STOCK MARKET EFFICIENCY Short Notes Prepared by Hayford Kumah

OBJECTIVES 1. Concept of efficiency 2. Importance of market efficiency 3. Three levels of efficiency 4. Implication of market efficiency for investors and companies

Efficiency In an efficient capital market, security prices rationally reflect available information The Efficient Market Hypothesis implies that, if new information is revealed about a firm, it will be incorporated into the share price rapidly and rationally, with respect to the direction of the share price movement and the size of that movement.

Importance of Market Efficiency To encourage share buying To give correct signals to company managers (appreciation in prices) To help allocate resources

Three Levels of Efficiency Weak form: prices reflect past price information Semi-strong form: prices reflect relevant publicly available information (past and present like dividend announcements, right issues, technological breakthroughs, resignations etc) Strong form: prices reflect all information including those privately held (information available to insiders)
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Implications of EMH for Investors Investors will be well informed and can make own decisions instead of paying premium to fund managers for their expert knowledge to act on their behalf Companies will be pressured to provide adequate and timely information for investor consumption Insiders will not have undue advantage

Implications of EMH for Companies Usage of creative accounting to boost profits will be discovered by investors Share issues will not be delayed to when prices are favorable (current price is the correct price) Large issues will not depress the market price Signals from price movement inform management about investor perception of their stewardship role

Corporate Finance - Introduction OBJECTIVES Overview of corporate finance Objectives of the firm Ownership and control Role of financial manager Financial intermediation Focus of indicative content

Overview Investment decisions (project appraisal) Risk and return 1. Risk and project appraisal
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2. Portfolio theory 3. Capital asset pricing models Sources of finance 1. Stock markets 2. Long and short term debt finance 3. Treasury and working capital management Corporate value 1. Capital structure 2. Valuing shares 3. Dividend policy 4. Mergers Managing risk 1. Derivatives 2. Exchange rate risk

Introduction Objectives of the business Ownership and control Role of financial manager Role of financial institutions and markets

Objectives of the firm Target market share Maximizing profits Maximizing long term shareholder wealth Minimizing employee agitation Creating an ever-expanding empire
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Discuss other objectives

Ownership and control Challenges posed by separating ownership and control Managing dysfunctional effects of the separation 1. Link managerial rewards to shareholder wealth improvement 2. Sackings 3. Selling shares and takeover threat 4. Corporate governance 5. Information flow

Role of financial manager Interaction with financial markets Investment Treasury management Risk management Strategy formulation and implementation

Financial intermediation Concept of financial intermediation Participants 1. Brokers 2. Financial institutions Activities involved 1. Risk transformation 2. Maturity transformation 3. Volume transformation
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Intermediaries Economies of Scale Efficiency in gathering information about participants Risk spreading Transaction costs

Financial Markets Primary market Secondary markets

Institutions in Financial System The banking sector 1. Retail banks 2. Wholesale banks 3. International banks 4. Building societies 5. Other finance houses Long term Savings institutions 1. Pension funds 2. Insurance funds Risk Spreaders 1. Unit trusts 2. Mutual funds

The Markets Bond markets Forex markets

 Share markets Derivative markets

Indicative Content of Course

managers.
Investment Appraisal Dividend Policy Capital Structure Decision Alternative financing methods Company valuation methods Merger and Acquisition Financial distress

THANK YOU

CAPITAL INVESTMENT APPRAISAL

OBJECTIVES Understand the relationship of long and short-term decision making Know the importance of the time value of money Use the traditional techniques of ARR and Payback Understand the principles of Discounted Cash flow Calculate NPV and IRR Long-run & Short-run Decision Making Similarities 1. Choice between alternatives 2. Consideration of future costs and revenue
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3. Importance of incremental and relevant costs and revenue Differences 1. Requirement for investment decision 2. Time scale and quantum of money needed 3. Treatment of uncertainty and inflation

Decision to Invest Confidence in the future Alternatives available Investors attitude to risk (risk v return)

Accounting Rate of Return This is the ratio of average profits (after depreciation) to the capital invested Profits may be before or after tax Capital invested may be initial capital invested or the average capital invested over the life of the project

Advantages and Disadvantages Advantage 1. Simple Disadvantage 1. Ignores the timings of cash flows 2. Accounting profit used may be subjective (different conventions used) 3. No universally accepted method of calculating ARR Payback This is the time required for the cash inflows from a capital investment project to equal the cash outflows Decision rule:
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Accept the project with the shortest payback period Advantages

1. Simple to understand and calculate 2. More objective because it uses cash flows rather than profits 3. Favors quick return projects which may produce faster growth and enhance liquidity 4. Minimizes time related risks because projects with faster payback are selected
Disadvantages May not consider cash flows after payback period. It is a rough measure of liquidity and not overall project worth Provides a crude measure of the timing of cashflows

Discounted Cash Flow (DCF) Measures These use cash flows and make allowance for the time value of money 1. Net Present Value (NPV) 2. Internal Rate of Return (IRR) NPV
1. NPV = Ci

(1+r)i Where Ci = is the cash flow (+ or -) at period i i = is the period number r = is the cost of capital The discount factor 1 (1+r)i NB: DF at time zero is 1 (This is the present time)

Internal Rate of Return (IRR) IRR is the discount rate which gives a zero NPV
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 Cost of capital is the discount rate used in NPV and IRR calculations

Expected Value Used to even out the effects of uncertainty It is the average value of an event which has several possible outcomes. It is the product of the value of each outcome multiplied by its probability

Profitability Index PV of future cash flows Initial investment Decision rule If PI > 1 then accept the project If PI < 1 then reject the project

Post audit of investment decisions Comparison of forecast and actual results for each of the project elements Review forecasting methods used to assess accuracy and appropriateness Review sources of information used for the appraisal Review appraisal and analysis carried out Review unforeseen factors which arose Review the decision process. Was it reasonable based on evidence available