Question 7.SE.2: Consider each of the following. 1 An investor expects to mak...
Consider each of the following.
- An investor expects to make abnormal gains on her stock market investments by analysing published annual reports, relevant newspaper articles, industry reports and published share prices.
- Dorsal plc, a business listed on the London Stock Exchange, received a confidential letter from a rival business on 30 July 2016 offering to buy all its shares at a premium of 20 per cent on their current market value. At a private meeting, convened on the same day, the directors of Dorsal plc agreed to accept the offer and made a public announcement of this decision on 3 August 2016.
- Juniper plc is an airport operator that is listed on the London Stock Exchange. Recently, the board of directors agreed to change the company’s depreciation policy concerning airport runways. In future, these assets will be written off over 100 years rather than 50 years. This change, which will reduce the annual depreciation charge over the next 50 years, is solely designed to increase reported profits over that period and thereby create a better impression to investors of business performance.
Required:
(a) What is the maximum level of market efficiency that the investor is assuming in (1) above? Briefly explain your answer.
(b) What would be the share price reaction to the announcement in (2) above under the strong form of market efficiency and why?
(c) What is the maximum level of market efficiency that the board of directors is assuming in (3) above that is consistent with such behaviour? Briefly explain your answer.
(a) The weak form of market efficiency is the maximum level of efficiency assumed. When a market shows efficiency beyond this form (that is, semi-strong or strong forms of efficiency) current share prices reflect all publicly available information. There would, therefore, be no point in examining the type of published information mentioned in order to achieve abnormal gains.
(b) There will be no share price reaction. Under the strong form of market efficiency, the share price will rise on 30 July 2016, when the decision to accept the offer is made. All information, whether or not it is formally put into the public domain, will be available to the market.
(c) The maximum level of efficiency assumed is the weak form. Under the semi-strong form of market efficiency, you cannot fool the market. Investors will ‘see through’ cosmetic changes in accounting policies. Thus, the lengthening of the depreciation period should not provoke a share price reaction.