Market Efficiency and
Capital Structure
Some classic arguments
FIN 819
Today’s plan
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Review of the key ideas in option pricing
How to improve this course
Investment Decision vs. Financing Decision
Market efficiency
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Does the stock price follow a random walk?
Three forms of Market Efficiency
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Weak form efficiency
Semi-strong form efficiency
Strong form efficiency
The capital structure without corporate taxes
Valuing risky corporate bonds
Capital structure with corporate taxes
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Levered and unlevered betas
Two theories for the optimal capital structure in the real world.
FIN 819
Key ideas in option pricing
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There are two important ideas in option pricing
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No arbitrage argument
Replicating portfolios
These two ideas have a lot of applications.
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Get the PV of a piece of uncertain cash flow in the future
Used to show or derive a lot of important results in modern
finance (two famous examples)
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Black-Sholes formula
Capital structure irrelevancy in the case of no corporate tax
The no arbitrage condition is a much weaker condition than
the equilibrium one, and thus has been widely applied in
finance. Now it is an important phrase of the Finance
language.
FIN 819
The ideas to improve FIN 819
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Some students have concerns:
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Overlapping with BUS 785
Too easy
More challenging materials
My ideas:
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No overlap, few lectures
About 8-10 cases to be used
No quizzes
Two teams presenting the same case
Your Ideas
FIN 819
Investment vs. Financing
Asset
Liabilities and equity
Debt: D
V
Equity: E
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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
FIN 819
Financing and market Efficiency
Market Efficiency
Market efficiency is concerned about
whether capital markets have all
information about the cash flows and
risk of projects.
FIN 819
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)
FIN 819
Market efficiency and random
walk
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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.
FIN 819
What is a random walk of stock
prices?
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The movement of stock prices from day
to day DO NOT reflect any pattern.
Statistically speaking, the movement of
stock prices is random.
FIN 819
A Random Walk example
Heads
Heads
$106.09
$103.00
Tails
$100.43
$100.00
Heads
Tails
$100.43
$97.50
Tails
Coin Toss Game
FIN 819
$95.06
Three forms of market
efficiency
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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
FIN 819
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.
FIN 819
Efficient Market Theory
$90
EI’s Stock
Price
70
50
Cycles
disappear
once
identified
Last
Month
FIN 819
This
Month
Next
Month
Semi-strong form of market
efficiency
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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.
FIN 819
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
FIN 819
Market Efficiency
Fama & French
Return vs. Book-Market
Average return, percent
25
20
15
10
5
0
Highest
FIN 819
Book-Market Ratio
Strong form of market efficiency
Strong Form Efficiency - Market prices reflect
all information that could in principle be used
to determine true value.
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Inside trading
• Investors use private information to predict
future price movements
FIN 819
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
FIN 819
Some exercises
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2.
If stock markets are efficient in the weakform, 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 average
b. Insiders can make abnormal profits
c. Every January, the stock market earns abnormal
return
FIN 819
Look at the both sides of a
balance sheet
Asset
Liabilities and equity
Market value of equity
E
Market value of the asset
V
Market value of debt
D
V=E+D
FIN 819
Capital structure
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Capital structure refers to the mix of debt
and equity of a firm.
Capital structure has two related
questions:
• Does the capital structure affect the value of a
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firm? Or does the amount of debt a firm has
affect its value?
What is the optimal amount of debt a firm
should have?
FIN 819
Does capital structure affect
the firm value?
Equity
Debt
Debt
Equity
Govt.
Slicing the pie doesn’t
affect the total amount
available to debt
holders and equity holders
Slicing the pie can
affect the size of the slice
going to government
FIN 819
Equity
wasted
Debt
Govt.
Slicing the pie can
affect the size of the
wasted slice
Capital structure without
corporate taxes
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If there is no corporate tax, we will have
the following two famous results
• M&M propositions 1 and 2
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Pay attention to the condition for these
propositions to be valid
Why do we consider such simple,
unrealistic situations?
FIN 819
MM’s proposition 1 (without tax)
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Modigliani & Miller
• If the investment opportunity is fixed,
there
are no taxes, and capital markets function
well, the market value of a company does not
depend on its capital structure.
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What is the intuition for this result?
Can we use different ways to prove this?
