0. Efficient Capital Markets and Capital Structure
Session 2
Efficient Capital Markets and Capital Structure

1. Learning Objectives
LO 1: Explain an efficient market and its three types.
LO 2: Explain the three foundations for market efficiency.
LO 3: Discuss the evidence for the efficiency of the market.
LO 4: Explain the challenges for the three foundations of market efficiency and some empirical evidence brought about by Behavioral Finance.
LO 5: Explain the intuition behind homemade leverage and Modigliani-Miller Proposition I & II for capital structure without corporate taxes.

2. Outline Efficient Market Hypothesis (EMH) Behavioral Finance
Empirical Challenges to EMH
Implications of EMH for Corporate Finance
Capital Structure and Firm Value
Capital Structure Without Corporate Taxes

3. 1. Efficient Market Hypothesis (EMH)
An efficient capital market is one in which security prices fully and quickly reflect all available information.
If current price already reflects this information, such information will not be able to predict future prices.
Market efficiency is a funny thing:
Markets are efficient precisely because there are lots of well-paid, well-financed, and smart security analysts who don’t believe that the markets are efficient…and their actions make the market efficient!

4. Stock Price Reactions Stock Price Overreaction to “good news”
Delayed response to “good news”
Efficient market response to “good news”
Days before (-) and after (+) announcement

5. Stock Price Reactions Efficient market response to “bad news”
Delayed response to “bad news”
Overreaction to “bad news”
Days before (-) and after (+) announcement

6. Foundations of Market Efficiency
Investor Rationality
Independent Deviations from Rationality
No Arbitrage

7. The Different Types of Efficiency
Weak Form
Security prices reflect all information in past prices.
Semistrong Form
Security prices reflect all publicly available information.
Strong Form
Security prices reflect all information—public and private.

8. Information Sets All information relevant to a stock
Information set of publicly available information
Information set of past prices

9. Weak Form Market Efficiency
Security prices reflect all information found in past prices.
If the weak form of market efficiency holds, then technical analysis is not valuable.
Since stock prices only respond to new information, which by definition arrives randomly, stock prices are said to follow a random walk.
Stock prices following a random walk is not the same thing as stock prices having random returns.

10. Why Technical Analysis Fails
Investor behavior tends to eliminate any profit opportunity associated with stock price patterns.
Stock Price
If it were possible to make big money simply by finding “the pattern” in the stock price movements, everyone would do it, and the profits would be competed away.
Sell
Sell
Buy
Buy
Time

11. Semistrong Form Market Efficiency
Security prices reflect all publicly available information.
Publicly available information includes:
Historical price and volume information
Published financial statements
Any events that could affect the stock prices (Congress passes the new financial bill, Fed increases the interest rate, etc.)
If semistrong form of market efficiency holds, then fundamental analysis is not valuable.

12. Strong Form Market Efficiency
Security prices reflect all information— public and private.
Strong form efficiency incorporates weak and semistrong form efficiency.
Strong form efficiency says that anything pertinent to the stock and known to at least one investor is already incorporated into the security’s price.

13. What the EMH Does and Does NOT Say
Investors can throw darts to select stocks.
This is almost, but not entirely, true.
An investor must still decide how risky a portfolio he/she wants based on risk aversion and the expected return.
Price fluctuates daily and hence is inconsistent with market efficiency.
This is incorrect.
Prices reflect information.
New information may arrive daily.
Prices are random so uncaused.
The price CHANGE is driven by new information, which by definition arrives randomly.

14. The Evidence
The record on the EMH is extensive. There are both supporting and contradicting evidence.
Studies fall into three broad categories:
Are changes in stock prices random? Are there profitable “trading rules?”
Event studies: does the market quickly and accurately respond to new information?
The record of professionally managed investment firms.

15. Are Changes in Stock Prices Random?
Can we really tell?
Many psychologists and statisticians believe that most people want to see patterns even when faced with pure randomness.
People claiming to see patterns in stock price movements are probably seeing optical illusions.
A matter of degree
Even if we can spot patterns, we need to have returns that beat our transactions costs.
Random stock price changes support weak form efficiency.

