Chapter 13: Corporate Financing Decisions and Efficient Capital Markets13.1 Can Financing Decisions Create Value?

13.2 A Description of Efficient Capital Markets

13.3 The Different Types of Efficiency

13.4 The Evidence

13.5 Implications for Corporate Finance

13.6 Summary and Conclusions

13.1 Can Financing Decisions Create Value?

Earlier parts of the book show how to evaluate investment projects according the NPV criterion.

The next five chapters concern financing decisions.

What Sort of Financing Decisions? Typical financing decisions include:

How much debt and equity to sell When (or if) to pay dividends When to sell debt and equity

Just as we can use NPV criteria to evaluate investment decisions, we can use NPV to evaluate financing decisions.

How to Create 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, however.

A Description of Efficient Capital Markets 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 no good.

Firms should expect to receive the fair value for securities that they sell. Firms cannot profit from fooling investors in an efficient market.

Reaction of Stock Price to New Information in Efficient and Inefficient Markets

Stock Price

-30 -20 -10 0 +10 +20 +30

Days before (-) and after (+)

announcement

Efficient market response to “good news”

Overreaction to “good news” with reversion

Delayed response to

“good news”

Reaction of Stock Price to New Information in Efficient and Inefficient Markets

Stock Price

-30 -20 -10 0 +10 +20 +30

Days before (-) and after (+)

announcement

Efficient market response to “bad news”

Overreaction to “bad news” with reversion

Delayed response to “bad news”

The Different Types of Efficiency Weak Form

Security prices reflect all information found in past prices and volume.

Semi-Strong Form Security prices reflect all publicly available

information.

Strong Form Security prices reflect all information—public and

private.

Weak Form Market Efficiency Security prices reflect all information found in

past prices and volume.

If the weak form of market efficiency holds, then technical analysis is of no value.

Often weak-form efficiency is represented as

Pt = Pt-1 + Expected return + random error t

Since stock prices only respond to new information, which by definition arrives randomly, stock prices are said to follow a random walk.

Why Technical Analysis FailsS

tock

Pri

ce

Time

Investor behavior tends to eliminate any profit opportunity associated with stock price patterns.

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

Getting TechnicalBarron’s March 5, 2003

Getting TechnicalBack to Buy Low, Sell High Barron’s March 12, 2003

Getting Technical, continued. Most technical indicators fall into two categories -- trend

followers and overbought/oversold oscillators. The former include such tools as moving averages and pattern

breakouts. The latter include such tools as the relative strength index and stochastics. All of them work great when used as designed. The problem is that most people simply apply them all the time, and that can cause problems.

For example, if moving averages are trend-following tools that signal a change in trend when prices cross them, what happens when there's no trend?

If we apply the commonly used 50-day moving average and prices have been in a trading range for six months, it's not uncommon for the market to cross the average many times in both directions. The result is a series of losses.

So, there's nothing wrong with the tool; it's just the wrong one to use under the circumstances.

Getting Technical, continued Clearly, the bull market is over. Arguably, the bear market is over,

too. We can't be sure of that until more time passes. I believe it ended last July. During that market bottom, we saw a big

rush to the exits in the form of a big price decline and reversal -- as well as the biggest volume on record except for the post-September 11 period.

And even though the major market indexes made lower lows in October, it wasn't by much. There was neither a significantly lower low nor a significantly lower high. The classic definition of a declining trend was not met, so the bear market was broken.

Even if the market undercuts those lows once again, that alone would not a bear market make. A bearish signal would come only if the market cannot trade back up to its range top in the next cycle. A lower low and a lower high would mark a new bearish trend.

…the end of a bear market doesn't necessarily lead directly to a new bull market. Conditions are now ripe for a 1970s-style, decade-sized flat market (see chart 1). Sure, we could hit a new low here, but I don't believe it will be a significantly lower low.

Semi-Strong Form Market Efficiency Security Prices reflect all publicly

available information. Publicly available information includes:

Historical price and volume information

Published accounting statements.

Information found in annual reports.

Strong Form Market Efficiency Security Prices reflect all information—

public and private. Strong form efficiency incorporates

weak and semi-strong form efficiency. Strong form efficiency says that

anything pertinent to the stock and known to at least one investor is already incorporated into the security’s price.

Relationship among Three Different Information Sets

All informationrelevant to a stock

Information setof publicly available

information

Informationset of

past prices

Some Common Misconceptions Much of the criticism of the EMH has been

based on a misunderstanding of the hypothesis says and does not say.

What the EMH Does and Does NOT Say Investors can throw darts to select stocks.

This is almost, but not quite, true. An investor must still decide how risky a portfolio he

wants based on risk aversion and the level of expected return.

Prices are random or uncaused. Prices reflect information. The price CHANGE is driven by new information,

which by definition arrives randomly. Therefore, financial managers cannot “time” stock and

bond sales.

