Part. A
Q1.i) What factors determine the expected return of a portfolio?
ii) Distinguish between selection and allocation in the context of portfolio management.
Part B
QB1) Compare and contrast the notions of weak-form, semi-strong-form and strong-form marketm efficiency.
QB2) Critically examine the following concepts:
a) Capital Asset Pricing Model
b) Arbitrage Pricing Theory
a) Explain the patterns (effects) in equity returns?
b) According to the above study, what effects can be seen in the Australian market? Explain. You are asked to use similar articles for more information.
Part C
QC.1.a. Explain the motives behind mergers and takeovers.
QC.1.b. Consider the following two quotations.
The quotation below is taken from: Jensen and Ruback (1983) ‘The Market for Corporate Control’,
Journal of Financial Economics, Vol. 11(April): 5-50.
“Many controversial issues regarding the market for corporate control have yet to be settled and many new issues have yet to be studied. It is clear, however, that much is now known about this market. Indeed, it is unlikely that any set of transactions has been studied in such detail. In brief, the evidence seems to indicate that corporate takeovers generate positive gains, that target firm shareholders benefit, and that bidding firm shareholders do not lose. Moreover, the gains created by corporate takeovers do not appear to come from the creation of market power. Finally, it is difficult to find managerial actions related to corporate control that harm stockholders; the exceptions are those actions that eliminate an actual or potential bidder, for example, through the use of targeted large block repurchases or standstill agreements.” Jensen and Ruback (1983), p. 43.
The quotation below is taken from: Renneboog and Zhao (2014) ‘Director networks and takeovers’,
Journal of Corporate Finance, Vol. 28: 218–234.
“In this paper, we focus on how the connections of bidder and target firms impact on various aspects of mergers and acquisitions (M&As) in the UK. In a network context, we study the frequency of takeovers, the M&A process (in particular, the duration of the negotiation and the success versus failure at the end of the negotiation process), the means of payment (all-equity, all-cash or mixed offers), the retention or attraction of directors of the target firm on the board of the merged firm, and whether there is a difference in terms of abnormal returns at the announcement of connected and non-connected M&As.” Renneboog and Zhao (2014), page 219.
Question QC1.b: Do takeovers increase the value of the target, or the bidder company, and/or aggregate market value?
NB: 1) Understanding the notions in articles is more important than an entanglement with the advanced math in many articles; and
Do not plagiarise the article content, instead cite or better yet, paraphrase it and always give full references. This shows that your opinions are informed opinions.
The expected return on the portfolio would be dependent on the following factors.
Stock Selection for the portfolio
If the portfolio consists of stocks that tend to offer higher returns, then it will have an impact of the portfolio returns as well. However, on the other if the constituent stocks have lower average returns, then the expected return on the portfolio would diminish (Damodaran, 2008). Consider there are two portfolios X and Y. X has equal share of both A and B whose average returns are 10% and 20% respectively. However, Y has equal share of both A and C whose average returns are 10% and 5% respectively.
Expected returns on X = 0.5*10 + 0.5*20 = 15% pa
Expected returns on Y = 0.5*10 + 0.5*5 = 7.5%
Hence, higher return stock should be selected while accounting for underlying risk.
Weights of the stocks
In order to enhance the expected returns, maximum weightage must be given to the stock that has be highest expected return. For instance, assume another portfolio Z is in place now which constitutes 25% of A and 75% of B (Petty et. al., 2015).
Hence, expected returns on Z = 0.25*10 + 0.75*20 = 17.5% pa
Thus, superior returns are delivered by altering the weight of the individual stock.
Stock Selection refers to the traditional approach to portfolio management where the aims and objectives of the underlying investor were taken into consideration and thus the stocks were selected so as to ensure that these objectives of the investor are met while respecting the constraints in the process. The various aims and objectives dealt with requirement of income at specific time periods along with the requirement of liquidity and returns. Hence, those securities are included in the portfolio which tends to serve the objectives of investment without any regard to efficiency (Brealey, Myers and Allen, 2008).
The Stock allocation approach to portfolio management is a modern approach which is based on Markowitz theory and takes into consideration the risk return features of the various asset classes and available securities and based on this an optimum portfolio is chosen which tends to maximise the return per unit risk rather than the focusing on the individual objectives of the given investor. This is a superior approach since the emphasis is on selection of optimum portfolio from the aspect of efficiency which augers well for the investor (Parrino and Kidwell, 2011).
The various forms of market efficiency are illustrated below.
