Principles
of
Corporate
Finance
Chapter 13
Efficient Markets and
Behavioral Finance
Tenth Edition
Slides by
Matthew Will
McGraw Hill/Irwin
Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved
14- 2
Topics Covered
We Always Come Back to NPV
What is an Efficient Market?
– Random Walk
– Efficient Market Theory
The Evidence Against Market Efficiency
Behavioral Finance
Six Lessons of Market Efficiency
McGraw Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved
14- 3
Return to NPV
NPV employs discount rates
These discount rates are risk adjusted
The risk adjustment is a byproduct of
market established prices
Adjustable discount rates change asset
values
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Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved
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Return to NPV
Example
The government is lending you $100,000 for 10 years at 3% and only
requiring interest payments prior to maturity. Since 3% is obviously
below market, what is the value of the below market rate loan?
Assume the market return on equivalent risk projects is 10%.
 10 3,000  100,000
NPV  100,000   

t 
10
(
1
.
10
)
(
1
.
10
)
 t 1

 100,000  56,988
 $43,012
McGraw Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved
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Efficient Market Theory
Weak Form Efficiency
– Market prices reflect all historical information
Semi-Strong Form Efficiency
– Market prices reflect all publicly available
information
Strong Form Efficiency
– Market prices reflect all information, both
public and private
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Efficient Market Theory
Fundamental Analysts
– Research the value of stocks using NPV and other
measurements of cash flow
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Efficient Market Theory
Technical Analysts
– Forecast stock prices based on the watching the
fluctuations in historical prices (thus “wiggle
watchers”)
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Efficient Market Theory
Cumulative Abnormal Return (%)
Announcement Date
39
34
29
24
19
14
9
4
-1
-6
-11
-16
Days Relative to annoncement date
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14- 9
Efficient Market Theory
Average Annual Return on Mutual Funds and the
Market Index
50
40
30
20
10
0
-10
Funds
-20
Market
-30
1962
1963
1964
1965
1966
1967
1968
1969
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
-40
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14- 10
Efficient Market Theory
IPO Non-Excess Returns
Average Return (%)
20
IPO
Matched Stocks
15
10
5
0
First
McGraw Hill/Irwin
Second
Third
Fourth
Fifth
Year After
Offering
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Price Anomalies
Log Deviations From Royal Dutch Shell / Shell T&T Parity
1973 - 2006
40.0
30.0
Deviation, %
20.0
10.0
0.0
-10.0
-20.0
-30.0
-40.0
-50.0
McGraw Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved
14- 12
Efficient Market Theory
2000 Dot.Com Boom
PV (index ) March 2000 
PV ( index ) October
McGraw Hill/Irwin
2002

Div
rg
Div
rg


154.6
.092  .08
154 . 6
. 092  . 074
 12,883
 8 ,589
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved
14- 13
Efficient Market Theory
1987 Stock Market Crash
PV (index ) pre crash 
PV ( index ) post crash 
McGraw Hill/Irwin
Div
rg
Div
rg


16.7
.114  .10
16 . 7
. 114  . 096
 1193
 928
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14- 14
Behavioral Finance
Arbitrage limitations
LTCM example
Factors related efficiency and psychology
1. Attitudes towards risk
2. Beliefs about probabilities
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Lessons of Market Efficiency
Markets have no memory
Trust market prices
Read the entrails
There are no financial illusions
The do it yourself alternative
Seen one stock, seen them all
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Example: How stock splits affect value
Cumulative
abnormal
return %
40
35
30
25
20
15
10
5
0
Month relative to split
-29
0
30
Source: Fama, Fisher, Jensen & Roll
McGraw Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved