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B40.2302 Class #10
 BM6 chapters 13, 18.4
13: Financing decisions and market efficiency
 18.4, non-BM6 material: The effect of
asymmetric information
 non-BM6 material: The effect of market
inefficiency

 Based on slides created by Matthew Will
 Modified 11/14/2001 by Jeffrey Wurgler
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
Principles of Corporate Finance
Brealey and Myers

Sixth Edition
Corporate Financing and the Six
Lessons of Market Efficiency
Slides by
Matthew Will,
Jeffrey Wurgler
Irwin/McGraw Hill
Chapter 13
©The McGraw-Hill Companies, Inc., 2000
14- 3
Topics Covered
 We Always Come Back to NPV
 What is an Efficient Market?
3 forms
 Some supporting evidence

 Efficient Market Theory
Irwin/McGraw Hill
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14- 4
Return to NPV
 A basic similarity between investment and
financing decisions: Can think about both in
NPV terms

The decision to purchase a factory (investment
decision), or sell a bond (financing decision), each
involve valuation of a risky asset

Each decision could in principle add value
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Return to NPV
Example: the value of a below-market-rate loan
As part of a policy of encouraging small business,
the government is lending you $100,000 for 10 years
at 3%. What is the value of this below-market-rate
loan?
NPV(loan)  amount borrowed - PV of interest
- PV of principal
Irwin/McGraw Hill
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Return to NPV
Example: the value of a below-market-rate loan
As part of a policy of encouraging small business, the government is
lending you $100,000 for 10 years at 3%. What is the value of this
below-market-rate loan? Assume the market return on equivalent-risk
projects is 10%.
 10 3,000  100,000
NPV(loan)  100,000  

t
10
(
1
.
10
)
(
1
.
10
)
 t 1

 100,000  56,988
 $43,012
The firm adds over $43,000 in value by
accepting the below-market-rate loan. (Thank you Uncle Sam.)
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Return to NPV
Some differences between investment and financing decisions
 Number of financing decisions is expanding faster
 Financing decisions usually easier to reverse
 Probably easier to add value through investment decisions



In investment decisions, firm is competing for NPV>0 investments with
other industry competitors
In financing decisions, firm is competing for NPV>0 financing
opportunities with all firms, governments, investors around the world
All of this competition may lead to “efficient markets” in which
NPV(financing) = 0 (ignoring tax shields, other financing costs/benefits).
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Return to NPV
How does market efficiency affect financing?
 Think of value of firm as an APV calculation:
PV(firm) = PV(investments base-case) + NPV(financing)
 Under M&M assumption of efficient markets…
NPV(financing) = 0
(no “below-market-rate” loans/overpriced stock issues available)
(and assuming no tax shields, issue costs, etc. as before)
 … which leads to M&M conclusion:
PV(firm) = PV (investments base-case)
while “financing is irrelevant” because it’s NPV=0
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
14- 9
Return to NPV
How does market efficiency affect financing?
 But in inefficient markets, maybe NPV(financing) >0
Financing may be “relevant” if firm can find ways to finance at
“below-market” costs, i.e. ways to finance below its rational cost of
capital
 So market efficiency is central to M&M conclusion
 Are markets efficient or not?




A controversial issue in finance
Evidence that markets are approximately efficient
However, can find exceptions if one looks carefully at the data
These may be important enough to affect financing decisions
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Market Efficiency: 3 versions
 Weak Form Efficiency
Market prices reflect past price information.
 Prices move as a “random walk”

 Semi-Strong Form Efficiency

Market prices reflect all publicly available
information, not just past prices
 Strong Form Efficiency

Market prices reflect all information, both public
and private.
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Weak Form Efficiency
 Early discovery: The day-to-day changes in
stock prices (or bond prices) DO NOT reflect
any strong pattern
 Instead, prices seem to take a “random walk”
up and down
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Weak Form Efficiency
In the coin toss game, winnings
are a random walk
Heads
Heads
$106.09
$103.00
Tails
$100.43
$100.00
Heads
Tails
$97.50
Tails
Irwin/McGraw Hill
$100.43
$95.06
©The McGraw-Hill Companies, Inc., 2000
14- 13
Weak Form Efficiency
5 yrs of S&P 500?
or
5 yrs of the coin toss game (with drift)?
Level
180
130
80
Month
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Weak Form Efficiency
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Weak Form Efficiency
 Technical Analysis
Idea is to forecast stock prices based on
fluctuations in past prices
 T.A. doesn’t pay if markets are weak form
efficient

