1. 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

2. 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

3. 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

4. 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?

5. 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 %.

6. 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).

7. 12- 7 Random Walk Theory $103.00 $100.00 $106.09 $100.43 $97.50 $100.43 $95.06 Coin Toss Game Heads Tails

8. 12- 8 Random Walk Theory

9. 12- 9 Random Walk Theory

10. 12- 10 Random Walk Theory

11. 12- 11 Random Walk Theory

12. 12- 12 Random Walk Theory

13. 12- 13 Random Walk Theory

14. 12- 14 Random Walk Theory

15. 12- 15 Efficient Market Theory Last Month This Month Next Month $40 30 20 Microsoft Stock Price Cycles disappear once identified Actual price as soon as upswing is recognized

16. 12- 16 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

17. 12- 17 Efficient Market Theory  Fundamental Analysts –Research the value of stocks using NPV and other measurements of cash flow

18. 12- 18 Efficient Market Theory  Technical Analysts wiggle watchers –Forecast stock prices based on the watching the fluctuations in historical prices (thus “wiggle watchers”)

19. 12- 19 Efficient Market Theory Announcement Date

20. 12- 20 Efficient Market Theory Average Annual Return on Mutual Funds and the Market Index

21. 12- 21 Efficient Market Theory IPO Non-Excess Returns Year After Offering

22. 12- 22 Price Anomalies Deviation, % Log Deviations From Royal Dutch Shell / Shell T&T Parity 1973 - 2006

23. 12- 23 Efficient Market Theory 2000 Dot.Com Boom

24. 12- 24 Efficient Market Theory 1987 Stock Market Crash

25. 12- 25 Behavioral Finance  Arbitrage limitations  LTCM example  Factors related efficiency and psychology 1.Attitudes towards risk 2.Beliefs about probabilities

26. 12- 26 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

27. 12- 27 Example: How stock splits affect value -290 30 Source: Fama, Fisher, Jensen & Roll

28. 12- 28 Web Resources www.thecorporatelibrary.com www.towers.com www.businessweek.com www.forbes.com Click to access web sites Internet connection required