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7- 1 Market Efficiency and Long-term Financing 7- 2 A $1 Investment in Different Types of Portfolios: 1926-1996 (Fig. 12.4) Index ($) Small Company Stocks $4,495.99 $1,370.95 Large Company Stocks $33.73 Long-Term Government Bonds $13.54 $8.85 Treasury Bills Inflation Year-End

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Market Efficiency and Long-term Financing

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a 1 investment in different types of portfolios 1926 1996 fig 12 4


A $1 Investment in Different Types of Portfolios: 1926-1996 (Fig. 12.4)

Index ($)

Small Company Stocks



Large Company Stocks


Long-Term Government Bonds



Treasury Bills



market efficiency
Market Efficiency
  • An efficient capital market is one in which the purchase or sale of any security at the prevailing market price is a zero–NPV transaction. That is, you can expect to earn only a return adequate (‘normal return’) to compensate you for the risk you bear.
market efficiency theory
Market Efficiency Theory

In an Efficient Capital Market prices reflect all relevant information. You cannot consistently earn excess or ‘abnormal’ profits.

conditions needed for an efficient market
Conditions needed for an Efficient Market
  • A large number of rational investors (analysts, MBAs, CFAs) who seek to maximize their wealth
  • Information is widely available
  • Firms like Merrill Lynch, Morgan Stanley, etc. spend lots of money to collect and analyze informatio
market efficiency6
Market Efficiency

Does this mean prices remain always the same and won’t move?

No !!!

Random Walk - Security prices change randomly, with no predictable trends or patterns.

summary why are price changes random
Summary: Why are price changes random?
  • Prices react to information
  • Flow of information is random
    • by definition, otherwise news is not news!
  • Competition assures prices quickly and accurately reflect information
  • Therefore, price changes are random
three forms of market efficiency
Three Forms of Market Efficiency
  • Weak form
    • current prices reflect past prices and patterns irrespective of the actual firm’s fundamentals
  • Semi-strong form
    • all public information (economic and accounting) is reflected in stock prices
  • Strong form
    • all information (public and private) is reflected in stock prices

Technical Analysts - Investors who attempt to identify over- or undervalued stocks by searching for patterns in past prices.

Head and Shoulders Triple Tops


Fundamental Analysts - Analysts who attempt to find under- or overvalued securities by analyzing fundamental information, such as earnings, asset values, and business prospects.

reaction of stock price to new information in efficient and inefficient markets
Reaction of Stock Price to New Information in Efficient and Inefficient Markets

Price ($)

Overreaction andcorrection





Insider Information

Delayed reaction

Efficient market reaction

Days relativeto announcement day










Efficient market reaction: The price instantaneously adjusts to and fully reflects new information; there is no tendency for subsequent increases and decreases.Delayed reaction:The price partially adjusts to the new information; 8 days elapse before the price completely reflects the new informationOverreaction:The price over-adjusts to the new information; it “overshoots” the new price and subsequently corrects.

the bottom line
The Bottom Line
  • As a corporate financial manager (or investor) you should expect financing transactions (buying or selling of securities) to be a zero-NPV transaction.
  • To consistently produce value from your firm’s financing transactions would require either:
    • consistently fooling investors
    • constantly creating new securities
evidence on market efficiency
Evidence on Market Efficiency
  • Strong Form
    • insider trading
  • Semi-strong form
    • event studies
    • mutual fund performance
    • anomalies
  • Weak form
    • technical analysis
    • serial correlation and momentum
mutual fund and professional manager performance
Mutual Fund and Professional Manager Performance
  • Casual evidence indicates that mutual funds do not outperform market indices
  • WSJ stock picking contest (1990-1996)
    • Pros won 44/77 times versus dart throwing monkeys
    • Pros won 40/77 times versus DJIA
market efficiency anomalies
Market Efficiency Anomalies
  • Size Effect
  • January Effect
  • Monday Effect
  • Value Line Enigma
  • Crash of 1987

