ACCA FM Syllabus F. Business Valuations - Efficient Market Hypothesis (EMH) - Past Papers ^{1 / 4}

Ring Co has in issue ordinary shares with a nominal value of $0·25 per share. These shares are traded on an efficient capital market. It is now 20X6 and the company has just paid a dividend of $0·450 per share. Recent dividends of the company are as follows:

Ring Co also has in issue loan notes which are redeemable in seven years’ time at their nominal value of $100 per loan note and which pay interest of 6% per year.

The finance director of Ring Co wishes to determine the value of the company.

Ring Co has a cost of equity of 10% per year and a before-tax cost of debt of 4% per year. The company pays corporation tax of 25% per year.

The finance director of Ring Co has been advised to calculate the net asset value (NAV) of the company.

Which of the following statements about capital market efficiency is/are correct?

(1) Insider information cannot be used to make abnormal gains in a strong form efficient capital market
(2) In a weak form efficient capital market, Ring Co’s share price reacts to new information the day after it is announced
(3) Ring Co’s share price reacts quickly and accurately to newly-released information in a semi-strong form efficient capital market

A. 1 and 2 only
B. 1 and 3 only
C. 3 only
D. 1, 2 and 3

Gurdip plots the historic movements of share prices and uses this analysis to make her investment decisions.

To what extent does Gurdip believe capital markets to be efficient?

A. Not efficient at all
B. Weak form efficient
C. Semi-strong form efficient
D. Strong form efficient

Gemlo Co is planning an expansion of existing business operations costing $10 million in the near future and is assessing its current financial position as part of preparing a business case in support of seeking new finance.

The business expansion is expected to increase the profit before interest and tax of Gemlo Co by 20% in the first year.

The planned business expansion by Gemlo Co has already been announced to the stock market. Information on the expected increase in profit before interest and tax has not yet been announced and the company has not decided on how the expansion is to be financed.

The ordinary shares of the company are currently trading at $3·75 per share on an ex dividend basis. The irredeemable loan notes have a cost of debt of 7%.

The 7% loan notes have a cost of debt of 6% and will be redeemed at a 5% premium to nominal value after seven years. The interest cover of Gemlo Co is 6 times.

Companies operating in the same business sector as Gemlo Co have an average debt/equity ratio of 40% on a market value basis and an average interest cover of 9 times.

Gemlo Co agrees with a bank that its business expansion will be financed by a new issue of 8% loan notes.

The company then announces to the stock market both this financing decision and the expected increase in profit before interest and tax arising from the business expansion.

Required:
Assuming the stock market is semi-strong form efficient, analyse and discuss the effect of the financing and profitability announcement on the financial risk and share price of Gemlo Co.

Note: Up to 2 marks for relevant calculations. (6 marks)

Which of the following statements are correct?

(1) If a capital market is weak form efficient, an investor cannot make abnormal returns by using technical analysis

(2) Operational efficiency means that efficient capital markets direct funds to their most productive use

(3) Tests for semi-strong form efficiency focus on the speed and accuracy of share price responses to the arrival of new information

A. 1 and 2 only
B. 1 and 3 only
C. 2 and 3 only
D. 1, 2 and 3

An investor believes that they can make abnormal returns by studying past share price movements.

In terms of capital market efficiency, to which of the following does the investor’s belief relate?

A. Fundamental analysis
B. Operational efficiency
C. Technical analysis
D. Semi-strong form efficiency

Gurdip plots the historic movements of share prices and uses this analysis to make her investment decisions.

To what extent does Gurdip believe capital markets to be efficient?

A. Not efficient at all
B. Weak form efficient
C. Semi-strong form efficient
D. Strong form efficient

The equity beta of Fence Co is 0•9 and the company has issued 10 million ordinary shares. The market value of each ordinary share is $7•50. The company is also financed by 7% bonds with a nominal value of $100 per bond, which will be redeemed in seven years’ time at nominal value. The bonds have a total nominal value of $14 million. Interest on the bonds has just been paid and the current market value of each bond is $107•14.

The equity beta of Fence Co is 0•9 and the company has issued 10 million ordinary shares. The market value of each ordinary share is $7•50. The company is also financed by 7% bonds with a nominal value of $100 per bond, which will be redeemed in seven years’ time at nominal value. The bonds have a total nominal value of $14 million. Interest on the bonds has just been paid and the current market value of each bond is $107•14.

The risk-free rate of return is 4% per year and the average return on the stock market is 11% per year. Both companies pay corporation tax at a rate of 20% per year.

Required:

(d)Discuss the differences between weak form, semi-strong form and strong form capital market efficiency, and discuss the significance of the efficient market hypothesis (EMH) for the financial manager. (8 marks) (25 marks)