Financing Decisions and Market Efficiency
(Ch. 13)
BACKGROUND
·
So far
we have focused on the investment decision.
To simplify, we fixed the financing decision (at 100% equity financing)
and talked about how the investment decision should be made.
·
Now
it’s time to start looking at financing decisions:
o
Dividend
decision (how much you pay out as dividends versus how much you reinvest
determines how much new external financing you will need to do)
o
Capital
structure decision: how should a project or a firm be financed? How much of the
firm’s capital should be debt and how much equity?
·
Initially,
we’ll fix the investment decision, and focus just on financing decisions;
i.e., we look at
financing decisions separately by themselves.
Later, we’ll look at the interaction between
them, e.g., how the financing decision affects a project’s NPV and therefore
influences the investment decision.
For now:
o
A
project has already been selected.
o
We
have to decide what capital structure to adopt, and what dividend policy to
follow
·
The
key question right now is: do financing decisions matter?
o
Do
they affect the value of a project or the value of a firm?
o
If so,
how do we determine the optimal dividend policy or the optimal capital
structure?
·
Financing
decisions ultimately represent transactions the firm makes in capital markets
(e.g. issuing securities or repurchasing securities).
Before we turn to the specifics of financing decisions, we need to understand how capital markets work.
So we look at the Efficient Market Hypothesis (EMH), which summarizes the
essential nature of capital markets.
EFFICIENT
MARKET HYPOTHESIS: THE BASIC IDEA
·
The
starting point for EMH was the observed fact that prices follow a random walk
o
Successive
price changes (or returns) are independent or uncorrelated
o
No
systematic tendency for price increases to be followed by price increases
(positive correlation) or price increases to be followed by decreases (negative
correlation)
o
Today’s
price change is independent of past price changes; cannot predict future prices
by analyzing past prices
·
More
precisely, stock prices follow a random walk with drift.
Prices systematically move up over time, since expected returns are
positive. But on a given day we cannot predict whether the actual
return will be higher than expected or lower than expected. Deviations of actual return from expected return are random.
(Long-term price trend is positive; deviations from the trend are random)
·
Why
should prices follow a random walk? 2
ways to think about it:
o
If
future prices were predictable, investors could make easy profits.
If prices were expected to increase tomorrow, investors would rush to buy
today. This would increase the
price to the correct level today.
=>
As investors trade to exploit them, the
superior profits disappear. Price
changes are no longer predictable once today’s price has adjusted.
o
Prices
reflect information. Prices change
only when there is new information. New
information, by definition, is randomly positive or negative (e.g., when a
company announces quarterly earnings, there’s a 50% chance that actual
earnings will be higher than the market expects, and a 50% chance they will be
lower). So the price changes in
response to new information are randomly positive or negative.
=>
price changes are random/unpredictable because new information is
random/unpredictable
·
Bottom
line: cannot use information about past prices to predict future returns
·
What
holds true for information about past prices should also be true for other
information available to investors => no matter what information an investor
uses, he should not be able to predict future returns, and actual
returns should be randomly higher or lower than expected.
EMH
– FORMAL DEFINITION
·
A
market is efficient if today’s prices fully reflect all available information
·
We
define three forms of market efficiency, corresponding to how much information
is properly reflected in prices:
o
Market
is weak-form efficient if today’s prices fully reflect information about past
prices (and trading volume)
o
Market
is semi-strong-form efficient if today’s prices fully reflect all publicly
available information (including info about past prices, but excluding inside
info)
o
Market
is strong-form efficient if today’s prices fully reflect all information (both
public and inside info)
·
Based
on above discussion, we expect markets to be semi-strong-form efficient.
All the information available to investors should be properly
reflected in the price and therefore useless for predicting future prices.
EMH
– THE EVIDENCE
·
There
have been literally thousands of studies. Not
an academic issue. If you find
markets are inefficient, have found a rule to make money (lots of it).
·
Preponderance
of the evidence:
·
Stock
prices have had some specific random pattern in the past
·
If
you look at a thousand different predictive variables, by random chance some
will generate predictions that fit the pattern that stock prices actually
had
·
But
if it’s just a coincidence, the same predictive variables won’t work again
·
Don’t
have a sufficient number of formal studies yet, but it seems the anomalies that
worked in the past don’t work again in the future
EVENT
STUDY OF TAKEOVER ANNOUNCEMENTS
Event Study
Procedure:
1) Take a large number of firms which had the event
(i.e., where the company was the target of a a takeover attempt)
2) Compute average abnormal return (AR) for the
announcement day and 20 days before and after
·
Recall
from Chs. 7-8 that AR = actual return – Ex post E(R)
·
Actual
return = Ex ante E(R) + impact of economy-wide news + impact of firm-specific
news
·
Ex
post E(R) = Ex ante E(R) + impact of economy-wide news
·
So
AR isolates the impact of firm-specific news
·
Average
AR on the announcement day represents the average effect of the firm-specific
news we started with: a firm becoming a takeover target
3) Plot
the cumulative value of average abnormal return (CAR) from 20 days before
announcement to 20 days after
·
In
takeovers, acquiring firms pay large premiums over the existing market price
(20-30% or more)
·
So the
announcements are clearly good news for the target firm’s stock.
