Download - Corporate Financing and Market Efficiency
FIN 351-lecture 8
Corporate Financing and Market Efficiency
Where to get money for good projects
Today’s 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
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?
What have we learned in the last lecture (1)?
WACC without tax
WACC with tax
de rVD
rVE
WACC
EDVwhere
eVE
dVD r +Tc)r-(1 =WACC
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
tddd r
principalcpn
r
cpnr
cpn
111
P2bond
)( fmdfd rRrr
What have we learned in the last lecture (2)?
The cost of equity is calculated by using • CAPM
• Dividend growth model
)r-(R+r=r fmfe i
gP
DIVr
gr
DIVP e
e
0
110
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.
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 firm’s 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 firm’s balance sheet:• Debt (12 years maturity, 8% coupon): $200 million
• Common stocks:$110 million If the tax rate is 35%, should John suggest to his boss to take
the project or not?
Solution
%91.8)1(
68.18509.1
200)
09.1*09.0
1
09.0
1(*16
45365.22*20
%16.10%6.5*1.1%4
%9
1212
ed
e
d
rED
Ert
ED
DWACC
D
E
r
r
Investment vs. Financing
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
Asset Liabilities and equity
VDebt: D
Equity: E
Market Efficiency
Market efficiency is concerned about whether capital markets have all information about the cash flows and risk of projects.
Financing and market Efficiency
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)
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.
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.
A Random Walk example
$103.00
$100.00
$106.09
$100.43
$97.50
$100.43
$95.06
Coin Toss Game
Heads
HeadsHeads
Tails
Tails
Tails
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
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.
Efficient Market Theory
Last Month
This Month
Next Month
$90
70
50
EI’s Stock Price
Cycles disappear
once identified
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.
Efficient Market Theory
-16
-11
-6
-14
9
14
19
24
2934
39
Days Relative to annoncement date
Cu
mu
lati
ve A
bn
orm
al R
etu
rn
(%)
Announcement Date
Market Efficiency
0
5
10
15
20
25
Av
era
ge
re
turn
, pe
rce
nt
Highest
Book-Market Ratio
Fama & FrenchReturn vs. Book-Market
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
Efficient Market Theory
-16
-11
-6
-14
9
14
19
24
2934
39
Days Relative to annoncement date
Cu
mu
lati
ve A
bn
orm
al R
etu
rn
(%)
Announcement Date
Some exercises
1. If stock markets are efficient, what should the correlation between stock returns for two non-overlapping periods?
2. Which is the most likely to contradict the weak-form of efficiency
a. Over 25% of mutual funds outperform the market on average
b. Insiders can make abnormal profits
c. Every January, the stock market earns abnormal return
Several types of securities
Three types of securities• Common Stock
• Preferred stock
• Corporate debt
Common Stock
Common stocks have the following forms:• Treasury stock
• Issued shares
• Outstanding shares
• Authorized share capital
• Par value
Ownership of the corporation
Corporate debt
Corporate bonds• Primary rate
• Funded debt
• Sink fund
• Callable bond
• Subordinate debt
• Secure debt
Preferred stock
Preferred stock and common stock• Priority and voting rights
Preferred stock and bond• Obligation and bankruptcy