Corporate Financing and
Market Efficiency
Where to get money for
good projects
Financial management: lecture 10
Today’s plan





Review WACC
Investment Decision vs. Financing Decision
Equity and debt financing
Does the stock price follow a random walk?
Three forms of Market Efficiency
•
•
•
Weak form efficiency
Semi-strong form efficiency
Strong form efficiency
Financial management: lecture 10
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?
Financial management: lecture 10
What have we learned in the
last lecture (1)?

WACC without tax
WACC 
E
D
re  rd
V
V
where V  D  E

WACC with tax
D (1 - Tc)r + E r
WACC = V
d V e
Financial management: lecture 10
What have we learned in the
last lecture (2)?

The cost of bond
• It is the YTM, the expected return required
•
the investors.
That is
Pbond 
cpn
cpn
cpn  principal


1  rd 1  rd 2
1  rd t
• The expected return on a bond can also be
calculated by using CAPM
rd  r f   d ( Rm  r f )
Financial management: lecture 10
by
What have we learned in the
last lecture (2)?

The cost of equity is calculated by using
• CAPM
re = rf + e (R m - rf )
• Dividend growth model
DIV1
DIV1
P0 
 re 
g
re  g
P0
Financial management: lecture 10
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.
Financial management: lecture 10
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:$110 million
If the tax rate is 35%, should John suggest to his boss to take
the project or not?
Financial management: lecture 10
Solution
rd  9%
re  4%  1.1* 5.6%  10.16%
E  20 * 22.65  453
1
1
200
D  16 * (

)

 185.68
12
12
0.09 0.09 *1.09
1.09
D
E
WACC 
(1  t )rd 
re  8.91%
DE
DE
NPV  30  4.5 / WACC  30  4.5 / 0.0891  20.51
Financial management: lecture 10
Investment vs. Financing
Asset
V
Liabilities and equity
Debt: D
Equity: E


Investment decisions or capital budgeting is
about how to take projects to maximize V.
Financing decisions are about how to raise
capital (E or D) to finance the projects that
are to be taken
Financial management: lecture 10
Types of Securities

Equity

Debt
• Common stock
• Preferred stock
• Commercial paper
• Debentures
• Guaranteed notes
• Remarketable debt
• Euro notes
• Sterling notes
• New Zealand dollar notes
• Bank loans
Common Stock
Treasury Stock
Stock that has been repurchased by the company
and held in its treasury
Issued Shares
Shares that have been issued by the company.
Outstanding Shares
Shares that have been issued by the company and
held by investors.
Authorized
Common
Stock Share Capital
Maximum number of shares that the company
is permitted to issue, as specified in the firm’s
articles of incorporation.
Par Value
Retained Earnings
Value of security
shown on certificate.
Earnings not paid out
as dividends.
Addiotional Paid Up Capital
Difference between issue price and par
Common Stock


Book Value vs. Market Value
Book value is a backward looking
measure. It tells us how much capital
the firm has raised from shareholders in
the past. It does not measure the value
that shareholders place on those shares
today. The market value of the firm is
forward looking, it depends on the future
dividends that shareholders expect to
receive.
Common Stock
Example - H.J. Heinz Book Value vs. Market Value (5/2007)
Total Shares outstanding = 322 million
Common Shares ($.25 par)
108
Additional paid in capital
Retained earnings
Treasury shares at cost
581
5,779
- 4,406
Other
Net common equity (Book Value)
- 219
1,843
Common Stock
Example - H.J. Heinz Book Value vs. Market Value
(5/2007)
Total Shares outstanding = 322 million
May 2007 Market price =
$46/sh
# of shares
x 322
Market Value $14.812 billion
Common Stock
Corporate Equity Holdings
Banks & Savings
0.3%
Other
1.4%
Households
27.1%
Rest of World
Insurance
12.6%
Companies
8.0%
Mutual Funds
28.3%
Pension Funds
22.3%
Preferred Stock
Preferred Stock - Stock that takes
priority over common stock in
regards to dividends.
Net Worth - Book value of common
shareholder’s equity plus
preferred stock.
Floating-Rate Preferred Preferred stock paying dividends
that vary with short term interest
rates.
Corporate Debt



