Managing Finance

Introduction, Capital Markets and Market Efficiency

Managing Finance
Denis Scanlan and Chloe Wu Assessment Assignment 50% (2,500 words) Examination 50% (2 hour closed book)

Managing Finance

The role of a corporate financial manager is to: maximise the value of the company.

Corporate Financial Theory

V= f (I,F,D,M)

The value of the company is a function of:

the investment decision (I) the financing decision (F) the dividend (or distribution) decision (D) the management of corporate resources (M)

The decision making process

Key stages

Intelligence (identify the problem) Design (determine possible solutions) Choice (select and implement a solution) Review (review impact of selected solution)

Corporate capitalism = Pursuit of Intelligent Greed

Managing Finance: key topics

Capital Markets and Market Efficiency - EMH Ratio Analysis and working capital management Long term finance Investment appraisal Portfolio Theory and CAPM Capital Structure and debt policy Dividend policy Mergers and Acquisitions Risk management

Financial Markets
A market is a place where the negotiated exchange of assets and liabilities occurs
Characteristics of financial markets

Many buyers and sellers Very liquid Highly volatile Lots of cheap and widely available information

Capital Markets
Capital markets are the places where long term finance links supply and demand Stock Exchanges:

NYSE, LSE, AIM, NASDAQ

Primary market - where new issues of equity and debt are made
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Secondary market - for dealing in securities already in issue.

Types of financial markets

Open outcry markets Buyers and sellers meet face to face
Commodity markets Quote driven systems Buyers and sellers interact remotely

Private markets Inter-bank foreign exchange markets Arrangements for suitable parties

Characteristics of buyers and sellers

Rational Profit driven Well informed Seek a reward for a risk

Characteristics of the marketplace

Functions based on supply and demand For every buyer there is a seller

it is the operations of buyers and sellers constantly seeking bargains that forces markets and prices back to equilibrium

Understanding efficiency

Pricing efficiency Operational efficiency Allocational efficiency

What is market efficiency

In terms of stock markets and capital markets market efficiency generally refers to pricing efficiency

Perfect markets
A perfect market has the following features:

Perfect competition and free information No transaction costs No taxes Infinitely divisible financial assets Bankruptcies are costless

Efficient markets/perfect markets

Remember A perfect market implies an efficient market but an efficient market does not imply a perfect markets

The importance of market efficiency

Promotes investor trust in the market and thus encourages capital investment Promotes allocational efficiency Improves market information and therefore choice of investments

Efficient Market Hypothesis

A security price is an equilibrium price between rational, well informed, profit seeking decision makers.
Buy/sell decisions are based on available information

THE FORMAL HYPOTHESIS ALL AVAILABLE INFORMATION IN THE PUBLIC DOMAIN IS DISCOUNTED INTO THE PRICE OF A FINANCIAL SECURITY

Testing EHM
The hypothesis cannot be proved directly
Fama (1970) suggested 3 levels of efficiency

Weak form efficiency Semi strong form efficiency Strong form efficiency

Weak form efficiency

Prices reflect all historical public information

Prices fully reflect all information contained in past price movements

Weak form efficiency

Tests suggest that prices follow patterns that can be used to predict future prices Studies generally show that prices follow a random walk - prices have no memory

Random Walk

One days price change can not be predicted by looking at a previous days price change. Prices respond to information which is random

Share price Positive Information

Neutral/no new Information

Negative Information

Random Walk

?
Time Today Future

0 Past
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How Share Prices Respond to New Information

Semi strong form efficiency

Prices reflect all public information, past and present Anomalies Timing effects Small firms capitalisation Value investing Investment bubbles

Strong form efficiency

Prices reflect all public and private information, past and present

EMH general conclusions

Markets are generally weak/semi strong form efficiency
Pricing is generally regarded as inefficient Possible reasons

Varying price of risk Incomplete arbitrage Persistent losers

Implications of market efficiency

Financial models can be relied upon to maximise shareholder wealth No point in creative accounting No point in agonising over the timing of funding issues No point in trying to spot under-valuations

Information efficiency

What information affects prices? firm-specific information; macro-economic information; industry-specific information How quickly do prices react to this information? How appropriate is the price adjustment to the information?
Price Price

Price

Efficient Market
Time
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Slow-learning Market
Time

Overreacting Market
Time

Examination of market efficiency

Technical analysis: analysing the price movement patterns

Fundamental analysis: studying the impact of macroeconomic variables, sector factors and corporate operations
Event studies: evaluating the impact of a corporate events on equity returns
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