Title: Chapter 13 Corporate Financing and Market Efficiency
1Chapter 13 Corporate Financing and Market
Efficiency
- Can Financing Decisions Create Value?
- A Description of Efficient Capital Markets
- The Different Types of Efficiency
- The Evidence
- Implications for Corporate Finance
2Can Financing Decisions Create Value?
- Example Suppose Jays Electronics is thinking
about relocating its plant to Mexico where labor
costs are lower. In the hope that it can stay in
Ontario, the company has submitted an application
to the province to guarantee a five-year bank
term loan for 2 million. With a provincial
guarantee, a chartered bank has offered to make
the loan (interest payments are paid at the end
of each year) at an interest rate of 5 percent.
This is an attractive rate because the normal
cost of debt capital for Jays Electronics is 10.
What it the NPV of this potential financing
transaction?
3What Sort of Financing Decisions?
- Typical financing decisions include
- How much debt and equity to sell
- When (or if) to pay dividends
- When to sell debt and equity
- Just as we can use NPV criteria to evaluate
investment decisions, we can use NPV to evaluate
financing decisions.
4How to Create Value through Financing
- Fool Investors
- Empirical evidence suggests that it is hard to
fool investors consistently. - Reduce Costs or Increase Subsidies
- Certain forms of financing have tax advantages or
carry other subsidies. - Create a New Security
- Sometimes a firm can find a previously-unsatisfied
clientele and issue new securities at favorable
prices. - In the long-run, this value creation is
relatively small, however.
5A Description of Efficient Capital Markets
- An efficient capital market is one in which stock
prices fully reflect available information. - The EMH has implications for investors and firms.
- Since information is reflected in security prices
quickly, knowing information when it is released
does an investor no good. - Firms should expect to receive the fair value for
securities that they sell. Firms cannot profit
from fooling investors in an efficient market.
6Ex How Does an Efficient Market Work?
- Suppose the F-stop Camera Corporation (FCC) is
attempting to develop a camera that will double
the speed of the auto-focusing system now
available. FCC believes this research has a
positive NPV. - Consider the share of FCC. One of the determinant
of the shares price is the probability that FCC
will be the company to develop the new
auto-focusing system first. In an efficient
market we would expect the price of the shares of
FCC to rise if this probability increases. - Now, suppose a well-known engineer is hired by
FCC to help develop the new auto-focusing system.
Assuming an efficient market, what do you think
will happen to FCCs share price when this is
announced?
7The Different Types of Efficiency
- Weak Form
- Security prices reflect all information found in
past prices and volume. - Semi-Strong Form
- Security prices reflect all publicly available
information. - Strong Form
- Security prices reflect all informationpublic
and private.
8Weak Form Market Efficiency
- Security prices reflect all information found in
past prices and volume. - Often weak-form efficiency is represented as
- Pt Pt-1 Expected return random error t
- Since stock prices only respond to new
information, which by definition arrives
randomly, stock prices are said to follow a
random walk.
9Testing 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).
10Random Walk Theory
Coin Toss Game
Heads
106.09
Heads
103.00
100.43
Tails
100.00
Heads
100.43
97.50
Tails
95.06
Tails
11Random Walk Theory
12Random Walk Theory
13Random Walk Theory
14Random Walk Theory
SP Composite (correlation -.07)
Return in week t 1, ()
Return in week t, ()
15Efficient 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
16Why Technical Analysis Fails
Investor behavior tends to eliminate any profit
opportunity associated with stock price patterns.
Stock Price
If it were possible to make big money simply by
finding the pattern in the stock price
movements, everyone would do it and the profits
would be competed away.
Time
17Semi-Strong Form Market Efficiency
- Security prices reflect all publicly available
information. - Publicly available information includes
- Historical price and volume information
- Published accounting statements.
- Information found in annual reports.
18Event Studies How Tests Are Structured
- Event studies are one type of test of the
semi-strong form of market efficiency. - This form of the EMH implies that prices should
reflect all publicly available information. - To test this, event studies examine prices and
returns over timeparticularly around the arrival
of new information. - Test for evidence of underreaction, overreaction,
early reaction, delayed reaction around the
event.
