Corporate Financing and Market Efficiency Where to get money for good projects FIN 351-lecture 8

Today’s plan Review WACC Investment Decision vs. Financing Decision Does the stock price follow a random walk? Three forms of Market Efficiency Weak form efficiency Semi-strong form efficiency Strong form efficiency Several types of securities 2

What have we learned in the last lecture ? Motivation for WACC How do we know that a project is worth taking? How do we find the cost of capital for a project ? What is the formula of WACC without tax? What is the formula of WACC with tax? Should we use the market value or book value of equity and debt in calculating WACC? 16

What have we learned in the last lecture (1)? WACC without tax WACC with tax

What have we learned in the last lecture (2)? The cost of bond It is the YTM, the expected return required by the investors. That is The expected return on a bond can also be calculated by using CAPM 23

What have we learned in the last lecture (2)? The cost of equity is calculated by using CAPM Dividend growth model 23

What have we learned in the last lecture (2)? Three steps in calculating WACC First step: Calculate the market value of each security and calculate its portfolio weight Second step: Determine the cost of capital on each security. Third step: Calculate a weighted average cost of capital on these securities.

A summary example John Cox, a recent MBA student of SFSU, was asked by his boss in Geothermal to decide whether the firm should take an expansion project: the cost of the project is $30 million, and the project is expected to generate a perpetual incremental cash flow of $4.5 million. Currently, Geothermal has 20 million shares of common stocks outstanding, with a market price of $22.65 per share. The Beta of the firm’s equity is 1.1. The risk free rate is 4% and the market risk premium is 5.6%. The firm also has long-term debt, with the YTM of 9%. John also got the following information from the firm’s balance sheet: Debt (12 years maturity, 8% coupon): $200 million Common stocks:$110 million If the tax rate is 35%, should John suggest to his boss to take the project or not?

Solution

Investment vs. Financing Asset Liabilities and equity Investment decisions or capital budgeting is about how to take projects to maximize V. Financing decisions are about how to raise capital (E or D) to finance the projects to be taken Debt: D V Equity: E 3

Financing and market Efficiency Market efficiency is concerned about whether capital markets have all information about the cash flows and risk of projects. 4

Efficient capital markets Efficient Capital Markets – If capital markets are efficient, then security prices reflect all relevant information about asset values ( cash flows and risk) 5

Market efficiency and random walk Market efficiency concepts are very abstract. How can we use a simple way to check whether the stock market (one of the capital markets) is efficient or not? If the stock price follows a random walk, then the stock market is efficient.

What is a random walk of stock prices? The movement of stock prices from day to day DO NOT reflect any pattern. Statistically speaking, the movement of stock prices is random.

A Random Walk example Coin Toss Game $106.09 $103.00 $100.43 $100.00 Heads Heads $103.00 $100.43 Tails $100.00 Heads $100.43 $97.50 Tails $95.06 Tails Coin Toss Game

Three forms of market efficiency The random walk concept is still abstract Financial economists have used three more specific forms to characterize or judge market efficiency. Weak-form Semi-strong form Strong form

Weak-form of market efficiency Weak Form Efficiency - Market prices reflect all information contained in the history of past prices, or you cannot use past stock prices to predict future prices Technical Analysts - Investors who attempt to identify over- or undervalued stocks by searching for patterns in past prices.

Efficient Market Theory $90 70 50 EI’s Stock Price Cycles disappear once identified Last Month This Month Next Month

Semi-strong form of market efficiency Semi-Strong Form Efficiency - Market prices reflect all publicly available information such as earnings, price-to-earnings ratios,etc. Fundamental Analysts - Analysts who attempt to fund under- or overvalued securities by analyzing fundamental information, such as earnings, asset values, and business prospects.

Efficient Market Theory Announcement Date

Market Efficiency 12

Strong form of market efficiency Strong Form Efficiency - Market prices reflect all information that could in principle be used to determine true value. Inside trading Investors use private information to predict future price movements

Efficient Market Theory Announcement Date

Some exercises If stock markets are efficient, what should the correlation between stock returns for two non-overlapping periods? Which is the most likely to contradict the weak-form of efficiency Over 25% of mutual funds outperform the market on average Insiders can make abnormal profits Every January, the stock market earns abnormal return

Several types of securities Three types of securities Common Stock Preferred stock Corporate debt

Common Stock Common stocks have the following forms: Treasury stock Issued shares Outstanding shares Authorized share capital Par value Ownership of the corporation

Corporate debt Corporate bonds Primary rate Funded debt Sink fund Callable bond Subordinate debt Secure debt

Preferred stock Preferred stock and common stock Priority and voting rights Preferred stock and bond Obligation and bankruptcy