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As part of a policy of encouraging small business, the government is lending you $100,000 for 10 years at 3%. What is the value of this below-market-rate loan?
Example: the value of a below-market-rate loan As part of a policy of encouraging small business, the government is lending you $100,000 for 10 years at 3%. What is the value of this below-market-rate loan? Assume the market return on equivalent-risk projects is 10%.
The firm adds over $43,000 in value byaccepting the below-market-rate loan. (Thank you Uncle Sam.)
But in inefficient markets, maybe NPV(financing) >0Financing may be “relevant” if firm can find ways to finance at “below-market” costs, i.e. ways to finance below its rational cost of capital
So market efficiency is central to M&M conclusion
Are markets efficient or not? A controversial issue in finance Evidence that markets are approximately efficient However, can find exceptions if one looks carefully at the data These may be important enough to affect financing decisions
Average “abnormal returns” (returns relative to CAPM benchmark) around the announcement that firm X is a takeover target pattern is consistent with semi-strong efficiency: once news is out, no abnormal returns
Case 3. Many investors may be irrational, but the rational investors offset their effect with arbitrage trades
• The most general, most powerful argument
• Arbitrage: “the simultaneous purchase and sale of the same, or essentially similar, security in two different markets at advantageously different prices”
• For example: If McDonald’s is overpriced, arbitrageurs can short-sell McDonald’s, buy Burger King to hedge their risk, and hold on for a low-risk (hopefully riskless) profit
• This forces McDonald’s price back down to the efficient value
• Argument is less compelling when there are costs/risks to this sort of arbitrage
How Much Should a Firm Borrow?
Principles of Corporate FinanceBrealey and Myers Sixth Edition
Pecking Order Theory of Incremental Financing Decisions - Theory that uses asymmetric information to argue that firms prefer to fund their investments using internal finance, then (if internal finance is insufficient) by debt issues, then (as a last resort) by equity issues.
Pecking Order Theory of Capital Structure – Theory in which capital structure evolves as the cumulative outcome of past incremental financing decisions, each of which is taken using the above rule.
Pecking Order TheoryWhere does the POT of financing decisions come from?
Starting point is that managers know more than investors about firm value -- and that investors recognize their disadvantage
I.e., there is “asymmetric information” I.e., the market is semi-strong form efficient but not strong-form
efficient
This seems reasonable … E.g., when a company announces a dividend increase, price goes up This is because investors interpret the increase as a sign of managers’
confidence in future earnings So the dividend increase carries information only if managers do indeed
Our products were popular for a while, but the fad is fading. It is all downhill from here. How are we going to compete with the new entrants? Fortunately our stock price has held up – we’ve had some good short-run news for the press and security analysts. Now’s the time to issue stock.
Managers of U are thinking:
Sell stock at our current low price? Ridiculous! It’s worth at least twice as much. A stock issue now would hand a free gift to the new investors – the old investors would be selling a big piece of the pie for a small price. I just wish those stupid, skeptical investors would appreciate the true value of this company. Oh well, the decision is obvious: we’ll issue debt, not underpriced equity.
Pecking Order Theory Thus, asymmetric information favors debt over equity issues
Debt is higher on the “pecking order” than equity In practice, debt issues are more common than equity issues,
consistent with the P.O. prediction
Internal finance is even better It is highest on the pecking order Investing with internal finance sends no signal about the firm’s true
value; it avoids issue costs and information problems completely May therefore be worth accumulating internal finance
Thus, ‘pecking order of incremental financing choices’ A theory of day-to-day financing decisions ‘Internal finance preferred to debt issues preferred to equity issues’
‘Pecking order theory of capital structure’ Says that ‘capital structure is just the cumulative outcome of past,
pecking-order-driven financing decisions’ No “grand plan” or “optimal” debt-equity ratio Each firm’s debt-equity ratio just reflects its cumulative requirements
for external finance
Fits empirical fact: Profitable firms have lower D/E ratios P.O. theory is consistent with this fact: more profits more
internal finance available don’t need outside money. (Whereas less profitable firms issue and accumulate debt because they don’t have internal funds)
Tradeoff theory predicts the opposite: more profits more value to tax shields should have more debt
Our theoretical arguments for market efficiency are strong, but have some holes
In practice, “arbitrage” is usually costly and/or risky It is costly to short-sell overpriced stocks Individual stocks don’t have perfect substitutes; e.g., the “short
McDonalds, hedge with long Burger King” trade has risk Real “arbitrageurs” may be capital-constrained: they can’t pursue all
the good opportunities (NPV>0 trades) that they perceive And so forth … Bottom line is that theoretical argument for market efficiency is
strong, but not overwhelming: There is some evidence of inefficiency when one looks carefully at the data
14- 40 What should managers do in inefficient markets?
Remember the pecking-order logic: In markets that are semi-strong but not strong efficient, managers try to avoid issuing equity, since it sends a bad signal, stock price drops instantly
But if (as some evidence suggests) markets are not even semi-strong efficient, then investors may underreact to the bad news (overvaluation) inherent in a new stock issue
If so, managers may be able to “time the market” – get an overpriced equity issue out without a big price drop
Effectively, they can obtain equity at an irrationally low cost This benefits incumbent shareholders at the expense of the new ones Can they do this? Do they?
Evidence of successful “market timing” – firms seem to issue equity when its price is too high (cost of equity is low), repurchases when price too low (cost of equity is high)
[9] IPOs underperform the market index
[10] SEOs underperform the market index
[11] When aggregate equity issues are high relative to aggregate debt issues, subsequent equity market returns are low
[12] Repurchases outperform (beat) the market index
Financing theory when markets are not semi-strong efficient, e.g. when investors underreact to the bad news in equity issue or the good news in a repurchase
Says raise whatever form of finance is currently available at the lowest risk-adjusted cost. (In M&M efficient markets, this makes no sense, since all forms of finance are efficiently priced at the same risk-adjusted cost.)
For example, issue equity if it is relatively overpriced, or long-term debt if it is relatively overpriced, or short-term debt if it is relatively overpriced
Consistent with empirical evidence that firms can “time the market”