19How Tests Are Structured (cont.)
- Returns are adjusted to determine if they are
abnormal by taking into account what the rest of
the market did that day. - The Abnormal Return on a given stock for a
particular day can be calculated by subtracting
the markets return on the same day (RM) from the
actual return (R) on the stock for that day - AR R Rm
- The abnormal return can be calculated using the
Market Model approach - AR R (a bRm)
20Reaction of Stock Price to New Information in
Efficient and Inefficient Markets
Stock Price
Overreaction to good news with reversion
Delayed response to good news
Efficient market response to good news
-30 -20 -10 0 10 20 30
Days before (-) and after () announcement
21Reaction of Stock Price to New Information in
Efficient and Inefficient Markets
Efficient market response to bad news
Stock Price
Delayed response to bad news
-30 -20 -10 0 10 20 30
Overreaction to bad news with reversion
Days before (-) and after () announcement
22Event Studies Dividend Omissions
Efficient market response to bad news
S.H. Szewczyk, G.P. Tsetsekos, and Z. Santout Do
Dividend Omissions Signal Future Earnings or Past
Earnings? Journal of Investing (Spring 1997)
23Event Studies Takeover Announcement
Announcement Date
24Event Study Results
- Over the years, event study methodology has been
applied to a large number of events including - Dividend increases and decreases
- Earnings announcements
- Mergers
- Capital spending
- New issues of stock
- The studies generally support the view that the
market is semistrong-form efficient. - In fact, the studies suggest that markets may
even have some foresight into the futurein other
words, news tends to leak out in advance of
public announcements.
25The Record of Mutual Funds
- If the market is semistrong-form efficient, then
no matter what publicly available information
mutual-fund managers rely on to pick stocks,
their average returns should be the same as those
of the average investor in the market as a whole. - We can test efficiency by comparing the
performance of professionally managed mutual
funds with the performance of a market index.
26Efficient Market Theory
Average Annual Return on 1493 Mutual Funds and
the Market Index
27Strong Form Market Efficiency
- Security prices reflect all informationpublic
and private. - Strong form efficiency incorporates weak and
semi-strong form efficiency. - Strong form efficiency says that anything
pertinent to the stock and known to at least one
investor is already incorporated into the
securitys price.
28Insider Trading
- Officers, directors, and major shareholders of a
firm are considered insiders who may have
non-public important information. The SEC, the
Ontario Securities Commission (and its
counterparts in other provinces) prohibited the
trade of securities based on pieces of
information that have not yet become news. - To enforce regulation, the OSC and the SEC
require insiders to reveal any trading they might
do in their own companys share.
29Relationship among Three Different Information
Sets
30What the EMH Does NOT Say
- If EMH holds there should be no upward trend in
stock price. - If EMH holds, investors can not earn any return
- If EMH holds, investors can throw darts to select
stocks. - If EMH holds, stock prices should not go up over
time. - If EMH holds, daily fluctuations should not exist
as prices reflect the fundamental value of the
firm. - EMH can not hold because there are not enough
active traders.
31Views Contrary to Market Efficiency
- Stock Market Crash of 1987, Dot.com bubble.
- The NYSE dropped between 20-percent and
25-percent Monday following a weekend during
which little surprising information was released. - Nasdaq fell 72 during a two year period.
- Temporal Anomalies
- Turn of the year, month, week.
- Speculative Bubbles
- Sometimes a crowd of investors can behave as a
single squirrel. - Size
- Small cap stocks seem to outperform large cap
stocks. - Value versus Growth
- Value stock-price stocks outperform growth stocks.
32Efficient Market Theory
2000 Dot.Com Boom
33Why Doesnt Everybody Believe the EMH?
- There are optical illusions, mirages, and
apparent patterns in charts of stock market
returns. - The truth is less interesting.
- There is some evidence against market efficiency
- Seasonality
- Small versus Large stocks
- Value versus Growth stocks
- The tests of market efficiency are weak.
