Ch 14: Financing decisions and market 14- 1

efficiency
 So far our focus has been on the investment
decision. Now we turn to the problem of
paying for these investments.
– Should it issue more stock or should it borrow?
– Should it borrow short term or long term
– Should it reinvest most of its earning or pay
dividends.
 Financing decisions and market 14- 2

efficiency
 Although it’s helpful to separate investment
and financing decisions, there are basic
similarities in the criteria for making them.
The decision to purchase a machine tool
and to sell a bond each involve valuation of
a risky asset. The face that one asset is real
and the other is financial doesn’t matter. In
both case, we end up with calculating NPV.
 Financing decisions and market 14- 3

efficiency
 However, it may be harder to find positive
NPV financing opportunities.
 Investors who supply financing are
numerous and they are smart. They
(somehow) know your business’s risk and
assign a fair discount rate to your cash flow.
That is, your securities are fairly priced and
the capital markets are efficient.
 Difference between investment 14- 4

and financing decisions

 The number of different securities and
financing strategies is well into the hundreds.
In some ways, financing decisions are more
complicate than investment decisions.
 When firms look at capital investment
decisions, it does not assume that it is facing
perfect, competitive markets. The firm own a
unique asset that give it an edge over its
competitors.
 Difference between investment 14- 5

and financing decisions

 In financing markets your competition is all
other corporations seeking funds.
 14- 6

Efficient Market
 The movement of stock prices from day to
day DO NOT reflect any pattern.
 Statistically speaking, the movement of
stock prices is a random walk.
 14- 7

Random Walk Theory

 14- 8

Efficient Market Theory

 past price cannot be used to forecast future
price.
– If so, investors can make easy profit. But in a
competitive market, easy profits don’t last. As
investors try to take advantage of the
information in past prices, price adjust
immediately.
– As a result, market prices reflect all historical
information in past prices.
 This is called the weak Form Efficiency
 14- 9

Efficient Market Theory

 Semi-Strong Form Efficiency
– Market prices reflect all publicly available
information, such as those available in the
news. Stock price respond immediately to
public information such as the announcement
of the last quarter’s earning.
– Read the article posted on Webct.
 14- 10

Efficient Market: The evidence

The
adjustment in
price after the
release of
information is
immediate
 14- 11

Efficient Market: The evidence

 Research shows that the major part of price
change occur within 5 to 10 minutes of the
announcement of news
 Therefore, stock price reflects all historical
information and project managers normally
cannot make easy money through “pattern
finding” or “information mining”.
 14- 12

Efficient Market Theory

 Strong Form Efficiency
– Market prices reflect all information, both
public and private
 14- 13

Efficient Market: The evidence

 Test of the strong form of efficient market
hypothesis have examined the
recommendations of professional security
analysts and have looked for mutual funds
or pension funds that could predictably
outperform the market.
 14- 14

Efficient Market: The evidence

Average Annual Return on Mutual Funds and the
Market Index

Return on funds are after expenses

 14- 15

Efficient Market: The evidence

 The professional managed funds fail to recoup the
costs of management.
 Many professionally managed funds have given
up the pursuit of superior performance. They
simply “buy the index”.
 How far could indexing go? Not 100%.
 To provide incentives to gather costly information,
price cannot reflect all information. There must be
some profits available to allow the costs of
information to be recouped.
 The evidence against market 14- 16

efficiency
 Are stock price determined by fundamentals?
– Dutch company Royal Dutch Petroleum and the
British Company Shell Transport and Trading.
Royal Dutch gets 60% of earning and Shell T&T
gets 40%.
• So the stock price should be proportional. However,
…
 14- 17

Price Anomalies
 The evidence against market 14- 18

efficiency
 Bubbles:
– Bubbles are also evidence that prices can
disconnect from fundamentals.
– NASDAQ index rose 580% from 1995 to 2000,
then fell 78% from its peak between 2000 and
2002.
– Yahoo began trading in 1996 and appreciated
by 1400% in three years.
 14- 19

Behavioral Finance
 Arbitrage limitations
 In an efficient market, if prices get out
of line, then arbitrage forces them back
in line.
 The arbitrageur earns a profit by buying
low and selling high and waiting for
prices to converge to fundamentals.
Thus arbitrage trading is often called
convergence trading.
 14- 20

Behavioral Finance
 In practice arbitrage is harder than it looks.
Trading cost can be significant.
For example, in the Shell example, if you
borrow to do convergence trading---???
 14- 21

Behavioral Finance
 LTCM example
• Convergence in interest rate in Europe with
euro replacing the countries’ previous
currencies.
 14- 22

Six Lessons of Market Efficiency

 Managers should assume at least as a
starting point, that there are no free lunches
to be has on Wall Street.
 14- 23

Six Lessons of Market Efficiency

Markets have no memory
Trust market prices
Market prices impound all available information
about the value of each security. If you operate on
the basis that you are smarter than others at
predicting price changes, your financial policy is an
elusive will-o’-the wisp.
Read the entrails
Example: if the company’s bonds are offering a
much higher yield than the average, you can deduce
that the firm is probably in trouble.
 14- 24

Six Lessons of Market Efficiency

There are no financial illusions
Investors are unromantically concerned with
the firms’ cash flow and the portion of those
cash flows to which they are entitled.
Some firms devote considerable ingenuity to
the task of manipulating earning reported to
shareholders. This is done by creative
accounting. It seems that shareholders in
general can look behind the figures.
 14- 25

Six Lessons of Market Efficiency

The do it yourself alternative
Seen one stock, seen them all
Stocks are close substitutes and demand should be very
elastic. Suppose you want to sell a large block of stock,
high elasticity means that you only need to cut the
offering price slightly to sell your stocks.
But, this does not follow. When you come to sell your
stocks, other investors may suspect that you want to get
rid of it because you know something they don’t.