·
When we
conduct an event study as a test of market efficiency, our main focus is on the
speed and efficiency of the market’s reaction to this good news.
·
If markets
are efficient, the market’s reaction should have the following shape:
o
Average AR on the announcement day should be
positive (since there is good news); so CAR should increase
o
Average AR before and after the announcement day
should be zero (since the firm-specific news of different firms should be
randomly positive or negative); so CAR should stay unchanged
o
The CAR should plot as a step function: horizontal
at zero till the announcement, a single sharp increase on the announcement day,
and then horizontal again at the new level
o
The key issue is that there should be no
predictable increase or decrease in the CAR after the announcement day.
Once the takeover attempt has been announced and become public
information, you should not be able to consistently earn positive abnormal
returns by either buying or short-selling these stocks.
Information that a takeover is in progress should not allow you to
predict future returns.
·
As we see
from fig. 13.5 on p 354 of the book, the actual results pretty much conform to
this (except for some leakage before the announcement due to insider trading)
o
The only people who can profit from the
announcements are insiders trading before the announcement
o
If you buy right after the announcement (at the
closing price that day, or the next day) you are already too late.
The market price reacts immediately, reaches the correct level and then
just fluctuates randomly around that value.
There is no further systematic movement, either up or down.
On average, the market doesn’t under-react initially (and keep moving
up) or over-react initially (and drift back down)
EMH
– KEY IMPLICATION
·
Securities
are correctly priced:
o
Price is indeed PV of future cashflows
o
Buying securities is a zero NPV investment
o
When you buy securities, E(R) = required return
·
Literal
interpretation of market efficiency: all securities are always correctly priced
·
More
pragmatic interpretation:
o
At any point in time, there are some under-priced securities and some
over-priced ones
o
There may even be points in time when the market as a whole (or a
specific sector like tech stocks) is too high or too low
o
However, there are no predictable rules to determine in advance
which stocks are under-priced, or when the market is too high or too low
=> even though mis-pricing exists, there are no reliable rules which can be used to
exploit mis-pricing.
IMPLICATIONS
OF EMH FOR FINANCING DECISIONS: THE 6 LESSONS
·
Markets
have no memory:
o
Doesn’t
make sense to say, issue shares after price goes up, and hold back after price
falls.
o
That
assumes that after an increase, the price is expected to fall, and vice versa.
In an efficient market such predictable patterns don't exist.
o
Inside
info is a separate issue though.
·
Trust
market prices:
o
Don’t
expect to make money for your company by “beating the market”
o
It
doesn’t matter how smart you are, or how well you understand a given market;
you still can’t systematically beat the market’s prediction for how interest rates or exchange rates or oil prices
will change
·
Read
the entrails:
o
use
the information contained in market prices
o
e.g.,
what today’s price of gold or oil tells you about the PV of future gold
production or oil production
o
or
what today’s long-term interest rates tell you about how short term rates
are expected to change
·
There
are no financial illusions:
o
Don’t
expect to increase your stock price by fooling the market; the market is not
easily fooled
o
e.g.
stock splits. By increasing the
number of shares each stockholder holds, you don’t do anything to increase
stockholder wealth. In and of
themselves, stock splits don’t increase the stock price.
o
Stock
prices do go up when companies announce splits, but that’s because
explicitly or implicitly, firms promise to increase future dividends.
You are simultaneously announcing a stock split and a future increase
in dividends. The market reacts
positively to the dividend news, not the split.
·
Investors
will not pay extra for a firm to do what they can do themselves:
o
e.g.
companies sometimes justify mergers by saying combining the two firms will
produce a more diversified firm with stable earnings
o
That’s
true, and it’s also true that investors want diversification
o
But
that’s still not going to make the value of the merged firm any higher than
the combined value they had before
o
Investors
can diversify themselves by holding shares in both companies; for the firms to
diversify by merging gives investors no extra benefit
o
Many
issues in corporate finance can be clarified by asking whether investors can
achieve for themselves what the firm is proposing to do for them by taking a given
decision
o
e.g.
issuing debt creates financial leverage and makes a firm’s stock more
risky. But s/h can borrow on
their own accounts and create the same effect of making their investment in
the firm’s stock riskier (by buying on margin).
So even s/h who are looking for riskier stocks won’t pay
more for a firm which has higher leverage.
·
Seen
one stock, seen them all:
o
all
stocks are zero NPV investments, offering a fair return for the risk you take
o
to
construct a diversified portfolio, it doesn’t make very much difference
which specific set of 30 or 40 stocks you pick
o
investors
don’t have much reason to care whether they hold a specific stock or not;
they just want a well-diversified portfolio of a given risk
o
investors
will regard different stocks as close substitutes. Demand curves for stocks are pretty close to horizontal.
o
Unless
the market concludes you have some inside info, large quantities of stock can
be sold by offering very small discounts
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