into the decision-making process. (1990) Empirical tests almost uniformly support the weak-form EMH and generally reject the strong form, but there is no agreement on the results of the tests used for the semi-strong form. (2001) Time-series and cross-sectional tests give evidence that markets are not always efficient in the semi-strong form, but results from event studies, such as news of stock splits, first-day price adjustments for initial public offerings, exchange listings and announcements of accounting changes seem to support the semi-strong form. (2001) As long as an investor’s average exposure is approximately one month or longer, the average monthly exchange rate better characterizes the asset price than the price on any particular day. (2001)
In addition, monthly average exchange rates are more relevant for testing the efficient market hypothesis (EMH) if price adjustments are not instantaneously efficient–a market may be efficient even if imperfect that is, price adjustments may be efficient on a month-to-month basis, even if not on a day to day basis (1997). Systematic, nonrandom interest rate differentials may introduce systematic bias in the monthly average returns, and any implications for the EMH must be interpreted in this light. Specifically, non-randomness in monthly exchange rates cannot disconfirm the EMH unless interest rate differentials are included in the asset returns. Randomness in monthly series would still tend to support market efficiency. (1998 ) One of the most important ideas in financial economics is the much criticized Efficient Market Hypothesis. This hypothesis lays out a simple definition of market efficiency. According to the hypothesis, a financial market is efficient if asset prices in that market reflect all relevant past information and if those prices absorb all new and relevant information instantaneously. (1998) Thus, academics spent a great time testing the EMH and despite the views of many practitioners, the vast majority of empirical evidence examined by university researchers indicates that the world’s major forex, equity and bond markets are all fairly efficient. (1998 )
However, the EMH does not rule out the existence of inefficiency at all times. Instead, it implies that when inefficiencies do appear that smart investors exploit these inefficiencies. As they do so, perhaps by buying ‘overpriced’ assets and selling ‘under priced’ assets, they make abnormal, risk-adjusted profits. In the absence of barriers to entry, the smell of these profits then attracts other investors and eventually the inefficiency disappears. In a highly competitive and efficient financial market then, we should not expect risk-adjusted, abnormal profits to persist for very long. (2001) But, because capital markets are always changing and creating new financial instruments, even the staunchest believers in the efficiency of financial markets would probably concede that new ‘inefficiencies’ appear on a relatively frequent basis. (2001 ) If this is a good description of the way today’s capital markets evolve, then an investment vehicle packed with very smart, experienced people and that has the strategic flexibility to exploit a wide range of occasional market inefficiencies, might stand a chance of earning abnormal profits on a consistent basis. The efficient market hypothesis (EMH) states simply that it is impossible to consistently outperform the market on a risk-adjusted basis after transaction costs and taxes. It forms the basic benchmark of analysis in financial economics and can be described, less formally, as the old economic adage: ‘There is no such thing as a free lunch.’ (2001 )
The most common form of the Efficient Markets Hypothesis (EMH) states that market prices fully reflect all publicly available information ( 1970). The EMH has been highly influential among academics, but practitioners and regulators appear unconvinced. Investors work hard to identify mis-priced stocks on the basis of public data, or pay others to do so, even though the EMH asserts that such efforts are wasted. Managers seek to boost stock prices by hiding bad news in footnotes, and regulators work hard to defeat such efforts, even though the EMH asserts that information is reflected in prices no matter how obscure its presentation. (1988 ) Beliefs about inefficiency play a central role in the debate over recognizing expenses for incentive stock options. Opponents of expensing argue that the resulting lower net income will inappropriately reduce market prices, while proponents argue the market does not fully recognize compensation costs reported only in footnotes. In efficient markets, however, expensing these costs has no direct effect on prices, as long as the details of the compensation are included in footnotes. (1988) The decision to expense option costs could reduce stock price indirectly, even in efficient markets, by affecting the terms of contracts between the reporting firm and other parties (1986).
