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

2. 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

3. 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

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

5. 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

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

7. 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.

8. 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?

9. Solution

10. 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

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

12. 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

13. 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.

14. 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.

15. 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

16. 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

17. 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.

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

19. 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.

20. Efficient Market Theory
Announcement Date

21. Market Efficiency 12

22. 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

23. Efficient Market Theory
Announcement Date

24. 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

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

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

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

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