EFFICIENT CAPITAL MARKETS AND CAPITAL STRUCTURE The CEO of Angelina Corporation, Sara Brown is meeting with the company’
Posted: Wed Mar 30, 2022 3:45 pm
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:
No debt
Proposed
Proposed
Proposed
Proposed
(Original structure $000)
restructuring 1
restructuring 2
restructuring 3
restructuring 4
Debt
0
500,000
400,000
300,000
200,000
Equity
1,000,000
650,000
850,000
800,000
830,000
Firm value
1,000,000
1,150,000
1,250,000
1,100,000
1,030,000
Percentage of debt
0
43.48
32.00
27.27
19.42
Percentage of equity
100
56.52
68.00
72.73
80.58
Return to shareholders after restructuring
4.80%
10.10%
13.60%
6.10%
5.12%
Weighted average cost of capital (WACC)
15.80
9.50
9.30
10.20
14.50
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?
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:
No debt
Proposed
Proposed
Proposed
Proposed
(Original structure $000)
restructuring 1
restructuring 2
restructuring 3
restructuring 4
Debt
0
500,000
400,000
300,000
200,000
Equity
1,000,000
650,000
850,000
800,000
830,000
Firm value
1,000,000
1,150,000
1,250,000
1,100,000
1,030,000
Percentage of debt
0
43.48
32.00
27.27
19.42
Percentage of equity
100
56.52
68.00
72.73
80.58
Return to shareholders after restructuring
4.80%
10.10%
13.60%
6.10%
5.12%
Weighted average cost of capital (WACC)
15.80
9.50
9.30
10.20
14.50
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?