However, the EMH is still influential because there is no alternative theory that explains why we observe the inefficiencies we do. For example, why should the market under react to large earnings changes, rather than overreact? Without a theory predicting how and why markets are inefficient, studies showing mispricing can be viewed as statistical flukes resulting from fishing expeditions (1998; 2001). Statistics that are costly to extract from data are not completely revealed by prices precisely because trading on those statistics does not generate profits sufficient to cover the extraction cost. Proponents of efficient markets have long recognized this point, but typically invoke extraction costs only as a last resort, to reinterpret evidence of mispricing to be consistent with rationality (1992). In contrast, the IRH uses these costs as the foundation for specific and testable predictions about the nature and form of inefficiencies and their implications for financial reporting research, practice, and regulation. The following section discusses these implications in detail. Event studies use the EMH to predict that prices rise after good news and fall after bad news, and price-association studies use the EMH to infer investors’ interpretations of data from observed price responses, pioneered by and (1968 ) as the EMH makes no such prediction, because it ignores extraction costs. The link between extraction cost and price reaction also requires changes in the inferences drawn from price movements.
Assume that a firm’s stock price rises by 5 percent in response to a public announcement. Researchers could use the EMH to infer that the announcement suggests a 5 percent increase in value, a 5 percent price reaction is possible only if investors who trade on the statistics included in the announcement perceive more than a 5 percent increase in value, because price changes reflect those perceptions incompletely. (1990) The smaller the trading interest driven by the information, the more it must influence traders’ perceptions to create a 5 percent increase in price. (2001) find that reported earnings numbers are more closely associated with prices than cash flows, sales and other financial statement data. Using the EMH, they infer that investors view earnings information as more relevant than the other data ( 1990). It may seem unlikely that the costs of extracting statistics about earnings surprises are high enough to generate measurable returns. However, prices in noisy rational expectations models react completely to a statistic only if all market participants base their trading strategies on that statistic. While the out-of-pocket costs of collecting earnings statistics may be small, the costs of collecting information include opportunity costs.
The EMH presents a paradoxical view of the demand for financial analysis: perfectly efficient markets reveal information so completely that no one will bother collecting it, but if no one collects it, then the information is not revealed. Market features that reduce extraction costs such as the presence of analysts or an active financial press tend to increase information collection. Variation across investors also yields some interesting predictions. Information held by investors with more capital to put at risk or less risk aversion drives more trading interest; such investors can benefit more from information, and should be more willing to devote resources to analysis. ( 2001) This suggests that information tends to be concentrated in the s of those managing large portfolios. (1990) finds that market prices react to the component of earnings reflecting a previously announced debt-equity swap. Because the gain from the swap was public data when the swap was first announced, the EMH predicts no price reaction to this component of income when total earnings are announced. This reaction to old information can therefore be interpreted as an overreaction. However, another interpretation is that not all investors are aware of the initial swap announcement, causing the market to under react to the information that a component of earnings is old news as the EMH has been successful largely because its simple assumptions account so well for financial market behavior.
Q2. Modigliani-Miller is often accused of ‘over-elaborate theorizing in relation to their work on the Cost of Capital, Company Valuation and Dividend Irrelevance. Review and evaluate this criticism.
Despite the accusations that got as it says that the two have over elaborated their work and theorem, but still the two authors remain tough and successful in times as they integrate that a financial theory stating that the market value of a firm is determined by its earning power and the risk of its underlying assets, and is independent of the way it chooses to finance its investments or distribute dividends. Thus, a firm can choose between three methods of financing: issuing shares, borrowing profits as the theorem gets much more complicated, but the basic idea is that, under certain assumptions, it makes no difference whether a firm finances itself with debt or equity but in defense, Miller explains the concept using the following analogy: “Think of the firm as a gigantic tub of whole milk. The farmer can sell the whole milk as is or he can separate out the cream and sell it at a considerably higher price than the whole milk would bring but, of course, what the farmer would have left would be skim milk with low butterfat content and that would sell for much less than whole milk. That corresponds to the levered equity. The M and M proposition says that if there were no costs of separation and no government dairy-support programs, the cream plus the skim milk would bring the same price as the whole milk.” (1988 )
M & M argue that the firm’s value is determined by the investment policy and that the split between dividends and funds to be reinvested does not affect this value, under the assumptions explained. This argument is also supported by and and brings people to the real world scenario with wrinkles of imperfection in its capital markets, a far cry from the understanding of a perfect capital market and argue that changes in dividend policies from low-to-high payouts, for example, should not have a bearing on the market value of the shares, but rather on the clientele that the firm will attract. (1988) However M & M’s counter-argument to this is that the effects on the prices are attributable to the informational content of dividends with respect to future earnings rather than to the dividend itself. The shift in the clienteles questing to satisfy their preferences is what may cause prices to change. This characteristic allows firms to avoid having to identify the indifference curves of individual shareholders when establishing their investment policies. There is a strong consistency between the M & M views and those of the ‘dividend irrelevance’ proponents and the ‘residual theory’ respectively. (1988 )
