1. Corporate Financing and the Six Lessons of Market Efficiency Principles of Corporate Finance Sixth Edition Richard A. Brealey Stewart C. Myers Lu Yurong Chapter 13 McGraw Hill/Irwin

2. 13- 2 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Topics Covered  We Always Come Back to NPV  What is an Efficient Market?  Random Walk  Efficient Market Theory  The Evidence on Market Efficiency  Six Lessons of Market Efficiency

3. 13- 3 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 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. 13- 4 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 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. 13- 5 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 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. 13- 6 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 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. 13- 7 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Random Walk Theory $103.00 $100.00 $106.09 $100.43 $97.50 $100.43 $95.06 Coin Toss Game Heads Tails

8. 13- 8 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Random Walk Theory

9. 13- 9 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Random Walk Theory

10. 13- 10 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Random Walk Theory

11. 13- 11 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Random Walk Theory

12. 13- 12 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Random Walk Theory

13. 13- 13 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Random Walk Theory

14. 13- 14 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Random Walk Theory

15. 13- 15 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 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

16. 13- 16 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Efficient Market Theory  Fundamental Analysts  Research the value of stocks using NPV and other measurements of cash flow

17. 13- 17 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Efficient Market Theory  Technical Analysts wiggle watchers  Forecast stock prices based on the watching the fluctuations in historical prices (thus “wiggle watchers”)

18. 13- 18 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Efficient Market Theory Last Month This Month Next Month $90 70 50 Microsoft Stock Price Cycles disappear once identified

19. 13- 19 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Efficient Market Theory Announcement Date

20. 13- 20 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Efficient Market Theory Average Annual Return on 1493 Mutual Funds and the Market Index

21. 13- 21 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Efficient Market Theory IPO Non-Excess Returns Year After Offering

22. 13- 22 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Efficient Market Theory 1987 Stock Market Crash

23. 13- 23 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Efficient Market Theory 1987 Stock Market Crash

24. 13- 24 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 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

25. 13- 25 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Example: How stock splits affect value -290 30 Source: Fama, Fisher, Jensen & Roll

26. 13- 26 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Preparation for Next Class  Please read:  BM Chapter 14, P383-400