1. copyright © 2003 McGraw Hill Ryerson Limited 12-1 prepared by: Carol Edwards BA, MBA, CFA Instructor, Finance British Columbia Institute of Technology Fundamentals of Corporate Finance Second Canadian Edition

2. copyright © 2003 McGraw Hill Ryerson Limited 12-2 Chapter 12 Corporate Financing and the Lessons of Market Efficiency Chapter Outline  Differences Between Investment and Financing Decisions  What is an Efficient Market?  Lessons of Market Efficiency

3. copyright © 2003 McGraw Hill Ryerson Limited 12-3 Investment vs Financing Differences Between Investment and Financing Decisions  Smart investment decisions make shareholders wealthier.  Likewise, smart investment decisions also make shareholders wealthier. For example, if a firm can sell a security for more than it is worth, this is a great deal for the shareholders. But it is a lousy deal for the buyers!

4. copyright © 2003 McGraw Hill Ryerson Limited 12-4 Investment vs Financing Differences Between Investment and Financing Decisions  Companies regularly find projects with positive NPV’s. There are many opportunities for smart managers to capitalize on their firm’s expertise, technology or its competitive advantages.  However, it is not so easy to find positive NPV investment decisions. To do so, you would have to consistently trick investors into overpaying for your firm’s securities.

5. copyright © 2003 McGraw Hill Ryerson Limited 12-5 Investment vs Financing Differences Between Investment and Financing Decisions  However, it would be difficult to consistently “trick” investors because investment markets are intensely competitive. This means it is hard to make, or lose, money using financing strategies. It is rare to make money by finding cheap financing because investors who supply financing demand fair terms. Conversely, it is rare to lose money on an issue because competition among investors prevents them from demanding more than fair terms.

6. copyright © 2003 McGraw Hill Ryerson Limited 12-6 Investment vs Financing Differences Between Investment and Financing Decisions  As a general rule, you should assume that any securities your firm issues will be sold for their true value.  True value means a price which incorporates all the information which is currently available to investors.

7. copyright © 2003 McGraw Hill Ryerson Limited 12-7 What is an Efficient Market? Market Efficiency  In efficient capital markets security prices rapidly reflect all relevant information about asset values. Thus, all securities are fairly priced in light of the information which is available to investors.  If securities are fairly priced, then selling securities at prevailing market terms is never a positive NPV transaction.  Likewise, when buying securities, it is impossible to consistently earn excess profits.

8. copyright © 2003 McGraw Hill Ryerson Limited 12-8 What is an Efficient Market? Random Walk  Studies of the market have shown that market prices follow a random walk.  A random walk means that security prices change randomly without predictable trends or patterns. That is, stock prices seem to wander randomly, just as likely to go up as down, on any particular day, regardless of what has occurred on previous days.

9. copyright © 2003 McGraw Hill Ryerson Limited 12-9 What is an Efficient Market? Random Walk  Many studies of the market have shown that studying past price information provides little information about future price changes.  Want proof? Look at figure 12.1 on page 362 of your text. Can you tell which chart is for the stock market and which is the result of a random coin toss game?

10. copyright © 2003 McGraw Hill Ryerson Limited 12-10 What is an Efficient Market? Random Walk  Does the fact that stock prices follow a random walk mean that they are just “plucked out of a hat”?

11. copyright © 2003 McGraw Hill Ryerson Limited 12-11 What is an Efficient Market? Random Walk  No, that is not the correct conclusion!  What the Random Walk Theory means is this: If the stock of ABC jumps up today, you cannot assume that it will do the same thing tomorrow. However, ABC’s price change didn’t just pop out of nowhere! There must have been a good reason for the change in price …  Did they report increased earnings? Or, a new product line which investors expect will boost profits? Or, …

12. copyright © 2003 McGraw Hill Ryerson Limited 12-12 What is an Efficient Market? Technical Analysis  Technical analysts are investors who attempt to identify over- or undervalued stocks by searching for patterns in past prices. However, if stock prices follow a random walk then technical trading rules are useless.

