Corporate Financing Decisions Market Efficiency 1Finance - Pedro Barroso

Can Financing Decisions Create Value? We have seen how to evaluate investment projects according to the NPV criterion Next we will study financing decisions, such as: – How much debt and equity to sell – When to sell debt and equity – When (or if) to pay dividends We can use NPV to evaluate financing decisions 2Finance - Pedro Barroso

Creating Value through Financing 1.Fool Investors  Empirical evidence suggests that it is hard to fool investors consistently 2.Reduce Costs or Increase Subsidies  Certain forms of financing have tax advantages or carry other subsidies 3.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 3Finance - Pedro Barroso

Efficient Capital Markets Hypothesis An efficient capital market is one in which stock prices fully reflect available information 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 little good – Firms should expect to receive the fair value for securities that they sell. Firms cannot profit from fooling investors in an efficient market 4Finance - Pedro Barroso

No Free Lunch The only way you can get higher returns is by taking on more risk There is no information out there that can be used to construct strategies that earn returns higher than required for their risk When we say ‘prices are correct,’ we are implicitly stating what ‘correct’ is, i.e., we are assuming an asset pricing model – Joint hypothesis problem Proponents of EMH claim that active money management is a wasted effort 5

Finance - Pedro Barroso Random Walks In a random walk, the best forecast of future prices is today’s price Efficient markets  prices follow random walk – Only strictly true if the discount rate does not change over time – Over short time frames returns should look random If we all thought that the price of an asset was going up in the future, then we would start buying today and the price would go up right now, not in the future 6

Finance - Pedro Barroso S&P or Coin Toss? 7

Finance - Pedro Barroso Information Past Prices Public Private Weak Semi-strong Strong Type of information Form of efficiency 8

Finance - Pedro Barroso Weak Form (past prices) Postulates that current prices fully reflect all information in past prices – Using past prices, returns, volumes will produce no predictable patterns that can be exploited to yield better returns in the future Technical analysis – Search for recurring and predictable patterns in prices – Believe in slow response of prices to fundamentals – Called “chartists” because they study charts of past stock prices and volumes ( candlesticks, heads and shoulders, moving averages) Even if there are patterns, they are self-destructing – Discovery leads to exploitation and ultimately invalidation 9

Finance - Pedro Barroso Semi-Strong Form (public information) Postulates that current prices fully reflect all past prices and all publicly available information Fundamental analysis (using economic and accounting information) – Sorting through income statements, talking to the company – Studying industries and the macroeconomy Some evidence for semi-strong efficiency – No abnormal returns after public announcement – Professional money managers do not outperform the market consistently 10

Finance - Pedro Barroso Strong (private information) Postulates that current prices fully reflect all information, public and private Strong-from efficiency says that insider trading will not produce profits – Knowing a merger is going to take place before it is announced publicly will not produce profits Although illegal, evidence that prices move before public announcements, suggesting insider information Insider trading appears profitable, indicating markets are not strong form efficient – These profits are short-lived, suggesting the market may be close to efficient 11

Finance - Pedro Barroso Why Should Markets be Efficient? There are a large number of competing profit- seeking investors – It is not necessary that the average investor is smart, only that there are a few smart investors (with deep pockets) New information about securities comes to markets in a random fashion Forces of arbitrage – Smart investors exploit the mispricing in securities until it disappears 12

Finance - Pedro Barroso Evidence for Stock prices appear to move randomly New information appears to be quickly incorporated into prices – Event studies Professional money managers do not beat the market on average 0+t -t Days relative to announcement date 13

Finance - Pedro Barroso Evidence against Inexplicable market crashes (October 1987) Inexplicable market bubbles ( ) Arbitrage opportunities – Royal Dutch Petroleum Company vs Shell Transport and Trading Company Value versus growth (Fama and French) Reaction to earnings announcements. Existence of so many investment funds “Anomalies” 14

Finance - Pedro Barroso Four Lessons of Market Efficiency 1.Markets have no memory Do not raise equity after price rise – that doesn’t make it any more likely to fall subsequently 2.Trust market prices The alternative is you need to know not only more than anyone else, but you need to know more than everyone else 3.Read the entrails Security prices can tell a lot about future Probability of bankruptcy can be gauged from bond prices rather than financial statements 4.Don’t overpay for money management 15

The Record of Mutual Funds Taken from Lubos Pastor and Robert F. Stambaugh, “Mutual Fund Performance and Seemingly Unrelated Assets,” Journal of Financial Economics, 63 (2002). 16Finance - Pedro Barroso

Implications for Corporate Finance Because information is reflected in security prices quickly, investors should only expect to obtain a normal rate of return – Awareness of information when it is released does an investor little good. The price adjusts before the investor has time to act on it Firms should expect to receive the fair value for securities that they sell – Fair means that the price they receive for the securities they issue is the present value – Thus, valuable financing opportunities that arise from fooling investors are unavailable in efficient markets 17Finance - Pedro Barroso

Implications for Corporate Finance The EMH has three implications for corporate finance: 1.The price of a company’s stock cannot be affected by a change in accounting 2.Financial managers cannot “time” issues of stocks and bonds using publicly available information 3.A firm can sell as many shares of stocks or bonds as it desires without depressing prices There is conflicting empirical evidence on all three points 18Finance - Pedro Barroso