13 corporate financing

8/7/2019 13 Corporate Financing

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Ch.13 Corporate Financing and the Six Lessons of Market Efficiency

-- move to the right-hand side of the B/S: corporate financing problem how to raise money

-- assumption: We take the firms present real assets and future investment strategy as given, and

then we determine the best financing strategy.

13-1 Net Present Value of Borrowing

--NPV of borrowing

example: Your firm is offered by the government a loan of $100,000 for 10 years at an interestrate of 3%.

NPV of the loan = = +

+

10

1t 10r)(1

100,000tr)(1

3,000100,000

Q: What is the opportunity cost of capital r?rephrase the question: What interest rate would my firm have to pay in order to borrow money

directly from the capital markets rather than the government?

--difference between investment and financing decisions

1) Financing decisions are easier to reverse than investment decisions. (Their abandonment value

is higher.)

2) nature of competition

investment decisions: Firms face imperfect competitive (good) markets. (unique assets and fewcompetitors)

Make superior profits. NPV > 0

financing decisions: Firms face competition from all other corporations and investors

comparably numerous and smart.

Securities issued are fairly priced. NPV = 0

--fundamental financial concept: efficient capital markets

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If capital markets are efficient, purchase of sale of any security at the prevailing market price is

never a positive-NPV transaction.

13-2 What Is An Efficient Market?

--market efficiency:

well-functioning capital market (loosely speaking)

Information is widely and cheaply available to investors.

All relevant and ascertainable information is already reflected in security prices.

--Price changes are random. (Kendall, 1953)

He finds that:

a) Stock and commodity price changes show no regular cycles (or patterns).

b) Particularly, the prices seemed to follow a random walk (i.e., the price changes are

independent of one another):

1~

1~

++=

+ ttP

tP or 1

~1

~+

++=+ tt

Pt

P , where )2,0(~~ N .

diagrams of the simple random walk processes:

a) 1~

1~

++=

+ ttP

tP , )2,0(~~ N (a random walk with no drift)

b) 1~

1~

+++=

+ ttP

tP , )2,0(~~ N (a random walk with a drift of)

Note that the two processes are AR(1) with coefficient equal to 1.

implication: You cant predict the next periods price from the current price.

-- example:

a game:

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A0 = $100

Toss a coin: win 3% if H, lose 2.5% if T.

At follows a random walk after playing several (t) times.

comparison of two charts (Figure 13-1)

notes:

a) In the game, expected return = %25.0%)5.2(2

1%3

2

1=+

annualized return = %1352%25.0 =

variance = %5625.72)25.05.2(2

12)25.03(2

1=+

annualized variance = %25.393525625.7 =

Now please recall the historical performance of S&P 500 in ch. 7.

b) The model in the game involves percentage changes.

1000=A

rAAA ~001+= , where

%5.2,

%3

2

1

,2

1

)(=

=

=r

rrf

rA

A~1

0

1+= r

A

A~1

0

1=

rtr~

1~

=+

1~

1~

++=

+ ttr , where

%25.0%5.2,

%25.0%3

2

1

,2

1

)(=

=

=

f

and %25.0=

or 1~

1~

++=

+ ttr , where )2,0(~~ N and %25.0= .

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This process is a special case of AR(1) 1~

1~

+++=

+ ttr

tr .

c) The model 1~1~ ++=+ ttr , where )2,0(~~ N , can also be expressed as:

ztA

A+=

, ( )

where tz = and )1,0(~~ N ,

when we let t = 1.

What does the probability distribution for A t look like? Equation ( ) allows us to derive

it. The left-hand side of the equation is the proportional return provided by the asset A in

a short period of time t . It shows that

)2,(~ ttN

A

A

.

Note that AA

Aln=

. The equation then becomes:

)2,(~ln ttNA

)2,(~0

lnln ttNAt

A

Since the initial value A0 is given, we have

)2,0

(ln~ln ttANt

A + .

Therefore, tA follows a log-normal distribution.

d) The continuous-time version of equation ( ) is known as geometric Brownian motion:

dzdtA

dA+= ,

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where dtdz = and )1,0(~~ N [i.e., ),0(~ dtNdz and )2

,0(~ dtNdz ].

