FIN 819 Market Efficiency and Capital Structure Some classic arguments

FIN 819 Today’s plan Review of the key ideas in option pricing How to improve this course Investment Decision vs. Financing Decision Market efficiency Does the stock price follow a random walk? Three forms of Market Efficiency Weak form efficiency Semi-strong form efficiency Strong form efficiency The capital structure without corporate taxes Valuing risky corporate bonds Capital structure with corporate taxes Levered and unlevered betas Two theories for the optimal capital structure in the real world.

FIN 819 Key ideas in option pricing There are two important ideas in option pricing No arbitrage argument Replicating portfolios These two ideas have a lot of applications. Get the PV of a piece of uncertain cash flow in the future Used to show or derive a lot of important results in modern finance (two famous examples) Black-Sholes formula Capital structure irrelevancy in the case of no corporate tax The no arbitrage condition is a much weaker condition than the equilibrium one, and thus has been widely applied in finance. Now it is an important phrase of the Finance language.

FIN 819 The ideas to improve FIN 819 Some students have concerns: Overlapping with BUS 785 Too easy More challenging materials My ideas: No overlap, few lectures About 8-10 cases to be used No quizzes Two teams presenting the same case Your Ideas

FIN 819 Investment vs. Financing Investment decisions or capital budgeting is about how to take projects to maximize V. Financing decisions are about how to raise capital (E or D) to finance the projects to be taken Asset Liabilities and equity V Debt: D Equity: E

FIN 819 Market Efficiency Market efficiency is concerned about whether capital markets have all information about the cash flows and risk of projects. Financing and market Efficiency

FIN 819 Efficient capital markets Efficient Capital Markets – If capital markets are efficient, then security prices reflect all relevant information about asset values ( cash flows and risk)

FIN 819 Market efficiency and random walk Market efficiency concepts are very abstract. How can we use a simple way to check whether the stock market (one of the capital markets) is efficient or not? If the stock price follows a random walk, then the stock market is efficient.

FIN 819 What is a random walk of stock prices? The movement of stock prices from day to day DO NOT reflect any pattern. Statistically speaking, the movement of stock prices is random.

FIN 819 A Random Walk example $ $ $ $ $97.50 $ $95.06 Coin Toss Game Heads Tails

FIN 819 Three forms of market efficiency The random walk concept is still abstract Financial economists have used three more specific forms to characterize or judge market efficiency. Weak-form Semi-strong form Strong form

FIN 819 Weak-form of market efficiency Weak Form Efficiency - Market prices reflect all information contained in the history of past prices, or you cannot use past stock prices to predict future prices Technical Analysts - Investors who attempt to identify over- or undervalued stocks by searching for patterns in past prices.

FIN 819 Efficient Market Theory Last Month This Month Next Month $ EI’s Stock Price Cycles disappear once identified

FIN 819 Semi-strong form of market efficiency Semi-Strong Form Efficiency - Market prices reflect all publicly available information such as earnings, price-to-earnings ratios,etc. Fundamental Analysts - Analysts who attempt to fund under- or overvalued securities by analyzing fundamental information, such as earnings, asset values, and business prospects.

FIN 819 Efficient Market Theory Announcement Date

FIN 819 Market Efficiency

FIN 819 Strong form of market efficiency Strong Form Efficiency - Market prices reflect all information that could in principle be used to determine true value. Inside trading Investors use private information to predict future price movements

FIN 819 Efficient Market Theory Announcement Date

FIN 819 Some exercises 1. If stock markets are efficient in the weak- form, what should the correlation between stock returns for two non-overlapping periods? 2. Which is the most likely to contradict the weak-form of efficiency a. Over 25% of mutual funds outperform the market on average b. Insiders can make abnormal profits c. Every January, the stock market earns abnormal return

FIN 819 Look at the both sides of a balance sheet AssetLiabilities and equity Market value of the asset V Market value of equity E Market value of debt D V=E+D

FIN 819 Capital structure Capital structure refers to the mix of debt and equity of a firm. Capital structure has two related questions: Does the capital structure affect the value of a firm? Or does the amount of debt a firm has affect its value? What is the optimal amount of debt a firm should have?

