FINANCIAL MANAGEMENT 1
QUIZ 1
CHAPTER 1
INTRODUCTION TO
FINANCIAL MANAGEMENT
●
●
●
Engaging in business is like gambling, it is
too risky.
SHAREHOLDERS: managers who govern
the business on behalf of the owners
FINANCIAL MANAGEMENT: the process
of
planning,
directing,
organizing,
controlling, and monitoring (PDOCM) of the
monetary resources in order to achieve the
objectives and goals of the business.
➔ Objectives and goals: Maximize
profit, minimize losses
➔ Financial
Managers
are
responsible for the management of
these monetary resources. (Ex.
CFO, Treasurer, Controller)
II.
PARTNERSHIP
●
●
●
●
KINDS OF BUSINESS ORGANIZATIONS
I.
SOLE PROPRIETORSHIP
●
●
●
●
●
●
●
Simplest form of business organization.
Owned by an individual known as the
sole proprietor (1).
It is subject to fewer government
regulations.
Registered through the Department of
Trade and Industry (DTI).
➔ Business
Name
Registration
System (BNRS)
➔ Business Permit
➔ BIR
Business income is not subject to
separate taxation.
Taxation = Professional Income (Ex.
Professor) + Business Income (Ex.
Barbershop, Accounting Firm), with this
you will become a mixed income earner
and will be taxed as one.
DISADVANTAGES:
➔ Unlimited Liability - Debts and
losses of the business shall be
borne by the personal assets of the
owner in time of bankruptcy.
➔ Limited Life - The death of the
business owner leads to the
termination of the proprietorship.
➔ Amount of capital raised is
significantly limited.
●
●
●
●
Article 1767, New Civil Code (NCC) - a
contract of two or more persons who
bind themselves to contribute money,
property, or industry to a common fund,
with the intention of dividing the profits
among themselves.
Has a juridical personality separate
and distinct from that of each partner
and is created by contract.
Separate Taxation like Corporation =
25% corporate income tax, amended by
the CREATE law.
➔ Tax of the partnership is different
from that of the partners.
Unlimited liability (General Rule but
subject to exemptions)
➔ General Partnership - All the
partners have unlimited liability,
wherein creditors may claim their
separate assets in case of
bankruptcy.
➔ Limited Partnership - Limited
partners that have liability to the
creditors only up to the extent of
their capital contribution, thus, their
separate assets are safe from the
claims of creditors.
Limited Life - the death of one of the
partners will result in the dissolution of
the partnership.
➔ Retirement
➔ Admission
➔ Incorporation
➔ Death
May be constituted in any form, whether
oral or written.
The contract of the partnership having a
capital of 3,000 or more, in money or
property is required to be:
➢ In public instrument
➢ Recorded in the Office of the
Securities
and
Exchange
Commission (SEC).
➔ Failure to comply shall not affect the
liability of the partnership and the
members thereof to third persons
(Article 1771-1772 of NCC)
Capital raised is usually more compared
to Sole Proprietorship because of the
larger number of sources of capital.
1 diamla, foronda, gan
III.
CORPORATION
●
●
●
●
●
Corporation Code of the Philippines
(CCP) - an artificial being created by the
operation of the law, having the right of
succession and powers, attributes and
properties expressly authorized by law
or incident to its existence (Section 2 of
CCP).
➔ Juridical Personality; Can sue and
be sued.
Composed of five to fifteen incorporators
and must also be registered with the
Securities and Exchange Commission
(SEC).
➔ Unless you are going to put up a
One Person Corporation (OPC).
Separate Taxation = 25% corporate
income tax amended by the CREATE
law.
➔ Dividends are also subject to tax.
➔ Dual Taxation wherein the income
of the corporation is subject to
corporate income tax while the
earnings
of
the
owners/shareholders are subject to
separate individual income tax.
Unlimited life/ Perpetual life but subject
to stricter government regulations.
Limited liability for stockholders - the
claim of the creditors is only up to the
amount of capital investments of these
shareholders and the personal assets
are not subject to appropriations.
