Corporate Financing and the Six Lessons of Market Efficiency Principles of Corporate Finance Sixth Edition Richard A. Brealey Stewart C. Myers Lu Yurong Chapter 13 McGraw Hill/Irwin

13- 2 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Topics Covered  We Always Come Back to NPV  What is an Efficient Market?  Random Walk  Efficient Market Theory  The Evidence on Market Efficiency  Six Lessons of Market Efficiency

13- 3 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 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

13- 4 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 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?

13- 5 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 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 %.

13- 6 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 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).

13- 7 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Random Walk Theory $ $ $ $ $97.50 $ $95.06 Coin Toss Game Heads Tails

13- 8 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Random Walk Theory

13- 9 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Random Walk Theory

McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Random Walk Theory

McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Random Walk Theory

McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Random Walk Theory

McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Random Walk Theory

McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Random Walk Theory

McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 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

McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Efficient Market Theory  Fundamental Analysts  Research the value of stocks using NPV and other measurements of cash flow

McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Efficient Market Theory  Technical Analysts wiggle watchers  Forecast stock prices based on the watching the fluctuations in historical prices (thus “wiggle watchers”)

McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Efficient Market Theory Last Month This Month Next Month $ Microsoft Stock Price Cycles disappear once identified

McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Efficient Market Theory Announcement Date

McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Efficient Market Theory Average Annual Return on 1493 Mutual Funds and the Market Index

McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Efficient Market Theory IPO Non-Excess Returns Year After Offering

McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Efficient Market Theory 1987 Stock Market Crash

McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Efficient Market Theory 1987 Stock Market Crash

McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 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

McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Example: How stock splits affect value Source: Fama, Fisher, Jensen & Roll

McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Preparation for Next Class  Please read:  BM Chapter 14, P