Chapter 13: Corporate Financing

Decisions and Efficient Capital Markets

13.1 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 Overreaction to “good
news” with reversion

Delayed
response to
“good news”
Efficient market
response to “good news”

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

Days before (-) and
after (+) announcement
Reaction of Stock Price to New Information in
Efficient and Inefficient Markets
Efficient market
Stock Delayed
response to “bad news”
Price response to
“bad news”

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

Overreaction to “bad Days before (-) and
news” with reversion after (+) announcement
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 Fails
Investor behavior tends to eliminate any profit
opportunity associated with stock price patterns.
Stock Price

If it were possible to make

Sell
big money simply by
Sell finding “the pattern” in the
stock price movements,
Buy everyone would do it and
the profits would be
Buy
competed away.

Time
Getting Technical
Barron’s March 5, 2003
Getting Technical
Back 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 information
relevant to a stock

Information set
of publicly available
information

Information
set 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

1.2

0.8

0.6

0.4

0.2

0
With different
1 2 3patterns,
4 5 6 you7may
8 believe
9 10 11 that
12you
13 can predict
14 15 16 17the18next value
19 20 21 22 2
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 – (a + bRM)
Event Studies: Dividend Omissions
Cumulative Abnormal Returns for Companies Announcing
Cumulative abnormal returns

Dividend Omissions

0.146 0.108
(%)

0.032 0
-0.244
-8 -6 -4
-0.72 -2 -0.483 0 2 4 6 8
-1
Efficient market
-2
response to “bad news”
-3
-3.619
-4
-4.563-4.747-4.685-4.49
-5 -5.015 -4.898
-5.183
-5.411
-6

Days relative to announcement of dividend omission

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 Funds
Annual Return Performance of Different Types of U.S.
Mutual Funds Relative to a Broad-Based Market Index
(1963-1998)

0.00%
Annual Return Performance

All funds Small- Other- Growth Income Growth and Maximum Sector
-10.00% company aggressive funds funds income capital funds
growth growth funds gains
funds funds funds
-20.00%

-30.00%

-40.00%

-50.00%

-60.00%

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 EMH
Security prices reflect past price data.
 Semistrong-Form EMH
Security prices reflect publicly available information.
 Strong-Form EMH
Security prices reflect all information.
 There is abundant evidence for the first two
forms of the EMH.