➔ Except if there is fraud. The concept
of Piercing Veil of Corporate
Fiction (PVCF) will come in.
Characteristics
of Business
Organization
Sole
Propriet
orship
Partnersh
ip
Corpora
tion
*Except in General Professional Partnership
(GPP), this partnership will not be taxed like a
corporation.
➔ Section 22(B) of NIRC, general
partnerships are those formed by a person
for the sole purpose of exercising their
common profession, no part of the income
of which is derived from engaging in any
trade or business.
➔ For tax purposes, the term corporation
shall include partnership no matter how
created
or
organized,
joint-stock
companies,
joint-venture
accounts
(Cuentas en participación), association, or
insurance companies but does not include
general professional partnerships and joint
venture or consortium formed for the
purpose of engaging in petroleum, coal,
geothermal or other energy operations
pursuant to an operating consortium
agreement under a service contract with
the Government.
➔ As an exception, GPP’s income is not
taxed separately using the 25% corporate
income tax
**Except when the doctrine of Piercing the Veil
of Corporate Fiction applies.
➔ Shall disregard the separate personality of
the corporation because the veil of
corporate fiction was used as a shield to
perpetuate fraud, justify wrong, defeat
public inconvenience, or defend crime.
➔ The effect is to make the directors, officers,
and shareholders, involved in fraud or
crime, liable for the obligation of the
corporation.
TYPES OF CORPORATION
A. AS TO LEGAL STATUS
●
Owner(s)
called
are Manager
Partners
Shareho
lders
Owner
Managers
Separate
and NO
are
NO
YES
Owner’s Liability Unlimite
d
Unlimited
Limited*
*
Separate
Taxation
NO
YES*
YES
Life
of
Business
the Limited
Limited
Unlimite
d
●
De Jure Corporation - organized in
accordance with the law.
➔ Strict or substantial compliance
with the statutory requirements for
its incorporation.
➔ It exists in fact and in law.
➔ Articles of Incorporation + By Laws
= SEC
De Facto Corporation - exists only in
fact but not in law because there is a flaw
in its incorporation.
➔ Has no legal right to corporate
existence as against the state.
2 diamla, foronda, gan
B. AS TO FUNCTIONS AND GOVERNING
LAW
●
●
Public Corporation - organized by
state for the government to promote
general welfare of the public.
➔ Governed by special laws and
Local Government Code of
Philippines.
➔ EX. SSS, GSIS, PhilHealth
the
the
the
the
Private Corporation - organized by
private individuals for the purpose of
generating profit.
➔ Governed by the Law on Private
Corporation
➔ EX. Jollibee, San Miguel, SM,
PLDT
C. AS TO THE EXISTENCE OF STOCKS
●
●
Stock Corporation - capital stock is
divided into shares and is authorized to
distribute to the holders thereof of such
shares dividends or allotments of the
surplus profits. (Sec. 3 of the Corporate
Code of the Philippines)
➔ Owners are called shareholders or
stockholders.
➔ Profit = Share Dividends
Non-stock Corporation - has no stock
issuances and no distribution of
dividends to its members.
➔ A corporation is not automatically
considered a stock corporation if
there is a statement of capital
stock.
➔ are
called
members
not
stockholders
➔ E.g. Academic institutions
➔ Supreme Court: If the dividends
are not supposed to be declared or
there is no distribution of retained
earnings, the corporation is still a
non-stock corporation. Moreover,
the owners are called members.
➔ Profit = Reinvested in the
Company
D. AS TO SHARES BEING TRADED IN
THE STOCK EXCHANGE
●
Publicly listed Company - Shares are
offered to the public or traded in the
Philippine stock exchange.
➔ Undergoes initial public offering
(IPO).
●
Privately owned Company - Shares are
not traded in the stock market.
➔ A corporation “going private”
because
it
restricts
the
stockholders to a certain group,
usually family members.
➔ Sometimes called a close or
closely held corporation or
privately held corporation.
