Capital Financing Decision and Efficient Capital Markets Text : Chapter 13.

Capital Financing Decision

and Efficient Capital Markets

Text : Chapter 13

EMH-2 Can Financing Decisions Create Value?

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

• The next few chapters concern financing decisions, such as:– How much debt and equity to sell

– When to sell debt and equity

– When (or if) to pay dividends

EMH-3 Creating 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.

EMH-4 Efficient Market Hypothesis

• Eugene Fama, 1964

A market where there are huge number of rational,

profit-maximizers actively competing, with each trying

to predict the future market values of individual

securities, and where important current information is

almost freely available to all participants.

EMH-5 The Implication of EMH

• 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.

– What changes stock prices?

New Information!

– What do we mean by new information?

• To managers, major shareholders vs. other investors

EMH-6

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”

EMH-7 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”

EMH-8 Forms of Efficient Market Hypothesis

• Weak Form Efficient Market– Prices reflect information set of past prices

– Is there any strong relationship between current and past returns?

• Semi-strong Form Efficient Market– Prices reflect publicly available information

– Is there significant market reactions to public announcements?

• Strong Form Efficient Market– Prices reflect all information relevant to a stock

– Is future price predictable?

EMH-9 Weak Form Market Efficiency

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

• Often weak-form efficiency is represented as

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

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

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

EMH-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).

EMH-11 Past vs. Future Returns: Microsoft

EMH-12 Past vs. Future Returns: Dow Jones Index

EMH-13 Past vs. Future Returns: CAC Index

EMH-14 Can past return predict future return?

• Fama(1965): 1st order autocorrelation (about .03)

• Fama and French (1986): Higher order autocorrleation is negative and even smaller

• Other variables help to explain longer term return– Dividend yield

– E-P ratio

– high-low grade bond yield spread

EMH-15 Semi-strong EMH - Event studies

• Security Prices reflect all publicly available information.

• In M&A, average increase for the target firms’ stock price is about 15%, while the average daily return is only .04%

• Stock price seem to adjust within a day to event announcement

EMH-16 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.

EMH-17 Event Studies: Dividend Omissions

Cumulative 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)

EMH-18 Some Interesting Results of Event Studies

– New stock issue : (-3% usually)

– Share Repurchase

– Change of dividend

– Stock split

EMH-19 Event studies

• Change of accounting rule

EMH-20 Strong-Form EMH

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

• Buy-and-hold strategy beat most of the other strategy• Portfolio performance of WSJ specialists vs. random selection

• Studies of Value Line

– Adjusted for risk and size, G1 stocks have higher return than

G5 stocks up to 1 year-horizon (Huberman and Kandel)

– The announcement of G2 stocks change to G1 bring 2.44% permanent return over 3 days. (Stcikel, 1985)

– The effect of rank change is stronger for small firms

(Stcikel, 1985)

EMH-21 Strong-form EMH : Mutual Fund

EMH-22 The Record of Mutual Funds

Annual 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).

EMH-23 Strong-form EMH

• Mutual fund performance– Jensen (1969)

• 1945-1964, return to investors:1% lower per year than index (after management and other expense, but before loan fees)

– Ippolito(1989)• 1965-1984, .83% per year above index

– Experience of Taiwan vs. US

– Problem of index choice

EMH-24 Relationship among Three Different

Information Sets

All informationrelevant to a stock

Information setof publicly available

information

Informationset of

past prices

EMH-25 Evidence against EMH

• 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. Size effect

• Temporal Anomalies– January effect– Monday effect– Sunshine and full moon

• Speculative Bubbles– Sometimes a crowd of investors can behave as a single

squirrel.

EMH-26 Some Criticism

• Is EMH is testable?– Problem of joint testing between EMH and CAPM

• Does EMH suggest that we can randomly choose

the components of portfolio, since the securities

are always fairly priced?

EMH-27 Implications for Financial Managers

• Markets have no memory– Do not expect historical moment will return

– Can managers time the market?

• Trust the market price– Why are you smarter than thousands of million investors

out there in the market?

• Reading the market price changes– The stock market reactions

– The yield curve

EMH-28 Implications for Financial Managers

• No financial illusion– Accounting change, Stock split

• Do it yourself alternative– Diversification , M&A