Market Efficiency and Long-term Financing

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Market Efficiency and Long-term Financing
7-1
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A 1 Investment in Different Types of Portfolios
1926-1996 (Fig. 12.4)
7-2
Index ()
4,495.99
Small Company Stocks
1,370.95
Large Company Stocks
33.73
Long-Term Government Bonds
13.54
8.85
Treasury Bills
Inflation
Year-End
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Market Efficiency

• An efficient capital market is one in which the
  purchase or sale of any security at the
  prevailing market price is a zeroNPV
  transaction. That is, you can expect to earn only
  a return adequate (normal return) to compensate
  you for the risk you bear.

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Market Efficiency Theory

• In an Efficient Capital Market prices reflect
  all relevant information. You cannot consistently
  earn excess or abnormal profits.

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Conditions needed for an Efficient Market

• A large number of rational investors (analysts,
  MBAs, CFAs) who seek to maximize their wealth
• Information is widely available
• Firms like Merrill Lynch, Morgan Stanley, etc.
  spend lots of money to collect and analyze
  informatio

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Market Efficiency
Does this mean prices remain always the same and
wont move?
No !!!
Random Walk - Security prices change randomly,
with no predictable trends or patterns.
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Summary Why are price changes random?

• Prices react to information
• Flow of information is random
• by definition, otherwise news is not news!
• Competition assures prices quickly and accurately
  reflect information
• Therefore, price changes are random

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Three Forms of Market Efficiency

• Weak form
• current prices reflect past prices and patterns
  irrespective of the actual firms fundamentals
• Semi-strong form
• all public information (economic and accounting)
  is reflected in stock prices
• Strong form
• all information (public and private) is reflected
  in stock prices

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Technical Analysts - Investors who attempt to
identify over- or undervalued stocks by searching
for patterns in past prices.
Head and Shoulders Triple Tops
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Fundamental Analysts - Analysts who attempt to
find under- or overvalued securities by analyzing
fundamental information, such as earnings, asset
values, and business prospects.
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Reaction of Stock Price to New Information in
Efficient and Inefficient Markets
Price ()
Overreaction andcorrection
220 180 140 100
Insider Information
Delayed reaction
Efficient market reaction
Days relativeto announcement day
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6
8
6
4
2
0
2
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Efficient market reaction The price
instantaneously adjusts to and fully reflects new
information there is no tendency for subsequent
increases and decreases.Delayed reaction The
price partially adjusts to the new information 8
days elapse before the price completely reflects
the new informationOverreaction The price
over-adjusts to the new information it
overshoots the new price and subsequently
corrects.
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Market Efficiency
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The Bottom Line

• As a corporate financial manager (or investor)
  you should expect financing transactions (buying
  or selling of securities) to be a zero-NPV
  transaction.
• To consistently produce value from your firms
  financing transactions would require either
• consistently fooling investors
• constantly creating new securities

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Evidence on Market Efficiency

• Strong Form
• insider trading
• Semi-strong form
• event studies
• mutual fund performance
• anomalies
• Weak form
• technical analysis
• serial correlation and momentum

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Mutual Fund and Professional Manager Performance

• Casual evidence indicates that mutual funds do
  not outperform market indices
• WSJ stock picking contest (1990-1996)
• Pros won 44/77 times versus dart throwing monkeys
• Pros won 40/77 times versus DJIA

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Market Efficiency Anomalies

• Size Effect
• January Effect
• Monday Effect
• Value Line Enigma
• Crash of 1987

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Small Firms versus Large Firms
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Long-term Financing
Debt and Equity
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Corporate Long-term Debt

• Main characteristics
• Debt holders have no ownership in the firm
• no voting rights, no residual claim
• Benefits
• Tax deductibility of interest payments
• Monitoring and discipline
• Costs
• Possibility of financial distress
• Potential conflict of interest with owners
  (agency cost of debt)
• Traded on organized exchanges and over-the-counter

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Preferred Stock

• Cumulative versus Non-cumulative
• Is preferred stock really debt?
• Corporate seller's tax disadvantage
• Unlike interest, dividends are not tax deductible
• Corporate buyer's tax advantage
• 70 of dividend income received from other
  domestic firms are exempt from federal corporate
  taxation

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Common Stock

• Par Value some value assigned to stock for no
  particular reason. Most stocks have par values
  of 1.00 or 0.01
• Authorized versus Issued Common Stock All shares
  to be sold must be authorized by the articles of
  the corporation.
• Additional Paid in Capital (Capital in Excess of
  Par Value) usually refers to amounts of directly
  contributed equity capital in excess of par
  value.
• Retained Earnings Corporate earnings not paid
  out as dividends.

