Transcript Capital Markets, Market Efficiency and Financial Performance

2BUS0197 – Financial Management
Capital Markets and
The Efficient Market
Hypothesis
Lecture 4
Francesca Gagliardi
Learning outcomes
By the end of this session students should appreciate:

The range of business finance sources

The significance of capital markets for a company

The efficient market hypothesis and the forms of
market efficiency

The implications of the efficient market hypothesis
also in light of the available empirical evidence
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Sources of business finance

Internal finance
 Retained earnings – cash generated by a company
 Efficiency savings – created by more efficient
management of working capital

External finance
 Equity – issue of ordinary shares
 Debt – raised through loans
Note: External finance also classified according to time
horizon (short-, medium-, long-term)

An efficient financing policy aims to raise the appropriate
level of funds, at the time they are needed, at the lowest
possible cost
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Balance between internal and external
finance

The decision on the relative usage of internal and
external finance will depend on:
1.
Level of finance required – small investments may be
financed through retained earning, larger projects likely
to require external funds
2.
Cash flow from existing operations – the higher this
is, the more internal sources can be raised
3.
Opportunity cost of retained earnings – the required
return on equity (cost of equity) is greater than the
required return on debt (cost of debt)
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Balance between internal and external
finance
4.
Cost of external finance – the issue costs and the
commitment to pay interest debt associated with raising
external finance can be avoided by using retained
earnings
5.
Availability of external financing sources – range of
sources available depends on firms’ characteristics
(e.g. non-listed firms constrained on the amount of
equity finance that can be raised; high geared firms
perceived as risky, hence credit constrained)
6.
Dividend policy – the higher the amount of distributed
dividends, the more reliant on external financing
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Capital markets and firm financing

Capital markets are organisational frameworks within which longterm financial securities are traded

Companies needing long-term finance can meet investors who have
finance to offer

The finance traded may be:

Equity finance, hence issue of new ordinary shares

Debt finance, companies choose from loans and debt securities

Investors can buy and sell both company and government securities

The financial assets traded on capital markets include: ordinary
shares; debentures; loan stocks; bonds; preference shares;
eurobonds; treasury bills etc.
6
Primary and secondary capital
markets

Primary markets: for new issues of equity and debt.
Companies can raise long-term funds from financial
institutions and investors

Secondary markets: for dealing in existing securities.
Investors can sell assets or buy new ones

The secondary market is also a source of pricing
information for the primary market

Hence, the secondary market helps to increase the
efficiency with which the primary market allocates new
funds to their best use
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UK capital markets

The London Stock Exchange (LSE) is the main
market for the equity and bonds

Smaller companies unable to seek a listing on the
LSE can apply for a listing on the Alternative
Investment Market (AIM)
 AIM
operated by the LSE since 1995
 Market capitalisations between £2m and £100m
8
Making trading decisions in capital
markets

Investors base their decision making on the
information provided by:
 Companies’
 Financial
financial statements
analysis
 Companies’
dividend announcements
 Market
expectations of future macroeconomic
conditions (i.e. inflation, interest rates)
 Companies’
investment decisions
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Capital market efficiency

Both companies and investors want capital
markets to assign fair prices to the securities
being traded. In other words, efficiency of capital
markets is required
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Efficient markets’ characteristics

Operational efficiency: transaction costs should be
as low as possible and trading should occur quickly

Pricing efficiency: prices of capital market
securities fully and fairly reflect all information
concerning past events and all events that the
market expects to occur in the future

Allocative efficiency: funds allocated to the most
efficient/profitable companies
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Efficient market hypothesis (EMH)

Concerned with establishing the prices of capital
market securities

States that the prices of securities fully and fairly
reflect all relevant available information (Fama,
1970)

Market efficiency refers to both the speed and the
quality of the price adjustment to new information

Testing of hypothesis led to recognition of three
forms of market efficiency
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Weak form efficiency

Capital markets are weak form efficient if current
share prices reflect past information only

It is not possible to make abnormal profits in such
markets by using technical analysis to study past
share price movements

Strong supporting empirical evidence: share prices
follow a random walk (e.g. Kendall, 1953; Fama,
1965; Megginson, 1997)
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Semi-strong form efficiency

Capital markets are semi-strong form efficient if
current share prices:
 Reflect
all historical information
 Reflect
all publicly available information
 React
quickly and accurately to incorporate any new
information as it becomes available

It is not possible to make abnormal returns through
studying publicly available company accounts

The empirical evidence supports this proposition
(Fama et al, 1977; Franks et al, 1977)
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Strong form efficiency

Capital markets are strong form efficient if share
prices reflect full information, publicly available or
not

No one can make abnormal returns from share
dealing

However, capital markets do not meet all the
conditions for strong form efficiency since some
investors do make abnormal profits by insider
dealing
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Implications of efficient market hypothesis
If the stock market is efficient…

Paying for investment research is not profitable

No point in studying financial statements

No bargains on the stock market

Managers just need to focus on making the best
investment decisions, since the market will interpret
them correctly and the share price will adjust accordingly

Manipulation of accounts will not mislead the market

Timing of new issues of shares is not critical since
shares are never underpriced
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Does the EMH hold?

Research suggests that most stock markets respond
quickly and accurately to new information, and that
only through insider dealing can investors make
abnormal gains

Capital markets seem to be semi-strong form
efficient
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Anomalies in share price behaviour

Although share prices tend to respond quickly and accurately
to new information, research has shown some anomalies in
the behaviour of share prices

Calendar effects – trading at particular times of the day/year can
lead to positive or negative results

Size anomalies – returns from investing in smaller companies
greater in the long-run than the average return from all
companies. Possible reasons: compensation for higher risk,
better growth prospects due to starting lower base

Value effects – above average returns from investing in value
stocks, i.e. shares with high earnings, cash flows or tangible
assets relative to current share price
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Behavioural finance

Alternative view to the EMH

Seeks to understand the market implications of the
psychological factors underlying investor decisions
and offers

Starting point: investors do not appear in practice to
be consistently able to make decisions maximising
their own wealth

Suggests that irrational investor behaviour can have
significant and long-lasting effects on share price
movements (e.g. Shleifer, 2000)
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Summary
Today we looked at:

Sources of business finance

Why capital markets are important for companies

The efficient market hypothesis and its implications

Empirical evidence on the validity of the efficient
market hypothesis
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Readings
Textbook

Watson D. and Head A., (2009), Corporate Finance Principles
and Practice, 5th edition, FT Prentice Hall, Chapter 2,
sections 2.1, 2.2, 2.3
Research papers

Fama, E. (1998), Market Efficiency, Long-term Returns and
Behavioural Finance, Journal of Financial Economics, 49, pp.
283-306

Akintoye, I. R. (2008), Efficient Market Hypothesis and
Behavioural Finance: A Review of the Literature, European
Journal of Social Sciences, 7 (2), pp. 7-17
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Your tutorial activities for next week
During the seminar you will be expected to work on:


Q2, 3 p.66 (5th ed)
Q2, 3 p.64 (4th ed)
To prepare for the seminar you should answer the following
practice questions:


Q3, 7 p.63; Q1 p.64 (5th ed)
Q3, 7 p.61; Q1 p.62 (4th ed)
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