The process is considered to be a reasonable assumption of stock price movements and is

widely used in finance for pricing assets. For instance, the Black-Scholes pricing equation

of European call option is based upon this assumption.

--a test for random walk

intention: To assess whether there is any tendency for price changes to persist from one day to

the next.

method:

Calculate .,...,2,1,1

1 Tt

tP

tPtP

tr =

= (T obs)

Plot )1,( +trtr to see if there is any systematic pattern of covarying:

1

2

1

Tr

r

r

Tr

r

r

3

2

Cov(X,Y) oryx

YXCov

),(

=

X Y

systematic patterns:

a) (+,+) (-,-) 10 <

b) (+,-) (-,+) 01


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-- arguing in the other way around (Figure 13-3):

predictable cycles (systematic patterns) self-destruction by investors trading

--two types of investments help to make price changes random:

a) fundamental analysts: studying the companys business

b) technical analysts: studying the past price record

($$$$ supplement)

--competitive (efficient) markets and random price changes:

competition:

Competition among investors will lead to a stock market in which prices reflect true value

equilibrium prices which incorporate all the information available to investors (i.e., an efficient

market).

new information:

If stock prices reflect all relevant information, then they will change only when new

information arrives.

New information cannot be predicted ahead of time.

Price changes cannot be predicted ahead of time. Price changes must reflect only the unpredictable.

The series of price changes must be random.

arguing in the other way around:

If past price changes could be used to predict future price changes (i.e., patterns in prices exist),

investors try to take advantage of the information in past prices.

In competitive markets, prices adjust immediately until the superior profits from studying past

price movements disappear.

All the information in past prices will be reflected in todays price, not tomorrows. Patterns in prices will no longer exist. Price changes in one period will be independent of changes in the next, i.e., price will

follow a random walk.

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-- three forms of the efficient market theory:

a) weak form of efficiency

definition: Stock prices reflect all information contained in the record of past prices.

implication: It is impossible to make consistently superior profits simply by looking for patterns

in stock prices.

b) semistrong form of efficiency

definition: Prices reflect not just past prices but all other published (i.e., public) information.

implication: Prices will adjust immediately to public information such as the announcement of a

proposal to merge two companies.

It is impossible to make consistently superior returns just by reading the newspaper,

looking at the companys annual accounts, and so on.

c) strong form of efficiency

definition: Prices reflect past prices, public information, and all the information that can be

acquired by painstaking analysis of the company and the economy.

implication: We wouldnt find any superior investment managers who can consistently beat the

market.

Inside information is hard to find.

Prices would always be fair and investment in securities is fair (i.e., no abnormal

return).

-- the evidence:

a) weak form

two kinds of tests:

Use statistical (mechanical) tests of independence: autocorrelation tests, run tests.

Measure the profitability of some trading rules (e.g., 5% filter rule).

The results support this view of efficiency.

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b) Semistrong form

event studies:

Examine how rapidly security prices respond to different items of news, such as earnings or

dividend announcements, news of takeover, or macroeconomic information.

adjustment for market effects (in order to isolate the effect of an announcement on the price of a

stock):

an example: A 5% return in a stock during a period surrounding an announcement of a

takeover.

This increase is not meaningful unless you know what the aggregate stock market did during

the same period and how this stock normally acts under such conditions.

We need to adjust the stocks rates of return for the rates of return of the overall marketduring the period considered.

way of adjustment:

abnormal stock return = actual stock return expected stock return

This abnormal return abstracts from the fluctuations in the stock price that result from

marketwide influences.

Expected return can be derived by two ways:

1) the market model

2) the average return on the similar stocks (firms with similar size, product, etc.)

two studies:

1) merger announcements (Keown and Pinkerton, 1981)

price run-up and takeover premium:

In most takeovers, the acquiring firm is willing to pay a large premium over the

current market price of the acquired firm. Therefore, when a firm becomes the target of a

takeover attempt, its stock price increases in anticipation of the takeover premium.

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Figure 13-5 illustrates the price run-up of a sample of 194 acquired firms during the

period surrounding the announcement day.

result:

The prices of target stocks take a big upward jump on the announcement day, but from

then on, the run-up is over.

