Good Firm is highly profitable and will grow rapidly in the future. Bad Firm barely makes a profit and will not grow at all. In an efficient market

Question

BlackTom AI · Accepted Answer

In an efficient market prices already reflect all available information, so expected returns are determined by risk-adjusted required returns rather than raw profitability or growth alone.

Relevant concepts:
- Efficient Market Hypothesis (EMH): security prices incorporate all known information; no systematic excess returns from publicly available info.
- Valuation and expected return: for a growing dividend-paying firm, the Gordon growth model gives P0 = D1 / (r - g), which rearranges to r = D1/P0 + g. Expected return r equals the dividend yield plus growth, and equals the required return for the level of risk.

Step-by-step reasoning:
1. Let Good Firm have higher expected future cash flows (higher D1 and larger g) than Bad Firm (small D1, g ≈ 0).
2. In an efficient market, those higher expected cash flows are reflected in a higher current price P0 for Good Firm.
3. Using r = D1/P0 + g, the market price P0 adjusts so that the implied expected return r equals the required return for that security’s risk.
4. If both firms have the same risk profile, their required returns r will be the same; differences in D1 and g are exactly offset by differences in P0 so investors earn the same expected (risk-adjusted) return.
5. If risk differs, prices adjust so that riskier assets provide higher expected returns, again yielding no arbitrage.

Why the correct answer is correct:
Because prices reflect future profitability and growth, higher expected profits for Good Firm are already capitalized into a higher price; thus, after accounting for price and risk, both stocks offer comparable investment value in an efficient market — they are equally good investments on a risk-adjusted basis.

Why other options are wrong:
- “Better to buy Bad Firm” or “Better to buy Good Firm”: These ignore that prices already adjust to expected fundamentals; you cannot systematically profit from buying one over the other without additional information or mispricing.
- “Both stock prices react equally to the same information”: Reaction magnitudes depend on volatility, information relevance, and risk exposures; EMH does not imply equal price sensitivity.

Conclusion: Therefore, in an efficient market the correct conclusion is that both stocks are equally good investments, which matches the provided answer.

Good Firm is highly profitable and will grow rapidly in the future. Bad Firm barely makes a profit and will not grow at all. In an efficient market单项选择题

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