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 of debt 1 2 3 4 5 Pay a dividend to the owners of equity 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 Sale of assets financial and real New financing Total 1000 0 0 1000 Principle and interest payments 6000 perpetual debt 5 interest rate Dividend payment to stockholders Investment in new positive NPV projects Cash deposited in the firm s checking account Investment in T Bills Repurchase of debt or equity Total 300 50 500 50 100 0 1000 Assume 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 Sale of assets financial and real New financing Total 1 1000 0 0 1000 Principle and interest payments 6000 perpetual debt 5 interest rate Dividend payment to stockholders Investment in new positive NPV projects Cash deposited in the firm s checking account Investment in T Bills Repurchase of debt or equity Total 300 50 900 50 100 0 1400 How 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 The firm 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 2 In essence the NPV of each of these decisions is zero For example if the financial markets are perfect efficient and in equilibrium then NPV of debt financing 0 NPV of equity financing 0 So 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 information There is currently a debate as to the degree of efficiency of the security markets Therefore market efficiency deals with the degree to which information is reflected in a security s price Implications of an efficient and perfect and in equilibrium market an example Firms can fund positive NPV projects using a wide variety of financing choices As stated above each of the possible financing choices will have no affect on the value of the firm since all have a zero NPV Using this assume a financial manager is trying to decide how to finance a new project The project requires a time zero initial investment of 100 and produces an expected cash flow of 110 in one year The opportunity cost of capital is 7 and the project NPV is 2 80 The firm has two financing