EFFICIENT CAPITAL MARKETS AND CAPITAL STRUCTURE
The CFO of Baldwin Corporation, Gregg Williams is meeting with the company’s board of directors to discuss the possible effect of the company’s capital budgeting project on the stock price. Gregg believes that when the NPV of $159,624 is released in conjunction with existing information on the company, the stock price will increase by $0.15 given that the company has 1,000,000 shares outstanding. Gregg believes that all investors are rational and will make investment decisions after analyzing all available information. Gregg’s belief is consistent with the theory of efficient capital markets, which he studied at the graduate school.
The theory of efficient capital markets holds that stock prices reflect all available information. Gregg gave the implications of the theory as follows:
- 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.
- Prices of stocks will only change if new information becomes available.
- There are many market participants such that no one participant controls the market
- Firms should expect to receive fair value for securities that they sell. Fair means that the price they receive from selling securities is the present value of cashflows that the asset is expected to generate. Thus, valuable financing opportunities that arise from fooling investors does not exist in efficient markets.
A board member, Jon Milosvoski has drawn Gregg’s attention to three forms of market efficiency namely weak form efficiency, semi-strong efficiency, and strong form efficiency. Mr. Milosvoski explains that under each form, different types of information are assumed to reflect in stock prices.
Another board member, David Jefferson, says that new research studies are emerging in behavioral finance that question the rationality of investors. Mr. Jefferson 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 house-money effect.
The meeting was postponed to next week when the board will meet to finish the discussion on the efficient markets and consider capital structure of Baldwin Inc.
The board chairman wants you to address the following questions before the next meeting.
1. 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.
2. An individual investor, Ms. Jones wants to invest in Baldwin Inc. 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. Jones earn above-average returns using this material public information?
3. Ms. Jones is consulting with her financial advisor, Robert Carl. Robert believes that stock prices move in trends. He also believes that new information does not quickly get to all investors and that it takes time to analyze and act on the new information. He tells Ms. Jones that if investors take time to analyze the information and react, and possibly overreact to it, prices may always deviate from fair market values. Does Robert Carl believe in market efficiency? Explain why.
4. Determine whether the following statements by Gregg are correct or incorrect about efficient market hypothesis:
a. it implies perfect forecasting ability (correct or incorrect)
b. it implies that prices reflect all available information (correct or incorrect)
c. it implies an irrational market (correct or incorrect)
d. it implies prices do not change (correct or incorrect)
e. it results from keen competition among investors (correct or incorrect)
f. investors can reap abnormal profit consistently (correct or incorrect)
5. Explain how behavioral biases of overconfidence, regret, representativeness, and familiarity can affect investment behavior of investors of Baldwin Inc.
6. Given the board meeting next week on capital structure of the company, what are some of the agenda to be discussed at the meeting?
7. Baldwin Inc. wants to determine the optimal capital structure that will maximize the value of the company. Various capital structures have been analyzed as follows:
See attachment for data
What optimal capital structure do you recommend for Baldwin Inc. and why?