Investment appraisal and efficient market hypothesis
PART A: Investment Appraisal
Determination of cash flows
Calculation of NPV
The NPV of the equipment is $298,352. The value is positive implying that the equipment is viable. Under the NPV criterion, a firm should accept an investment whose NPV is more than zero (Chandra, 2014). Therefore, Stream Stop Ltd. Torrent Flood Defences Plc should undertake the project.
Mistakes made within the original proposal
Appraisal technique: The Company made an error in the choice of the method of evaluating the investment. The return on investment uses the net profit in determining the worth of an investment (Röhrich, 2014). Investment analysis should be based on cash flows. A project can be profitable but not generating cash to the company. Besides, return on investment ignores the time value of money. Investments should be assessed using discounting techniques.
Treatment of market research cost: Investment analysis should be an incremental analysis. Only relevant costs and incomes should be considered. The company included the market research cost as part of the equipment’s initial investment (Röhrich, 2014). Market research is a sunk cost since the company has already incurred it and this will not change whether the company purchases the equipment or not. Market research cost and any preliminary expenses should be ignored in the evaluation of the investment.
Overhead costs: All costs and revenues included in an investment appraisal should be incremental costs and revenues. The company should analyse the proposed investment to identify the incremental costs (Röhrich, 2014). The overheads included as part of the project costs should not include those absorbed from the existing overheads.
Part B. Efficient Market Hypothesis
Stock market efficiency refers to whether the stock prices reflects all the information accessible to the players in the market at any time (Keown, Martin and Petty, 2008). Investors in the market rely on the past, current and future information to make investment decisions. Market efficiency is important to investors since it determines whether an investor can benefit from trading based on information that relevant in pricing but not yet reflected in the prices of stocks (Keown, Martin and Petty, 2008). It determines whether technical analysis and fundamental analysis are profitable. It also affects the pricing of stocks which is important in the valuation of securities. Market efficiency is influenced by the type of information available to investors and the speed with which the market reacts to available new information.
Forms of market efficiency
Weak form
In markets that have a weak form of information efficiency, stock prices reflect all past or historical information. Therefore, past price movements are already reflected in the current price of the stock (Moretto, 2008). It is impossible for investors to use past price movements to identify mispriced securities. Technical analysis is not profitable under the weak form level of efficiency. Technical analysis involves the study of past price patterns to determine future movements in prices (Moretto, 2008). In such markets, stock prices follow a trendless and random walk. Prices changes are random, and there is a relationship between successive movements hence the trend cannot be identified.
Semi-strong form
Stock prices in markets that exhibit semi-strong level of efficiency reflect all available public information. This includes both the past and current information. Investors are unable to use publicly available information to identify if there are any mispriced stocks (Hillier, 2010). Investors determine the intrinsic value of a stock to determine whether it is overpriced or under-priced and make a decision to purchase or sell the stock. In semi-strong efficient markets, fundamental analysis does not generate any arbitrage profits. The market reacts to new information once it is made public (Hillier, 2010). For instance, if a company announces a proposed merger, stock prices will change even before the actual merger occurs. In these markets, events and announcements such as the death of the CEO, stock splits, the announcement of mergers, among other events, affect the stock price.
Strong form of efficiency
In this form of efficiency, stock prices reflect all private and public information. This includes all past, present and future information on matters affecting the stock (Megginson and Smart, 2008). In this case, future information such as planned merger, the release of financial statements, declaration of dividends, among others, are reflected in the current stock prices. This implies that the mere publication or announcement of such events do not have any impact on the prices of the company’s security (Megginson and Smart, 2008). In such markets, insider trading is not possible since even private information is reflected in the stock prices.
Stock markets of developed countries
The level of market efficiency varies from one country to another based on several factors. Studies have shown that stock markets in developed countries are more efficient than those in developing countries (Megginson and Smart, 2008). Thus, most of the markets are efficient in pricing for most people and most of the time. Companies in developed countries have to comply with regulations regarding disclosure of financial and other information to the public as well as the relevant stakeholders. They also have to adhere to the high standards of corporate governance. Therefore, investors in such markets have more access to relevant information about stocks. Most companies’ information is publicly available hence they are easily reflected in stock prices (Megginson and Smart, 2008). This ensures that most stocks in such markets are efficiently priced.
Besides, stock markets in developed countries are dominated by well-established investors including institutional investors. Most of the investors are experienced and have to expertise to gather necessary stock information. There are fewer panic decisions hence most stocks are correctly priced as there is limited imbalance in demand and supply of most stocks.
Developed countries also have well-established communication systems. Thus, information about a company can reach the stock market and most investors almost immediately (Berk and DeMarzo, 2011). Therefore, the stock markets can react immediately to such information and reflect such in stock prices. In developing countries, even the release of information by a company may take time to reach all participants in the stock market.
Despite the high level of efficiency in stock markets of developed countries, they are not perfectly efficient. The strong-form of efficiency may not be fully achieved. Not all investors in developed countries’ stock markets have access to all private and public information. Besides, not all companies release information to the public promptly. Therefore, the markets efficient price most stocks for most investors and for most of the time.
Bibliography
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Chandra, P. (2014). Fundamentals of financial management. New Delhi: Tata McGraw-Hill
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Megginson, W. and Smart, S. (2008). Introduction to corporate finance. Southbank, Vic.:
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Moretto, E. (2008). Managerial finance. [Bradford, England]: Emerald.
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