FIN 319: Intermediate Financial Management Spring 2006

1
FIN 319 Intermediate Financial ManagementSpring
2006

• Corporate Financing Decisions and Efficient
  Capital Markets
• (Based on RWJ Chapters 13)

2
Efficient 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
  info.
• We will see that the EMH has implications for
  investors/firms/financial managers.

3

• Preview
• Because information is reflected in prices
  immediately, investors should only expect to
  obtain an equilibrium rate of 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 fair value for
  securities that they sell.
• Financial managers cannot time issues of bonds
  and stocks.
• A firm can sell as many shares of stocks or bonds
  as it wants without fear of depressing price.
• Stock and bond markets cannot be affected by
  firms artificially increasing earnings (cooking
  the books).

4
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
5
Bausch Lomb, Alcon
CDC Announces Study Results
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Different Types 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.
• Can't trade on the basis of past returns and
  expect abnormal profits.

7

• 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.

8

• 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.

9
Who 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.

10

• 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 than the market's estimate,
  reflected in current price, then there may be
  money to be made.
• Not too likely.

11

• Insiders
• Trade on private information. Often on impending
  changes in control structure or new product
  innovations.
• Probably.

12

• 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.

13

• 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.
• Insiders
• Reports of insiders who trade in their own shares
  show these traders are able to achieve abnormal
  profits.

14
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.

15

• Timing of Issuance of Financing
• Year to year variation in the use of new
  financing is partly explained by firms' attempts
  to time new issues. New issues seem to follow
  rises in stock price.
• Attempts to exploit weak form inefficiency
• Price rise simply reflects 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.