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