12-1
Fundamentals
of Corporate
Finance
Second Canadian Edition
prepared by:
Carol Edwards
BA, MBA, CFA
Instructor, Finance
British Columbia Institute of Technology
copyright © 2003 McGraw Hill Ryerson Limited
12-2
Chapter 12
Corporate Financing and the Lessons
of Market Efficiency
Chapter Outline
Differences Between Investment and
Financing Decisions
 What is an Efficient Market?
 Lessons of Market Efficiency

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12-3
Investment vs Financing
• Differences
Between Investment and
Financing Decisions


Smart investment decisions make
shareholders wealthier.
Likewise, smart investment decisions also
make shareholders wealthier.
 For
example, if a firm can sell a security for more
than it is worth, this is a great deal for the
shareholders.
 But it is a lousy deal for the buyers!
copyright © 2003 McGraw Hill Ryerson Limited
12-4
Investment vs Financing
• Differences
Between Investment and
Financing Decisions

Companies regularly find projects with positive
NPV’s.
 There
are many opportunities for smart managers to
capitalize on their firm’s expertise, technology or its
competitive advantages.

However, it is not so easy to find positive NPV
investment decisions.
 To
do so, you would have to consistently trick
investors into overpaying for your firm’s securities.
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12-5
Investment vs Financing
• Differences
Between Investment and
Financing Decisions

However, it would be difficult to consistently
“trick” investors because investment markets are
intensely competitive.
This means it is hard to make, or lose, money using
financing strategies.
 It is rare to make money by finding cheap financing
because investors who supply financing demand fair
terms.
 Conversely, it is rare to lose money on an issue
because competition among investors prevents them
from demanding more than fair terms.

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12-6
Investment vs Financing
• Differences
Between Investment
and Financing Decisions
As a general rule, you should assume
that any securities your firm issues will be
sold for their true value.
 True value means a price which
incorporates all the information which is
currently available to investors.

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12-7
What is an Efficient Market?
• Market

Efficiency
In efficient capital markets security prices
rapidly reflect all relevant information about
asset values.
 Thus,
all securities are fairly priced in light of the
information which is available to investors.


If securities are fairly priced, then selling
securities at prevailing market terms is never
a positive NPV transaction.
Likewise, when buying securities, it is
impossible to consistently earn excess profits.
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12-8
What is an Efficient Market?
• Random
Walk
Studies of the market have shown that
market prices follow a random walk.
 A random walk means that security
prices change randomly without
predictable trends or patterns.

 That
is, stock prices seem to wander
randomly, just as likely to go up as down,
on any particular day, regardless of what
has occurred on previous days.
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12-9
What is an Efficient Market?
• Random
Walk
Many studies of the market have shown that
studying past price information provides
little information about future price changes.
 Want proof?

 Look
at figure 12.1 on page 362 of your text.
Can you tell which chart is for the stock
market and which is the result of
a random coin toss game?
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12-10
What is an Efficient Market?
• Random

Walk
Does the fact that stock prices follow
a random walk mean that they are
just “plucked out of a hat”?
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12-11
What is an Efficient Market?
• Random


Walk
No, that is not the correct conclusion!
What the Random Walk Theory means is this:
 If
the stock of ABC jumps up today, you cannot
assume that it will do the same thing tomorrow.
 However, ABC’s price change didn’t just pop out
of nowhere!
 There must have been a good reason for the
change in price …

Did they report increased earnings? Or, a new
product line which investors expect will boost
profits? Or, …
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12-12
What is an Efficient Market?
• Technical

Analysis
Technical analysts are investors
who attempt to identify over- or
undervalued stocks by searching for
patterns in past prices.
However,
if stock prices follow a
random walk then technical trading
rules are useless.
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12-13
What is an Efficient Market?
• Technical Analysis

