B40.2302 Class

1
B40.2302 Class 10

• BM6 chapters 13, 18.4
• 13 Financing decisions and market efficiency
• 18.4, non-BM6 material The effect of asymmetric
  information
• non-BM6 material The effect of market
  inefficiency
• Based on slides created by Matthew Will
• Modified 11/14/2001 by Jeffrey Wurgler

2
Principles of Corporate Finance Brealey and Myers
Sixth Edition

• Corporate Financing and the Six Lessons
  of Market Efficiency

• Slides by
• Matthew Will, Jeffrey Wurgler

Chapter 13

• The McGraw-Hill Companies, Inc., 2000

Irwin/McGraw Hill
3
Topics Covered

• We Always Come Back to NPV
• What is an Efficient Market?
• 3 forms
• Some supporting evidence
• Efficient Market Theory

4
Return to NPV

• A basic similarity between investment and
  financing decisions Can think about both in NPV
  terms
• The decision to purchase a factory (investment
  decision), or sell a bond (financing decision),
  each involve valuation of a risky asset
• Each decision could in principle add value

5
Return to NPV

• 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?

6
Return to NPV

• 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 by
• accepting the below-market-rate loan. (Thank
  you Uncle Sam.)

7
Return to NPV

• Some differences between investment and financing
  decisions
• Number of financing decisions is expanding faster
• Financing decisions usually easier to reverse
• Probably easier to add value through investment
  decisions
• In investment decisions, firm is competing for
  NPVgt0 investments with other industry competitors
• In financing decisions, firm is competing for
  NPVgt0 financing opportunities with all firms,
  governments, investors around the world
• All of this competition may lead to efficient
  markets in which NPV(financing) 0 (ignoring
  tax shields, other financing costs/benefits).

8
Return to NPV

• How does market efficiency affect financing?
• Think of value of firm as an APV calculation
• PV(firm) PV(investments base-case)
  NPV(financing)
• Under MM assumption of efficient markets
• NPV(financing) 0
• (no below-market-rate loans/overpriced stock
  issues available) (and assuming no tax shields,
  issue costs, etc. as before)
• which leads to MM conclusion
• PV(firm) PV (investments base-case)
• while financing is irrelevant because its
  NPV0

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Return to NPV

• How does market efficiency affect financing?
• But in inefficient markets, maybe NPV(financing)
  gt0
• Financing 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 MM 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

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Market Efficiency 3 versions

• Weak Form Efficiency
• Market prices reflect past price information.
• Prices move as a random walk
• Semi-Strong Form Efficiency
• Market prices reflect all publicly available
  information, not just past prices
• Strong Form Efficiency
• Market prices reflect all information, both
  public and private.

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Weak Form Efficiency

• Early discovery The day-to-day changes in stock
  prices (or bond prices) DO NOT reflect any strong
  pattern
• Instead, prices seem to take a random walk up
  and down

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Weak Form Efficiency
In the coin toss game, winnings are a random walk
Heads
106.09
Heads
103.00
100.43
Tails
100.00
Heads
100.43
97.50
Tails
95.06
Tails
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Weak Form Efficiency
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Weak Form Efficiency
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Weak Form Efficiency

• Technical Analysis
• Idea is to forecast stock prices based on
  fluctuations in past prices
• T.A. doesnt pay if markets are weak form
  efficient

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Weak Form Efficiency
90 70 50
Microsoft Stock Price
The idea Cycles self-destruct once identified
Last Month
This Month
Next Month
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Semi-Strong Form Efficiency
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
Announcement Date
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Semi-Strong Form Efficiency
Another situation consistent with semi-strong
efficiency How stock splits affect value
-29
0
30
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Semi-Strong Form Efficiency

• Fundamental Analysis
• Idea is to find undervalued stocks from analysis
  of the fundamental value of cash flows
• F.A. doesnt pay if markets are semi-strong
  efficient

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Semi-Strong Form Efficiency
Average Annual Return on 1,493 Mutual Funds and
the Market Index, 1962-1992.
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Strong Form Efficiency

• Strong form efficiency says that market prices
  properly reflect
• all public and private information
• This is an extreme version of efficiency,
  nobody believes it
• Proof that markets do not reflect all private
  information
• -- illegal insider trading is profitable