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Common Stock

• Dividends payment of dividends is at the
  discretion of the Board of Directors.
• Shareholders' Rights
• Straight Voting Directors are elected one at a
  time. You may cast all your votes for each
  member of the BOD.
• Cumulative Voting Directors are elected all at
  once. You may cast all your votes for one member
  of the BOD. In general, if N directors are to be
  elected, it takes 1/(N 1) percent of the shares
  1 share to assure a deciding vote for one
  director.

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Shareholders' Voting Rights
Assume 3 directors to be elected and you own 20
shares Straight Voting Directors are elected
one at a time You may cast all your votes for
each member of the BOD 20 shares 20
votes Cumulative Voting Directors are elected
all at once You may cast all your votes for one
member of the BOD votes shares
directors to be elected (20 shares) (4
directors to be elected) 60 votes For
cumulative voting if N directors are to be
elected, it takes 1/(N1) percent of the stock
1 share to assure a deciding vote for one
director 25 of the shares 1 share will
guarantee you one deciding vote for 1 director
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What differentiates Debt from Equity?
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Patterns of Corporate Financing 1981 - 1992
Internally generated funds
Long-term Debt
New Equity Sales
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Types of Equity Issues

• Private Direct Placement
• Florida Panther Holdings, Inc., February 12,
  1999
• Initial Public Offering (IPO)
• Ticketmaster Online, December 2, 1998
• "Will offer 7 million shares of common stock at
  14"
• Seasoned Equity Offering (SEO)
• American Online, Sept. 19, 1995
• "Will offer 3.5 million shares of common
  stock"
• 1.95 million by company 1.55 million by its
  shareholders
• Rights Offer
• Revco, April 1994
• each stockholder as of June 13 will receive
  0.305 of a transferable right for each Revco
  common share held.

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IPOs The Biggest Pops

• Nine of the 10 biggest first-day gains by IPOs
  were Internet stocks
• Issuer Offering Date Change
• theglobe.com 11/12/98 474
• MarketWatch.com 1/15/99 471
• Broadcast.com 7/16/98 249
• EarthWeb 11/10/98 247
• Ticketmaster Online 12/2/98 243
• uBid 12/3/98 220
• Secure Computing 11/17/95 202
• Artificial Life 12/17/98 176
• eBay 9/24/98 163
• Yahoo! 4/12/96 154
• Source The Wall Street Journal January, 1999

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Pricing of Initial Public Offerings
Underpricing phenomenon IPO's rise in value on
first day of issue by an average of
15 Examples In 1980, when Apple Computer
went public, shares were offered at 22 per
share and jumped to 36. Boston Chicken stock
was offered at 20 per share and jumped to 49
on the first day of trading. Should you invest
in each IPO given the average 15 return on an
IPO during the first day?
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Why Does Underpricing Occur?

• Helps sell issues.
• Insurance against lawsuits
• Helps avoid "winner's curse"
• Uninformed small investors buy more of
  overpriced IPOs
• Informed investors buy more of underpriced IPOs

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Stock Market Reaction to Seasoned Equity Offering
On average stock prices fall. Why?
- Management may know firm is overvalued -
Management may know future earnings of the firm
are going to be poor - Issuing equity may imply
the firm has too much debt or too little
equity - High issue costs - Downward sloping
demand curves
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Rights Offerings
An issue of common stock to existing
shareholders. "privilege subscription" Example
April 8, 1994, Revco to raise 217
Million Stockholders of record as of 6/13/94
will receive 0.305 transferable right for each
share of stock Subscription price of 14 per
share Rights to expire 7/7/94 Proceeds used
to facilitate acquisition of Hook-SupeRx, Inc.
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Value of Rights The Individual Shareholder
DOTCOM Corporation Rights Offer
Design Corp. gives existing shareholders the
opportunity to buy 1 additional share at 15 per
share for 3 rights owned. 1 share includes 1
right. Current Share price30 - What is the
ex-rights share price?0 - What is the value of a
right before the offering? - What is the value of
a right after the offering?