Corporate Financing Decisions and Efficient Capital Markets

Corporate Financing Decisions and Efficient Capital Markets

AgendaHow to add value in financing

Intro to the EMH

Types of Efficiency

Misconceptions

Valuation

Financing Opportunities

• While many companies find that there are a lot of NPV-positive (profitable) projects out there, there are very few financing opportunities that are NPV -positive.

3 Ways to Create Valuable Financing Opportunities

1) Trick Investors with complex securities2) Reduce costs or increase subsidies to the security3) Create a new security

Tricking Investors

• Traditionally, companies raise capital in equity markets by issuing common stock or preferred stock.

• In order to bring in more capital per dollar of obligation, firms can create complex securities that trick investors into thinking its worth more than it really is:

Tricking Investors Example

• 100 shares of common stock issued @ $10 each = $1000 raised

• 50 shares of FinSec ABC gives you the exercisable right to convert to 100 shares of common stock in a 1.5 year period, with rights to convert to mezzanine debt between years 5-10.– Sounds like you get a lot of flexibility that will lead to a good investment right? Well

mezzanine debt is nearly useless in certain situations, and the company could be planning on this.

– Still, some investors can be tricked into paying $1100 for this issuance, despite the fact that they would just end up converting to common stock and effectively paying a $1 per share more.

Reduce Costs or Increase Subsidies

• Certain forms of financing have greater tax advantages than others (interest expense is deductible)

• By packaging your debt and equity issuances into one transaction with the investment bank, you only have to pay for one issuance instead of two

Create a New Security

• Corporations use to only issue common stock and straight debt• Now:– Zero coupon bonds, adjustable bonds, floating rate bonds, putable

bonds, credit enhanced debt securities, receivable backed securities, adjusted rate preferred stock, convertible adjustable stock, convertible exchangeable preferred stock, adjustable rate convertible debt, zero coupon convertible debt, debt with mandatory common stock purchase contracts.

New Securities

• Each has it’s own advantages and investment community niche, but these securities cannot be easily replicated by combining other ones

• Example:– Putable bonds allow investors to sell the bond back to the company

at a fixed price, creating a price floor and protecting the investors from downside risk. This allows the issuer to charge more for the bond’s protection and create more value

The Efficient Market Hypothesis

• An efficient capital market is one in which stock prices fully reflect all available information

• To illustrate, we begin with an example:

What determines the willingness of investors to hold shares of FB at a particular price?

Probability of creating a successful drug first

In an efficient market, we expect price to increase as probability goes up.

If the lead cancer research team is hired by First Biotech, what will happen to stock price?

What if the lead cancer research team is paid an amount that fully reflects their contribution to the firm?

So when does the price change occur?

In an efficient market, price of shares adjusts immediately to new information

Implications of the EMH

• Because information is reflected in prices as soon as the information is available, investors do not have time to trade on it and make a return.

• Firms should expect to receive fair value of securities issued. Financing by tricking investors or other methods will not work in an efficient capital market.

Professors vs. Students

The moral of the story reflects the logic in the EMH: if you think you found a way to pick a winning stock, you probably haven’t. Someone has already figured the same thing out and the pattern is gone.

So what causes market efficiency?

• Rationality• Independent deviations from Rationality• Arbitrage

Rationality as a cause of EM’s

• Everyone takes new information in conjunction with old information and translates it to a new share price in largely the same way.

• When their analysis suggests stock price should go up by $1 per share, there is no reason to wait to buy, so they will buy the stock until price has gone up $1, then stop.

Independent Deviations From Rationality

• Press release from First Biotech suggests that cancer research is going better than expected- but we don’t know exactly how this vague, qualitative information will exactly translate to how many sales they will have.– Some will be overly optimistic, some will be overly pessimistic– These sentiments will cancel out, yielding efficient price movements

Arbitrage

• What is arbitrage?Simultaneous purchase of one asset, and the sale of a substitute asset.

So arbitrage is the EMH involves that professional, calculating investors that undertake arbitrage transactions, dominate the uninformed speculation of amateur investors, thus making markets more efficient, since amateurs wield less investing power.

Market Response Times

• Some information may affect stock prices more quickly than others:– When First Biotech announces that it’s research is going well, stock

price will shoot up instantly. – What about when Yu Chemicals (one of the suppliers of the drug

compound) loses an American friendly CEO? • Might take investors a little while to realize the connection

• 3 types of information with different response times:– Information on past prices, publicly available info, and all information

Types of Efficient Markets: Weak Form

Buy

Sell

Sell

Sell

Sell

Buy

Buy

Buy

Buy

Information based only on past price.

A capital market is said to be weakly efficient if it fully incorporates information on past prices.

The above strategy would not work in a weakly efficient market.

Weak Form

• Historical price information is the easiest to find, so if patterns in price movements existed, everyone would do these strategies, and any profits would disappear.

Types of Efficient Markets: Strong and Semi-Strong

• A market is semi-strong if it reflects all public information and past prices

• A market is strong if it reflects all information, public and private

Past Prices

Public Info

ALL Info

Example

• An investor decides to sell a stock after its price rises.– A market that is weak will:• Prevent the strategy from being profitable• Allow the strategy to be profitable

• An investor decides to buy a stock if a news release is good– A market that is semistrong will:• Prevent the strategy from being profitable• Allow the strategy to be profitable

Example

• If a person believes in strong form efficiency, so that knowing all information relative to the stock cannot yield profits, what would be their position on insider knowledge for insider trading?

Chances are they wouldn’t care. As soon as the insider tried to trade on the information, the market would realize what is going on and shoot up before the insider could buy stock

What’s wrong with this argument?

Likelihood of each type of EM existing:

• Weak: Probable- it is cheap and easy to find patterns in stock prices using computers and statistics

• Semi-strong: Less probable- investors must be good at economics and statistics and know a lot of details about companies and industries.

• Strong: low likelihood- empirical evidence suggests that this is unlikely

Misconceptions about EMH

“The Efficacy of Dart Throwing”

• “…throwing darts at the financial page will produce a portfolio that can be expected to do as well as any managed by a professional.”– Almost, but not quite true• What the EMH says is that on average the manager will not produce

abnormal or excess returns• Still have to worry about risk exposure and diversification

Price Fluctuations

• Why does price fluctuate from day to day if the EMH suggests that at every point in time where there is no new information there should be a “true” price– There is always new information

Stockholder Disinterest

• Can a market really be efficient if only a fraction of shares outstanding change hands on a given day?– An individual will only trade a stock if the value of the stock differs

enough from the market price to justify transaction costs– Interested traders are using all available public information, so they

can efficiently price it

Why does this all matter?

• The efficient market hypothesis is a critical assumption in the study of finance and economics- the reason most of your professors believe in it

• If markets are efficient, what we’re doing is largely useless• Implications in options pricing (and really any kind of pricing)