The joint role of capital structure and interest rate risk management in relation to an insurer’s financial structure is examined. The presented empirical evidence conforms to the extended propositions of an interior optimum leverage ratio as evidence shows that a market reward is linked to the management of interest rate risk. Insurer equity value initially declines with increased interest rate risk and rises with high exposure to interest rate risk. Thus, the empirical evidence is presented that is consistent with the extended propositions of an interior optimum leverage ratio. This situation is hypothesized to result from the combination of the tax shield associated with leverage and the costs associated with the increased probability of insolvency and financial distress. (1992) Evidence is also presented that a market reward is tied to the management of interest rate risk as the equity value at first declines with increased interest rate risk, but then rises with high exposure to interest rate risk. This fluctuation is interpreted as a general market aversion to risk that is difficult for the individual investor to hedge at low to medium levels of interest rate risk. (1992)
However, high levels of interest rate risk are shown to reward those firms that operate in markets characterized by significant information asymmetries regarding the financial condition of individual firms. The decision to expend scarce resources in the control of interest rate risk is hypothesized to be related to the protection of the insurer’s franchise value, and may indeed be used to signal the existence of this franchise value to outside investors. (1992) Important insights are gained by viewing the insurer as a financial intermediary that issues contingent claims to a set of policyholders and uses the proceeds to purchase a portfolio of assets. Management is charged with investing the insurer’s assets in order to maximize the risk-adjusted return on capital or, alternatively, maximize the value of ownership claims. In offering insurance policies, the insurer effectively levers ownership capital by “borrowing” from the policyholders. (1992) A critical role of equity capital or “insurer surplus” is the creation of a buffer against the possibility that losses exceed the net premiums collected plus the interest and dividends earned between the time of premium receipt and the time of disbursement. The greater the capital, the more certain policyholders are that they will receive compensation for insured losses. Competition in insurance markets requires that premiums are set at levels that both compensate policyholders for the use of their funds and, in order to attract capital, also provide a competitive return to the shareholders as compensation for their role as residual risk bearers.
In addition to laws governing the distribution of assets among the various claimants, the relation between the value of shareholder and policyholder claims against the assets of a property-liability insurer is based on the current value of insurer assets, time to maturity of the aggregate policyholder claim, and the stochastic processes underlying both asset returns and the aggregate policyholder claim. It is often convenient to view the relation between shareholder and policyholder in an option framework. (1992) In competitive markets with full information, policyholder premiums will reflect not only the current distribution of asset returns, but the ability to switch from one distribution to another. Financial theory provides some insights by examining the incentives associated with differing financial structures. The alternative theories regarding the impact of leverage and interest rate risk on economic value are not necessarily contradictory. Rather, they address different factors that simultaneously affect firm value. The question is not the direction of each individual effect, but which effect is expected to dominate. The theories differ largely with respect to the ability of the firm’s various claimholders to recognize financial risk and prevent expropriation of value by shareholders. (1992)
The argument can be made that, in perfect markets, a firm’s choice of financial structure is totally irrelevant. This argument is presented first, not because it is considered more important than the other theories, but because it provides a basis for examining them. ( 1982) The assumption of perfect markets is unrealistic, but the resulting model is useful for pedagogical purposes. Like the capital structure model, the result is not as important as what the result indicates about the underlying assumptions. Given the standard assumptions of complete and frictionless security markets, arbitrage arguments establish that hedging behavior, if costless, has no effect on firm value. Both shareholders and policyholders will be indifferent regarding the degree to which risk is hedged. If costly, hedging behavior will reduce the value of the firm since scarce resources are being expended to eliminate individual or nonsystematic risk that already has been diversified by the individual shareholders. (1993), Security-specific risk is eliminated through diversification. Because markets are complete, policyholders likewise can obtain any desired risk profile through portfolio formation (1985). However, like the original Modigliani-Miller irrelevance arguments, insights into the value of asset-liability management can be gained by turning around the arguments. Firms spend considerable resources in asset allocation decisions. If the selection of a particular level of interest rate risk matters, it is because one or more of the aforementioned assumptions is violated. (1985)