Debt has the unique feature of allowing the
borrowers to walk away from their obligation to pay,
in exchange for the assets of the company.
“Default Risk” is the term used to describe the
likelihood that a firm will walk away from its
obligation, either voluntarily or involuntarily.
“Bond Ratings”are issued on debt instruments to
help investors assess the default risk of a firm.
Corporate Debt
Prime Rate - Benchmark interest rate charged
by banks.
Funded Debt - Debt with more than 1 year
remaining to maturity.
Sinking Fund - Fund established to retire debt
before maturity.
Callable Bond - Bond that may be
repurchased by firm before maturity at
specified call price.
Corporate Debt
Subordinate Debt - Debt that may be repaid in
bankruptcy only after senior debt is repaid.
Secured Debt - Debt that has first claim on
specified collateral in the event of default.
Investment Grade - Bonds rated Baa or above
by Moody’s or BBB or above by S&P.
Junk Bond - Bond with a rating below Baa or
BBB.
Corporate Debt
Eurodollars - Dollars held on deposit in a bank outside
the United States.
Eurobond - Bond that is marketed internationally.
Private Placement - Sale of securities to a limited
number of investors without a public offering.
Protective Covenants - Restriction on a firm to protect
bondholders.
Lease - Long-term rental agreement.
Convertible Securities
Warrant - Right to buy shares from a company
at a stipulated price before a set date.
Convertible Bond - Bond that the holder may
exchange for a specified amount of another
security.
Convertibles are a combined security,
consisting of both a bond and a call
option.
Patterns of Corporate Financing


Firms may raise funds from external
sources or plowback profits rather than
distribute them to shareholders.
Should a firm elect external financing,
they may choose between debt or equity
sources.
Patterns of Corporate Financing
150
New Debt
New Equity
Internal Funds
100
50
0
-50
Year
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
-100
1995
Percent of total sources
200
1950
1952
1954
1956
1958
1960
1962
1964
1966
1968
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
Debt Ratio, %
Patterns
Corporate
Financing
Debt to (Debt of
+ Equity)
Ratio for Non-Financial
Firms
60
50
40
30
Market debt ratio
Book debt ratio
20
10
0
Market Efficiency
Market Efficiency
Market efficiency is concerned about
whether or nor capital markets have all
relevant information about the cash
flows and risk of projects to price
securities accordingly.
Financial management: lecture 10
Efficient capital markets
Efficient Capital Markets – If capital markets are
efficient, then security prices reflect all relevant
information about asset values.
Financial management: lecture 10
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.
Financial management: lecture 10
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.
Financial management: lecture 10
A Random Walk example
Heads
Heads
$102.09
$101.00
Tails
$97.43
$100.00
Heads
Tails
$100.43
$97.50
Tails
Coin Toss Game
Financial management: lecture 10
$95.06
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
Financial management: lecture 10
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.
Financial management: lecture 10
Efficient Market Theory
$90
EI’s Stock
Price
70
50
Cycles
disappear
once
identified
Last
Month
Financial management: lecture 10
This
Month
Next
Month
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.
Financial management: lecture 10
Cumulative Abnormal Return
(%)
Efficient Market Theory
39
34
29
24
19
14
9
4
-1
-6
-11
-16
Announcement Date
Days Relative to annoncement date
Financial management: lecture 10
Market Efficiency
Fama & French
Return vs. Book-Market
Average return, percent
25
20
15
10
5
0
Highest
Financial management: lecture 10
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
Financial management: lecture 10
Cumulative Abnormal Return
(%)
Efficient Market Theory
Announcement Date
39
34
29
24
19
14
9
4
-1
-6
-11
-16
Days Relative to annoncement date
Financial management: lecture 10
Some exercises
1.
2.
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
a. Over 25% of mutual funds outperform the market on
b.
c.
average
Insiders can make abnormal profits
Every January, the stock market earns abnormal
return
Financial management: lecture 10