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Theory of efficient markets

• When should market efficiency hold?
• Case 1. All investors are rational
• Rational investors value securities for the
  present value of their future cash flows.
• So if P / PV(cash flows), they will buy or sell
  until it does.
• Case 2. Some investors are irrational, but their
  misperceptions are uncorrelated
• Optimistic and pessimistic investors will cancel
  out

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Theory of efficient markets

• When should market efficiency hold?
• 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 McDonalds is overpriced,
  arbitrageurs can short-sell McDonalds, buy
  Burger King to hedge their risk, and hold on for
  a low-risk (hopefully riskless) profit
• This forces McDonalds price back down to the
  efficient value
• Argument is less compelling when there are
  costs/risks to this sort of arbitrage

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Principles of Corporate Finance Brealey and Myers
Sixth Edition

• How Much Should a Firm Borrow?

• Slides by
• Matthew Will, Jeffrey Wurgler

Chapter 18.4

• The McGraw-Hill Companies, Inc., 2000

Irwin/McGraw Hill
25
Topics Covered

• Pecking Order Theory
• Theory of financing decisions
• Theory of capital structure

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Pecking Order Theory

• 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.

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Pecking Order Theory

• Where 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 know more in the first place

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Pecking Order Theory

• How does asymmetric information affect the
  choice between debt and equity?
• Imagine two companies, O and U.
• To investors, they appear identical.
• But Os managers know that Os stock is
  Overpriced
• And Us managers know that Us stock is
  Underpriced
• Both O and U have an investment project and need
  to raise . Should they issue equity or debt?

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Pecking Order Theory

• Managers of O are thinking
• 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 weve
  had some good short-run news for the press and
  security analysts. Nows the time to issue
  stock.
• Managers of U are thinking
• Sell stock at our current low price?
  Ridiculous! Its 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 well issue
  debt, not underpriced equity.

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Pecking Order Theory

• So O wants to issue stock, but U wants to issue
  debt.
• Investors (in the pecking order theory) are not
  stupid they understand these motives
• They view stock issues as a sign of overvaluation
• They view debt issues as a sign of undervalution
• So Os stock price will drop if it announces a
  stock issue, presumably eliminating the
  overvaluation (semi-strong efficient)
• In practice, stock prices do fall upon
  announcement of a new stock issue
• Thinking this through, even O will prefer debt
  over stock issues.

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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 firms 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

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Pecking Order Theory

• 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 firms 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 ? dont
  need outside money. (Whereas less profitable
  firms issue and accumulate debt because they
  dont have internal funds)
• Tradeoff theory predicts the opposite more
  profits ? more value to tax shields ? should have
  more debt

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• Market Inefficiency and Corporate Finance

• Slides by
• Jeffrey Wurgler

Not in book
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Topics Covered

• Evidence of market inefficiency?
• Market timing theory
• Theory of financing decisions
• Theory of capital structure

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Evidence of market inefficiency?

• 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 dont have perfect substitutes
  e.g., the short McDonalds, hedge with long
  Burger King trade has risk
• Real arbitrageurs may be capital-constrained
  they cant pursue all the good opportunities
  (NPVgt0 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

36
Evidence of market inefficiency?

• Calendar effects
• refer to appendix slide 1 January effect Small
  stocks do well in January
• 2 September effect Stocks in general do badly
  in September
• 3 Turn-of-month effect Stocks do well around
  the turn of the month

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Evidence of market inefficiency?

• Firm characteristics effects
• 4 Size effect Small-cap stocks do better than
  large-cap stocks
• 5 Book-to-market effect Stocks with high
  book-to-market equity ratios (value stocks) do
  better than stocks with low ratios (growth
  stocks)

38
Evidence of market inefficiency?

• Overreaction to non-news?
• 6 Is there real information driving all the
  major market moves?

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Evidence of market inefficiency?

• Underreaction to genuine news?
• 7 Post-earnings-announcement drift stocks seem
  to underreact to earnings announcements
• 8 Momentum stocks that have gone up in past
  3-12 months keep going up, and vice-versa.

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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?

41
Market timing

• 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

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Market Timing Theory

• Market timing theory of financing decisions
• 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
  MM 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

43
Market Timing Theory

• Market timing theory of capital structure
• Says capital structure is just the cumulative
  outcome of market-timing-motivated financing
  decisions
• No grand plan or optimum debt/equity ratio
• Capital structure just the cumulative outcome of
  past efforts to time the markets