Corporate Financial Theory

1. Corporate FinancialTheory Lecture 5

2. Topic Flow Chart Goal of Finance = Maximize Value of Firm HOW? Get the most cash Steps 1. Methods to evaluate projects cash flow (NPV, IRR, etc) 2. Develop risk adjusted discount rates for use in NPV 3. Apply NPV, IRR, Decision Trees, PVI, etc to capital budgeting decisions 4. Changes in capital structure influence discount rates 5. Financial Distress can result form changes in capital structure

3. Efficient Capital Markets • Switches gears • Past lectures decided how to spend money (invest) • Today’s lecture deal with raising money (financing decisions) • Fisher Separation Theorem

4. Efficient Capital Markets Cost of Capital = Price of Money Interest Rates Demand Supply Equilibrium exists in capital markets Quantity

5. Market Efficiency Theory sez Capital markets reflect all relevant information. You can not consistently earn excess profits. SML Expected Return (%) Risk

6. Return to NPV Example The government is lending you $100,000 for 10 years at 3% and only requiring interest payments prior to maturity. Since 3% is obviously below market, what is the value of the below market rate loan?

7. Return to NPV Example The government is lending you $100,000 for 10 years at 3% and only requiring interest payments prior to maturity. Since 3% is obviously below market, what is the value of the below market rate loan? Assume the market return on equivalent risk projects is 10%.

8. Market Efficiency Lost Interest Rates Demand Supply Funding Shortage Equilibrium Rate = 10 % Subsidized Rate = 3 % Quantity

9. Efficient Market Theory • Weak Form Efficiency • Market prices reflect all historical information

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

11. 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).

12. Random Walk Theory Coin Toss Game Heads $106.09 Heads $103.00 $100.43 Tails $100.00 Heads $100.43 $97.50 Tails $95.06 Tails

13. Random Walk Theory

14. Random Walk Theory

15. Random Walk Theory S&P 500 Five Year Trend? or 5 yrs of the Coin Toss Game?

16. Random Walk Theory

17. Efficient Market Theory • Weak Form Efficiency • Market prices reflect all historical information • Semi-Strong Form Efficiency • Market prices reflect all publicly available information

18. Efficient Market Theory Microsoft Stock Price $40 30 20 Actual price as soon as upswing is recognized Cycles disappear once identified Last Month This Month Next Month

19. Efficient Market Theory Announcement Date

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

21. 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

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

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

24. Efficient Market Theory The average return 1972–2001 on stocks of firms over the six months following an announcement of quarterly earnings. The 10% of stocks with the best earnings news (portfolio 10) outperformed those with the worst news (portfolio1) by about 1% per month.

25. Price Anomalies Log Deviations From Royal Dutch Shell / Shell T&T Parity 1980 - 2004 Deviation, %

26. Efficient Market Theory Historical performance

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

28. 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

29. Behavioral Finance • Factors related efficiency and psychology • Attitudes towards risk • Beliefs about probabilities • Limits to arbitrage • Incentive problems and the subprime crisis • LTCM

30. Efficient Market Theory 2009 Recession

31. Efficient Market Theory 2000 Dot.Com Boom

32. Efficient Market Theory 1987 Stock Market Crash

33. Market Efficiency Theory • Conflicts in Theory • Stock market crash of 1987 • Daily fluctuations • Culprits? • Arbitrage • Computers • Institutions

34. READ TEXT CH 14 & 15 FOR TERMINOLOGY Corporate Financing

35. Obligations Funds Banks Insurance Cos. Brokerage Firms Obligations Funds Depositors Policyholders Investors Financial Markets Company Intermediary Investor

36. Types of Financing 1 - Equity 2 - Debt 3 - Hybrids Financial Markets

37. Equity Holdings 2011

38. Bond Holdings 2011

39. Initial Public Offering (IPO) Investment Banker Underwriter Broker Prospectus & Shelf Registration Underpricing Initial Offering Process

40. IPO “Friends and Family” Senator Barbara Boxer’s IPO participation (2000)

41. The Top Managing Underwriters 2011

42. Underwriting Spreads (2010)

43. Motives For An IPO Percent of CFOs who strongly agree with the reason for an IPO

44. Average Initial IPO Returns

45. Initial Offering Average Expenses on 1767 IPOs from 1990-1994

46. IPO Proceeds

47. Investment Vehicles (2011)

48. SPEs and Enron • Special-Purpose Entities (SPEs) • Raise cash through equity and debt • Do not show up on balance sheet Mahonia JP Morgan Enron

49. Types of Equity • Partnerships • LLP & LLPs • Public Benefit Corporations • Trusts • Real Estate Investment Trust (REIT) • Private equity

50. Private Equity Returns