Weak Form of market efficiency
As per this form, the future stock prices follow a random walk and thus are independent of the past price trends. The future prices of the stocks would essentially be driven by the information flow in the future and no such pattern can be derived from any analysis of historical prices. As a result, this argument renders technical analysis as useless while giving some utility to the fundamental analysis (Petty et. al., 2015).
Semi-Strong Form of market efficiency
As per this form, the stock prices tend to adjust to any new information in the public domain in such a swift manner that market participants cannot initiate trades based on this information in order to consistently beat the market. As a result, this form of market efficiency renders both technical and fundamental analysis as useless as the price adjustment is so quick that no trade can be made by the market participants (Damodaran, 2008).
Strong Form of market efficiency
As per this form, the market price of a stock tends to build in all the private and public information that may be available with regards to the stock. Further, any deviation from the intrinsic price is so quick that the it cannot be used to beat the market on a sustainable basis. This form is not true in any stock market as it makes glaring assumptions with regards to the information symmetry and lack of taxes and incidental costs (Shim and Siegel, 2008).
The CAPM is a theoretical framework which aims to establish a linear relationship between risk and the expected returns on the stock. While it is a simple and useful model, it has certain shortcomings indicated below (Brealey, Myers and Allen, 2008).
The risk free rate and the market returns are not constant values and are dynamic on a daily basis.
The underlying assumption that the money could be lent and borrowed at the risk free rate is not true and essentially would depend on the underlying risk profile of the borrower and lender.
There are concerns with regards to the beta not being able to faithfully capture the systematic risk.
As per this model, there is a relationship between the underlying risk and return of the stock which can be predicted by multifactor analysis such as macroeconomic variables (inflation, unemployment GDP) along with factors that may be specific to a particular industry. Unlike CAPM which is a single factor model, APM tends to focus on multitude of factors so as to spot short term arbitrage opportunities by finding the difference between intrinsic price of stock and the actual market price. The main shortcoming of this model is the underlying complexity and limitation with regards to accounting for every variable that may impact the stock price (Damodaran, 2008).
C(a) The various patterns in equity returns are highlighted below (Petty et. al., 2015; Parrino and Kidwell, 2011; Damodaran, 2008).
Size effect – As per this effect, typically firms that are smaller in size tend to outperform the companies that are larger in size in terms of returns.
Book to Market Effect – As per this effect, the stocks having higher book to market value are cheaper and value stocks and must be invested into as compared to the ones with comparatively lower book to market value.
Earnings to Price Effect – As per this effect, the stocks having higher earnings to price ratio tend to outperform the stocks with lower earnings to price ratio in terms of return in the long run.
Cash flow to Price Effect – As per this effect, returns on those firms which tend to generate higher cash flows per unit of price is lower as compared to those firms which tend to generate lower cash flows per unit of price.
Leverage Effect – As per this effect, the underlying valuation of any stock in the market is dependent on the underlying leverage present in the capital structure as typically high volatility in stock price is associated with high leverage and hence companies having low leverage are considered to be relatively safe bets with lower price volatility.
Liquidity Effect – Typically higher the liquidity on a given stock, lower would be the return expected on the stock as the bid ask spread would be lower. Hence, for stocks having low spread, it is likely that they would be held for longer periods as compared to those with higher spreads.
b) The various anomalies that are seen in case of equity returns are not able to get an explanation from the traditional CAPM approach which is essentially a single factor model based on beta. Hence, it makes sense to use modern approach suggested by Fama French which takes into consideration multiple parameters to accurate determine the returns on the stock. There have been numerous research studies in the context of anomalies of stock return specific to Australian market and evidence has been found with regards to the existence of liquidity effect, size effect and B/M effect to various degrees. However, the given study takes into consideration the Fama French approach which has been successfully deployed in the US market. The given research finds that the larger portfolios tend to have lower returns as compared to those with smaller portfolios that tend to have higher returns (Damodaran, 2008). Hence, the presence of the size effect is confirmed in the study which is in line with empirical observations collected from other studies conducted in the Australian context.
With regards to B/M ratio, it is apparent that the returns of those stocks that have a higher B/M ratio tend to be higher than those stocks that have a lower B/M ratio. This is in line with the empirical evidence collected from previous studies in the Australian market and lends support to the existence of B/M effect as per which value stocks tend to outperform growth stocks. Additionally, it has been found in the study that a U shaped relationship tends to exist between the underlying leverage levels and the returns on stock. As a result, portfolio which either have low or high leverage tend to outperform those which have leverage in the middle range. This does hint towards the presence of a leverage effect but the result obtained is contrary to that obtained by previous research conducted in the US context which concluded the relationship to be of inverted U shape. Hence, further research is required on this aspect in the Australian concept (Gharghor, Lee and Veeraraghavan, 2009).