34Implications for Corporate Finance
- The EMH has three implications for corporate
finance - The price of a companys stock cannot be affected
by a change in accounting. - Financial managers cannot time issues of stocks
and bonds using publicly available information. - A firm can sell as many shares of stocks or bonds
as it desires without depressing prices. - There is conflicting empirical evidence on all
three points.
35Efficient Market Theory
IPO Non-Excess Returns
Year After Offering
36Practice Questions q8
- Which statements contradicts EMH (specify type)
- Tax-exempt municipal bonds offer lower pretax
returns than taxable government bonds. - Managers make superior returns on their purchases
of their companys stock. - There is a positive relation between the return
on the market in one quarter and the change in
aggregate profits in the next quarter. - There is disputed evidence that stocks which have
appreciated unusually in the recent past continue
to do so in the future. - The stock of an acquired firm tends to appreciate
in the period before the merger announcement. - Stocks of companies with unexpectedly high
earnings appear to offer high returns for several
months after the earning announcement. - Very risky stock on average give higher returns
than safe stocks.
37Chapter 14 Corporate Financing
- Common Stock
- Preferred Stock
- Corporate Long-Term Debt The Basics
- Patterns of Long-Term Financing
38Example Western Redwood Corp.
- Formed in 1976 with 10,000 shares issued and sold
for 1 per share. - By 2004, the company had retained 100,000.
- Western Redwood Corporation Equity Accounts, 2004
Common stock (10,000 shares outstanding) 10,000
Retain earnings 100,000
Total shareholders equity 110,000
39Example Western Redwood Corp.
- Issues 100,000 shares at 20 per share at 2004
- Western Redwood Corporation Equity Accounts, 2004
Common stock (10,000 shares outstanding) 210,000
Retain earnings 100,000
Total shareholders equity 310,000
40Market Value and Book Value
- Market Value is the price of the stock multiplied
by the number of shares outstanding. - Also known as Market Capitalization
- Book Value
- The sum of par value, (contributed surplus
value in access of par upon issue), accumulated
retained earnings, and adjustments to equity is
the common equity of the firm, usually referred
to as the book value of the firm.
41Enbridge Inc., 2003
42Enbridge Inc., 2003
43Enbridge Inc., 2003
44Enbridge Inc., 2003
45Authorized vs. Issued Common Stock
- The articles of incorporation must state the
number of shares of common stock the corporation
is authorized to issue. - The board of directors, after a vote of the
shareholders, may amend the articles of
incorporation to increase the number of shares. - Authorizing a large number of shares may worry
investors about dilution because authorized
shares can be issued later with the approval of
the board of directors but without a vote of the
shareholders.
46Enbridge Inc., 2003
47Shareholders Rights
- The right to elect the directors of the
corporation by vote constitutes the most
important control device of shareholders. - Directors are elected each year at an annual
meeting by a vote of the holders of a majority of
shares who are present and entitled to vote. - The exact mechanism varies across companies.
- The important difference is whether shares are to
be voted cumulatively or voted straight.
48Cumulative versus Straight Voting
- The effect of cumulative voting is to permit
minority participation. - Under cumulative voting, if there are N directors
up for election, then 1/(N1) percent of the
stock plus one share will guarantee you a seat. - With cumulative voting, the more seats that are
up for election at one time, the easier it is to
win one. - Straight voting works like a U.S. political
election. - Shareholders have as many votes as shares and
each position on the board has its own election. - A tendency to freeze out minority shareholders.
49Cumulative vs. Straight Voting Example 1
- Imagine a firm with two shareholders
- Mr. MacDonald and Ms. Laurier.
- Mr. MacDonald owns 60 of the firm ( 600
shares) and Ms. Laurier 40 ( 400 shares). - There are three seats up for election on the
board.
50Cumulative vs. Straight Voting Example 2
- There are 2 million shares outstanding. How many
shares do you need to own to be certain that you
can elect at least one director under - a) straight voting? b) cumulative voting?
51Proxy Voting
- A proxy is the legal grant of authority by a
shareholder to someone else to vote his or her
shares. - For convenience, the actual voting in large
public corporations is usually done by proxy. - If shareholders are not satisfied with
management, an outside group of shareholders can
try to obtain as many votes as possible via
proxy. - Proxy battles are often led by large pension
funds like the Ontario Teachers Pension Board or
the British Columbia Investment Management
Corporation.