The price adjustment is immediate. The announcement of the takeover attempt is fullyreflected in the stock price on the announcement day.

Within the day, the new stock prices apparently reflect on average the magnitude of the

takeover premium.

notes:

i) cumulative abnormal return (CAR) over T-day period = 1)1(1

+=

tAR

T

t

example: 1%, -1.5%, 1.2%

CAR over the 3-day period = (1+0.01)(1-0.015)(1+0.012) 1 = 0.6788%

ii) Prices on the day before the public announcement show a sustained upward drift (not

jump). This is evidence of a gradual leakage of information about a possible takeover

attempt.

2) earnings and dividend announcements (Patell and Wolfson, 1984)

When a firm publishes its latest earnings or announces a dividend change, the major part of

the adjustment in price occurs within 5 or 10 minutes of the announcement.

c) strong form

most tests: Examine the performance of mutual funds or pension funds (in particular,

investigate whether they could consistently outperform the market).

two studies:

1) Carhart (1997)

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Figure 13-6: Compare the average annual returns on 1,493 U.S. mutual funds to the market

index during 1962-1992. It shows that mutual funds outperform the market in 15

years of the 31-year period.

This is a fairly crude comparison. Low-beta stocks or large-firm stocks usually have given

below-average returns. The formal approach to measuring the performance is to compare each

fund with a benchmark portfolio of similar securities. The result from this approach is:

The funds earns a lower return than the benchmark portfolios after expenses and roughly

matched the benchmarks before expenses. This result is typical.

a note : the characteristic-based approach (Daniel et. al., 1997)

($$$ another paper of Carhart)

2) Malkiel (1995)

Forbs Magazine has published annually since 1975 an honor roll of the most consistently

successful mutual funds. If you had invested an equal sum in each of these exceptional funds

each year, Malkiel fund that:

you would have outperformed the market in only 5 of the following 16 years and that

your average annual return before paying any initial fees would have been more than 1%

below the return on the market.

a note: WSJ match played each quarter

index funds: Maximize diversification and minimize the costs of managing the portfolio.

Corporate pension plans now invest over a quarter of their U.S. equity holdings in index funds.

notes:

1) Other studies include corporate insider trading and the performance of security analysts.

2) The benchmark or the market for comparison in these tests is referred to as a passive

portfolio. It in effect represents a buy-and-hold policy (strategy) on a risk-adjusted basis.

Supplement to Section 13-2 on Market Efficiency

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-- Eugene Famas work on the efficient market theory:

Most of the early work related to efficient capital markets was based on the random walkhypothesis. This early academic work contained extensive empirical analysis without much

theory behind it. Fama attempted to formalize the theory and organize the growing empirical

evidence.

-- Fama (1970)

information at a specified point in time:

In this paper, Fama presented the efficient market theory in terms of a fair game model.

Unlike work done under the random walk hypothesis, which dealt with price movements over

time, the fair game model deals with price at a specified point in time. It assumes that the price

of a security fully reflects all available information at that point in time. The model requires

that the information structure be specified enough detail so that it is possible to indicate that

what is meant by fully reflect.

the fair game model:

Define an equation: tjPttjrEttjPE ,)]|1,~(1[)|

1,~

( +

+=+

,

where tjP , = current price of security j at time t,

1,~

+tjP = actual (random) price of security j at time t+1,

1,~+tj

r = one period actual (random)rate of return of security j at time t+1,

t = current set of information that is assumed to be fully reflected in thesecurity

price at time t. The information set includes all current and past values of anyrelevant variables and the knowledge of all the relevant relationships among the

variables.

This equation indicates that the expected price of security j, given the full set of information

available at time t, is equal to the current price times 1 plus the expected return on security j,

given the set of information available.

Define the second equation:

)|1,

~(

1,~

1,~

ttjPE

tjP

tjX

+

+=

+

.This equation describes the excess market value for security j.

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In an efficient market, we have 0)|1,~

( =+ ttjXE .

This equation indicates that the market reflects a fair game with respect to the information set

t . This means that investors can be confident that current prices fully reflect all available

information and are consistent with the risk involved.

