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Chapter Outline
13.1 Can Financing Decisions Create Value?
13.2 A Description of Efficient Capital Markets 13.3 The Different Types of Efficiency 13.4 The Evidence
13.5 The Behavioral Challenge to Market Efficiency 13.6 Empirical Challenges to Market Efficiency
13.7 Reviewing the Differences 13.8 Implications for Corporate Finance 13.9 Summary and Conclusions
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13.1 Can Financing Decisions Create Value?
Earlier chapters discussed how to evaluate projects according to the NPV criterion.
We now address financing as opposed to investing decisions.
NPV criteria are also used to evaluate financing decisions.
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What Sort of Financing Decisions? Typical financing decisions include:
How much debt and equity to sell When (or if) to pay dividends When to sell debt and equity What types of debt and equity to issue
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How to Create Value through Financing
1. Fool investors 2. Reduce costs or increase subsidies 3. Create a new security Minimizing the cost of capital is consistent with maximizing firm value
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13.2 A Description of Efficient Capital Markets
An efficient market is one in which stock prices are in equilibrium, and fully reflect all available information.
The Efficient Market Hypothesis (EMH) has implications for investors and firms.
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13.2 A Description of Efficient Capital Markets
Implications of the EMH.
Since information is quickly reflected in security prices, knowing information after it is released does an investor no good. Firms should expect to receive the fair value for the securities they sell.
Investors should expect to receive the fair value for securities they buy and sell
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What is Market equilibrium?
In equilibrium, stock prices are stable. No general tendency to buy or sell.
Expected price equals actual price. Stocks plot on the SML
Rs = D1/P0 + g = RF + (RM - RF)B.
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How is equilibrium established?
If Rs = D1 + g > Rs, then P0 is too low. P0
^
^
If the price is lower than the fundamental value, then the stock is a bargain. Buy orders will exceed sell orders, the price will be bid up, and D1/P0 falls until D1/P0 + g = Rs = Rs.
^
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Why Do Stock Prices change?
P0
^
D1 ri g
Ri = RF + (RM - RF )bi may change due to: Inflation expectations
Risk aversion Company risk
Expected g may change. Amount, timing, and risk of expected cash flows may change
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Efficient Market Hypothesis (EMH)
Securities are normally in equilibrium, and are fairly priced.
One cannot consistently beat the market except through good luck superior analytical ability private information
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Reaction of Stock Price to New Information in Efficient and Inefficient Markets
Stock Price
Overreaction to good news with reversion
Delayed response to good news
Efficient market response to good news
-30 -20 -10 0 +10
+20
+30
Days before (-) and after (+) announcement
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Reaction of Stock Price to New Information in Efficient and Inefficient Markets
Stock Price
Efficient market response to bad news
Delayed response to bad news
-30
-20
-10
0
+10
+20
+30
Overreaction to bad news with reversion
Days before (-) and after (+) announcement
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13.3 The Different Types of Efficiency
Weak Form
Security prices reflect all information found in past prices and volume.
Semi-Strong Form
Security prices reflect all publicly available information.
Strong Form
Security prices reflect all information--public and private.
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Weak Form Market Efficiency
Security prices reflect all information found in past prices and volume.
Prices immediately adjust to information releases Technical analysis is of no value.
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Weak Form Market Efficiency
Weak form efficiency is often represented as Pt = Pt-1 + Expected return + random error t
Since stock prices only respond to new information, which by definition arrives randomly, stock prices are follow a random walk.
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Why Technical Analysis Fails
Stock Price
Investor behavior tends to eliminate any profit opportunity associated with stock price patterns.
Sell Sell Buy Buy If it were possible to make big money simply by finding "the pattern" in the stock price movements, everyone would do it and the profits would be competed away. Time
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Semi-Strong Form Market Efficiency Security prices reflect all publicly available information.
Publicly available information includes:
Historical price and volume information Published accounting statements. Information found in annual reports.
Analysts' estimates
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Strong Form Market Efficiency
Security Prices reflect all information--both public and private.
