Question

Bluesteel is a SME that manufactures luxury goods for several well-known chain stores. In real terms, the company has experienced only a small growth in turnover in recent years, but it has managed to maintain a constant, if low, level of reported profits by careful control of costs. It has paid a constant nominal dividend for several years and its director has publicly stated that the primary objective of the company is to increase the wealth of shareholders. The capital structure of BlueSteel is as below £m Overdraft 1·0 10 year fixed interest bank loan 2·0 Share capital and reserves 4·5 ––– 7·5 ––– BlueSteel has the agreement of its existing shareholders to make a new issue of shares on the stock market but has been informed by its bank that current circumstances are unsuitable. The bank has advised that if new shares were to be issued now they would be significantly under-priced by the stock market, causing BlueSteel to issue many more shares than necessary in order to raise the amount of finance it requires. The bank recommends that the company waits for at least six months before issuing new shares, by which time it expects the stock market to have become strong-form efficient. Required: 3 Discuss the meaning and significance of the different forms of market efficiency (weak, semi-strong and strong) and comment on the recommendation of the bank that BlueSteel waits for six months before issuing new shares on the stock market.

Answer 1

Meaning of the Market Efficiency:

Market efficiency describe the extent to which available information can quickly reflected in the market price. This factor was developed by Eugene Fama in the 19^th century. All relevant information tends to change the share price in the market and when that information is changes the stock price in the market also changes. It simply means that the asset prices is directly proportional to the information available.

The information consist in Market Efficiency are:

· Past Information: Historical data reflects the future. Hence the companies reported figures helps investor to know the future or to predict the future of the company while making investment decisions.

· Public information: These information are available at any platform whether online or offline through company announcement and predictions made by the specialist. These information is easily available to the public to know the working of the company.

· Private Information: These information is available and known by the insiders of the company they can be Board of Director or corporate leaders.

                               

Types of Market efficiency and their significances:

Eugene Fama developed a framework of market efficiency that laid out three forms of efficiency: weak, semi-strong, and strong. They are further explained below:

Weak Form

In the weak-form efficient market hypothesis, all historical prices of securities have already been reflected in the market prices of securities. It is assume that the historical data plays a major role in the current security prices. The volume of the information should be available for research.

Semi-strong Form

In a semi-strong-form efficient market, prices reflect all publicly known and available information, including all historical price information. Under this assumption, analyzing any public financial disclosures made by a company to determine every detail which should be taken into account in the stock’s market price. On simpler terms an investor could not earn normal returns on surprise announcements since the market would quickly react to the new information but with the company disclosure he could earn abnormal return also.

Strong Form

In a strong-form efficient market, security prices fully reflect both public and private information. Even the knowledge of private information cannot confirm the superior result in the market because no one is reliable on the insider information. Hence, the non-public information is of no use for the investors.

Recommendation of the bank:

The bank recommended BlueSteel to wait before issuing new shares in the market because from the capital structure it can be easily identified that the company can raise its capital through securities rather than new issue. It can also be seen that the past information available for the company has only small growth which is not attractive to the point of view of investors. The company doesn’t reflect strong historical information which determine the future price so if the company issue its shares currently it will be undervalued due to market tendency and lack of interest of the investor. If the company waits for another 6 months and non-public information becomes unavailable with the public information of company disclosure it can attract the investor to invest. Since, the private information doesn’t involve with the public information although it is available, it become irrelevant. Hence, the bank recommended that it is better to wait for six months.