EFFICIENT CAPITAL MARKETS AND CAPITAL STRUCTURE
The CEO of Angelina Corporation, Sara Brown is meeting with the company’s board of directors to discuss efficient capital markets and behavioral challenges and their impact on the company’s stock. She explains that if capital markets are efficient, management cannot create value by fooling investors, and market value of stock reflects underlying intrinsic value. She added that stock prices reflect available information. Investors are rational and will analyze the available information and adjust their estimates of stock price in a rational way. Sara gave the following statements about the efficient market hypothesis:
Statement 1: Because information is reflected in prices immediately, investors should expect to obtain a normal rate of return. Information reflects so quickly in stock prices that no investor can gain competitive advantage over other investors.
Statement 2: Stock prices reflect underlying value.
Statement 3: Prices of stocks will only change if new information becomes available.
Statement 4: Managers cannot boost stock prices through creative accounting.
Statement 5: All shares of stock have the same expected returns.
A board member, David Goldreich has drawn Sara’s attention to three forms of market efficiency namely weak-form efficiency, semi-strong efficiency, and strong-form efficiency. Mr. Goldreich explains that under each form, different types of information are assumed to reflect in stock prices.
Another board member, Michael Burton, says that new research studies are emerging in behavioral finance that question the rationality of investors. Mr. Burton explains that investors do not act rationally all the time in the investment decision making process so the market cannot be efficient. The results of the studies indicate that investors are prone to heuristics-driven biases such as overconfidence, decision regret, familiarity, conservatism, representativeness, and confirmation bias. The meeting was postponed to next week when the board will meet to finish the discussion on the efficient markets and consider the capital structure of Angelina corporation.
The board chairman wants you to address the following questions before the next meeting.
1. Determine whether the following statements by Sara Brown about efficient market hypothesis are correct or incorrect:
a. Statement 1
b. Statement 2
c. Statement 3
d. Statement 4
e. Statement 5
2. What different types of information are assumed to reflect in the company’s stock price? Explain the different types of information under each form of market efficiency as stated by Mr. Goldreich.
3. An individual investor, Ms. Brenda Biswa wants to invest in Angelina corporation. She has gathered data on the company from the current issue of the company’s annual financial report, newspapers, and press release of the capital investment project. Assuming the market is semi-strong efficient, can Ms. Biswa earn above-average returns using this material public information? Explain.
4. Ms. Brenda Biswa is consulting with her financial advisor, Paul Marsh. Paul believes that new information does not quickly get to all investors and that it takes time to analyze and act on new information. He tells Ms. Biswa that investors are not rational, deviations from rationality are similar across investors, and arbitrage, although costly, cannot eliminate inefficiencies. Does Paul Marsh believe in market efficiency? Explain why.
5. Explain how behavioral biases of overconfidence, regret, representativeness, and familiarity can affect investment behavior of investors of Angelina Corporation.
6. The board is meeting to discuss its capital structure. Explain the basic goal of financial management with regard to capital structure to the board of Angelina Corporation.
7. Angelina Corporation wants to determine the optimal capital structure that will maximize the value of the company by restructuring its finances. The original capital structure has no debt with a firm value of $1,000,000 (in millions) and the four possibilities under the new capital structure are presented below:
(Original structure $000)
Percentage of debt
Percentage of equity
Return to shareholders after restructuring
Weighted average cost of capital (WACC)
Base only on the information in the table, should Angelina Corporation restructure the firm? Explain. If yes, which proposed capital structure do you recommend for Angelina Corporation and why?
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