(1984) attempts to explain the existence of a bimodal risk classification within the banking industry, he develops an option model in which the value-maximizing bank chooses either a high-risk or a low-risk strategy while mid-range options are suboptimal. Banks with high franchise value will maximize wealth by reducing the variance of asset values, while marginally solvent or truly insolvent banks that have not been so declared by the regulatory authority will maximize value by increasing portfolio variance. concentrates on increasing credit risk, but his model is equally appropriate to changes in financial risk associated with increasing leverage or increasing interest rate exposure. (1984) reexamine the use of q as a measure of monopoly power and economic rents. They argue that the market valuation of the future economic returns for a firm is “appropriately capitalized by an efficient capital market,” in contrast to the usual measures of profitability, which include distortions imposed by accounting rules and tax laws. However, rather than simply imputing monopolistic power to the firm with q greater than one, they divide total firm value into three components: the present value of the existing capital stock, capitalized rents associated with monopolistic power, and capitalized rents associated with ownership of scarce resources. In their analysis, q provides an upper bound for monopolistic power.
Maintaining higher levels of capital can be interpreted as a signal that the firm has growth opportunities and provides a clear indication that the firm is committed to them in helping to mitigate the problem with underinvestment. Firms in industries with higher growth opportunities may also not want to share the potential gains with bondholders. Likewise, (1993) relate the use of hedging to firms that have more growth opportunities. Again, this may be taken as a signal that management does not want to place the growth opportunities at risk. Just as variants of the Modigliani-Miller theory predict nonlinearities with value first increasing with leverage and then dropping as the probability of incurring some costs of financial distress increases, the alternative theories presented earlier predict a variety of linear and nonlinear changes in value resulting from the firm’s decision to increase volatility by taking on exposure to interest rate risk. (1988) Although several functional forms may be used to model the nonlinearities, we found the squared terms for leverage and duration to capture the essential nonlinear shape and to be statistically significant.
In addition to the obvious managerial implications, our findings have important implications for insurance regulators. One of the primary rationales for the existence of an extensive system of insurance regulation is preventing insolvency and protecting policyholders from loss. Nevertheless, because of their focus on statutory accounting, which allows companies to record assets at book values and liabilities at nominal values, regulators have been unable to measure the level of financial risk at any point in time or to estimate the effect on financial risk when economic conditions change. This does not mean that all companies are in balance sheet equilibrium. (1988) Certain companies are well known to be unhappy with their current levels of gearing and are making strenuous attempts to adjust their balance sheets. But when companies on average feel comfortable with their financial positions, the difficulties faced by certain individual firms need not pose macroeconomic problems: the business of firms in financial distress can be absorbed by others through purchases of their assets, through takeovers, or by competing away the customers of the distressed firms. Similarly profitable investment opportunities passed up by firms struggling to adjust their balance sheets are open to their less indebted competitors. This provides a rationale for examining the aggregate evidence on corporate indebtedness rather than focusing on the experience of individual firms when the purpose of the exercise is to determine the macroeconomic effects of debt. (1982)
A similar point has been made by (1983). In his analysis of the US Great Depression, he observed that ‘most larger corporations entered the decade with sufficient cash and liquid reserves to finance operations and any desired expansion unless it is believed that the outputs of large and of small businesses are not potentially substitutes, the aggregate supply effect must be regarded as not of great quantitative importance.’ This argument is less applicable when whole sectors or regions of the economy are in financial difficulties so that those who might otherwise be interested in absorbing the business of financially distressed firms are themselves under pressure. It is clear that there are certain sectors which are currently in this position. This pattern is consistent with companies in these sectors experiencing financial difficulties, although it is also likely to reflect considerable over-capacity. (1982) The analysis of company financial decisions has been a subject of much controversy since the publication of the (MM) irrelevance propositions in 1958 (1958). They showed that in perfect capital markets, the market valuation of a company and its cost of capital are independent of its capital structure. This implies that a company cannot increase its market valuation by increasing its gearing ratio even though the cost of borrowing might be significantly lower than the perceived cost of equity capital. (1982)
The reason is that when a company increases their gearing ratio it is changing the composition of the income stream it pays out with more being paid out to those who hold its debt and less being paid out to those who hold its equity. But if investors in the market can borrow and lend at the same rate of interest as the company, then they can replicate any change in corporate capital structure by borrowing and lending themselves. (1982) As such, arbitrage considerations dictate that the valuation of the company should be independent of its capital structure. The effect is that the cost of equity capital rises reflecting its greater risk when the company is more highly geared to exactly the amount required for the weighted average cost of debt and equity capital to be unchanged by the change in capital structure. By proving the irrelevance of capital structure in perfect capital markets, MM were able to draw attention to the circumstances where capital structure would be important: ‘showing what doesn’t matter can also show, by implication, what does’ (1988). Anything that means that investors are able to borrow and lend at different rates of interest to the firm falls into the category.
