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Fundamentals Of Corporate Finance Macroeconomics

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Question:

Discuss about the Fundamentals of Corporate Finance Macroeconomics.
 
 

Answer:

Introduction:

A stock is a security that entitles the stock holder to some form of ownership of the corporation in question. The possession of a stock enables the stock holder to earn the returns against the stock in a certain period of time. A stock market is an institution that enables the sale and purchase of stocks on a regular basis. It represents an aggregation of individuals buying and selling stocks. The stock market is an extremely significant medium of raising funds for the different corporations and also to investors for earning potential profit. Before investing in the stock market, a potential investor has to take into consideration a lot of issues concerning the regular functioning of the stock market. The stock market represents an aggregation of different firms and organizations. Hence it is subject to extreme volatility and changes in any macroeconomic parameter will large affect the stock market, that is, the stock prices and returns on stocks. Stock prices and hence the stock returns change constantly depending on the market conditions. This is why the stock market is associated with uncertainty to a large extent. The extent of risk that each stock is subject to varies across stocks and is determined by corporation-specific or market factors. When a certain stock yields a higher return, it is generally subject to higher risk also. The rationale behind this is that when an investor is investing in a risky stock, the compensation required will also be high. Again, if an investor trades in the stock market on a regular basis, he will be subject to more risk than someone who utilizes the stock market as a long-term investment medium. The investment decision of a first time investor in the stock market will depend upon a number of macroeconomic parameters and changing economic conditions.

Demographic changes bring about large scale transformations in the output demand structure of the economy. The product preferences and the purchasing patterns of consumers change with changes in the demographics of a country. The organizations involved in the production of various commodities and providing various services take into account the purchasing patterns of different sets of consumers before making production decisions because that enables the maximization of sales and profits. When demographic changes take place, the patterns change and hence it affects the business decisions of firms which ultimately influence the prices of their stock.  Thus demographic changes have to be taken into consideration by any first time investor before investing in the stock market.

The most important demographic variable affecting the business decisions of corporations is the income of individuals. The income of individuals is a primary determinant of their purchasing pattern (Pindyck, 2009). With changes in the income, the tastes and preferences of potential consumers change and it affects the demand for commodities produced or services offered by different corporations. An increase in the income resulting in an increase in the demand for commodities will lead to an expansion of the businesses under consideration. This will accordingly affect the stock prices and the stock returns for an investor. When a business performs well, the yield of their market stock is generally more. Hence it will be profitable to invest in the stocks of that organization.

Age is a very significant demographic determinant of the demand structure in an economy. If the age dependency ratio of a country increases, the demand for some products and services falls and the demand for some other products and services increase (Varian, 2009). Thus, the organizations producing the former will be at a loss and those producing the latter would expand. This will affect their stock prices and hence returns.

Geographic location of individuals also affects the demand structure. A certain product may be more in demand in some particular geographic area and the demand may be less or zero in some other area (Mankiw, 2014). Accordingly the location of the business firm producing that product will determine the performance of the firm and accordingly the stock price and returns.

Economic growth is a very important factor in determining the business conditions of a country. Without economic growth, businesses will not be able to expand and the stock market will remain low. When a country experiences economic growth, it leads to the advancement of the business environment (Mankiw, 2012). Thus, the corporations will perform better and this will reflect in their stock prices. The growing phase of a country is a potential investment phase for stock market investors.  Economic growth also draws foreign investment into a country in potentially growing corporations and this expands these businesses. This leads to an increase in the valuation of their stocks and affects potential investors. Economic growth also indicates growing aggregate demand in the economy which translates into growth for various business organizations in the country. This directly affects their stocks and hence should be considered by investors. Stock market trading should not be undertaken, at least for the first time, during times of recession (Blanchard and Johnson, 2012). This is because during recessions, the performance of the economy is low and the demand for output and services is also low. Thus firms face low aggregate demand and have no scope for growth. This reduces the value of their stocks in the stock market. The different phases of a business cycle are determined by the economic conditions of a country. This directly affects the business organizations and hence the stock patterns in the stock market.

