Corporate Financing and the Six Lessons of Market Efficiency

Principles of Corporate Finance

Sixth Edition

Richard A. Brealey

Stewart C. Myers

Lu Yurong

Chapter 13

McGraw Hill/Irwin

13- 2

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Topics Covered

We Always Come Back to NPV What is an Efficient Market?

Random Walk

Efficient Market Theory The Evidence on Market Efficiency Six Lessons of Market Efficiency

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Return to NPV

NPV employs discount rates These discount rates are risk adjusted The risk adjustment is a byproduct of market

established prices Adjustable discount rates change asset values

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Return to NPV

Example

The government is lending you $100,000 for 10 years at 3% and only requiring interest payments prior to maturity. Since 3% is obviously below market, what is the value of the below market rate loan?

repayment loan of PV-

pmtsinterest of PV- borrowedamount NPV

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Return to NPV

Example

The government is lending you $100,000 for 10 years at 3% and only requiring interest payments prior to maturity. Since 3% is obviously below market, what is the value of the below market rate loan?

Assume the market return on equivalent risk projects is 10%.

012,43$

988,56000,100

)10.1(

000,100

)10.1(

000,3000,001NPV

10

10

1

tt

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Random Walk Theory

The movement of stock prices from day to day DO NOT reflect any pattern.

Statistically speaking, the movement of stock prices is random (skewed positive over the long term).

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Random Walk Theory

$103.00

$100.00

$106.09

$100.43

$97.50

$100.43

$95.06

Coin Toss Game

Heads

Heads

Heads

Tails

Tails

Tails

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Random Walk Theory

S&P 500 Five Year Trend?or

5 yrs of the Coin Toss Game?

80

130

180

Month

Le

ve

l

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Random Walk Theory

S&P 500 Five Year Trend?or

5 yrs of the Coin Toss Game?

80

130

180

230

Month

Le

ve

l

13- 10

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Random Walk Theory

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Random Walk Theory

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Random Walk Theory

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Random Walk Theory

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Random Walk Theory

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Efficient Market Theory

Weak Form Efficiency Market prices reflect all historical information

Semi-Strong Form Efficiency Market prices reflect all publicly available

information

Strong Form Efficiency Market prices reflect all information, both public

and private

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Efficient Market Theory

Fundamental Analysts Research the value of stocks using NPV and other

measurements of cash flow

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Efficient Market Theory

Technical Analysts Forecast stock prices based on the watching the

fluctuations in historical prices (thus “wiggle wiggle watcherswatchers”)

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Efficient Market Theory

Last Month

This Month

Next Month

$90

70

50

Microsoft Stock Price

Cycles disappear

once identified

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Efficient Market Theory

-16

-11

-6

-1

4

9

14

19

24

29

34

39

Days Relative to annoncement date

Cu

mu

lati

ve

Ab

no

rma

l Re

turn

(%

)

Announcement Date

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Efficient Market Theory

-40

-30

-20

-10

0

10

20

30

40

1962

1977

1992

Re

turn

(%

)

FundsMarket

Average Annual Return on 1493 Mutual Funds and the Market Index

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Efficient Market Theory

0

5

10

15

20

First Second Third Fourth Fifth

Av

era

ge

Re

turn

(%

)

IPO

Matched Stocks

IPO Non-Excess Returns

Year After Offering

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Efficient Market Theory

1987 Stock Market Crash

119310.114.

7.16)( crash pre

gr

DivindexPV

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Efficient Market Theory

1987 Stock Market Crash

119310.114.

7.16)( crash pre

gr

DivindexPV

928096.114.

7.16)( crashpost

gr

DivindexPV

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Lessons of Market Efficiency

Markets have no memoryTrust market pricesRead the entrailsThere are no financial illusionsThe do it yourself alternativeSeen one stock, seen them all

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Example: How stock splits affect value

0

5

10

15

20

25

30

35

Month relative to split

Cumulative abnormal return %

-29 0 30

Source: Fama, Fisher, Jensen & Roll

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Preparation for Next Class

Please read:

BM Chapter 14 , P383-400