The fact that companies and investors pay different rates of tax on interest income means that in post tax terms it is often cheaper for investors to achieve a particular flow of post tax income by holding the shares of companies with debt than by borrowing on their own account and holding the shares of companies without debt. So, adherents of the view that company real decisions are taken independently of company financial decisions, would expect adjustments to the stock of debt to be brought about by corresponding adjustments to the outstanding stock of equity by changes in dividend payments and net equity issues. (1982)
Q3. In both Traditional and Modern Financial theory, a distinction is made between Equity and Long term Debt as being the two components of ‘ Long Term Capital Employed ‘. This distinction has been criticized as unrealistic. Review and evaluate the criticism.
In the absence of capital gains tax indicates that companies can improve their value by increasing their indebtedness when the effective rate of corporation tax is greater than the income tax rate of individual investors. In effect by borrowing at a low net rate of interest and paying out dividends early they are enabling investors to lend the proceeds at a more favourable rate thereby making a profit. (1997) When capital gains taxes are taken into account the incentives to corporate borrowing are greater because capital gains are reduced by paying out dividends early. Indexation of the capital gains tax base makes corporate borrowing less profitable in inflationary conditions because it reduces the incentive to have a highly geared capital structure to avoid paying tax on the purely inflationary gains on equity. It should be noted that if the tax system is such as to encourage corporate borrowing then increases in nominal interest rates raise the incentive for companies to borrow: larger gains can be made by paying out greater dividends and allowing shareholders to lend the funds at a greater rate. ( 1997)
The gearing relationship shows that companies adjust their indebtedness in response to changes in the incentive to corporate borrowing but it does not indicate how this change is brought about: because of the budget constraint impinging on companies, a change in borrowing implies a change in at least one other expenditure or financing flow. Financial economists study the issue decision to understand more fully why firms choose to issue a particular security and how investors in the financial markets react to that choice. ( 1986) The research documents several results about investor reaction to the announcement of convertible debt security offers. First, price reactions to convertible debt security offer announcements are negative and statistically significant. Second, the average price reaction to convertible debt security offer announcements lays between the average prices reactions to common equity and straight debt security offer announcements. Since existing research has been unsuccessful in identifying factors that explain these announcement period results, there is little definitive empirical evidence that explains either the convertible-debt-issuance decision or investor reactions to the issuance decision. ( 1986) There is an examination of the decision to raise capital using a hybrid security like convertible debt rather than a standard security like straight debt or common equity. Existing research suggests that the choice between straight debt and common equity is partially predictable. ( 1986)
This is important because, even though existing studies have demonstrated a significantly negative stock price reaction to convertible debt offerings (1984; 1986), they fail to document a significant cross-sectional relation between excess returns and firm specific explanatory variables. Recent research suggests that investor reaction to straight debt announcements can be explained by the partial anticipation of the offer (1993; 1996). These two theories make different empirical predictions about issuer motives that are based on the relative levels, and the specific sources, of debt-and equity-related financing costs. According to the risk-shifting hypothesis, issuers would prefer convertible debt issues to straight debt because they face high bondholder/stockholder agency costs. The theory does not identify an explicit source of equity-related financing costs. Therefore, after controlling for investors’ expectations regarding the likelihood that an issuer will offer a debt-like security, the risk-shifting hypothesis predicts that convertible debt issuers will have significantly higher agency costs than straight debt issuers. After controlling for investors’ expectations regarding the likelihood that an issuer will offer an equity-like security, the backdoor-equity hypothesis predicts that convertible debt issuers will have significantly higher adverse selection and financial distress costs than issuers of equity.
