1. RATE OF RETURN CONCEPTS èExpected: Return an investor can expect, given initial outlay and cash flow forecasts èExamples: IRR, bond yield èRequired: The minimum acceptable rate of return on an asset èExample: the cost of capital èRealized: Return received after the fact èExample: Microsoft returns from Chap. 7

2. EFFICIENT CAPITAL MARKETS Three equivalent versions. In an efficient market: èAsset prices reflect all available information èOn average, expected asset returns equal required returns èPurchase of sale of an asset is a zero-NPV transaction Note: nothing said about realized returns

3. IMPLICATIONS OF MARKET EFFICIENCY èValue additivity: V(A+B) = V(A) + V(B) èThis why NPV works èAsset price movements are random èIf they weren’t, investors could profit from their predictability èAsset prices react quickly to new information

4. STOCK PRICE REACTION TO NEWS

5. LIMITATIONS ON MARKET EFFICIENCY èEfficient market concept is about competition èWhat “frictions” can limit the effectiveness of competition? èTransaction costs èTaxes èCostly communication èRegulatory restrictions

6. MARKET EFFICIENCY, NPV AND NEW FINANCING èWhat makes us think we can find positive- NPV projects? èWhy might markets for real assets be less efficient than securities markets? èHow do we rely on market efficiency when we issue new securities to finance an asset?

7. NEW PROJECT EXAMPLE Starting point: Existing assets, shares outstanding and share price

8. ISSUE NEW SHARES TO FINANCE PROJECT New project has cost of $120 and generates additional cash flows of $20 per year  n new shares issued at price P*

9. ISSUING NEW SHARES IN AN EFFICIENT MARKET èProject has NPV = $20/.10 - $120 = $80 èShare price rises by $4 to $54 and firm issues 120/54 = 2.22 million new shares èOriginal shareholders gain by $4 x 20 = $80 (I.e., they capture full amount of NPV)

10. ISSUING NEW SHARES IN AN INEFFICIENT MARKET èSuppose instead investors don’t react to news of new project and share price remains at $50 èFirm must now issue 120/50 = 2.4 million new shares to finance project èWhen investors realize that total firm is worth $1200, price per share will rise to only $1200/22.4 = $53.57

11. CONSEQUENCES OF MARKET INEFFICIENCY FOR SHAREHOLDERS èAfter dust settles, original shareholders have gained $3.57 x 20 = 71.43 èNew shareholders have gained $3.57 x 2.4 = $8.57 èNew shareholders have received more than the 10% return that they demanded to invest in the firm’s shares