Chapter 13 Flashcards
What are corporations?
A way of organising people to produce goods and services
3 features of a corporation?
- owners not necessarily managers (executive members are both managers and owners)
- can be closely held (family) or widely (public)
- limited liability (unlike partnerships)
What does limited liability mean?
Investors can only lose what they invest, done to encourage investment
See rest of L1 intro stuff
now
See example at top of CH13 notes
now
Explain the difference between financing and investment decisions?
Investment decisions are simpler (F decisions have lots of different strategies), F decisions are easier
Why are financing decisions easier? (2)
- Less degree of finality (easier to reverse)
- Difficult to make money by F strategies due to higher competitiveness tf not looking for a positive NPV
Explain why markets are considered efficient?
Prices of stocks appear to follow a random walk (ie. successive changes in value are independent) tf odds of going up or down are the same day-day
Why is there no day-day trend in stock markets?
As soon as cycles/trends are recognised by investors, they buy(/sell) until the price is pushed up(/down) tf eliminating the trend, tf stock once again offers normal risk-adjusted rate of return
What would happen if past prices -> prediction of future prices?
->easy profits which can’t happen in a competitive market tf ALL (not just price) info will be reflected in today’s prices, not tomorrow’s tf RW tf market efficiency
What is weak market efficiency and what is its implication?
When prices reflect information contained in record of past prices
Makes it impossible to make consistent SNP (RW)
What is semistrong market efficiency and what is its implication?
Prices reflect not only all info in past prices, but also all other public information
Prices respond immediately to the release of public information (eg. merger proposal)
What is strong market efficiency and what is its implication?
Prices reflect all info regarding analysis of company, economy etc (public +private info)
Will find lucky and unlucky investors but no one who can consistently profit off market
Read iii top of page 1 side 2
shows need to account for market movements
What does figure 13.4 show regarding takeover announcements?
Shows stock price jumps on day of announcement then is normal again
May drift up before if investors are expecting a takeover
Define takeover premium?
The difference between the estimated real value of a a company and the price paid to acquire it
How often according to 13.5 do mutual funds beat the markets?
Roughly 40% of the time
Define risk adjusted return?
Measure of an investment’s return by measuring how much risk is involved
In an efficient market what is it not possible to do? What does this mean for securities?
Not possible to find EXPECTED returns greater (or less) than the risk-adjusted opportunity cost of capital. This means securities trade at their fundamental value, based on future cash flows (C(t)) and opportunity cost of capital (r)
2 pieces of evidence against market efficiency?
1) Earnings announcement puzzle
2) New issue puzzle
Explain what the earnings announcement puzzle is?
Looking at stock performance from 1972-2001, top 10% of firms with best news on earnings only outperform those with the worst news by about 1%/month. This implies the market is ‘slow’ to react and tf takes time for investors to be fully aware of the significance (?)
Explain what the new issue puzzle is?
IPOs often see buyers get an immediate capital gain, however these often don’t hold up in the LR
What is the constant-growth formula used for?
Checking if shares are fairly valued
Shows that a small reduction in growth rate of dividends can lead to a large reduction in the present value of stocks
What are bubbles?
When speculative frenzies from investors -> asset prices reaching levels that cannot be easily explained by the outlook for profits and dividends
2 examples of asset price bubbles?
Japanese bubble
dot.com boom
Check I can briefly explain both of them
Fundamentally, why do stock prices deviate from fundamental values?
People are 100% rational 100% of the time
Why aren’t people are 100% rational 100% of the time? (2 and explained)
1) Attitudes towards risk:
eg. some investors may looks at past losses/gains and allow them to affect their decisions (wrongly)
2) Beliefs about probabilities:
eg. investors may make errors in assessing probability theory such as putting more weight on recent events rather than treating all equally
Define arbitrage?
A strategy that exploits market inefficiency and generates superior returns if and when prices return to fundamental values
Risk of arbitrage?
Prices may diverge even further before converging tf -> firing of those investing in it or value of companies falling to bankruptcy levels
What are the first 3 lessons of market efficiency, explained? (Apply to efficient markets)
1) Markets have no memory
(Weak form hypothesis shows sequence of past prices contains no info on future prices)
2) Trust market prices
(Prices can be trusted since they compound ALL available info)
3) Read the entrails
(Bing able to read bond/stock prices can teach us a lot about the firm) (ie. bonds trading at low prices imply firm is in trouble)
What are the second 3 lessons of market efficiency, explained? (Apply to efficient markets)
4) There are no financial illusions
(Investors are only concerned with the firm’s cash flows and how much they are entitled to)
5) The do-it-yourself alternative
In an efficient market investors will not pay others for what they can do themselves (eg. they aren’t interested in a merger -> a diversified firm if they can just buy the stock of both firms anyway)
6) Seen one stock, seen them all
(Stocks don’t have ‘unique qualities’, they only have fair returns for their risk tf almost perfect subs. (tf almost perfectly elastic demand))