Incorporates weak and semi-strong forms of EMH
Anything pertinent to the stock, and known to at least one investor, is already incorporated into the security's price.
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Relationship among Three Different Information Sets
All information to relevant a stock
Information set of publicly available information
Information set of past prices
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Conflicting Views Regarding the EMH
Acceptance of the EMH is one of the most contentious issues among finance academics and practitioners. Much criticism of the EMH is based on a misunderstanding of what the hypothesis says
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The EMH Does NOT Say
Investors can throw darts to select stocks.
Investors must make the portfolio allocation decision based on personal risk aversion and the expected return.
Prices are random or uncaused.
Prices reflect information. Price CHANGES are driven by new information, which arrives randomly.
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13.4 The Evidence
The research on the EMH is extensive, and most evidence supports market efficiency.
Studies fall into 3 broad categories:
1. Are changes in stock prices random? Are there profitable trading rules?
2. Event studies: Does the market quickly and accurately respond to new information?
3. The record of professional investors
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Are Changes in Stock Prices Random?
Do stock price patterns exist/persist?
Performance of technical analysis Construction of profitable trading rules
Empirical evidence strongly supports the weak form of the EMH.
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Event Studies
Event Studies test the semi-strong form of market efficiency.
Examine prices and returns over time, particularly around the arrival of new information. Look for evidence of under reaction, overreaction, early reaction, delayed reaction around the event.
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Event Study Results
Event study methodology has been applied to:
Dividend increases and decreases Earnings announcements Mergers Capital spending decisions New issues of stock
These studies generally support semi-strong form efficiency.
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The Record of Professional Money Managers
If the market is semistrong-form efficient, mutual-fund managers' average returns should be the same as the market as a whole. Market efficiency is tested by comparing the performance of managed mutual funds with the performance of a market index.
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The Strong Form of the EMH
Some studies of strong-form market efficiency investigate insider trading.
Many studies indicate that insider trading is abnormally profitable. Strong form efficiency is not substantiated by the evidence. Private information enables one to beat the market on a consistent basis
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Views Contrary to Market Efficiency
Two major challenges to the EMH
Behavioral finance Empirical anomalies
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13.5 Behavioral Challenges to the EMH
Rationality and standard finance Independent deviations from rationality
Representativeness Conservativism
Arbitrage
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13.6 Empirical Challenges to the EMH
Limits to arbitrage Earnings surprises Size small cap versus large cap stocks Value versus growth stocks Crashes Speculative bubbles
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13.7 Reviewing the Differences
Financial Economists belong to three camps:
1. Market efficiency 2. Behavioral finance 3. Those that admit that they don't know "There are more things in heaven and earth, Horatio, than are dreamt of in your philosophy." Hamlet, I, v, 166
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13.8 Implications for Corporate Finance
Because information is quickly reflected in security prices, investors should only expect to obtain a normal (equilibrium) rate of return.
Awareness of information when it is released does an investor little good.
The security price adjusts before the investor has time to act on it.
Financial market efficiency versus product market efficiency
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13.8 Implications for Corporate Finance
Firms should expect to receive fair value for the securities they sell.
Fair value is the intrinsic value of the security. Financing opportunities that arise from fooling investors are unavailable in efficient markets.
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13.8 Implications for Corporate Finance
Additional implications for corporate finance:
1. The price of a company's stock cannot be affected by a change in accounting.
2. Financial managers cannot time issues of stocks and bonds using public information.
3. A firm can sell as many shares of stock or bonds as it desires, without depressing prices.
There is conflicting evidence on all 3 points.
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13.9 Summary and Conclusions
There are 3 forms of the EMH:
Weak Form: Security prices reflect past price and volume data. Semi-strong Form: Security prices reflect all publicly available information. Strong Form: Security prices reflect all information.
There is abundant evidence for the first two forms of the EMH.
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Summary and Conclusions
Markets are generally efficient because:
100,000 or so trained analysts--MBAs, CFAs, and PhDs--work for firms like Fidelity, Merrill, Morgan, and Prudential. These analysts have similar access to data and billions of dollars to invest. News is reflected in stock prices almost instantaneously.