EFFICIENT CAPITAL MARKETS AND CAPITAL STRUCTURE

The CEO of Angelina Corporation, Sara Brown is meeting with the companys board of directors to discuss efficient capital markets and behavioral challenges and their impact on the companys stock. She explains that if capital markets are efficient, management cannot create value by fooling investors, and market value of stock reflects underlying intrinsic value. She added that stock prices reflect available information. Investors are rational and will analyze the available information and adjust their estimates of stock price in a rational way. Sara gave the following statements about the efficient market hypothesis:

Statement 1: Because information is reflected in prices immediately, investors should expectto obtain a normal rate of return. Information reflects so quickly in stock prices that no investor can gain competitive advantage over other investors.

Statement 2: Stock prices reflect underlying value.

Statement 3: Prices of stocks will only change if new information becomes available.

Statement 4: Managers cannot boost stock prices through creative accounting.

Statement 5: All shares of stock have the same expected returns.

A board member, David Goldreich has drawn Saras attention to three forms of market efficiency namelyweak-form efficiency, semi-strong efficiency, and strong-form efficiency. Mr. Goldreich explains that under each form, different types of information are assumed to reflect in stock prices.

Another board member, Michael Burton, says that new research studies are emerging inbehavioral financethat question the rationality of investors. Mr. Burton explains that investors do not act rationally all the time in the investment decision making process so the market cannot be efficient. The results of the studies indicate that investors are prone to heuristics-driven biases such asoverconfidence,decision regret, familiarity, conservatism, representativeness, and confirmation bias. The meeting was postponed to next week when the board will meet to finish the discussion on the efficient markets and considerthe capital structureof Angelina corporation.

The board chairman wants you to address the following questions before the next meeting.

1. Determine whether the following statements by Sara Brown about efficient market hypothesis arecorrector incorrect:

a. Statement 1

b. Statement 2

c. Statement 3

d. Statement 4

e. Statement 5

2.Whatdifferent types of informationare assumed to reflect in the companys stock price? Explain the different types of information under each form of market efficiency as stated by Mr. Goldreich.

3. An individual investor, Ms. Brenda Biswa wants to invest in Angelina corporation. She has gathered data on the company from the current issue of the companys annual financial report, newspapers, and press release of the capital investment project. Assuming the market issemi-strong efficient, can Ms. Biswa earn above-average returns using this material public information? Explain.

4.Ms. Brenda Biswa is consulting with her financial advisor, Paul Marsh. Paul believes that new information does not quickly get to all investors and that it takes time to analyze and act on new information. He tells Ms. Biswa that investors are not rational, deviations from rationality are similar across investors, and arbitrage, although costly, cannot eliminate inefficiencies. Does Paul Marsh believe inmarket efficiency? Explain why.

5. Explain how behavioral biases ofoverconfidence,regret, representativeness,and familiarity can affect investment behavior of investors of Angelina Corporation.

6. The board is meeting to discuss its capital structure. Explain the basic goal of financial management with regard to capital structure to the board of Angelina Corporation.

7. Angelina Corporation wants to determine theoptimal capital structurethat will maximize the value of the company by restructuring its finances. The original capital structure has no debt with a firm value of $1,000,000 (in millions) and the four possibilities under the new capital structure are presented below:

	No debt	Proposed	Proposed	Proposed	Proposed
	(Original structure $000)	restructuring 1	restructuring 2	restructuring 3	restructuring 4
Debt	0	500,000	400,000	300,000	200,000
Equity	1,000,000	650,000	850,000	800,000	830,000
Firm value	1,000,000	1,150,000	1,250,000	1,100,000	1,030,000
Percentage of debt	0	43.48	32.00	27.27	19.42
Percentage of equity	100	56.52	68.00	72.73	80.58
Return to shareholders after restructuring	4.80%	10.10%	13.60%	6.10%	5.12%
Weighted average cost of capital (WACC)	15.80	9.50	9.30	10.20	14.50

Base only on the information in the table, should Angelina Corporation restructure the firm? Explain. If yes, which proposed capital structure do you recommend for Angelina Corporation and why?