FIN 351-lecture 8

Corporate Financing and Market Efficiency

Where to get money for good projects

Today’s plan

Review WACC Investment Decision vs. Financing Decision Does the stock price follow a random walk? Three forms of Market Efficiency

• Weak form efficiency

• Semi-strong form efficiency

• Strong form efficiency

Several types of securities

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?

What have we learned in the last lecture (1)?

WACC without tax

WACC with tax

de rVD

rVE

WACC

EDVwhere

eVE

dVD r +Tc)r-(1 =WACC

What have we learned in the last lecture (2)?

The cost of bond• It is the YTM, the expected return required by

the investors.

• That is

• The expected return on a bond can also be calculated by using CAPM

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r

cpnr

cpn

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P2bond

)( fmdfd rRrr

What have we learned in the last lecture (2)?

The cost of equity is calculated by using • CAPM

• Dividend growth model

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gP

DIVr

gr

DIVP e

e

0

110

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.

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?

Solution

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68.18509.1

200)

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%16.10%6.5*1.1%4

%9

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ed

e

d

rED

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ED

DWACC

D

E

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Investment vs. Financing

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

Asset Liabilities and equity

VDebt: D

Equity: E

Market Efficiency

Market efficiency is concerned about whether capital markets have all information about the cash flows and risk of projects.

Financing and market Efficiency

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)

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.

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.

A Random Walk example

$103.00

$100.00

$106.09

$100.43

$97.50

$100.43

$95.06

Coin Toss Game

Heads

HeadsHeads

Tails

Tails

Tails

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

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.

Efficient Market Theory

Last Month

This Month

Next Month

$90

70

50

EI’s Stock Price

Cycles disappear

once identified

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.

Efficient Market Theory

-16

-11

-6

-14

9

14

19

24

2934

39

Days Relative to annoncement date

Cu

mu

lati

ve A

bn

orm

al R

etu

rn

(%)

Announcement Date

Market Efficiency

0

5

10

15

20

25

Av

era

ge

re

turn

, pe

rce

nt

Highest

Book-Market Ratio

Fama & FrenchReturn vs. Book-Market

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

Efficient Market Theory

-16

-11

-6

-14

9

14

19

24

2934

39

Days Relative to annoncement date

Cu

mu

lati

ve A

bn

orm

al R

etu

rn

(%)

Announcement Date

Some exercises

1. If stock markets are efficient, what should the correlation between stock returns for two non-overlapping periods?

2. 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

Several types of securities

Three types of securities• Common Stock

• Preferred stock

• Corporate debt

Common Stock

Common stocks have the following forms:• Treasury stock

• Issued shares

• Outstanding shares

• Authorized share capital

• Par value

Ownership of the corporation

Corporate debt

Corporate bonds• Primary rate

• Funded debt

• Sink fund

• Callable bond

• Subordinate debt

• Secure debt

Preferred stock

Preferred stock and common stock• Priority and voting rights

Preferred stock and bond• Obligation and bankruptcy