Corporate Financing and Market Efficiency

1. Corporate Financing and Market Efficiency Where to get money for good projects Financial management: lecture 10

2. Today’s plan • Review WACC • Investment Decision vs. Financing Decision • Equity and debt financing • Does the stock price follow a random walk? • Three forms of Market Efficiency • Weak form efficiency • Semi-strong form efficiency • Strong form efficiency Financial management: lecture 10

3. 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 10

4. What have we learned in the last lecture (1)? • WACC without tax • WACC with tax Financial management: lecture 10

5. 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 10

6. What have we learned in the last lecture (2)? • The cost of equity is calculated by using • CAPM • Dividend growth model Financial management: lecture 10

7. 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 10

8. 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 10

9. Solution Financial management: lecture 10

10. 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 that are to be taken Debt: D V Equity: E Financial management: lecture 10

11. Types of Securities • Equity • Common stock • Preferred stock • Debt • Commercial paper • Debentures • Guaranteed notes • Remarketable debt • Euro notes • Sterling notes • New Zealand dollar notes • Bank loans

12. Common Stock Treasury Stock Stock that has been repurchased by the company and held in its treasury Issued Shares Shares that have been issued by the company. Outstanding Shares Shares that have been issued by the company and held by investors.

13. Par Value Value of security shown on certificate. Retained Earnings Earnings not paid out as dividends. Common Stock Authorized Share Capital Maximum number of shares that the company is permitted to issue, as specified in the firm’s articles of incorporation. Addiotional Paid Up Capital Difference between issue price and par

14. Common Stock • Book Value vs. Market Value • Book value is a backward looking measure. It tells us how much capital the firm has raised from shareholders in the past. It does not measure the value that shareholders place on those shares today. The market value of the firm is forward looking, it depends on the future dividends that shareholders expect to receive.

15. Common Stock Example - H.J. Heinz Book Value vs. Market Value (5/2007) Total Shares outstanding = 322 million

16. Common Stock Example - H.J. Heinz Book Value vs. Market Value (5/2007) Total Shares outstanding = 322 million

17. Common Stock

18. Preferred Stock Preferred Stock - Stock that takes priority over common stock in regards to dividends. Net Worth - Book value of common shareholder’s equity plus preferred stock. Floating-Rate Preferred - Preferred stock paying dividends that vary with short term interest rates.

19. Corporate Debt • Debt has the unique feature of allowing the borrowers to walk away from their obligation to pay, in exchange for the assets of the company. • “Default Risk” is the term used to describe the likelihood that a firm will walk away from its obligation, either voluntarily or involuntarily. • “Bond Ratings”are issued on debt instruments to help investors assess the default risk of a firm.

20. Corporate Debt Prime Rate - Benchmark interest rate charged by banks. Funded Debt - Debt with more than 1 year remaining to maturity. Sinking Fund - Fund established to retire debt before maturity. Callable Bond - Bond that may be repurchased by firm before maturity at specified call price.

21. Corporate Debt Subordinate Debt - Debt that may be repaid in bankruptcy only after senior debt is repaid. Secured Debt - Debt that has first claim on specified collateral in the event of default. Investment Grade - Bonds rated Baa or above by Moody’s or BBB or above by S&P. Junk Bond - Bond with a rating below Baa or BBB.

22. Corporate Debt Eurodollars - Dollars held on deposit in a bank outside the United States. Eurobond - Bond that is marketed internationally. Private Placement - Sale of securities to a limited number of investors without a public offering. Protective Covenants - Restriction on a firm to protect bondholders. Lease - Long-term rental agreement.

23. Convertible Securities Warrant - Right to buy shares from a company at a stipulated price before a set date. Convertible Bond - Bond that the holder may exchange for a specified amount of another security. Convertibles are a combined security, consisting of both a bond and a call option.

24. Patterns of Corporate Financing • Firms may raise funds from external sources or plowback profits rather than distribute them to shareholders. • Should a firm elect external financing, they may choose between debt or equity sources.

25. Patterns of Corporate Financing

26. Patterns of Corporate Financing Debt to (Debt + Equity) Ratio for Non-Financial Firms Debt Ratio, %

27. Market Efficiency Market Efficiency Market efficiency is concerned about whether or nor capital markets have all relevant information about the cash flows and risk of projects to price securities accordingly. Financial management: lecture 10

28. Efficient capital markets Efficient Capital Markets – If capital markets are efficient, then security prices reflect all relevant information about asset values. Financial management: lecture 10

29. 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 10

30. 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 10

31. A Random Walk example $102.09 Heads Heads $101.00 $97.43 Tails $100.00 Heads $100.43 $97.50 Tails $95.06 Tails Coin Toss Game Financial management: lecture 10

32. 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 10

33. 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 10

34. Efficient Market Theory $90 70 50 EI’s Stock Price Cycles disappear once identified Last Month This Month Next Month Financial management: lecture 10

35. 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 10

36. Efficient Market Theory Announcement Date Financial management: lecture 10

37. Market Efficiency Financial management: lecture 10

38. 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 10

39. Efficient Market Theory Announcement Date Financial management: lecture 10

40. 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 10