Corporate Financing and Market Efficiency

Financial management: lecture 10

Corporate Financing and Market Efficiency

Where to get money for good projects


Today’s plan

Review WACC Investment Decision vs. Financing Decision Equity and debt financing Does the stock price follow a random walk? Three forms of Market Efficiency

• Weak form efficiency• Semi-strong form efficiency• Strong form efficiency


What have we learned in the last lecture ? Motivation for WACC

• How do we know that a project is worth taking?• How do we find the cost of capital for a project ?• What is the formula of WACC without tax?• What is the formula of WACC with tax?• Should we use the market value or book value of

equity and debt in calculating WACC?


What have we learned in the last lecture (1)? WACC without tax

WACC with tax

de rVDr

VEWACC

EDVwhere

eVE

dVD r +Tc)r-(1 =WACC


What have we learned in the last lecture (2)? The cost of bond

• It is the YTM, the expected return required by the investors.

• That is

• The expected return on a bond can also be calculated by using CAPM

tddd rprincipalcpn

rcpn

rcpn

111

P 2bond

)( fmdfd rRrr


What have we learned in the last lecture (2)? The cost of equity is calculated by using

• CAPM

• Dividend growth model

)r-(R+r=r fmfe e

gP

DIVrgr

DIVP ee

0

110


What have we learned in the last lecture (2)? Three steps in calculating WACC

• First step: Calculate the market value of each security and calculate its portfolio weight

• Second step: Determine the cost of capital on each security.

• Third step: Calculate a weighted average cost of capital on these securities.


A summary example John Cox, a recent MBA student of SFSU, was asked by his

boss in Geothermal to decide whether the firm should take an expansion project: the cost of the project is $30 million, and the project is expected to generate a perpetual incremental cash flow of $4.5 million. Currently, Geothermal has 20 million shares of common stocks outstanding, with a market price of $22.65 per share. The Beta of the firm’s equity is 1.1. The risk free rate is 4% and the market risk premium is 5.6%. The firm also has long-term debt, with the YTM of 9%. John also got the following information from the firm’s balance sheet:• Debt (12 years maturity, 8% coupon): $200 million• Common stocks:$110 million

If the tax rate is 35%, should John suggest to his boss to take the project or not?


Solution

51.200891.0/5.430/5.430

%91.8)1(

68.18509.1200)

09.1*09.01

09.01(*16

45365.22*20%16.10%6.5*1.1%4

%9

1212

WACCNPV

rED

ErtED

DWACC

D

Err

ed

e

d


Investment vs. Financing

Investment decisions or capital budgeting is about how to take projects to maximize V.

Financing decisions are about how to raise capital (E or D) to finance the projects that are to be taken

Asset Liabilities and equity

VDebt: D

Equity: E

Types of Securities Equity

• Common stock• Preferred stock

Debt• Commercial paper• Debentures• Guaranteed notes• Remarketable debt• Euro notes• Sterling notes• New Zealand dollar notes• Bank loans

Common StockTreasury Stock

Stock that has been repurchased by the company and held in its treasury

Issued Shares

Shares that have been issued by the company.

Outstanding Shares

Shares that have been issued by the company and held by investors.

Common StockAuthorized Share Capital Maximum number of shares that the company

is permitted to issue, as specified in the firm’s articles of incorporation.

Par Value

Value of security shown on certificate.

Retained Earnings

Earnings not paid out as dividends.

Addiotional Paid Up CapitalDifference between issue price and par

Common Stock Book Value vs. Market Value Book value is a backward looking

measure. It tells us how much capital the firm has raised from shareholders in the past. It does not measure the value that shareholders place on those shares today. The market value of the firm is forward looking, it depends on the future dividends that shareholders expect to receive.

Common StockExample - H.J. Heinz Book Value vs. Market Value (5/2007)Total Shares outstanding = 322 million

1,843Value)(Book equity common Net 219-Other

4,406-costat sharesTreasury 5,779earnings Retained

581capitalin paid Additional108par) ($.25 SharesCommon

Common StockExample - H.J. Heinz Book Value vs. Market Value

(5/2007)

Total Shares outstanding = 322 million

billion $14.812ValueMarket 322x shares of #

$46/sh= priceMarket 2007May

Common StockCorporate Equity Holdings

Mutual Funds28.3%

Pension Funds22.3%

Insurance Companies

8.0%

Rest of World12.6%

Households27.1%

Other1.4%

Banks & Savings0.3%

Preferred StockPreferred Stock - Stock that takes

priority over common stock in regards to dividends.