With regards to existence of liquidity effect in the Australian context, the researchers are divided as the current study fails to establish its presence but previous studies in this regards have indicated the presence of various premiums associated with liquidity associated with investment in different time horizons. Hence, it would be fair to conclude that no consensus exists in this regard. The current study indicates the existence of a mild C/P effect and it is in line with the understanding of this effect that as C/P value increases, there is a downward trend in terms of returns. Also, a E/P effect is quite visible on the basis of the given research that has been conducted and it tends to support the empirical observations that have been observed in the US market. It is noteworthy in this regard that the E/P effect is comparatively more strong for stocks have negative earnings that for those which display a positive earnings. Future research in these regards could bring more clarity on the difference in strength of the E/P effect (Gharghor, Lee and Veeraraghavan, 2009).
1a. The various motives behind mergers and takeovers are as follows (Brealey, Myers & Allen, 2008).
Synergies – The most common motive is this as it is widely believed that merged entity would be bigger than the sum total of two individual entities due to savings in cost or enhanced revenues by ensuring cross selling of products in newer markets that can be accessed through this route.
Diversification – Another common reason which is adopted by conglomerates is diversification of strategic business units so that the business risk could be adequately hedged and also the various lucrative businesses could be acquired in line with the existing market conditions.
Market Power – The merger of two big companies can potentially be motivated through the desire to increase the market clout as the formed entity would be big enough so as to impact the prices and cause a change in the market structure for the benefit of the merged entity.
Rapid Growth – With regards to achieving growth, a company has two alternatives and the takeover route is the inorganic route where the related business investment is made perhaps in a geography or product line where the company intends to enter and therefore enhance the presence.
Acquisition of specific skills or capabilities – Typically, firms that are lacking in a particular aspect or skill tend to look for specific targets so as to make up for the skill deficiency through the acquisition route. This is especially the case when the same cannot be developed using the internal capabilities in a time bound manner.
b) One of the key topics of research with regards to mergers and acquisitions has been the concept of value creation in such deals. There has been wide debate with regards to the value creation from such deals with studies yielding contradictory results. In order to summarise the value creation in corporate takeovers, there are various studies that have been conducted from various perspective considering a host of variables that tend to impact the value created. The key data in this regard is provided by various event studies that tend to measure the abnormal returns that are witnessed when the announcement regarding the takeover or merger is first made (Petty et. al., 2015).
With regards to target firms shareholders, studies have indicated double digit monthly returns ranging from 16 % to 29%. However, the returns have been comparatively less spectacular in case of merger target firms although they have been positive (Brown and Warner,1980). But, certain researchers estimate that the reaction of shareholders to the initial news tends to underestimate the extent of value creation since it does not consider the share premium that has been paid by the acquirer even before the takeover has taken place (Dodd and Ruback, 1977). Further, it has also been empirically observed that there is no difference in the potential gains realised by the shareholders of the target firms irrespective of whether the bid goes through or not. However, in such cases, if no bidder gets attracted within a period of two years, then all the potential gains that the stock realised at the time of the offer would be lost in a gradual manner.
With regards to shareholders of the bidding firm, it has been empirically observed in various event studies that for successful bids, there is creation of some shareholder value as represented by increase in the share price but it is significantly lower than that created for the target firm. However, the above is limited only to tender offers as in case of mergers due to mixed nature of observations. But more evidence in this regards, hints that in case of mergers, the gains for the bidding firm as reflected by the immediate movement in the stock price tends to be almost zero (Asquith, Bruner and Mullins, 1983). The negative perception of mergers in the minds of the investors is also supported by certain empirical studies which indicate that the news of the unsuccessful bids in case of mergers typically leads to a mild positive response from the market (Asquith and Kim, 1982). However, there is considerable debate between researchers with regards to utility of abnormal returns by the bidding firms accurately capturing the creation of value as it might be anticipated to some extent and also because the gains for the bidder firms may be gradual as compared to the target firm which is able to cash out at the time of the merger or takeover (Jensen and Ruback, 1983).
