CHAPTER 3

MARKETS: CAN YOU TRUST THEM?

INTRODUCTION

How do managers know whether they are managing the company in the best interests of the owners? If financial markets are efficient, the answer is simple: Managers should monitor the share price of the company’s common stock to find out what public investors think about the company, its future prospects, and its management decisions. And what should managers do to maximize share price? Well, they need to understand how investors value common stock so that they can identify and implement value-maximizing operating and financing policies.

Let’s consider the notion of financial market efficiency first—perhaps the most critical requirement for relying on market prices for allocating resources ...

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