Efficient Market Hypothesis Versus Behavioral Finance Models

Part A – Efficient Market Hypothesis Versus Behavioral Finance Models

These resources will help you to complete this discussion:

* Klontz, B. T., & Horwitz, E. J. (2017). Behavioral finance 2.0: Financial psychology. Journal of Financial Planning, 30(5), 28–29.

* Ross, S. A., Westerfield, R. W., Jaffe, J. F., & Jordan, B. D. (2018). Corporate finance: Core principles and applications (5th ed.). New York, NY: McGraw-Hill.

* Chapter 13, “Efficient Capital Markets and Behavioral Challenges,” pages 390–422. This chapter contrasts two of the primary theories of investing: the efficient market hypothesis (EMH) and the behavioral finance view. They are primarily mutually exclusive concepts and color investors’ view of how much they can impact investment returns.

* YaleCourses. (2012). Behavioral finance and the role of psychology [Video] | Transcript. Retrieved from https://www.youtube.com/watch?v=chSHqogx2CI

There are two primary theories of investing: the efficient market hypothesis (EMH) and the behavioral finance view. They are primarily mutually exclusive concepts and color investors’ views of how much they can impact investment returns.

The EMH indicates that all past, present, and anticipated information is already factored in the prices of stock. Hence, it is very difficult to outperform the market. Thus, it would be prudent to just invest in market indexes such as the S&P 500 index. Warren Buffett’s mentor, famed financial pioneer Benjamin Graham, introduced the concept of the erratic Mr. Market, which is the stock market. Mr. Market is always there to buy and sell, but his prices are not necessary instructive or reflect real values. Behavioral finance models indicate that Mr. Market is unstable; thus, the markets can get too enthusiastic and bubbles can occur on the upside.

On the downside, Mr. Market can overreact to bad news, which can result in market crashes. If investors can stay unemotional, they could take advantage of Mr. Market and buy during depressed times and sell during inflated times.

These concepts are not only important in corporate finance with institutional investors but in personal finance for individual investors. There is compelling empirical evidence on both sides of the argument, and it will be wise to see both sides of the coin.

After reading about the two schools of thought, which do you personally believe in: the EMH or behavioral finance? Explain why, and give examples to justify your response.

 

Costs of Financing

These resources will help you to complete this discussion:

* Ross, S. A., Westerfield, R. W., Jaffe, J. F., & Jordan, B. D. (2018). Corporate finance: Core principles and applications (5th ed.). New York, NY: McGraw-Hill.

* Chapter 12, “Risk, Cost of Capital, and Valuation,” pages 357–389. This chapter deals with one of the most well known financial concepts: the cost of capital, or how to figure the threshold rate for investment projects.

* Edspira. (n.d.). Weighted average cost of capital (WACC) [Video] | Transcript. Retrieved from https://youtu.be/46oLXwClvkw

* Beers, B. (2018, February 9). How is debt “a relatively cheaper form of finance than equity”? Retrieved from https://www.investopedia.com/ask/answers/05/debtcheaperthanequity.asp

Not all financing is created equal. Some types are cheaper than others and some are riskier than others for the issuing company. This is an issue for all businesses, large and small. All businesses are striving to come up with a combination of financing that is not only safe for them but low in cost. The primary types of financing are debt/bonds, preferred stock, new common stock, and internal common stock (retained earnings). Firms will have a combination of these financing options and, as a result, will have a weighted average of their various types of cost of capital.

It is important for you to understand the cost of capital and what factors impact the level of costs. Firms that can lower costs of capital typically have a better array of investing options and with that more opportunities to increase company value.

For this discussion, prepare a post that considers these points:

* How is risk incorporated to determine the weighted average cost of capital (WACC) for a company?

* Which of the cost components that go into WACC is the most expensive form of financing to a firm, and which is the cheapest? Explain why, and indicate ways companies can lower their WACC.