Advanced Managerial Finance

In Ji Jang

Capital Market Efficiency and Corporate Finance Decisions


Corporate Investment and Financing Decisions

• Investment

 NPV Rule: Invest in projects that are worth more than they cost

• Financing

 NPV Rule analog? Issue securities for which investors will pay more than they are worth?

Shareholder ‘Golden Rule’ for Value Creation• Create ‘valuable’ financing opportunities

• Do for shareholders what they can’t do just as well for themselves

• Applications: Fool investors?

 Subsidized financing

 Create new securities

 Risk management

Rate of Return Concepts

• Expected return Anticipated return on investment (IRR, bond yield)

• Required return Discount rate, cost of capital, minimum acceptable return

• Realized return After-the-fact return, historical return

Efficient Capital Markets• Three equivalent definitions. In an efficient capital market:

 1. Security prices = discounted cash flow values (all relevant information reflected in security prices)

 2. Expected security return = required return

 3. Purchase of a traded security is a zero-NPV transaction

• Market efficiency is about expected and required returns, and nothing to do with realized return

Foundations of Market Efficiency• 1. Rationality

 All investors are rational, adjust their estimates in a rational way

• 2. Independent deviations from rationality

 Offsetting irrationality

• 3. Arbitrage

 Profit from simultaneous purchasing and selling of a security

Efficiency is a Matter of Degree• Weak form efficiency

 Today’s price reflects all past information

• Semi-strong form efficiency

 Today’s price reflect all publicly available information

• Strong form efficiency

 Today’s price reflects all information (public and private)

Implications of Market Efficiency• No predictable patterns in security prices (effectiveness of

fundamental vs. technical analysis)

• Stock price changes follow a random walk

• Prices adjust rapidly (immediately) to new information

Efficient and Inefficient Stock Price Reactions to New Information

Market Reaction to New Information: The Event Study Technique

• 1. Examine a company’s stock return on the days before and after an announcement

• 2. What return would we have expected?  E(R)=Rf + β(Rm-Rf)

• 3. Abnormal return (AR)=Return – E(R)

• 4. Calculate cumulative AR (CAR) for the days leading to and after the event

• 5. Average these CAR across companies experiencing a similar event

Example: Companies Announcing Dividend Omissions

Arbitrage as a Mechanism for Enforcing Market Efficiency• Arbitrage opportunities: Opportunity to simultaneously

buy and sell assets that are perfect substitutes but have different prices

• A true arbitrage opportunity yields a profit with no risk and no net investment

• Example: Whole bonds and STRIPS

 Put-Call Parity

 Covered Interest Arbitrage

3Com and Palm: A missed arbitrage opportunity?• March 2, 2000: 3Com sells 5% of its Palm subsidiaries in an

IPO. 3Com planned to distribute remaining Palm shares to 3Com shareholders at a later date.

• If you owned one share of 3Com, you receive 1.5 shares of Palm

• Price of 3Com shares should be at least = 1.5 times Palm shares

• Palm closes at $95.06 on IPO day. 3Com closes at $81.81.

• Market viewed rest of 3Com business -$60.78. (Negative 22 billion for 3Com).

• Can you construct an arbitrage strategy?

The case of 3Com and Palm

Implications of EMH for Corporate Finance• Prices of a company’s stock cannot be affected by accounting

choices, financial choices

• Financial managers cannot ‘time’ the issues of stocks and bonds using publicly available information

• Information in market prices: Managers can learn from market prices

Earnings management around SEO/ IPO

SEO/IPO long-term underperformance

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