FIN 819 Does capital structure affect the firm value? EquityDebt Equity Debt Govt. Slicing the pie doesn’t affect the total amount available to debt holders and equity holders Slicing the pie can affect the size of the slice going to government Slicing the pie can affect the size of the wasted slice wasted

FIN 819 Capital structure without corporate taxes If there is no corporate tax, we will have the following two famous results M&M propositions 1 and 2 Pay attention to the condition for these propositions to be valid Why do we consider such simple, unrealistic situations?

FIN 819 MM’s proposition 1 (without tax) Modigliani & Miller If the investment opportunity is fixed, there are no taxes, and capital markets function well, the market value of a company does not depend on its capital structure. What is the intuition for this result? Can we use different ways to prove this?

FIN 819 MM’s proposition 2 (without tax) Modigliani & Miller If the investment opportunity is fixed, there are no taxes, and capital markets function well, the expected rate of return on the common stock of a levered firm increases in proportion to the debt-equity ratio (D/E), expressed in market values. The WACC is a constant.

FIN 819 Example - River Cruises - All Equity Financed M&M (Debt Policy Doesn’t Matter)

FIN 819 Example cont. 50% debt M&M (Debt Policy Doesn’t Matter)

FIN 819 r DVDV rDrD rErE WACC WACC without taxes in MM’s view

FIN 819 Valuing risky debt So far, we have learned how to value a risk- free debt. By risk-free debt, we mean that bond investors always get paid for what they are promised when they lend money to firms or governments. In reality, corporate bonds are not risk-free. When firms borrow money from the bond holders, they may not have enough cash to pay the bond holders in the future.

FIN 819 Valuing risky debt To illustrate how to value a risky debt, we focus on a simple situation: Firms have a zero-coupon bond. More specific, suppose that a firm has issued $K million zero-coupon bonds maturing at time T. Let the market value of the firm asset at time T be V(T).

FIN 819 Valuing risky corporate debts Using the put-call parity, we have Where P(K,T) is the value of a European put option with the strike price K and the maturity date T Please try to derive this formula and understand this situation?

FIN 819 Problem: On march 4, 1994, Chrysler was the eighth largest U.S. firm according to Fortune magazine. It issued 20-years zero-coupon debt with book value of $ billion. The book value of the asset is $43.83 billion and the market value of equity is $ billions. The risk free rate was 8% and the volatility of the asset return is 30%. What is the market value of the debt? What is the interest rate charged on Chrysler’s debt? Example

FIN 819 Solution The market value of the debt is $5.98 million The interest rate charge on Chrysler’s debt is 9.11%. The market value of the asset is $27.03 million

FIN 819 Capital structure with taxes If there is corporate tax, we also have two famous results: M&M propositions 1 and 2 Remember that to make the two propositions valid, we still have to assume that the investment opportunity is fixed and the financial market functions very well.

FIN 819 MM’s propositions withtax MM’s proposition 1 firm value = value of all equity firm + PV (tax shield) PV(tax shield)=T c D MM’s proposition 2 The weighted average cost of capital is decreasing with the ratio of D/E, and the cost of equity is increasing with D/E. Can you prove and understand these results?

FIN 819 WACC Graph

FIN 819 Optimal Capital structure with tax So according to M&M proposition 1 with tax, the optimal capital structure is that firms issue all the debt. In the real world, very few firms issue all the debt to raise money What is wrong with M&M propositions?

FIN 819 Capital structure with financial distress cost Costs of Financial Distress - Costs arising from bankruptcy or distorted business decisions before bankruptcy. Market Value =Value if all Equity Financed + PV Tax Shield - PV Costs of Financial Distress

FIN 819 Optimal Capital structure Trade-off Theory - Theory that capital structure is based on a trade-off between tax savings and distress costs of debt. Pecking Order Theory - Theory stating that firms prefer to issue debt rather than equity if internal finance is insufficient.

FIN 819 Financial Distress Debt Market Value of The Firm Value of unlevered firm PV of interest tax shields Costs of financial distress Value of levered firm Optimal amount of debt Maximum value of firm