Technical analysis may not work, but
technical analysts can help keep the
markets efficient!
 Look
at figure 12.2 on page 363.
 Let’s say that technical analysts spot the
upward trend in this stock’s price.
 Based on the trend, they forecast that the
stock’s price will go to $60 per share.
Can you see what happens as soon as
they come to this conclusion?
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12-14
What is an Efficient Market?
• Technical Analysis
 The analysts instantaneously bid up the
price of the stock to the present value of its
expected future price.
 Result:
 As soon as a price trend becomes apparent
to technical analysts, they immediately
eliminate it by their trading.
 Thus any pricing cycles self-destruct as
soon as they are recognized by investors.
 This means no one can consistently forecast
the future from past price activity.
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12-15
What is an Efficient Market?
• Efficient Market Theory
 You can’t make superior profits by studying
past stock prices.
 Any information in those stock prices is
already reflected in the stock’s current price.
Any market where this theory holds true
is called weak-form efficient.
 Weak-form efficiency means that market
prices rapidly reflect all information
contained in the history of past prices.

copyright © 2003 McGraw Hill Ryerson Limited
12-16
What is an Efficient Market?
• Efficient Market Theory
 So you can’t make superior profits by studying
past stock prices …
 But what about other publicly available
information?
 Investors
don’t just look at stock prices to make
their decisions.

They also look at a firm’s business prospects, the state
of the economy, what the central bank is doing with
interest rates, etc.
Could you make more than a fair rate of return
by basing your investment decisions
on this type of information?
copyright © 2003 McGraw Hill Ryerson Limited
12-17
What is an Efficient Market?
• Efficient Market Theory
 Fundamental analysts are investors who
attempt to find over- and undervalued
securities by analyzing fundamental
information, such as earnings, asset
values, and business prospects.
 Can fundamental analysts “beat the
market” and deliver excess returns to
investors?
What do you think?
copyright © 2003 McGraw Hill Ryerson Limited
12-18
What is an Efficient Market?
• Efficient Market Theory
 Researchers have looked at various
types of fundamental information –
earnings and dividend announcements,
plans to issue securities or to merge, and
other types of macroeconomic news.
 Their conclusions?
 Market
prices already reflect all publicly
available information.
 Thus it is impossible to make superior returns
by studying such information.
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12-19
What is an Efficient Market?
• Efficient Market Theory
 Semi-Strong form efficient markets are
markets where prices reflect all publicly
available information.
 Strong-form efficient markets rapidly
reflect all information that is potentially
available to determine true value.
 In
such a market all prices would be fair and
no investor would be able to make
consistently superior forecasts of stock
prices.
copyright © 2003 McGraw Hill Ryerson Limited
12-20
What is an Efficient Market?
• Efficient Market Theory
 If markets are strong-form efficient, then it
is impossible to beat the market’s
performance by studying any kind of
information.
 Your
best solution as an investor would be to
hold a diversified portfolio of securities known
as an index.
copyright © 2003 McGraw Hill Ryerson Limited
12-21
What is an Efficient Market?
• Efficient

Market Theory
More and more investment managers
have come to believe in the market’s
efficiency.
 They
have given up the pursuit of superior
performance.
 Instead, they simply “buy the index”, which
provides them with diversification, and a fair
rate of return, while minimizing the cost of
managing the portfolio.
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12-22
What is an Efficient Market?
• Efficient

Market Theory
Indexing makes sense if no investor can
consistently get useful information ahead
of the “rest of the pack”.
 When
information does arrive, investors
trade on it immediately, and stock prices
respond almost instantaneously.

This insures that it is very difficult, even
for a professional money manager, to
consistently outperform the market.
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12-23
What is an Efficient Market?
• Efficient

Market Theory
There are 3 forms of the efficient-market
theory:
 Weak

form (the random walk theory)
Market prices reflect all information contained
in past market prices.
 Semi-strong

Market prices reflect all publicly available
information.
 Strong

form
form
Market prices reflect all known information.
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12-24
What is an Efficient Market?
• No

Theory is Perfect
Though there is a great deal of evidence
to support the efficient market theory, it
would be wrong to pretend that there are
no puzzles or apparent exceptions.
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12-25
What is an Efficient Market?
• No

