Market Efficiency and Long-term Financing

7-1

A $1 Investment in Different Types of Portfolios: 1926-1996 (Fig. 12.4)

0.1

1

10

100

1000

10000

1925 1935 1945 1955 1965 1975 1985 1995

Index ($)

$4,495.99

$33.73

$13.54

$8.85

$1,370.95

Small Company Stocks

Large Company Stocks

Long-Term Government Bonds

Treasury Bills InflationYear-End

7-2

7-3Market Efficiency

An An efficient capital market is one in is one in which the purchase or sale of any which the purchase or sale of any security at the prevailing market price is security at the prevailing market price is a zero–NPV transaction. That is, you can a zero–NPV transaction. That is, you can expect to earn only a return adequate expect to earn only a return adequate (‘normal return’) to compensate you for (‘normal return’) to compensate you for the risk you bear. the risk you bear.

7-4

In an Efficient Capital Market prices In an Efficient Capital Market prices reflect all relevant information. You reflect all relevant information. You cannot consistently earn cannot consistently earn excessexcess or or ‘‘abnormal’abnormal’ profits profits. .

Market Efficiency Theory

7-5Conditions needed for an Efficient Market

A large number of rational investors A large number of rational investors (analysts, MBAs, CFAs) who seek to (analysts, MBAs, CFAs) who seek to maximize their wealthmaximize their wealth

Information is widely availableInformation is widely available

Firms like Merrill Lynch, Morgan Firms like Merrill Lynch, Morgan Stanley, etc. spend lots of money to Stanley, etc. spend lots of money to collect and analyze informatiocollect and analyze informatio

7-6Market Efficiency

Random Walk - Security prices change randomly, with no predictable trends or patterns.

Does this mean prices remain always the same and won’t move?

7-7Summary: Why are price changes random?

Prices react to informationPrices react to information

Flow of information is randomFlow of information is random by definition, otherwise news is not news!by definition, otherwise news is not news!

Competition assures prices quickly Competition assures prices quickly and accurately reflect informationand accurately reflect information

Therefore, price changes are randomTherefore, price changes are random

7-8Three Forms of Market Efficiency

Weak formWeak form current prices reflect current prices reflect past prices and patterns past prices and patterns

irrespective of the actual firm’s fundamentalsirrespective of the actual firm’s fundamentals

Semi-strong formSemi-strong form all all public informationpublic information (economic and accounting) (economic and accounting)

is reflected in stock pricesis reflected in stock prices

Strong formStrong form all informationall information (public and private) is reflected in (public and private) is reflected in

stock pricesstock prices

7-9Technical Analysts - Investors who attempt to identify over- or undervalued stocks by searching for patterns in past prices.

Head and Shoulders Triple Tops

7-10

Fundamental Analysts - Analysts who attempt to find under- or overvalued securities by analyzing fundamental information, such as earnings, asset values, and business prospects.

Reaction of Stock Price to New Information in Efficient and Inefficient Markets

Efficient market reaction: The price instantaneously adjusts to and fully reflects new information; there is no tendency for subsequent increases and decreases.Delayed reaction: The price partially adjusts to the new information; 8 days elapse before the price completely reflects the new informationOverreaction: The price over-adjusts to the new information; it “overshoots” the new price and subsequently corrects.

Price ($)

Days relativeto announcement day–8 –6 –4 –2 0 +2 +4 +6 +7

220

180

140

100

Overreaction andcorrection

Delayed reaction

Efficient market reaction

Insider Information

7-12Market Efficiency

Did you make an “Abnormal” return (AR=R-E[R])?No Yes

Based on: WeakForm

Semi-StrongForm

StrongForm

WeakForm

Semi-StrongForm

StrongForm

AllRelevantInfo

consistent consistent consistent ? ? inconsistent

All PublicInfo consistent consistent ? ? inconsistent inconsistent

HistoricalStockPatterns

consistent ? ? inconsistent inconsistent inconsistent

7-13The Bottom Line

As a corporate financial manager (or As a corporate financial manager (or investor) you should expect financing investor) you should expect financing transactions (buying or selling of securities) transactions (buying or selling of securities) to be a zero-NPV transaction. to be a zero-NPV transaction.

To consistently produce value from your To consistently produce value from your firm’s financing transactions would require firm’s financing transactions would require either:either:

consistently fooling investors consistently fooling investors

constantly creating new securitiesconstantly creating new securities

7-14Evidence on Market Efficiency

Strong FormStrong Form insider tradinginsider trading

Semi-strong formSemi-strong form event studiesevent studies

mutual fund performancemutual fund performance

anomaliesanomalies

Weak formWeak form technical analysistechnical analysis

serial correlation and momentumserial correlation and momentum

7-15

Casual evidence indicates that mutual Casual evidence indicates that mutual funds do not outperform market indicesfunds do not outperform market indices

WSJ stock picking contest (1990-1996)WSJ stock picking contest (1990-1996) Pros won 44/77 times versus dart throwing monkeysPros won 44/77 times versus dart throwing monkeys