Irwin/McGraw Hill
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Weak Form Efficiency
$90
Microsoft
Stock Price
70
The idea:
50
Cycles selfdestruct once
identified
Last
Month
Irwin/McGraw Hill
This
Month
Next
Month
©The McGraw-Hill Companies, Inc., 2000
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Semi-Strong Form Efficiency
Cumulative Abnormal Return
(%)
Average “abnormal returns” (returns relative to CAPM benchmark) around the
announcement that firm X is a takeover target
 pattern is consistent with semi-strong efficiency: once news is out, no abnormal returns
Irwin/McGraw Hill
39
34
29
24
19
14
9
4
-1
-6
-11
-16
Announcement Date
Days Relative to annoncement date
©The McGraw-Hill Companies, Inc., 2000
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Semi-Strong Form Efficiency
Another situation consistent with semi-strong efficiency:
How stock splits affect value
35
30
Cumulative
abnormal
return %
25
20
15
10
5
0-29
0
30
Month relative to split
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
14- 19
Semi-Strong Form Efficiency
 Fundamental Analysis
Idea is to find undervalued stocks from analysis
of the “fundamental value” of cash flows
 F.A. doesn’t pay if markets are semi-strong
efficient

Irwin/McGraw Hill
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Semi-Strong Form Efficiency
Average Annual Return on 1,493 Mutual Funds and the
Market Index, 1962-1992.
40
30
Return (%)
20
10
0
-10
Funds
Market
-20
-30
Irwin/McGraw Hill
19
92
19
77
19
62
-40
©The McGraw-Hill Companies, Inc., 2000
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Strong Form Efficiency
• Strong form efficiency says that market prices properly reflect
all public and private information
• This is an extreme version of efficiency, nobody believes it
• Proof that markets do not reflect all private information:
-- illegal insider trading is profitable
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Theory of efficient markets
When should market efficiency hold?

Case 1. All investors are rational
• Rational investors value securities for the present value of
their future cash flows.
• So if P =/= PV(cash flows), they will buy or sell until it
does.

Case 2. Some investors are irrational, but their
misperceptions are uncorrelated
• Optimistic and pessimistic investors will “cancel out”
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Theory of efficient markets
When should market efficiency hold?

Case 3. Many investors may be irrational, but the rational
investors offset their effect with arbitrage trades
• The most general, most powerful argument
• Arbitrage: “the simultaneous purchase and sale of the same, or
essentially similar, security in two different markets at advantageously
different prices”
• For example: If McDonald’s is overpriced, arbitrageurs can short-sell
McDonald’s, buy Burger King to hedge their risk, and hold on for a
low-risk (hopefully riskless) profit
• This forces McDonald’s price back down to the efficient value
• Argument is less compelling when there are costs/risks to this sort of
arbitrage
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
Principles of Corporate Finance
Brealey and Myers

Sixth Edition
How Much Should a Firm Borrow?
Slides by
Matthew Will,
Jeffrey Wurgler
Irwin/McGraw Hill
Chapter 18.4
©The McGraw-Hill Companies, Inc., 2000
14- 25
Topics Covered
 Pecking Order Theory
Theory of financing decisions
 Theory of capital structure

Irwin/McGraw Hill
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Pecking Order Theory
Pecking Order Theory of Incremental Financing
Decisions - Theory that uses asymmetric
information to argue that firms prefer to fund their
investments using internal finance, then (if internal
finance is insufficient) by debt issues, then (as a last
resort) by equity issues.
Pecking Order Theory of Capital Structure –
Theory in which capital structure evolves as the
cumulative outcome of past incremental financing
decisions, each of which is taken using the above
rule.
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Pecking Order Theory
Where does the POT of financing decisions come from?
 Starting point is that managers know more than investors about
firm value -- and that investors recognize their disadvantage


I.e., there is “asymmetric information”
I.e., the market is semi-strong form efficient but not strong-form
efficient
 This seems reasonable …



E.g., when a company announces a dividend increase, price goes up
This is because investors interpret the increase as a sign of managers’
confidence in future earnings
So the dividend increase carries information only if managers do indeed
know more in the first place
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Pecking Order Theory
How does asymmetric information affect the choice between
debt and equity?
-
Imagine two companies, O and U.
To investors, they appear identical.
But O’s managers know that O’s stock is Overpriced …
And U’s managers know that U’s stock is Underpriced …
Both O and U have an investment project and need to raise $.
Should they issue equity or debt?
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Pecking Order Theory
Managers of O are thinking:
Our products were popular for a while, but the fad is fading. It is all
downhill from here. How are we going to compete with the new entrants?
Fortunately our stock price has held up – we’ve had some good short-run
news for the press and security analysts. Now’s the time to issue stock.
Managers of U are thinking:
Sell stock at our current low price? Ridiculous! It’s worth at least twice
as much. A stock issue now would hand a free gift to the new investors –
the old investors would be selling a big piece of the pie for a small price.
I just wish those stupid, skeptical investors would appreciate the true
value of this company. Oh well, the decision is obvious: we’ll issue debt,
not underpriced equity.
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Pecking Order Theory
 So O wants to issue stock, but U wants to issue debt.
 Investors (in the pecking order theory) are not stupid – they
understand these motives


They view stock issues as a sign of overvaluation
They view debt issues as a sign of undervalution
 So O’s stock price will drop if it announces a stock issue,
presumably eliminating the overvaluation (semi-strong efficient)

