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Topics: 14.1 Differences between investment and financing decisions 14.2 What is market efficiency? 14.3 Types of market efficiency 14.4, 14.6 Empirical evidence 14.8 Implications and lessons of market efficiency
Background
Till now you learned how to spend money - the capital budgeting decision - the left-hand side of the balance sheet Now you will learn how to raise money i.e. financing the capital expenditures - the right-hand side of the balance sheet Hold the firms capital budgeting decision constant and determine what is the best financing strategy
14.1 Differences between Investment and 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
Financing decisions easier to reverse Capital investment decisions - positive NPV projects, firm does not assume it is facing a perfectly competitive market
Where might value come from?
Financing Schemes. If securities issued by firm are fairly priced then the financing activities have NPV = 0 Key QUESTION: Are securities fairly priced?
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An Example
You have a project, which yields perpetuity of $1 every year. The discount rate for the project is 10%. The required initial capital outlay is $5. NPV of the project: Value of the equity (if 100% owned)
You have only $3 needed for the investment. You form a company to finance the project. You decide to sell 40% of the ownership of the company to your friend for $2.
Is the equity sold to your friend fairly priced? Is financing NPV enhancing?
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A market in which information is widely and cheaply available to investors and all relevant information is already reflected in security prices - Prices are right at any time
Any new information disseminates quickly and is instantly reflected in share prices
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Example: Reaction of Stock Price to New Information in Efficient and Inefficient Markets
Stock Price
+20
+30
Firms expect fair value for securities they sell In the words of press:
. Because prices are efficient - they reflect all available facts. Future prices differ from current prices only if buyers or sellers get new information. This by definition, is random. But why should prices be efficient? Put simply, if they are not, it means the market is ignoring pricesensitive information. But this gives whoever has that information a chance to make big profits by trading on it. As soon as he does so, the overlooked information is incorporated in the price. This will make it efficient. -The Economist, December 5, 1992
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If stock prices follow eqn. (14.1) they are said to follow a random walk Pt = Pt-1 + expected return + et (random error) E(Pt) = Pt-1 + expected return
If a market is weak form efficient it is impossible to make consistently superior returns by technical analysis. Why? No arbitrage principle/law of one price
Sell
Stock Price
Sell
Buy Buy
Time
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If a market is strong form efficient it is impossible to make consistently superior returns from insider information
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All information relevant to a stock Information set of publicly available information Information set of past prices
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the first one above relates to weak form efficiency, the second and third to semi-strong it is hard to test strong form, but what evidence there is suggests that it does not hold (insider trading is profitable)
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CART0
CAR ARt
T 0 t 0
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Graphically
Cumulative abnormal returns (%)
Cumulative Abnormal Returns for Companies Announcing Dividend Omissions
1 0.146 0.108 -8 -6 -4 -0.72 0.032 0 -0.244 -2 -0.483 0 -1 -2 -3 -3.619 -4 -5 -6 -4.49 -4.563 -4.685 -4.747 -4.898 -5.015 -5.183 -5.411
Most event studies do not conclude that there are profit opportunities.
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Expert money managers (mutual funds) do not outperform the market consistently
Annual Return Performance of Different Types of U.S. Mutual Funds Relative to a Broad-Based Market Index (1963-1998)
All funds
Smallcompany growth
Otheraggressive growth
Growth
Income -0.39%
Sector -1.06%
-2.13%
-2.17%
-5.41%
-8.45%
Taken from Lubos Pastor and Robert F. Stambaugh, Mutual Fund Performance and Seemingly Unrelated Assets, Journal of Financial Exonomics, 63 (2002).
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3. Tests on Strong form efficiency Strong form efficiency does not hold - insider trading profitable
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Why?
You would like to buy 3Com and sell Palm.
Figure 14.9 Returns on Value vs. Growth (Fama & French 1998)
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Markets have no memory - sequence of past price changes contain no information about future changes Accounting and efficient markets
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Review Questions
Why are markets efficient?
Assigned Problems # 14.4 - 7, 9, 12, 14, 17-20 (For Q20, the diagram is at the end of the page)
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Example
On May 15, 1997, the government of Kuwait offered to sell 170 million BP shares, worth about $2 billion. Goldman Sachs was contacted after the stock market closed in London and given one hour to decide whether to bid on the stock. They decided to offer $11.59 per share, and Kuwait accepted. Then Goldman Sachs started looking for buyers. They lined up 500 institutional and individual investors worldwide and resold all the shares at $11.70. The resale was complete before the London Stock Exchange opened the next morning. Goldman Sachs made $15 million overnight. What does this deal say about market efficiency?
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