(1984) demonstrates that the inclusion of conversion privileges can mitigate the distortionary investment incentives created by risky straight debt. That is, conversion features impose a payoff structure on the equityholders’ residual claim that alters the incentive to overinvest in risky projects. Different designs of the convertible debt contract can control the shape of the equity’s payoff structure, and hence the firm’s investment incentives. Thus, the risk-shifting hypothesis predicts that convertible bonds are a substitute for straight debt and that the substitution of long term capital within equity and debt is most likely to occur in firms facing significant risk incentive problems. Consequently, debt issuers that appear to be similar to straight debt issuers are expected to differ from these firms primarily in their ability to increase the risk of their investment opportunities. Survey evidence reported by (1955), (1966), (1977) suggests that issuers often view debt as a delayed equity offer. In other words, the primary motivation for the issuance of convertible debt is to obtain common equity financing at a better price than the issue date stock market price.
(1992) notes that the sale of straight debt may cause some firms to incur other value-reducing costs and if financial distress is costly, firms that are highly leveraged and have relatively poor future prospects will forgo long-term debt issues. For these firms, significant financial distress costs would outweigh the adverse-selection costs. (1992) also argues that short-term debt issues followed by a common equity issue at maturity would not solve the firm’s financing problem if issuers face a steady-state level of asymmetric information to allow managers to obtain financing immediately through a delayed equity offer. Overall, many factors that influence the debt/equity decision in security choice models retains significance when the firm has access to other financing instruments and that the marginal contribution of some issue, issuer, and macroeconomic variables is sensitive to the exogenous specification of the feasible set of security choices. This evidence is consistent with the interpretation that security choices are partially predictable. (1996) For example, large firms may have greater coverage by equity analysts. Large firms may be more vulnerable to managerial discretion and free cash flow problems, so total assets also may proxy for stockholder/management agency costs (1986; 1990).
The significance of the dividend yield, the leverage variable, and the market-to-book variable confirms the importance of the agency costs of debt in the security choice decision for these firms. The equity-related financing costs indicate that long term capital involving debt offers are issued when future economic conditions are expected to be good. ( 1986) These issuers also tend to float relatively large issues, which confirm investor concerns about adverse selection. The significance of the difference in excess returns is consistent with and (1984) argument that private information by managers makes equity issues unattractive. In addition, since the marginal agency costs of managerial discretion decrease with leverage and the profitability of the firm’s investment opportunities, our results provide no support for the prediction that this particular equity-related cost influences the expected security offer choice decision between straight debt and debt-like convertible debt. Most do not object to the idea that those with greater incomes should pay a progressively higher rate of income tax based on their greater ability to pay. Clearly, in long-term capital gains, tax rate structures have not in fact been streamlined to include fewer brackets and the regressive bubble bracket has not been completely eliminated which can potentially stimulate long-term growth and revitalize real estate activity in a country.
The total composition of debt in the capital structure showed numbers that were higher than those for the utilities that were the obligors on the power purchase agreements. In fact, investors are buying assets to get to those contracts and leveraging them again. Furthermore, these contracts would mitigate the unknown risks. Therefore, the equity capital that will flow against a debt to round out the capital structure will inherently have less risk. ( 1986) Theoretically, this leads in a lower charge on return. That may not be the preferred way of attracting capital to finance infrastructure, but it certainly is a way of bringing low-cost resources and assets into the marketplace. Of course, different investments have required different capital structures, but investors have found bilateral contracts to be much more effective and less risky than investments in merchant generation, which relied on market revenues. ( 1986)
Companies are able to reduce their indebtedness significantly by these changes in expenditure and it’s financing. At the same time their total market value, which in this model is ultimately related to the replacement cost of their stock of capital, is hardly changed. This means that the value of their equity rises by roughly the amount that the value of debt fall as the percentage rise in the value of equity is smaller because equity represents about 80 percent of the balance sheet. So despite the fact that dividends fall throughout most of the simulation, the market value of equity rises to reflect the fact that at the end of the simulation period the equity holders will have a much larger claim on the value of companies. Equity prices do not rise by so much because the claim of each share is reduced as new equity is issued. Nevertheless, accepting that company debt is not now at excessive levels in aggregate, some reasons remain for not dismissing entirely the view that the recession was exacerbated by debt problems in the company sector. First it is likely that part of the expansion in the economy in the late-1980s can be explained by the response of companies to insufficient levels of gearing.
