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Corporate Financing and Market Efficiency

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Motivation for WACC How do we know that a project is ... If the stock price ... Inside trading Investors use private information to predict future price ... – PowerPoint PPT presentation

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Title: Corporate Financing and Market Efficiency


1
Corporate Financing and Market Efficiency
  • Where to get money for good projects

2
Todays plan
  • Review WACC
  • Investment Decision vs. Financing Decision
  • Does the stock price follow a random walk?
  • Three forms of Market Efficiency
  • Weak form efficiency
  • Semi-strong form efficiency
  • Strong form efficiency
  • Several types of securities

3
What have we learned in the last lecture ?
  • Motivation for WACC
  • How do we know that a project is worth taking?
  • How do we find the cost of capital for a project
    ?
  • What is the formula of WACC without tax?
  • What is the formula of WACC with tax?
  • Should we use the market value or book value of
    equity and debt in calculating WACC?

4
What have we learned in the last lecture (1)?
  • WACC without tax
  • WACC with tax

5
What have we learned in the last lecture (2)?
  • The cost of bond
  • It is the YTM, the expected return required by
    the investors.
  • That is
  • The expected return on a bond can also be
    calculated by using CAPM

6
What have we learned in the last lecture (2)?
  • The cost of equity is calculated by using
  • CAPM
  • Dividend growth model

7
What have we learned in the last lecture (2)?
  • Three steps in calculating WACC
  • First step Calculate the market value of each
    security and calculate its portfolio weight
  • Second step Determine the cost of capital on
    each security.
  • Third step Calculate a weighted average cost of
    capital on these securities.

8
A summary example
  • John Cox, a recent MBA student of SFSU, was asked
    by his boss in Geothermal to decide whether the
    firm should take an expansion project the cost
    of the project is 30 million, and the project is
    expected to generate a perpetual incremental cash
    flow of 4.5 million. Currently, Geothermal has
    20 million shares of common stocks outstanding,
    with a market price of 22.65 per share. The Beta
    of the firms equity is 1.1. The risk free rate
    is 4 and the market risk premium is 5.6. The
    firm also has long-term debt, with the YTM of 9.
    John also got the following information from the
    firms balance sheet
  • Debt (12 years maturity, 8 coupon) 200 million
  • Common stocks110 million
  • If the tax rate is 35, should John suggest to
    his boss to take the project or not?

9
Solution
10
Investment vs. Financing
Liabilities and equity
Asset
  • Investment decisions or capital budgeting is
    about how to take projects to maximize V.
  • Financing decisions are about how to raise
    capital (E or D) to finance the projects to be
    taken

Debt D
V
Equity E
11
Financing and market Efficiency
  • Market Efficiency
  • Market efficiency is concerned about whether
    capital markets have all information about the
    cash flows and risk of projects.

12
Efficient capital markets
Efficient Capital Markets If capital markets
are efficient, then security prices reflect all
relevant information about asset values ( cash
flows and risk)
13
Market efficiency and random walk
  • Market efficiency concepts are very abstract.
  • How can we use a simple way to check whether the
    stock market (one of the capital markets) is
    efficient or not?
  • If the stock price follows a random walk, then
    the stock market is efficient.

14
What is a random walk of stock prices?
  • The movement of stock prices from day to day DO
    NOT reflect any pattern.
  • Statistically speaking, the movement of stock
    prices is random.

15
A Random Walk example
106.09
Heads
Heads
103.00
100.43
Tails
100.00
Heads
100.43
97.50
Tails
95.06
Tails
Coin Toss Game
16
Three forms of market efficiency
  • The random walk concept is still abstract
  • Financial economists have used three more
    specific forms to characterize or judge market
    efficiency.
  • Weak-form
  • Semi-strong form
  • Strong form

17
Weak-form of market efficiency
  • Weak Form Efficiency - Market prices reflect all
    information contained in the history of past
    prices, or you cannot use past stock prices to
    predict future prices

Technical Analysts - Investors who attempt to
identify over- or undervalued stocks by searching
for patterns in past prices.
18
Efficient Market Theory
90 70 50
EIs Stock Price
Cycles disappear once identified
Last Month
This Month
Next Month
19
Semi-strong form of market efficiency
  • Semi-Strong Form Efficiency - Market prices
    reflect all publicly available information such
    as earnings, price-to-earnings ratios,etc.

Fundamental Analysts - Analysts who attempt to
fund under- or overvalued securities by analyzing
fundamental information, such as earnings, asset
values, and business prospects.
20
Efficient Market Theory
Announcement Date
21
Market Efficiency
22
Strong form of market efficiency
  • Strong Form Efficiency - Market prices reflect
    all information that could in principle be used
    to determine true value.
  • Inside trading
  • Investors use private information to predict
    future price movements

23
Efficient Market Theory
Announcement Date
24
Some exercises
  • If stock markets are efficient, what should the
    correlation between stock returns for two
    non-overlapping periods?
  • Which is the most likely to contradict the
    weak-form of efficiency
  • Over 25 of mutual funds outperform the market on
    average
  • Insiders can make abnormal profits
  • Every January, the stock market earns abnormal
    return

25
Several types of securities
  • Three types of securities
  • Common Stock
  • Preferred stock
  • Corporate debt

26
Common Stock
  • Common stocks have the following forms
  • Treasury stock
  • Issued shares
  • Outstanding shares
  • Authorized share capital
  • Par value
  • Ownership of the corporation

27
Corporate debt
  • Corporate bonds
  • Primary rate
  • Funded debt
  • Sink fund
  • Callable bond
  • Subordinate debt
  • Secure debt

28
Preferred stock
  • Preferred stock and common stock
  • Priority and voting rights
  • Preferred stock and bond
  • Obligation and bankruptcy
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