-- Fama (1976)

joint distribution of security prices:

In this paper, Fama defines efficient markets as the following equation:

)1

|...,,2

,1

()1

|...,,2

,1

( = tntPtPtPfmtnt

Pt

Pt

Pmf . (1)

It says that the joint distribution of security prices, mf , given the set of information that the

market uses to determine security prices at t1, is identical to the joint distribution of prices, f,

that would exist if all relevant information available at t1 were used.

interpretation orefficiency implication:

The distribution of prices in time period t (predicted in the previous time period t-1 and based

on the information structure the market uses) is not different from the prices predicted by using

all relevant information from the previous time period t-1.

There must be no difference between the information the market uses and the set of allrelevant information. This is the essence of an efficient marketit instantaneously and fully

reflects all relevant information.

another implication from information theory:

Using information theory, market efficiency also means that net of costs, the utility value of

the gain from information to an individual i must be zero:

)0,

(),

(t

Vit

V = (2)

where ),( itV = expected utility value from the information structure to the ith individual,

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)0,

(t

V = expected utility value without the information.

Note that the costs include the cost ofundertaking courses of action and the costs of

transmitting and evaluating messages. Some of these costs in securities markets are

transactions costs, e.g., brokerage fees, bid-ask spreads, costs involved in searching for the best

price, and taxes, as well as data costs and analysts fees.

example of weak-form efficiency:

The relevant information structure, it, , is defined to be the set of historical prices on all

assets.

If capital markets are efficient, then equation (1) says that the distribution of security prices

today has already incorporated past price histories and equation (2) says that no one would pay

anything for the information set of historical prices.

a note: addition reference of E.F. Fama --Foundations of Finance, Basic Books, New York,

1976.

13-3 Puzzles and Anomalies What Do They Mean for the Financial Manager?

--an example:

Figure 7-1: Abnormally high returns on the stocks of small firms from the CAPM.

Although small firms had higher betas, the difference was not nearly large enough to explain

the difference in returns.

possible explanations:

1) Investors could have demanded a higher expected return from small firms to compensate for

some extra risk factor that is not captured in the simple CAPM. (See ch. 8.)

2) The superior performance of small firms could simply be a coincidence. Figures 7-1 and 8-11

shows that this superior performance in the U.S. is limited or disappear at recent years.[However, some believe that the small-firm effect is a pervasive phenomenon because the fact

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is found in many other countries.]

3) We could have here an important exception to the efficient market theory. [But, it is

surprisingly difficult to get rich by exploiting such anomalies.]

a note: a conclusion from Rolls (1994) work on anomalies:

Over the past decade, I have attempted to exploit many of the seemingly most promising

inefficiencies by actually trading significant amounts of money according to a trading rule

suggested by the inefficienciesI have never yet found one that worked in practice, in the

sense that it returned more after cost than a buy-and-hold strategy.

--short-term behavior of stock prices:

Stock returns appear to:

1) be higher in January than in other months,

2) be lower on a Monday than on other days of the week,

3) mostly come at the beginning and end of the day.

However, to have any chance of making money from such short-term patterns, you need to be a

professional trader.

--Do investors respond slowly to new information?

long-term mispricing : the anomalies that involve in long-term delay in reaction to news

two examples

a) the earnings announcement puzzle: long-term underreaction to the earnings announcement

Figure 13-7 shows that the 10% of stocks of firms with the best earnings (unexpected

earnings) news outperform those with the worse news by more than 4% over the two months

following the announcement. (Bernard and Thomas, 1989)

b) the new-issue puzzle: long-term underperformance of new issues

For example, if you bought stock immediately following each initial public offering (IPO)and then held for 5 years, your average annual return would have been 33% less than the

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return on a portfolio of similar-sized stocks. (Loughran and Ritter, 1995)

But, the jury is still out on the puzzle:

Loughran and Ritter found that most new issues have involved growth stocks with high

market values with limited book assets. When the long-run performance of new issues is

compared with a portfolio that is matched in terms of both size and book-to-market, the

difference in performance disappears.

The new-issue puzzle could turn out to be the book-to-market puzzle (discussed earlier inFigure 8-11) in disguise.

--stock market anomalies and behavioral finance

behavioral finance: an alternative theory that might explain these apparent anomalies

two areas of studies:

1) investors attitudes toward risk

observation by psychologists:

Losers tend to regret their actions and kick themselves for having been so foolish.

