Discussion Issues and Derivations

  1. Why does it matter whether markets are efficient?
    The question of whether markets are efficient or not matters for several reasons from the perspective of corporate financial decisions:
    a. The question of whether the objective function of maxmizing firm value is equivalent to an objective of maximizing stock prices rests on the question of whether markets are efficient. If markets are efficient, maximizing stock prices is equivalent to maximizing stockholder wealth; if we add the assumption that bondholders are protected from expropriation, this translates into maximizing firm value.
    b. If markets are efficient, all securities issued by the firm to raise capital will be at fair market value. Thus, the only rationale for adding special features (such as convertibility) is because it makes fundamental sense from the perspective of the firm. If markets are not efficient, it is conceivable that some types of securities can be over valued and other types under valued, and firms will be much more likely to issue the former (even if it does not make fundamental sense).
    c. If markets are efficient, any information relating to the firm will show up in prices. It therefore makes sense for firms to reveal information speedily to markets and let markets react to them, rather than try to manage the release of information.
  2. How do you test for market efficiency?
    There are two basic tests for market efficiency. To read more about them, you can download my notes on the topic by clicking here.
  3. Should firms take advantage of inefficient markets to issue overvalued securites?
    When market inefficiencies exist, it is an open question as to whether firms should take advantage of them to raise fresh capital. As an example, assume that a firm's stock is overvalued, and the firm knows it is overvalued. If it goes out and issues stock at this price, it is essentially transferring wealth from the new stockholders in the firm to the old stockholders.
    The reason this is dangerous is that all stockholders, new and old, own the equity in the firm now. To the extent that the firm knew that its stock was overvalued, it has taken advantage of some its owners. While it is under no financial or legal obligation know to do so, credibility is one of the most important components of how a firm is viewed in financial markets and such actions negatively affect credibility.