Corporate Financing Decisions and Efficient Capital Markets

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Corporate Financing Decisions and Efficient
Capital Markets
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Corporate Financing Decisions and Efficient
Capital Markets

• An efficient market is one in which current
  market prices reflect all available information.
• What information is available? Depends on
  costs/benefits of collection/evaluation/use of
  information.
• We will see that the EMH has strong implications
  for investors/firms/financial managers.

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Preview An Efficient Market

• Because information is reflected in prices
  immediately, investors should only expect to
  obtain an equilibrium rate of expected return (as
  predicted by the SML). Awareness of information
  when it is released does the investor no good.
  The price adjusts before the investor can trade
  on it.
• Firms should expect to receive a fair value for
  securities they issue.
• Financial managers cannot time issues of
  securities.
• A firm can sell as many shares of stock or as
  many bonds as it wants without fear of depressing
  the price.
• Stock and bond markets cannot (barring fraud) be
  affected by firms artificially increasing
  earnings (cooking the books).

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Reaction of Stock Price to New Information in
Efficient and Inefficient Markets
StockPrice Overreaction
and reversion Early response
Delayed response Efficient
market response to new information
Days before () and after()
announcement
Public announcement day
30 20 10 0 10 20
30
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Forms of Market Efficiency

• Weak Form Efficiency
• A capital market is said to be weakly efficient
  or to satisfy weak-form efficiency if current
  prices fully incorporate the information in past
  prices (more generally trading information).
• Can't trade on the basis of past returns and
  expect abnormal profits.

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Forms of Market Efficiency

• Semi-Strong Form Efficiency
• A market is said to be semi-strong form efficient
  if current market prices fully incorporate all
  publicly available information (e.g., information
  in the WSJ).
• Since past prices are publicly available
  information, if a market is semi-strong form
  efficient, it is necessarily weak form efficient.
• In a market that is semi-strong form efficient
  investors cannot trade based on publicly
  available information and expect profits in
  excess of an equilibrium expected return (as
  specified by, for example, the SML).

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Forms of Market Efficiency

• Strong Form Efficiency
• A market is said to be strong form efficient if
  current market prices fully incorporate all
  (including inside) information.
• Since publicly available information is a subset
  of all information, if a market is strong form
  efficient it is semi-strong form efficient and
  weak form efficient.
• In a strong form efficient market no investor can
  make profits in excess of the equilibrium
  expected return trading on any information
  (including "inside" information).
• This is obviously an extreme form of efficiency.

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Who Thinks They Can Beat The Market?

• Chartists Technical Analysis
• These folks analyze "charts" or graphs of
  movements of different aspects of the stock
  markets.
• Share price movements
• Trading Volume
• Ratios of volumes on up price movements to those
  on down price movements
• Chartists believe that there exist identifiable
  and exploitable trends or patterns in these
  variables.
• Hardly believable. But the jury is still out.

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• Fundamental Analysis
• Based upon the belief that stock market values
  reflect economic values. And that there is
  publicly available information that will allow
  them to form a better estimate of value than is
  contained in market prices.
• If there is information (examples?) that will
  allow an analyst to form a better estimate of
  future dividends (or cash flow) than the market's
  estimate, as reflected in current price, then
  there may be money to be made.
• In liquid markets, its not too likely.

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• Insiders
• Trade on private information. Often on impending
  changes in control structure or new product
  innovations.
• Probably, it is illegal but Martha showed us what
  that means.

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The Scientific Evidence

• Are Stock Prices Random?
• Serial correlation of stock returns near zero.
• More complete tests show that after expected
  return is accounted for, past returns add little
  or no information to help predict future returns.
• Technical analysts may be observing "optical
  illusions".
• People are not good at understanding randomness
  Think of the iPod and its random play setting!

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WHICH IS THE REAL MARKET INDEX?THIS ONE
Level
Months
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... OR THIS ONE?
Level
Months
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• Event Studies
• Is new information concerning a firm quickly and
  completely incorporated into stock price?
• Stock Splits
• Dividend/Earnings Announcements
• Mergers
• Capital Expenditures
• Findings generally support semi-strong form
  efficiency.

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• Mutual Fund Performance
• Mutual fund managers, who use public information
  and presumably have the time and talent to
  process the information they collect, cannot
  consistently beat the SP 500 index.

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The Record of Mutual Funds
Taken from Lubos Pastor and Robert F. Stambaugh,
Evaluating and Investing in Equity Mutual
Funds, unpublished paper, Graduate School of
Business, University of Chicago (March 2000).
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• Insiders
• Reports of insiders who trade in their own
  shares show these traders are able to achieve
  abnormal profits.

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• Contrary Views
• Shiller - Are stock prices too variable?
• Fads/bubbles in stock prices.
• Momentum studies.
• Seasonalities
• January Effect
• Size Effect
• Book-to-Market Effect
• Underperformance of IPO and Seasoned Equity
  Issues
• Suggestive Occurrences
• October 19, 1987
• Tulip Craze of 17th Century in Holland

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Implications for Corporate Finance

• Accounting and the EMH
• In a semi-strong form efficient market purely
  cosmetic accounting practice changes won't fool
  investors. Studies support this result.
• Changes in depreciation methods
• Accounting for inventories
• Reporting mergers and acquisitions
• All can change earnings reports but do not affect
  stock prices.
• When information is withheld or incorrect
  information is provided prices can be affected.

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• Timing the Issuance of New Financings
• Year to year variation in the use of new
  financing appears as if it is explained by firms'
  attempts to time new issues. New issues seem to
  follow rises in stock price.
• May be attempts to exploit weak or semi-strong
  form inefficiency.
• Price rise may simply reflect a new investment
  opportunity.
• Inside information.
• Price Pressure
• In an efficient market a firm will be able to
  issue as much equity as it wishes without fear of
  depressing price due to an "over-supply" of its
  claims.

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What the EMH Does and Does Not Say

• Does Say
• Prices reflect underlying value.
• Financial managers cannot time stock and bond
  issues.
• Sales of stock and bonds will not depress prices.
• You cannot cook the books.
• Doesn't Say
• Prices are uncaused.
• Prices should not fluctuate.
• Investors all need to know all information.
• All shares of stock have the same expected
  returns.
• Investors should throw darts to select stocks.
• There is no upward trend in stock prices.