Q1. Efficient market is one in which stock prices fully reflect the information of a company, either positive or negative. If the information from a company is positive, investor will give a good response and the price of shares of this company will increase. Since the information is reflected in price at once, normal rate of return should only be obtained. Also the price that the firm received from issuing securities is the present value, and valuable financing opportunities are unavailable. There are three conditions that will cause market efficiency, which are the rationality of investors, dependent deviations from rationality and arbitrage.
Three forms are divided by researcher according to the availability of information. The first one is Weak Form. The price in this form were just focused the past stock price. This is the cheapest, easiest strategy to find the pattern in stock price. But the future information is random due to random walk hypothesis therefore it is unable to generate any profit. The Semistrong Form will appear when all information is publicly available, including the historical price information. The price should rise at once when the news release and no chance for profit when the investor analysis the information. The Strong Form appears in which the price reflects all information publicly or privately on market. Secret news or insider’s news is useless for investors to earn profit in this form.
Arbitrage will generates profit from the rationally purchase and sale of similar stocks in market in order to make the profit riskless. The rationally decision is included estimate the business rationally and methodically. So in Weak Form just need to obtain the historical stock information is enough for knowing the different of price. But financial statement, economic and politic situation is needed to consider in order to obtain the arbitrage in Semistrong Form. And some private information like the purchase of resources or amalgamations of firms are needed for understands in order to obtain arbitrage in Strong Form.
Q2. Below are the advantage and disadvantage of different investment rules. Net Present Value is used to calculate the net change in company’s asset with respect to a project after considering the time value of money. So company can base on the result to make the decision, where positive NPV should accept the project. The advantage of NPV is accurate to obtain the best decision since it can fairly rank different projects and classify them by their size and duration. Because NPV consider and apply cash flow and discount rate, difficult to estimate and full of uncertainty of these two elements will be the disadvantage of NPV. Payback period is used to make decision by comparing break-even point that the project can payback within a predetermined cutoff.
The advantage of it is simple and directly analysis. Also, it is useful for short-term project that cash management is the first priority since it payback mainly focus on liquidity of the project. The disadvantage is payback ignore time value of money and the cash flow after cutoff period, so some cost may neglected and cause an inaccurate result. Discounted Payback Period will convert the cash flow as the present value and compare the discounted break-even point that the project can discounted cash flows payback within a predetermined cutoff. Since the calculating is similar with Payback so they share their advantage and disadvantage. Since the time value of money is considered so result can be more accurate, but it also specified the discount rate so the analysis will become more complicated.
Internal Rate of Return is the discount rate that NPV become zero. It will accept the project that has a greater discount rate compare to IRR. It is usually used because it is easy for manager to find out the rate of return. But it is no accurate when the project have some non-normal cash flow or when evaluating mutually exclusive projects.
Finally, Profitability index is used to measure profitability among different projects. It obtains present value by discounting the cash flow. With formula: benefit/cost ratio, profit of all positive NPV project can be ranked properly. Therefore it is useful for manager to rank and select suitable projects through the list. But discount rate is difficult to calculate because it is very uncertain. And profitability index will be broken down by other resource constraints.
In conclusion, there are similarities between some investment rules. NPV, IRR and PI consider the time value of money while the left rules do not. Although it is more complicated when computing with discount rate, the more accurate and detailed result can be work out so it is worth to do so, just like the rules discounted payback period and payback period. Moreover, IRR can give the accurate result to manager quickly, but it may affect by the non-normal cash flow. Therefore using NPV may be the right choice of rules to evaluating mutually exclusive projects. As a result, managers should choose different rules for particular situations.
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Topic: Efficient Market
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