➔ does not undergo IPO
CORPORATIONS
THAT
ARE
ACCEPTABLE IN PHILIPPINE LAW
NOT
➔ Limited liability Company - A business
structure that combines the tax advantage
(10%) of a partnership (GPP) and the
limited liability advantage of a corporation.
➔ Professional Corporation - Composed of
persons with the same professions such as
Doctors, Lawyers, or Certified Public
Accountants.
GOALS OF THE CORPORATION
➔ All forms of business organizations
whether sole proprietorship, partnership, or
corporation has the goal of maximizing
earnings or profit.
➔ For a sole proprietorship or the partners,
profit maximization may be the end goal.
➔ However, for corporations,
profit
maximization is just a means to the ultimate
goal of the corporation.
➔ Stock price maximization/Shareholder’s
wealth maximization - the increase in the
value of stock price resulting in capital
gains that shareholders will yield on their
investments.
➔ Market value maximization - is given
more emphasis than of profit maximization
for the following reasons:
➔ Maximizing the market value of the
corporation, a discount rate which
reflects the risks of capitalization
and the time value of money is
taken into consideration.
➔ In maximizing future profits, the
company may opt to decrease and
postpone its dividend declaration,
and instead, it will reinvest the
freed-up cash.
● In Summary, the goal of sole
proprietorship and partnership is to gain
profit; while, corporations are shareholder’s
wealth
maximization,
stock
price
maximization,
and
market
value
maximization.
3 diamla, foronda, gan
INAPPROPRIATE
WAYS
ON
HOW
MANAGEMENT MAXIMIZES THE PROFIT
OF THE CORPORATION
●
●
Management wants to accelerate sales by
materially increasing the swelling prices of
the goods offered to the consumers, or
Management wants to reduce expenses by
cutting wage rates of the laborers or buying
cheapest material for production
FINANCIAL
MANAGERS
CORPORATION
●
OF
responsibility of raising and managing the
capital or funds of the company; transaction
and maintaining good relationships with
various banks; and the formulation of the
company’s credit policies collection (inflow of
funds).
➔ Fundraising activities
➔ Cash balance
➔ Bank loans, issuance of bonds
THE
FINANCIAL MANAGERS are responsible
for managing the monetary resources of
the corporation in order to maximize the
firm’s value.
➔ They are also responsible for
dealing with the different financial
markets.
➔ These managers are the agents
who act on behalf of the principals
(owners/shareholders) to perform
investment,
financing,
and
operation decisions.
FINANCIAL MANAGERS ARE:
1. BOARD OF DIRECTORS - they are direct
owners and are elected by the shareholders
to manage the corporation. They are charged
with ultimate governance of the corporation.
Thus, they have the ultimate responsibility for
decking on highly important financial matters
of the corporation. Moreover, BOD decides on
when to declare and how much dividends per
share to distribute.
➔ Can vote unless they are ratified
➔ Dual personality involved (both an
owner and manager)
➔ decides on high risk investments,
expansion, buying of PPEs, issuance
of bonds, and loans.
2. CHIEF FINANCIAL OFFICER - also known
as the Vice President for Finance (VPFinance), who has responsibility over financial
planning and formulation of financial
corporate strategies.
➔ Under his supervision are the
Treasurer and the Controller
➔ Oversees the company’s financial
statements
3. TREASURER - focuses on the financial
aspect of the corporation; has the
4. CONTROLLER - focuses on the accounting
and budgeting aspect of the corporation; he is
responsible for the custody of financial
records, preparation of the financial
statements, and interpretation of financial
statements
➔ Bookkeeping, auditing, recording,
budgeting
GENERAL
MANAGER
●
●
ROLE
OF
FINANCIAL
INVESTING DECISION or also known as
capital budgeting, answers the question:
“what assets should the corporation
acquire in order to provide better returns in
the future.”
➔ Investing activities - outflows of
cash to acquire Non-Current Assets
(land, building, equipment - will
prompt faster production) - to
generate cash (if they are used for
operations).
FINANCING DECISION applies in the
event that the cash available is insufficient
from the retained earnings; answers the
question on “how much funds can be raised
and how to raise such funds” or “how to
raise funds in order to finance the
investment and operating activities of the
firm.”