The Evidence The record on the EMH is extensive, and

in large measure it is reassuring to advocates of the efficiency of markets.

Studies fall into three broad categories:

1. Are changes in stock prices random? Are there profitable “trading rules”?

2. Event studies: does the market quickly and accurately respond to new information?

3. The record of professionally managed investment firms.

Are Changes in Stock Prices Random?

Can we really tell? Many psychologists and statisticians believe that

most people want to see patterns even when faced with pure randomness.

People claiming to see patterns in stock price movements are probably seeing optical illusions.

A matter of degree Even if we can spot patterns, we need to have

returns that beat our transactions costs. Random stock price changes support

weak-form efficiency.

What Pattern Do You See?Randomly Selected Numbers

0

0.2

0.4

0.6

0.8

1

1.2

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25With different patterns, you may believe that you can predict the next value in the series—even though you know it is random.

Event Studies: How Tests Are Structured Event Studies are one type of test of the semi-

strong form of market efficiency. This form of the EMH implies that prices should reflect

all publicly available information. To test this, event studies examine prices and

returns over time—particularly around the arrival of new information.

Test for evidence of under reaction, overreaction, early reaction, delayed reaction around the event.

How Tests Are Structured (cont.) Returns are adjusted to determine if they are

abnormal by taking into account what the rest of the market did that day.

The Abnormal Return on a given stock for a particular day can be calculated by subtracting the market’s return on the same day (RM) from the actual return (R) on the stock for that day:

AR= R – RM

The abnormal return can be calculated using the Market Model approach:

AR= R – ( + RM)

Event Studies: Dividend OmissionsCumulative Abnormal Returns for Companies Announcing

Dividend Omissions

0.146 0.108

-0.72

0.032-0.244

-0.483

-3.619

-5.015-5.411-5.183

-4.898-4.563-4.747-4.685-4.49

-6

-5

-4

-3

-2

-1

0

1

-8 -6 -4 -2 0 2 4 6 8

Days relative to announcement of dividend omission

Cum

ulat

ive

abno

rmal

ret

urns

(%

)

Efficient market response to “bad news”

S.H. Szewczyk, G.P. Tsetsekos, and Z. Santout “Do Dividend Omissions Signal Future Earnings or Past Earnings?” Journal of Investing (Spring 1997)

Event Study Results Over the years, event study methodology has

been applied to a large number of events including: Dividend increases and decreases Earnings announcements Mergers Capital Spending New Issues of Stock

The studies generally support the view that the market is semistrong-from efficient.

In fact, the studies suggest that markets may even have some foresight into the future—in other words, news tends to leak out in advance of public announcements.

Issues in Examining the Results Magnitude Issue Selection Bias Issue Lucky Event Issue Possible Model Misspecification

The Record of Mutual Funds If the market is semistrong-form efficient,

then no matter what publicly available information mutual-fund managers rely on to pick stocks, their average returns should be the same as those of the average investor in the market as a whole.

We can test efficiency by comparing the performance of professionally managed mutual funds with the performance of a market index.

The Record of Mutual FundsAnnual Return Performance of Different Types of U.S. Mutual Funds Relative to a Broad-Based Market Index

(1963-1998)

-60.00%

-50.00%

-40.00%

-30.00%

-20.00%

-10.00%

0.00%All funds Small-

companygrowthfunds

Other-aggressive

growthfunds

Growthfunds

Incomefunds

Growth andincomefunds

Maximumcapitalgainsfunds

Sectorfunds

Ann

ual R

etur

n P

erfo

rman

ce

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).

The Strong Form of the EMH

One group of studies of strong-form market efficiency investigates insider trading.

A number of studies support the view that insider trading is abnormally profitable.

Thus, strong-form efficiency does not seem to be substantiated by the evidence.

Views Contrary to Market Efficiency Stock Market Crash of 1987

The market dropped between 20 percent and 25 percent on a Monday following a weekend during which little surprising information was released.

Temporal Anomalies Turn of the year, —month, —week.

Speculative Bubbles Sometimes a crowd of investors can behave as a

single squirrel.

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.

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.

Why Doesn’t Everybody Believe the EMH? There are optical illusions, mirages, and

apparent patterns in charts of stock market returns.

The truth is less interesting. There is some evidence against market

efficiency: Seasonality Small versus Large stocks Value versus growth stocks

The tests of market efficiency are weak.

Summary and Conclusions An efficient market incorporates information in

security prices. There are three forms of the EMH:

Weak-Form EMHSecurity prices reflect past price data.

Semistrong-Form EMHSecurity prices reflect publicly available information.

Strong-Form EMHSecurity prices reflect all information.

There is abundant evidence for the first two forms of the EMH.