1. Corporate Financing Decisions and Efficient Capital Markets

2. Corporate Financing Decisions and Efficient Capital Markets
An efficient market is one in which current market prices reflect all available information.
What information is available? Depends on costs/benefits of collection/evaluation/use of information.
We will see that the EMH has implications for investors/firms/financial managers.

3. Preview – An Efficient Market
Because information is reflected in prices immediately, investors should only expect to obtain an equilibrium rate of return (as predicted by the SML). Awareness of information when it is released does the investor no good. The price adjusts before the investor can trade on it.
Firms should expect to receive a fair value for securities they sell.
Financial managers cannot time issues of bonds and/or stocks.
A firm can sell as many shares of stock or as many bonds as it wants without fear of depressing the price.
Stock and bond markets cannot be affected by firms artificially increasing earnings (cooking the books).

4. Reaction of Stock Price to New Information in Efficient and Inefficient Markets
Stock Price Overreaction and reversion
Early
response
Delayed response
Efficient market response to new information
Days before (–) and after(+) announcement
Public announcement day
– – –

5. “Forms” of Market Efficiency
Weak Form Efficiency
A capital market is said to be weakly efficient or to satisfy weak-form efficiency if current prices fully incorporate the information in past prices.
Can't trade on the basis of past returns and expect abnormal profits.

6. “Forms” of Market Efficiency
Semi-Strong Form Efficiency
A market is said to be semi-strong form efficient if current market prices fully incorporate all publicly available information (e.g., information in the WSJ).
Since past prices are publicly available information, if a market is semi-strong form efficient, it is necessarily weak form efficient.
In a market that is semi-strong form efficient investors cannot trade based on publicly available information and expect profits in excess of an equilibrium expected return (as specified by, for example, the SML).

7. “Forms” of Market Efficiency
Strong Form Efficiency
A market is said to be strong form efficient if current market prices fully incorporate all (including inside) information.
Since publicly available information is a subset of all information, if a market is strong form efficient it is semi-strong form efficient and weak form efficient.
In a strong form efficient market no investor can make profits in excess of the equilibrium expected return trading on any information (including "inside" information).
This is obviously an extreme form of efficiency.

8. Who Thinks They Can Beat The Market?
Chartists: Technical Analysis
These folks analyze "charts" or graphs of movements of different aspects of the stock markets.
Share price movements
Trading Volume
Ratios of volumes on up price movements to those on down price movements
Chartists believe that there exist identifiable and exploitable trends or patterns in these variables.
Hardly believable. But the jury is still out.

13. Why Technical Analysis Fails
Investor behavior tends to eliminate any profit opportunity associated with stock price patterns.
Stock Price
If it were possible to make big money simply by finding “the pattern” in the stock price movements, everyone would do it and the profits would be competed away.
Sell
Sell
Buy
Buy
Time

14. Fundamental Analysis
Based upon the belief that stock market values reflect economic values. And that there is publicly available information that will allow them to form a better estimate of value than is contained in market prices.
If there is information (examples?) that will allow an analyst to form a better estimate of future dividends than the market's estimate, reflected in current price, then there may be money to be made.
Not too likely.

15. Insiders
Trade on private information. Often on impending changes in control structure or new product innovations.
Probably.

16. The Evidence Are Stock Prices Random?
Serial correlation of stock returns near zero.
More complete tests show that after expected return is accounted for, past returns add no information to help predict future returns.
Technical analysts may be observing "optical illusions".

17. WHICH IS THE REAL MARKET INDEX? THIS ONE?
Level
Months

18. ... OR THIS ONE?
Level
Months

19. Event Studies
Is new information concerning a firm quickly and completely incorporated into stock price?
Stock Splits
Dividend/Earnings Announcements
Mergers
Capital Expenditures
Findings generally support semi-strong form efficiency.

21. Mutual Fund Performance
Mutual fund managers, who use public information and presumably have the time and talent to process the information they collect, cannot consistently beat the S&P 500 index.

22. The Record of Mutual Funds
Taken from Lubos Pastor and Robert F. Stambaugh, “Evaluating and Investing in Equity Mutual Funds,” unpublished paper, Graduate School of Business, University of Chicago (March 2000).

23. Insiders
Reports of insiders who trade in their own shares show these traders are able to achieve abnormal profits.

24. Shiller - Are stock prices too variable?
Contrary Views
Shiller - Are stock prices too variable?
Fads/bubbles in stock prices.
Momentum studies.
Seasonalities
January Effect
Size Effect
Book-to-Market Effect
Underperformance of IPO and Seasoned Equity Issues
Suggestive Occurrences
October 19, 1987
Tulip Craze of 17th Century in Holland

25. Implications for Corporate Finance
Accounting and the EMH
In a semi-strong form efficient market purely cosmetic accounting practice changes won't fool investors. Studies support this result.
Changes in depreciation methods
Accounting for inventories
Reporting mergers and acquisitions
All can change earnings reports but do not affect stock prices.
When information is withheld or incorrect information is provided prices can be affected.

26. Timing of Issuance of Financing
Year to year variation in the use of new financing is partly explained by firms' attempts to time new issues. New issues seem to follow rises in stock price.
Attempts to exploit weak form inefficiency
Price rise simply reflects new investment opportunity
Inside information
Price Pressure
In an efficient market a firm will be able to issue as much equity as it wishes without fear of depressing price due to an "over-supply" of its claims.

27. What the EMH Does and Does Not Say
Does Say
Prices reflect underlying value.
Financial managers cannot time stock and bond issues.
Sales of stock and bonds will not depress prices.
You cannot cook the books.
Doesn't Say
Prices are uncaused.
Prices should not fluctuate.
Investors all need to know all information.
All shares of stock have the same expected returns.
Investors should throw darts to select stocks.
There is no upward trend in stock prices.