Pros won 40/77 times versus DJIAPros won 40/77 times versus DJIA

Mutual Fund and Professional Manager Performance

7-16

Market Efficiency Anomalies

Size EffectSize Effect

January EffectJanuary Effect

Monday EffectMonday Effect

Value Line EnigmaValue Line Enigma

Crash of 1987Crash of 1987

7-17

-4

-2

0

2

4

6

8

10

% S

ize

Pre

miu

m

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

Month

Small Firms versus Large FirmsSmall Firms versus Large Firms

7-18

Debt and EquityDebt and Equity

Long-term Financing

7-19Corporate Long-term Debt

Main characteristicsMain characteristics Debt holders have no ownership in the firmDebt holders have no ownership in the firm

no voting rights, no residual claimno voting rights, no residual claim

Benefits:Benefits: Tax deductibility of interest paymentsTax deductibility of interest payments Monitoring and disciplineMonitoring and discipline

Costs: Costs: Possibility of financial distressPossibility of financial distressPotential conflict of interest with owners (agency Potential conflict of interest with owners (agency cost of debt)cost of debt)

Traded on organized exchanges and over-the-Traded on organized exchanges and over-the-countercounter

7-20Preferred Stock

Cumulative versus Non-cumulativeCumulative versus Non-cumulative

Is preferred stock really debt?Is preferred stock really debt?

Corporate seller's tax disadvantageCorporate seller's tax disadvantage

Unlike interest, dividends are not tax deductibleUnlike interest, dividends are not tax deductible

Corporate buyer's tax advantageCorporate buyer's tax advantage

70% of dividend income received from other domestic 70% of dividend income received from other domestic firms are exempt from federal corporate taxationfirms are exempt from federal corporate taxation

7-21Common Stock

Par ValuePar Value: some value assigned to stock for no particular : some value assigned to stock for no particular reason. Most stocks have par values of $1.00 or $0.01reason. Most stocks have par values of $1.00 or $0.01

AuthorizedAuthorized versus versus IssuedIssued Common Stock: All shares to Common Stock: All shares to be sold must be authorized by the articles of the be sold must be authorized by the articles of the corporation. corporation.

Additional Paid in Capital (Capital in Excess of Par Additional Paid in Capital (Capital in Excess of Par Value):Value): usually refers to amounts of directly contributed usually refers to amounts of directly contributed equity capital in excess of par value. equity capital in excess of par value.

Retained EarningsRetained Earnings: Corporate earnings not paid out as : Corporate earnings not paid out as dividends.dividends.

7-22Common Stock

DividendsDividends: payment of dividends is at the discretion of : payment of dividends is at the discretion of the Board of Directors.the Board of Directors.

Shareholders' RightsShareholders' Rights

Straight VotingStraight Voting: Directors are elected one at a : Directors are elected one at a time. You may cast all your votes for each member of time. You may cast all your votes for each member of the BOD.the BOD.

Cumulative VotingCumulative Voting: Directors are elected all at : Directors are elected all at once. You may cast all your votes for one member of once. You may cast all your votes for one member of the BOD. In general, if N directors are to be elected, it the BOD. In general, if N directors are to be elected, it takes 1/(N + 1) percent of the shares + 1 share to takes 1/(N + 1) percent of the shares + 1 share to assure a deciding vote for one director.assure a deciding vote for one director.

7-23Shareholders' Voting Rights

Assume Assume 33 directors to be elected and you own 20 shares directors to be elected and you own 20 shares

Straight VotingStraight Voting: Directors are elected one at a time: Directors are elected one at a time

You may cast all your votes for each member of the BODYou may cast all your votes for each member of the BOD

20 shares = 20 votes20 shares = 20 votes

Cumulative VotingCumulative Voting: Directors are elected all at once: Directors are elected all at once

You may cast all your votes for one member of the BODYou may cast all your votes for one member of the BOD# votes = # shares × # directors to be elected: # votes = # shares × # directors to be elected:

(20 shares) × (4 directors to be elected) = 60 votes(20 shares) × (4 directors to be elected) = 60 votes

For cumulative voting if N directors are to be elected, it takes 1/(N+1) percent of the For cumulative voting if N directors are to be elected, it takes 1/(N+1) percent of the stock + 1 share to assure a deciding vote for stock + 1 share to assure a deciding vote for oneone director director

25% of the shares + 1 share will guarantee you one deciding vote for 1 director25% of the shares + 1 share will guarantee you one deciding vote for 1 director

7-24What differentiates Debt from Equity?

