L5 FINANCIAL MANAGEMENT

EQUITY (1): FINANCIAL MARKETS AND MARKET EFFICIENCY

Question 1.

Internal Finance: retained earnings are the most commonly referred to and most
commonly used source of internal finance. Retained earnings in its purest sense is
surplus cash (not profit) that is not needed to meet day to day commitments and
therefore is available for discretionary investment purposes. The difference between
profit, earnings and cash is paramount. It is important to remember that a company
can only invest surplus cash which may not be the same as 'earnings' in the financial
statements. Cash is also unlikely to equate to the amount of retained profit and the
any reserves.

Efficiency savings are often overlooked as a source of internal finance. By

permanently reducing cash outflow a company can free up cash for discretionary
investment purposes. There are 2 ways this can be achieved:

 a company can become more cost efficient (i.e. spending less to generate the
same or more revenue) which will increase profit and ultimately should increase
cash.
 a company can manage their working capital more efficiently. Working capital is
the combination of current assets and current liabilities that a company operates
with on a day to day basis. By minimising the amount of non-cash current assets
(e.g. stock and debtors) and maximising the cash holding period for liabilities
(e.g. not paying suppliers early) the resulting cash that is freed up can be used
for investment.

External Finance: equity refers to company shares and in the main we are talking
about ordinary shares here. A share issue is relevant if management want to sell a
stake in the company in order to raise funds. Ordinary shareholders own the
company and accordingly have a say about how it is run. This power is exercised
through their voting right. Equity share issues are expensive (especially if a stock
market listing is involved) and are usually only relevant for raising large sums of
money.

Debt can be either borrowing (i.e. from a bank or other lending institution) or
marketable debt such as bonds. Borrowing tends to be a common source of funding
for companies of all sizes but certainly for smaller companies who may not have the
profile, credit rating or trading history to make a bond launch successful. Borrowing
is more appropriate for smaller amounts of money as the lender takes the default risk
for any non-payment although larger loans can often be syndicated across multiple
lenders. Traded debt such as bonds tends to be used for larger sums and in that
respect has similar cost constraints as an equity issue.

Leasing is similar to borrowing in that if a company enters into a leasing agreement

it has contractual lease payment liabilities which are like to loan repayments and are
just as binding. Whilst a loan may be secured on a specific asset or classes of asset
(e.g. land and buildings) a lease will nearly always be secured on the asset that is
being leased. This means if the lease payments are not met the asset will be
recalled from the lessee (the user) by the lessor (the lender).

1
LECTURE 2
 L5 FINANCIAL MANAGEMENT
EQUITY (1): FINANCIAL MARKETS AND MARKET EFFICIENCY

Internal vs External factors: the decision whether companies use internal or

external financing is multifaceted. Firstly, internal sources can only be used if
there are any available! and then it has to be enough. Internal sources of finance
are often used by companies first as they are viewed as cheaper and usually that
is correct. However, we must recognise that if a company has shareholders then
any surplus money in the company is owned by the shareholders and that money
must generate returns at least equivalent to the cost of equity (i.e. shareholders
required rate of return) or it would be better returned to shareholders through
dividends. External finance will be used when internal sources are exhausted and
then the type of finance used will depend on some of the factors outlined above, I
particular:

 the amount of money needed

 whether the company can pursue anyone to lend to it
 the individual cost of the different sources of finance
 the length of time the money is needed for.
 how much trading history the company has
 whether the company has existing shareholders

Question 2.
A perfect capital market is said to exhibit the following characteristics:

 No taxes or transaction costs

 Free entry and exit
 Many buyers and sellers
 Participants are utility maximisers
 Information is costless and freely available

Clearly no market can be said to fully exhibit all of those characteristics indeed some
freely functioning markets would struggle to exhibit any! However, investors do not
need markets to be perfect in order to be suitable for investment, they need them to
be efficient and to properly and fairly reflect prices.

An efficient market is said to exhibit the following characteristics which in some

cases are subtly but importantly different to a perfect market:

 Low transaction costs and taxes

 Information widely available at low cost
 Good liquidity (volume) with no investor able to dominate the market
 Ease of access to the market either directly or through 3rd parties (e.g. brokers)

Question 3.
Technical analysis is the study of historic chart patterns to predict future movements
in the price of a security. Technical analysis is based on the concept that prices
trend, have support levels (prices at which demand (buying) is created which causes
price rises) and resistance levels (prices at which supply (selling) is created which
causes price falls). There is a significant element of behavioural finance in Technical
analysis.

2
LECTURE 2
 L5 FINANCIAL MANAGEMENT
EQUITY (1): FINANCIAL MARKETS AND MARKET EFFICIENCY

Fundamental analysis is the study of company, security or market fundamentals to

determine whether a particular security is properly priced in the market. From an
equity point of view this means the study of company performance and financial
standing compared to that of its competitors. Fundamental analysts will consider a
company's position to its standing in the market and decide whether the company is
set to grow or decline. From this point a decision can be made whether to buy (go
long) or sell (go short) the company's share.

