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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
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Corporate Financing and Market Efficiency Where to get money for good projects Financial management: lecture 9
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 Financial management: lecture 9
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? Financial management: lecture 9
What have we learned in the last lecture (1)? • WACC without tax • WACC with tax Financial management: lecture 9
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 Financial management: lecture 9
What have we learned in the last lecture (2)? • The cost of equity is calculated by using • CAPM • Dividend growth model Financial management: lecture 9
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. Financial management: lecture 9
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? Financial management: lecture 9
Solution Financial management: lecture 9
Investment vs. Financing Liabilities and equity Asset • 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 Debt: D V Equity: E Financial management: lecture 9
Financing and market Efficiency Market Efficiency Market efficiency is concerned about whether capital markets have all information about the cash flows and risk of projects. Financial management: lecture 9
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) Financial management: lecture 9
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. Financial management: lecture 9
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. Financial management: lecture 9
A Random Walk example $106.09 Heads Heads $103.00 $100.43 Tails $100.00 Heads $100.43 $97.50 Tails $95.06 Tails Coin Toss Game Financial management: lecture 9
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 Financial management: lecture 9
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. Financial management: lecture 9
Efficient Market Theory $90 70 50 EI’s Stock Price Cycles disappear once identified Last Month This Month Next Month Financial management: lecture 9
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. Financial management: lecture 9
Efficient Market Theory Announcement Date Financial management: lecture 9
Market Efficiency Financial management: lecture 9
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 Financial management: lecture 9
Efficient Market Theory Announcement Date Financial management: lecture 9
Some exercises • If stock markets are efficient, what should the correlation between stock returns for two non-overlapping periods? • Which is the most likely to contradict the weak-form of efficiency • Over 25% of mutual funds outperform the market on average • Insiders can make abnormal profits • Every January, the stock market earns abnormal return Financial management: lecture 9
Several types of securities • Three types of securities • Common Stock • Preferred stock • Corporate debt Financial management: lecture 9
Common Stock • Common stocks have the following forms: • Treasury stock • Issued shares • Outstanding shares • Authorized share capital • Par value • Ownership of the corporation Financial management: lecture 9
Corporate debt • Corporate bonds • Primary rate • Funded debt • Sink fund • Callable bond • Subordinate debt • Secure debt Financial management: lecture 9
Preferred stock • Preferred stock and common stock • Priority and voting rights • Preferred stock and bond • Obligation and bankruptcy Financial management: lecture 9