Corporate Financing Decisions Market Efficiency 1Finance - Pedro Barroso.

Corporate Financing DecisionsMarket Efficiency

1Finance - Pedro Barroso

Can Financing Decisions Create Value?

• We have seen how to evaluate investment projects according to the NPV criterion

• Next we will study financing decisions, such as:– How much debt and equity to sell– When to sell debt and equity– When (or if) to pay dividends

• We can use NPV to evaluate financing decisions

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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

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Efficient Capital Markets Hypothesis

• 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 little good

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

4Finance - Pedro Barroso

Finance - Pedro Barroso

Random Walks• In a random walk, the best forecast of future prices is

today’s price• Efficient markets prices follow random walk

– Only strictly true if the discount rate does not change over time

– Over short time frames returns should look random• If we all thought that the price of an asset was going

up in the future, then we would start buying today and the price would go up right now, not in the future

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Finance - Pedro Barroso

S&P or Coin Toss?

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Finance - Pedro Barroso

Information

Past Prices

Public

Private

Weak

Semi-strong

Strong

Type of information

Form of efficiency

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Finance - Pedro Barroso

Weak Form (past prices)• Postulates that current prices fully reflect all information

in past prices– Using past prices, returns, volumes will produce no predictable

patterns that can be exploited to yield better returns in the future

• Technical analysis– Search for recurring and predictable patterns in prices– Believe in slow response of prices to fundamentals– Called “chartists” because they study charts of past stock prices

and volumes (candlesticks, heads and shoulders, moving averages)

• Even if there are patterns, they are self-destructing– Discovery leads to exploitation and ultimately invalidation

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Finance - Pedro Barroso

Semi-Strong Form (public information)

• Postulates that current prices fully reflect all past prices and all publicly available information

• Fundamental analysis (using economic and accounting information) – Sorting through income statements, talking to the

company– Studying industries and the macroeconomy

• Some evidence for semi-strong efficiency– No abnormal returns after public announcement– Professional money managers do not outperform the

market consistently

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Finance - Pedro Barroso

Strong (private information)• Postulates that current prices fully reflect all information,

public and private• Strong-from efficiency says that insider trading will not

produce profits– Knowing a merger is going to take place before it is announced

publicly will not produce profits

• Although illegal, evidence that prices move before public announcements, suggesting insider information

• Insider trading appears profitable, indicating markets are not strong form efficient– These profits are short-lived, suggesting the market may be close

to efficient

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Finance - Pedro Barroso

Why Should Markets be Efficient?• There are a large number of competing profit-

seeking investors– It is not necessary that the average investor is smart,

only that there are a few smart investors (with deep pockets)

• New information about securities comes to markets in a random fashion

• Forces of arbitrage– Smart investors exploit the mispricing in securities until

it disappears

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The Record of Mutual Funds

Taken from Lubos Pastor and Robert F. Stambaugh, “Mutual Fund Performance and Seemingly Unrelated Assets,” Journal of Financial Economics, 63 (2002).

-2.13%

-8.45%

-5.41%

-2.17% -2.29%

-1.06%-0.51%-0.39%

All funds Small-companygrowth

Other-aggressive

growth

Growth Income Growth andincome

Maximumcapital gains

Sector

16Finance - Pedro Barroso