52Dividends
- Unless a dividend is declared by the board of
directors of a corporation, it is not a liability
of the corporation. - A corporation cannot default on an undeclared
dividend. - The payment of dividends by the corporation is
not a business expense. - Therefore, they are not tax-deductible.
- Dividends (of Canadian corporations) received by
individual shareholders are partially sheltered
by a dividend tax credit. - Canadian corporations do not pay taxes on
dividends for amounts they receive from Canadian
corporations.
53Classes of Shares
- When more than one class of share exists, they
are usually created with unequal voting rights. - Many companies issue dual classes of common
stock. The reason has to do with control of the
firm. - Firms going public with dual classes of shares in
Canada are often family controlled. - Lease, McConnell, and Mikkelson found the market
prices of U.S. stocks with superior voting rights
to be about 5-percent higher than the prices of
otherwise-identical stocks with inferior voting
rights.
54Corporate Long-Term Debt The Basics
- Interest versus Dividends
- Is It Debt or Equity?
- Basic Features of Long-Term Debt
- Different Types of Debt
- Repayment
- Seniority
- Security
- Indenture
55Interest versus Dividends
- Debt is not an ownership interest in the firm.
Creditors do not usually have voting power. - The device used by creditors to protect
themselves is the loan contract (i.e.,
indenture). - The corporations payment of interest on debt is
considered a cost of doing business and is fully
tax-deductible. Dividends are paid out of
after-tax dollars. - Unpaid debt is a liability of the firm. If it is
not paid, the creditors can legally claim the
assets of the firm. - One of the costs of issuing debt is the
possibility of financial failure.
56Is It Debt or Equity?
- Some securities blur the line between debt and
equity. - Corporations are very adept at creating hybrid
securities that look like equity but are called
debt. - Obviously, the distinction is important for tax
purposes. - A corporation that succeeds in creating a debt
security that is really equity obtains the tax
benefits of debt while eliminating its bankruptcy
costs.
57Basic Features of Long-Term Debt
- The bond indenture usually lists
- Amount of Issue (typically denominated with a
1000 face value), Date of Issue, Maturity - Denomination (Par value)
- Coupon, typically semiannual
- Security
- Sinking Funds
- Call Provisions
- Covenants
- Features that may change over time
- Rating
- Yield-to-Maturity
- Market Price
58Enbridge Inc., 2003
59Back to Preferred Shares
- A preferred share represents equity of a
corporation, but is different from common stock
because it has preference over common in the
payments of dividends and in the assets of the
corporation in the event of bankruptcy. - Preferred shares have a stated liquidating value.
- For example, CIBC 2.25 preferred translates
into a dividend yield of 9 of the stated 25
value. - Preferred dividends are either cumulative or
noncumulative. - Firms may have an incentive to delay preferred
dividends, since preferred shareholders receive
no interest on the cumulated dividends. - Preferred shares have a lower yield than debt.
60Tax loophole in Canada
- Corporate investors are exempt from income taxes
on dividends ? they would be willing to pay a
premium for these shares (compared to similar
debt instruments) as a consequence, yields are
low. - Low taxed companies may therefore prefer to issue
these shares compared to debt (i.e., for these
companies the debt tax shield is of limited
usage).
61Tax loophole in Canada
- Zero Tax Ltd., a corporation not paying any
income taxes, can issue preferred shares
attractive to Full Tax Ltd., a second corporation
taxable at a combined federal and provincial rate
of 45. Zero Tax is seeking 1000 in financing
through either debt or preferred stock. Zero Tax
can issue either debt with a 10 coupon or
preferred stock with a 6.7 dividend. - Preferred (6.7) Debt (10)
- Issuer Zero Tax Ltd.
- Preferred dividend/interest paid 67.00 100.00
- Dividend tax at 40 26.80 0.00
- Tax deduction on interest 0.00 0.00
- Total financing cost 93.80 100.00
- After-tax cost 9.38 10.00
- Purchaser Full Tax Ltd.