(Kahneman and Tversky, 1979)

implications:

Once investors have suffered a loss, they may be even more concerned not to risk a further

loss and therefore they become particularly risk-averse.

Conversely, investors may be more prepared to run the risk of a stock market dip after theyhave experienced a period of substantial gains. (Thaler and Johnson, 1990)

the theories in chapters 7 through 9:

We assumed that investors are concerned solely with the distribution of the possible

returns.

We did not allow for the possibility that investors may look back at the price at which they

purchased stock and feel elated when their investment is in the black and depressed when itis in the red.

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2) investors beliefs about probabilities

observations by psychologists of two systematic biases in assessing the probability offuture uncertain outcomes:

a) People commonly look back to what has happened in recent periods and then assume that

this is representative of what may occur in the future.

The temptation is to project recent experience into the future and to forget the lessons

learned form the more distant past.

b) Most of us believe that we are better-than-average stock pickers. (overconfidence)

a note: For evidence, see Odean (1998, 2001).

two issues:

1) How far such behavior traits help to explain stock market anomalies.

example: the tendency to place too much emphasis on recent events and therefore to overreact

to news

It fits the long-term underperformance of new issues but doesnt help to explain the long-term

underreaction to earnings announcements.

Famas (1998) point:

Unless we have a theory of human nature that can tell us when investors will overreact and

when they will underreact, we are just as well off with the efficient-market theory which

tells us that overreactions and underreactions are equally likely.

a note: Barberis et. Al. (1998) seeks to model why investors may both underreact and

overreact.

2) We need to explain why professional investors have not competed away the apparent profit

opportunities that such irrationality offers.

a note: Many financial institutions employ behavioral finance specialists to advise them onthese biases.

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-- the dot.com bubble in 1990s

the boom in high-tech stocks:

1) The Nasdaq Composite Index rose 580% from the start of 1995 to its high in March 2000.

The boom ended even more rapidly than it began. By November 2001, the index had fallen

64%.

2) Yahoo! shares, which began trading in April 1996, appreciated by 1,400% in just 4 years.

At this point, Yahoo! stock was valued at $124 billion, more than that of GM, Heinz, and

Boeing combined.

But, just over a year later, its market capitalization was little more than $6 billion.

irrational exuberance:

Alan Greenspan and Robert Shiller attributed the run-up in prices to irrational exuberance.

Shiller argued that, as the bull market developed, it generated irrational optimism about the

future and stimulated demand for shares. Moreover, as investors racked up profits on their

stocks, they became even more confident in their opinions.

question:

If individual investors were carried away by irrational optimism, why didnt smart professional

investors step in, sell high-tech stocks, and force their prices down to fair value?

Or were the pros rationally reluctant to undertake selling if they could not be sure where and

when the boom would end?

a note: the theory of bubbles

Some economists believe that the market price is prone to bubbles.

TheJournal of Economic Perspective 4 (Spring 1990) contains several articles on bubbles.

Bubbles are situations in which price grows faster than fundamental value, but investors dontsell because they expect prices to keep rising. All such bubbles pop eventually, but they can in

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theory be self-sustaining for a while.

-- the crash of 1987 and relative efficiency

the episode: On Monday, October 19, 1987, the DJIA fell 23% in one day.

first question: Who were the guilty parties?

1) index arbitrageurs: They trade back and forth between index futures and the stocks

comprising the market index, taking advantage of any price discrepancies.

the fact: Arbitrageurs did contribute to the trading volume of selling stocks and buying

future, but they were the messengers who tried to transmit the selling pressure in the

futures market back to the exchange.

2) institutional investors who implement portfolio insurance schemes (the immediate cause)

portfolio insurance: the schemes to put a floor on the value of an equity portfolio by

progressively selling stocks and buying safe, short-term debt securities as

stock prices fall.

Thus, the selling pressure on that Black Monday led portfolio insurers

to sell still more.

questions:

1) Stocks fell worldwide when portfolio insurance was significant only in the U.S.

2) If sales were triggered mainly by the trading tactics, they should have conveyed little

fundamental information, prices should have bounced back after confusion haddissipated.

second question: Do prices reflect fundamental values?

fact: There was no obvious, new fundamental information to justify such a sharp and widespread

decline in share values.

