Financing Decisions and the Efficient Market Hypothesis in Introductory Finance, Study notes of Economics

Download Financing Decisions and the Efficient Market Hypothesis in Introductory Finance and more Study notes Economics in PDF only on Docsity! UCSB ECON 134A: Introductory Finance Spring quarter 2009 Instructor: Ragnar Arnason Lecture 13: Efficient Capital Markets and Corporate Financing (Corresponds to Ch. 13 in textbook) Can Financing Decisions Create Value? • Financing decisions (Capital Structure): – How much and what types of debt to hold – How much equity and what types to have • Before established that it is possible to create value by judicious investment decisions (Capital budgeting) • What about financing decisions (Capital structure)? – How much debt and equity to sell – When to sell debt and equity – When (or if) to pay dividends • Nota bene: We can use PV to evaluate financing decisions. Example: Stock price reaction to “good” news Stock Price -30 -20 -10 0 +10 +20 +30 Days before (-) and after (+) announcement Efficient market response to “good news” Overreaction to “good news” with reversion Delayed response to “good news” Why should there be market efficiency? • Investor Rationality and Efficiency – Investors are rational and they systematically collect and analyze relevant information.  Not a strong argument • Independence of events – Investors are not rational but the overly optimistic are cancelled out by the overly pessimistic.  Weak argument • Arbitrage – Some investors are rational and efficient and their trades bring the prices to the fair level  Strong argument Different Types of Market Efficiency • Weak Form – Security prices reflect all historical information about security prices and volumes. • Semistrong Form – Security prices reflect all publicly available information relevant to security prices • Strong Form – Security prices reflect all information—public and private relevant to security prices The Empirical Evidence • The record on the EMH is extensive, and, in large measure, it is reassuring to advocates of the efficiency of markets. • Studies fall into three broad categories: 1. Are changes in stock prices random? Are there profitable “trading rules?” 2. Event studies: does the market quickly and accurately respond to new information? 3. The record of professionally managed investment firms. Are Changes in Stock Prices Random? • Weak form of market efficiency suggests unpredictable (i.e. random) stock price movements • The random walk hypothesis So ut is independent, identically distributed stochastic term • It is possible to test whether actual stock price movements conform with random walk 1t t tp p a u tu IID A random walk p0=10, ut=NIID(0,1) 0 2 4 6 8 10 12 14 16 18 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 Generally it is found that the random walk hypothesis cannot be rejected Event Study Results • Over the years, event study methodology has been applied to a large number of events including: – Dividend increases and decreases – Earnings announcements – Mergers – Capital Spending – New Issues of Stock • The studies generally support the view that the market is semistrong form efficient. • Studies suggest that markets may even have some foresight into the future, i.e., news tends to leak out in advance of public announcements. The Record of Mutual Funds • If the market is semistrong form efficient, then no matter what publicly available information average returns of mutual funds should be about the market as a whole. • We can test efficiency by comparing the performance of professionally managed mutual funds with the performance of a market index. The record of different types of mutual funds relative to the market index -2.13% -8.45% -5.41% -2.17% -2.29% -1.06% -0.51%-0.39% All funds Small- company growth Other- aggressive growth Growth Income Growth and income Maximum capital gains Sector So underperformance (after fees) relative to the market average! This also conforms with the semi-strong EMH! Implications for Corporate Finance • Because information is reflected in security prices quickly, investors should only expect to obtain a normal rate of return. – Awareness of information when it is released does an investor little good. The price adjusts before the investor has time to act on it. • Firms should expect to receive the fair value for securities that they sell. – Fair means that the price they receive for the securities they issue is the present value. – Thus, valuable financing opportunities that arise from fooling investors are unavailable in efficient markets. Implications for Corporate Finance • The EMH has three implications for corporate finance: 1. The price of a company’s stock cannot be affected by a change in accounting. 2. Financial managers cannot “time” issues of stocks and bonds using publicly available information. 3. A firm can sell as many shares of stocks or bonds as it desires without depressing prices. • There is conflicting empirical evidence on all three points. END