Question 1: Studies find that a considerable number of companies have zero or very little debt in their capital structure. Critically evaluate how this contradicts with the prominent capital structure theories and what factors can explain zero or very little debt for companies.
Question 2: Critically discuss the performance of professionally managed investment funds in the context of the Efficient Market Hypothesis. Does empirical evidence support or refute the hypothesis?
Question 3: After extensive medical and marketing research, Mega plc believes it can penetrate the pain reliever market. It is considering two alternative products. The first is a medication for headache pain. The second is a pill for headache and arthritis pain. Both products would be introduced at a price of £4 per package. The headache-only medication is projected to sell 5 million packages a year, whereas the headache and arthritis remedy would sell 20 million packages a year. Cash costs of production are expected to be £1.50 per package for the headache-only brand. Production costs are expected to be £1.70 for the headache and arthritis pill. Both products requires further investment. The headache-only pill could be produced using equipment costing £10.2 million. That equipment would last three years and have no resale value. The machinery required to produce the headache-arthritis remedy would cost £20 million and last three years. The firm expects that equipment to have a £2 million resale value at the end of year 3. Mega plc uses reducing balance (20 per cent) depreciation and believe that the appropriate discount rate for this investment is 13%. The firm faces a corporate tax rate of 24%.
• Discuss which capital appraisal technique is more suitable to evaluate both the projects? Ensure you provide a discussion relevant to this case. (No calculation required in this part) • Use appropriate capital appraisal technique(s) to evaluate the projects and suggest to the company which project should be undertaken if the objective is to maximise shareholders’ wealth. (Total marks: 30%)
Question 4: Critically discuss the role of ownership structure and its implications for agency cost in explaining the variation in dividend policies of firms. (Maximum word count: 1000) (Total Marks: 40%).
Question 5: The supply of long-term treasury bonds may affect the issuance of long-term corporate bond. Critically evaluate this statement. (Maximum word count: 800) (Total Marks: 30%) (TOTAL 100%)
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The Performance of Professionally Managed Investment Funds in the Context of the Efficient Market Hypothesis: An Empirical Examination
Introduction:
The Efficient Market Hypothesis (EMH) is a cornerstone theory in financial economics that posits that financial markets efficiently incorporate all available information, making it impossible for investors to consistently outperform the market through active management. This theory has profound implications for the performance of professionally managed investment funds, as their success is predicated on the ability to identify mispriced assets and generate superior returns. In this critical discussion, we will explore the EMH, analyze the performance of professionally managed investment funds, and assess empirical evidence to determine whether it supports or refutes the hypothesis.
Efficient Market Hypothesis:
The Efficient Market Hypothesis, first proposed by Eugene Fama in the 1960s, asserts that in an efficient market, asset prices fully reflect all available information. The hypothesis is categorized into three forms: weak, semi-strong, and strong. The weak form assumes that past price and volume information is already reflected in current prices. The semi-strong form extends this to suggest that all publicly available information is reflected in prices. The strong form contends that even private information is fully incorporated into asset prices.
Performance of Professionally Managed Investment Funds:
Professionally managed investment funds, such as mutual funds and hedge funds, operate on the premise that skilled fund managers can exploit market inefficiencies to generate returns that surpass market benchmarks. However, the EMH challenges this assumption, arguing that any information relevant to asset prices is rapidly incorporated, leaving little room for consistent outperformance.
One key aspect of professionally managed funds is active management, where fund managers engage in market analysis, stock picking, and timing to gain an edge. This active approach contradicts the EMH, which suggests that such efforts should be in vain. Empirical studies have sought to evaluate the performance of these funds in light of the EMH, revealing a nuanced picture.
Empirical Evidence:
Numerous studies have attempted to test the EMH and assess the performance of professionally managed funds. One of the pioneering works in this field is the study by Michael Jensen in 1968, who introduced the concept of alpha, a measure of a fund's risk-adjusted excess return. Jensen's study found evidence of positive alpha in some funds, suggesting outperformance after accounting for risk.
However, subsequent research has provided a more complex view. Fama and French (1993) extended the analysis by introducing factors like size and value, indicating that some funds exhibited superior returns but could be explained by exposure to specific risk factors rather than managerial skill. This led to the development of the Three-Factor Model, expanding the understanding of risk and return.
Further studies, such as those by Malkiel (2003) and Malkiel and Saha (2005), have cast doubt on the ability of actively managed funds to consistently outperform the market. These studies argue that, on average, actively managed funds fail to beat passive index funds over the long term after accounting for fees and transaction costs.
While evidence supporting the EMH has been substantial, there are also studies that challenge its assumptions. Lo (2005) introduced the Adaptive Markets Hypothesis, proposing that market efficiency is dynamic and subject to change due to the evolving nature of investor behavior, learning, and adaptation.
Conclusion:
In conclusion, the performance of professionally managed investment funds in the context of the Efficient Market Hypothesis is a subject of ongoing debate and empirical scrutiny. While early studies suggested the possibility of outperformance, subsequent research has tempered these findings. The introduction of risk factors and the Three-Factor Model has provided alternative explanations for apparent alpha, raising questions about the true source of excess returns.
Empirical evidence, on the whole, tends to align with the EMH, suggesting that active management struggles to consistently outperform the market. However, the debate is not settled, with some researchers proposing alternative hypotheses, such as the Adaptive Markets Hypothesis, which acknowledges the dynamic nature of markets and the potential for evolving inefficiencies.
Investors and academics alike continue to grapple with the implications of these findings. As technology and information dissemination evolve, the debate over market efficiency and the performance of professionally managed funds is likely to persist. The critical examination of this relationship underscores the ongoing quest to understand the complexities of financial markets and the challenges associated with consistently achieving superior investment returns.
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