It appears that either prices were irrationally high before the Black Monday or irrationallylow afterward. The efficiency theory is less compelling than before.

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one explanation:

It is difficult to value common stocks. Investors almost always price a common stockrelative to yesterdays price or relative to todays price of comparable securities.

If information arrives smoothly, then as time passes, investors become more and moreconfident that todays price level is correct.

When investors lose confidence in the benchmark of yesterdays price, there may be a

period of confused trading and volatile prices before a new benchmark is established.

important lessons: relative efficiency

The crash does not undermine the evidence for market efficiency with respect to relative

prices.

a note: Relative pricing includes prices set relatively across comparable securities and across

time.

-- market anomalies and the financial manager

(or market inefficiency and corporate financing)

first point:

The financial manager needs to be confident that, when the firm issues new securities, it can do

so at a fair price.

notes: Two reasons that this may not be the case:

1) The financial manager may have information that other investors not have. (The strong-formefficiency is not 100% true.)

2) Investors may have the same information as management, but be slow to react to it.

overpricing of the firms stock and financing:

question: If your firms stock is truly overpriced, does this mean that you can raise capital

cheaply and invest in some project?

sensible decisions:

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1) You can help your shareholders by selling the stock and using the cash to invest in other

capital market securities.

2) You should never issue stock to invest in a project that offers a lower rate of return thanyou could learn elsewhere in the capital market.

underpricing of the firms stock and financing:

sensible decision:

If your firms stock is sufficiently underpriced, it may pay to forego an opportunity to invest in a

positive-NPV project rather than to allow new investors to buy into your firm at a low price.

[But, you may instead be able to finance your good project by an issue of debt.]

conclusion:

The market inefficiency would affect the firms choice of financing but not its real investment

decisions.

13-4 The Six Lessons of Market Efficiency

-- widespread agreement:

Capital markets function sufficiently well in the sense that opportunities for easy profits are rare.

important implications for the financial manager

-- Lesson 1: Markets Have No Memory

market having no memory weak form of the efficiency hypothesis (i.e., the sequence of past price changes contains no information about future changes.)

example of corporate financing

managers inclination: Favor equity rather than debt financing after an abnormal price rise and

be reluctant to issue stock after a fall in price.

The idea is to catch the market while it is high and to wait for a rebound

while it is low.

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lesson: Since the market has no memory, the cycles that financial managers seem to rely on do

not exist.

a note: High stock prices in general market movement signal expanded investmentopportunities and the need to finance them. We would expect to see firms raise more

money in total when stock prices are historically high.

But this does not explain why firms prefer to raise the extra cash at these times by an issue

of equity rather than debt.

-- Lesson 2: Trust Market Prices

reason: In an efficient market, prices impound all available information about the value of each

security.

implication: There is no way for most investors to achieve consistently superior rates of return.

firms exchange-rate policy or its purchases and sales of debt:

The financial managers should not operate on the basis that they are smarter than others at

predicting currency changes or interest-rate moves. [Otherwise, they will trade a consistent

financial policy for an elusive will-o-the-wisp.]

example: Orange Countys losses in 1994

The county treasurer had raised large short-term loans (reverse repo) which he then used

to invest in long-term bonds (reverse floaters) and bet on a fall in interest rates.

However, interest rates subsequently rose and the county had lost $1.7 billion.

-- Lesson 3: Read the Entrails

Prices impound all available information.

If you can learn to read the entrails, security prices can tell us a lot about the future.

two examples:

1) The markets assessment of a firms bonds (besides the information in its financial statements)

can provide important information about estimating the probability of bankruptcy.

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2) Differences between the long-term interest rate and the short-term rate tell you something

about what investors expect to happen to future short-term rates.

illustration: current long-term rate higher than the short-term rate future short-term rates rising

Suppose that investors are confident that interest rates are set to rise over the next year (i.e.,

future short-term rates will rise).