➔ Inflow through fundraising activities
such as loans, stocks, or bonds.
➔ The financial managers accumulate
funds through the following means:
◆ performing
long
term
financing through bank
loans if the prevailing
interest rate is not high
◆ issuance of financial assets
such as share of stocks
4 diamla, foronda, gan
●
(equity security) or bonds
(debt security)
○ EX. if stock price is
high, sell it otherwise,
don’t sell it
OPERATING DECISION should decide on
how much funds should be allocated to
each operating unit. It answers the
question: “how much funds will be allocated
to support the day-to-day transactions of
the firm.”
➔ Outflow/Inflow of Current Assets
Outflow
provide security on the part of the
shareholders or investors.
5. SPECIALIST MONITORING - it is assumed
that employees will perform their functions
well if they are monitored by their superior.
CONFLICTS BETWEEN STOCKHOLDERS
AND BONDHOLDERS
●
●
Inflow
Raw Materials
Sales
Direct Labor
COGS
Overhead
Gross Profit
RETAINED
EARNINGS
MANAGERS’ DECISION)
●
Net Income
RESOLUTION OF AGENCY PROBLEM
●
Agency conflicts are problems between the
principal and agent of the company.
➔ shareholders (principal)
➔ financial managers (agents)
●
(FINANCIAL
APPROPRIATED
➔ PLOWBACK or reinvest (EX. for
expansion)
➔ Market value rises
UNAPPROPRIATED
➔ Dividends will be available for the
stockholders
ETHICAL CONSIDERATIONS
●
SOLUTIONS TO MITIGATE
1. COMPENSATION PLANS - these incentives
are provided in order to motivate these
managers to perform better so that the goal of
maximizing the value of the firm may be
achieved. the companies would offer
incentives to their managers such as:
➔ additional bonuses
➔ percentage interest in the net income
➔ stock options
2. THREATS AS TO CHANGE IN BOARD OF
DIRECTORS - the shareholders have the
power to elect a new set of BOD if they are not
satisfied with the performance of the board.
3. THREATS
AS
TO
MANAGEMENT
TAKEOVERS - management takeover
indicates that the old management team is
replaced by the new management.
4. LEGAL
AND
REGULATORY
REQUIREMENTS - these requirements
imposed upon the corporation, especially
those publicly listed companies, aim to
The stockholders, as owners of the firm,
want the financial managers to invest in
risky investments (high risk/risk takers).
The bondholders, as the lenders of the firm,
oppose risky investments (low risk).
●
●
●
Maximizing the firm’s market value or the
maximization of the shareholder’s wealth is
achieved through an ethical manner of
doing business.
The company should maintain its
Corporation Social Responsibility (CSR) at
all times.
Ethics and the goal of maximizing
shareholder wealth generally lean towards
similar ends because ethical behavior
builds good reputation that will benefit the
organization.
Between ethics and profit goals, ethics will
prevail.
CHAPTER 2
FINANCIAL ENVIRONMENT
FINANCIAL ENVIRONMENTS
●
●
factors and situations that primarily affect
the financial aspects of the corporation.
SOURCES OF FINANCING
➔ Financial Market
➔ Financial Intermediaries
5 diamla, foronda, gan
●
●
The main source of funds used for
investments and operations comes from
the savings of the investors.
Financing transactions take place in
financial markets with the intervention of
the different financial intermediaries and
institutions.
CAPITAL ALLOCATION PROCESS
●
●
●
In a well-functioning economy, capital flows
efficiently from those who supply the capital
to those who demand it.
Suppliers of capital - individuals and
institutions with “excess funds.” These
groups are saving money and looking for a
rate of return on their investment.
Demanders or users of capital individuals, and institutions who need to
raise funds to finance their investment
opportunities. These groups are willing to
pay a rate of return on the capital they
borrow.
DIFFERENT TYPES OF MARKETS
●
Market - a venue where goods and
services are exchanged.
A. FINANCIAL MARKETS
● a
place
where
individuals
and
organizations wanting to borrow funds are
brought together with those having a
surplus of funds.
