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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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7-1

Market Efficiency and Long-term Financing


A 1 investment in different types of portfolios 1926 1996 fig 12 4 l.jpg

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

  • 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.


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Market Efficiency Theory

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


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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


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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.


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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


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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


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

Head and Shoulders Triple Tops


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


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Reaction of Stock Price to New Information in Efficient and Inefficient Markets

Price ($)

Overreaction andcorrection

220

180

140

100

Insider Information

Delayed reaction

Efficient market reaction

Days relativeto announcement day

+4

+6

–4

–2

0

+2

+7

–8

–6

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.



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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


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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


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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


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Market Efficiency Anomalies

  • Size Effect

  • January Effect

  • Monday Effect

  • Value Line Enigma

  • Crash of 1987



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Long-term Financing

Debt and Equity


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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


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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


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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.


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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.


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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



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Patterns of Corporate Financing 1981 - 1992

Internally generated funds

Long-term Debt

New Equity Sales


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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.”


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IPO’s: The Biggest Pops

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

Issuer Offering Date % Change

theglobe.com 11/12/98 474

MarketWatch.com 1/15/99 471

Broadcast.com 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


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Pricing of Initial Public Offerings

Underpricing phenomenon:

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

Examples:

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?


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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


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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


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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.


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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?