They will prefer to wait before they make long-term loans, and any firm that wants to borrow

long-term money today will have to offer the inducement of a higher rate of interest. In other

words, the long-term rate of interest will have to be higher than the one-year rate.

real example: the merge of HP and Compaq

On Sept. 3, 2001, the two firms announced the proposal to merge because of significant cost

structure improvements and access to new growth opportunities. [Note that these two types of

gains are the usual synergies related to a merger.]

Over the following two days, HP shares underperformed the market by 21% and Compaq

shares underperformed by 16%. [Figure 13-8] On Nov. 6, the Hewlett family announced

that it would vote against the proposal. Investors took heart that the next day HP shares gained

16%.

Note that the merger eventually proves to be successful later in 2003. [The reason could be that

management did have important information that investors lacked.] But the point is that the

price reaction of the two stocks provided a potentially valuable summary of investor opinion

about the effect of the merger on firm value.

--Lesson 4: There Are No Financial Illusions

no financial illusions:

In an efficient market, investors are unromantically concerned with the firms cash flows and

the portion of these cash flows to which they are entitled.

example: stock dividends and splits

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Subdividing the existing shares or distributing more shares as dividends increases the number

of shares outstanding but does not affect the firms future cash flows or the proportion of these

cash flows attributable to each shareholder.

a classic study of stock splits by Fama et. al. (1969):

Figure 13-9: Price rises around the time of the split announcement (before the split takes

place).

implication: The decision to split is both the consequence of a rise in price and the cause of a

further rise.

Shareholders are not as hard-headed as we make out. They care about the formas well as the substance.

explanation: The study also found that during the subsequent year, two-thirds of the splitting

firms announced above-average increases in cash dividends.

There was no unusual rise in the stock price at any time after the split.

The split was accompanied by an explicit or implicit promise of a dividend increaseand the rise in price at the time of the split had nothing to do with a taste for splits

but with the information that it was thought to convey.

a note: The above-average increases in cash dividends imply that the splitting firms appears to

be unusually successful in other ways.

Asquith et. al. (1989) found that stock splits are frequently preceded by sharp increases in

earnings. Such earnings increases are very often transitory. However, the stock split

appears to provide investors with an assurance that in this case the rise in earnings is

indeed permanent.

-- Lesson 5: The Do-It-Yourself Alternative

the alternative: In an efficient market, investors will not pay others for what they can do

equally well themselves.

implication: Many of the controversies in corporate financing center on how well individuals

can replicate corporate financial decisions.

think: 1) Mergers produce a more diversified and hence more stable firm?

2) Creating (or increasing) financial leverage will make stockholders better off?

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-- Lesson 6: Seen One Stock, Seen Them All

perfect substitutes: Investors dont buy a stock for its unique qualities. They buy it because it

offers the prospect of a fair return for its risk. Stocks should be like very similar bands of coffee, almost perfect substitutes. The demand for a firms stock should be highly elastic. [If its expected return

is low relative to its risk, nobody will want to hold that stock. If the reverse is

true, everybody will scramble to buy.]

implications of elastic demand:

a) You can sell large blocks of stock at close to the market price as long as you can convince

other investors that you have no bad private information.

evidence:

1) In June 1977, the Bank of England offered its holding of BP shares for sale at 845 pence.

The bank owned nearly 67 million shares of BP. The total value was about US$970

million.

Just before the Banks announcement, the price of BP stock was 912 pence. Over the next

two-week application period, the price drifted down to 898 pence. [Price almost didnt

change.] Thus, by the final application date, the discount being offered was only 6%. But

the discount brings in applications for US$4.5 billion worth of stock, 4.7 times the amount

on offer. [The demand is indeed highly elastic.]

2) The study on secondary offerings by Scholes (1972) shows that the effect of the offerings

was a slight reduction in the stock price. But the decline was almost independent of the

amount offered. Estimate of the demand elasticity for a firms stock was -3,000.

3) Asquith and Mullins (1986) found that new stock issues by utilities drove down their

stock prices on average by only 0.9%.

a question: Since demand is very elastic, you need only to cut the offering price very slightly

to get rid of your large blocks of stock?

b) The amount of We may indeed hope, but all we can

rationally expect in an efficient market isthat we shall obtain a return that is just

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sufficient to compensate for the time

value of money and for the risks we

bear

Source: Brealey & Myestock for sale at the moment is not in itself relevant information.

13 corporate financing

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