In practice, stock prices do fall upon announcement of a new stock issue
 Thinking this through, even O will prefer debt over stock issues.
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14- 31
Pecking Order Theory
 Thus, asymmetric information favors debt over equity issues


Debt is higher on the “pecking order” than equity
In practice, debt issues are more common than equity issues,
consistent with the P.O. prediction
 Internal finance is even better



It is highest on the pecking order
Investing with internal finance sends no signal about the firm’s true
value; it avoids issue costs and information problems completely
May therefore be worth accumulating internal finance
 Thus, ‘pecking order of incremental financing choices’


A theory of day-to-day financing decisions
‘Internal finance preferred to debt issues preferred to equity issues’
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Pecking Order Theory
 ‘Pecking order theory of capital structure’



Says that ‘capital structure is just the cumulative outcome of past,
pecking-order-driven financing decisions’
No “grand plan” or “optimal” debt-equity ratio
Each firm’s debt-equity ratio just reflects its cumulative requirements
for external finance
 Fits empirical fact: Profitable firms have lower D/E ratios


P.O. theory is consistent with this fact: more profits  more
internal finance available  don’t need outside money. (Whereas less
profitable firms issue and accumulate debt because they don’t have
internal funds)
Tradeoff theory predicts the opposite: more profits  more value
to tax shields  should have more debt
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000

Market Inefficiency and
Corporate Finance
Slides by
Jeffrey Wurgler
Not in book
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Topics Covered
 Evidence of market inefficiency?
 Market timing theory
Theory of financing decisions
 Theory of capital structure

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14- 35
Evidence of market inefficiency?
 Our theoretical arguments for market efficiency are strong,
but have some holes
 In practice, “arbitrage” is usually costly and/or risky





It is costly to short-sell overpriced stocks
Individual stocks don’t have perfect substitutes; e.g., the “short
McDonalds, hedge with long Burger King” trade has risk
Real “arbitrageurs” may be capital-constrained: they can’t pursue all
the good opportunities (NPV>0 trades) that they perceive
And so forth …
Bottom line is that theoretical argument for market efficiency is
strong, but not overwhelming: There is some evidence of inefficiency
when one looks carefully at the data
Irwin/McGraw Hill
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14- 36
Evidence of market inefficiency?
 Calendar effects

[refer to appendix slide 1] January effect: Small stocks do well in
January

[2] September effect: Stocks in general do badly in September

[3] Turn-of-month effect: Stocks do well around the turn of the month
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Evidence of market inefficiency?
 Firm characteristics effects

[4] Size effect: Small-cap stocks do better than large-cap stocks

[5] Book-to-market effect: Stocks with high book-to-market equity
ratios (“value stocks”) do better than stocks with low ratios (“growth
stocks”)
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Evidence of market inefficiency?
 Overreaction to non-news?

[6] Is there real information driving all the major market moves?
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Evidence of market inefficiency?
 Underreaction to genuine news?

[7] Post-earnings-announcement drift: stocks seem to underreact to
earnings announcements

[8] Momentum: stocks that have gone up in past 3-12 months keep
going up, and vice-versa.
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What should managers do
in inefficient markets?
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 Remember the pecking-order logic: In markets that are semistrong but not strong efficient, managers try to avoid issuing
equity, since it sends a bad signal, stock price drops instantly
 But if (as some evidence suggests) markets are not even
semi-strong efficient, then investors may underreact to the
bad news (overvaluation) inherent in a new stock issue
 If so, managers may be able to “time the market” – get an
overpriced equity issue out without a big price drop



Effectively, they can obtain equity at an irrationally low cost
This benefits incumbent shareholders at the expense of the new ones
Can they do this? Do they?
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14- 41
Market timing
 Evidence of successful “market timing” – firms seem to
issue equity when its price is too high (cost of equity is low),
repurchases when price too low (cost of equity is high)

[9] IPOs underperform the market index

[10] SEOs underperform the market index

[11] When aggregate equity issues are high relative to aggregate debt
issues, subsequent equity market returns are low

[12] Repurchases outperform (beat) the market index
Irwin/McGraw Hill
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14- 42
Market Timing Theory
 ‘Market timing theory of financing decisions’




Financing theory when markets are not semi-strong efficient, e.g.
when investors underreact to the bad news in equity issue or the good
news in a repurchase
Says raise whatever form of finance is currently available at the
lowest risk-adjusted cost. (In M&M efficient markets, this makes no
sense, since all forms of finance are efficiently priced at the same
risk-adjusted cost.)
For example, issue equity if it is relatively overpriced, or long-term
debt if it is relatively overpriced, or short-term debt if it is relatively
overpriced
Consistent with empirical evidence that firms can “time the market”
Irwin/McGraw Hill
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14- 43
Market Timing Theory
 ‘Market timing theory of capital structure’



Says capital structure is just the cumulative outcome of markettiming-motivated financing decisions
No “grand plan” or “optimum” debt/equity ratio
Capital structure just the cumulative outcome of past efforts to time
the markets
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000