This paper seeks to analyze and discuss the statement: “If the capital market is efficient, there is no need to spend time setting a particular capital structure and dividend policy for a listed company.” The framework used to analyze and discuss the statement includes knowing the concept of an efficient capital market, knowing the purpose of setting capital structure and dividend policy, and knowing their implications. The paper will also attempt to restate and reverse the proposition being analyzed and see the effect of resulting arguments about the validity and implication of such a proposition or statement.
An efficient capital market means a situation where an investor would not be in a position to beat the market or not be able to earn an abnormally high rate of return from investments since the prices of present stocks of listed companies are assumed to reflect all the required information for decision making. In other words, it would only be by luck and not as a matter of strategy if one investor would be able to earn an abnormally high rate of return. The theory also assumes complete rationality of all investors as each would be attempting to maximize his return but that anyone would not be in a position to take advantage of any information since the same is assumed to be known to all of the other investors (Brigham and Houston, 2002; Weston and Brigham (1993).
To set up a particular capital structure for a given company is to choose the proper mix of debt and equity that a firm can use to finance its assets. Such an act, therefore, presupposes a target capital structure in relation that what will minimize a firm’s weighted average cost of capital (WACC) to maximize shareholders’ wealth. It is this optimal capital structure under a minimized WACC that the firm is likely to evaluate decisions on projects or investments that it would accept or reject. As a rule, it would use the same in accepting capital projects or investment options that would provide a return that is at least higher than WACC and reject the capital budgeting projects that would be below the said cost of capital as approximated under an optimal target financing mix (Brigham and Houston, 2002).
Dividend policy, on the other hand, presupposes also the importance of using the same for influencing the stock price of the company which will have to attain minimized weighted cost of capital, like the capital structure. Dividend policies may be designed under the signaling hypothesis where the investors may regard dividend changes as signals of management’s earnings forecasts. The signaling hypothesis could be expressed in the argument that a dividend increase would cause an increase in the stock price, while a dividend cut may lead to stock price decline (Brigham and Houston, 2002, Van Horne, 1992). It can be inferred therefore that a dividend policy was meant to reduce the cost of equity which forms part of the computation of cost of capital that must also be minimized.
However, according to Brigham and Houston (2002), no one can establish a clear relationship between dividend policy and the cost of capital. They argued that investors in aggregate cannot be seen to uniformly prefer either higher or lower dividends. However, the same authors noted that individual investors do have strong preferences so that some prefer higher dividends, while others prefer capital gains (Brigham and Houston, 2002). In noting again the differences among individuals, they still maintained that such would help explain why it is difficult to reach any definitive conclusions regarding the optimal dividend payout. Thus they argued that despite such absence of definite findings on optimal dividend payout ratio, the authors believed that both evidence and logic suggest that investors have a preference for firms that follow a stable, predictable dividend policy (Brigham and Houston, 2002).
To put it simply setting up a target capital structure and designing the appropriate dividend policy is a choice to a corporation under a particular industry because each industry is assumed also to be facing different levels of risks at a certain point in time. Such strategy is therefore aimed at what will maximize the wealth to the stockholders or shareholders just like the case of setting up an efficient capital structure.
Going back to the statement that if the capital market is efficient, there is no need to spend time setting a particular capital structure and dividend policy for a listed company, a fresher perspective or deeper insight may be derived by trying to restate the same.
If such a proposition is restated, it could be argued that aiming to maximize the stockholder’s wealth by the use of capital structure and dividend policy would be made useless because of the incapacity of any investor to be able to outdoor beat the market by gaining abnormally high rate of return.
It can easily de deciphered that there seems to be some fallacy in the argument given the assumed equality of beating the market by earning abnormally high returns with maximizing wealth. To illustrate the fallacy by using numbers, it can be assumed that an abnormally high return can say 15% or higher as the normal market rate is 12% or lower.
To sustain the argument of using proposition would be to say that since 12% is the maximum rate and that it would be impossible to reach 15%, the company need not have to design its capital structure or its dividend policy because whatever it does, it could only reach the normal rate of 12% or lower. After all, the capital market is efficient.
