Efficient Market Hypothesis Case Study Example | Topics and Well Written Essays - 2000 words

Efficient Market Hypothesis - Case Study Example In fact investors can predict the future stock prices, based on the past stock prices and even by analyzing financial information such as company earnings and asset values. This paper would examine the relationship between EMH and the future predictions of stock prices based on technical and fundamental analysis. When stocks rose by high percentages the analysts could say that it was due to the efficacy of stock markets and therefore the positive rally reflected the true performance of the company. Efficient markets do exist in theory (Dobbins, & Witt, 1979). For example according to financial theory there are efficient stock markets that especially don't permit market manipulation by investors. However the practical scenario negates this proposition very often. For instance the rally of the stock could be attributed partially to the equity issue and not to the efficiency of the markets. According to many financial economists that future stock/share prices are partially predictable on the basis of past stock price patterns as well as some fundamental valuation metrics. Further economists pointed that these predictable patterns lead investors to earn excess returns with reference to excess risk adjusted rates. The following three problems explain why excessive reliance on fundamental financial analysis isn't going to benefit the investor or shareholder. As(a). Asset substitution problem As and when debt to equity ratio increases investors tend to substitute new assets through new investment thus relatively increasing debt in place of equity. Assuming that investing is riskier, there is still a fairer chance of success against failure thus obliging both debt-holders and share holders to condone such risky investment decisions on the part of management (Campbell, 1987). Successful investments on shares lead to cumulative share holder benefits while unsuccessful ones lead to cumulative debt-holder woes.(b). Underinvestment problem Investors would not hesitate to reject investment in shares with positive Net Present Value (NPV) because they would not be bothered to increase the value of the firm any more than to allow the accrual of benefits associated with riskier debt to debt-holders themselves rather than to share holders.(c). Free cash flow problem Finally there is the problem of free cash flow. In the absence of free cash flow benefits accruing to investors, the management has a tendency to reduce the value of the firm through prodigal behavior, such as granting bonuses and higher salaries. Therefore higher levels of leverage would act as a preventive factor of such behavior and ensure discipline. 2. Overall analysisNext there is the problem of taxes. When corporate taxes are considered the firm is entitled to interest expense deduction which enables it to increase value of its assets. According to Modigliani and Miller (1963) the tax exemption allows the firm to reduce the leverage-based premium in the cost associated with raising the equity capital. Subsequently Miller added personal taxes to the equation.Some authors go a long way to discuss the most efficient ways in managing systematic risk, unsystematic risk and total