Question 4.
The three forms of market efficiency are as follows:

(1) Weak form efficiency - Definition: Security prices reflects past information only.
Implication: Making abnormal returns using trading rules based on study of past
share price movements is not possible.

(2) Semi-strong form efficiency - Definition: Security prices reflect past information
and all publicly available information. Implication: It is not possible to make abnormal
returns through studying company accounts, etc.

(3) Strong form efficiency - Definition: Security prices reflect all available information,
publicly available or not. Implication: It is not possible to make any abnormal returns

Question 5.

(1) Empirical Evidence:

 Random walk hypothesis
 Serial correlation tests and run tests
 Filter tests

For full explanations see Watson and Head pp.43-4.

(2) Empirical Evidence:

 Stock splits
 Anticipation of annual reports and mergers.

For full explanations see Watson and Head pp.44.

Question 6.
(1) Calendar effects: research has identified a number of short- and long-term
calendar-based influences on security prices. More accurately, studies suggest there
are periods of the week, month and year where there is more likely to be buying
pressure or selling pressure, thereby causing price increases or declines. Common
examples are:

 Monday morning effects

 Friday afternoon effects
 Month or year-end effects
 The end of tax year effect

3
LECTURE 2
 L5 FINANCIAL MANAGEMENT
EQUITY (1): FINANCIAL MARKETS AND MARKET EFFICIENCY

(2) Size anomalies: research has shown that on average, returns from investing in
smaller companies outstrip those from investing in larger companies. Indeed, there
are many investment funds that specialise entirely in investing in small capitalisation
companies. The reasons for this are unclear but could be due to smaller companies
being on a steeper part of the growth curve than larger companies and therefore
generating a higher relative return. It is also likely in some way to be related to the
higher risk of investing in smaller companies. Management of these companies will
be aware that their shareholders will require a higher return than that required from a
larger more stable company and should set their company strategy accordingly to
satisfy the shareholders.

(3) Value effects: research has shown that it may be possible to earn greater returns
from shares classed a value stocks. Value stocks are shares who price to earnings
(PE) ratio is low. A low PE ratio can be a signal that a share is undervalued relative
to the company performance, although a low PE ratio can also mean that investor
sentiment in this company is poor and that a performance decline is expected.

Question 7.

(a) Weak-form Efficient Market

Day 1 Value of Stimac’s shares: £3

Value of Hoult’s shares: £6

Day 2 Information is private, therefore no change.

Day 5 Information is current, therefore no change.

Day 10 Savings is current, but Day 5 information is now reflected in the share
prices.

Value of Stimac’s shares: £5

Value of Hoult’s shares: £5.25*
£m

Previous value 48
Value of acquisition 9
57
Less purchase price 15
42
Price per share = £42m / 8m = £5.25

(b) Semi-strong Efficient Market

Day 1 As above

Day 2 Information is private, therefore no change.

4
LECTURE 2
 L5 FINANCIAL MANAGEMENT
EQUITY (1): FINANCIAL MARKETS AND MARKET EFFICIENCY

Day 5 Offer information is current, therefore is reflected in the share

prices:

Value of Stimac’s shares: £5.00

Value of Hoult’s shares: £5.25

Day 10 Savings are now public information:

Value of Stimac’s shares: £5.00

Value of Hoult’s shares: £6.25**

**( £42m + £8m ) / 8m = £6.25 per share

(c) Strong Form Efficient Market

Day 2 All information, private or currently available is reflected in the

share prices from day 2:

Value of Stimac’s shares: £5.00

Value of Hoult’s shares: £6.25

Days 5&10 As above

5
LECTURE 2
 L5 FINANCIAL MANAGEMENT
EQUITY (1): FINANCIAL MARKETS AND MARKET EFFICIENCY

Phase Test Preparation

Q1. D Historic revenue

This is the only factor that is not relevant as it is in the past and will not affect a
company’s future financing decision.

Q2. A Study information about companies in detail in order to determine

whether their share price is under or over-priced
This is the only accurate description of what fundamental analysis is

Q3. E Share prices appear to move in a random fashion as new information

arises
This is an accurate description of what weak-form market efficiency is. B implies
markets aren’t even weak form efficient. A and C both imply semi-strong form
efficiency. D implies strong form efficiency.

Q4. A Historic and current publicly available information

This is the information that is reflected in share price in a semi-strong form market.

Q5. B Share prices fully and fairly reflect only publicly available information
This is the only statement of the five that is consistent with semi-strong form
efficiency. Statement A implies no degree of market efficiency. C implies weak form
efficiency is present, as does statement D. Statement E is consistent with strong
form efficiency.

Q6. B Insider dealing is not possible if a capital market is semi-strong from

efficient
This is the only incorrect statement. If markets are semi-strong form efficient this
implies that share prices move quickly and accurately to reflect information as it
becomes available. Hence using fundamental analysis will bring no abnormal gains.

6
LECTURE 2