- Before-tax income 67.00 100.00
- Tax 0.00 45.00
- After-tax income 67.00 55.00
- After-tax yield 6.70 5.50
62Other Reasons for Preferred Shares
- Regulatory firms can pass the tax disadvantage to
their customers. - Firms issuing preferred shares can avoid the
threat of bankruptcy while at the same time not
surrender control (no voting rights on preferred
shares).
63Patterns of Long-Term Financing
- For Canadian firms, internally generated cash
flow dominates as a source of financing. - Firms usually spend more than they generate
internallythe gap is financed by new sales of
debt and equity. - Net new issues of equity are dwarfed by new sales
of debt. - This is consistent with the pecking order
hypothesis. - Leverage ratios for Canadian firms are
considerably higher than they were in the 1960s.
64The Long-Term Financial Gap
65Chapter 15 How Corporations Issue Securities
- Issuing securities involves the corporation in a
number of decisions. - This chapter looks at how corporations issue
securities to the investing public. - The basic procedure for selling debt and equity
securities are essentially the same. This chapter
focuses on equity.
66Topics Covered
- Venture Capital
- The Initial Public Offering
- Other New-Issue Procedures
- Security Sales by Public Companies
- Rights Issue
- Private Placements and Public Issues
67Venture Capital
- The limited partnership is the dominant form of
intermediation in this market. - There are five types of suppliers of venture
capital - Old-line wealthy families.
- Private partnerships and corporations.
- Large industrial or financial corporations with
established venture-capital subsidiaries. - The federal government (through crown-related
firms). - Individuals, typically with incomes in excess of
100,000 and net worth over 1,000,000. Often
these angels have substantial business
experience and are able to tolerate high risks.
68Stages of Financing
- Seed-Money Stage
- Small amount of money to prove a concept or
develop a product. - Start-Up
- Funds are likely to pay for marketing and product
refinement. - First-Round Financing
- Additional money to begin sales and
manufacturing. - Second-Round Financing
- Funds earmarked for working capital for a firm
that is currently selling its product but still
losing money. - Third-Round Financing
- Financing for a firm that is at least breaking
even and contemplating expansion a.k.a.
mezzanine financing. - Fourth-Round Financing
- Financing for a firm that is likely to go public
within six months a.k.a. bridge financing.
69U.S. Venture Capital Investments
70Initial Offering
- Initial Public Offering (IPO) - First offering of
stock to the general public. - Underwriter - Firm that buys an issue of
securities from a company and resells it to the
public. - Offering price The price of a share at IPO.
- Spread - Difference between public offer price
and price paid by underwriter. - Prospectus - Formal summary that provides
information on an issue of securities.
71The Top Managing Underwriters
72The Public Issue in Canada
- Regulation of the securities market in Canada is
carried out by provincial commissions. - In the U.S., regulation is handled by a federal
body (SEC). - The regulators goal is to promote the efficient
flow of information about securities and the
smooth functioning of securities markets. - All companies listed on the TSX come under the
jurisdiction of the Ontario Securities Commission
(OSC). - Other provinces have similar legislation and
regulating bodies. - The Canadian Securities Administration (CSA)
coordinates regulation.
73New Issue Procedure
- Steps involved in issuing securities to the
public - Management obtains approval from the board of
directors. - The firm prepares a preliminary prospectus to the
OSC. - The OSC studies the preliminary prospectus and
notifies the company of any changes required. - Once the revised, final prospectus meets with the
OSCs approval, a price is determined and a
full-fledged selling effort gets under way.
74The Process of Raising Capital
Steps in Public Offering Time 1.
Pre-underwriting conferences 2. Registration
statements 3. Pricing the issue 4. Public
offering and sale 5. Market
stabilization
Several months 20-day waiting period
Usually on the 20th day
After the 20th day 30 days after
offering
75- The overallotment option known as the Green Shoe
provision gives members of the underwriting group
the option to purchase additional shares at the
offering price less fees and commissions. The
option has a short maturity and is limited to
about 10 of original number of shares issued. - Investment Dealers
- In 2003, RBC Dominion Securities was the leading
underwriter by revenue.