 

Inflation has large scale effects on the stock market via channels of the output market. The purchasing power of individuals reduces when inflation takes place in a country. The prices of the inputs required in the production process are higher, the demand for commodities and services falls, the revenues of firms decrease and this leads to a decline in the profits of the firms. Consequently, the business framework is interrupted and this affects the prices of the stocks of various companies in the economy. The economy slows down as a result and this translates into further adverse effects for the stock market. Inflation expectations are directly proportional to actual inflation (Dornbusch, Fischer and Startz, 2013). When inflation takes place in a country, people expect prices to move further up and revise their expectations accordingly. Though the purchasing power of the consumer falls, the adjusting inflation expectations might ultimately lead to consumers spending more cash that they had anticipated. This may be because consumers expect the value of money to reduce even further via further inflation and hence are reluctant to hold cash. Thus inflation affects the output market as well as the stock market but the degree and the direction of effects are different for the two markets. This might create confusion for the potential investors of the stock market. Inflation adversely affects the profit levels of corporate firms via channels of increased inputs costs. This may lead to unemployment and hence fall in the general income level in the country (Dornbusch, Fischer and Startz, 2013). Stock market investors may switch between stocks or stop investing altogether as a consequence of the fluctuating performance of different corporations. Some companies and consequently their stocks might perform well in times of high inflation whereas some other companies might be in worse situation. Before investing in a stock, an individual investor must analyze how inflation affects the performance of the companies in whose stock he or she is planning to invest. Again, deflation affects different companies in different ways. Thus the stock investment should be considered after analyzing the impact of changing price levels of different businesses. When the economy is in an inflationary phase, businesses which are adversely affected should not be invested in. Some organizations benefit from price hikes and hence these organizations generate the potential investment opportunities during times of inflation. The inflation expectations can positively or negatively affect the stock market and the direction and degree of impact will be determined by the hedging structure of the firms and the government policies in action during the period concerned. Investors have to account for the different phases of economic cycles to evaluate the impact of inflation on potential stock. There is generally a positive correlation between unexpected inflation and stock returns according to past studies (Ross, Westerfield and Jordan, 2015).

 The government and the central bank can greatly influence the stock market via changes in the fiscal and monetary policies. Expansionary fiscal policy leads to an expansion of the output market because of increased economic activity (Dornbusch, Fischer and Startz, 2013). This translates into an expansion of the stock market. Expansionary fiscal policy leads to increases in aggregate demand, employment and income. Thus the level of spending increases along with           expanding consumer confidence. This leads to increased sales and profits for corporate firms and thus the stocks rise. Hence when the economy is expanding as a consequence of expansionary fiscal policy, the stock market booms and this marks a potential period for investors to invest in the stock market (Dornbusch, Fischer and Startz, 2013). Fiscal policy stimulates the economy very effectively and hence marks a recorded improvement in the stock market. Expansionary monetary policy indicates an increase in the money supply of an economy. When the money supply increases, given the money demand, interest rates would fall. As interest rates fall, saving in the bank and bonds becomes less attractive to people. Stocks being an alternative investment opportunity, the demand for stocks would rise. This might lead to an increase in stock prices. On the other hand, falling interest rates lowers the cost of borrowing and hence investment levels increase. The stock market accordingly performs well. Thus fiscal and monetary policies affect the stock market to a great extent.

There are various other factors that influence the performance of the stock market. At any one point of time the combined effect of all the macroeconomic factors on the stock market should be considered before making any investment in the stock market. The stock market is, directly or indirectly, affected by the output market and the financial market. Hence any changes in either of the two markets will affect the stock market and all these factors have to be considered (Ross, Westerfield and Jordan, 2015).

 

References

Pindyck, R. and Rubinfeld, D. (2009). Micreconomics. 7th ed. New Jersey: Prentice Hall.

Varian, H. (2009). Intermediate Microeconomics: A Modern Approach. 8th ed. New York: W. W. Norton & Company.

Mankiw, N.  (2014). Principles of Microeconomics. 7th ed. USA: South-Western College Pub.

Blanchard, O. and Johnson, D. (2012). Macroeconomics. 6th ed. New York: Pearson Education.

Dornsbusch, R. Fisher, S. and Startz, R. (2013). Macroeconomics. 12th ed. New York: McGraw Hill Education.

Mankiw, N. (2012). Macroeconomics. 8th ed. New York: Worth Publishers.

Ross, S., Westerfield, S. and Jordan, B. (2015). Fundamentals of Corporate Finance. 11th edn. New York: McGraw-Hill Education.

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