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Unformatted text preview: EMBA 807 Corporate Finance Dr. Rodney Boehme Page 1 CHAPTER 13 CORPORATE-FINANCING DECISIONS AND EFFICIENT CAPITAL MARKETS Assigned problems are 5, 8, 10, 11, 12, 14, 16, and 22. I. Introduction to Market Efficiency A Description of Efficient Capital Markets Prices in informationally efficient capital or financial markets should reflect all available information. An important consequence of market efficiency is that investments in publicly traded financial securities, such as stocks and bonds, are zero NPV investments (as opposed to the assumed positive NPVs of most real or productive assets). Investors should expect to earn a fair or normal return that is consistent with the risk (defined by CAPM or APT) of the security. Companies should expect to receive a fair price when they issue securities. Current prices should represent a fair and unbiased forecast or estimate of the true, intrinsic, or fundamental value of the firm, i.e., the Present Value of all future expected cash flows. If this were not the case, we would find many instances where security prices were systematically biased , i.e., either consistently underpriced or overpriced. Some reasons why market efficiency is a critical issue and concept: 1. It affects the price that the firm will receive for any new stocks and bonds that it may issue. Also, if a firm can sell new stock that is overvalued, it is perhaps likely to do such. 2. It affects the cost of capital or required rate of return on securities. The cost of capital affects the capital budgeting or new capital expenditure decisions. 3. If you want to link management compensation to stock price or shareholder value, then it is especially important that the stock price be representative of the true value of the firm, i.e., stockholders want a stock price that is fair and unbiased. 4. An assets price should be driven by unbiased estimates of future cash flows and the true systematic risk associated with the cash flows. If this were not the case, investors would be able to earn returns that are inconsistent with the true level of risk of an asset. Portfolio managers are very interested in any mispricing in the stock market. A mispriced stock would be thought of as cash lying in the street waiting for someone to pick it up. Normal versus Abnormal Returns If financial markets are not efficient, then strategies would exist that can systematically earn above normal or below normal returns , referred to as abnormal returns. However, in order to actually calculate any abnormal return for any given asset, we first need some Asset Pricing Model such as the Arbitrage Pricing Theory or Capital Asset Pricing Model that gives us an estimate or idea of what the normal or expected return to that asset should have been....
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This note was uploaded on 10/07/2009 for the course CF CF taught by Professor Cf during the Spring '09 term at American Academy of Art.
- Spring '09