5Market Efficiency and Financing

5Market Efficiency and Financing - Market Efficiency and...

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Market Efficiency and Financing
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Firm Objective Maximize Value Capital Budgeting Decision Invest in projects that add value to the firm Financing Decision Maximize firm  value through optimal capital structure Payout Decision Return excess cash to investors to maximize shareholder wealth
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Financing Decision Maximize firm value through optimal capital structure Implement a capital structure with the optimal mix of equity and debt Issue the right kind of debt and equity securities to match assets
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Where we’ve been, and where we are going Up to this point, we have been concentrating on capital budgeting… figuring out which assets and projects our firm should invest in Now, we are going to concentrate on financing… figuring out how to get the capital to fund those projects and other needs of the firm
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What is the financing decision? The financing decision deals with funding the capital needs of the firm There are many decisions to make Should the firm reinvest earnings, buy back stock, retire debt, or pay the cash out as dividends? Should the firm issue more stock or borrow to raise funds? Should the firm issue short-term or long-term bonds? What type of bonds should the firm issue?
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Market Efficiency As the first part of our look at financing, we will look at market efficiency We can learn several important lessons by understanding how efficient markets affect our financing decisions We can also learn by looking at some cases where markets are not efficient, and the implications for our firm
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What is an efficient market? An efficient market is one where the prices of all assets reflect all available information The expected risk-adjusted excess return of any trade based on any available information is zero No trader could consistently gain risk-adjusted excess returns by trading on available information Seem unreasonable? Might at first, but markets may be reasonably close And, by understanding when markets are and are not efficient, we can make better financing decisions
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Why do we care if markets are efficient? We are still trying to maximize NPV with the financing decision Think of a financing decision as a project Is it possible to make a positive-NPV financing decision? Not if markets are efficient If markets are not efficient, then we may be able to get “cheap” financing that increases the value of the firm Is it possible to make a negative-NPV financing decision? Not if markets are efficient… interesting So, we need to understand efficiency, know when it is likely to apply and when it is less likely to apply, and understand the implications of efficiency for our financing decisions
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Why would we think that market efficiency may be possible? There are many investors (millions), and many of these
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This note was uploaded on 09/22/2011 for the course FINANCE 117 taught by Professor Tingtingque during the Summer '11 term at University of Iowa.

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5Market Efficiency and Financing - Market Efficiency and...

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