Chapter 13: Corporate Financing Decisions and Efficient Capital Markets13.1 Can Financing Decisions Create Value?What Sort of Financing Decisions?How to Create Value through FinancingA Description of Efficient Capital MarketsReaction of Stock Price to New Information in Efficient and Inefficient MarketsSlide 7The Different Types of EfficiencyWeak Form Market EfficiencyWhy Technical Analysis FailsGetting Technical Barron’s March 5, 2003Getting Technical Back to Buy Low, Sell High Barron’s March 12, 2003Getting Technical, continued.Getting Technical, continuedSemi-Strong Form Market EfficiencyStrong Form Market EfficiencyRelationship among Three Different Information SetsSome Common MisconceptionsWhat the EMH Does and Does NOT SayThe EvidenceAre Changes in Stock Prices Random?What Pattern Do You See?Event Studies: How Tests Are StructuredHow Tests Are Structured (cont.)Event Studies: Dividend OmissionsEvent Study ResultsIssues in Examining the ResultsThe Record of Mutual FundsSlide 29The Strong Form of the EMHViews Contrary to Market EfficiencyImplications for Corporate FinanceSlide 33Why Doesn’t Everybody Believe the EMH?Summary and ConclusionsChapter 13: Corporate Financing Decisions and Efficient Capital Markets13.1 Can Financing Decisions Create Value?13.2 A Description of Efficient Capital Markets13.3 The Different Types of Efficiency13.4 The Evidence13.5 Implications for Corporate Finance13.6 Summary and Conclusions13.1 Can Financing Decisions Create Value?Earlier parts of the book show how to evaluate investment projects according the NPV criterion.The next five chapters concern financing decisions.What Sort of Financing Decisions?Typical financing decisions include:How much debt and equity to sellWhen (or if) to pay dividendsWhen to sell debt and equityJust as we can use NPV criteria to evaluate investment decisions, we can use NPV to evaluate financing decisions.How to Create Value through Financing1. Fool Investors-Empirical evidence suggests that it is hard to fool investors consistently.2. Reduce Costs or Increase Subsidies-Certain forms of financing have tax advantages or carry other subsidies.3. Create a New Security-Sometimes a firm can find a previously-unsatisfied clientele and issue new securities at favorable prices. -In the long-run, this value creation is relatively small, however.A Description of Efficient Capital MarketsAn efficient capital market is one in which stock prices fully reflect available information.The EMH has implications for investors and firms.Since information is reflected in security prices quickly, knowing information when it is released does an investor no good.Firms should expect to receive the fair value for securities that they sell. Firms cannot profit from fooling investors in an efficient market.Reaction of Stock Price to New Information in Efficient and Inefficient MarketsStock Price-30 -20 -10 0 +10 +20 +30Days before (-) and after (+) announcementEfficient market response to “good news”Overreaction to “good news” with reversionDelayed response to “good news”Reaction of Stock Price to New Information in Efficient and Inefficient MarketsStock Price-30 -20 -10 0 +10 +20 +30Days before (-) and after (+) announcementEfficient market response to “bad news”Overreaction to “bad news” with reversionDelayed response to “bad news”The Different Types of EfficiencyWeak FormSecurity prices reflect all information found in past prices and volume.Semi-Strong FormSecurity prices reflect all publicly available information.Strong FormSecurity prices reflect all information—public and private.Weak Form Market EfficiencySecurity prices reflect all information found in past prices and volume.If the weak form of market efficiency holds, then technical analysis is of no value.Often weak-form efficiency is represented asPt = Pt-1 + Expected return + random error tSince stock prices only respond to new information, which by definition arrives randomly, stock prices are said to follow a random walk.Why Technical Analysis FailsStock PriceTimeInvestor behavior tends to eliminate any profit opportunity associated with stock price patterns.If it were possible to make big money simply by finding “the pattern” in the stock price movements, everyone would do it and the profits would be competed away.SellSellBuyBuyGetting TechnicalBarron’s March 5, 2003Getting TechnicalBack to Buy Low, Sell High Barron’s March 12, 2003Getting Technical, continued.Most technical indicators fall into two categories -- trend followers and overbought/oversold oscillators.The former include such tools as moving averages and pattern breakouts. The latter include such tools as the relative strength index and stochastics. All of them work great when used as designed. The problem is that most people simply apply them all the time, and that can cause problems.For example, if moving averages are trend-following tools that signal a change in trend when prices cross them, what happens when there's no trend?If we apply the commonly used 50-day moving average and prices have been in a trading range for six months, it's not uncommon for the market to cross the average many times in both directions. The result is a series of losses.So, there's nothing wrong with the tool; it's just the wrong one to use under the circumstances.Getting Technical, continuedClearly, the bull market is over. Arguably, the bear market is over, too. We can't be sure of that until more time passes.I believe it ended last July. During that market bottom, we saw a big rush to the exits in the form of a big price decline and reversal -- as well as the biggest volume on record except for the post-September 11 period.And even though the major market indexes made lower lows in October, it wasn't by much. There was neither a significantly lower low nor a significantly lower high. The classic definition of a declining trend was not met, so the bear market was broken.Even if the market undercuts those lows once again, that alone would not a bear market make. A bearish signal would come only if the market cannot trade back up to its range top in the next cycle. A lower low and a lower high would mark a new bearish trend.…the end of a bear market doesn't necessarily lead directly to a new bull market. Conditions are