Question

Discuss the meaning of an efficient market. What are some of the limitations to the efficient market hypothesis?

Discuss some of the factors that a firm can and cannot control when assessing their Weighted Average Cost of Capital (WACC)

Answer 1

1. An efficient market is one where in the stock prices are close to the intrinsic value and are in equilibrium. In a market that is efficient the prices always fully reflect information that is available. The investors in this market are confident that they will get good prices. Limitations of efficient market hypothesis:

(i) The investors under this model assume that they will always receive good prices with no regard to prevailing economic conditions which is not always realistic.

(ii) Information bias exists where in investors are not always able to make an optimal decision.

(iii) There is representative bias wherein the investors try to avoid risk of losses in situations that are uncertain. When they use heuristic biases, the market becomes inefficient.

2. Factors that the firm cannot control while assessing WACC:

1. The financial state of the stock markets and the prices of the stocks , the interest rate levels. Generally the stock and bond market, the interest rates are in equilibrium and stable. However, unforseen circumstances disrupt the markets and make it difficult for firms to raise capital at reasonable rates.

2. Investors aversion to the risk influences the market risk premium for the company which is well beyond its control. This effects the cost of equity and overall WACC.

3. The tax rates are set by the government and the firm has no control over them. Lower tax rates on debt increase the cost of capital and lower tax rates on dividends and capital gains push more of stock financing.