If the premise is sustained, it would mean that under an efficient capital market, the fallacy, therefore, becomes clearer with the illustration. It would be tantamount to stating that if assuming that all companies are operating under perfect market competition, where the marginal revenue is the same as marginal cost, there would be no need to plan to operate at a minimum cost because anyway there is no chance to earn a higher return than the market.
Under the statement being analyzed, companies are left nothing to do as their profitability would just come by chance as well. This would be absurd.
By arguing using the reverse of the original proposition, it can be stated that in the absence of an efficient capital market, wealth maximization strategies such as setting a particular capital structure or dividend policy would mean to be most favorable. In other words, it could be asserted or argued that the reason why firms can maximize wealth is due to the absence of an efficient capital market. It could therefore be posited that not all information is reflected in the prices and that some stocks could be overvalued or undervalued at times. It could be argued that some investors are better informed than others so that those who have more information are in a better position as they would be taking advantage of that information.
When the capital market is not efficient, there is a lack of complete rationality. One theory that explains it is the behavioral finance theory which assumes that not all investors are rational and they could have their own biases. Would it mean then that investors are better positioned because they have biases that could serve them well? Or, would the irrational people become losers in the decision make process because they are not rational? Behavioral finance is worth looking at in light of these possibilities.
Behavioral finance can be defined as that body of knowledge that takes exceptions to what has been traditionally assumed under expected maximization (Ritter, 2003). Hong (2007) attempted to introduce literature on behavioral finance with what the latter has achieved empirically and theoretically. This includes admitting the growth of behavioral finance for the last fifteen years given the resulting considerable bodies of both theory and empirical evidence (Hong, 2007 citing Hirshleifer, 2001). Empirically, Hong mentioned as evidence the capacity of behavioral finance to forecast stock returns on the empirical front using a long list of variables (Hong, 2007). New datasets were used in research for a better understanding of the real determinants of the behavior and performance of investors both locally but also globally (Hong, 2007 citing Odean, 1999; Huberman, 2001, Guiso, Sapienza and Zingales, 2004).
The occurrence of investment decisions as found by the researcher bears witness to the presence of behavioral finance theory as explained by the author. On the theoretical side, Hong (2007) described the extent of present research along three separate lines. These include understanding the reasons for rational businessmen’s failure to eliminate the predictability patterns, explanation of the specific nature of the patterns of predictability, and an examination of corporate managers’ behavior. In essence, the object of behavioral finance is to assume that not all decisions are rational because of the presence of some factors that may be uncertain or extraneous (Hong (2007)
By applying the argument in reverse of the statement being analyzed, it would mean that lack of rationality is causing people to maximize wealth. Hong (2007) cited recent researches that were conducted for demonstration of the interrelationships among existing models and new datasets, both within behavioral finance and across other disciplines.
The fact that some investors are affected by macroeconomic shocks would prove that decision maker would rather not allow the market to correct the prices as they have the feeling that their investments could suffer losses if they will not move. If analyzed, the decision may indeed be a reaction to an external event but they could not just trust the market to do the correction because not anyone could tell that they could suffer worst if they will not act.
Citing other data sets, Hong (2007) asserted evidence on both loss aversion and over-trading on the part of investors in their database, which confirmed earlier results from some of the authors of the said study. Loss aversion, which is not necessarily rational, is a natural reaction of most investors and hence this could only be confirmatory also of the overriding purpose of financial management which is stockholders’ wealth maximization (Brigham and Houston, 2002).
If there is evidence of both loss aversion and over-trading on the part of investors under behavioral finance, it could be argued such is lack of rationality could be causing them to maximize their wealth or minimizing their wealth if these investors lose them from their investments. If on one side, it is argued that they would indicate maximize their wealth by their lack of rationality then it can be said that lack of rationality could indeed cause one to be wealthy. If this is true then man will not have to study in school to control one’s emotion in decision making since it could be that plenty of emotions or being irrational could just be the means to become wealthy.
