Financing Decisions and Efficient Capital Markets

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Executive Summary

Corporate Financing Decision.

Concept of Efficient Capital Markets

Efficient capital markets are those in which current market prices reflect available information. Current market prices reflect the underlying present value of the securities .

There is no way to make unusual or excess profits by using the available information. 29/03/13

Can Financing Decision Create Value?

Financing decision includes:

How much debt and equity to sell? What type of debt and equity to sell? When to sell Debt and Equity?

Financing decision is evaluated by the net present value criterion.

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Can Financing Decision Create Value?

Three ways to create valuable financing opportunities:
1)

Fool Investor. Reduce Cost or Increase Subsidies. Create a New Security.

2)

3)

Example: Suppose Vermont electronics company is thinking about relocating its plant to Mexico where labor costs are lower. In the hope that it can stay in Vermont , the company has submitted an application to the state of Vermont to issue $2 million in five years tax exempt industrial bonds. The coupon rate on industrial revenue bonds in Vermont is currently 5%. This is an attractive rate because 29/03/13 the normal cost of debt capital for Vermont electronics Company is

Efficient Market Hypothesis

EMH has implications for investors and for firms.

Because information is reflected in price immediately, investor should only expect to obtain a normal rate of return. The price adjusts before the investor has time to trade on it.

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Firm should expects to receive the fair value for securities that they sell. Fair means that the price they receive for the securities they issue is the present value. Thus valuable financing opportunities that arise from fooling investors are unavailable in efficient capital markets.

Types of Efficiency

The Weak Form:

Information is based only on past prices . A capital market is said to be weakly efficient if it fully incorporates the information in past stock prices. Often weak form efficiency is represented mathematically as

Pt = Pt-1 + Expected return + Random error

Equation states that the price today is equal to the sum of the last observed price plus the expected 29/03/13

Efficient Market Response

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Types of Efficiency

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Types of Efficiency

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Types of Efficiency
The Semi-strong and Strong Forms:

If weak-form efficiency is controversial, even more contentious are the two stronger types of efficiency, semi strong-form efficiency and strong-form efficiency. A market is semi strong form efficient if prices reflect (incorporate) all publicly available information, including information such as published accounting statements for the firm as well as historical price information. A market is strong-form efficient if prices reflect all information, public or private.

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Types of Efficiency

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Some Common Misconceptions about the Efficient-Market Hypothesis

The Efficacy of Dart Throwing Price Fluctuations Stockholder Disinterest

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Concept Check

Trans Trust Corp. has changed how it accounts for inventory. The change does not change tax, but the resulting earnings report released this quarter is 20 percent higher than what it would have been under the old accounting system. There is no other surprise in this earnings report. Will the stock price be higher when the market learns that the earnings are higher?

A famous economist just announced his findings that the recession is over and the economy is 29/03/13 entering the expansion stage once again. Can

The abnormal return (AR) on a given stock for a particular day can b calculated by subtracting the markets return on the same day (Rm)a measured by a broad based index such as the S&P composite indexfrom th actual return (R) on the stock for that day. We write this algebraically as:

A way to think of the tests of the semi strong form is to examine the following system of relationships:

According to the efficient-market hypothesis, a stocks abnormal return at tim t, ARt, should reflect the release of information at the same time, t. An information released before then, though, should have no effect on abnorma returns in this period, because all of its influence should have been felt before In other words, an efficient market would already have incorporated previou information into prices. Because a stocks return today cannot depend on wha the market does not yet know, the information that will be known only in th future cannot influence the stocks return either. Hence the arrows point in th direction that is shown, with information in any one time period affecting only that periods abnormal return. Event studies are statistical studies that examin whether the arrows are as shown or whether the release of information influences returns on other days.
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Problem

Compute the abnormal rates of return for the following stocks during period t (ignore differential systematic risk):

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