16. What Pattern Do You See?
Click on the chart, and Excel will recalculate the series of random numbers automatically. You never know what you’ll see, but it’s kind of a fun game to make up projections of the stock price in the 26th period.

17. Event Studies
Event Studies are one type of test of the semistrong form of market efficiency.
Recall, this form of the EMH implies that prices should reflect all publicly available information.
To test this, event studies examine prices and returns over time—particularly around the arrival of new information.
Test for evidence of underreaction, overreaction, early reaction, or delayed reaction around the event.

18. Event Study Results
Over the years, event study methodology has been applied to a large number of events including:
Dividend increases and decreases
Earnings announcements
Mergers
New Issues of Stock
The studies generally support the view that the market is semistrong form efficient.

19. The Record of Mutual Funds
If the market is semistrong form efficient, then no matter what publicly available information mutual fund managers rely on to pick stocks, their average returns should be the same as those of the average investor in the market as a whole.
We can test efficiency by comparing the performance of professionally managed mutual funds with the performance of a market index.

20. The Record of Mutual Funds
Taken from Lubos Pastor and Robert F. Stambaugh, “Mutual Fund Performance and Seemingly Unrelated Assets,” Journal of Financial Economics, 63 (2002).

21. The Strong Form of the EMH
One group of studies of strong form of market efficiency investigates insider trading.
A number of studies support the view that insider trading is abnormally profitable.
Thus, strong form efficiency does not seem to be substantiated by the evidence.

22. 2. Behavioral Finance Rationality People are not always rational.
Many investors fail to diversify, trade too much, and seem not to try to minimize taxes by selling winners and holding losers.

23. Behavioral Finance Independent Deviations from Rationality
Psychologists argue that people deviate from rationality in predictable ways:
Representativeness: drawing conclusions from too little data (“law of small numbers”)
This can lead to bubbles in security prices (subprime crisis…).
Conservatism: people are too slow in adjusting their beliefs to new information.
Security prices seem to respond too slowly to earnings surprises.

24. Behavioral Finance

25. Behavioral Finance Arbitrage
Suppose that your superior, rational analysis shows that company ABC is overpriced.
Arbitrage would suggest that you should short the shares.
After the rest of the investors come to their senses, you make money because you were smart enough to “sell high and buy low.”
But what if the rest of the investment community doesn’t come to their senses in time for you to cover your short position?
This makes arbitrage risky.
Limits to Arbitrage
“Markets can stay irrational longer than you can stay solvent.” John Maynard Keynes

26. 3. Empirical Challenges to EMH
Earnings Surprises
Stock prices adjust slowly to earnings announcements.
Behavioralists claim that investors exhibit conservatism.
Size
Small cap stocks seem to outperform large cap stocks.
Value (low market-to-book or low P/E) versus Growth (high market-to-book or high P/E)
Value stocks outperform growth stocks.

27. Empirical Challenges to EMH
Crashes
On October 19, 1987, the stock market dropped between 20 and 25 percent on a Monday following a weekend during which little surprising news was released.
A drop of this magnitude for no apparent reason is inconsistent with market efficiency.
Bubbles
Subprime housing and the financial crisis
Tech stock bubble of the late 1990s.

28. 4. Implications of EMH for Corporate Finance
The EMH has some implications for corporate finance. For example:
The price of a company’s stock cannot be affected by a change in accounting.
Financial managers cannot “time” issues of stocks and bonds using publicly available information.
An acquiring firm cannot buy an “under-valued” firm in a mergers & acquisition transaction.
There is conflicting empirical evidence on all these points.

29. 5. Capital Structure and Firm Value
The value of a firm is defined to be the sum of the value of the firm’s debt and the firm’s equity.
V = B + S S B
If the goal of the firm’s management is to make the firm as valuable as possible, then the firm should pick the debt-equity ratio that makes the pie as big as possible. S S B B
Value of the Firm

30. Importance of Capital Structure
Taken from Servaes and Tufano (2006): CFO Views on the Importance and Execution of the Finance Function.

31. Importance of Target Debt Ratio
Graham and Harvey (2001) found that 81% of the firms have target debt ratio.

32. 6. Capital Structure Without Corporate Taxes
Key Assumptions:
No corporate taxes (to be relaxed later);
No costs of financial distress (to be relaxed later);
Fixed investment policy;
Individuals can borrow as cheaply as firms.

