Monash UniversityFINANCE BFF5270

Which of the following is not true about the small firm premium?

Select one:

a.The small firm premium may be partly explained by risk because small firms have greater information assymetries.

b.The small firm premium can be explained by the CAPM.

c.The small firm premium has largely disappeared from the 1980s onwards.

d.The small firm premium is difficult to exploit as it requires investors to buy highly illiquid stocks with his transaction costs.

e. The small firm premium is highly seasonal.

 

Answer:

d. The small firm premium is difficult to exploit as it requires investors to buy highly illiquid stocks with his transaction costs.

Step-by-step explanation

Small-cap stocks typically have lower stock prices, which means that market appreciations are greater than those seen in large-cap stocks. The January effect, which refers to the stock price trend shown by small-cap stocks in late December and early January, is tagged onto the small firm effect. At that time, these stocks typically grow, making small-cap funds even more appealing to investors.

In the usual course of the capital budgeting process, firm conduct contributes to higher stock price valuation. Firms should understand an excess return on their capital budgets because they allow new capital investments up to the point that marginal cost equals marginal expected return. The firm's excess return causes an upward revision of its stock price, which results in an ex post risk-adjusted excess return to stockholders. The imperfect, or lagged, conversion of operational decisions (the asset side of the balance sheet) into market valuation decisions results in excess returns (the financing side of the balance sheet).

The size of the excess dollar returns to the company relative to the size of the firm's market value determines the scale of the upward price revision and, as a result, the size of the abnormal returns to the stockholder. Furthermore, small businesses as a category are more likely than larger businesses to have larger capital expenditures as a percentage of overall market size (capital spending intensity ratio).
As a result, smaller businesses produce higher relative excess capital budget returns (i.e., returns above their cost of capital) than larger businesses. Small-business owners benefit from higher abnormal returns as a result of this. The small firm premium is the name for this phenomenon.

The premium for small businesses is due to a higher capital intensity ratio (i.e., the ratio of the capital budget to total market value). The effect is the market's reaction to new knowledge about a company's investment activity, which results in a price change. Since companies are expected to invest in prospects with a positive net present value, we expect the majority of price increases to be upward revisions.

References

Pepperdine Digital Commons | Pepperdine University Research, digitalcommons.pepperdine.edu/cgi/viewcontent.cgi?article=1194&context=jef.

Roll, R. (1983). On computing mean returns and the small firm premium. Journal of Financial Economics, 12(3), 371-386.