Net Worth - Book value of common shareholder’s equity plus preferred stock.

Floating-Rate Preferred - Preferred stock paying dividends that vary with short term interest rates.

Corporate Debt Debt has the unique feature of allowing the

borrowers to walk away from their obligation to pay, in exchange for the assets of the company.

“Default Risk” is the term used to describe the likelihood that a firm will walk away from its obligation, either voluntarily or involuntarily.

“Bond Ratings”are issued on debt instruments to help investors assess the default risk of a firm.

Corporate DebtPrime Rate - Benchmark interest rate charged

by banks.Funded Debt - Debt with more than 1 year

remaining to maturity.Sinking Fund - Fund established to retire debt

before maturity.Callable Bond - Bond that may be repurchased

by firm before maturity at specified call price.

Corporate DebtSubordinate Debt - Debt that may be repaid in

bankruptcy only after senior debt is repaid.Secured Debt - Debt that has first claim on

specified collateral in the event of default. Investment Grade - Bonds rated Baa or above

by Moody’s or BBB or above by S&P.Junk Bond - Bond with a rating below Baa or

BBB.

Corporate DebtEurodollars - Dollars held on deposit in a bank outside

the United States.Eurobond - Bond that is marketed internationally.Private Placement - Sale of securities to a limited

number of investors without a public offering.Protective Covenants - Restriction on a firm to protect

bondholders.

Lease - Long-term rental agreement.

Convertible SecuritiesWarrant - Right to buy shares from a company

at a stipulated price before a set date.Convertible Bond - Bond that the holder may

exchange for a specified amount of another security.

Convertibles are a combined security, consisting of both a bond and a call

option.

Patterns of Corporate Financing

Firms may raise funds from external sources or plowback profits rather than distribute them to shareholders.

Should a firm elect external financing, they may choose between debt or equity sources.

Patterns of Corporate Financing

-100

-50

0

50

100

150

200

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

Year

Perc

ent o

f tot

al s

ourc

es

New DebtNew EquityInternal Funds

Patterns of Corporate FinancingD

ebt R

atio

, %Debt to (Debt + Equity) Ratio for Non-Financial Firms


Market Efficiency

Market efficiency is concerned about whether or nor capital markets have all relevant information about the cash flows and risk of projects to price securities accordingly.

Market Efficiency


Efficient capital markets

Efficient Capital Markets – If capital markets are efficient, then security prices reflect all relevant information about asset values.


Market efficiency and random walk Market efficiency concepts are very

abstract. How can we use a simple way to check

whether the stock market (one of the capital markets) is efficient or not?• If the stock price follows a random walk, then

the stock market is efficient.


What is a random walk of stock prices? The movement of stock prices from day

to day DO NOT reflect any pattern. Statistically speaking, the movement of

stock prices is random.


A Random Walk example

$101.00

$100.00

$102.09

$97.43

$97.50

$100.43

$95.06

Coin Toss Game

Heads

HeadsHeads

Tails

Tails

Tails


Three forms of market efficiency The random walk concept is still abstract Financial economists have used three

more specific forms to characterize or judge market efficiency.• Weak-form• Semi-strong form• Strong form


Weak-form of market efficiencyWeak Form Efficiency - Market prices reflect

all information contained in the history of past prices, or you cannot use past stock prices to predict future prices

Technical Analysts - Investors who attempt to identify over- or undervalued stocks by searching for patterns in past prices.


Efficient Market Theory

Last Month

This Month

Next Month

$90

70

50

EI’s Stock Price

Cycles disappear

once identified


Semi-strong form of market efficiency Semi-Strong Form Efficiency - Market

prices reflect all publicly available information such as earnings, price-to-earnings ratios,etc.

Fundamental Analysts - Analysts who attempt to fund under- or overvalued securities by analyzing fundamental information, such as earnings, asset values, and business prospects.



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Market Efficiency

0

5

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25

Ave

rage

retu

rn, p

erce

nt

Highest

Book-Market Ratio

Fama & FrenchReturn vs. Book-Market


Strong form of market efficiencyStrong Form Efficiency - Market prices reflect

all information that could in principle be used to determine true value.

Inside trading• Investors use private information to predict

future price movements



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Announcement Date


Some exercises1. If stock markets are efficient, what should the

correlation between stock returns for two non-overlapping periods?

2. Which is the most likely to contradict the weak-form of efficiency

a. Over 25% of mutual funds outperform the market on average

b. Insiders can make abnormal profitsc. Every January, the stock market earns abnormal

return

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Corporate Financing and Market Efficiency

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