33. Example: Capital Structure, EPS, and ROE
Consider an all-equity firm that is considering going into debt (Maybe some of the original shareholders want to cash out). There are no taxes.
Proposed
$20,000
$8,000
$12,000
2/3 8%
240
$50
Current
Assets $20,000
Debt $0
Equity $20,000
Debt/Equity ratio 0.00
Interest rate n/a
Shares outstanding 400
Share price $50
The firm borrows $8,000 and buys back 160 shares at $50 per share.

34. EPS and ROE Under Current Structure
Recession Expected Expansion
EBIT $1,000 $2,000 $3,000
Interest 0 0 0
Net income $1,000 $2,000 $3,000
EPS _$2.5_ _$5.00_ _$7.50_
ROA _5%_ _10%_ _15%_
ROE _5%_ _10%_ _15%_
Current Shares Outstanding = 400 shares
EPS: $ $ $7.50
ROA: 5% % %
ROE: 5% % %

35. EPS and ROE Under Proposed Structure
Recession Expected Expansion
EBIT $1,000 $2,000 $3,000
Interest
Net income $360 $1,360 $2,360
EPS _$1.50_ _$5.67_ _$9.83_
ROA _1.8%_ _6.8%_ _11.8%_
ROE _3.0%_ _11.3%_ _19.7%_
Proposed Shares Outstanding = 240 shares
EPS: $ $ $9.83
ROA: 1.8% % %
ROE: 3.0% % %

36. Financial Leverage and EPS
12.00
Debt
10.00
8.00
No Debt
6.00
Advantage to debt
Break-even point
EPS
4.00
2.00
0.00
1,000
2,000
3,000
Disadvantage to debt
(2.00)
EBIT in dollars, no taxes

37. Homemade Leverage: An Example
Recession Expected Expansion
EPS of Unlevered Firm $2.50 $5.00 $7.50
Earnings for 40 shares _$100_ _$200_ _$300_
Less interest on $800 (8%) _$64_ _$64_ _$64_
Net Profits _$36_ _$136_ _$236_
ROE (Net Profits / $1,200) _3.0%_ _11.3%_ _19.7%_
We are buying 40 shares of a $50 stock, using $800 in margin. We get the same ROE as if we bought into a levered firm.
Our personal debt-equity ratio is:
Note, 40 shares at $50 per share represents a $2,000 investment, but we match the leverage ratio by borrowing $800 of the purchase price. Thus, we actually invest $1,200 of our own funds.
Earnings: $100 $200 $300
Less Interest on $800 debt: $64 $64 $64
Net profits: $36 $136 $236
ROE: 3.0% % %

38. Homemade (Un)Leverage: An Example
Recession Expected Expansion
EPS of Levered Firm $1.50 $5.67 $9.83
Earnings for 24 shares $36 $136 $236
Plus interest on $800 (8%) $64 $64 $64
Net Profits $100 $200 $300
ROE (Net Profits / $2,000) 5% 10% 15%
Buying 24 shares of an otherwise identical levered firm along with some of the firm’s debt gets us to the ROE of the unlevered firm.
This is the fundamental insight of M&M.
In this case, we invest $1,200 into the levered firm’s equity and $800 into the firm’s debt. This represents a total investment of $2,000.

39. MM Proposition I (No Taxes)
We can create a levered or unlevered position by adjusting the trading in our own account.
This homemade leverage suggests that capital structure is irrelevant in determining the value of the firm:
VL = VU

40. MM Proposition II (No Taxes)
Leverage increases the risk and return to stockholders
Rs = R0 + (B / SL) (R0 - RB)
RB is the yield on debt (cost of debt)
Rs is the return on (levered) equity (cost of equity)
R0 is the return on unlevered equity / return on asset
B is the value of debt
SL is the value of levered equity

41. MM Proposition II (No Taxes)
The derivation is straightforward (first equation is by M&M Prop I):

42. MM Proposition II (No Taxes)
Cost of capital: R (%) R0 RB RB
Debt-to-equity Ratio

43. Readings
Chapter 13, 14 ( )