1. Corporate Financing and the Six Lessons of Market Efficiency
Principles of
Corporate Finance
Eighth Edition
Chapter 13
Corporate Financing and the Six Lessons of Market Efficiency
Slides by
Matthew Will
McGraw-Hill/Irwin
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved

2. Topics Covered We Always Come Back to NPV What is an Efficient Market?
Random Walk
Efficient Market Theory
The Evidence on Market Efficiency
Puzzles and Anomalies
Six Lessons of Market Efficiency

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

8. Random Walk Theory

9. Random Walk Theory

10. Efficient Market Theory
Microsoft Stock Price
$90 70 50
Actual price as soon as upswing is recognized
Cycles disappear once identified
Last Month
This Month
Next Month

11. Random Walk Theory

12. Random Walk Theory FTSE 100 (correlation = -.08)
Return in week t + 1, (%)
Return in week t, (%)

13. Random Walk Theory Nikkei 500 (correlation = -.06)
Return in week t + 1, (%)
Return in week t, (%)

14. Random Walk Theory DAX 30 (correlation = -.03)
Return in week t + 1, (%)
Return in week t, (%)

15. Random Walk Theory S&P Composite (correlation = -.07)
Return in week t + 1, (%)
Return in week t, (%)

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. Efficient Market Theory
Fundamental Analysts
Research the value of stocks using NPV and other measurements of cash flow

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

19. Efficient Market Theory
Announcement Date

20. Efficient Market Theory
Average Annual Return on 1493 Mutual Funds and the Market Index

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

22. Efficient Market Theory
2000 Dot.Com Boom

23. 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

24. Example: How stock splits affect value
-29 30
Source: Fama, Fisher, Jensen & Roll