Expected return is the cost of capital because it is the rate of return that we

Expected return is the cost of capital because it is

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Expected return is the cost of capital because it is the rate of return that we can get by not undertaking the project, but instead invest in the financial markets.
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40 Chapter 12, 13, 22: Market Efficiency Intrinsic Value of Stocks In theory, the intrinsic value of stocks is “the present value of future cash flows” . o Future cash flows (E.g. dividends, free cash flows) o Discount rate (E.g. CAPM) Announcements and news o Contains both an expected component and a surprise component o For example, if the EPS expectation was $1 before earnings announcement, while the actual announcement is $1.1, only $0.10 will affect the stock price. Capital Market Efficient Capital Market Market in which security prices reflect available information. o Efficient markets are a result of investors trading on the unexpected portion of announcements o There are many investors out there doing research o As new information comes to market, this information is analyzed and trades are made based on this information o Therefore, prices should reflect all available public information Stock prices are “fairly” priced o Efficient markets involve random price changes because we cannot predict surprises o If this is true, then you should not be able to earn “abnormal” or “excess” returns
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41 Three Forms of Market Efficiency Strong Form Semi-Strong Form Weak Form Prices reflect all information, including public and private. Investors could not earn abnormal returns regardless of the information they possessed. Empirical evidence indicates that markets are NOT strong form efficient and that insiders could earn abnormal returns Prices reflect all publicly available information including trading information, annual reports, press releases, etc. Investors cannot earn abnormal returns by trading on public information Implies that fundamental analysis will not lead to abnormal returns Prices reflect all past market information such as price and volume. Investors cannot earn abnormal returns by trading on market information. (Price and Volume) Implies that technical analysis will not lead to abnormal returns. Foundations of Market Efficiency Investor rationality Arbitrage As new information comes to market, investors analyze this information rationally and make rational trades. Even if some irrational investors might create mis-pricing in the market, the arbitrageurs will step in and correct such mis-pricing. Common Misconceptions about EMH Does that mean that I can’t make money at all? o Efficient markets do not mean that you c an’t make money. They do mean that, on average, you will earn a return that is appropriate for the risk undertaken and there is not a bias in prices that can be exploited to earn excess returns.
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