Chapter 13 → 16

Corporate Finance
Chapter 13: Efficient Markets and Behavioral Finance

Efficient Markets

Financing decisions are much easier than investment decisions since:

● The abandonment value is higher for financing decisions since their finality is
easier to reverse
● It is harder to make money by smart financing strategies since the financial
markets are more competitive than product markets.

Competitive market: a market in which future prices can’t be determined by past prices
since they follow a random walk and there is no pattern. Otherwise, it would be very easy
to make profits. In a competitive market, easy profits don’t last since prices adjust
immediately, and the past only reflects today’s information and not tomorrow’s.

Efficient market: In these the security prices reflect all of the available information
instantaneously, so securities are fairly priced, security returns are unpredictable and
no one earns consistent superior returns.

There are 3 levels of market efficiency depending on the degree of information reflected
in security prices:

1. Weak market efficiency: prices reflect the information contained in the record of
past prices and it is impossible to consistently make superior profits by studying
past returns because they follow a random walk.
2. Semi strong market efficiency: prices reflect not just past prices but all other
public information and prices will adjust immediately to it.
3. Strong market efficiency: prices reflect all the information that can be acquired
by painstaking analysis of the company and the economy, so there are no
superior investment managers who can consistently beat the market.

If all investors hold index funds then nobody will be collecting information and prices will
not respond to new information when it arrives. An efficient market needs some smart
investors who gather information and attempt to profit from it. To provide incentives to

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gather costly information, prices cannot reflect all information. There must be some
profits available to allow the costs of information to be recouped. But if the costs are
small, relative to the total market value of traded securities, then the financial market
can still be close to perfectly efficient.

Anomalies of the Efficient Market Theory

In an efficient market it is not possible to find expected returns greater (or less) than the
risk-adjusted opportunity cost of capital. This implies that every security trades at its
fundamental value, based on future cash flows (Ct) and the opportunity cost of capital
(r). If price differs from fundamental value, then investors can earn more than the cost of
capital, by selling if the price is too high and buying when it is too low.

∞
𝐶𝑡
𝑃= ∑ 𝑡
𝑡=1 (1+𝑟)

Small-firm effect

Why there are abnormally high returns on the stocks of small firms considering CAPM:

1. investors have demanded a higher expected return from small firms to

compensate for some extra risk factor that is not captured in the simple CAPM.
2. the superior performance of small firms could simply be a coincidence
3. The small-firm effect could be an important exception to the efficient-market
theory that gave investors the opportunity for consistently superior returns over
a period of several decades.

Short-term behavior of stock prices

Returns appear to be higher in January than in other months, they seem to be lower on a
Monday than on other days of the week, and most of the daily return comes at the
beginning and end of the day.

The earnings announcement puzzle

Investors underreact to the earnings announcement and become aware of the full
significance only as further information arrives.

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The new-issue puzzle

When firms issue stock to the public, investors typically rush to buy. On average those
lucky enough to receive stock receive an immediate capital gain. However, researchers
have found that these early gains often turn into losses.

Consequences of the difficulty to value common stocks from scratch:

1. Investor’s usually take yesterday’s price as correct, adjusting upward or

downward on the basis of today’s information.
2. Most of the tests of market efficiency are concerned with relative prices and
focus on whether there are easy profits to be made, and not on true value.

Bubbles: speculative frenzy, and asset prices then reach levels that cannot easily be
justified by the outlook for profits and dividends. They can happen when prices rise
rapidly, and more and more investors join the game on the assumption that prices will
continue to rise. They can be self-sustaining for a while but will always end up bursting.

Chapter 14: An Overview of Corporate Financing

Patterns of Corporate Financing

Corporations invest in long-term assets and in net working capital. Most of the cash to
pay for these investments is generated internally: it comes from cash flow allocated to
depreciation and from retained earnings. This investment into the firm is good since it
provides positive NPV, increasing shareholder value.

➔ Usually, internal funds (retained earnings plus depreciation) cover most of the
cash needed for investment. However, in case of deficit, companies must cut
back on dividends to increase retained earnings, or it must raise new debt or
equity capital from outside investors.

2 basic financing decisions:

1. What fraction of profits should be put back into the business rather than paid out
to shareholders?
2. What fraction of the financial deficit should be met with debt rather than equity?

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The amount of investments that are financed by internal funds rather than external
funds depend on the company and the behavior of its financial manager, having both
strategies and some pros and cons. This also happens when choosing the balance
between equity and debt ratio.

Common Stock

Authorized shared capital: e maximum number of shares that can be issued by a

company.

● Issued and outstanding: shares held by investors

● Issue but nor outstanding: repurchased shares held in the company’s treasury
until they are canceled or resold.

A corporation is owned by its common stockholders, which means that they are the ones
to make investment and operating decisions or have the right to vote in widely owned
corporations. Some of this common stock is held directly by individual investors, but the
greater proportion belongs to financial institutions such as mutual funds, pension
funds, and insurance companies.

