Notes 1

Within the context of the various business specializations, discuss the relevance and importance
of “corporate finance” in the analysis of firms’ performance.
This question is important. It sets the background to “financial analysis”.
1. Why one needs to carry out financial analysis? For investing in the securities of the firm? For
lending the firms? or for what?
2. Management of any firm is a collection of various business personnel. While some are
“marketing”, or “HR”, or “management”, or “accounting”, or “MIS”, or “finance” oriented, they all
have somehow different outlook to the management and performance of the firm. This is why, it
is useful to be aware that each business specialization has an implicit “objective”. What are
they???
3. Now, we go back to the basics….. Economics. In economics, the father of all specializations, the
objective is to maximize the economic profit. This is very similar to the finance objective. By now
you all know what that is: ROA – WACC.
4. This is why, in basic microeconomics, we read the theory of the firm, mainly, in its two forms:
Perfect competition and Monopoly. Why? If competitive, ROA will always be equal (close to)
WACC. In monopoly, ROA is greater than WACC!
Perfect Competition: In competitive markets, we have 5 main conditions, and 4 implications….

In any competitive industry, total revenue is the Square (P X Q) and total cost is also equal to P X
Q. The difference is ZERO…… Total cost includes “the opportunity” cost of capital (in economics)
which is WACC (as in finance). In Monopoly, things are different. In the graph below, the profit is
the SHADED AREA!!!!! Here ROA > WACC!!!
To conclude,,,,, there is nothing more important in financial analysis than measuring return on
assets (ROA), and estimating the weighted average cost of capital (WACC). This is also why, one
needs to be aware of (1) what affects ROA and what affects WACC. This is really the backbone of
financial analysis.
While proper financial analysis relies on efficient pricing of financial securities, efficient pricing
rests of operational efficiency.
1. One objective of financial analysis is whether or not to invest in the stock of a company. If the
stock’s price is determined in the market “in an efficient manner” financial analysis is useful. If not,
any analysis will not be useful.
2. Then you need to define pricing efficiency. Once you do that, you need to explain operational
efficiency and its implications.
3. To remind you,,,,,, the Efficient market Hypothesis (EMH) is:
Weak Form EMH: Suggests that all past information is priced into securities. Fundamental analysis
of securities can provide an investor with information to produce returns above market averages
in the short term, but there are no "patterns" that exist. Therefore, fundamental analysis does not
provide long-term advantage and technical analysis will not work.
Semi-Strong Form EMH: Implies that neither fundamental analysis nor technical analysis can
provide an advantage for an investor and that new information is instantly priced in to securities.
Strong Form EMH. Says that all information, both public and private, is priced into stocks and that
no investor can gain advantage over the market as a whole. Strong Form EMH does not say some
investors or money managers are incapable of capturing abnormally high returns because that
there are always outliers included in the averages.
4. Operational Efficiency:
The definition is of operational efficiency or liquidity: Liquidity is the ability to trade on the
secondary market “immediately” and at the “right” prices. Right prices means that the difference
between the buy and sell price is very small, as a percentage of their average (liquidity cost). Then,
you explain the importance of “liquidity”. Two reasons:
(a) When the liquidity of listed securities improves, stock markets raise the accessibility of funds
to finance long term capital investments. This is due to the fact that traders are assured of getting
their buy and order executed “immediately” on the secondary market.
(b) Liquid stock markets improve investors’ diversification benefits and this guides to a swing in
their portfolios from low risk and low return investments to higher risk (high-return) investments.
Naturally, this capital shift increases savings and investments and improves their allocated
efficiency.
- Once you define liquidity and its importance, you can discuss its implications.
(a) If liquidity cost is low, prices of listed securities will be efficient. (Efficient Market
Hypothesis….).
(b) If prices are efficient, the market index would be highly correlated with the performance of the
national economy.
(c) If prices are efficient, you can estimate the systematic risk (beta) for all stocks. Indeed, all of
them, nearly, would be POSITIVE. In addition, the beta values would be sensible (around +0.7 to
+1.4). You would not find stocks with negative beta….
(d) If liquidity cost is low, the probability distribution of stock returns would be NORMAL, and will
not have FAT-TAIL ENDS as shown below. If s stock’s price has fat tail distribution, its risk is infinite.
Also, the standard deviation has no meaning. Also, its beta will be strange….. like negative or >4
Following this, its is useful to be aware that the Amman Stock Exchange and highlight suffers from
illiquidity or high liquidity cost, or operational inefficiency. A question: Do you think that in
Amman, there is a relationship between the performance of the company (ROA – WACC)? If not,
why not?????
Not, since it has fat tail so prob, jai bl imt7an final

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Within the context of the various business specializations, discuss the relevance and importance

of “corporate finance” in the analysis of firms’ performance.

This question is important. It sets the background to “financial analysis”.

Perfect Competition: In competitive markets, we have 5 main conditions, and 4 implications….

3. To remind you,,,,,, the Efficient market Hypothesis (EMH) is:

Not, since it has fat tail so prob, jai bl imt7an final

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