1. The McGraw-Hill Companies, Inc., 2000
Principles of Corporate Finance
Brealey and Myers Sixth Edition
Corporate Financing and the Six Lessons of Market Efficiency
Slides by
Matthew Will
Chapter 13
Irwin/McGraw Hill
The McGraw-Hill Companies, Inc., 2000

2. Topics Covered We Always Come Back to NPV What is an Efficient Market?
Random Walk
Efficient Market Theory
The Evidence on Market Efficiency
Six Lessons of Market Efficiency

3. Return to NPV NPV employs discount rates.
These discount rates are risk adjusted.
The risk adjustment is a byproduct of market established prices.
Adjustable discount rates change asset values.

4. Return to NPV
Example
The government is lending you $100,000 for 10 years at 3% and only requiring interest payments prior to maturity. Since 3% is obviously below market, what is the value of the below market rate loan?

5. Return to NPV
Example
The government is lending you $100,000 for 10 years at 3% and only requiring interest payments prior to maturity. Since 3% is obviously below market, what is the value of the below market rate loan?
Assume the market return on equivalent risk projects is 10%.

6. Random Walk Theory
The movement of stock prices from day to day DO NOT reflect any pattern.
Statistically speaking, the movement of stock prices is random (skewed positive over the long term).

7. Random Walk Theory Coin Toss Game $106.09 $103.00 $100.43 $100.00
Heads
$106.09
Heads
$103.00
$100.43
Tails
$100.00
Heads
$100.43
$97.50
Tails
$95.06
Tails

8. Random Walk Theory

9. Random Walk Theory

10. Random Walk Theory

11. Random Walk Theory

12. Random Walk Theory

13. Random Walk Theory

14. Random Walk Theory

15. Efficient Market Theory
Weak Form Efficiency
Market prices reflect all historical information.
Semi-Strong Form Efficiency
Market prices reflect all publicly available information.
Strong Form Efficiency
Market prices reflect all information, both public and private.

16. Efficient Market Theory
Fundamental Analysts
Research the value of stocks using NPV and other measurements of cash flow.

17. Efficient Market Theory
Technical Analysts
Forecast stock prices based on the watching the fluctuations in historical prices (thus “wiggle watchers”).

18. Efficient Market Theory
$90 70 50
Microsoft Stock Price
Cycles disappear once identified
Last Month
This Month
Next Month

19. Efficient Market Theory
Announcement Date

20. Efficient Market Theory
Average Annual Return on 1493 Mutual Funds and the Market Index

21. Efficient Market Theory
IPO Non-Excess Returns
Year After Offering

22. Efficient Market Theory
1987 Stock Market Crash

23. Efficient Market Theory
1987 Stock Market Crash

24. Lessons of Market Efficiency
Markets have no memory
Trust market prices
Read the entrails
There are no financial illusions
The do it yourself alternative
Seen one stock, seen them all

25. Example: How stock splits affect value
-29 30
Source: Fama, Fisher, Jensen & Roll