TTU FIN 3322 - Corporate Financing and Market Efficiency

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Chapter 13 - Corporate Financing and Market Efficiency (331 – 337, bottom of 348 to the middle of 349)In this chapter, we define market efficiency and discuss how market efficiency applies to financing choices of a firm.******************************************************************************At this point of the course, we shift the focus from capital budgeting decisions (which projects should the firm select) to financing decisions (how do we acquire the funds to finance good projects). These financing decisions will also determine who receives the cash flows from the accepted projects.- The capital budgeting decision affects the asset side of the balance sheet.- The financing decision (typically) determines the makeup of the liability and equity side of the balance sheet.The owners of the debt and equity are (combined) the owners of the firm’s assets and therefore share in the cash flows of these assets.Principal and interest payments are the portion of a firm’s cash flow paid to the owners of debt. These payments are set by contract.What happens if the company cannot meet the contractual obligations of the debt contract?What can the firm do with the excess cash flow (i.e., cash flows above the payments owed to the owners ofdebt?)1. Pay a dividend to the owners of equity2. _______________________________3. _______________________________4. _______________________________5. _______________________________Let’s apply this concept to financing a project. Consider the following firm:Cash flow from assets (financial and real, e.g., interest, dividends, CF from projects) $1000Sale of assets (financial and real) $ 0New financing $ 0Total $1000Principle and interest payments ($6000 perpetual debt, 5% interest rate) $ 300Dividend payment to stockholders $ 50Investment in new (positive NPV) projects $ 500Cash deposited in the firm’s checking account $ 50Investment in T-Bills $ 100Repurchase of debt or equity $ 0Total $1000Assume that we have identified another valuable project (one with a positive NPV) using the tools learned in the first half of this course. This project requires a $400 initial investment in land and machinery.What financing method should the firm use to acquire the $400 of funds for the project?Cash flow from assets (financial and real, e.g., interest, dividends, CF from projects) $1000Sale of assets (financial and real) $ 0New financing $ 0Total $10001Principle and interest payments ($6000 perpetual debt, 5% interest rate) $ 300Dividend payment to stockholders $ 50Investment in new (positive NPV) projects $ 900Cash deposited in the firm’s checking account $ 50Investment in T-Bills $ 100Repurchase of debt or equity $ 0Total $1400How can we balance out the cash inflows and cash outflows?1. _______________________________2. _______________________________3. _______________________________4. _______________________________5. _______________________________Which is the best method?The answer to this last question affects:1. Capital structure policy- Should the firm borrow money or sell new stock to meet its needs for cash?- Should the firm borrow with short-term or long-term debt?- Should the firm borrow with straight debt or convertible debt?2. Dividend policy - Should the firm reduce its scheduled dividend payments to stockholders and use these savings to invest into the new project or should it continue to pay high dividends forcing the firm to raise cash in some other way?3. Sale of assets – Should the firm sell off some of its financial or real assets to finance the project?4. Lease versus buy decisions - Should the firm buy land, machinery, and other assets needed for the project or should the firm rent these assets?5. Mergers and acquisitions - Should a cash-rich firm acquire a cash-poor firm (which has a lot of good projects)?These questions are important even if the firm does not have a particular project to finance.- Should the firm issue debt to retire equity (or vice versa)?- Should the firm restrict its current dividends to pay for unidentified future projects?- Should the firm sell off some of its financial or real assets that it thinks are overvalued?- Should the firm sell its assets and lease them back from the purchaser?- Should the firm seek to acquire undervalued merger candidates?If financial markets are perfect, efficient, and in equilibrium, then the answer to these questions is simple - Thefirm's value will not be affected by the decision. Therefore:- Finance the project with debt or equity - the firm's value will not be affected by the choice.- Pay high (or low) dividends - the firm's value will not be affected by the choice.- Sell (or don’t sell) financial or real assets - the firm's value will not be affected by the choice.- Lease (or buy) assets - the firm's value will not be affected by the choice. Here, the rental market is perfect, efficient, and in equilibrium.- Acquire (or don't acquire) another firm - the firm's value will not be affected by the choice. Here, the market value of the acquired firm is established in a perfect, efficient, and in equilibrium market.In essence, the NPV of each of these decisions is zero.2For example, if the financial markets are perfect, efficient, and in equilibrium, then:NPV of debt financing = $0NPV of equity financing = $0So, either financing choice has the same effect on firm value.A quick review: why would the NPV be zero for each choice? For example, why would the NPV of debt financing be zero?If the NPV of borrowing money is positive, then what does this imply about the NPV of lending money?Thus, competition in the financial markets forces the NPV to zero.Therefore, the important decisions for the firm are those that affect the asset side of the balance sheet - such as project selection/rejection. Firm value cannot be increased by the financing decision.Definition of an efficient market - An efficient market is one where prices for securities (and other assets) reflect all relevant (and available) information.The three forms of efficiency- Weak-form efficiency - security prices reflect only past price (and return) information.- Semi-strong form efficiency - security prices reflect all publicly available information- Strong form efficiency - security prices reflect all (relevant) informationThere is currently a debate as to the degree of efficiency of the security markets.Therefore, market efficiency deals with the degree to which


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TTU FIN 3322 - Corporate Financing and Market Efficiency

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