Key Concepts in Finance: Efficient Markets, Agency Problems, and Capital Structure
If the utility of each possible profit expectation is multiplied by the number of ways in which it can occur, and if we then divide the sum of these products by the total number of possible cases, a mean utility (moral expectation) will be obtained, and the profit which corresponds to this utility will equal the value of the risk in question. (p. 24 of 1954 reprint (Samuelson, Probability, Utility, and the Independence Axiom 1952))
Semi-Strong Efficient Markets Tests
Semi-strong form efficiency is an aspect of the Efficient Market Hypothesis (EMH) that assumes that current stock prices adjust rapidly to the release of all new public information.
Efficient Market Hypothesis Explained – The weak form of EMH assumes that the current stock prices reflect all available security market information. It contends that past price and volume data have no relationship to the direction or level of security prices. It concludes that excess returns cannot be achieved using technical analysis.
Agency Problems
The agency problem is a conflict of interest inherent in any relationship where one party is expected to act in another’s best interests. In corporate finance, the agency problem usually refers to a conflict of interest between a company’s management and the company’s stockholders. The manager, acting as the agent for the shareholders, or principals, is supposed to make decisions that will maximize shareholder wealth even though it is in the manager’s best interest to maximize his own wealth.
Internal Rate of Return
The term internal refers to the fact that the calculation excludes external factors, such as the risk-free rate, inflation, the cost of capital, or various financial risks. It is also called the discounted cash flow rate of return (DCFROR).
To calculate IRR using the formula, one would set NPV equal to zero and solve for the discount rate (r), which is the IRR. Because of the nature of the formula, however, IRR cannot be calculated analytically and must instead be calculated either through trial-and-error or using software programmed to calculate IRR.
Optimal Capital Structure
An optimal capital structure is the objectively best mix of debt, preferred stock, and common stock that maximizes a company’s market value while minimizing its cost of capital. In theory, debt financing offers the lowest cost of capital due to its tax deductibility. However, too much debt increases the financial risk to shareholders and the return on equity that they require. Thus, companies have to find the optimal point at which the marginal benefit of debt equals the marginal cost. According to economists Modigliani and Miller, in the absence of taxes, bankruptcy costs, agency costs, and asymmetric information. In an efficient market, the value of a firm is unaffected by its capital structure.
Efficiency: Strong vs. Weak vs. Semi-Strong
The weak form efficiency theory, the most lenient of the bunch, argues that stock prices reflect all current information but also concedes that anomalies may be found by researching companies’ financial statements thoroughly. The semi-strong form efficiency theory goes one step further, promoting the idea that all information in the public domain is used in the calculation of a stock’s current price. That means it is impossible for investors to identify undervalued securities and generate higher returns in the market by utilizing either technical or fundamental analysis. Those who subscribe to this version of the EMH believe that only information that is not readily available to the public can help investors boost their returns to a performance level above that of the general market. The strong form efficiency theory rejects this notion, stating that no information, public or inside information, will benefit an investor because even inside information is reflected in the current stock price.