Q4. Along with the EMH, the Capital Asset Pricing Model {CAPM} is often described as one of the ‘ twin pillars’ of Modern Finance Theory. Evaluate the assumptions and Validity of the CAPM. Does it still merit this description?
The capital asset pricing model (CAPM) developed by Sharpe and Lintner was the first to successfully demonstrate a technique for evaluating the risk of the cash flow from a future investment project and for measuring the cost of capital of the project. Since its introduction, it has steadily dominated as the model used by large American companies in their capital budgeting process. Despite the criticisms being hurled against CAPM, data suggest that the model can still be an effective tool for those who prefer to use it. Most large U.S. companies have built into their capital budgeting process a theoretical model that economists are now debating the value of. This is the capital asset pricing model (the CAPM) developed many years ago by (1964) and (1965). This model was apparently successful attempt to show how to assess the risk of the cash flow from a potential investment project and to estimate the project’s cost of capital, the expected rate of return that investors will demand if they are to invest in the project but, recently the empirical tests of the CAPM has supported the use of the model.
The fact that investors did hold these assets implies that investors would demand vastly different rates of return for investing in different projects. To the extent that the assets are claims to cash flows from a variety of real activities, these facts support the view that the cost of capital is very different for different projects. Like for instance, Standard & Poor’s 500-stock price index (the S&P 500) earned an average annual return of 11.9 percent whereas U.S. Treasury bills (T-bills) earned only 3.6 percent. Since the average annual inflation rate was 3.1 percent during this period, the average real return on T-bills was hardly different from zero. S and P stocks, therefore, earned a hefty risk premium of 8.3 percent over the nominally risk-free return on T-bills. The performance of the stocks of small firms was even more impressive; they earned an average annual return of 16.1 percent. To appreciate the economic importance of these differences in annual average, consider how the value of a dollar invested in each of these types of assets in 1926 would have changed over time. (1992)
The CAPM was developed, at least in part, to explain the differences in risk premium across assets. According to the CAPM, these differences are due to differences in the riskiness of the returns on the assets. The model asserts that the correct measure of riskiness is its measure known as beta and that the risk premium per unit of riskiness is the same across all assets. Given the risk-free rate and the beta of an asset, the CAPM predicts the expected risk premium for that asset. In this section, we will derive a version of the CAPM. ( 2000) In the next section, we will examine whether the CAPM is actually consistent with the average return differences. When the CAPM assumptions are satisfied, everyone in the economy will hold all risky assets in the same proportion. Hence, the betas computed with reference to every individual’s portfolio will be the same, and we might as well compute betas using the market portfolio of all assets in the economy. ( 2000) The CAPM predicts that the ratio of the risk premium to the beta of every asset is the same. That is, every investment opportunity provides the same amount of compensation for any given level of risk, when beta is used as the measure of risk. Models like the capital asset pricing model (the CAPM) help corporate managers by providing them with a practical way to learn about how investors judge the riskiness of potential investment opportunities in helping managers use the resources of their firms more efficiently.
In modern industrial economies, managers don’t easily know what the firm’s owners want them to do. Ownership and management are typically quite separate. Managers are hired to act in the interests of owners, who hold stock in the corporation but are otherwise not involved in the business. Owners send some general messages to managers through the stock market. If stockholders do not like what managers are doing, they sell their stocks, and the market value of the firm’s stock drops. The representatives of stockholders on the firm’s board of directors notice this and turn to the managers for corrective action. In this way, therefore, stock prices act like an oversight mechanism. However, stock prices don’t act fast enough. They don’t give managers specific directions ahead of time about which projects to pursue and which to avoid. Managers must make these capital expenditure decisions and then later find out, by the stock market’s reaction, whether or not the firm’s owners approve. Theory suggests one simple rule for corporate managers to follow when making capital expenditure decisions: Maximize the value of the firm. Then, if some stockholders disagree with management decisions, they can sell their stock and be at least as well off as if management had made different decisions.