Theory is Perfect
Insider trading is one exception.
 Company
managers have consistently made
superior profits when they deal in their own
company’s stock.
 This violates the strong form of the efficient
market theory, because it implies that
managers know more about their company’s
prospects than the market does.
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12-26
What is an Efficient Market?
• No

Theory is Perfect
It is not surprising that insiders would
make superior profits, but there are other
anomalies:
Small Cap Effect – investors in smaller
companies have outperformed investors in
larger firms.
 Book vs Market – stocks with high ratios of
book value of equity to market value have
outperformed stocks with low ratios of book
to market.
 The
copyright © 2003 McGraw Hill Ryerson Limited
12-27
What is an Efficient Market?
• No

Theory is Perfect
Despite these anomalies, there is
widespread agreement that capital
markets function well.
 So
when economists come across an
exception to the efficient market theory, such
as the small cap effect, they do not throw out
the theory.
 Instead, they ask themselves what is not
allowed for in the theory or their tests of the
theory.
copyright © 2003 McGraw Hill Ryerson Limited
12-28
Lessons of Market Efficiency
• Markets

Have No Memory
Past prices contain no information about
future price changes.
 You
as a financial manager may be
reluctant to sell your firm’s securities after a
fall in price.
 However, it is not possible to consistently
time the market.
 So such logic does not make sense in
efficient markets!
copyright © 2003 McGraw Hill Ryerson Limited
12-29
Lessons of Market Efficiency
• Markets

Have No Memory
However, sometimes, as a manager, you may
have access to inside information the market
does not know.
 Perhaps
it is some good news which will cause the
price of the stock to rise when it is revealed.
 Therefore, if the company sells its shares at the
current price, instead of waiting until the good news
gets out, it will be offering its securities at a bargain
basement price.
copyright © 2003 McGraw Hill Ryerson Limited
12-30
Lessons of Market Efficiency
• Markets


Have No Memory
Naturally it makes sense for you as a manager
to be reluctant to sell shares when you have
favourable inside information.
However, such information has nothing to do
with the history of the stock price!
copyright © 2003 McGraw Hill Ryerson Limited
12-31
Lessons of Market Efficiency
• There Are


No Financial Illusions
In efficient markets, investors are
unromantically concerned only with a firm’s
cash flows and the portion of those cash flows
which they are entitled to.
Studies have shown that it is not possible to
increase market value through creative
accounting.
 Investors
are not easily fooled by companies
which change their accounting methods to boost
their earnings.
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12-32
Lessons of Market Efficiency
• There Are
No Free Lunches on Wall
Street or Bay Street

In efficient markets, you can trust market
prices.
 You
should be suspicious of any “simple” rule
which explains why one type of security is cheap
and another is expensive.
There is probably a good reason for the
difference in price.
 The trick is to figure out the real explanation.

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12-33
Summary of Chapter 12
Competition among investors leads to
efficient markets.
 Efficient markets are markets in which prices
rapidly reflect new information and investors
find it difficult to consistently make “superior”
returns.
 In efficient markets, you can hope to beat the
market, but in reality all you can expect is a
return which will fairly compensate you for
the time value of money and for the risk you
bear.

copyright © 2003 McGraw Hill Ryerson Limited
12-34
Summary of Chapter 12

The efficient market theory comes in 3 flavours:
– you cannot earn superior returns by
looking for trends in historic price data. Price changes
follow a random walk and have no predictive power.
 Semi-Strong form – you cannot earn superior returns
by doing fundamental analysis.
 Strong form – you cannot earn superior returns using
any type of information. The best you can do is to
assume that all securities are fairly priced.
 Weak-form
There is considerable evidence which supports
the efficient market theory.
 There is also some contradictory evidence.

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12-35
Summary of Chapter 12

There are several implications of the efficient
market theory:
 Sophisticated
investors understand that it is not easy
to earn superior returns in the market.

They know that capital markets are highly competitive.
 Smart
financial managers assume that capital
markets are generally efficient.
 They know that:
Investors will not provide their firm with cheap financing.
 Because security prices are fairly set, it is easier to add
value by smart investment decisions than by smart
financing decisions.

copyright © 2003 McGraw Hill Ryerson Limited