Chapter 12 Principles PrinciplesofCorporateFinance Concise Edition Efficient Markets and Behavioral Finance Slides by Matthew Will Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill/Irwin

12- 2 Topics Covered  We Always Come Back to NPV  What is an Efficient Market? –Random Walk –Efficient Market Theory  The Evidence Against Market Efficiency  Behavioral Finance  Six Lessons of Market Efficiency

12- 3 Return to NPV  NPV employs discount rates  These discount rates are risk adjusted  The risk adjustment is a byproduct of market established prices  Adjustable discount rates change asset values

12- 4 Return to NPV Example The government is lending you $100,000 for 10 years at 3% and only requiring interest payments prior to maturity. Since 3% is obviously below market, what is the value of the below market rate loan?

12- 5 Return to NPV Example The government is lending you $100,000 for 10 years at 3% and only requiring interest payments prior to maturity. Since 3% is obviously below market, what is the value of the below market rate loan? Assume the market return on equivalent risk projects is 10 %.

12- 6 Random Walk Theory  The movement of stock prices from day to day DO NOT reflect any pattern.  Statistically speaking, the movement of stock prices is random (skewed positive over the long term).

12- 7 Random Walk Theory $ $ $ $ $97.50 $ $95.06 Coin Toss Game Heads Tails

12- 8 Random Walk Theory

12- 9 Random Walk Theory

Random Walk Theory

Random Walk Theory

Random Walk Theory

Random Walk Theory

Random Walk Theory

Efficient Market Theory Last Month This Month Next Month $ Microsoft Stock Price Cycles disappear once identified Actual price as soon as upswing is recognized

Efficient Market Theory  Weak Form Efficiency –Market prices reflect all historical information  Semi-Strong Form Efficiency –Market prices reflect all publicly available information  Strong Form Efficiency –Market prices reflect all information, both public and private

Efficient Market Theory  Fundamental Analysts –Research the value of stocks using NPV and other measurements of cash flow

Efficient Market Theory  Technical Analysts wiggle watchers –Forecast stock prices based on the watching the fluctuations in historical prices (thus “wiggle watchers”)

Efficient Market Theory Announcement Date

Efficient Market Theory Average Annual Return on Mutual Funds and the Market Index

Efficient Market Theory IPO Non-Excess Returns Year After Offering

Price Anomalies Deviation, % Log Deviations From Royal Dutch Shell / Shell T&T Parity

Efficient Market Theory 2000 Dot.Com Boom

Efficient Market Theory 1987 Stock Market Crash

Behavioral Finance  Arbitrage limitations  LTCM example  Factors related efficiency and psychology 1.Attitudes towards risk 2.Beliefs about probabilities

Lessons of Market Efficiency  Markets have no memory  Trust market prices  Read the entrails  There are no financial illusions  The do it yourself alternative  Seen one stock, seen them all

Example: How stock splits affect value Source: Fama, Fisher, Jensen & Roll

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