Question

In: Finance

a) Why can’t “increase the market share or maximize firm efficiency.”? b) What are "junk bonds"?...

a) Why can’t “increase the market share or maximize firm efficiency.”?

b) What are "junk bonds"? (3 pts)

c) What does IPO stands for?

d) If you are the sole owner of a business and you burn $100 bills every month and laugh at the burning, is this $100 agency cost? Why not?

e) As an average investor, should you actively trade stocks if you believe it is a semi-strong form efficient market? Why?

Solutions

Expert Solution

a) Why can’t “increase the market share or maximize firm efficiency.”?

Market share is the percent of total sales in an industry generated by a particular company. Market share is calculated by taking the company's sales over the period and dividing it by the total sales of the industry over the same period. This metric is used to give a general idea of the size of a company in relation to its market and its competitors.

Innovation is one method by which a company may increase market share. When a firm brings to market a new technology its competitors have yet to offer, consumers wishing to own the technology buy it from that company, even if they previously did business with a competitor. Many of those consumers become loyal customers, which adds to the company's market share and decreases market share for the company from which they switched.

By strengthening customer relationships, companies protect their existing market share by preventing current customers from jumping ship when a competitor rolls out a hot new offer. Better still, companies can grow market share using the same simple tactic, as satisfied customers frequently speak of their positive experience to friends and relatives who then become new customers. Gaining market share via word of mouth increases a company's revenues without concomitant increases in marketing expenses.

Companies with the highest market share in their industries almost invariably have the most skilled and dedicated employees. Bringing the best employees on board reduces expenses related to turnover and training, and enables companies to devote more resources to focus on their core competencies. Offering competitive salaries and benefits is one proven way to attract the best employees; however, employees in the 21st century also seek intangible benefits such as flexible schedules and casual work environments.

Lastly, one of the surest methods to increase market share is acquiring a competitor. By doing so, a company accomplishes two things. It taps into the newly acquired firm's existing customer base, and it reduces the number of firms fighting for a slice of the same pie by one. A shrewd executive, whether in charge of a small business or a large corporation, always has his eye out for a good acquisition deal when his company is in a growth mode.

b) What are "junk bonds"?

Junk bonds are bonds that carry a higher risk of default than most bonds issued by corporations and governments. A bond is a debt or promises to pay investors interest payments and the return of invested principal in exchange for buying the bond. Junk bonds represent bonds issued by companies that are struggling financially and have a high risk of defaulting or not paying their interest payments or repaying the principal to investors.

Junk bonds are also called high-yield bonds since the higher yield is needed to help offset any risk of default

From a technical viewpoint, a high-yield, or "junk" bond is pretty much the same as a regular corporate bonds since they both represent debt issued by a firm with the promise to pay interest and return the principal at maturity. Junk bonds differ because of their issuers' poorer credit quality.

Bonds are fixed-income debt instruments that corporations and governments issue to investors to raise capital. When investors buy bonds, they're effectively loaning money to the issuer who promises to repay the money on a specific date called the maturity date. At maturity, the investor is repaid the principal amount invested. Most bonds pay investors an annual interest rate during the life of the bond, called a coupon rate.

For example, a bond that has a 5% annual coupon rate means that an investor who purchases the bond earns 5% per year. So, a bond with a $1,000 face—or par—value will receive 5% x $1,000 which comes to $50 each year until the bond matures.

c) What does IPO stands for?

An initial public offering (IPO) refers to the process of offering shares of a private corporation to the public in a new stock issuance. Public share issuance allows a company to raise capital from public investors. The transition from a private to a public company can be an important time for private investors to fully realize gains from their investment as it typically includes share premiums for current private investors. Meanwhile, it also allows public investors to participate in the offering.

A company planning an IPO will typically select an underwriter or underwriters. They will also choose an exchange in which the shares will be issued and subsequently traded publicly.

The term initial public offering (IPO) has been a buzzword on Wall Street and among investors for decades. The Dutch are credited with conducting the first modern IPO by offering shares of the Dutch East India Company to the general public. Since then, IPOs have been used as a way for companies to raise capital from public investors through the issuance of public share ownership. Through the years, IPOs have been known for uptrends and downtrends in issuance. Individual sectors also experience uptrends and downtrends in issuance due to innovation and various other economic factors. Tech IPOs multiplied at the height of the dot-com boom as startups without revenues rushed to list themselves on the stock market. The 2008 financial crisis resulted in a year with the least number of IPOs. After the recession following the 2008 financial crisis, IPOs ground to a halt, and for some years after, new listings were rare. More recently, much of the IPO buzz has moved to a focus on so-called unicorns—startup companies that have reached private valuations of more than $1 billion.