The cognitive theory asserts the presence of documented systematic errors in the way people think such as when people feel overconfident and when they rely more on experience by refusing to see the changing conditions of the market. These errors could be considered behaviors and when translated into preferences and biases, do create distortions that are considered departures or variations from what is rational. It is therefore the work of behavioral finance to give allowance to these kinds of documented behaviors so that existing theories on finance should be modified accordingly in explaining things.
To assert that lack of rationality because of inefficient of the capital market allows better profit maximization strategies, would be arguing complete lack of rationality among investors and it would be hard to believe who would prosper in many situations. Such a world would be really hard to contemplate because the results would simply be unbelievable.
As contrasted to behavioral finance, the modern finance theory builds on the Efficient Market Hypothesis (EMH) asserts that competition among investors who are looking for high profits would be made to bring the value to the correct one. EMH must be interpreted to be closely associated and related to an efficient capital market (Ritter, 2003). Using rationality as an assumption where all investors have them must also imply an element of randomness or uncertainty of what will happen in the future. The EMH theory does not claim to fully know well what will happen in the future given that its assumption that the markets will eventually be rationally making unbiased forecasts of the future has the effect of making a forecast for which decision-makers would believe to be reliable for decision making. In this context, behavioral finance does not then necessarily contradict the modern finance theory but may indeed supplement the theory when information is not efficient or complete for decision-makers to use (Ritter, 2003).
What this means is that the EMH does not assume a perfect market where there is no possibility of errors and in fact, luck in earning an abnormally high return is still possible. It cannot mean though firms will no longer have to minimize their cost of capital as the assumption of complete rationality to make an unbiased forecast of the prices would simply be eventually expected for the meantime. In statistics, the fact that there is an element of the randomness of events that will occur in the future will neither deny also the existence of some data that could be used for decision making to at least make a decision that is more favorable than just left to chance. Just like as asserted by Brigham and Houston (2002), the fact the there was no definitive relationship between dividend payment of pay-out ratio, there is evidence that investors would prefer more stable dividends than not at all. It is the element of uncertainty in the future that should encourage more planning to avoid planning given the uncertainty would be an act of recklessness.
Documented patterns on how people behave in their investments are noted by cognitive psychologists. One example is heuristics which are the rules of thumb to simplify decision-making. If the user is not careful though, this could lead the person to make biases, particularly when conditions have changed. A suboptimal decision could only be expected as a result (Ritter, Jay, 2003, citing Shlomo and Thaler, 2001). Another type of bias is overconfidence. It is said that people want to be confident about themselves but sometimes this is exceeded thus the consequence could be problematic. The nature of being an entrepreneur makes it very probable because of the need to rise again and again after every fall or just the person’s inherent association of being positive-minded. Overconfidence can be manifested in little diversification as one would be tempted to invest most in one that generates high returns which are familiar. This explains the reason for investors maintaining their investments in local companies.
Relying on experience is part of cognitive bias and not necessarily rational because of the desire to view the future as just a continuation of the past. It could be safely argued that the use of financial ratios of successful companies in the past is being used by the decision-makers. To a certain extent, it can be asserted the setting a capital structure and dividend policy could just be an example or application of cognitive bias which is part of behavioral finance. It is not a necessary part of an efficient capital market that has been practiced by decision-makers even at present. This is great evidence that applying some concepts of non-efficient capital market concepts as the original proposition would like to be believed is simply not supported by clear empirical evidence.
It can be concluded that the statement as analyzed in this case may indicate an attempt to equate the efficiency of the capital market with the strategy of wealth optimization strategy in the life of companies. However, the proposition appeared to be an oversimplification of the relationship between two broad concepts. To deny the capacity of entities to maximize wealth through setting up a particular capital structure because of the possibility that the capital market is efficient would be amounting as well denial for companies to plan and make choices. This will make things absurd as there would arise a lack of necessity to choose among options and would deny choices that will be made by managers. It would be tantamount to denial also of the factors that would make exceptions about human rationality. As presented in this paper, there are alternative theories that would criticize the EMH or efficient capital market theory and which are also supported by evidence in research. One is the behavioral finance theory which asserts exceptions to rationality. When an argument was prepared in reverse, it was found absurd to sustain the statement that lack of rationality should encourage wealth maximization strategies by setting up a particular structure and dividend policy.
References
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