13. copyright © 2003 McGraw Hill Ryerson Limited 12-13 What is an Efficient Market? Technical Analysis  Technical analysis may not work, but technical analysts can help keep the markets efficient! Look at figure 12.2 on page 363. Let’s say that technical analysts spot the upward trend in this stock’s price. Based on the trend, they forecast that the stock’s price will go to $60 per share. Can you see what happens as soon as they come to this conclusion?

14. copyright © 2003 McGraw Hill Ryerson Limited 12-14 What is an Efficient Market? Technical Analysis  The analysts instantaneously bid up the price of the stock to the present value of its expected future price.  Result: As soon as a price trend becomes apparent to technical analysts, they immediately eliminate it by their trading.  Thus any pricing cycles self-destruct as soon as they are recognized by investors. This means no one can consistently forecast the future from past price activity.

15. copyright © 2003 McGraw Hill Ryerson Limited 12-15 What is an Efficient Market? Efficient Market Theory  You can’t make superior profits by studying past stock prices. Any information in those stock prices is already reflected in the stock’s current price.  Any market where this theory holds true is called weak-form efficient.  Weak-form efficiency means that market prices rapidly reflect all information contained in the history of past prices.

16. copyright © 2003 McGraw Hill Ryerson Limited 12-16 What is an Efficient Market? Efficient Market Theory  So you can’t make superior profits by studying past stock prices …  But what about other publicly available information? Investors don’t just look at stock prices to make their decisions.  They also look at a firm’s business prospects, the state of the economy, what the central bank is doing with interest rates, etc. Could you make more than a fair rate of return by basing your investment decisions on this type of information?

17. copyright © 2003 McGraw Hill Ryerson Limited 12-17 What is an Efficient Market? Efficient Market Theory  Fundamental analysts are investors who attempt to find over- and undervalued securities by analyzing fundamental information, such as earnings, asset values, and business prospects.  Can fundamental analysts “beat the market” and deliver excess returns to investors? What do you think?

18. copyright © 2003 McGraw Hill Ryerson Limited 12-18 What is an Efficient Market? Efficient Market Theory  Researchers have looked at various types of fundamental information – earnings and dividend announcements, plans to issue securities or to merge, and other types of macroeconomic news.  Their conclusions? Market prices already reflect all publicly available information. Thus it is impossible to make superior returns by studying such information.

19. copyright © 2003 McGraw Hill Ryerson Limited 12-19 What is an Efficient Market? Efficient Market Theory  Semi-Strong form efficient markets are markets where prices reflect all publicly available information.  Strong-form efficient markets rapidly reflect all information that is potentially available to determine true value. In such a market all prices would be fair and no investor would be able to make consistently superior forecasts of stock prices.

20. copyright © 2003 McGraw Hill Ryerson Limited 12-20 What is an Efficient Market? Efficient Market Theory  If markets are strong-form efficient, then it is impossible to beat the market’s performance by studying any kind of information. Your best solution as an investor would be to hold a diversified portfolio of securities known as an index.

21. copyright © 2003 McGraw Hill Ryerson Limited 12-21 What is an Efficient Market? Efficient Market Theory  More and more investment managers have come to believe in the market’s efficiency. They have given up the pursuit of superior performance. Instead, they simply “buy the index”, which provides them with diversification, and a fair rate of return, while minimizing the cost of managing the portfolio.

22. copyright © 2003 McGraw Hill Ryerson Limited 12-22 What is an Efficient Market? Efficient Market Theory  Indexing makes sense if no investor can consistently get useful information ahead of the “rest of the pack”. When information does arrive, investors trade on it immediately, and stock prices respond almost instantaneously.  This insures that it is very difficult, even for a professional money manager, to consistently outperform the market.

23. copyright © 2003 McGraw Hill Ryerson Limited 12-23 What is an Efficient Market? Efficient Market Theory  There are 3 forms of the efficient-market theory: Weak form (the random walk theory)  Market prices reflect all information contained in past market prices. Semi-strong form  Market prices reflect all publicly available information. Strong form  Market prices reflect all known information.

24. copyright © 2003 McGraw Hill Ryerson Limited 12-24 What is an Efficient Market? No Theory is Perfect  Though there is a great deal of evidence to support the efficient market theory, it would be wrong to pretend that there are no puzzles or apparent exceptions.