1. Stock Market
● Equity securities are being issued
and traded.
● Stockholders may sell their stock
investments or the firm may issue
additional stocks if the stock price is
overvalued or may purchase stocks
if undervalued.
2. Bond Market
● Debt securities are being issued
and traded.
● Referred as the fixed-income
market because the investors or
bondholders receive fixed interest
payments from their investments.
● EX. If the firm has to raise funds but
the stock price is undervalued, the
firm may issue debt securities
rather than equity securities.
3. Money Market
● Short-term debts with maturities of
one year or less are used as a
source of financing.
● EX. Treasury bill
4. Capital Market
● Long-term
debt
and
equity
securities are involved in financing.
● EX. Treasury note: more than one
year but not more than 10 years,
treasury bond: more than 10 years
B. OTHER MARKETS
1. Physical Market
● Real asset or tangible markets
● Products involved are real estate,
property plant, and equipment,
inventories, etc.
● Assets that do not qualify as
financial assets are sold in this type
of market.
● EX. Acquisition of raw materials to
be used for manufacturing of
products.
2. Spot Market
● Assets or goods are sold for and
delivered on the spot or today.
● The determination of price and
delivery of goods is on the same
date.
● EX. A rice dealer went to the farm
during harvest to purchase all the
harvest at an agreed price and to be
delivered on the same day.
3. Future Market
● Future contracts - a contract that
gives the purchaser an obligation to
buy an asset and the seller an
obligation to trade an asset at a
predetermined price at a future
date.
● EX. A rice dealer went to the farm a
month before the harvest to
purchase all the future harvest at an
agreed price and to be delivered on
the day of the harvest.
● EX. Investing in a forward contract
and option contract to hedge
foreign currency transaction
➔ Forward contract - the
exchange rate used to value
6 diamla, foronda, gan
the purchase or sale of
foreign currency is a forward
rate. Hence, the forward
rate is determined today but
the delivery of investment in
foreign currency is in the
future.
➔ Option contract - A
derivative whose value is
derived from the price of an
“underlying” asset.
4. Private Market
● Negotiation and agreement take
place personally between two
parties.
● Makes the contract unique or tailormade.
● EX. Investing in life insurance,
When a depositor opens a savings
or checking account in a bank.
5. Public Market
● Security
or
contracts
with
standardized features are being
traded or held by individuals.
IMPORTANCE OF FINANCIAL MARKETS
●
●
●
Well-functioning financial markets facilitate
the flow of capital from investors to the
users of capital.
➔ Markets provide savers with returns on
their money saved/invested, which
provide them money in the future.
➔ Markets provide users of capital with
the necessary funds to finance their
investment projects.
Well-functioning
markets
promote
economic growth.
Economies with well-developed markets
perform better than economies with poorlyfunctioning markets.
WHAT ARE DERIVATIVES? HOW CAN THEY
BE USED TO REDUCE OR INCREASE RISK?
● A derivative security’s value is “derived”
from the price of another security (e.g.,
options and futures).
● Can be used to “hedge” or reduce risk. For
example, an importer, whose profit falls
when the dollar loses value, could
purchase currency futures that do well
when the dollar weakens.
●
Also, speculators can use derivatives to bet
on the direction of future stock prices,
interest rates, exchange rates, and
commodity prices. In many cases, these
transactions produce high returns if you
guess right, but large losses if you guess
wrong. Here, derivatives can increase risk.
FINANCIAL INTERMEDIARIES
●
Organizations that provide financing to
individuals,
corporations,s
or
other
organizations by raising funds or money
from investors.
1. Mutual Funds (MF)
● The investment company pools money
from the investors then invests these
accumulated amounts in a portfolio of
securities whether equity (shares of
stock), debt (bonds), or money market
(short-term securities).
● The investor’s purchased shares of
the investment company thereby
giving the former the right to receive
the dividends.
● The
Securities
and
Exchange
Commission is what regulates these
mutual funds.
2. Unit Investment Trust Fund (UITF)
● The investment company sells units of
investment to investors to accumulate
a trust fund.