Long-term Financing

Debt and Equity


Corporate Long-term Debt

  • Main characteristics
    • Debt holders have no ownership in the firm
      • no voting rights, no residual claim
    • Benefits:
      • Tax deductibility of interest payments
      • Monitoring and discipline
    • Costs:
      • Possibility of financial distress
      • Potential conflict of interest with owners (agency cost of debt)
    • Traded on organized exchanges and over-the-counter
preferred stock
Preferred Stock
  • Cumulative versus Non-cumulative
  • Is preferred stock really debt?
    • Corporate seller's tax disadvantage
      • Unlike interest, dividends are not tax deductible
    • Corporate buyer's tax advantage
      • 70% of dividend income received from other domestic firms are exempt from federal corporate taxation
common stock
Common Stock
  • Par Value: some value assigned to stock for no particular reason. Most stocks have par values of $1.00 or $0.01
  • Authorized versus Issued Common Stock: All shares to be sold must be authorized by the articles of the corporation.
  • Additional Paid in Capital (Capital in Excess of Par Value): usually refers to amounts of directly contributed equity capital in excess of par value.
  • Retained Earnings: Corporate earnings not paid out as dividends.
common stock22
Common Stock
  • Dividends: payment of dividends is at the discretion of the Board of Directors.
  • Shareholders' Rights
    • Straight Voting: Directors are elected one at a time. You may cast all your votes for each member of the BOD.
    • Cumulative Voting: Directors are elected all at once. You may cast all your votes for one member of the BOD. In general, if N directors are to be elected, it takes 1/(N + 1) percent of the shares + 1 share to assure a deciding vote for one director.

Shareholders' Voting Rights

Assume 3 directors to be elected and you own 20 shares

Straight Voting: Directors are elected one at a time

You may cast all your votes for each member of the BOD

20 shares = 20 votes

Cumulative Voting: Directors are elected all at once

You may cast all your votes for one member of the BOD

# votes = # shares × # directors to be elected:

(20 shares) × (4 directors to be elected) = 60 votes

For cumulative voting if N directors are to be elected, it takes 1/(N+1) percent of the stock + 1 share to assure a deciding vote for one director

25% of the shares + 1 share will guarantee you one deciding vote for 1 director


Patterns of Corporate Financing 1981 - 1992

Internally generated funds

Long-term Debt

New Equity Sales


Types of Equity Issues

  • Private Direct Placement
    • Florida Panther Holdings, Inc., February 12, 1999
  • Initial Public Offering (IPO)
    • Ticketmaster Online, December 2, 1998
    • "Will offer 7 million shares of common stock at $14"
  • Seasoned Equity Offering (SEO)
    • American Online, Sept. 19, 1995
    • "Will offer 3.5 million shares of common stock"
    • 1.95 million by company; 1.55 million by its shareholders
  • Rights Offer
    • Revco, April 1994
    • “each stockholder as of June 13 will receive 0.305 of a transferable right for each Revco common share held.”
ipo s the biggest pops
IPO’s: The Biggest Pops

Nine of the 10 biggest first-day gains by IPOs were Internet stocks

Issuer Offering Date % Change 11/12/98 474 1/15/99 471 7/16/98 249

EarthWeb 11/10/98 247

Ticketmaster Online 12/2/98 243

uBid 12/3/98 220

Secure Computing 11/17/95 202

Artificial Life 12/17/98 176

eBay 9/24/98 163

Yahoo! 4/12/96 154

Source: The Wall Street Journal January, 1999


Pricing of Initial Public Offerings

Underpricing phenomenon:

IPO's rise in value on first day of issue by an average of15%


In 1980, when Apple Computer went public, shares were offered at $22 per share and jumped to $36.

Boston Chicken stock was offered at $20 per share and jumped to $49 on the first day of trading.

Should you invest in each IPO given the average 15% return on an IPO during the first day?


Why Does Underpricing Occur?

  • Helps sell issues.
  • Insurance against lawsuits
  • Helps avoid "winner's curse"
    • Uninformed small investors buy more of overpriced IPO’s
    • Informed investors buy more of underpriced IPO’s

Stock Market Reaction to

Seasoned Equity Offering

On average stock prices fall. Why?

- Management may know firm is overvalued

- Management may know future earnings of the firm are

going to be poor

- Issuing equity may imply the firm has too much debt or too little equity

- High issue costs

- Downward sloping demand curves


Rights Offerings

An issue of common stock to existing shareholders.

"privilege subscription"

Example: April 8, 1994, Revco to raise $217 Million

Stockholders of record as of 6/13/94 will receive 0.305

transferable right for each share of stock

Subscription price of $14 per share

Rights to expire 7/7/94

Proceeds used to facilitate acquisition of Hook-SupeRx, Inc.


Value of Rights:

The Individual Shareholder

DOTCOM Corporation Rights Offer

Design Corp. gives existing shareholders the opportunity to

buy 1 additional share at $15 per share for 3 rights owned.

1 share includes 1 right. Current Share price=$30

- What is the ex-rights share price?0

- What is the value of a right before the offering?

- What is the value of a right after the offering?