25. copyright © 2003 McGraw Hill Ryerson Limited 12-25 What is an Efficient Market? No Theory is Perfect  Insider trading is one exception. Company managers have consistently made superior profits when they deal in their own company’s stock. This violates the strong form of the efficient market theory, because it implies that managers know more about their company’s prospects than the market does.

26. copyright © 2003 McGraw Hill Ryerson Limited 12-26 What is an Efficient Market? No Theory is Perfect  It is not surprising that insiders would make superior profits, but there are other anomalies: The Small Cap Effect – investors in smaller companies have outperformed investors in larger firms. Book vs Market – stocks with high ratios of book value of equity to market value have outperformed stocks with low ratios of book to market.

27. copyright © 2003 McGraw Hill Ryerson Limited 12-27 What is an Efficient Market? No Theory is Perfect  Despite these anomalies, there is widespread agreement that capital markets function well. So when economists come across an exception to the efficient market theory, such as the small cap effect, they do not throw out the theory. Instead, they ask themselves what is not allowed for in the theory or their tests of the theory.

28. copyright © 2003 McGraw Hill Ryerson Limited 12-28 Lessons of Market Efficiency Markets Have No Memory  Past prices contain no information about future price changes. You as a financial manager may be reluctant to sell your firm’s securities after a fall in price. However, it is not possible to consistently time the market. So such logic does not make sense in efficient markets!

29. copyright © 2003 McGraw Hill Ryerson Limited 12-29 Lessons of Market Efficiency Markets Have No Memory  However, sometimes, as a manager, you may have access to inside information the market does not know. Perhaps it is some good news which will cause the price of the stock to rise when it is revealed. Therefore, if the company sells its shares at the current price, instead of waiting until the good news gets out, it will be offering its securities at a bargain basement price.

30. copyright © 2003 McGraw Hill Ryerson Limited 12-30 Lessons of Market Efficiency Markets Have No Memory  Naturally it makes sense for you as a manager to be reluctant to sell shares when you have favourable inside information.  However, such information has nothing to do with the history of the stock price!

31. copyright © 2003 McGraw Hill Ryerson Limited 12-31 Lessons of Market Efficiency There Are No Financial Illusions  In efficient markets, investors are unromantically concerned only with a firm’s cash flows and the portion of those cash flows which they are entitled to.  Studies have shown that it is not possible to increase market value through creative accounting. Investors are not easily fooled by companies which change their accounting methods to boost their earnings.

32. copyright © 2003 McGraw Hill Ryerson Limited 12-32 Lessons of Market Efficiency There Are No Free Lunches on Wall Street or Bay Street  In efficient markets, you can trust market prices. You should be suspicious of any “simple” rule which explains why one type of security is cheap and another is expensive.  There is probably a good reason for the difference in price.  The trick is to figure out the real explanation.

33. copyright © 2003 McGraw Hill Ryerson Limited 12-33 Summary of Chapter 12  Competition among investors leads to efficient markets.  Efficient markets are markets in which prices rapidly reflect new information and investors find it difficult to consistently make “superior” returns.  In efficient markets, you can hope to beat the market, but in reality all you can expect is a return which will fairly compensate you for the time value of money and for the risk you bear.

34. copyright © 2003 McGraw Hill Ryerson Limited 12-34 Summary of Chapter 12  The efficient market theory comes in 3 flavours: Weak-form – you cannot earn superior returns by looking for trends in historic price data. Price changes follow a random walk and have no predictive power. Semi-Strong form – you cannot earn superior returns by doing fundamental analysis. Strong form – you cannot earn superior returns using any type of information. The best you can do is to assume that all securities are fairly priced.  There is considerable evidence which supports the efficient market theory.  There is also some contradictory evidence.

35. copyright © 2003 McGraw Hill Ryerson Limited 12-35 Summary of Chapter 12  There are several implications of the efficient market theory: Sophisticated investors understand that it is not easy to earn superior returns in the market.  They know that capital markets are highly competitive. Smart financial managers assume that capital markets are generally efficient. They know that:  Investors will not provide their firm with cheap financing.  Because security prices are fairly set, it is easier to add value by smart investment decisions than by smart financing decisions.