● The trusts fund may be invested also
in equity, debt, or balance of equity
and debt. Hence, the investors own
units of investments not shares of
stock.
● Bangko Sentral ng Pilipinas is the
regulatory body which supervises
these UITF.
3. Pension Fund
● Pooled
contribution
from
the
employees or from the employers that
serves as the investment plans for the
retirement benefits of the employees.
● Can be invested in shares of stocks or
in a mutual fund to increase the
amount of pensions received by the
retirees.
7 diamla, foronda, gan
4. Financial Institutions
● Provides additional financial services
other than pooling and investing of
funds.
● An example is a bank that may serve
as debtor and creditor at the same
time by accepting cash deposits from
savers (borrowing) and providing
loans to individuals or other firms
(lending).
● Another example is the insurance
company that sells protection against
losses from fortuitous events like fire,
accidents, and death.
TRANSFER OF SECURITIES
1. Direct Transfer
● The equity securities evidenced by stock
certificates and debt securities evidenced
by bond securities are issued directly to
the investors.
● These securities do not pass through the
possession
of
any
financial
intermediaries.
2. Indirect Transfer
● The issuing company seeks the aid of the
financial institution to easily issue their
securities to the investors, thus there is
meditation between the issuer and the
investor.
● The investor may acquire securities from
an intermediary that is different from what
has been issued by the corporation.
● Indirect transfer through Investment
Bank
➔ The securities of the company are
bought by the investment bank or
the underwriter with the intention of
reselling them to a prospective
investor.
➔ The securities of the issuing
company will be in the hands of the
investors.
➔ No new form of capital is created.
● Indirect transfer through Financial
Intermediary
➔ The securities of the company are
bought
by
these
financial
intermediaries
without
the
intention of reselling it rather they
will sell their own securities to new
investors.
➔ The securities of the issuing
company are in the possession of
the financial intermediaries while
the new investors will get the
securities issued by the financial
intermediaries.
➔ EX. Investors will receive the
insurance policies issued by the
insurance companies.
➔ A new form of capital is created.
STOCK MARKET TRANSACTIONS
●
●
●
●
●
Stock Market - shares of stocks of a
corporation are sold to new investors
and/or existing stockholders,
The Philippines had two stock markets:
➔ Manila Stock Exchange (MSE)
➔ Makati Stock Exchange (MkSE)
These two markets were unified from the
Philippine Stock Exchange with 8
constituent indices such as:
➔ PSE Composite Index (PSEi)
➔ PSE All Shares Index (ALL)
➔ PSE Holding Firms Index (HDG)
➔ PSE Industrial Index (IND)
➔ PSE Financial Index (FIN)
➔ PSE Mining and Oil Index (M-O)
➔ PSE Property Index (PRO)
➔ PSE Services Index (SVC)
EX. Apple Computer decides to issue
additional stock with the assistance of its
investment banker. An investor purchases
some of the newly issued shares. Is this a
primary market transaction or a secondary
market transaction?
➔ Since new shares of stock are
being issued, this is a primary
market transaction.
EX. What if instead, an investor buys
existing shares of Apple stock in the open
market. Is this a primary or secondary
market transaction?
➔ Since no new shares are created,
this is a secondary market
transaction.
8 diamla, foronda, gan
●
●
●
●
Initial Public Offering (IPO) Markets
➔ Markets where the stocks of a
closely held corporation, going
public, are offered to the public for
the first time.
➔ Closely held corporations undergo
IPO in order to raise additional
capital to finance their operating and
investing activities.
➔ This is in the form of indirect
transfer through an investment
bank.
➔ However, the corporation may also
undergo IPO through direct transfer
where individual investors may place
their respective bid prices and the
corporation selling directly to them.
➔ Generally, the IPO transaction is
classified as a primary market
transaction.
➔ An
exception is when
the
outstanding
stocks
of
the
corporation owned by the existing
shareholders were sold to the public,
the IPO transaction is under a
secondary market transaction.