Investors and the media heavily speculate on these companies and their decision to go public via an IPO or stay private.

d) If you are the sole owner of a business and you burn $100 bills every month and laugh at the burning, is this $100 agency cost? Why not?

An agency cost is a type of internal company expense which comes from the actions of an agent acting on behalf of a principal. Agency costs typically arise in the wake of core inefficiencies, dissatisfactions and disruptions, such as conflicts of interest between shareholders and management. Payment of the agency cost is to the acting agent.As early as 1932, American economists Gardiner Coit Means and Adolf Augustus Berle discussed corporate governance in terms of an “agent” and a “principal,” in applying these principals towards the development of large corporations, where the interests of the directors and managers differed from those of owners.

The Principal-Agent Relationship of Agency Cost

As an example, shareholders may want management to run the company in a fashion which increases shareholder value. Conversely, the administration may look to grow the company in other ways which may conceivably run counter to the shareholders’ best interests.

This opposing party dynamic, known as the principal-agent relationship, primarily refers to the relationships between shareholders and management personnel. In this scenario, the shareholders are principals, and management operatives act as agents. However, the principal-agent relationship may also refer to other pairs of connected parties with similar power characteristics, such as the relationship between politicians, functioning as agents and communities of voters, functioning as principals. In an extension of the principal-agent dynamic known as the "multiple principal problems" describes a scenario where a person acts on behalf of a group of other individuals.

A Closer Look at Agency Costs

Agency costs include any fees associated with managing the needs of conflicting parties, in the process of evaluating and resolving disputes. This cost is also known as agency risk. Agency costs are necessary expenses within any organization where the principals do not yield complete autonomous power. Due to their failure to operate in a way which benefits the agents working underneath them, it can ultimately negatively impact their bottom lines. These costs mainly refer to economic incentives such as performance bonuses, stock options and other carrots which would stimulate agents to execute their duties properly. The agent's purpose is to help a company thrive, thereby aligning the interests of all stakeholders.

e) As an average investor, should you actively trade stocks if you believe it is a semi-strong form efficient market? Why?

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.

Semi-strong form efficiency contends that security prices have factored in publicly-available market and that price changes to new equilibrium levels are reflections of that information. It is considered the most practical of all EMH hypotheses but is unable to explain the context for material nonpublic information (MNPI). It concludes that neither fundamental nor technical analysis can be used to achieve superior gains and suggests that only MNPI would benefit investors seeking to earn above average returns on investments.

EMH states that at any given time and in a liquid market, security prices fully reflect all available information. This theory evolved from a 1960s PhD dissertation by U. S. economist Eugene Fama. The EMH exists in three forms: weak, semi-strong and strong, and it evaluates the influence of MNPI on market prices. EMH contends that since markets are efficient and current prices reflect all information, attempts to outperform the market are subject to chance not skill. The logic behind this is the Random Walk Theory, where all price changes reflect a random departure from previous prices. Because share prices instantly reflect all available information, then tomorrow’s prices are independent of today’s prices and will only reflect tomorrow’s news. Assuming news and price changes are unpredictable then novice and expert investor, holding a diversified portfolio, would obtain comparable returns regardless of their expertise.

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.

The strong form of EMH also assumes that current stock prices reflect all public and private information. It contends that non-market and inside information as well as market information are factored into security prices and that nobody has monopolistic access to relevant information. It assumes a perfect market and concludes that excess returns are impossible to achieve consistently.

EMH is influential throughout financial research, but can fall short in application. For example, the 2008 Financial Crisis called into question many theoretical market approaches for their lack of practical perspective. If all EMH assumptions had held, then the housing bubble and subsequent crash would not have occurred. EMH fails to explain market anomalies, including speculative bubbles and excess volatility. As the housing bubble peaked, funds continued to pour into subprime mortgages. Contrary to rational expectations, investors acted irrationally in favor of potential arbitrage opportunities. An efficient market would have adjusted asset prices to rational levels.

Example of Semi-Strong Efficient Market Hypothesis

Suppose stock ABC is trading at $10, one day before it is scheduled to report earnings. A news report is published the evening before its earnings call that claims ABC's business has suffered in the last quarter due to adverse government regulation. When trading opens the next day, ABC's stock falls to $8, reflecting movement due to available public information. But the stock jumps to $11 after the call because the company reported positive results on the back of an effective cost-cutting strategy. The MNPI, in this case, is news of the cost-cutting strategy which, if available to investors, would have allowed them to profit handsomely.


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