Also, there are computation issues for estimation of precise gains for the bidder firm. One of the contributory reasons in this regards is the difference in size due to which even if the absolute gains are evenly split, in percentage terms, the gains for the target firm would significantly outweigh the bidder firm. This effect is confirmed by the study done by Asquith, Bruner and Mullins (1983) who based on event studies, concluded that the returns for bidder firms are significantly greater when the target is more than 10% of the size of the bidder as compared to when it is lesser. Also, certain studies also indicate post-merger correction in the bidder stock which can be explained on the basis of error in estimation of merger related gains which may not actually transform. Further, it is likely that regulatory changes and other issues related to integration of the firms may also have an effect on the likely efficiency gains which are reflected in the stock price only when these are unfolded (Jensen and Ruback, 1983).
A logical conclusion of the above impact is that on the whole value is created since neither of the party is ending up losing although the gains are comparatively higher for target firms in comparison to bidders. Further, there is evidence to support that gains in case of merged entities do not arise necessarily from synergies or cost savings but from the change in the corporate control which essentially leads to higher valuation for the companies (Bradley, 1980). Considering the complex landscape where a plethora of players and legal regulations are involved, it would be naïve to expect that the value creation is as simple as transfer of wealth from the target that is being acquired or merged with. The exact gains are in actuality dependent on a host of factors ranging from level of information available in the public domain about the merger/takeover, antitrust violations and also the issues of corporate control (Jensen and Ruback, 1983).
Further, it is estimated that the level of connection of directors also has an impact on the frequency of takeovers and the mode in which it is executed which in turn could influence the process and amount of value creation. Typically, the companies that have well connected directors tend to have more access to information and are able to forge better trust with the top management of the target firm which ensures the above average activeness of these firm with regards to mergers and acquisitions (Liu, 2014). Further, research in this regard indicates that the probability of implementation of a successful takeover tends to enhance in a statistical significant manner, if atleast director is common to both the firms Also, in case of networked firms led by their CEO’s there is a drastic decrease in the amount of time used for negotiation irrespective of the fact whether they proceed with the takeover or not. Besides, in takeovers where there is relation between the firms, equity is comparatively more often used for compensation rather than cash which is reflective of the greater transparency and also information premium gained through such access (Wu, 2011). Also, another advantage associated with connected M&A’s is the fact that there is a significantly greater chance that the key management of the target firm would be retained. It is apparent that all the above factors hint towards the process of M&A being completed in a more efficient manner which in the long term should enhance the overall value creation. However, with regards to creation of value, the market does not seek to believe that better networked CEO’s and directors tend to work out better deals and hence thus no superior returns are derived for these. This is rather strange and unpredictable and hints to the continued research in this field so as to understand as to capture the exact parameters that tend to drive the value generation in case of mergers and acquisitions (Renneboog and Zhao, 2014).
References
Asquith, P. and Kim, E.H. (1982), The impact of merger bids on the participating firms security holders, Journal of Finance, 37, 1209-1228.
Asquith, P., Bruner, R. and Mullins, D.W.(1983), The gains to bidding firms from merger, Journal of Financial Economics, 11(April), 45-67
Bradley, M. (1980), Interfirm tender offers and the market for corporate control, Journal of
Business 53, 345-376.
Brealey, R., Myers, S. and Allen, F. (2008), Principles of Corporate Finance (Global edition), New York: McGraw Hill Publications
Brown, S. and Warner, J. (1980), Measuring security price performance, Journal of Financial Economics, 8, 552-558.
Damodaran, A. (2008), Corporate Finance, London: Wiley Publications
Dodd, P. and Ruback, R. (1977), Tender offers and stockholder returns: An empirical analysis, Journal of Financial Economics 5, 351-374.
Gharghor, P., Lee R. and Veeraraghavan, M. (2009), Anomalies and stock returns: Australian evidence, Accounting and Finance, 49, 555 – 576.
Jensen,M.C. and Ruback R.S. (1983), The Market for Corporate Control, Journal of Financial Economics, 11(April), 5-50.
Liu, Y. (2014). Outside options and CEO turnover: The network effect, Journal of Corporate Finance, 28, 201–217
Parrino, R. and Kidwell, D. (2011), Fundamentals of Corporate Finance, London: Wiley Publications
Petty, J.W., Titman, S., Keown, A.J., Martin, P., Martin J.D. & Burrow, M. (2015), Financial Management: Principles and Applications, Sydney: Pearson Australia,
Shim, J.K. and Siegel, J.G. (2008), Financial Management, New York: Barrons
Renneboog, L. and Zhao, Y. (2014), Director networks and takeovers, Journal of Corporate Finance, 28, 218–234.
Wu, Q. (2011). Information conduit or agency cost: top managerial and director interlock between target and acquirer. Working Paper, Arizona State University.
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