Seasoned Offering
➔ The issuance of additional shares of
stocks of the company after its first
time offering in order to finance the
capital budget or to improves its
capital structure.
➔ This may be done by family
corporations
or
public
listed
corporations.
Primary Markets
➔ Involved with the issuance or selling
of new shares of stocks to the
investors through the aid of
investment bankers.
➔ The cash proceeds from secondary
market transactions go to the selling
shareholders, not the corporation.
➔ The transaction in this market
changes the size of the capital
structure of the company.
Secondary Market
➔ Involved with the sale of the
outstanding shares of stocks to the
existing shareholders or to new
investors.
➔ The capital structure is not affected
by secondary market transactions.
STOCK MARKET EFFICIENCY
●
●
●
●
●
●
Market Efficiency - if the stock market
shows that the market prices of the stocks
are about equal or close to intrinsic values.
In this situation, the stock price reflects all
publicly available information hence, is
fairly priced.
Investors’ returns or losses under an
efficient market are relatively low.
Market Inefficiency - stock prices are
considered to be highly overvalued or
undervalued. Hence, the investors are not
confident to invest unless they knew some
information over the other.
Securities are normally in equilibrium and
are “fairly priced.”
Investors cannot “beat the market” except
through good luck or better information.
IMPLICATIONS OF MARKET EFFICIENCY
● You hear in the news that a medical
research company received FDA approval
for one of its products. If the market is
highly efficient, can you expect to take
advantage of this information by
purchasing the stock?
➔ No. If the market is efficient, this
information will already have been
incorporated into the company’s
stock price. So, it’s probably too late
for her to “capitalize” on the
information.
IMPLICATION OF MARKET INEFFICIENCY
● A small investor has been reading about a
“hot” IPO that is scheduled to go public later
this week. She wants to buy as many
shares as she can get her hands on, and is
planning on buying a lot of shares the first
day once the stock begins trading. Would
you advise her to do this?
9 diamla, foronda, gan
➔ Probably not. The long-run track
record of hot IPOs is not that great
unless you are able to get in on the
ground floor and receive an
allocation of shares before the
stock begins trading. It is usually
hard for small investors to receive
shares of hot IPOs before the stock
begins trading.
POSSIBLE REASONS MARKETS MAY NOT
BE EFFICIENT
●
●
It is costly and/or risky for traders to take
advantage of mispriced assets.
Cognitive biases cause investors to make
systematic mistakes that lead to
inefficiencies. This is an area of research
known as “behavioral finance.” Behavioral
finance borrows insights from psychology
to better understand how irrational
behavior can be sustained over time. Some
examples include:
➔ Evaluating risks differently in up
and down markets.
➔ Overconfidence leads to selfattribution bias and hindsight bias.
THREE LEVELS OF EFFICIENCY IN
EFFICIENT MARKET HYPOTHESIS (EMH)
CLASSIFICATION OF STOCK PRICES
1. Market Value
● Also known as perceived value.
● Price of stock which is currently traded
in the market.
2. Intrinsic Value
● The true value of the stock
● The price that the willing buyer will bid
and a willing seller will ask provided that
all necessary information about the
stock is available.
● It can be estimated through the
following:
➔ Dividend Discount Model
➔ Corporate Valuation Model
★ If the market value is equal to the
intrinsic value, the stock price is at
equilibrium.
★ If the market value is higher than the
intrinsic value, the stock price is deemed
as overvalued. Stockholders are expected
to sell than to buy shares.
★ If the market value is lower than the
intrinsic value, the stock price is
undervalued. Investors are expected to
purchase more shares to take advantage of
the lower price.
1. Weak form
● The information regarding past or
historical prices of a particular stock is not
conclusive in predicting stock prices.
● An investor cannot beat the market by
simply analyzing the past performances
of the stock.
2. Semi-strong form
● All public information is already
incorporated in the stock prices.
● Investors cannot beat the market solely
by analyzing the published financial
reports of the company unless they have
information from company insiders.
3. Strong form
● Investors cannot beat the market even
with insider information.
● Investors in this market cannot earn high
returns.
10 diamla, foronda, gan