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Chapter 13

Chapter 13. Principles of Corporate Finance, 8/e (Special Indian Edition). Corporate Financing and the Six Lessons of Market Efficiency. Topics Covered. We Always Come Back to NPV What is an Efficient Market? Random Walk Efficient Market Theory The Evidence on Market Efficiency

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Chapter 13

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  1. Chapter 13 Principles of Corporate Finance, 8/e (Special Indian Edition) Corporate Financing and the Six Lessons of Market Efficiency

  2. Topics Covered • We Always Come Back to NPV • What is an Efficient Market? • Random Walk • Efficient Market Theory • The Evidence on Market Efficiency • Puzzles and Anomalies • Six Lessons of Market Efficiency

  3. Return to NPV • NPV employs discount rates • These discount rates are risk adjusted • The risk adjustment is a byproduct of market established prices • Adjustable discount rates change asset values

  4. Return to NPV Example The Tamil Nadu Government allows the companies to defer the payment of sales tax (with certain exceptions, of course) to the State Government for a period of 14 years. This is equivalent to an interest-free loan from the state government. What is the NPV of the loan?

  5. Return to NPV Example Assume that your company sets up a new plant in Tamil Nadu and that you expect to collect Rs.5 million of sales tax every year. Suppose the opportunity cost of borrowing is 10%. Then the NPV is: = Rs.28.74 million

  6. Random Walk Theory • The movement of stock prices from day to day DO NOT reflect any pattern. • Statistically speaking, the movement of stock prices is random (skewed positive over the long term).

  7. Random Walk Theory Coin Toss Game Heads Rs.106.09 Heads Rs.103.00 Rs.100.43 Tails Rs.100.00 Heads Rs.100.43 Rs.97.50 Tails Rs.95.06 Tails

  8. Random Walk Theory Sensex Five Year Trend? Or 5 yrs of Coin Toss Game?

  9. Random Walk Theory

  10. Efficient Market Theory Infosys Stock Price Rs.3100 2900 2828 Actual price as soon as upswing is recognized Cycles disappear once identified Last Month This Month Next Month

  11. Random Walk Theory Infosys Stock Returns: 1994 - 2006

  12. Random Walk Theory Sensex (correlation = 0.06) Return in week t + 1, (%) Return in week t, (%)

  13. Random Walk Theory Nikkei 500 (correlation = -.06) Return in week t + 1, (%) Return in week t, (%)

  14. Random Walk Theory S&P Composite (correlation = -.07) Return in week t + 1, (%) Return in week t, (%)

  15. Efficient Market Theory • Weak Form Efficiency • Market prices reflect all historical information • Semi-Strong Form Efficiency • Market prices reflect all publicly available information • Strong Form Efficiency • Market prices reflect all information, both public and private

  16. Efficient Market Theory • Fundamental Analysts • Research the value of stocks using NPV and other measurements of cash flow

  17. Efficient Market Theory • Technical Analysts • Forecast stock prices based on the watching the fluctuations in historical prices (thus “wiggle watchers”)

  18. Efficient Market Theory Announcement Date

  19. Efficient Market Theory Average Annual Return on 1493 Mutual Funds and the Market Index

  20. Efficient Market Theory IPO Non-Excess Returns Year After Offering

  21. Efficient Market Theory 2000 Dot.Com Boom (Valuation of Nifty) Crores PV (index) October 2000 PV (index) October 2002 Crores

  22. Lessons of Market Efficiency • Markets have no memory • Trust market prices • Read the entrails • There are no financial illusions • The do it yourself alternative • Seen one stock, seen them all

  23. Example: How stock splits affect value -29 0 30 Source: Fama, Fisher, Jensen & Roll

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