Theoretically, a fund manager has an option of selecting a portfolio with a pin where the efficient market hypothesis is true. The argument is that prices of a portfolio are known with certainty meaning that the pin risk in a portfolio is mitigated. However, this is always not so because, under this hypothesis, the price of a portfolio is equal to the fundamental value of the same portfolio. This means that the returns are equal to the opportunity cost of capital, which is not attractive to investors.
In addition to unattractive returns, fund managers may not opt to invest in a portfolio by considering the efficient market hypothesis alone. Other factors besides information efficiency determine a portfolio choice. For instance, the investor’s objectives in purchasing the portfolio; some may want to gain prestige ownership in a company and not returns oriented.
The extents to which firms rely on internal financing depend on the financial capability of the firm. Internal funds arise from non-cash expenses like depreciation and reserve accounts like profit and loss and premium. Firms that are able to raise and maintain adequate funds in these accounts rely heavily on internal financing because it is convenient and cheap. In addition, managers who wish to enjoy the comfort of working will avoid external borrowings consequently avoiding pressure from investors.
Another reason why firms rely on internal financing is the risk associated with external borrowing. High debt ratio increases chances of bankruptcy because of high financing costs. This makes the company unattractive to investors lowering its market price per share. The company may also lack the required the required assets for collateral in external financing leaving it with the option of internal funds only.
References
Brealey, R., Myers, S., & Allen, F. (2011). Financing Decisions and Market Efficiency. In R. A. Brealey, S. C. Myers, & F. Allen, Principles of Corporate Finance (pp. 312-360). Columbus: McGraw-Hill/Irwin.
Reinhart , C., & Rogoff, K. (2009). The Aftermath of Financial Crises. American Economic Review, 466-472.
