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

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

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.

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?

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%.

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).

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

Random Walk Theory

Random Walk Theory

Random Walk Theory

Random Walk Theory

Random Walk Theory

Random Walk Theory

Random Walk Theory

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.

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

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

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

Efficient Market Theory Announcement Date

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

Efficient Market Theory IPO Non-Excess Returns Year After Offering

Efficient Market Theory 1987 Stock Market Crash

Efficient Market Theory 1987 Stock Market Crash

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

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