Item Debt Equity

Cash FlowFixed Promised payments

Uncertain residual cash flows

Seniority Senior to equitySubordinated to debt

Tax ConsequencesInterest is deductible

Dividends are not deductible

Control RightsOnly get control rights in default

Comes with control rights (can vote)

7-25Patterns of Corporate Financing 1981 - 1992

19811982

19831984

19851986

19871988

19891990

19911992

0

100

200

300

400

500

-100

-200

Internally generated funds Long-term Debt

New Equity Sales

7-26Types of Equity IssuesPrivate Direct PlacementPrivate Direct Placement

Florida Panther Holdings, Inc., February 12, 1999Florida Panther Holdings, Inc., February 12, 1999

Initial Public Offering (IPO)Initial Public Offering (IPO) Ticketmaster Online, December 2, 1998Ticketmaster Online, December 2, 1998 "Will offer 7 million shares of common stock at $14" "Will offer 7 million shares of common stock at $14"

Seasoned Equity Offering (SEO)Seasoned Equity Offering (SEO) American Online, Sept. 19, 1995American Online, Sept. 19, 1995 "Will offer 3.5 million shares of common stock" "Will offer 3.5 million shares of common stock" 1.95 million by company; 1.55 million by its shareholders1.95 million by company; 1.55 million by its shareholders

Rights OfferRights Offer Revco, April 1994Revco, April 1994 “ “each stockholder as of June 13 will receive 0.305 of a each stockholder as of June 13 will receive 0.305 of a transferable right for each Revco common share held.”transferable right for each Revco common share held.”

7-27IPO’s: The Biggest Pops

Nine of the 10 biggest first-day gains by IPOs were Internet stocksNine of the 10 biggest first-day gains by IPOs were Internet stocks

IssuerIssuer Offering DateOffering Date % Change% Change

theglobe.comtheglobe.com 11/12/9811/12/98 474474

MarketWatch.comMarketWatch.com 1/15/991/15/99 471471

Broadcast.comBroadcast.com 7/16/987/16/98 249249

EarthWebEarthWeb 11/10/9811/10/98 247247

Ticketmaster OnlineTicketmaster Online 12/2/9812/2/98 243243

uBiduBid 12/3/9812/3/98 220220

Secure ComputingSecure Computing 11/17/9511/17/95 202202

Artificial LifeArtificial Life 12/17/9812/17/98 176176

eBayeBay 9/24/989/24/98 163163

Yahoo!Yahoo! 4/12/964/12/96 154154

Source: The Wall Street Journal January, 1999Source: The Wall Street Journal January, 1999

7-28Pricing of Initial Public Offerings

Underpricing phenomenon:Underpricing phenomenon:

IPO's rise in value on first day of issue by an average ofIPO's rise in value on first day of issue by an average of 15%15%

Examples:Examples:

In 1980, when Apple Computer went public, shares were In 1980, when Apple Computer went public, shares were offered at $22 per share and jumped to $36.offered at $22 per share and jumped to $36.

Boston Chicken stock was offered at $20 per share and Boston Chicken stock was offered at $20 per share and jumped to $49 on the first day of trading.jumped to $49 on the first day of trading.

Should you invest in each IPO given the average 15% return on Should you invest in each IPO given the average 15% return on an IPO during the first day?an IPO during the first day?

7-29Why Does Underpricing Occur?

Helps sell issues.Helps sell issues.

Insurance against lawsuitsInsurance against lawsuits

Helps avoid "winner's curse" Helps avoid "winner's curse"

Uninformed small investors buy more of overpriced IPO’sUninformed small investors buy more of overpriced IPO’s

Informed investors buy more of underpriced IPO’sInformed investors buy more of underpriced IPO’s

7-30Stock Market Reaction to Seasoned Equity Offering

On average stock prices fall. Why?On average stock prices fall. Why?

- Management may know firm is overvalued- Management may know firm is overvalued

- Management may know future earnings of the firm are - Management may know future earnings of the firm are going to be poorgoing to be poor

- Issuing equity may imply the firm has too much debt or too - Issuing equity may imply the firm has too much debt or too little equitylittle equity

- High issue costs- High issue costs

- Downward sloping demand curves- Downward sloping demand curves

7-31Rights Offerings

An issue of common stock to existing shareholders.An issue of common stock to existing shareholders."privilege subscription""privilege subscription"

ExampleExample: April 8, 1994, Revco to raise $217 Million: April 8, 1994, Revco to raise $217 MillionStockholders of record as of 6/13/94 will receive 0.305 Stockholders of record as of 6/13/94 will receive 0.305 transferable right for each share of stocktransferable right for each share of stock

Subscription price of $14 per shareSubscription price of $14 per share

Rights to expire 7/7/94Rights to expire 7/7/94

Proceeds used to facilitate acquisition of Hook-SupeRx, Inc.Proceeds used to facilitate acquisition of Hook-SupeRx, Inc.

7-32Value of Rights: The Individual Shareholder

DOTCOM Corporation Rights OfferDOTCOM Corporation Rights Offer

Design Corp. gives existing shareholders the opportunity to Design Corp. gives existing shareholders the opportunity to buy 1 additional share at $15 per share for 3 rights owned.buy 1 additional share at $15 per share for 3 rights owned.

1 share includes 1 right. Current Share price=$301 share includes 1 right. Current Share price=$30

- What is the ex-rights share price?0- What is the ex-rights share price?0- What is the value of a right - What is the value of a right beforebefore the offering? the offering?- What is the value of a right - What is the value of a right afterafter the offering? the offering?