A key input to that process is the cost to the firm of financing capital expenditures, known more simply as the cost of capital. This is the expected rate of return that investors will require for investing in a specific project or financial asset. The cost of capital typically depends on the particular project and the risk associated with it. To be able to evaluate projects effectively, managers must understand how investors assess that risk and how they determine what risk premium to demand. Providing such an understanding is the focus of most research in the area of asset pricing. An asset pricing model provides a method of assessing the riskiness of cash flows from a project. ( 2000) The model also provides an estimate of the relationship between that riskiness and the cost of capital (or the risk premium for investing in the project). According to the CAPM, the only relevant measure of a project’s risk is a variable unique to this model, known as the project’s beta. In the CAPM, the cost of capital is an exact linear function of the rate on a risk-free project and the beta of the project being evaluated. A manager who has an estimate of the beta of a potential project can use the CAPM to estimate the cost of capital for the project. If the CAPM captures investors’ behavior adequately, then the historical data should reveal a positive linear relation between the average return on financial assets and their betas. (2000)
(1993) think that may not be necessary. Instead they show that the lack of empirical support for the CAPM may be due to the inappropriateness of some assumptions made to facilitate the empirical analysis of the model. Such an analysis must include a measure of the return on the aggregate wealth portfolio of all agents in the economy, and say most CAPM studies do not do that. Most empirical studies of the CAPM assume, instead, that the return on broad stock market indexes, like the NYSE composite index, is a reasonable proxy for the return on the true market portfolio of all assets in the economy. However, in the United States, only one-third of non-governmental tangible assets are owned by the corporate sector, and only one-third of corporate assets are financed by equity. Furthermore, intangible assets, like human capital, are not captured by stock market indexes. and (1993) abandon the assumption that the broad stock market indexes are adequate. Following (1972), they include human capital in their measure of wealth. Since human capital is, of course, not directly observable, and must use a proxy for it. They choose the growth of labor income. When and (1993, forthcoming) also allow for time-varying betas, they show that the CAPM is able to explain 57 percent of the cross-sectional variation in average returns. They show that not all time variations in beta matter – only those that comove with the expected risk premium on the market portfolio.
However, and demonstrate that when the use of a better proxy for the market portfolio results in a two-beta model instead of a one-beta model and when the CAPM holds in a conditional sense (period-by-period with betas and expected returns varying over time), unconditional expected returns will be linear with market beta as well as a measure of beta instability over business cycles. One could therefore argue that the CAPM really implies that more than beta is needed to explain the cross section of expected returns on financial assets. An input to the capital budgeting process is the cost of capital. Financial managers most often use the CAPM to estimate the cost of capital for which they need to know the market risk premium. Textbooks advocate using the historical value for the US equity premium as the market risk premium (2001). The CAPM became the preferred model for determining the cost of capital following the classic studies by and (1972) and and (1973) showing strong empirical support for it as (1972) found that the data are consistent with the predictions of the CAPM.
(1999) shows that for a given cost of capital, a wide range of hurdle rates will result in decisions that are close to the optimal decision based on dynamic programming. In what follows, we extend (1999) and show that a single, high enough hurdle rate will result in near optimal decisions for a wide range of values for the cost of capital. This would explain why a manager may continue to use the same hurdle rate even though the cost of capital has changed by a substantial amount. The investment decision is also fairly insensitive to the volatility parameter that determines the distribution of future investment opportunities one gives up by deciding not to wait and take the project on . The capital budgeting process plays an important role in most corporations. The textbook approach to capital budgeting involves computing the net present value of projects using the cost of capital as the discount rate and choosing the projects that maximize firm value. The predominant approach to estimating the cost of capital is to use the CAPM. The CAPM itself has been challenged in the recent academic literature. In addition, there is disagreement about what is a reasonable value for the market risk premium, a key input to the CAPM. The academic consensus is that the historical average market risk premium may overstate the true market risk premium by as much as a factor of two. This raises the question why managers report in surveys that they use the CAPM and do not complain about its shortcomings (2001).
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