● Majority voting: each director is voted upon separately and stockholders can cast
one vote for each share that they own.
● Cumulative voting: the directors are voted upon jointly and stockholders can, if
they wish, allot all their votes to just one candidate, giving more power to
minorities.

There might be two classes of common stocks that have the same cash-flow rights but
one of them has a higher control right with higher voting power. This may be used to
toss out bad management or to force management to adopt policies that enhance
shareholder value. The last ones also usually are sold at premium price since they may
come with extra benefits.

Common stocks are issued by corporations. But a few equity securities are issued not by
corporations but by partnerships or trusts.

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Partnerships Trusts and REITs

The partnership units are just like the
shares in an ordinary corporation, having
dividends and contribution on losses. It
has the advantage that the profits avoid
corporate income tax. However, it has a
limited life contrary to corporations that
can outlive their initial founders.
It is the possibility to be the passive
owner of a single asset. They are not
taxed if they distribute at least 95% of
earnings to the REITs’ owners, who must
pay whatever taxes are due on the
dividends.

Preferred stock: it offers a series of fixed payments to the investor. The company can
choose not to pay a preferred dividend, but in that case, it may not pay a dividend to its
common stockholders. This means that the firm must pay all past preferred dividends
before common stockholders

Debt

When companies borrow money, they promise to make regular interest payments and to
repay the principal. However, this liability is limited. Stockholders have the right to
default on the debt if they are willing to hand over the corporation’s assets to the
lenders.

The company’s payments of interest are regarded as a cost and are deducted from
taxable income. Thus, interest is paid from before-tax income, whereas dividends on
common and preferred stock are paid from after-tax income. Therefore, the government
provides a tax subsidy for debt that it does not provide for equity.

There are many types of debts securities, and their mixture reflects the financial
manager’s response to several questions:

1. Should the company borrow short-term or long-term?

2. Should the debt be fixed or floating rate?
3. Should you borrow dollars or some other currency?
4. What promises should you make to the lender?
5. Should you issue straight or convertible bonds?

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There are many promises that a company makes that look like debt but are presented in
other names. These include accounts payable, which are simply obligations to pay for
goods that have already been delivered and are therefore like short-term debt. Other
arrangements might be leasing equipment on a long-term basis instead of buying it: the
firm promises to make a series of lease payments to the owner of the equipment, which
is just like the obligation to make payments on an outstanding loan.

Given the enormous variety of corporate securities, it’s no surprise to find hybrids that
incorporate features of both debt and equity. The dividing line between debt and equity
is sometimes hard to locate, but these are some overall features of both:

● Equity is a residual claim that participates in the upsides and downsides of the
business after debt claims are satisfied. Equity has residual cash-flow rights and
residual control rights.
● Debt has first claim on cash flows, but its claim is limited. It does not participate
in the upsides of the business. Debt has no control rights unless the firm defaults
or violates debt covenants.

Financial Markets and Institutions

Primary market Secondary market

Sale of shares to raise new capital, which Sale of second-hand shares, transaction
are more infrequent. partial ownership of a firm from one
person to the other that has no influence
on the company’s assets

Individuals don’t sell their stocks on the secondary market alone, using the help of a
brokerage

Financial institutions act as financial intermediaries that gather the savings of many
individuals and reinvest them in loans or in the financial markets. These include banks,
savings and loan companies, insurance companies, mutual funds.

Why are financial intermediaries different from a manufacturing corporation?

1. The financial intermediary may raise money in special ways, for example, by
taking deposits or by selling insurance policies.

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2. The financial intermediary invests in financial assets, such as stocks, bonds, or

loans to businesses or individuals, while the manufacturing company’s main
investments are in real assets, such as plants and equipment.

Contribution from financial intermediaries to individual well-being:

● The payment mechanism: banks and others provide ways for individuals and
firms to send and receive payments quickly and safely over long distances via
checking accounts, credit cards, and electronic transfers.
● Borrowing and lending: Almost all financial institutions are involved in channeling
savings toward those who can best use them. It is cheaper and more convenient
to use a financial intermediary to link up the borrower and the lender.
● Pooling risk: Financial markets and institutions allow firms and individuals to
pool their risks, which means sharing the risk

Chapter 15: How Corporations Issue Securities

Venture Capital

The success of a new business depends critically on the effort put in by the managers.
Therefore, venture capital firms try to structure a deal so that management has a strong
incentive to work hard. Venture capitalists rarely give a young company up front all the
money it will need. At each stage they give enough to reach the next major checkpoint.

When a new business raises venture capital, these cash-flow rights and control rights
are usually negotiated separately. The venture capital firm will want a say in how that
business is run and will demand representation on the board and a significant number of
votes. The venture capitalist may agree that it will relinquish some of these rights if the
business subsequently performs well. However, if performance turns out to be poor, the
venture capitalist may automatically get a greater say in how the business is run and
whether the existing management should be replaced.

