Financial Management (Lecture 6)

Financial Management(N12403)

Lecture 6 Efficient Capital Markets & Financing Decisions

Lecturer: Farzad Javidanrad

(Autumn 2014-2015)

Corporate Financing Decisions The main objectives of firms are to create value and also maximise the value of the company (increase the shareholder’s wealth) through investing in different real or financial assets.

Investing Investing on real assets on financial assets

Objectives: 1 − Create more values for the company and its shareholders 2 − Maximising the value of the existing assets

Corporate Financing Decisions

Three questions need to be answered:

1.

How much debt and equity or a mixture of them should be sold. This is the question about the capital structure of the company.

2.

What type of debt and equity they should sell. This is the question about long or short-term and also about payout policy.

3.

When to sell them (or when to raise the money). This is about timing.

• The Net Present Value (NPV) criterion was used to evaluate different projects. Here we use the same principle to evaluate financing decisions. • But some credible financial models indicate that valuable financial opportunity does not exist.

Corporate Financing Decisions

Using lack of knowledge of investors Some securities can be more attractive if it is tailored for specific group of buyers or if they are introduced in a proper time. For e.g. the risk-averse buyers may be happy to pay a good price for securities with low level risks. These types of securities are usually in high demand after financial crisis.

Creating new securities that attract specific group of buyers

In the presence of asymmetric information, the capital market is not efficient and buyers can be easily misled about the real risk and the valuation of complex securities. E.g. 2007 crisis in the sub-prime mortgage in the USA.

some forms of financing bring taxes down, they will be valuable for companies but this is the job of experts and they need to be well-paid.

Ways to create valuable financing opportunities Reducing cost & Increasing subsidies

In some cases, the company can be benefited from relocation and get local or governmental subsidies.

Efficient Capital Market Farzad Javidanrad

 It is impossible to get benefited of finding under-valued or overvalued securities all the time.  Getting excess return above the average market’s return can occur randomly. Impossible to beat the market consistently.

Price of an asset reflects all relevant and available information about the intrinsic value of the asset  Securities are fairly traded in the market.

Efficient Market Hypothesis (EMH)

They are not under-valued or over-valued.

 Everyone knows about the real values of the securities in the market and adjust their information about the change of values without any delay.

Efficient Capital Market • The new version of the theory is partly developed by Eugene Fama in early 1960s which states it is impossible to beat the market all the time, for example finding an undervalued or even overvalued stocks, as the prices include all relevant information and can be adjusted immediately if there is new and unexpected information. There is no obvious trend for the prices of different stocks as it is a random walk variable and analytical skills or methods cannot predict the next move. • According to the efficient market hypothesis information is freely available for all agents in the market an individual investor (or speculator) cannot consistently get returns above the average market returns at a specific level of risk.

Efficient Capital Market The existence of under-valued stocks motivates investors to trade in capital market for profit, and as a result of their trades, prices of stocks change instantly. Searching for mispriced securities and trading them leads to the efficiency of the capital markets where prices of securities reflect the intrinsic value of them. Existence of undervalued security motivates investors to trade

Prices of stocks change instantly until they reach to their market values

This leads to the market efficiency where market prices reflect the intrinsic values of the security

Efficient Capital Market • The theory mostly rejected by the behavioural finance academics based on the evidences on irrationality of investors in financial markets which has led the market and the whole economy into instability and crisis. • There would be also a big question about the efficiency and philosophy of the hedge funds and mutual funds if the theory was correct.

• According to Andrei Shleifer (2000) the foundations of market efficiency are:

Rationality

All Investors have the homogeneous (same) anticipation and same preferences in the market .

Investors do not follow each other. There is no mass movement or Independent Deviation herding. Sometimes they might be irrational but there is no collective From Rationality behaviour.

Arbitrage

If prices get out of the line, then the arbitrageurs (who are professional investors in terms of earning profit by buying low and selling high) force the prices to go back to the market equilibrium.

Efficient Capital Market • This picture shows how efficient market respond to the new information . Slow or delayed response has been shown by the black dotted curve and those who had over-reaction to the good news regress to the point of final adjustment. • In the efficient market, the response is instantaneous (solid broken line).

Adopted from Hillier’s book from http://firmsmarkets.blogspot.co.uk/2012/01/13.html

Different Types of Efficiency • There are three levels of market efficiency, based on the degree of information reflected in the price of securities. Weak Form Semi-Strong Form Strong Form • The only data available for investors is the past (historical) prices. • No serial correlation between past prices and current prices. • No specific pattern in price movements. • Investment strategies cannot provide any long-run benefit using those data, but some fundamental analysis (including financial statement of the company, analysis of management strategies and their records, competitors, economic state and etc. ) may provide some investors a reasonable profit but not always.

• Past prices and other public information are available for investors, including proposal to merge, quarterly earnings, after and before tax profit.

• Any form of information including public or private is available for all investors, including all financial statements, plans and strategies and etc.

• Prices immediately respond to the new information which is publicly available in internet or press.

• The price of a security almost instantaneously responds to the new information (public or private) and in fact, the prices are fair and reflect all these information.

• Some investors who have some private information about the company are in a better position in the capital market to make a profitable deal (short-selling) for a very short period of time but this is not the case in the long-run.

• No investor has superiority in compare to others and there is no time to make a profitable trade once the new information emerges.

Six Lessons of Market Efficiency • Brealey et al. (2014) list six lessons of market efficiency: i.

Markets have no memory. The history of market prices has no pattern to be used in the future.

ii.

Trust market prices. Market prices possess all available information about the value of each security. No way to have a consistent high rate of return over time.

iii. Read the entrails. We need to read how to use information hidden in data, for example the difference between the short and long term rates gives an idea about investors’ expectations. iv. There are no financial illusions. Investors are concerned about the company’s cash flows and what they are entitled. v.

The Do-it-Yourself Alternative. In an efficient market, there will be no place for hedge funds or mutual funds companies. Investors will not pay others to do what they can do equally well

themselves with the same level and type of information.

vi. Seen one stock, seen them all. Shares are almost perfect substitutes for one another. The price elasticity of demand is very high. It is the risk-return combination which is important – not the name of the company.

Implications of Non-Efficient Markets for Financial Managers • The previous six lessons were based on the efficient markets but what financial managers can do if markets are not efficient? • According to Brealey et al. (2014): 1. Financial managers of non-financial companies should not engage in speculation activities in the financial market. On average they gain nothing if they try to imitate hedge funds. They do not have more knowledge in compare to hedge funds. They may see the opportunity but lose severely. 2. In the case that share of a company is mispriced, the financial manager of the company should not think to issue more shares to increase more capital for investment but he/she must find a way to increase cash for the investment projects either through encouraging shareholders to sell part of their shares (when the share is over-priced) or through borrowing (when they are under-priced)

3. If the share price of the company is caught in a bubble, they need to act wisely to increase their real assets because if the bubble bursts there will be no valuable financial asset to count on.