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Unformatted text preview: 1 RISK, COST OF CAPITAL AND CAPITAL BUDGETING Ross, Westerfield & Jaffe “Corporate Finance” 7th ed. Chapter 12 Summary of the WACC calculations 2 Using WACC for all projects 3 Re(B) = 7% + 1.2(8%) =16.6% Re(A) = 7% + 0.6(8%) =11.8% βA = 0.6 βFirm = 1.0 βB = 1.2 The SML and Subjective Approach 4 21% WACC=15% B A High risk (+6%) 10% Moderate risk (0%) 7% Low risk (‐4%) βA = 0.6 βB = 1.2 5 Reducing the Cost of Capital: What is Liquidity? Recently a number of academics have argued that the expected return on a stock and the firm’s cost of capital are negatively related to the liquidity of the firm’s shares as well. The trading costs of holding a firm’s shares include brokerage fees, the bid‐ask spread and market impact costs. Liquidity, Expected Returns and the Cost of Capital 6 The cost of trading an illiquid stock reduces the total return that an investor receives. Investors thus will demand a high expected return when investing in stocks with high trading costs. This high expected return implies a high cost of capital to the firm. Liquidity and the Cost of Capital 7 Liquidity An increase in liquidity, i.e. a reduction in trading costs, lowers a firm’s cost of capital. What the Corporation Can Do 8 The corporation has an incentive to lower trading costs since this would result in a lower cost of capital. A stock split would increase the liquidity of the shares. A stock split would also reduce the adverse selection costs thereby lowering bid‐ask spreads. Liquidity and Adverse Selection 9 There are a number of factors that determine the liquidity of a stock. One of these factors is adverse selection. This refers to the notion that traders with better information can take advantage of specialists and other traders who have less information. The greater the heterogeneity of information, the wider the bid‐ask spreads, and the higher the required return on equity. What the Corporation Can Do 10 The companies can also disclose more information. Especially to security analysts, to narrow the gap between informed and uninformed traders. This should reduce spreads. Companies can also facilitate stock purchases through the Internet. Direct stock purchase plans and dividend reinvestment plans handles on‐line allow small investors the opportunity to buy securities cheaply. 11 CORPORATE FINANCING DECISIONS AND EFFICIENT CAPITAL MARKETS Ross, Westerfield & Jaffe “ Corporate Finance” 7th ed.: Chapter 13 What Sort of Financing Decisions? 12 Typical financing decisions include: How much debt and equity to sell When (or if) to pay dividends When to sell debt and equity How to Create Value through Financing 13 1. Fool Investors 2. Reduce Costs or Increase Subsidies 3. Empirical evidence suggests that it is hard to fool investors consistently. Certain forms of financing have tax advantages or carry other subsidies. Create a New Security Sometimes a firm can find a previously‐unsatisfied clientele and issue new securities at favorable prices. In the long‐run, this value creation is relatively small, however. How to Create Value through Financing Financing decisions can be harder than investment decision because of the number of assets to choose from However, financing decisions can also be easier to reverse. Its hard to make or lose money, the nature of the competition tends to drive NPV to 0. Just as we can use NPV criteria to evaluate investment decisions, we can use NPV to evaluate financing decisions. NPV of Financing Decisions 15 Example: the government offers to lend your firm $100,000 for 10 years at 3%. Should you accept this offer? NPV = amount borrowed – present value of interest repayments – present value of principal repayment 10 3,000 100,000 = 100,000 (1 r )t (1 r )10 t 1 Use r = 10%: 10 3,000 100,000 NPV 100,000 $43,012 10 t (1.10) t 1 (1.10) Note: You can borrow at 3% when the fair rate is 10% A Description of Efficient Capital Markets 16 An efficient capital market is one in which stock prices fully reflect available information. Suppose IBM announces it has invented a new, faster and better microprocessor. The price of a share of IBM should increase immediately to a new equilibrium level. The EMH has implications for investors and firms. Since information is reflected in security prices quickly, knowing information when it is released does an investor no good. Firms should expect to receive the fair value for securities that they sell. Firms cannot profit from fooling investors in an efficient market (markets are in equilibrium). Reaction of Stock Price to New Information in Efficient and Inefficient Markets 17 Stock Price Overreaction to “good news” with reversion Delayed response to “good news” Efficient market response to “good news” Intrinsic value of the stock ‐30 ‐20 ‐10 0 +10 +20 +30 Days before (‐) and after (+) announcement Reaction of Stock Price to New Information in Efficient and Inefficient Markets 18 Stock Price Efficient market response to “bad news” ‐30 ‐20 ‐10 Overreaction to “bad news” with reversion Delayed response to “bad news” 0 +10 +20 +30 Days before (‐) and after (+) announcement Foundations of the EMH Rationality: All investors are rational and base their expectations of future prices using all available information in a rational way. Independent deviations from rationality: A weaker notion, that does not require rationality but only countervailing and independent irrationalities. Arbitrage: Rational investors adjust their portfolios to take advantage of arbitrage opportunities. Arbitrage dominates and removes profits from irrational investments/inefficiencies The Different Types of Efficiency 20 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 private. prices reflect all information—public and Relationship among Three Different Information Sets 21 All information relevant to a stock Information set of publicly available information Information set of past prices Weak Form Market Efficiency 22 Security prices reflect all information found in past prices and volume. If the weak form of market efficiency holds, then technical analysis is of no value. Often weak‐form efficiency is represented as Pt = Pt‐1 + Expectedreturn + random error t Since stock prices only respond to new information, which by definition arrives randomly (and is independently and identically distributed), stock prices are said to follow a random walk. Are Price Changes Random?: The random walk theory Random walk: A trajectory that consists of taking successive random steps. Stock prices have changes that are independent and identically distributed. Past movement of a price cannot be used to detect and pinpoint its future value. For example, have a look at the graphs in the next slide. One graph plots the value of an investment that assumes new values based on a coin toss. The other plots the S&P index over a normal economic period. The Random Walk Theory The Random Walk Theory Each dot shows a pair of returns for Microsoft stock on two successive days between March 1990 and July 2001. The circled dot records a daily return of 1 percent and then 1 percent on the next day. The scatter diagram shows no significant relationship between returns on successive days The Random Walk Theory The last figure suggests that Microsoft’s price changes were effectively uncorrelated. Today’s price change gave investors almost no clue as to the likely change tomorrow. Imagine that it were not the case and that changes in Microsoft’s stock price were expected to persist for several months. As soon as a cycle becomes apparent to investors, they immediately eliminate it by their trading Why Technical Analysis Fails 27 Stock Price Investor behavior tends to eliminate any profit opportunity associated with stock price patterns. Sell Sell 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. Buy Time Semi‐Strong Form Market Efficiency 28 Security Prices reflect all publicly available information. Publicly available information includes: Historical price and volume information Published accounting statements. Information found in annual reports. Strong Form Market Efficiency 29 Security Prices reflect all information—public and private. Strong form efficiency incorporates weak and semi‐ strong form efficiency. Strong form efficiency says that anything pertinent to the stock and known to at least one investor is already incorporated into the security’s price. What the EMH Does and Does NOT Say 30 Much of the criticism of the EMH has been based on a misunderstanding of the hypothesis says and does not say: Investors can throw darts to select stocks. This is almost, but not quite, true. An investor must still decide how risky a portfolio he wants based on risk aversion and the level of expected return. Prices are uncaused. Prices reflect information. The price CHANGE is driven by new information, which by definition arrives randomly. Therefore, financial managers cannot “time” stock and bond sales. ...
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