Venture capital firms pool funds from a variety of investors, seek out fledgling
companies to invest in, and then work with these companies as they try to grow, called
private equity investing. Most venture capital funds are organized as limited private
partnerships with a fixed life of about 10 years. Pension funds and other investors are

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the limited partners. The management company, which is the general partner, is
responsible for making and overseeing the investments, and in return receives a fixed
fee and a share of the profits, called the carried interest.

Venture capital investors tend to specialize in young high-tech firms that are difficult to
evaluate and they monitor these firms closely. They also provide ongoing advice to the
firms that they invest in and often play a major role in recruiting the senior management
team. Their judgment and contacts can be valuable to a business in its early years and
can help the firm to bring its products more quickly to market.

For every 10 first-stage venture capital investments, only two or three may survive as
successful, self-sufficient businesses. From these statistics come two rules for success
in venture capital investment:

1. Don’t shy away from uncertainty: accept a low probability of success, but don’t
buy into a business unless you can see the chance of a big, public company in a
profitable market.
2. Cut your losses: identify losers early, and if you can’t fix the problem throw no
good money after bad.

Initial Public Offering (IPO)

An initial public offering is usually made to raise new capital or to enable shareholders to
cash out. There are also other benefits to going public, including a readily available
yardstick of performance by the company’s stock prices; possibility to reward the
management team with stock options; the company can diversify its sources of finance
and reduce its borrowing cost since information about the company becomes more
widely available.

IPOs may be:

➔ Primary: new shares are sold to raise additional cash for the company.
➔ Secondary: the existing shareholders decide to cash in by selling part of their
holdings.

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Steps to make an IPO:

1. Select underwriters: they act as an financial midwives to a new issue. Firstly,

they provide the company with procedural and financial advice, then they buy the
issue, and finally they resell it to the public. They take the risk that the issue
might flop and they would be left with unwanted stock. When the sale of common
stock particularly risky, the underwriters may handle the sale on a best-efforts
basis, in which case they promise to sell as much of the issue as possible but
don’t guarantee to sell the entire amount. In return they are allowed to buy the
shares for less than the offering price at which the shares were sold to investors
2. Make a registration statement for the approval of the Securities and Exchange
Commission (SEC). It is a detailed document that presents information about the
proposed financing and the firm’s history, existing business, and plans for the
future. The most important sections of the registration statement are
distributed to investors in the form of a prospectus.
3. In addition, the issue needs to comply with the blue-sky laws of each state.
4. Determine the price of the stock: price–earnings ratios of the shares of the
company’s principal competitors; discounted-cash-flow calculations.
5. Search for potential investors: arranged meetings with reactions to the issue,
indicated to the underwriters how much stock they wished to buy and the price
that they were willing to pay.

A new issue is costly since there are substantial administrative costs. Preparation of the
registration statement and prospectus involved management, legal counsel, and
accountants, as well as the underwriters and their advisers. In addition, the firm had to
pay fees for registering the new securities, printing and mailing costs, and so on.

Under-pricing: when the offering price is less than the true value of the issued
securities, investors who buy it get a bargain at the expense of the firm’s original
shareholders. Whenever a company goes public, it is very difficult to judge how much
investors will be prepared to pay for the stock and sometimes the underwriters misjudge
dramatically. For IPOs, under-pricing usually exceeds all other issue costs.

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Under-pricing may be in the interests of the issuing firm, since:

● a low offering price on an IPO raises the price when it is subsequently traded in
the market and enhances the firm’s ability to raise further capital.
● Buyers won’t feel like they overpaid (winner’s curse)

The degree of under-pricing fluctuates sharply from year to year. Hot new-issue periods
arise because investors are prone to periods of excessive optimism and would-be
issuers time their IPOs to coincide with these periods.

Chapter 16: Payout Policy

Corporations can pay out cash to their shareholders in two ways:

1. They can pay a dividend: it is set by the board of directors. Its announcement
states that the payment will be made to all stockholders and, around a week later,
dividend checks are mailed. They can also be issued in the form of stock
dividends instead of cash. In some countries there is a minimum proportion of
earnings that must be distributed as dividends, and other restrictions may be
imposed by lenders. Companies usually pay a regular cash dividend each quarter,
but occasionally this is supplemented by a one-off extra or special dividend.
2. Or they can buy back some of the outstanding shares: the reacquired shares are
kept in the company’s treasury and may be resold if the company needs money.
This can be done in 4 main ways:
- The company announces that it plans to buy its stock in the open
market, just like any other investor
- The company makes tender offer where they offer to buy back a
stated number of shares at a fixed price, which is typically set at
about 20% above the current market level. The stakeholder can
then accept or deny this offer
- Employ a dutch auction: the firm states a series of prices at which
it is prepared to repurchase stock. Shareholders submit offers
declaring how many shares they wish to sell at each price and the
company calculates the lowest price at which it can buy the
desired number of shares.

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- repurchase sometimes takes place by direct negotiation with a

major shareholder.

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