FIN 819
MM’s proposition 2 (without tax)
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Modigliani & Miller
• If the investment opportunity is fixed,
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there
are no taxes, and capital markets function
well, the expected rate of return on the
common stock of a levered firm increases in
proportion to the debt-equity ratio (D/E),
expressed in market values.
The WACC is a constant.
FIN 819
M&M (Debt Policy Doesn’t Matter)
Example - River Cruises - All Equity Financed
Data
Number of shares
100,000
Price per share
$10
Market Value of Shares $ 1 million
Outcome
Operating Income
Earnings per share
Return on shares
State of the Economy
Slump
$75,000
$.75
7.5%
Expected
125,000
1.25
12.5%
FIN 819
Boom
175,000
1.75
17.5%
M&M (Debt Policy Doesn’t Matter)
Example
cont.
50% debt
Data
Number of shares
50,000
Price per share
$10
Market Value of Shares
$ 500,000
Market val ue of debt
$ 500,000
Outcome
State of the Economy
Slump
Expected
Boom
Operating Income
$75,000 125,000
175,000
Interest
$50,000 50,000
50,000
Equity earnings
$25,000 75,000
125,000
Earnings per share
$.50
1.50
2.50
15%
25%
Return on shares
FIN 819
5%
WACC without taxes in MM’s view
rE
r
WACC
rD
D
V
FIN 819
Valuing risky debt
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So far, we have learned how to value a riskfree debt. By risk-free debt, we mean that bond
investors always get paid for what they are
promised when they lend money to firms or
governments.
In reality, corporate bonds are not risk-free.
When firms borrow money from the bond
holders, they may not have enough cash to
pay the bond holders in the future.
FIN 819
Valuing risky debt
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To illustrate how to value a risky debt, we
focus on a simple situation:
• Firms have a zero-coupon bond.
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More specific, suppose that a firm has
issued $K million zero-coupon bonds
maturing at time T. Let the market value
of the firm asset at time T be V(T).
FIN 819
Valuing risky corporate debts
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Using the put-call parity, we have
D  Ke
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r f T
 P( K , T )
Where P(K,T) is the value of a European
put option with the strike price K and the
maturity date T
Please try to derive this formula and
understand this situation?
FIN 819
Example
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Problem: On march 4, 1994, Chrysler was the eighth
largest U.S. firm according to Fortune magazine. It
issued 20-years zero-coupon debt with book value of
$36.994 billion. The book value of the asset is $43.83
billion and the market value of equity is $21.0468
billions. The risk free rate was 8% and the volatility of
the asset return is 30%.
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What is the market value of the debt?
What is the interest rate charged on Chrysler’s debt?
FIN 819
Solution
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The market value of the debt is $5.98
million
The interest rate charge on Chrysler’s
debt is 9.11%.
The market value of the asset is $27.03
million
FIN 819
Capital structure with taxes
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If there is corporate tax, we also have
two famous results:
• M&M propositions 1 and 2
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Remember that to make the two
propositions valid, we still have to
assume that the investment opportunity
is fixed and the financial market
functions very well.
FIN 819
MM’s propositions withtax
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MM’s proposition 1
• firm value = value of all equity firm + PV (tax
shield)
• PV(tax shield)=TcD
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MM’s proposition 2
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The weighted average cost of capital is decreasing
with the ratio of D/E, and the cost of equity is
increasing with D/E.
Can you prove and understand these results?
FIN 819
WACC Graph
FIN 819
Optimal Capital structure with
tax
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So according to M&M proposition 1 with
tax, the optimal capital structure is that
firms issue all the debt.
In the real world, very few firms issue
all the debt to raise money
What is wrong with M&M propositions?
FIN 819
Capital structure with financial
distress cost
Costs of Financial Distress - Costs arising
from bankruptcy or distorted business
decisions before bankruptcy.
Market Value = Value if all Equity Financed
+ PV Tax Shield
- PV Costs of Financial
Distress
FIN 819
Optimal Capital structure
Trade-off Theory - Theory that capital structure
is based on a trade-off between tax savings
and distress costs of debt.
Pecking Order Theory - Theory stating that
firms prefer to issue debt rather than equity if
internal finance is insufficient.
FIN 819
Financial Distress
Market Value of The Firm
Maximum value of firm
Costs of
financial distress
PV of interest
tax shields
Value of levered firm
Value of
unlevered
firm
Optimal amount
of debt
Debt
FIN 819