14- 1Ch 14: Financing decisions and market efficiency

So far our focus has been on the investment decision. Now we turn to the problem of paying for these investments. – Should it issue more stock or should it borrow?– Should it borrow short term or long term– Should it reinvest most of its earning or pay

dividends.

14- 2Financing decisions and market efficiency

Although it’s helpful to separate investment and financing decisions, there are basic similarities in the criteria for making them. The decision to purchase a machine tool and to sell a bond each involve valuation of a risky asset. The face that one asset is real and the other is financial doesn’t matter. In both case, we end up with calculating NPV.

14- 3Financing decisions and market efficiency

However, it may be harder to find positive NPV financing opportunities.

Investors who supply financing are numerous and they are smart. They (somehow) know your business’s risk and assign a fair discount rate to your cash flow. That is, your securities are fairly priced and the capital markets are efficient.

14- 4Difference between investment and financing decisions

The number of different securities and financing strategies is well into the hundreds. In some ways, financing decisions are more complicate than investment decisions.

When firms look at capital investment decisions, it does not assume that it is facing perfect, competitive markets. The firm own a unique asset that give it an edge over its competitors.

14- 5Difference between investment and financing decisions

In financing markets your competition is all other corporations seeking funds.

14- 6

Efficient Market

The movement of stock prices from day to day DO NOT reflect any pattern.

Statistically speaking, the movement of stock prices is a random walk.

14- 7

Random Walk Theory

14- 8

Efficient Market Theory

past price cannot be used to forecast future price. – If so, investors can make easy profit. But in a

competitive market, easy profits don’t last. As investors try to take advantage of the information in past prices, price adjust immediately.

– As a result, market prices reflect all historical information in past prices.

This is called the weak Form Efficiency

14- 9

Efficient Market Theory

Semi-Strong Form Efficiency– Market prices reflect all publicly available

information, such as those available in the news. Stock price respond immediately to public information such as the announcement of the last quarter’s earning.

– Read the article posted on Webct.

14- 10

Efficient Market: The evidence

The adjustment in price after the release of information is immediate

14- 11

Efficient Market: The evidence

Research shows that the major part of price change occur within 5 to 10 minutes of the announcement of news

Therefore, stock price reflects all historical information and project managers normally cannot make easy money through “pattern finding” or “information mining”.

14- 12

Efficient Market Theory

Strong Form Efficiency– Market prices reflect all information, both

public and private

14- 13

Efficient Market: The evidence

Test of the strong form of efficient market hypothesis have examined the recommendations of professional security analysts and have looked for mutual funds or pension funds that could predictably outperform the market.

14- 14

Efficient Market: The evidence

Average Annual Return on Mutual Funds and the Market Index

Return on funds are after expenses

14- 15

Efficient Market: The evidence

The professional managed funds fail to recoup the costs of management.

Many professionally managed funds have given up the pursuit of superior performance. They simply “buy the index”.

How far could indexing go? Not 100%. To provide incentives to gather costly information,

price cannot reflect all information. There must be some profits available to allow the costs of information to be recouped.

14- 16The evidence against market efficiency

Are stock price determined by fundamentals?– Dutch company Royal Dutch Petroleum and the

British Company Shell Transport and Trading. Royal Dutch gets 60% of earning and Shell T&T gets 40%.

• So the stock price should be proportional. However, …

14- 17

Price Anomalies

14- 18The evidence against market efficiency

Bubbles:– Bubbles are also evidence that prices can

disconnect from fundamentals. – NASDAQ index rose 580% from 1995 to 2000,

then fell 78% from its peak between 2000 and 2002.

– Yahoo began trading in 1996 and appreciated by 1400% in three years.

14- 19

Behavioral Finance

Arbitrage limitations In an efficient market, if prices get out

of line, then arbitrage forces them back in line.

The arbitrageur earns a profit by buying low and selling high and waiting for prices to converge to fundamentals. Thus arbitrage trading is often called convergence trading.

14- 20

Behavioral Finance

In practice arbitrage is harder than it looks. Trading cost can be significant. For example, in the Shell example, if you

borrow to do convergence trading---???

14- 21

Behavioral Finance

LTCM example• Convergence in interest rate in Europe with

euro replacing the countries’ previous currencies.

14- 22

Six Lessons of Market Efficiency

Managers should assume at least as a starting point, that there are no free lunches to be has on Wall Street.

14- 23

Six Lessons of Market Efficiency

Markets have no memoryTrust market prices

Market prices impound all available information about the value of each security. If you operate on the basis that you are smarter than others at predicting price changes, your financial policy is an elusive will-o’-the wisp.

Read the entrailsExample: if the company’s bonds are offering a

much higher yield than the average, you can deduce that the firm is probably in trouble.

14- 24

Six Lessons of Market Efficiency

There are no financial illusionsInvestors are unromantically concerned with

the firms’ cash flow and the portion of those cash flows to which they are entitled.

Some firms devote considerable ingenuity to the task of manipulating earning reported to shareholders. This is done by creative accounting. It seems that shareholders in general can look behind the figures.

14- 25

Six Lessons of Market Efficiency

The do it yourself alternativeSeen one stock, seen them all

Stocks are close substitutes and demand should be very elastic. Suppose you want to sell a large block of stock, high elasticity means that you only need to cut the offering price slightly to sell your stocks.

But, this does not follow. When you come to sell your stocks, other investors may suspect that you want to get rid of it because you know something they don’t.