76Underwriting Spreads US (2003)
77Average Initial IPO Returns
78Initial Offering US
- Average Expenses on 1767 IPOs from 1990-1994
79The Costs of Public Offerings
- Costs of Going Public in Canada 1984-97
- Fees 6.00
- Underpricing 7.88
- TOTAL 13.88
- The above figures understate the total cost
because they ignore indirect expenses or the
overallotment option.
80From CNN.COM (Aug 18, 2004)
- Google plans to price the shares in a rare
auction-style IPO. The deal promises to put more
shares in the hands of ordinary investors rather
than wealthy investment banking clients. The
auction is also widely seen as a slap at Wall
Street and the clubby culture that contributed to
investigations into improper IPO trading
activities at the height of the dot-com bubble.
81General Cash Offers
- Seasoned Offering - Sale of securities by a firm
that is already publicly traded. - General Cash Offer - Sale of securities open to
all investors by an already public company. - Shelf Registration - A procedure that allows
firms to file one registration statement for
several issues of the same security. - Private Placement - Sale of securities to a
limited number of investors without a public
offering.
82Private Placements
- Avoid the costly procedures associated with the
registration requirements that are a part of
public issues. - The OSC and SEC restrict private placement issues
of no more than a couple of dozen knowledgeable
investors including institutions such as
insurance companies and pension funds. - The biggest drawback is that the securities
cannot be easily resold.
83Market Reaction to SEO
- Suppose that the CFO of a restaurant chain is
strongly optimistic about its prospect. From her
point of view, the companys stock price is too
low. Yet the company wants to issue shares to
finance expansion into another county. What is
she to do?
84The Announcement of New Equity and the Value of
the Firm
- The market value of existing equity drops on the
announcement of a new issue of common stock. - Reasons include
- Managerial Information
- Since the managers are the insiders, perhaps
they are selling new stock because they think it
is overpriced. - Debt Capacity
- If the market infers that the managers are
issuing new equity to reduce their debt-to-equity
ratio due to the specter of financial distress
the stock price will fall. - Falling Earnings
85Rights
- An issue of common stock offered to existing
shareholders is called a rights offering. - Prior to the 1980 Bank Act, chartered banks were
required to raise equity exclusively through
rights offerings. - If a preemptive right is contained in the firms
articles of incorporation, the firm must offer
any new issue of common stock first to existing
shareholders. - This allows shareholders to maintain their
percentage ownership if they so desire.
86Mechanics of Rights Offerings
- The management of the firm must decide
- The exercise (subscription) price (the price
existing shareholders pay for new shares). - How many rights will be required to purchase one
new share of stock. - These rights have value
- Shareholders can either exercise their rights or
sell their rights.
87Rights Offering Example
- National Power has 1 million shares outstanding.
Each share sells for 20. The company wants to
raise 5 million in new equity. Suppose the
exercise (subscription) price is set at 10 per
share. Find - Market value of company after rights issue.
- Number of new shares.
- Number of rights needed to buy a share.
- The value of the share after the rights offering.
- The value of a right.
- The cost of a new share to an outside investor.
88Time Line
Ex Right Date
Right Expiration Date
Right Issue Date
Rights announcement
P20 N1m
P16.67 N1m
P16.67 N1.5m
P16.67 N1m R3.33
89Theoretical Value of a Right
- The theoretical value of a right during the
rights-on period is - R0 (M0 S) / (N 1)
- Where,
- M0 Common share price during the rights-on
period - S Subscription price
- N Number of rights required to buy one new
share
90 Value of a Right after Ex-Rights Date
- When the stock goes ex-rights, its price drops
by the value of one right. - Me M0 R0
- Re (Me S) / N
- Where,
- Me is the common share price during the
ex-rights period.
91Self Practice
- Yoma Inc. is attempting to raise 5,000,000 in
new equity with a rights offering. The
subscription price will be 40 per share. The
stock currently sells for 50 per share and there
are 250,000 shares outstanding. - a. How many new shares will Yoma issue?
- b. How many rights will be required to buy one
share? - c. At what price will the stock sell when it goes
ex-rights if the total value of all stock
increases by the amount of the new funds? - d. What is the theoretical value of 1 right?