Chapter 4 Efficient Markets and Capital Financial Decisions
Chapter 4 Chapter 4 Efficient Markets and Capital Efficient Markets and Capital Financial Decisions Financial Decisions
What Sort of Financing Decisions? Typical financing decisions include: How much debt and equity to sell - When (or if)to pay dividends When to sell debt and equity Just as we can use NPV criteria to evaluate investment decisions,we can use NPV to evaluate financing decisions. 1
1 What Sort of Financing Decisions? What Sort of Financing Decisions? Typical financing decisions include: – How much debt and equity to sell – When (or if) to pay dividends – When to sell debt and equity Just as we can use NPV criteria to evaluate investment decisions, we can use NPV to evaluate financing decisions
How to Create Value through Financing 1.Fool Investors Empirical evidence suggests that it is hard to fool investors consistently. 2.Reduce Costs or Increase Subsidies Certain forms of financing have tax advantages or carry other subsidies. 3.Create a New Security Sometimes a firm can find a previously- unsatisfied clientele and issue new securities at favorable prices. In the long-run,this value creation is relatively small,however. 2
2 How to Create Value through Financing How to Create Value through Financing 1. Fool Investors • Empirical evidence suggests that it is hard to fool investors consistently. 2. Reduce Costs or Increase Subsidies • Certain forms of financing have tax advantages or carry other subsidies. 3. Create a New Security • Sometimes a firm can find a previouslyunsatisfied clientele and issue new securities at favorable prices. • In the long-run, this value creation is relatively small, however
Financial Decisions and Informational Efficiency Efficient:"1.Performing or functioning in the best possible and least wasteful manner;" Various definitions.For example: Allocative -most valuable projects financed. Operational -minimize costs of providing services. Informational -information is not 'wasted' 3
3 Financial Decisions and Financial Decisions and Informational Efficiency Informational Efficiency Efficient: “1. Performing or functioning in the best possible and least wasteful manner;” – Various definitions. For example: •Allocative – most valuable projects financed. •Operational – minimize costs of providing services. •Informational – information is not ‘wasted’
Efficient Market Hypothesis (EMH) An Efficient Market is One Where Information is Widely Available and Used Optimally. Good Deals'will not be available. Buying securities is a zero NPV investment NPV PV of Cash Flows -Price of security 4
4 Efficient Market Hypothesis (EMH) Efficient Market Hypothesis (EMH) An Efficient Market is One Where Information is Widely Available and Used Optimally. Ä‘Good Deals’ will not be available. ÄBuying securities is a zero NPV investment • NPV = PV of Cash Flows – Price of security
A Description of Efficient Capital Markets An efcient capital market is one in which stock prices fully reflect available information. The EMH has implications for investors and firms. Since information is reflected in security prices quickly,knowing information when it is released does an investor no good. - Firms should expect to receive the fair value for securities that they sell.Firms cannot profit from fooling investors in an efficient market. 5
5 A Description of Efficient Capital Markets A Description of Efficient Capital Markets An efficient capital market is one in which stock prices fully reflect available information. The EMH has implications for investors and firms. – Since information is reflected in security prices quickly, knowing information when it is released does an investor no good. – Firms should expect to receive the fair value for securities that they sell. Firms cannot profit from fooling investors in an efficient market
Reaction of Stock Price to New Information in Efficient and Inefficient Markets Stock Price Overreaction to“good news"with reversion ● Delayed ● response to good news" Efficient market response to "good news" -30 -20 -10 +10 +20 +30 Days before (-)and after (+)announcement 6
6 Reaction of Stock Price to New Information in Reaction of Stock Price to New Information in Efficient and Inefficient Markets Efficient and Inefficient Markets Stock Price -30 -20 -10 0 +10 +20 +30 Days before (-) and after (+) announcement Efficient market response to “good news” Overreaction to “good news” with reversion Delayed response to “good news
Reaction of Stock Price to New Information in Efficient and Inefficient Markets Stock Efficient market Delayed Price response to "bad news" response to "bad news" -30 -20-10 +10 +20 +30 Overreaction to "bad Days before (-)and news"with reversion after (+)announcement 7
7 Reaction of Stock Price to New Information in Reaction of Stock Price to New Information in Efficient and Inefficient Markets Efficient and Inefficient Markets Stock Price -30 -20 -10 0 +10 +20 +30 Days before (-) and after (+) announcement Efficient market response to “bad news” Overreaction to “bad news” with reversion Delayed response to “bad news
Consistency of EMH and Random Walk Prices will change to reflect all relevant new information New information,by definition,is unpredictable. Therefore,price changes must be unpredictable PROBLEM:What information is relevant? 8
8 Consistency of EMH and Random Walk Consistency of EMH and Random Walk Prices will change to reflect all relevant new information New information, by definition, is unpredictable. Therefore, price changes must be unpredictable PROBLEM: What information is relevant?
The Different Types of Efficiency Weak Form Security prices reflect all information found in past prices and volume. ■ Semi-Strong Form Security prices reflect all p publicly available information. Strong Form Security prices reflect all information-public and private. 9
9 The Different Types of Efficiency The Different Types of Efficiency Weak Form – Security prices reflect all information found in past prices and volume. Semi-Strong Form – Security prices reflect all publicly available information. Strong Form – Security prices reflect all information—public and private
